[Forbes] A Better Way For Corporations To Buy Green Power? The Proxy Revenue Swap
May 1, 2019
In recent years, corporate power purchase agreements (PPAs) to buy renewable energy have been a key driver for large-scale wind and solar projects. The PPA trend has grown rapidly in the U.S. Last year alone, the number of buyers jumped from 31 to 75 while the contracted volumes soared from 2,780 to 6,530 megawatts (MW).
Those numbers are expected to grow in coming years. However, some of these deals can be complex, with contracts that can run over a hundred pages. They can also involve certain risks that buyers may be unaware of.
Two Types of PPAs
There are two types of PPAs: physical and virtual. With a physical PPA, the project owner typically delivers electricity into the same power grid in which purchaser is located. The buyer takes delivery, with legal title to the energy (as well as the associated renewable energy credits - RECs). The buyer is also responsible for costs of moving power from the facility’s point of delivery into the grid to its physical location. These work best in competitive power markets.
Virtual PPAs involve some risk
By contrast, virtual PPAs (vPPAs) – which cover the majority of transactions in the U.S. - are financial structures involving contracts for differences, and no electricity is physically delivered. The buyer commits to paying fixed prices for both the energy and the RECs for every megawatthour (MWh) produced by their portion of the facility.
Most of today’s vPPAs are for wind, so we will focus on wind energy in this piece.
How Does the vPPA Work?
To illustrate, let’s assume Company A commits to buy all electricity from a 100 MW wind project for 10 years at a fixed price of $30 per MWh. During the contract duration, the facility owner will sell all of the energy from that project into the hourly spot market. When the wind is blowing, the turbines might be producing close to the full rated 100 MW. Other times, they may produce a small fraction of that, averaging perhaps 40-50% of rated capacity over the lifetime of the contract.
At the same time, the buyer purchases the physical energy it uses on the spot market. The wind farm owner then reimburses the buyer for any payments in excess of $30. Conversely, for every hour that the market price clears under $30, the buyer must make the seller whole.
The buyer gets sustainable energy and locks in the $30 for all energy the plant produces over a decade. There is potential value in fixing the energy price for a decade, since one typically cannot get a retail energy contract for more than five years.
However, the buyer also wears the market price risk. If future markets clear lower than the vPPA, the buyer may end up overpaying. This risk may be more prevalent in areas of high renewable saturation, like Texas, where there are over 24,000 MW of wind in the 78,000 MW system. The more wind one has on the system, the less valuable it may be, since the output may depress prices (it’s similar with solar in California).
Operational and Fuel Risks
That risk is fairly well recognized. However, there are two other less obvious risks that can also affect the economics of the deal: operational risk and fuel risk.
Operational Risk: The buyer is counting on the seller to operate the plant as advertised – with the critical considerations being turbine performance, turbine availability and curtailment. If the equipment is poorly maintained or is built in a transmission-constrained region, output will fall and the buyer must purchase more energy than anticipated on the spot market. It may also need to purchase more RECs. Conversely if the equipment is upgraded over the term of the vPPA – the buyer is on the hook to buy more power than it wanted.
Timing of maintenance may also create tensions between buyer and seller. The actual performance of the facility may vary from the expected output, based in part on operators’ decisions on when to shut down for maintenance, potentially exposing buyers to higher spot prices.
Fuel Risk: Since the fuel is wind, its availability is highly variable. A wind farm may over-deliver relative to plan, dumping more MWh into the market when prices are low, and exceeding customer demand. At other times, it may provide less energy than expected when prices are high. In both cases the customer is exposed to the spot market.
That’s a challenge in the short term, but perhaps more significant in the out years. Although, wind resources are studied exhaustively, accurately predicting the fuel resource over many square miles remains a significant challenge and a “miss” of 10%+ when predicting average power generation remains a real risk. Further, even if the average is accurately predicted, what happens if the actual weather changes over time, meaningfully altering actual production?
If that sounds theoretical, consider this: ERCOT no longer relies solely on a 30-year average temperature curve to predict weather. Since the weather has become so much hotter in recent years, it has added a 10-year trailing average to better predict load patterns. In a worst case, hotter days may reduce turbine output, just when prices are highest, adding more risk to the equation.
Collaborating to Solve the Problem
These are the types of challenges three companies – REsurety, Nephila Climate, and Allianz Risk Transfer teamed up to address, creating a product that firms up the volume – removing fuel risk. To do that, the companies' various skill sets had to be combined.
REsurety (which has contracted with 5,000 MW’s of project capacity) provides the data and analytics, tapping an enormous database containing the performance of every wind farm (over 800) in the U.S. REsurety analyzes all of that data - including weather, energy price, mechanical performance, and grid conditions - and uses it build distributions of future potential outcomes.
CEO Lee Taylor, who founded REsurety as the outgrowth of a project at Dartmouth’s Tuck Business School that was supported by Nephila, comments that it’s important to understand the fuel risk associated with renewables. In developing his project, he observed that lack of fuel certainty was a risk that commodity traders didn’t want, but that the insurance sector might be willing to embrace – if they had all of the right data to accurately assess the risks. So he created REsurety to offer that analysis and assess these probabilistic risks.
Taylor observes that in the past, weather-related risk was typically limited to the demand side of the power equation. Changes in electricity demand were largely driven by heating and cooling, while fossil-fueled supply was predictable. Today, though, weather affects both the supply and demand side, which drives more volatility and increases risk.
In anticipating these dynamics, Taylor says that REsurety might pose a question such as,
for the next decade, what’s the risk that temperatures spike in Texas at the same time the wind speed dies. Depending on how you hedge that, it can be incredibly painful. We approach from a probabilistic perspective and acting as actuary.”
Those risks can change appreciable over a short period. For example, in the Texas market, which has the largest wind portfolio in the country, Taylor comments that in just a few years, reserve margins have gotten a lot thinner, currently at 7.4%, compared with a targeted 13.7%. That has the potential to push prices higher during scarcity events, in a market where prices can soar to nosebleed heights of $9,000/MWh.
“We don’t know with certainty what the future will look like.” he observes.
“Our job is to get most data-informed view of what the future could hold as possible. REsurety provides the data and analyses that enable the insurance partners we work with to set the price. We track transactions once contracts are signed and then every month we read that data to say what happened, and who owes whom how much, and why.”
For its part, the insurance industry’s job is to get paid for taking that informed risk, and paying out in the event that unexpected weather and power market risks result. What they won’t pay out for though, is poor project management.
Here, REsurety’s data can inform them if turbines are poorly managed or operated, in which case the onus falls on the owner/developer. “We use data to strip those factors apart and settle the contract. We don’t take risk on the balance sheet. The risk taker in the majority of the contracts we support is a combination of Allianz Risk Transfer and Nephila.”
Nephila, an investment manager dedicated to the insurance and reinsurance sectors, bundles weather and climate-driven risks into a package on behalf of investors looking for strategies that lack correlation with financial markets. However, Nephila needs a sophisticated insurance partner with strong credit rating to write the actual contracts to its counterparties. That’s where Allianz Risk Transfer enters the picture (the two parties share the risks behind the scenes).
The Proxy Revenue Swap
Nephila structures the actual product, the proxy revenue swap (PRS). The basic concept is simple. The hedge provider (in this case, Allianz) pays the project a fixed lump sum for a defined period, irrespective of how much the wind blows or the actual hourly clearing prices.
For its part, the project pays Allianz an amount that varies over the same periods, equal to the “proxy revenue,” which is defined as the price times quantity for every hour – which can vary dramatically with power prices and the fuel resource.
Here’s where the ‘proxy’ part comes in. Proxy generation represents how much energy each individual wind turbine should have produced in any given hour given the observed “fuel” (a function of wind speed and air density) and the project specifications as provided by the project (primarily turbine performance and turbine availability). Settlement on “proxy” generation enables separation of the weather and market risk from the operational responsibilities of the owner.
The Proxy Revenue Swap: a 3rd party assumes the risk
COURTESY OF RESURETY
Nephila Climate’s CEO Richard Oduntan explains that if the project underperforms as a result of exogenous factors, such as a variance from projected wind speeds, during the ten years of the agreement, the owner is made whole. However, if the revenue is greater than expected, project owners “pay to us. They give up whatever windfall gain there is from the project.”
As Oduntan puts it, “We try to create products that give investors access to risk they might not otherwise have access to. It’s a ten year project that allows institutional investors to support renewables within the products we develop.” He notes that the benefits to stakeholders are threefold:
Investors get access to financing the risk of renewable projects
De-risked projects (for the first ten years, at least) become more bankable, allowing more debt to be taken on by project sponsors since revenues are fixed
Corporate energy buyers avoid risks they may not be comfortable with.
There is a good chance that the market is only going to become more volatile, and renewable output more difficult to model as our weather changes. Oduntan states that the parties already have to take climate change into account.
In the past everybody thought about weather-normal as a static average. But if you did that now it would be a mistake and would give you a distorted view of what normal is. Normal is no longer a static reference period from the past. It’s become dynamic.
REsurety’s Taylor notes that the proxy revenue swap is now beginning to be applied to solar as well, with the first projects of its type already closed in Australia, and U.S. projects in contracting phase. This approach works for both new undertakings, as well as repowering of existing wind projects. The first 10-year proxy revenue swap was applied in February to hedge output and revenue of a portfolio of three repowered projects totaling close to 400 MW in Texas.
He expects the entire sector to grow considerably in future years as more buyers become aware of the volumetric and operational risks they face and understand that it can be outsourced to third parties at a reasonable cost.
Peter Kelly-Detwiler is a principal at NorthBridge Energy Partners, a consulting firm providing expertise and market intelligence to companies navigating today's complex energy landscape.