The clean energy transition is changing how we think about and organize electric grids, and it is also leading to the development of new financing methods for renewable energy projects.
TL;DR
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Fewer generators are using PPAs and those that are (particularly large tech firms) are opting for shorter terms.
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Hedges and revenue swaps are changing how financiers manage risk in renewables projects.
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Equity financing and merchant generation are also on the rise.
Financing large energy projects has always been a gamble. Whether you are building a coal plant or wind farm, infrastructure projects can be risky and expensive.
As the way we generate electricity evolves, so too are the ways we finance said evolution. Historically, power purchase agreements (PPA) have long been the standard way that generators seek financing and sell their power. PPAs typically include a fixed price per megawatt-hour or a fixed percentage of an average market index price, and have time frames of up to 20 years or even longer.
In recent years PPA terms have been getting shorter, with the average decreasing from 20-25 years in 2017 to 12-15 years in 2019.
In the past, the only company that could buy a PPA was the utility, which meant that generators would sell their PPAs directly to utilities. More recently, talk of PPAs of between 5 to 10 years has been increasing, as large offtakers (companies that purchase PPAs) like Google, Microsoft and Facebook push for shorter terms.
Together with shorter PPA terms, large companies have begun buying PPAs in order to secure renewable electricity for their operations.
Many utilities have already fulfilled their responsibilities under state-level renewable procurement mandates, and are now voluntarily procuring green energy, which also puts less pressure on them to sign deals. Utility scale solar is also being adopted by vertically integrated utilities (e.g. in Florida) which have been allowed to pass up-front costs to customers through a process of rate-basing.
For example, in California only 30% of generators are expected to be using PPAs by 2022.
Colin Smith, a solar analyst at MacKenzie explains that traditional PPA term length doesn’t fit with the outlook and business model of digital firms. Smith says that these firms “[…] want to secure low-cost contracts but don’t want to be stuck with something for 10 years […] Facebook hasn’t been around for 20 years – it’s hard for them to sign a contract that is longer than they’ve been around.”
As more renewable energy generators enter the fray the market is increasingly becoming a buyers market. This increases competition among generators and encourages flexibility and innovation when it comes to terms lengths and financing in general.
Hedges and revenue swaps
The intermittency inherent in most renewable generation (such as solar and wind) adds additional financial risks for investors, since variable generation combined with variable pricing each year leads to uncertainty. This makes investors wary of financing expensive hardware projects, so to make it easier for financiers, many project developers will find ways to reduce project risk.
These risk mitigation efforts can be expensive but provide a certain degree of certainty for financiers.
Consequently, the use of hedges is increasing, as these provide a floor for prices and provide some security for investors. That said, “it’s not like there is an unlimited market for financial hedges. Each hedge needs to be priced a little lower than the one before,” says Starwood Energy CEO, Himanshu Saxena.
One advantage of hedges is that they can be more streamlined and easier to negotiate than PPAs which often involve protracted negotiations and review periods. Hedges using the International Swaps and Derivatives Association (ISDA) or European Federation of Energy Traders (EFET) rules also benefit from standardized agreements.
In the wind market, Proxy Revenue Swaps have been used whereby an insurance company takes the risk on the volume of electricity generation, (and consequently on the weather) with the settlement unit being the revenue. This locks in some portion of revenue which makes it far easier to secure financing. Kaspar Walet, founding partner at AI Energizer explains in more detail:
“[…] a Proxy Revenue Swap transfers price risk to the hedge counterpart. In addition, a Proxy Revenue Swap is structured to address some components of volumetric risk (that is, the amount of power produced by the project). There is a cost premium to the project owner for the transfer of such volumetric risk to the hedge counterparty. The Proxy Revenue Swap calculates a proxy for the amount of power produced by the project (or how much the project ‘should have’ produced) rather than basing the hedge on the project’s actual production of power.”
Equity financing and merchant generation
Alternatively, some companies are opting for equity financing for renewables projects. For example, London-based NextEnergy Capital plans to build as much as 1.2GW of solar without government subsidies or PPAs. Another option is for generators to sell their power to aggregators which can often secure better prices from utilities and the market.
Speaking of the market, more generators are turning to merchant generation, which refers to power generation by a non-utility or independent generator for competitive wholesale markets. Merchant generation does not involve long-term PPAs and deals with speculative power plants.
Writing for GE, energy analyst Jeremy Bowden explains that “[…] the less PPA coverage a buyer has, the more downside market price risk is passed to the generator. But a cleverly run plant should also be able to capture more of the high-priced periods in wholesale markets, which a PPA does not permit.”
The first merchant solar project in Canada was completed in November 2020 by EPC contractor GP Joule for renewable energy investment firm Elemental Energy. The 25.4MW solar plant plans to sell on the spot market in Alberta. And the 465MW Travers Solar plant in Alberta has also adopted a merchant funding plan, and is set to be ready in Q4 of 2022.
As the grid modernizes and becomes more decentralized the way we pay (and are paid) for electricity is changing as well. A 21st century grid requires equally up-to-date financing options, but just as there are vested interests pushing back against the spread of renewables, so too are there utilities that see the diversification of financing as a threat to their revenue streams.
Flexibility and adaptability are core values for any modern grid, so it only makes sense that the money that underpins the grid is equally unconstrained.
