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Viewpoint: Non-utility offtake deals need new risk modelling

UNITED STATES: Offtake agreements with non-utility buyers are the new engine driving the US wind power market.

They accounted for more than 3GW of the new installed capacity in the US last year and are expected to continue growing.

In deregulated energy markets, such as ERCOT in Texas and PJM in the east of the US, they may well become the norm rather than the exception.

This is already the case in Texas, where nearly all new offtake contracts are either hedges with financial institutions or contracts-for-difference with commercial and industrial (C&I) companies.

These non-utility power purchase agreements (PPAs) are undoubtedly more complex than traditional long-term utility PPAs.

This complexity brings opportunity for reward, but only for those with a comprehensive ability to understand and consider all the various possible scenarios and the associated technical and pricing risks.

Traditional utility PPAs pay out at a fixed rate, and often the basis risk - the price differential between the point of connection to the electricity supply grid and the financial settlement point - rests with the utility.

Conversely, hedges and C&I contract-for-difference deals often shift this basis risk back to the wind-farm owner, adding a variation in payment based on time of delivery that will affect the wind-farm revenue.

Hedges also often carry volumetric risk, which requires the wind-farm owner to pay the hedge provider if they do not meet their energy production quotas, and C&I deals tend to have heftier penalties for failing to reach minimum availability levels.

These non-utility PPA deals generally have shorter terms, which means the project will have a "merchant tail" — the period beyond the project's contracted power sales — and the uncertainty that comes with this, given that future energy prices remain extremely difficult to predict, especially on ten-year or longer timescales.

With a traditional fixed energy price, the relationship between a high or low wind year and revenue is simple: more wind equals more revenue, regardless of when the wind blows.

However, with non-utility offtake agreements, even though there is some security in the pricing, the timing of power production matters, particularly in downside scenarios.

Additionally, local wind-penetration levels on the grid are more important and a source of basis risk, such that if wind is blowing across the region, congestion will drive prices at the node below the prices at the hub.

Conversely, in low wind years like 2015, basis and curtailment risk might be reduced, but projects with hedge deals are more likely to be missing minimum production levels and end up paying out.

Multiple influencers

In a non-utility offtake agreement, to accurately calculate projected revenue, it is crucial to capture the time-varying uncertainties in both production and energy prices, and the interdependence of the two.

This poses a challenge for data analytics and market foresight and necessitates a reimagining of the current industry-standard risk models.

The old, simple models may suffice for estimating base-case project revenue, but failing to consider the time-variance of basis risk and payments against a hedge, how the wind farm will operate in a low wind year, or how electricity prices depend on wind penetration, could substantially throw off revenue calculations in downside scenarios.

In other words, we cannot operate under the assumption that a 1-in-100 production year equates to a 1-in-100 revenue year.

Hedges and C&I deals have been a key driver for recent wind-power expansion in the US and will only grow in importance. However, the increased complexity in these non-utility offtake structures requires advanced risk-modelling capabilities.

Underestimating the downside risks can hurt returns for owners, investors, or even hedge providers, while taking a conservative modelling approach could leave money on the table.

To date, growth in hedge and C&I offtake contracts has outstripped the increase in analytic capacity to understand the deals. As most of these contracts are relatively young, it remains to be seen who will ultimately prosper.

As is usually the case with fundamental market shifts, there will be both winners and losers.

Carl Ostridge is global validations engineer, energy assessment at DNV GL Energy (US)

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