Can CPPAs rescue the European electricity market?

Abstract

Corporate Power Purchase Agreements (CPPAs) are integral to the EU's electricity market reform strategy, offering long-term contracts between power producers and corporate consumers. CPPAs mitigate market and volume risks, stabilize prices, and support renewable energy financing, though their complexity and need for high credit ratings limit their widespread adoption.

Corporate Power Purchase Agreements (CPPAs) are a core component of the EU Commission strategy for the electricity market reform. While seemingly simple, these contracts are however quite complex and have far-reaching consequences for power producers, purchasers and the electricity market on a broader scale.

Understanding CPPAs

A power purchase agreement is “a bilateral contract between a power generator and a buyer, whereby the buyer agrees to purchase a defined amount of power from the generator from a specified source” (source).

A historical perspective

Power Purchase Agreements (PPAs) are a historical fixture of most energy systems. They are a bridge between fully centralised systems in which a public monopoly organises the full value chain from generation to distribution and a fully merchant system in which roles are separated along the value chain and where competition is free at the production and wholesale/retail levels. PPAs are typically State-backed commitments to purchase the production of a new power plant that is built by an independent power producer in a country that does have a liberalised power market. They provide investors with a form of certainty over the value of the energy produced and the quantities required. From this historical start, PPAs have been generalised to other use cases. One of them is to provide a hedge against market risk for significant projects.

A new breed of PPAs has however progressively emerged as market liberalisation was generalised. Important power consumers such as aluminium plants and factories started to realise that they were now exposed to price fluctuations on wholesale markets and that they needed a form of protection against price increases. Wholesale markets can provide financial instruments to that effect, such as futures but the liquidity and depth of the market remains limited for long-term horizons. 

Another important development was the wish by some consumers to ensure that their power was coming from renewable sources exclusively in a desire to reduce their environmental footprint. As market sourcing relies on the availability of supply options at a reasonable price at any given time, it is nearly impossible to guarantee a 100% renewable sourcing if these producers have already sold their production.

Corporate PPAs as an answer to the limits of wholesale markets

In Europe, one of the first Corporate PPA to emerge was Exeltium in France through which industrial customers collectively purchased nuclear production from EDF at a set price. These contracts have since then significantly evolved. 

Basically, a CPPA is a contract through which a commercial entity directly purchases power from a producer, generated at a specific plant or park. It circumvents the wholesale market and the volume, timing and price of deliveries are directly negotiated between the parties. There is a wide variety of formats for these contracts as they gain in sophistication over time but the central idea remains the same. In a physical PPA, the corporate client purchases the power from the generator and makes fixed payments. In exchange, the producer provides the client with guarantees of origin and sends the power to the energy supplier of the client. The customers then draws power from its energy supplier. The supplier serves as a go-between for physical delivery of the purchased power because it can provide positive or negative adjustment capacities should the producer deliver insufficient or excessive quantities. The customer would then pay the supplier for the cost differential resulting from these adjustments.

As these contracts are complicated and expensive to negotiate and setup, their tenor tends to be rather long, typically from 5 to 20 years. The tenor will be influenced by the industry of the purchaser as it reflects the duration of the business cycle. A CPPA for a data center will have a shorter tenor than for an aluminium plant (source).

The market for these contract is expected to range between 10% and 30% of renewable production in the EU by 2030 (source).

Understanding the underlying risk allocation

On the face of it, the mechanism of a PPA is rather straightforward. Things get complicated when the exact risk allocation is discussed. A standard CPPA covers two standard risks, market (price) risk and volume risk. 

Pricing power is a risky business

By agreeing to purchase a set amount of power over a pre-determined period for a fixed price, corporate consumers are covering themselves against upward volatility in power market prices. This has value for businesses that rely heavily on electricity for their production processes and whose margins can be adversely affected. CPPAs provide them with forward-looking certainty. At the other end of the deal, producers benefit from the same certainty for the price at which they will sell their production, increasing their ability to raise debt financing (a higher leverage translates into a higher return on equity) and reducing the cost of that debt since lenders will require lower risk premiums. 

It is however easy to see that significant deviations between market prices and the contractual price of the CPPA will put the agreement under pressure. Should market prices increase, the producer will incur a significant opportunity cost - i.e. the difference between the contractual price and the price it would have sold to on the markets. In extreme cases, it might even be more profitable to break the deal and pay penalties to sell on the market. The other way around, should market prices fall too low, then the corporate clients will be in a difficult situation where they are stuck with power prices that are structurally higher than those of their competitors, again putting the relation under strain. 

This divergence risk increases with time and in a context of global geopolitical and climate uncertainty, it presents a significant impediment against the longest tenors for CPPAs. 

Volume risk is a messy business

Volume risk describes the potential situation in which either the producer cannot deliver the contracted amount of energy or the consumer does not offtake it. In the producer’s case, especially if it is an intermittent renewable energy producer, this risk has a strong probability of occurrence. Weather variations in the short-run and climate change in the long run can affect the actual amount of energy that is produced. Even though renewables often have a priority of injection, network congestions can lead to curtailments. As this is a recurring issue, CPPAs often anticipate this and have built-in clauses allowing for market sourcing of the missing energy. 

On the other side, producers are exposed to the risk that corporate consumers no longer need the contracted energy. As these are private customers, their industrial needs may evolve over time and the power may no longer be required. This is often covered by take-or-pay clauses in the contracts but the customer may also choose to re-sell the energy on wholesale markets. 

The worst possible outcome for volume risk for producers is if the counterparty to the CPPA defaults and/or goes into bankruptcy. In this event, the producer should in emergency sell its production on wholesale markets and become fully exposed to both price and volume risks. This is a strong limitation to the development of CPPAs as the producers – and the banks providing the financing for their balance sheet – will require that clients have high credit ratings. Indeed CPPAs are often used as a form of guarantee for bank loans and in some instances are used to raise the initial financing to build the producing asset (source).

The fact that the client must have an investment grade credit rating strongly reduces the pool of potential customers and limits the expansion of the CPPA market, even though these contracts are an integral part of the European energy strategy. They can help secure financing for renewable assets and are contemplated for nuclear power plants.