The rise of Power Purchase Agreements (PPAs)

PPAs have become a solid alternative as subsidies on renewable electricity generation are becoming less generous or are disappearing entirely in the case of certain technologies or geographies. A record amount of PPAs were concluded in 2021 and PPA prices continue to crawl higher. Despite rising prices for key materials for renewable electricity installations and continued caution from utility off-takers, we still see a case for rising renewable PPA prices in 2022

In order to spur investments in the renewable energy sector for electricity generation, governments have historically provided ample financial incentives, such as subsidies or guaranteed prices/MWh, to ramp up supply. For example, under the previous version of the renewable energy law (EEG) in Germany, renewable energy assets were able to benefit from a pre-set fixed price/MWh of electricity produced (feed-in tariff) and also priority in dispatching power from this asset into the grid. Priority dispatch remains, yet the generosity of governments is declining, despite a very ambitious renewable energy generation agenda. Germany wants 100% of its electricity needs supplied from renewable sources by 2035. At the same time, investment costs for renewable power generation has come down considerably over the last years. Competition in the market is fierce and some very ambitious off-shore wind farm tenders in the Netherlands and Germany were even committed under zero subsidies.

To mitigate the effects from the less generous subsidies and potential fierce price competition on the wholesale markets, renewable electricity providers are increasingly using Power Purchase Agreements (PPA’s) to ensure long-terms stability in their earnings, besides production risks due to unforeseen weather patterns. In this contribution, we explain what PPA’s are and what is driving the existing dynamics in the PPA market.

A primer on PPA

A PPA is a contract between buyers (“off-takers”) and sellers (“generators”, “asset owners” or “investors”) in order to deliver and buy energy, often electricity. The parties agree on buying and selling a quantity of energy, which will be generated for example, by a renewable energy asset, such as wind or solar farms, for a period that is typically rather long-term, anywhere between 5 and 20 years, under a certain pre-defined price. In a PPA, a fixed price per megawatt hour (MWh) is agreed for the electricity generated by the renewable asset. This way, the seller is less exposed to the whims of the wholesale power markets, while it already needs to deal with volatility created by weather patterns. For illustration, high windspeeds boost windfarm output yet spot power prices would be under pressure since there’s more supply of electricity. Due to difficulties in storage, the excess wind has to be dumped on the imbalance market causing prices here to drop below zero on a near daily basis. However, low or extreme windspeeds put the windfarm out of operation while the ensuing lack of supply would drive up spot prices. Having at least the power price at a fixed level makes an asset’s cash flows more predictable for investors (besides the previously mentioned production risks), while allowing for a more aggressive capital structure than under wholesale price driven structures, and even more generous financing terms during construction, should the PPA already be signed before construction. The buyer gains by securing a clean source of energy at a pre-agreed price, helping them reach their decarbonization objectives. Typical PPA buyers are corporates and large utility companies.

PPA structures can vary significantly. One example of a structure is pay-as-produced, where a fixed price/MWh is paid for produced volumes up to an agreed production amount. However, (subject to a conservative minimum volume requirement), the producer is not under any obligation to deliver a specific volume so the production risk under the PPA is on the buyer. But there are also structures that put the volume risk on the generator (typically baseload PPAs), meaning the generator would need to source energy in the open market (at the spot price, which is likely to be higher than the PPA price) in case the renewable asset does not produce according to schedule (such as during long spells of low wind speeds or lack of sun) or pay financial compensation for non-delivery by reference to the difference between the PPA price and the spot price. In each case, this creates ‘shape risk’. From a different angle, PPA’s can be direct, which implies that power is directly delivered to the off-taker by involving a third party, such as a utility company, to ensure that this specific output reaches the buyer. PPAs can also be virtual, where the off-taker does not take delivery but only benefits from the pre-agreed price and the green credentials of the renewable PPAs.

Contracted PPAs nearly doubled during 2021

The market for PPA’s has grown significantly over the years. In a PPA market outlook note published by Pexapark recently, they found that over 11GW was contracted across Europe in 2021, showcasing a compounded growth rate of 42% over the last four years. A volatile power price environment at the end of last year kept utility off-takers on the side lines as the PPA is a long-dated instrument, while utilities sell the purchased power in the more liquid short dated markets. This short-dated power market experienced an immense spike in volatility, which pushed many of these utility contracts significantly out of the money and required them to post huge margin calls. However, the further ascent of corporates in the PPA space completely outweighed the lower purchases by utilities. Especially large energy-hungry corporates operating in the data and industrial space were eager to enter contracts in 2021, resulting in over a doubling of contracted power versus a year ago.

Volatility in the shorter dated power price market has come down slightly but has remained elevated, as shown in the charts below, which display the 30-day and 90-day volatility on the 1y forward German baseload power price. Obviously, there is nothing new to this as the Russia/Ukraine conflict is pushing up volatility. But a sticky volatility will imply that utility companies could remain less visible in the PPA market.

So does this hesitance of utility buyers give corporate buyers room to start negotiate PPA prices downwards? Especially considering the fact that PPA sellers seem to have turned the corner and are making excess profits above their levelized cost of energy (LCOE), as can be shown in the chart below. The LCOE is a minimum required price to break-even on the renewable energy asset, including capital costs and return on capital. The chart also shows that the spread between the 3y German baseload forward and the PPA still remains very favourable for utilities as off-takers to achieve a profit, suggesting that when power price volatility drops the bid from utilities could rise again.

The chart above also shows that onshore wind in the Netherlands and Germany can already theoretically survive without subsidies, since PPA prices currently sit above LCOE. Also, the planned reduction in subsidies on renewables according to the latest tender parameters suggest that more operators have already reverted to the PPA market as sellers, which can obviously put pressure on PPA prices. Could this imply that, combined with the drought in utility PPA off-takers, PPA prices should struggle in 2022?

A high level of competitiveness against fossil fuels still gives renewable PPA’s the upper hand

We think that PPA prices for renewable electricity could still rise this year. Firstly, the rise in natural gas prices has made renewables even more competitive in price against fossil fuels from an LCOE perspective. The left-hand chart below shows that this was already the case for some time and the gap continued to grow until mid-last year (which are the latest available numbers). The recent surge in natural gas prices should have made electricity generation through this fuel even less compelling. The spark spread gauges the theoretical profitability of the gas powered electricity plant, based on proceeds from electricity power markets deducted with variable costs, such as the price of natural gas and the price of EU carbon allowances. Indeed, the right hand chart below shows that the spark spread has gone deeply negative and reached historical lows recently.. Admittedly, dark spreads, which reflect the theoretical profitability of coal powered plants remain positive, yet the LCOE on German Coal plants (to keep an apples with apples comparison) sits at EUR 188 per MWh, which makes them by default uncompetitive compared to on-shore renewables.

It is important to note that the Bloomberg quoted LCOE’s are based on 2019 price levels. The underlying commodities that are needed to build a windfarm have surged since the pandemic faded, as shown in the chart below. Given the long lead-time of renewable energy projects, we assume that the existing projects coming to market had been produced at older lower commodity price levels, perhaps even benefitting from raw material hedges. New projects will obviously need to be manufactured at higher prices, since the developer is facing higher raw material costs. To illustrate the impact, renewable wind developer Vestas had to raise the price per MW installed by 21% during 2021. The chart below (also shown a couple of weeks ago in our weekly publication “Sustainaweekly”) illustrates that prices for commodities necessary for the energy transition, which have risen by a whopping 117% since the pandemic broke out. The current tension in Ukraine/Russia evens adds more upward price pressure to this, given that many metals are sourced from this region.

However, since all renewable PPA sellers will be confronted with higher costs, we expect them to collectively raise the bar for a higher PPA price. Also, these price rises should not result in wind power becoming suddenly less competitive vs fossil fuels, since the chart on the previous page showed that there’s also roughly 100% headroom before for example onshore wind power LCOE becomes less competitive against gas power LCOE. In case there’s equivalence between gas powered electricity LCOE and onshore wind electricity LCOE, after onshore wind energy LCOE has incorporated the effects of higher raw materials, buyers will still opt for the latter given the zero carbon emissions associated with renewable electricity. Furthermore, PPA buyers are also taking into consideration the day-by-day surge in power prices, which makes them eager to engage in long-term contracts to achieve stability in costs. Finally, we note that potential PPA sellers have an alternative to directly sell the power in wholesale market to capture the existing high price levels. This will obviously create scarcity for PPA buyers, hence giving them less buying power. Overall, we think that there’s more upside than downside risk in renewable energy PPA’s this year.