Renewable Energy Risk Management: The Benefits and Risks of a VPPA
Virtual Power Purchase Agreements (VPPAs) have become an attractive tool for corporate renewable energy procurement. They provide an opportunity to purchase renewables at a meaningful scale, allowing organizations the chance to make impactful progress towards their sustainability and carbon reduction goals. There are many benefits to VPPAs. However, these contracts have inherent risks that must be identified and understood, in order to engage in responsible renewable energy risk management
Benefits of a VPPA Contract
By entering into a VPPA contract and locking in a low fixed energy price, organizations can realize significant financial gains over the contract term. With the transfer of Renewable Energy Credits (RECs) as part of the VPPA, organizations are able to make legitimate claims around their use of clean energy and carbon reductions. They even have the chance to claim additionality because VPPAs are typically contracted with new renewable energy projects — meaning additional clean energy is added to the grid as a direct result of the power purchase agreement.
Entering into a VPPA as a means to acquire renewable energy provides your organization with excellent benefits, from both a sustainability and financial standpoint.
VPPAs Help Meet Sustainability Goals
If a company has a stated sustainability plan geared towards reducing their impact on the environment, a virtual power purchase agreement helps achieve a wide range of those goals. A VPPA contract can help organizations meet greenhouse gas emission reduction targets, even for geographically dispersed facilities, meet RE100 commitments, and make progress towards other corporate renewable energy procurement strategy objectives.
VPPAs Can Increase Your Net Present Value (NPV)
A properly structured VPPA can provide significant positive cash flows. As the price of solar has decreased rapidly in recent years, it is now possible to lock in a VPPA rate that is consistently below the projected wholesale market price for power at the settlement location. Urban Grid uses its extensive experience and expertise to structure VPPAs that provide positive modeled NPV as well as a hedge against future energy prices. When evaluating solar projects under development for a solar VPPA, it is critical to do your due diligence and make sure you’re contracting a VPPA with a project that:
- Is well developed
- Has limited development risks
- Has quality interconnection
- Is in a location with a stable wholesale power market
Solar VPPAs have the added benefit of producing during periods of higher market prices because solar energy projects operate during the peak price periods in the afternoon. Since wholesale market energy prices are higher during the day, solar projects can sell their energy at a higher market price. With a greater difference between the market energy price and the VPPA fixed price, your positive cash flows increase.
VPPAs Can Be An Effective Energy Hedge
A virtual power purchasing agreement can be very effective at acting as a financial hedge against electricity price volatility. By entering into a VPPA, the buyer is able to lock in a set price for both energy and RECs. A VPPA, if well correlated to your retail electricity spend, provide positive cash flows which offset higher conventional energy costs. A position in a long term VPPA acts as an insurance policy against historically volatile and projected rising electricity prices.
If you are looking to use a VPPA as a hedge, make sure to align your VPPA with your conventional energy supply, both in amount and location. Also, while it is possible to hedge 100% of your energy usage, that strategy is not advised as events including changes in your usage or in wholesale and retail price correlation can make the hedge less effective.
VPPA Risk Management
During your evaluation of VPPA contract opportunities, it’s important to fully understand the associated risks and how to manage them. The risks associated with a VPPA transaction include:
Market Price Risk
During VPPA evaluation, one of the primary risks that your organization will be faced with is exposure to wholesale power market prices. The financial success of the VPPA is predicated on the assumption that the wholesale energy prices in the contracted location will remain consistently higher than the VPPA fixed price. There are three risk management tools that can help reduce Market Price Risk:
It’s important to use a recognized, reputable energy price forecasting models and financial analysis including stress tests using a variety of best and worst-case scenarios is needed to assess the risk of taking a long position on energy prices.
Hourly market price
Compare renewable project production forecasts with the corresponding hourly market price. For example, wind projects typically produce more at night when prices are often lower; while solar projects produce during daylight hours when prices are higher.
Energy prices can be quite volatile. This volatility can be mitigated through specific contractual deal terms, such as price floors or price collars. In both cases, the VPPA price may be slightly higher to provide this protection.
All renewable energy projects — whether wind, water, or solar — are impacted by several variables including technology performance and weather variations. Buyers should ensure they are protected against shortfalls in project performance through key VPPA provisions such as performance and production guarantees. Make sure your project developer has performed extensive analysis to understand and determine the project’s expected energy output. This analysis includes the consideration of expected weather conditions as well as technology and equipment degradation.
Generally speaking, the VPPA buyer typically bears very limited performance risk unless the project severely underperforms. However, the consequences of underperformance can have an impact on the buyer, mainly the loss of potential financial upside and ability to make environmental and sustainability claims. For instance, if a project is underperforming and a certain number of RECs were expected and used in making certain sustainability claims, the buyer may fall short on those claims potentially resulting in legal and reputational issues. It is important to involve internal corporate teams including accounting and legal to understand the VPPA terms.
Inherent Legal and Regulatory Risks
VPPA’s come with a range of legal and regulatory risks that should be understood and where possible, eliminated through due diligence and contracting.
A VPPA is a “swap” agreement and thus may trigger reporting requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Dodd-Frank compliance requirements are minimal for most buyers — recordkeeping and reporting which is typically contractually handled by the project. However, if you are a buyer who is a financial institution, your Dodd-Frank compliance requirements may be more significant. Consult with your internal legal and accounting teams to determine your Dodd-Frank burden and if it is acceptable.
Change in law provisions
Many VPPA contracts include “change in law” provisions that are used to protect both the corporate buyer and project developer from the potential impact of regulatory changes. Again, consult with a professional who has prior experience with VPPA contracts to ensure your interests are protected by these provisions.
Experienced accounting firms
VPPAs accounting implications, including derivative accounting or mark to market requirements, are important risks to consider. While we cannot give accounting advice, we can say that corporate offtakes have successfully structured VPPAs to avoid any potential accounting issues. Again, it is important to involve internal and expert external accounting advisors to help avoid these issues.
A renewable energy project’s location can dramatically impact the risks and benefits of the virtual power purchase agreement associated with that project. The most common locational risks include:
Today, most project developers have a good understanding of basis risk and how to overcome it. The challenging part is determining which party bears this risk the buyer or the project developer. Energy is sold into the wholesale power grid at a busbar or node. Each node has its own market price. In each power region, there are also hubs, which are transactional locations which average the pricing of all busbars/nodes in the region. The difference between hub and node prices is the basis. Most VPPAs are hub settled to mitigate basis risk for the buyer. If the buyer does take on the basis risk, they typically can secure a lower VPPA fixed-rate, potentially resulting in greater returns.
Covariance risk is incurred when there’s an oversaturation of wind or solar in a particular area, which can lead to lower wholesale prices in the long-term. If a VPPA is located in a region where wind or solar energy is only a small percentage of the power supply, there will likely be no negative market price effects. However, in areas where wind/solar are a large percentage of supply, market prices can be depressed, resulting in required payments to the project by the buyer. These risks can be mitigated using the same means as for price risk, ie. price minimum price limits and 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.
VPPAs are subject to execution risk, ie. the project underdelivers or is never constructed. Due to the many development and execution risks faced by renewable energy projects, only a small percentage of these projects that begin development actually make it to construction. To limit exposure to this risk, perform comprehensive research and vet potential developers and projects before signing a long-term contract.
When VPPAs are well analyzed, structured, developed and negotiated they can provide substantial benefits including credible bundled RECs, a substantially positive modeled NPV, as well as a hedge against future energy price increases. However, there are risks inherent in any VPPA that must be identified and managed. These risks can be addressed and mitigated through thoughtful analysis and planning by your internal teams including accounting, legal, finance, sustainability, and energy. Equally important is close coordination with an experienced developer partner as you work through the process of evaluating a VPPA opportunity. Contact Urban Grid today to start assessing your options for a solar VPPA that maximizes benefits and minimizes risks.