June 25, 2018
This below is an excerpt from a Sustainable Leadership Blog Post originally posted on March 19, 2018, entitled “Corporate Renewable Energy Breakthrough: VPPA 2.0 Benefits & Risks“.
Since many more enterprises are interested in Virtual Power Purchase Agreements (VPPAs) than ever before – or even just a couple of months ago – it makes sense to republish the portion of a detailed Sustainability Roundtable Inc blog post from March that is focused on the top risks associated with VPPAs – which Sustainability Roundtable Inc Member-clients do not think that Developers and Supplier-Based Advisors are incented to emphasize enough.
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Those tasked with developing and driving Sustainability Programs at large enterprises are becoming increasingly familiar with Virtual Power Purchase Agreements (VPPAs). These no necessary first capital agreements that facilitate the financing of large scale, off-site Wind and Solar, projects have revolutionized the Corporate & Industrial renewable energy market as much as Power Purchase Agreements revolutionized the residential solar market. VPPAs have enabled high-credit enterprises to move away from the reputational risks inherent in “unbundled” Renewable Energy Certificates (RECs) that provide uncertain claims to causing new renewable energy (because they can be associated with renewable energy projects up to 14 years old) and commit to a financially advantageous path to 100% renewable energy through more credible “Bundled RECs” that provide a clear claim to causing new renewable energy because the provisions providing the “Bundled RECs” are bundled into the same contract that finances the new renewable energy project that creates the energy the Bundled RECs represent. See Not All RECs Are Equal.
From 10 GWs of Sole Off-taker VPPAs to 100 GWs of Aggregated VPPAs?
Sustainability Roundtable Inc. is a proud co-sponsor of the Rocky Mountain Institutes’s (RMI) Business Renewables Center (BRC) that is focused on helping to support and evolve the market for VPPAs. RMI’s BRC calculates that from 2013 through 2017 some sixty (60) top global corporations have caused a remarkable 10+ GW of new renewable energy to be developed in the U.S. through large scale, off-site PPAs and VPPAs (which are “virtual” because they do not procure electricity for the off-takers use). The pace of these large scale, off-site PPAs have only picked up in 2018 because – primarily – of two new developments. First, in the most favorable deregulated wholesale electricity markets in the U.S., the price corporate Off-takers must to commit to making the developer whole on for ten (10) or more years (i.e. the “VPPA Price”) has dropped substantially below the historically low, current wholesale electricity prices; and, second Aggregated Procurements are opening this market up from the few score of global corporations big enough to serve as a sole off-taker for 50-200+ MW renewable energy project to the thousands of enterprises interested in renewable energy but needing far less (e.g. just 10 MW or 38,000 RECs a year for ten years) to off-set their entire conventional electricity consumption in the U.S.
Developer Aggregations, Investor Aggregations & Buy-side Aggregations:
There are primarily three types of Aggregated VPPAs: Developer Aggregations, Investor Aggregations and Buyer Organized or Buy-side Aggregations. (See EnerNoc’s New Approaches to Power Purchase Agreements). Developer or Investor Aggregations reflect the needs of their sponsors who are not incented to emphasize the risks inherent in VPPAs. This is, in part, is due to the fact that the best way to reduce Buyer (i.e. “Off-takers” in this market) risks is to have the Developer or her or his financial Investors agree to accept those risk – or at least more of them – from the Off-taker. Consequently, since neither Developers nor Investors offering Aggregated VPPAs are incented to detail the risks associated with VPPAs- and because these large scale renewable energy projects are profitable enough for corporate Off-takers to now demand the Developers and Investors take on more risk while still delivering projects that, in the most favorable U.S. markets, still offer VPPA Prices below the historically low current market prices – Sustainability Roundtable Inc. reposts the below list of top risks associated with VPPAs.
The Top Ten Risks Associated with VPPAs:
The risks inherent in a VPPA transaction can be helpfully placed in three broad categories: Price Risks, Operational Risks, and Legal/Regulatory risks. Across these three categories, ten (10) risks, detailed below, must be managed by a carefully informed internal team and an experienced external procurement team:
I. Market Price Risks: The most important risk to be managed in a VPPA (CFD) is the market price risk. A sustained favorable price differential between the VPPA price and a higher market price can mean literally millions of dollars for the savvy corporate off-taker. Conversely, a bad guess can lead to significant financial loss. These risks include both Forecasting risks and Price Volatility. Below we discuss strategies for mitigating these risks.
1. Forecasting. Prior to entering any VPPA, Corporate buyers should utilize best in class energy price forecasting models and comprehensive financial analysis to analyze, quantify and assess the risk of taking a long position on the price of energy. This analysis can be complex and the forecasting data required to make the best decisions is expensive. For example, VPPAs are typically settled (i.e. the prices are compared) on an hourly basis, so it is important to line up the power production of the renewable energy facility with the appropriate hourly market price. For example, a West Texas wind project typically produces more of its output at night, when the energy prices are typically lower, and less in the afternoon hours of the summer when prices are high. So while the average market price may be higher, the realized market price may be substantially lower. Only the most sophisticated buyers have the resources to perform their own comprehensive financial and market analysis. In most cases, outside dedicated consulting or brokerage expertise can assist Buyer’s with the complexities of financial forecasting and price modeling. With an aggregated procurement, Corporate Buyers can join together to share expertise, analysis and practices as well as the costs of financial forecasting data and analysis.
2. Volatility Risks. Corporate Buyers can also mitigate price risk through the deal terms. Corporate Buyers are now successfully requiring minimum price limits and even price “collars” whereby the Corporate Buyer secures a higher minimum price in exchange for giving up potential profits if the price of energy goes above an agreed ceiling. In both cases, the Buyer will pay a slightly higher VPPA price up front, but the tradeoff is often worth it. In the first generation of VPPA transactions, the corporate buyer would be expected to cover the difference if the market price of energy dropped below the PPA price, even if the price of energy in the applicable wholesale market dropped below $0. This can happen in very windy markets where there is an oversupply of wind power and operators want to receive the PTC value. This problem can be solved in Buy-Side Aggregated Procurements, where numerous suppliers compete to offer attractive price mitigation structures. It is important to note that by putting a price floor into the deal, the amount of the contract that must be supported on the balance sheet or through a letter of credit is reduced.
3. Scale Risk. The benefit of a positive NPV from day one is in part a function of the large scale of the projects involved. Economies of scale in large renewable energy projects make the economics compelling. However, few corporate buyers have the demand and energy requirements necessary to support investment in a 200 MW Wind farm. However, by joining an Aggregated Procurement with a Buy Side Advised Consortium, Corporate buyers can get the benefit of the large project economies of scale, while only owning a 10MW commitment.
4. Time Risk. The first generation of VPPAs (2013-2016) were long tenured, reaching out 20-25 years. Longer term PPAs can drive lower borrowing costs, which are then reflected in lower pricing. However, many corporate buyers have much shorter decision horizons and resist entering longer term contracts in any aspect of their operations. The longer term deal will also result in higher potential risk. By reducing the contract term, you can reduce the overall risk of the transaction. This strong preference has been reflected in the competitive process and it is now possible to regularly secure 12 year terms for wind projects and 15 year terms for solar projects. And although it can create sub-optimal economics many developers are now willing to offer deals as short as ten years.
II. Operational Risks: Shifted to Seller:
5. Availability. The Contracting Supplier should bear the risk of keeping the plant running on a day to day basis, and the Buyer typically will not share the risk of keeping the facility up and running. VPPAs, like traditional PPAs should include an availability guaranty, to ensure that the Facility will deliver as promised.
6. Congestion and curtailment. The allocation of operational risks also includes the responsibility to bring the power to the market. This can lead to additional Transmission and Distribution (T&D) costs as a result of congestion pricing and/or curtailment if the Facility has interconnected to a line that is overcrowded. While VPPA 1.0 deals varied in their delivery point from the bus bar (at the project) to the regional market hub. Savvy buyers will want the Supplier to bear this risk, and be willing to pay a slight premium in order to settle the contract at the hub.
III. Legal and Regulatory Risks: Shared between Buyer and Seller:
7. Change of Law. The energy business is highly regulated. In addition, the market for renewable energy is also highly dependent on a variety of state and federal laws and regulations. When considering a VPPA, the buyers must carefully consider the impact of changes in law. In most cases, a change in law would impact the ability of the Seller to generate and sell the energy as agreed. So a typical change in law provision will give the Seller the ability to terminate the agreement in case of a change in law that has a materially negative impact on the Seller’s ability to perform. Corporate off takers should take care to ensure that any change of law provision is drafted to protect their interests as well, recognizing that the financability of the project may be impacted.
8. Dodd-Frank compliance. As the virtual power purchase agreement involves a financial transaction where the price of the RECs is set in reference to the movements of other prices, some have argued it could technically be deemed a “swap” subject to the regulation under Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Despite the fact that as a highly customized, untraded contract tied to a physical development, VPPAs a very long way from what Dodd Frank was intended to regulated. Consequently, even though VPPAs have not been legally determined to be subject to Dodd Frank and experts think it is unlikely they will be, Buyers and Sellers are concluded that it makes sense to file in accord with Dodd Frank in case VPPAs are ever in the future deemed to be subject to Dodd Frank (in part because most if not all of the requirements under Dodd Frank for Corporate Off-takers are likely to be limited to record keeping and reporting). Sellers regularly have far more experience with Dodd Frank and are willing to serve as the Reporting Party under Dodd-Frank, but corporate buyers should ensure that these requirements are met and that responsibility for serving as the Reporting Party is contractually assigned to the Seller. Moreover, VPPA Corporate Off-takers who are financial service firms should recognize that, as financial service firms, compliance with Dodd Frank may entail additional considerations and they should seek specialized legal counsel on the subject for at least their first VPPA.
9. REC certification and compliance. In order to use the RECs to meet renewable energy goals, it is necessary to ensure that the RECs are properly certified by a recognized body in order to maintain their legitimacy. This responsibility should be placed on the Seller, who may set a limit on the costs required to properly certify the RECs.
10. Accounting Treatment. The accounting treatment of a VPPA is important. The typical corporate finance/treasury office will not sign off on any VPPP transaction that would have a balance sheet impact. Nor will they allow any transaction that is required to be treated as a derivative and “marked to market.” While it is important for any corporate buyer to work through the issues with expert advisors, a properly structured VPPA will not be consolidated on the balance sheet of the corporate buyer as it is not a Variable Interest Entity and the VPPA does not constitute a lease. The VPPA should be structured to avoid derivative treatment as well and this can be accomplished by avoiding any “notional amount” of RECs to be acquired. The VPPA should be structured as the right to receive the output from an agreed capacity allocation from the project – also known as an “availability guaranty.” Buyer accounting teams should be into the internal procurement process early to enable them to be educated before the deal is structured and negotiated.
IV. Conclusions:
High credit corporate buyers can now see a profitable path in the U.S. to 100% renewable through a Buy-side Aggregated VPPA – or VPPA 2.0 – that provides Bundled RECs from a new, large scale, renewable energy project in the most favorable deregulated wholesale electricity markets in the U.S. And those Bundled RECs can be used to offset the GHG Emissions of the enterprise’s facilities – that are more often than not leased and geographically dispersed – across the U.S. When these Buy-side Aggregated VPPAs are well analyzed, structured, developed and negotiated they can provide more credible Bundled RECs, a substantially positive modeled NPV as well as a hedge against future energy price inflation. These benefits are substantial and are superior to the costs of the traditional unbundled RECs . A typical publicly traded fast growth technology firm with a total annual electricity demand for its own facilities that could be met by 10 to 30 MW of Wind or Solar capacity, might achieve its initial goal of 100% renewable energy for tis Scope 2 emissions (i.e. which is regularly overwhelming from its purchase of electricity) through just two years of planning and two to three smaller (e.g. 10 MW with 12 years of term) VPPA 2.0 transactions, each conservatively modelled to be in the money year one for the buyer and providing a seven figure NPV over term. There are, however, risks inherent in any VPPA that must be identified and managed. These risks include market prices, operational risks and legal/regulatory risks. These risks can be addressed and mitigated through a carefully informed internal team with the assistance of Buy-side Advisors with deep relevant expertise in renewable energy markets, financing, law, technology, corporate procurement and deal structuring; who can provide strategy development as well as financial analysis and a structuring of the transaction through business and legal negotiations that favor the buyers. Currently, a historically low but changing interest rate environment and substantial but declining federal tax subsidies has helped create intense competition among top developers that is providing a pronounced “buyers’ market” for high credit corporate buyers. In growing number of deregulated wholesale markets in the U.S., the price of developing and delivering new renewable energy is currently substantially below the historically low prevailing current local marginal price. Consequently, high credit buyers procuring through a Buy-side Aggregated VPPA can reasonably hope to lock in deals in these most favorable markets that are conservatively modeled to be “in the money” in year one. Moreover, through competitively sourced Buy-side Aggregated VPPAs, consortiums of corporate off-takers are winning better deal terms including: lower prices, shorter terms, and robust legal protections against downside financial exposure. Taken together, these changes constitute the emergence of VPPA 2.0, which is a breakthrough that is changing the fundamental question regarding corporate procurement of renewable energy from “how much will it cost?” to “how much, conservatively, will it make?”
1. Business Renewable Center, Deal Tracker, 2018 (SR Inc has supported the Rocky Mountain Institute’s Business Renewable Center since its inception in 2015 and is a proud current sponsor)