Power Purchase Agreements (PPA’s) have gained significant traction in the corporate energy purchasing market in recent years. In a recent FlexiDAO article, we highlighted PPA’s as a 2021 Energy Trend in Europe, following its rise in the last years. The reason is that this market is only beginning to show its true potential. There are avenues for rapid growth in the PPA market if barriers to contracting are removed and more innovative PPA products are created.
There have already been some innovations with PPA contracting structures and newer variants have come to market in the past couple of years. To help frame where the PPA market is now and what options are most common in the market, we created this guide to help your company navigate the Corporate PPA maze.
What is a Physical (or Sleeved) PPA?
A physical or sleeved PPA is a contract with a renewable energy generator for the delivery of electricity to a site via the power grid. The renewable energy developer and off-taker will agree a price for the lifetime of the PPA which would typically be a fixed €/MWh with some indexation every year.
A physical PPA will allow a third-party power supplier or marketer to sleeve the power volumes into a company's existing energy contract. Contracting with this method will mean a company will have to deal with variability of the renewable plants power production and how this matches their power consumption. This risk is typically transferred to a power marketer whose trading teams will be responsible for balancing the power volumes.
What is a Virtual (or Synthetic) PPA?
A virtual or synthetic PPA replicates the financial contract that is associated with a physical PPA but doesn’t involve the delivery of electricity. It’s essentially a “financial swap” contract that falls outside the scope of physical electricity delivery. The terms of the contract will usually be set up as a contract for difference.
The company will agree to a fixed price to pay for the electricity generated and then take a risk on the wholesale market outturn price. If the market price they receive for electricity is higher than their fixed price, they’ll have a net benefit on the contract. If it’s lower, then they will be loose out as they’re locked into a higher fixed power price.
Which type of PPA is best suited for my company?
The argument for which PPA to choose can be difficult as it can be hard to see the benefits and drawbacks of each option. The following table maps out the main considerations for both Physical and Virtual PPA agreements.
When we compare the differences between a Physical and Virtual PPA, we see that the two options are very similar. The cost savings, additionality and market image of both types will largely be the same. The differences between the two are hidden in the finer details.
Let’s look at the two main differences between the two and how it could impact a company’s decision on what route to take:
- Same Power Grid
When contracting a Physical PPA, the off-taker will need to be located in the same power grid as the renewable energy plant. Physical delivery of the electricity wouldn’t be possible otherwise.
Virtual PPA’s aren’t limited by this restriction and the renewable energy generator can be installed anywhere. This opens up the potential for cross-border PPA’s and gives a company more freedom to procure different types of renewable energy or even larger amounts.
However, the company may still want to have strong energy cost alignment with its local energy market. In this case, the renewable generator under a Virtual PPA would need to be located in the same grid as the off-taker or in a power market that is highly correlated with the off-takers home market. This will ensure an effective price hedge is made through the PPA.
Even though the off-taker and generator may be on different power grids, the production of cross-border Virtual PPAs can still be matched to local consumption using software tools. These tools allow companies to assess the energy matching effectiveness of the PPA and ultimately, its overall CO2 impact.
- Financial Derivative Accounting
The other main difference between a Physical and Virtual PPA is how they’re treated from an accounting perspective. With current accounting rules, companies based in the U.S. will use the U.S. GAAP accounting standards and those in Europe will use IFRS. For global companies, they may be required to report financials under both standards.
When it comes to PPA’s, the two accounting standards have different rules. One of the main differences is that Virtual PPA’s will potentially be viewed as a financial derivative under IFRS rules, but not under US GAAP. This is a significant issue as financial derivative accounting can impact a company's ongoing financial reporting.
In essence, the Virtual PPA will need to be re-valued using mark-to-market accounting every time the balance sheet is reported. This is a complex challenge as the PPA’s fair value will be based on forward energy prices. As the energy market is volatile – the PPA value on the balance sheet is also at risk of volatility - and any increases or decreases in value will need to be reported as profits or losses. A company will need to assess if it’s comfortable to take on this challenge before it chooses whether to pursue a Virtual PPA.
Accounting rules are subject to change and the goal is for more alignment between U.S. GAAP and IFRS so there is possibility for rule changes in the future.
Examples of PPA’s in Europe
For Physical PPA’s, a recent deal between Spanish supplier Iberdrola and Danone is likely to be an example. The deal isn’t stated as being physical or virtual but it's more likely that Iberdrola is both project developer and supplier in this case – and “sleeving power” to Danone’s facilities in Spain. The contract will result in Danone offtaking some power from what will be Europe's largest Solar PV plant.
On the Virtual PPA side, Novartis recently concluded a huge deal to offtake power from new solar plants in Spain. The contract is expected to “collectively add more than 275 MW of clean power to the grid”. This is an interesting example as Novartis will be subject to IFRS accounting standards and the PPA will likely be subject to derivative accounting. This suggests that corporates are willing to accept some level of financial reporting risk that comes with Virtual PPA’s.
In Europe, either Physical or Virtual PPAs will have largely the same impact from a carbon reduction perspective. The differences lie in the finer details and each corporate will need to decide which PPA to contract depending on their own circumstances. This will mean evaluating PPA options from a combination of economic, technical, and accounting perspectives. To keep up-to-date with the PPA market and other renewable energy topics, sign up to receive our monthly newsletter.