In this article you will learn how renewable energy developers (think solar and wind) determine the price of electricity under a Power Purchase Agreement or PPA.
We welcome comments on this article from both developers and consumers. To date Solomon has been unable to find any articles that answer the most basic question: How is my PPA price calculated? Indeed, the one paragraph the addresses the topic – a section in the Wikipedia article on Power Purchase Agreements — is inaccurate. Not only does it not answer the question but it confuses production with price and goes on to claim that the regulator sets the PPA price “in a regulated environment.” This is not the case.
A Power Purchase Agreement or PPA is entered into between a solar or wind developer and a purchaser or the renewable energy. The developer might be financing or leasing the project to the off-taker in which case the PPA is akin to a debt repayment or lease payment.Alternatively, the developer may be holding title to the project for the purpose of receiving any tax benefits or subsidies generated. In that case the PPA is simply a payment for the power produced during the term of the agreement.
The PPA specifies a number of terms and conditions. The most important of these are the following:
The price per kWh can be either fixed for the term or escalating.
Most agreements provide for an initial price for the first year – often 10% or more below the local utility tariff — with an annual escalator between 2-4%. By using an escalator the developer can start the price lower. However, consumers must beware: If the PPA escalator is greater than the rate at which utility prices increase over time, the PPA price could conceivably be greater than the utility tariff in a few years.
Recently, for example, we received two alternative bids from a developer for a 20-year term in the National Grid utility territory in upstate New York.
Discussions of PPA prices generally state that the price is “negotiated” by the developer and the off-taker. In fact off-takers can do little more than seek competitive prices. Ultimately they must be “price takers.”
So where does the PPA price come from? It is not arbitrary. Nor is it based on supply and demand in the electricity market. Rather, the PPA price is determined by the developer based on the developer’s desired return on capital.
Developers are like any other business: They seek a profit margin over and above their costs. In the case of retail goods such as cars or clothes, the profit margin is referred to as a markup. In the case of financial investments the margin is referred to as a return on capital.
Companies with money to invest (i.e., capital) will generally want to deploy their capital where it can earn the greatest return subject to the risk of repayment. Thus, if US Treasury bills paid 1% on deposits and a Greek bond paid 15% I would prefer to buy Greek bonds. But given that the Greek bond has a higher risk of default I might prefer to leave my funds in US Treasuries.
In the case of companies making investments in renewable energy, returns will be a function of the nature of projects available for finance and the risk of those projects. Large projects with low risks will generate the smallest but most secure returns. Small projects with high risks will generate the largest but least reliable returns.
The actual returns that are available to investors are a function of supply and demand. If there is a lot of money chasing a few potential borrowers interest rates will go down. By contrast, if borrowers need funds but there are few lenders, interest rates can be expected to go up.
Two years ago developers of solar and wind were in limited supply. With utility rates in some states soaring, borrowers such as municipalities and large commercial building owners with strong credits were eager to finance renewable energy projects. As a result, developers were able to lock up returns on their capital investments of 12-14% or more.
Recently there has been dramatic growth in the number of companies wishing to invest in renewables like solar and wind energy. This growth has meant that companies wishing to finance their projects have had more alternatives. With supply growing and demand steady the yields have fallen steadily. Today, solar and wind developers consider themselves fortunate if they can lock in returns of 8-10% on their investments.
In pricing a deal and setting a PPA price, developers will generally seek the highest return possible. But ultimately they
Preparing a Forward Projection Model
Once the capital costs of a project are known (see, e.g., How Much Does Solar Energy Cost), the developer will construct a forward projection model that shows the anticipated solar or wind production over the term of the PPA. This production will reflect
The developer will also project other
The developer will also project expenses associated with maintenance, insurance, replacement of inverters and any other costs anticipated over the lifetime of the project.
Finally, the developer will insert the initial capital outlay as well as any termination value that can be expected from the sale of panels or equipment at the end of the contract life (e.g., if the off-taker buys the project or if the panels or wind generators are sold for scrap). Tax credits, depreciation allowance and other subsidies will be calculated based on these capital costs and will be included as revenue.
Where Does the PPA Price Come From?
The forward projections will be plotted so that the developer can determine what its return on investment will be for any given PPA price per kWh.
The PPA price – which can be fixed or escalating as noted above – will now be inserted based on the developer’s desired return on capital. The model will show the revenue that will be derived – in additional to all other benefits such as tax credits – from the product of the price times the solar or wind production. After deducting for expenses the model will show the return on capital for any given PPA price.
Comparing the PPA Price to the Utility Avoided Cost
The developer may now compare the PPA price that generates the desirable return to the local utility price (plus an assumed escalator for the term of the PPA). Suppose, for example, the developer hopes for a 12% return on capital. Now suppose the forward projection model yields a price of $.11/kWh. But the local utility price is now $.105/kWh.
A consumer might have a problem agreeing to this deal unless (i) the consumer were convinced that utility prices would escalate quickly and begin to show savings or (ii) the consumer were highly motivated to secure environmental benefits of solar or wind despite the additional cost.
Accordingly, in this case our developer may wish to lower its return on capital in order to make its PPA price more attractive.
A consumer should always seek competitive bids for a renewable energy project. The reason should be clear from this analysis: One developer might seek a high return on capital of, say, 12% while another might be willing to build the project for a lower return of, say, 8%.
A competitive process ensures that a consumer will get the benefit of market forces that keep the developers return on capital – and thus its PPA price – in line with market expectations.