The role of Power Purchase Agreements in New Zealand
There is considerable new interest in the development of renewable electricity generation in New Zealand, including solar, wind and geothermal generation. There is also renewed interest in demand response and the use of battery storage to manage the variable nature of increasing levels of solar and wind generation.
Many of these renewable generators do not have their own retail customers. In the first instance, they will receive the wholesale market spot price for the generation they produce. Given the volatility of spot prices, these generators will often sell forward contracts to improve income certainty in order to secure project funding.
A form of forward contracting that is getting increasing mention is a power purchase agreement (PPA). We are interested in these arrangements because, like the sale of New Zealand energy certificates (NZ-ECs), they can support new investment in renewable generation. For this reason, we intend to publish a series of news items that discuss the use of PPAs and NZ-ECs. These publications will explain the ways that each mechanism supports renewable generation development, a comparison of the benefits of each, and how the two approaches should not be viewed as competitive, but rather as complementary to obtain the optimal benefit for generators and purchasers alike.
We would like to kick this discussion off by first describing in more detail what a PPA is and how it differs from other forms of forward contracting.
Defining a PPA in the New Zealand context
Generally, the term PPA refers to an agreement (a form of forward contract) between a power producer (generator) and a purchaser (an electricity retailer or consumer).
The PPA defines the terms of the forward contract, such as the volume to be settled, negotiated prices, and the settlement process. Since PPA arrangements are typically bespoke they are usually agreed via bilateral negotiation. A PPA is different from other forms of forward contracting in that the key terms of a PPA benefit the power producer, whereas for other forms of forward contracting these same terms typically benefit the purchaser.
Before describing these differences in detail, it is useful to first understand some key features of the New Zealand wholesale electricity market as these influence the definition of a PPA in the New Zealand context.
In New Zealand, the majority of electricity generated (there are exceptions, such as small-scale solar installed on residential rooftops) must in the first instance be sold in the wholesale market (to the clearing manager) and cannot be sold directly to an electricity retailer or consumer. This is why our wholesale market is often referred to as a gross pool.
This means that a PPA in New Zealand typically does not involve the sale of physical electricity but is a financial agreement to make settlements based on the difference between an agreed price and the associated spot price. These types of agreements are often referred to as a Contract for Difference (or CfD), in which the seller pays the purchaser when spot prices are higher than the agreed price, and vice versa, when spot prices are below the agreed price. These spot price and PPA settlements can be combined to mimic the financial outcome that would have occurred had the sale of physical electricity been possible. This is why PPAs in New Zealand are often referred to as “virtual” PPAs.
What then is the difference between a virtual PPA and other forms of forward contracting?
With a financial forward contract that is not a PPA, the following typically applies:
The term of the agreement is typically short, ranging from one to three years.
The volume of the agreement (to various degrees) matches the electricity consumption profile of the purchaser. The volume may be fixed or allowed to flex to match the actual consumption of the purchaser. The price in the contract tends to increase as the match to the purchaser’s consumption profile increases.
The settlement of prices are referenced to a location close to where the purchaser consumes electricity. The New Zealand wholesale electricity market is nodal, so spot prices are published at many locations throughout New Zealand, and supply and demand influences spot prices at these locations.
Apart from a force majeure event, settlement occurs irrespective of the generation output of the power producer.
A PPA has terms that are more beneficial to the power producer, as follows:
The term of the agreement tends to be longer.
The volume of the agreement (to various degrees) matches the electricity production profile of the power producer. The volume may be fixed or allowed to flex to match the actual production of the power producer.
The settlement of prices are referenced to a location close to where the power producer generates electricity.
In addition to force majeure events, settlement under the agreement may cease for a broader range of reasons that impact generation, such as unexpected plant failure or planned maintenance.
Overall, a purchaser can choose to support renewable generation by forward contracting with that generator and can add more value to this support by choosing the PPA option. The trade-off for the purchaser is that given the “hedging” characteristics of a PPA are not as strong as other forms of forward contracting, it should consider how it will manage spot price risk when the settlements under the PPA do not align well with its electricity consumption profile.
A good way to summarise is with a definition of a PPA: A power purchase agreement (or PPA) is an agreement where a power producer forward contracts with a purchaser, the term of the agreement tends to be longer than with other forms of forward contracting, and the volume and settlement location under the agreement matches (to various degrees) the output of the power producer. As New Zealand operates a gross pool market, the form of the agreement is typically a contract for difference, enabling the PPA settlement combined with spot price settlement to mimic the direct sale of electricity from the power producer to the purchaser.
In future news items, we will discuss how consumers can combine the benefits of forward contracting (including PPAs) with generators coupled with the sale of NZ-ECs to maximise their support for renewable generation and enable credible claims for doing so.