Can PPAs hedge against market volatility?

Higher than usual demand for energy has caused the price of energy to rise in the past few months. This has hit Europe especially hard due to its reliance on natural gas. With renewable continually contributing a greater share in the European energy mix, inspiratia assesses how renewables can navigate price action in the energy market.

The reality of the current energy market is that prices of energy are primarily dictated by fossil fuel counterparts. Unlike renewables, fossil fuels are a commodity, not a technology. Their prices constantly fluctuate and recently set new highs because improved extraction techniques battle against the depletion of reserves. Additionally, the abrupt and quick ramp up of demand for energy has compounded this issue.

Further exacerbating this is the current geopolitical event which has embroiled Ukraine and Russia. The breakdown of diplomatic relations has caused already high natural gas prices to spike, with benchmark Dutch gas futures rising by as much as 69% to €145 per MWh and German power for March 2022 rising by 58%.

This situation means the cost drivers of European energy will be high for the foreseeable future, potentially spilling over into renewable energy pricing this year.

The increasing uptake of subsidy-free renewables raises questions over the long-term economic viability of projects in a merchant market which are now being exposed to market forces.

In addition to external forces that may affect demand for energy, increased renewables adoption compounds the effect of intraday and seasonal price cannibalism. This means price changes due to energy supply variation from renewables as well as from external sources need to be addressed.

As the European Green Deal kicks into effect, renewables share in the energy mix is set to increase in the coming future. Long-term, price cannibalisation and general market fluctuations in renewables is becoming a bigger factor to consider. That said, a shift in PPA structures that enables a more dynamic approach to pricing and can account for swings in the market due to cannibalisation or market volatility will be needed.

Reality check

With gas storage reaching well levels below the 10-year average, Europe is becoming more dependent on imports. Thus, Russia's reluctance to increase gas exports to Europe created a geopolitical issue that adds to the supply demand imbalance generated by Covid-19.

European gas storage in TWh, 2010 to February 2022

Source: Aggregated Gas Storage Inventory (2021), inspiratia

This has translated to a knock-on effect on electricity prices which quadrupled in Germany in 2021. In the same time period, PPA prices have almost doubled, from €40/MW to €70/MW( £33/MW $44/MW to £58/MW $78/MW). This price hike can also be attributed to price increases in raw materials used for plant construction.

This has incentivised developers to make up the revenue they could have otherwise made selling their electricity on the day-ahead market. However, with the price hikes seen in the last few months, renewable energy is still relatively cheaper than its fossil fuel counterparts, as seen below.

Select European energy price trends, 2021 to February 2022

Source: statista (2021), Pexapark (2021), inspiratia

Across Europe, energy intensive businesses halted or reduced production towards the end of 2021. Notably,  multinational chemicals producer BASF cut off fertiliser production in its Antwerp, Belgium and Ludwigshafen, Germany plants due to high gas prices.

BASF went on to sign a PPA agreement with French multinational utility Engie, to provide 20.7 terawatt hours of energy across 25 years, effective since 1 January [2022]. High energy prices and uncertainties in the energy futures markets provides an ideal opportunity to boost uptake of cheaper renewable power under attractive under PPA agreements.

PPAs in unforeseen volatility

With this rise in price, PPA structures may be adapted to accommodate unforeseen events in the energy market and maintain their strength as a hedging tool. The ability to contractually agree energy prices, especially through a volatile period, is attractive.

PPA prices themselves are determined from forward curves and contracts which are subject to fluctuations. In the energy market, utilities are accustomed to dealing with intra-day volatility. However, volatility in forward curves mean PPA contracts will benefit from becoming shorter with more detailed structures to guard against strong price action in the market.

This shields companies from long term market convolution and translates to lower risk on company balance sheets. Additionally, shorter PPA deals allows the market to converge on how to price certain risks.

The nature and structure of PPA deals in the future will have to change to maintain their hedging ability and by extension the attractiveness of renewables as investments.

In their 2022 European PPA outlook, Zurich-based PPA advisor, Pexapark, noticed an increase in discounts for pay-as-produced PPAs which is triggering demand for short term and baseload PPAs. This shift in PPA structure preference means active monitoring and managing of revenues is required as a hedging strategy in short term and baseload PPAs. The volatility of capture prices makes baseload PPAs uncertain.

PPA future structures that protect renewables growth

Short term PPAs

In the past, traditional PPAs have averaged 15-20 years in length. However, with the effects of price cannibalisation and external market forces on the price of energy, longer PPA deals may not prove to be an ideal mechanism for both developer and offtaker under current market conditions. This is especially the case with corporate PPAs.  

In their PPA outlook Pexapark noted that renewable energy investors are developing key portfolio management capabilities and energy risk management infrastructure that will enable hedging mechanisms to be robust under shorter term and baseload PPAs. This is to ensure fair prices for PPAs can be better determined and that the PPAs remain attractive even in times of uncertainty – raising the value of signing multiyear contracts.

Some of these strategies include creating hybrid structures in which a percentage of baseload supply is contracted at a fixed price and the remaining percentage is contracted at a floating price with a discount to the market.

Also, more dynamic approaches can be incorporated in PPA structures with allow for price. PPAs can be constructed with collars where the offtaker can provide a floor price, protecting the developer from low prices. The developer also provides a cap which limits the offtakers exposure to price spikes. This creates a collar which provides a hedge against volatility within the energy market.

In addition, their is the growing option of virtual PPAs (vPPA) based on day-ahead average prices, along with cross-border vPPAs, which enables offtakers to seek more competitive PPA prices in a market other than their own.  

Such PPA structures allow for price protection and bolster the short term PPA market. According to Pexapark, a more liquid short-term PPA market frees a key bottleneck for renewables growth. This will enable more corporate offtakers who may not have an appetite for long term agreements to enter the renewables market. With there being a delay between negotiations and deal announcement, the demand for such deals will be seen in coming months.

Long term PPAs

To supplement the rise in the short term PPA market, a rise in large scale corporate offtakers is expected. These energy intensive entities seeking to reduce greenhouse emissions are expected to seek out corporate or bespoke agreements with offshore wind farms to provide for their energy needs.

This is therefore a great opportunity for subsidy-free offshore wind projects to benefit from. Despite 10-year plus PPA agreements predicted to decline, the large volume expected from these projects allows longer term deals to be a cornerstone of renewables growth.

This has been kickstarted by BASF acquiring a 49.5% stake in Vattenfall's 1.5 GW Hollandse Kust Zuid offshore wind farm at a cost of €300 million (£251m US$336m) which includes a hedging agreement via a long-term PPA. Similar bespoke large-scale deals are expected to occur in the renewables market.