PPA Market: "It’s a bit of a gamble"

Power purchase agreements (PPAs) – electricity supply contracts between electricity producers and consumers – saw a surge in popularity during the energy crisis due to a spike in electricity prices. Now that prices are back to normal, the German PPA market has cooled a little. But PPAs continue to be an attractive supply model for companies, in particular.

What challenges do PPAs create for a power supply across different locations?

For one thing, PPAs require a lot of organizational effort, in other words: high transaction costs. So for PPAs to be financially feasible, the project needs to be a certain size. Another challenge is the counterparty risk, where buyers walk away because they can’t afford to pay.

This can cause serious problems for companies that are struggling financially. The question is whether they are offered PPAs at all and if so, at what terms? Here’s an example: SAP is the kind of company that we all think will still be around in ten or twenty years; it’ll be able to pay after it’s signed the contract. But for a German steel producer, where you’re wondering how long it’ll be able to keep producing steel with these rising electricity prices – that’s different.

Transaction costs are high in part because of the investigation of the buyer, as it involves many parties conducting due diligence on the buyer.

You mentioned that the project size can be a challenge. What does that mean?

It pertains to the transaction costs, which include due diligence, and all the lawyers it takes to write a PPA. We’re not talking about a two-page document here – they are usually over 100 pages long. And that amount of work has to pay off somehow. As far as I know, initiatives to standardize agreements, especially international ones, haven’t got very far. And as to why location matters: If the company has locations in several countries, things get even more complicated.

How could PPAs and contracts for difference (CFDs) complement each other in the electricity market without negatively affecting each other?

To me, contracts for difference seem like a step backwards, because the government assumes part of the risk. This is not necessary at the moment, because there is sufficient demand for PPAs. Should the market situation change, or should development be accelerated by other means, I doubt that contracts for difference would be the right instrument. It would be better to cut red tape rather than provide government subsidies. Reducing bureaucracy would be more helpful for project development and approvals.

When I talk about PPAs, I’m primarily referring to corporate PPAs, which means industrial end customers. One sensible way to use CFDs would be a two-step approach: the producer gets a CFD, ceding some of the risk to the government, and then signs a PPA with the end customer. It’s important to mix risks at the different levels.

From the government’s perspective, I’d like to see as many PPAs as possible. Note that PPAs are actually quite versatile. The term stands for power purchase agreement, which in its usual application implies that it is a long-term contract – but electricity purchased on the spot market could technically also constitute a PPA. PPAs have a certain standard structure, but other components could be added. It doesn’t always have to be a fixed price, it could also be tied to the market price. PPAs are a very flexible form of contract.

What are current challenges the PPA is market facing in Germany and across Europe?

In the past, Germany’s subsidies and feed-in tariffs were too lucrative. I’m also critical of the frequent regulatory changes, such as the imposing of limits on electricity prices and windfall taxes based on average values from the energy exchange rather than the actual PPAs. If I wanted to conclude a new ten-year contract, where in the first phase the electricity price is very high, I would expect it to decrease eventually. Actually, I offer the customer a relatively low electricity price. But to start with, I still have to pay the windfall tax, because the electricity price on the energy exchange is too high.

Subsidies such as the transition electricity tariff (“Brückenstrompreis”) have also made PPAs much less attractive. If the system is constantly changing and there are no consistent framework conditions, industrial companies won’t be interested in setting a fixed price because there might be subsidies in the future. Constant governmental interference, no consistent framework conditions... Circumstances like this discourage investors.

How do companies decide whether to enter into a PPA?

There are several ways to go about decarbonizing. Buying certificates would be the first thing. This is also something that can be used to improve a company’s image. In theory, green PPAs can also help decarbonize, and they are much easier to explain to end customers. One reason not to sign a PPA, especially if it is the first time, is the sheer size of the contract, which energy purchasers have rarely studied in detail.

The war in Ukraine and the energy crisis caused electricity prices to skyrocket, which brought this topic to the attention of companies. Fluctuating prices on the energy exchange along with governmental interference make signing a PPA risky, since the company may not benefit from lower electricity prices in the future. Dealing with this issue and deciding which components should be included in your energy mix to minimize risk is a bit of a gamble. For example, in the USA, entire industries, such as tech or telecommunications, have signed PPAs. The risk is lower when most competitors have also entered a contract.

How can the financial risks of PPAs, such as buyer insolvency, be minimized?

For example, France has introduced a fund. A company who signs a PPA pays into this fund and is entitled to receive compensation from it if the contracting party becomes insolvent and can’t pay for the PPA, and the market price has fallen below the agreed PPA price. The French government is promoting this concept. You could argue that this is a standard case for insurance – if the product is solvent enough, it should also be insurable.