Renewable PPAs Are the Opposite of Risky Business
Over the past few years, local governments have transitioned from making commitments to renewable energy to taking bold actions—and off-site, wholesale power purchase agreements (PPAs) have made this possible. Today, nearly 200 US cities and counties and eight states have committed to 100 percent clean energy, covering approximately one in three Americans. Off-site PPAs—both virtual and physical—have been the primary procurement method used to advance these goals, representing over 90% of the 12.8 gigawatts (GW) that local governments procured between 2015 and 2020.
The widespread adoption of off-site PPAs is, at least in part, due to a variety of key benefits. Foremost of these is that off-site PPAs enable buyers to purchase far more electricity than can be produced by relying on on-site resources. Moreover, off-site PPAs allow cities to enable new renewable projects to be built without incurring large upfront expenditures and, in some cases, provide immediate and long-term cost savings.
Despite benefits such as these, many local governments today are still reluctant to sign off-site PPAs because they are perceived as novel, long-term contracts with considerable financial risk. But this perspective is both incomplete and inaccurate. To be sure, these contracts do involve some risks, and local governments should seek to understand these risks and the available solutions to mitigate them (see RMI’s new report A Local Government’s Guide to Off-Site Renewable PPA Risk Mitigation for more information).
However, in focusing exclusively on the new risks imposed by off-site PPAs, many local governments overlook the financial risks they are already exposed to. They may also fail to see how integrating PPAs into their energy procurement strategy might create a more robust approach.
Below we explore why business-as-usual electricity purchasing is inherently risky and how off-site PPAs can provide more certainty and reduce risk when paired with well-established and emerging strategies.
Business-as-Usual Electricity Purchasing Is Inherently Risky
Most large electricity consumers, including local governments, traditionally purchase electricity through wholesale market contracts or at a retail rate determined by their utility and state regulators. Both of these strategies can have financial risks that can impact local government budgets.
Local governments purchasing wholesale power typically do so to access lower prices and save money. However, as the recent extended electricity spike in Texas illustrates, relying on wholesale market purchases can result in significant short-term price fluctuations and financial risks. And while local governments can use financial contracts to protect themselves from these short-term spikes, these financial hedges can increase costs and are typically short-term contracts. This leaves cities exposed to the risk of long-term, systemic increases in electricity prices.
Local governments purchasing at a retail rate are similarly exposed to long-term price increases that might result from a variety of systemic changes. These risks are currently not top-of-mind for many US consumers. The United States has enjoyed relatively stable electricity prices over the past few decades, with commercial prices generally increasing about 2 percent per year since 2000 (roughly in line with inflation). Electricity prices could conceivably increase due to a variety of political, economic, or other forces over the coming years, though.
On the political front, an introduction of a carbon tax, cap and trade, or restrictions on fracking could all drive up the cost of fossil fuel generation. Alternatively, an accelerated adoption of electric vehicles could significantly boost demand for electricity, which could similarly increase prices. In addition, force majeure events—such as hurricanes, extreme cold, or wildfires—could knock out key pieces of grid infrastructure. This could lead to temporary or long-term price increases for utility customers, which was illustrated dramatically, and tragically, during the recent cold snap and blackouts in Texas.
The above possibilities are not predictions but rather examples of potential systemic risks that could increase electricity prices in the United States over the coming years. Local governments that continue to purchase electricity in their business-as-usual manner at prevailing prices are essentially putting all their eggs in one basket and betting that electricity prices will not rise.
Off-site PPAs Can Reduce Energy Purchasing Risks
PPAs offer an alternative electricity procurement to local governments, as well as other types of organizations, by allowing them to lock in their energy prices and hedge their bets to some degree. Since PPAs usually last for 10–20 years, a city with a PPA is more or less insulated from future electricity price increases depending on how much of their consumption the PPA serves.
The City of Houston’s physical PPA with NRG Energy is a great example of how PPAs can not only protect city budgets from future electricity price increases but also reduce costs immediately. The contract with NRG allows Houston to purchase solar energy for five years, with two one-year renewal options, and the deal is projected to save the city over $9 million per year.
While off-site PPAs reduce a city’s energy spend volatility, there are still some risks and potential downsides that should be understood—and fortunately there are a variety of available strategies for mitigating these risks and downsides.
The most prominent risk is price risk, or the potential for electricity prices to stay low or decline, resulting in the PPA buyer paying more for electricity than it would have otherwise. To mitigate this risk, local governments may decide to sign the PPA for only a portion of their annual electricity load or, in the case of virtual PPAs, put price floors into their contracts to limit the potential downside.
There are also more nuanced off-site PPA risks such as basis, shape, non-energy market, operational, and volume risk (all of which are discussed in detail in A Local Government‘s Guide to Off-Site Renewable PPA Risk Mitigation). However, developers, large corporate buyers, and specialized firms have developed risk mitigation mechanisms for these types of risks, many of which have become standard industry practices.
Consider, for example, operational risk. This is the potential for a wind or solar plant’s performance to be reduced due to mechanical failures, operator negligence, or external events. Industry standard contractual solutions mitigate this risk through production guarantees in physical PPAs (i.e., requirements for when and how much generation will be produced) and proxy-generation in virtual PPAs (i.e., where revenues are based upon weather-based renewable energy generation models as opposed to actual production).
For example, imagine that a city had a virtual PPA with a wind farm in Texas that experienced a mechanical failure during the recent cold snap. (Note: wind turbine failures were “the least important factor” in the Texas blackouts according to an ERCOT spokesperson.) If the city had a proxy generation-based virtual PPA, it would have continued to receive high revenues based on hourly market prices and wind speed-based generation estimates. Meanwhile, if the city had a virtual PPA based on actual generation, it would have missed out on these high market prices and the associated revenues.
Companies are also offering more emerging and innovative risk mitigation options. One such example is a settlement guarantee agreement (SGA). This is a financial transaction added on top of an existing virtual PPA that locks in the value of future variable virtual PPA settlements based on current market conditions. This type of agreement mitigates price risk (as well as shape and volume risk) by transferring the variable future value of virtual PPA settlements to an insurer in exchange for a fixed dollar amount.
For example, consider a city that signs a virtual PPA that an insurer estimates will provide the city with $100,000 per year in revenue over the next five years. However, this future revenue is uncertain; the city’s actual revenues could end up being significantly less if energy prices decline over the next few years. To secure some of the anticipated financial gains, the city could sign a 5-year SGA with the insurer to receive a guaranteed annual payment of $80,000 in exchange for the virtual PPA’s actual settlement amounts.
There Are Resources to Guide Local Governments
Off-site PPAs offer an incredibly powerful and useful tool for local governments to purchase unprecedented amounts of renewable energy and create a more robust energy strategy with less volatility. In addition, a city’s switch to renewable energy can produce a variety of other community benefits, such as cost savings, workforce development, and improved air quality.
Certainly, that does not mean that these contracts come without risks. Local government buyers should study the potential risks and pitfalls, evaluate their options carefully, and judiciously determine which PPAs and risk mitigation strategies are worth pursuing. At the same time, these buyers should not be intimidated by PPAs because they appear new or complex. These contracts are well-proven structures that corporations, utilities, universities, and others, including local governments, have all utilized in their efforts to become more sustainable.
If your local government is interested in utilizing off-site PPAs to accelerate the clean energy transition and receive the associated benefits, we recommend checking out our new report, A Local Government‘s Guide to Off-Site Renewable PPA Risk Mitigation, and the variety of useful resources, case studies, models, and other tools available from the American Cities Climate Challenge Renewables Accelerator.