How To Evaluate Power Purchase Agreement Risks Amidst Transmission Constraints

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George Todd Director, Renewables Advisory - Americas
Renewable Energy
Power Purchase Agreements

Electricity grid infrastructure is quickly becoming an important consideration when entering a contract known as a renewable Power Purchase Agreement (PPA) – either physically delivered or financial/virtual (VPPA).

An aging grid combined with a rapid buildout of naturally intermittent renewables poses unique changes and risks to settlement point prices that can affect the value of a PPA contract. However, it is possible to evaluate these risks early on using contractually-based mitigation strategies.

What Is a Power Purchase Agreement?

Electricity Grid Barriers

The North American electricity grid and generation mix are changing to a point that creates issues of reliability and volatility. Based on a report by the Department of Energy, roughly 70% of transmission lines and transformers are more than 25 years old along with 60% of circuit breakers being more than 30 years old. These extremely important grid components have expected useful lives estimated between 25 years and 50 years. The American Society of Civil Engineers issued a grade of D+ in 2017 for all forms of US infrastructure (including bridges, dams, energy, waterways, etc.), which is very telling of an impending problem in the next few years and not just the electricity grid.

Weathering the Storm

Aging grid infrastructure is unprepared to meet the transmission requirements during extreme weather events that continue to grow in both frequency and severity. While some of the impacts of these occurrences are unavoidable, increasingly detrimental effects on energy reliability and market prices could be reduced through investment in grid assets and more stringent requirements on generators and grid operators. For example, the California Camp Fire wildfire of 2018 was caused by compromised transmission line components failing during high-wind conditions sparking a fire. More recently, Winter Storm Uri wreaked havoc on an inadequately prepared ERCOT (Electric Reliability Council of Texas) grid and generation assets leading to widespread blackouts for days. In both cases, the inability of the transmission grid to respond to extreme weather and environmental conditions enabled these failures.

The Growing Demand for Renewables

Simultaneously, the rapid growth of renewables and their natural intermittency combine with an aging grid to intensify the challenge of providing reliability and smoothing volatility. Corporate sustainability and renewable energy strategies will become less voluntary over time and more of a “soft” requirement to maintain and expand supply chain partnerships in all industries. The growth of renewable energy capacity in North America will continue to increase steadily as corporate buyers leverage PPAs to meet SBTi (Science Based Targets Initiative), RE100, and other corporate renewable or carbon reduction pledges. In the chart below, the EIA reports that the proportion of power produced by non-emitting resources has more than doubled in the previous 12 years due to both private and corporate investment in renewables. This includes the continued development of technologies that have increased output over time as well as fluctuations in favorable weather conditions.

U.S. Annual Renewable Generation 2012 - Sept 2022

Chart: U.S. Annual Renewable Generation 2012 - Sept 2022

The largest concentration of North American renewable energy additions can be found in Texas and other western states. Texas serves as a focal point due to the favorable economics for corporate buyers’ VPPA contracts. It also provides a useful demonstration of variations in zonal deployments, disparities in zonal economics, and the risks and opportunities such disparities present when a VPPA contracts.

In a 2020 report published by ERCOT, the ramp-up of solar and wind additions to the grid has happened in ERCOT’s West and South Zones due to the vast availability of land, subsidies, and retirement of conventional generating assets. The explosive growth in these zones has caused an increase in transmission constraints, a tool used by ERCOT to manage grid stability by placing limits on generation. Such constraints can have a profound impact on settlement pricing, with supply-rich zones tending to experience negative market prices driven by limited transmission capability out of the zone. These factors are contributing to a higher concentration of renewable VPPAs being offered in the ERCOT North Zone.

The key takeaway is the area(s) of ERCOT where renewable generation projects are being implemented on the grid at higher rates poses a greater risk to price settlements.

This can be magnified when the Zone is near or anticipating oversaturation, and thus impacts the value of VPPAs.

This current market reality reinforces that the value of a Texas VPPA is directly impacted by the transmission saturation level of the grid in the zone where the project is located. Coupled with aging infrastructure, higher concentrations of projects located in zones approaching oversaturation add price settlement volatility, which may negatively impact the value of the VPPA. An appropriate evaluation of potential price movements and forward hourly risk assessments is therefore imperative to assist in choosing to mitigate these risks as much as possible. This could be managed by contractual terms such as a price floor, cost caps, and sharing of upside/downside risk.

How To Evaluate Power Purchase Agreements

  1. Where is the financial settlement point for the contract for differences?
  2. Is there seller-friendly contractual language that could impact the contract settlement negatively for the buyer?
  3. Is exposure capped, and how is the cap managed – annually or contract-life?
  4. What is the contractual language around generation curtailments?

While there are a lot of terms that are industry-standard, a changing PPA environment driven by pressures from tax equity investors and other financial institutions to maintain project viability will see less buyer-friendly terms. It is important to carefully evaluate all contractual terms with internal and external counsel and market experts.

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