Economic characteristics of power purchase agreements

Abstract

Renewable energy forms an increasing share of global electricity production. Renewable production holds near-zero marginal costs, making its production decisions mostly exogenous, controlled by weather. The high capital intensity of projects makes output prices crucial from the viewpoint of the project developers, operators, and financiers.

Power purchase agreements – PPAs – were born to fix long-term prices for a part of production of renewable energy projects, partly to calm financiers’ worries about price risk. In terms of financial economics, a PPA can be described as a forward contract with continuous delivery. This continuousness is reflected in a skewness in time-risk profile compared to a traditional forward or futures-contract.

Since corporate PPAs are of fixed delivery volume, during low production weather producers must purchase a possible production deficit from the general electricity market. These purchases, which are called spread covering, will systemically increase within specified electricity market areas. The effect yields from the correlation of production across renewable electricity producers.

From the perspective of the spot-market – the general electricity market – the result is likely an increased price volatility. The volatility is higher the closer to each electricity market hour new information on spread covering is revealed to the general market. This effect arises from an increasing rigidity of price elasticity of demand when moving time-wise closer to consumption, since industrial processes etc. have less time to adjust their use.

A PPA is not an optimal way of handling uncertainty, neither for renewable energy producers, for the technical functioning of the general electricity market, nor for common utility. This is due to three main factors: (1) Increased general market volatility caused by spread covering; (2) Faulty incentive structure between the parties; (3) Inefficiencies and moral hazards caused by incomplete or asymmetric information on production risk.

A recommended solution to avoid the increasing risks of PPAs – and renewable electricity – would be to make drastic changes to the electricity markets. A recommendable way would be to approach the issue through Wolak’s (2022) standardized fixed price forward contract, and to introduce a transparent, comprehensive electricity derivatives market. This would allow for global risk allocation solution to a problem arising from cointegrated weather in markets with limited geography.