PPAs: The consequences of the open market era.

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This interview with Luca Pedretti, COO and co-founder of Pexapark, outlines the consequences of the transition from a tariff-based market to an open market for renewable’s investors.

The transition from a tariff-based market to an open market means that investors in renewables are caught in a whirlwind of uncertainty. Luca speaks of the “seismic shifts” in the international energy market due to prevailing price risks. It is especially the case in key markets such as Europe, the United States, Australia and Latin America. A market that once was subsidised and stable, is now becoming increasingly volatile, complex and uncertain. These uncertainties now dominate the renewables market.

An open market also means greater reliance upon futures markets in which prices can be fixed between market participants at prevailing market expectations of future values. After all, utilities are essentially risk management companies that need to manage the risk they take on-board from renewable projects through PPAs.

At the moment, up to 25 GW of new build renewable energy is being realised in Europe per annum. However, state subsidies, which have been the hallmark of the renewable energy market since its inception, are starting to fall away and more capacity will have to be realised on the basis of PPAs.

Therefore, in order for utilities to offer longer-term power purchase agreements, they require stable access to open and liquid markets that allow them to manage the price risks contracted through new PPAs with renewable projects.

Hedging allows utilities to “spread their risks,” as Luca mentions. Furthermore, as state subsidies for renewables fall away, so banks will be less inclined to offer loans for capital expenditure and other investment projects for renewables.

Once again, an open market will ensure that market entrants and investors will have improved means by which to raise or invest capital into the renewables market.

According to Luca, on the one hand, there has been a rapid decrease in technology costs and production costs per unit of energy, both in wind and solar energy technologies. This has obviously made renewable energy far more attractive to investors. On the other hand, market prices have started to increase, which has energised new players, including new energy buyers, to enter the market. There has also been an internalisation of utilities by which many utilities have started to offer PPA products in other countries, as well as the emergence of corporate players.

The rise of PPAs has allowed energy investors to structure cash flows and help finance or re-finance renewables projects. It could be said that a PPAs have been replacing the former Feed-in Tariff (FIT) rate.

It’s important to note that there is clearly a difference between utilities that are essentially risk managers and rely on liquid, traded markets to manage risks on the supply side, as opposed to corporate and industrial clients on the demand side that require power for their own use.

Therefore, on the utility or supply side, the key driver for PPA is the level of liquidity in a given market, e.g. the turnover of future products on a given exchange and the tenor of those traded products. On the client user or demand side, the situation is more complex, in that sourcing a long-term PPA depends on many variables.

Generally, there is only a very limited natural long-term demand among client users. They are further vulnerable to the fact that long-term offerings from traders and utilities can be opportunistic or fragile, i.e. very risky.

Luca uses Germany as an example. Its total annual national industrial demand is 250 TWh. Of this, he estimates that approximately 50 TWh is willing to engage in longer tenors which are of interest to renewables. Typically, a given corporate user is willing to buy power over a long duration at a fixed price but will only do this for a limited amount of power, say 20% of its total consumption. In that case, the total demand for long-term tenors in Germany is reduced to 10 TWh.

With that in mind, there is currently 25 GW of new builds for renewables in Europe per annum. In Germany, that might be 2-4 GW. Most of these builds are still being done within traditional ‘support systems,’ whereby the state secures long-term prices for 20 years.

Assuming 4 GW of industrial long-term demand and perhaps 4 or 5 large traders or utilities able to offer long-term PPAs, a problem arises. Simply put, too many sellers, too few buyers. The demand is limited. Most PPA markets are clearly a buyer’s market.

Luca believes that it is not necessarily the case. For example, he cites projects that are financed under non-recourse project finance schemes, as many are, and which still require long-term security on the revenue side. That’s what the FIT regime provided and made lenders comfortable when lending for renewable energy projects. As stated before, PPAs could be considered a form of ‘FIT replacement’.

He goes on to say that the project finance model has generally come under stress as credit risks are typically higher with private off-takers, duration of contracts is shorter, and the products are not covering all risk factors.

Therefore, with current market trends, this long-term cash flow security is becoming scarcer and more expensive. Thus, Luca states how Pexapark believes that there will be an eventual trend toward more balance sheet-financed projects.

Luca points out that, for the most part, renewables projects will increasingly have far more exposure to energy market risks. This de facto increases the pressure on any organisation to effectively manage their energy risks and deal with price uncertainty.

How market players will adjust to this trend will be very interesting to watch, according to Luca. Clearly, more insecure projects require a higher rate of return, as they carry more inherent risks. With the former regime, many investors treated investments in renewables very much as they would bond investments, i.e. very low risk.

However, this asset class has changed – dramatically.

Luca expects far more investment among players in building risk management infrastructures. He believes that future investors will want to know how asset managers deal with volatility price risk, will wish to see a hedging strategy, and will request new KPIs such as revenues at risk (RAR) and value at risk (VAR). Luca says this is already happening and for Pexapark it is a fascinating development replete with opportunity.

Luca emphasises that the beauty of the renewables market is that it is far easier and more economical for new entrants to enter the playing field when compared to other energy markets. Entry into conventional energy markets such as coal-fired and nuclear power stations is notoriously capital intensive, prolonged and often taking many years before returns on investments can even be contemplated.

It’s worth adding that these non-renewable energy markets are also highly politicised, with powerful and well-established lobbies jostling for favours from lawmakers and regulators.

Luca does concede that an open renewables market will not necessarily guarantee less expensive energy for consumers and national grids. However, given that access to the renewables market is easier and less capital intensive for entrants, this should facilitate greater competition between providers and, in turn, should result in more competitive pricing structures.

Renewables are also far more flexible than old, fossil fuel-generated technologies in terms of shifts in market-related factors. For example, demand or the ability to adapt to new technology such as artificial intelligence inputs. Regarding artificial intelligence, Luca believes that solar will most benefit from its potential inputs, since it can more easily be used for small energy production, e.g. at the neighbourhood level or for other micro-markets.

Importantly, Luca also reminds us of the “externalised costs [primarily those to the environment and human health] with the old fossil fuel system.” Renewables, in which these externalised costs are reduced, should further ensure the sustainability and investment viability of the renewables market.

Luca: “Yes, absolutely!”. Pexapark believes that it is likely that renewable technology costs will continue to fall further, and so even more participants will enter the market.

Luca believes that the market integration of renewables is the final step in the transition to a 100% renewable energy world. He believes that “renewables will only succeed if fully integrated within market mechanisms.” Hence the need for open markets.

Investors and other energy players who wisen up to this volatility – and allied opportunities – will be the ones to reap the benefits of the open market.

Luca uses the gas industry by way of analogy. Like the renewable energy in its nascent era, the gas industry too was also very capital intensive. In the past, investment in gas relied also heavily on long-term contracts. Today, gas is monetised in spot contracts. That industry continues to be well-financed, with capital markets and players adapting as and when needed. He believes the same will be true for the renewables industry.

The frontier today for achieving a 100% renewable energy future is engaging in effective, value-adding merchant management for renewables; and Pexapark is at the forefront of this frontier.

Pexapark advises clients with their investments in wind farms, solar parks and hydro stations. Sign up to receive your free copy of our PPA Times. Read each monthly edition to stay on top of latest renewables market activity.

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