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07 December 2020

Physical and Virtual PPAs – Key Differences and Risks

Previously, we explored the concept of a corporate PPA, and how they can help companies directly source for renewable power and provide clear additionality to supporting renewable investment. Next, we explore the two main structure of PPAs in more detail, specifically the physical PPA and virtual PPA.

Physical PPAs are Relatively Straightforward but Have Physical Limitations

In physical PPAs (also known as sleeve PPAs), there is a physical connection between the renewable generator and the corporate buyer. This arrangement is only possible in a liberalized electricity market.

The renewable generator sells the power to a utility or grid operator, who “sleeves” power to a corporate buyer. The utility also manages the intermittent nature of the renewable generation and supplies additional power as needed to meet the company’s requirements.

There are different ways the contract can be set up. There could be one PPA (PPA 1) signed between the generator and utility and an equivalent PPA (PPA 2) signed between the corporate buyer and utility (example below). The terms in PPA 1 and 2 are identical, except PPA 2 also includes a sleeving arrangement and fee for the utility to manage the intermittency and top up any additional power required by the corporate buyer.

Figure 1: Example Physical PPA Arrangement

Another structure may include a direct PPA between the corporate buyer and renewable generator, along with a secondary PPA between the corporate buyer and utility.

Financial PPAs are Complex but Provide more Flexibility as No Physical Connection is Required

In financial PPAs (also known as virtual PPAs) no power is physically traded. The corporate buyer continues to buy electricity from its electricity supplier, while the renewable generator sells the power to the whole sale market.

The renewable generator enters into a derivative contract with the corporate buyer, whereby a strike price and market index are agreed. When wholesale electricity price in the market index is less than the strike price, the corporate buyer pays the renewable generator. Conversely, when the whole sale electricity prices are greater than the strike price, the renewable generator pays the corporate buyer. The contract acts as a hedge for both parties, guaranteeing a price for the buyer and seller.

Figure 2: Example Financial PPA Arrangement

Figure 3: Sample Payoff in Virtual PPA

The benefits of a financial PPA is that it does not require a physical connection, and by doing this one renewable generation site can meet the requirements of many assets spread across a region/country. This structure can also be used in assets where a sleeving arrangement or private wire is not possible due to commercial reasons, such as leased spaces.

With financial PPAs companies must consider the potential accounting implications. Under International Financial Reporting Standards (IFRS), a financial PPA may be considered as a derivative and require mark-to-market accounting. This means companies will have to report the change in value of the contract as a profit/loss each reporting period. PPAs normally span long periods (10-20 years), and because energy markets fluctuate this could lead big swings in the company’s reported earnings. While the swings are only on paper, senior management will likely be concerned about the volatility this has on reported earnings. Depending on the situation, the contract/project can be structured to avoid this.

In general, financial PPAs are relatively common in the US, while physical PPAs are common in Europe. However, financial PPAs have been graining traction in Europe over the recent past.

Figure 4: Physical vs. Financial PPAs

With corporate PPAs, corporates must be aware of the potential risks involved. There are a wide range of risks which must be understood to create a win-win situation for the generator and corporate buyer. Certain common risks are highlighted below:

Price risk – Risk associated to movements in wholesale prices. For example, the buyer could make substantial losses if the wholesale prices remain below the PPA strike price for a prolonged period.

Profile risk – Risk arising from hourly deviations of actual electricity production from the scheduled production due to unexpected weather conditions.

Volume risk – Risk associated to the variability of electricity production over a longer time-period such as a year. This can be due to a particularly rainy summer reducing solar output for a certain year.

Corporate PPAs are slowly but surely becoming a more popular method of procuring renewable energy due to its flexibility and ability to pinpoint clear additionality. Key considerations have been highlighted in this article but contract terms and the exact PPA structure will have to be considered based on the project’s unique context and risk tolerance of the corporate buyer.

Longevity Partners is a multi-disciplinary energy and sustainability consultancy which can support you in this field. We support businesses in their energy transition and have over 10 years of experience in renewable power feasibility studies and installations. We can help you develop your net zero strategy and source, negotiate, and evaluate corporate PPAs options with renewable power generators. For more information on our energy practice, please contact Anthony Maguire at [email protected].