Direct PPAs: Connecting with corporates
For onshore wind farm developers and solar PV developers in the UK, 2015 and 2016 have proved to be key years in their evolution. The UK Government has clearly come to the conclusion that onshore wind and solar PV projects in the UK are now advanced enough to stand on their own without the need (or justification) for a green subsidy. For energy from waste (EfW) plants, there continues to be a move away from local authority backed supply contracts to a merchant structure which relies upon waste supply and power offtake from corporates.
There are issues that arise regarding hurdles in the planning permission process, but the focus of this article is whether the development of an onshore wind farm, solar park or EfW/biomass facility can be commercially viable without a green subsidy by using a direct power purchase agreement (PPA) with a non-utility company offtaker who is willing to pay a higher price than the wholesale market price. We note that direct PPAs have already been used alongside green subsidies which further enhances their benefits.
The concept of direct PPAs has been in existence for many years but, in practice, their use has been relatively limited, primarily due to the availability of utility PPAs and the need for an investment grade utility offtaker in order to make a PPA "bankable" for the purposes of project financing. However, at a time when there is a material delta between the wholesale price for electricity that a generator will receive and the retail price for electricity that a large consumer can expect to pay, there is an incentive for generators and consumers alike to be creative and devise bilateral solutions in order to cut out the middle man and arbitrage the difference.
Bankability of direct PPAs
From a bankability perspective, the identity and creditworthiness of the offtaker will be a key consideration. As a general rule, funders do not like to be exposed to corporate credit risk for longer than three to five years. Funders have accepted long-term credit risk on utilities companies on project finance transactions to date, but taking the equivalent risk on a corporate whose business has nothing to do with electricity (other than a need to consume) is a very different proposition. It will be a challenge for funders to accept this risk without a form of credit support and funders are likely to review this on a case-by-case basis in the context of each transaction as a whole. If funders cannot accept the credit risk on the offtaker, they may disregard the price of power under the direct PPA and assume the price of power is based on the System Sell Price or another indexed price. This is unlikely to be attractive to sponsors as any upside under the direct PPA will only be taken into account in the equity financial model and not in the funders' base case.
Different types of direct PPAs
There are three main types of direct PPA, as follows:
- a contract for difference;
- a sleeving PPA; and
- a direct wire PPA.
We analyse each of these further below.
Contract for difference
A contract for difference (not to be confused with the specific contract for difference used by the Government to incentivise renewable energy development) is the simplest form of direct PPA. Under this form of contract, the generator and an offtaker enter into a contract for difference under which they both agree a market index price and an agreed strike price. If the market index price is above the strike price, the generator will have received a higher price than it was expecting to receive and conversely the offtaker will have had to pay a higher price than it was expecting to pay. Therefore, in this scenario, the generator will pay to the offtaker the difference between the strike price and market index price.
In the reverse scenario, where the market index price is below the strike price, the generator will have received a lower price than it was expecting to receive and, conversely, the offtaker will have had to pay a lower price than it was expecting to pay. The offtaker will therefore pay to the generator the difference between the strike price and market index price.
Under a contract for difference, there is no physical flow of electricity between the generator and the offtaker and therefore the contract for difference is closer to a financial instrument than a contract for the physical supply of power along direct wires.
This type of contract for difference has not been used as much as we would have expected given its simplicity and apparent effectiveness to fix power prices for both generators and offtakers. It is not entirely clear as to why this is the case. It may be due to the accounting treatment of the contract for difference. Although detailed consideration of the accounting treatment is beyond the scope of this article, we surmise that parties may be concerned that the contract for difference may have to be accounted for on a mark-to-market basis which would be very volatile for the profit and loss accounts of the relevant company. Parties would instead want to ensure that the arrangement is accounted for as a hedging instrument so that they achieve a fair value calculation.
Sleeving PPA
A sleeving PPA can be a bipartite or a tripartite agreement entered into between a generator and an offtaker and (in a tripartite situation) a licensed supplier. If the licensed supplier is not a party to the sleeving PPA itself, the sleeving PPA will have many references to the licensed supplier and the offtaker will need to enter into a separate agreement with the licensed supplier to pass on certain obligations under the sleeving PPA and ultimately to arrange for the physical export of power from the generating station to the grid and the delivery of power to the offtaker's premises.
Under a sleeving PPA, the generator agrees to sell its entire output of power (and potentially Renewables Obligation Certificates as well) to the offtaker for a price to be agreed between them. This may be a fixed price or an index-linked price (perhaps with a floor price), although a fixed price is more common. This is because the sleeving PPA is primarily used as a way for generators and non-utility offtakers to enter into long-term PPAs where the supply is not strictly coming from a third party licensed supplier and therefore the price can be determined bilaterally between the generator and the offtaker.
The offtaker is likely to be a corporate which is not a licensed supplier. Further, the generator is unlikely to be a licensed supplier. Therefore, the offtaker requires a contractual relationship with a licensed supplier so that the licensed supplier can take physical delivery of the power and act as the party responsible for the interface with the industry agreements such as the Distribution Connection Use of System Agreement. Only a licensed supplier is entitled to purchase power which is exported on to a local distribution network and it is the meter belonging to the licensed supplier which will be registered against the power exported by the generator. Furthermore, the licensed supplier and the offtaker will need to enter into a separate agreement under which the licensed supplier will physically supply the metered output from the sleeving PPA to the premises of the offtaker.
The licensed supplier will charge a fee to the offtaker for acting in its capacity as intermediary, but the sale and purchase of the power is still between the generator and the offtaker. The arrangements with the licensed supplier may also include payments to the generator for embedded benefits. Embedded benefits are any benefits that may now or in the future be realisable by any licensed supplier under industry agreements in the form of avoided transmission losses, transmission charges (including Triad benefits), distribution losses or distribution charges as a result of the generating facility being connected to a distribution system and not being connected to a transmission system, but excluding Generator Distribution Use of System Charges which will still need to be paid by the generator.
Direct wire PPA
A direct wire PPA requires proximity of the generating facility to the offtaker's premises so that a direct wire can be laid between the two premises. The advantage of this arrangement is that the contractual relationship for the sale and purchase of power can be bilateral between the generator and the offtaker. There is no need for a licensed supplier to be involved (in contrast to a sleeving PPA arrangement) and there is no need to connect to a distribution or transmission grid network, although, as discussed below, some form of grid connection is likely. Furthermore, there may be no need for the generator to hold a supply licence and this creates significant savings. We note that under a sleeving PPA arrangement, the generator also doesn't hold a licence, but, as discussed above, a charge is payable to a licensed supplier intermediary.
Under the Electricity Act 1989, it is an offence to generate, transmit, distribute or supply electricity without a licence or an exemption from the requirement to hold a licence. The requirement to hold a supply licence carries various financial and administrative burdens, including the requirement to become a party to numerous industry codes, such as the Balancing and Settlement Code. In this context it is relevant to consider, in particular, the financial implications of being a licensed electricity supplier.
Licensed electricity suppliers are subject to the financial costs of complying with the Renewables Obligation, as well as their proportionate share (determined by market share) of costs arising under the small-scale Feed-in Tariff scheme, Contracts for Difference, the Capacity Market and various other miscellaneous schemes. These costs are passed down to the customers of those licensed electricity suppliers (other than certain energy-intensive industry customers, who benefit from some exemptions from those costs). It is these additional costs which contribute to the material delta between wholesale and retail electricity prices. Therefore, being able to benefit from an exemption from the requirement to hold a supply licence offers a benefit to the supplier and its customers.
The Electricity (Class Exemptions from the Requirement for a Licence) Order 2001 sets out certain so-called class exemptions from the need to hold a supply, generation or distribution licence (as the case may be). Schedule 4 of the Order sets out the criteria that must be met by a supplier to benefit from an exemption under the Order. While a detailed discussion of all the criteria is outside of the scope of this article, the two main situations, relevant in this context, where an exemption may apply are as follows:
- a "class A" exemption, for small suppliers: this is where the person (other than a licensed supplier) is exempt from obtaining a supply licence if the person supplies electricity generated by themselves and does not at any time supply more than 5 MW in total and of which no more than 2.5 MW is supplied to domestic customers;
- a "class C" exemption, for on-site supply: this is where the electricity generated is used by only one customer, or group of customers on the same site as the electricity is generated, or the electricity is supplied to one or more off-site customers through a private wire arrangement.
While the Order is notoriously complex and unclear in its drafting (and in fact the Association for Decentralised Energy has recently renewed its efforts to push for reform in this area) it is always worth checking if the project satisfies its requirements as doing so can realise significant savings. See figure 1 for a diagrammatical overview of the supply licence exemptions offered by the Order.
Direct wire PPAs – a more detailed analysis
The fact that direct wire PPAs create a physical interface between a generator's plant and the offtaker's plant, gives rise to a number of considerations which are exclusive to direct wire PPAs and are not applicable to utility PPAs, CfDs or sleeving PPAs.
The need for a grid connection
In all likelihood either the generator or the offtaker or both parties will require a physical connection to a distribution or transmission grid network. The reasons for this are:
- the intermittent nature of supply from a wind farm or solar PV park will not match the baseload demand of the offtaker;
- even with a baseload generator such as a biomass or EfW plant, it is almost inevitable that the offtaker will need a power supply at a time when the generating plant is offline or that its power consumption needs do not match the output of the generating plant and therefore requires an additional power supply;
- the generator will require certainty that it can sell its power at a time when the offtaker does not require power for whatever reason.
It may be that the offtaker will construct or may already have a direct connection to the local distribution network (LDN) so that it can import power from the grid and purchase its surplus requirements from a licensed supplier via the grid at times when the generation facility is either not generating or is not generating a sufficient volume of electricity to meet the offtaker's demand. If this is the case, the generator will require that the offtaker's connection to the LDN is two-way so that the offtaker can import from and export on to the LDN. Therefore, if ever the generation facility is generating more than the volume required to meet the offtaker's demand, this surplus can be exported on to the LDN.
For the purposes of this article we will call this the "Offtaker Grid Connection Option".
Alternatively, it may be that the generator has its own grid connection. If this is the case, the offtaker will require a "firm" power supply from the generator. This means that the generator is required to supply all of the offtaker's power needs at all times regardless of whether the generator's plant is generating (subject only to grid outages). The generator will therefore require access to an alternative form of back-up supply. For the purposes of this article we will call this the "Generator Grid Connection Option".
Finally, it may be that both the generator and the offtaker have their own grid connection. In this situation, the generator will be obliged to supply all of its power to the offtaker in the first instance and will only be permitted to export any surplus on to the grid. Similarly, the offtaker will be required to offtake all the power generated by the generator in the first instance and will only be entitled to import power over and above that supplied by the generator. In our experience, this third option is most unlikely, because the cost of constructing two grid connections usually outweighs the benefits.
For the purposes of this article, we will explore further some of the issues surrounding the Offtaker Grid Connection Option and the Generator Grid Connection Option.
Treatment of surplus electricity
With respect to the Offtaker Grid Connection Option, the parties will need to agree the price payable for any power that is exported on to the LDN and whether this is paid for at the contract price or at the System Sell Price (or another index price). Clearly, from a generator's perspective, it will be argued that the contract price should be payable, in particular if the generator has assumed that the offtaker will always require the output from the generation facility. It may be that the generator will require a separate PPA with a licensed supplier who will offtake the surplus power not required by the direct wire offtaker. This requirement arises where the generator is not a licensed supplier or is not a party to the maximum 5mw (including 2.5mw to domestic customers) Balancing and Settlement Code. In this case, it is likely that the licensed supplier who purchases the surplus power at the grid connection point will only be willing to pay a discounted System Sell Price for this surplus power because it has no control or visibility over the timing and volume of this power. This type of offtake arrangement is often referred to as a "spill PPA".
With respect to the Generator Grid Connection Option, the parties will need to agree the price payable for any power that is delivered to the offtaker but which is not generated by the generator. The generator will need to enter into a power purchase and supply agreement with a licensed supplier pursuant to which this licensed supplier will agree to: (i) purchase any power generated but not consumed by the offtaker; and (ii) supply any power required by the generator or the offtaker. In our experience, it is likely that the generator and the offtaker will agree a pass through of costs from this power purchase and supply agreement so that the offtaker reimburses the generator for the cost of any power supplied to the offtaker from the licensed supplier.
The generator will need to consider if it requires any credit support from the offtaker: firstly, in general, but more particularly in respect of the generator's exposure to the licensed supplier for power ultimately consumed by the offtaker.
Figure 1: The Electricity (Class Exemptions from the Requirement for a Licence) Order 2001
Loss of offtaker
A key point to consider and mitigate against in order to make a direct wire PPA bankable is what happens in the event that the offtaker becomes insolvent or no longer requires the power. This is of particular concern under the Offtaker Grid Connection Option because the generator is connected to the offtaker's plant and may not have its own connection agreement with the local distribution network operator (DNO). It is for this reason that the generator is likely to require that the offtaker's plant is connected to the LDN for both import and export so that if the offtaker becomes insolvent or otherwise ceases to operate its facility, the generator has a means to export and sell its power. However, in this scenario, the generator would not have a direct connection agreement with the DNO.
The direct wire PPA may represent the generator's only contractual right to connect to the LDN. The direct wire PPA therefore must include a provision whereby the offtaker expressly grants the generator the right to be (and remain) connected to the relevant substation and for such connection point to remain energised for the term of the direct wire PPA.
The generator needs to be aware that where the connection granted by the DNO to the offtaker under the offtaker's connection agreement is de-energised, the generator will (through no fault of its own) lose its ability to export to the LDN. Such de-energisation may have occurred due to scheduled maintenance of the connection by the DNO, or another reason for which the offtaker is not responsible. In such a scenario, the generator is in no worse position than it would have been had it been the lead connecting party, with a direct contractual relationship with the DNO.
However, such de-energisation (or ultimately termination by the DNO) may arise as a result of a breach of the connection agreement by the offtaker. Therefore, the generator will wish to ensure that it has adequate protection/recourse against the offtaker under the direct wire PPA in the event it cannot export to the LDN due to the offtaker's breach of the connection agreement.
What form this protection takes is a point for commercial negotiation. The optimum position for the generator would be for it to have an uncapped indemnity protection for any losses it suffers as a result of the offtaker's breach of the connection agreement. Conversely, the offtaker may view such protection as draconian given the commercial benefits of the connection arrangement for the generator and the magnitude of the liability that could arise under such an indemnity. The offtaker may, therefore, consider damages at law or some form of capped liquidated damages regime to be more appropriate. The offtaker will also look for reciprocal protection against breaches or actions by the generator which cause a de-energisation or termination of the connection.
Another way in which the generator can mitigate its risk against offtaker insolvency is to procure land rights with respect to the route of the direct wire all the way to the substation and the connection to the LDN. This needs to be considered at an early stage of planning so the route can ideally be a standalone route and not rely too heavily on access to the offtaker's physical premises. Land rights bind the land and not the individual and therefore survive the offtaker's insolvency and will bind any insolvency official appointed.
In relation to the Generator Grid Connection Option, the offtaker will need to protect itself against breaches or de-energisation caused by the generator. The points made above will apply in reverse in relation to the Generator Grid Connection Option.
Further, under the Generator Grid Connection Option, if the offtaker becomes insolvent or ceases to require the power, the generator will have access to the grid to export its power, but the price it receives for its power might be lower than that paid by the direct wire offtaker. It is for this reason that funders might discount or even disregard the price of power to be paid for by the offtaker and instead assume a lower price of power in their financial model, perhaps based on wholesale power price forward curves.
DNO statutory duties
If the offtaker becomes insolvent under the Offtaker Grid Connection Option, it does not necessarily follow that the DNO will grant the generator a direct connection through the existing substation (notwithstanding that the generator may have secured relevant contractual protections with regard to access rights/ownership of the substation in the event of insolvency of the offtaker). This is because the DNO has a statutory duty to allocate unused grid capacity in an equitable manner. It may be that the insolvency of the offtaker means that the DNO can restructure connection arrangements to better suit the demands of that particular area. Technical advice can be sought through engagement with the DNO as to the materiality of this risk for the project in question (from the DNO itself, or a suitable technical consultant employed on the project).
Ideally, the generator and offtaker would procure a direct agreement with the DNO to enable the generator to step in and take over the offtaker's grid connection. However, in our experience, DNO's are reluctant to enter into direct agreements.
The ultimate protection for the generator in these circumstances is the DNO's statutory obligation to provide a connection to any user who applies for one (subject to certain circumstances set out in the Electricity Act 1989). If this connection is not the original connection which was the subject of the direct wire PPA, the generator should be offered a new connection by the DNO, albeit potentially through a different route and at a cost (particularly if new infrastructure is required). The time that such a new connection would take to be constructed and energised will also need to be taken into account.
| PRIVATE WIRE CASE STUDIES |
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Queen Elizabeth II Floating Solar PV ProjectThe Queen Elizabeth II Floating Solar PV Project (QEII) is a floating solar array project located on the Queen Elizabeth II Reservoir, London, with a total PV capacity of 6.33 MWp (Megawatts peak). QEII has been commissioned by Thames Water as part of its bid to self-generate one-third of its energy by 2020. The project developer is Lightsource Renewable Energy, which received financial backing from the Royal Bank of Scotland (senior) and AP capital (mezzanine). QEII is the first floating solar project to secure bank financing. The total cost of project is c.£6.5 million. The project will be connected directly to the Thames Water private network via a submerged cable. Thames Water will off-take all the energy generated by the system and use it to power nearby water treatment plants. Shotwick Solar ParkShotwick Solar Park (SSP) received full accreditation from Ofgem in March 2016. SSP has been built on the Deeside Industrial Estate in North Wales and has a total PV capacity of c72 MWp. It is the UK’s largest solar park with a private wire connection for commercial use. The Shotton paper mill in Deeside, owned by UPM, a Finnish forest industry company, has entered into a 25 year direct wire power purchase agreement with the project company under which UPM will purchase its energy directly from the project. While UPM is the principal offtaker, any surplus energy will be sold on to the grid to a licensed supplier. Crookedstone Solar FarmCrookedstone Solar Farm (CSF) is located in Antrim, Northern Island, and is connected directly to the private network of the nearby Belfast International Airport (BIA). CSF has a total PV capacity of 4.83 MWp and provides BIA with 27 per cent of its annual power demand. The project was fully funded (costing c.£5 million) and installed by Lightsource Renewable Energy. Going forward, Lightsource will also operate and manage the project. BIA has entered into a 25-year power purchase agreement and in the first six months of operation, CSF produced 2.79 million Kilowatt hours (kWh). BIA used 1.88 million kWh, leaving a balance of almost 910,000 kWh, which was exported to the Northern Ireland electricity grid. CSF is the first large-scale solar park in Northern Island, covers 14 hectares (35 acres) of land and consists of 18,630 solar panels. Lightsource won the Energy and Environment Innovation Prize at the Sustainable Ireland Awards in Belfast for its work on CSF. The above case studies are based on publicly available information |
Therefore, insolvency of the offtaker is not without risk to the generator and ultimately, sponsors and lenders alike will need to be comfortable with the creditworthiness of the offtaker or with the back-up plan in the case of the insolvency of the offtaker.
Physical interface
Given the physical interface between the generator's facility and the offtaker's facility, the parties will need to agree who is responsible for the operation and maintenance of the private wire itself and where the "delivery point" is. Furthermore, both parties should take out market standard insurance, with obligations to provide evidence of such policies to the other. This will give the parties comfort that the other has relevant insurance protection in place, particularly with regard to physical damage. It may be that the parties agree that a "knock-for-knock" style insurance arrangement is most efficient so that each party is responsible for its own property and personnel regardless of how the damage is caused (subject to carve-outs for wilful default or recklessness).
Conclusion
In our view, direct PPAs are likely to become more prominent in the market and could be a key feature of subsidy-free wind, solar, biomass and EfW projects. Sponsors and funders will need to consider the risks associated with direct PPAs and it will not be a "one size fits all" solution.
From a corporate offtaker's perspective, locking in a long-term fixed or indexed price power supply at a discount to market price is likely to be attractive. This is further enhanced where that power supply is from a renewable source which enhances an offtaker's green credentials, which is increasingly important from a corporate and social responsibility perspective.
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