Power Purchase Agreement Workshop

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PGREG April 2012

Raluca Dirjan

Power Purchase Agreement Regulatory and Commercial Key Issues

Agenda

ì  Outcome

ì  How is electricity different than other commodi5es?

ì  Market Structure � Evolu5on and Impact

ì  Regulatory concerns

ì  Contractual issues

ì  Q&A

Outcome

ì  Understand the basic concepts of electricity and the electricity industry chain

ì  Appreciate the role of the PPA in the electricity market

ì Map the main regulatory concerns

ì  Familiarise with the key provisions of a PPA

Why a PPA workshop?

ì  Ques5on to YOU

Why a PPA workshop?

ì  WB: the only thing that kept the lights on in CEE, Russia and Central Assia has been the recession

ì  Massive rounds of investments are needed to replace the exis5ng capaci5es that had been mostly built before the 1980s

ì  In addi5on: substan5al RES-‐E capaci5es are expected to crop up across the region by 2020 and beyond to keep up with the EU policies on climate change and security of supply

ì  Prac5oners can face LTSC issues in at least 3 different constella5ons: ì  legacy of the pre-‐liberalisa5on era ì  the new PPAs as an effect of the first step of liberalisa5on – opening up the

genera5on for compe55on – the IPP, BOTs and the award of the PPA on a long-‐term basis

ì  new built projects (typically project financed -‐ off balance sheet): where the wholesalers / suppliers / large industrial consumers would enter into long-‐term PPA with the generator, and this would secure a revenue stream to service to debt for financing the project

How is electricity different than other commodities ? (1)

ì  Truth no 1: electricity cannot be stored – all electricity needs to be generated when is needed – when demand varies over the course of a day, genera5on needs to vary exactly at the same 5me

ì  Truth no 2: electricity takes the path of least resistance – it is virtually impossible to command electricity to take a certain path, the thicker the cable the more electricity will want to flow through that cable and not through a skinny cable – final consumers simply get whatever electricity happens to be flowing by their appliances at the 5me they switch on the lights

ì  Truth no 3: electricity travels at the speed of light – each second output has be to precisely matched to demand – if not, frequency falls and bad things happen, including blackouts

How is electricity different than other commodities ? (2)

ì  Electricity as opposed to almost any other commodity (gas is the closest it can get) needs at all 5mes coordina5on: day-‐ahead, intra-‐day and in real 5me

ì  No maaer how liberalised is a market the SO has to be in charge at all 5mes – telling the plants when to run, when to increase or decrease output and when to stop

ì  SO has to make sure that: ì  Load is met at all 5mes ì  Relieve conges5ons on the transmission system ì  Call for reserves and use them when necessary

Electricity Industry Chain in a Liberalised Market

ì  5/6 main ac5vi5es: ì  ProducCon or GeneraCon ì  Transmission = high voltage level transport ì  DistribuCon = low voltage level transport ì  Supply = selling electricity to the final consumer ì  Trading = selling and buying electricity on the wholesale market ì  Metering – part of the supply or distribu5on ac5vity in some

jurisdic5ons (mostly all CEE), or on its own in others (Nord Pool markets and UK). In a perfectly reliable market metering should be separate from supply / distribu5on

Electricity Contractual Chain (1)

Generator

Wholesaler Spot market

Retailer

Consumer

PPA Spot sale

Spot purchase

Wholesale contract

Merchant Power Plant

Consumer tariffs (ini5ally) now Retail Contracts


ì  PPA ì  sale of electricity from a single generator to a wholesale company

(can be another generator or trader or even end-‐consumer typically non-‐household)

ì  Wholesaler buyer purchases the G output (kWh) ì  Wholesaler may buy the output of many generators under many

different PPAs (certainty this is the case with RES-‐E – very many generators at small capaci5es)

ì  Wholesale Market ì  Electricity from the wholesalers is sold/purchased either OTC or on

the spot markets/power exchanges ì  These trades allow wholesalers to balance their porholio on the

short term – since electricity cannot be stored


ì  Wholesale Contracts ì  Wholeseller sells to another one or to another retailer via a

wholesale contract ì  Ability to call on the spot markets allows the wholesale to offer to

the retailers firm sales for a defined quan5ty at a fixed priced ì  Deriva5ve contracts on electricity ì  Compe55on at this level of the market tends to encourage

innova5on in the terms offered to the retailers

ì  Retail Contracts (iniCally Tariffs) ì  Electricity is sold to final consumers

Market Structure � Evolution and Impact (1)

ì  Prior to liberalisa5on start-‐up (mid 1990s in con5nental Europe and mid 1980s UK) – ver5cally integrated companies carried out all the 5/6 businesses (listed on slide 8) typically serving certain regions

ì  Transport – as the only natural monopoly remained regulated

ì  GeneraCon, wholesale trading, retail supply – progressively opened to compeCCon

ì  Liberalisa5on in UK was driven by the poli5cal belief of the then Thatcher cabinet (inspired by the America model) that liberalisa5on and priva5sa5on are inherently a superior market model

ì  Liberalisa5on in Europe was driven by the Commission compe55on policies and the belief in the European single market model

Market Structure � Evolution and Impact (2) Liberalisation Start-‐up 1990

ì  First Electricity Direc5ve 96/92/EC – introduced a separa5on between the regulated part of the market (networks) and the compeCCve part of the market (G, T and S) ì  Removed legal monopolies – allowed large consumers to choose

their supplier (“eligibility” concept) ì  TPA – obliged ver5cally integrated companies to negoCate TPA to

their transmission and distribu5on networks ì  Unbundling (accoun5ng & management) – minimum level of

separa5on of the network business from the genera5on and supply business of the ver5cally integrated companies

ì  Gradual market opening è significant differences between MSs regarding the level of their market opening

Market Structure � Evolution and Impact (3) PPAs in the context of Liberalisation Start-‐up 1990

ì  Despite their vital role for the liberalisa5on LTSC are almost absent in electricity & gas secondary legisla5on at that 5me

ì  COM started to look into LTSC in mid – late 1990s to limit their dura5on – not hamper on opening the markets to compe55on

ì  Some precedents: rule of thumb – 15 years (eg: Electricidade de Portugal/Pego; Isab Energy/Enel; Rosen)

ì  BUT no methodologies had been displayed for the analysis of the foreclosure effects

ì  Market players already anCcipated since late 1990s that a 15 year dura5on will probably not be acceptable anymore

Market Structure � Evolution and Impact (4) 2nd Wave of Liberalisation

ì  2nd Electricity Direc5ve (2003/54/EC) and Cross Border Electricity Trading Regula5on (1228/2003) ì  aimed at full market opening (all consumers,

including house-‐hold) ì  regulated (as opposed to nego5ated) TPA ì  mandatory set up on NRAs ì  legal unbundling (not only accoun5ng &

management)

Market Structure � Evolution and Impact (5) PPA in the context of 2nd Wave of Liberalisation

ì  2004 onwards relevant cases on LTSC generally concerned long-‐term reservaCon rights on cross-‐border interconnectors signed before liberalisa5on

ì  some MSs introduced effec5ve measures leading to compe55on: ì  UK – state owned generator split into compe55ve companies and

Virtual Power Plants, ie: capacity release programmes ì  Italy – market share caps for the incumbents

ì  BUT the issue of LTSC was sCll not addressed

Market Structure � Evolution and Impact (6) Sector Inquiry 2007

ì  The SI was launched in 2005 and responded to concerns of the consumers and new entrants in the sector

ì  The final report iden5fied serious shortcomings affec5ng trading: ì  Concentra5on and market power ì  Ver5cal foreclosure ì  Lack of market integra5on ì  Lack of transparency è informa5on asymmetry and distrust in

the pricing mechanism ì  S5ll regulated prices/tariffs for the end consumers

Market Structure � Evolution and Impact (7) PPAs in the context of the Sector Inquiry 2007

ì  SI looked at PPAs – longer than 3 years and / or that are tacitly renewed è ver5cal foreclosure between genera5on and retail generally reduces the incen5ves to trade on the wholesale markets è as it affects: ì  Price forma5on on the spot market ì  Liquity (the lack of) – illiquid wholesale markets = barrier to entry & high price vola5lity ì  LTSC between par5es with opposite market posi5ons in the same MS tend to reduce the amount of open long and short

posi5ons needed to be closed on the wholesale market trading ì  LTSC export / import – add or reduce the amount of electricity that is available for trading in a given MS:

ì  LTSC imports may mi5gate the effects of the domes5c market foreclosure ì  LTSC exports may aggravate such affects

ì  SI – Remedies ì  Generally: Full and combined use of the Commission’s powers, in close co-‐opera5on with the NRAs

ì  An5trust Rules (Ar5cle 101, 102 and 106 TFEU) ì  Merger (Regula5on 139/2004) ì  State Aid (Ar5cles 107 and 108 TFEU)

ì  For PPAs: SI confirmed the ver5cal tying of markets by LTSC as a priority for review of case situa5ons under compe55on law and for providing guidance where required ì  When LTSC concluded by dominant companies foreclose the market è potenCal infringement of the AnCtrust Rules unless there are

“countervailing efficiencies benefiCng consumers” – in the analysis of the LTSC sunk investments made by the parCes are considered – Commission Guidelines on the applicaCon of ArCcle 81(3) [now arCcle 101 (3) TFEU]

Market Structure � Evolution and Impact (8) Relevant Case Law following the SI

ì  Lessons learnt ì  There is no EU legisla5on, guidelines, etc to ban outright LTSC ì  the COM will deal with LTSC only if they may substan5ally affect trade

between MS -‐ for the rest of the cases it is up to the na5onal authori5es to get involved

ì  as long as the market share of the companies involved does not exceed 15% they are considered de minimis and do not fall under the jurisdic5on of the COM, unless the agreement contains “black-‐listed” restrains

ì  “Black-‐listed” clauses – considered illegal in several decisions ì  Unclear termina5on rights ì  Fidelity rebates ì  Tacit renewal

ì  If the market share of at least one of the contracCng parCes exceeds 30% -‐ COM conducts a full-‐blown compe55on analysis of the an5-‐compe55ve effects of the LTSC to decide whether it infringes EC compe55on law


ì  Full-‐blown analysis – elements considered: ì  Market characteris5cs – level of ver5cal integra5on

ì  First element to be assessed ì  Looks at poten5al entry in supply and demand, and dominance

ì  Dura5on ì  is s5ll an enduring ques5on for energy policies in liberalised markets ì  but acceptance by the COM will mainly depend on the compe55on posi5on of the counterparty ì  the COM is suspicious of contracts longer than 5 years and considers that efficiencies generally do

not offset foreclosure effects beyond this limit ì  The COM also takes a more strict approach for the producer/trader contracts (rather than for the

fuel supply contracts, ie: mostly gas supply agreements) ì  Volumes ì  Exclusivity clause – par5cularly an issue when the customer/buyer represents a big part of the

total demand ì  Take-‐or-‐Pay (ToP) – one of main reasons why LTSC dry out the spot market; w/o the flexibility

mechanism of a ToP clause buyer will have to go on the spot markets to sell the surplus / buy the missing quan55es – but ToP and flexibility mechanisms are not banned per se


ì  Once a PPA/PPAs porholio is considered likely to create significant an5-‐compe55ve effects è analyse the poten5al efficiency gains and run a balancing exercise

ì  In theory for long-‐term PPAs to be cleared by the COM they should: ì  SubstanCally improve economic efficiency

ì  Already recognised by the COM: investment and entry considered to have contributed to the success of the liberalisa5on

ì  Give a fair share of benefits to the final consumers ì  if the long-‐term contract secures a lower price for the buyer which is then reflected in

lowers bills for the consumers ì  Indispensable or at least proporConal to the achievement of the efficiency gains

ì  Can only be judged on a case by case basis, but favourable precedent a price formula benefited the generator – explicitly considered by the COM an efficiency to benefit from an exemp5on under Ar5cle 101 (3)

ì  Na5onal compe55on authori5es are s5ll struggling with this criteria ì  Not afford the parCes the possibility to eliminate compeCCon in respect of a

substan5al part of the products in ques5on ì  Public service obligaCon

Market Structure � Evolution and Impact (11) Remedies

ì  If efficiency gains do not seem to clearly offset an5-‐compe55ve effects LT PPA can s5ll be accepted provided sa5sfactory remedies can be imposed or nego5ated

ì  Typical compe55on remedies: ì  Amending the PPA: dele5ng exclusivity, limi5ng the dura5on, reducing

the volume (100% to 70%) ì  Forbidding any ver5cal M&As to a dominant company for a certain

number of years ì  Note: security of supply argument in today’s world is likely to be

accepted only for gas supply agreements and to a lesser extent for PPAs

ì  Energy specific remedies: ì  Virtual Power Plants (VPPs), ie capacity release: forced dominant firms to

make capacity op5ons available for a pre-‐determined 5me horizon (Synergen case)

Market Structure � Evolution and Impact (12) Distrigaz & EDF – reliable precedents but not enough

Cases Distrigaz 2007 EDF 2009

Max duraCon 5 years 5 years

% of sales to come back on the market every year (ie: annual VPP)

70% 65%

Contract Clause No des5na5on clause No des5na5on clause

DuraCon of commitments 4 years for Distrigaz under 40% market share

10 years for EDF under 40% of the market share

Monitoring of Commitments Annual report Annual report & Independent Auditor

Others Effec5ve right to contract with alterna5ve supplier

Effec5ve right to contract with alterna5ve supplier

Commitments may be reopened if material changes in the na6onal law or the market context

Market Structure � Evolution and Impact (13) Certain uncertainties

ì  Mul5ple-‐step approach to analyse long-‐term PPAs has emerged ater the 2007 SI but no holisCc approach dedicated to PPAs yet

ì  Strong emphasis on investment but no robust methodology to ar5culate short and long-‐term efficiency criteria

ì  Balancing between an5-‐compe55ve effects and efficiencies remains largely at the discreCon of the COM

ì  Lack of predictability – ul5mate effect detrimental to crea5on of the Internal Energy Market, investment in new capaci5es, and on the prices to end-‐consumers

3rd Electricity Directive What’s new for PPAs

ì  Substan5ally increased powers of the Na5onal Regulatory Authori5es (NRAs): ì  Issue binding decisions on electricity undertakings ì  Carry out inves5ga5ons into the func5oning of the electricity markets ì  Decide and impose any necessary and proporConate measures to promote effecCve

compeCCon and ensure the proper funcConing of the market ì  Cooperate with the na5onal compe55on authori5es and the Commission in

conduc5ng an inves5ga5on rela5ng to compe55on law ì  Impose effecCve, proporConate and dissuasive penalCes on the electricity

undertakings that don’t comply with their obligaCons under the DirecCve or with any legally binding decision of the NRAs itself or of the ACER or to propose that a competent court imposes such penal5es

ì  Create appropriate and efficient mechanisms for regula5on, control and transparency to avoid any abuse of dominant posi5on, in par5cular to the detriment of consumers

ì  but the NRAs are bound to respect the contractual freedom regarding long-‐term contracts provided they are compaCble with EU law and consistent with EU policies

What is the role of a PPA in a liberalised market ?

ì  Contract for the sale of Energy and Availability from a generator to a wholesaler, retailer or directly to the end consumer

ì  Tradi5onally a PPA recognizes that the valuable service provided by a power plant is availability, not the actual produc5on of energy

ì  But in a reliable wholesale liberalised market it is OK for the G to be paid only for the actual running 5me – G takes over some of the market risk as well

ì  In today’s energy markets both the price risk and the volume risk have become freely nego5able clauses – it all boils down to the specific features of each market ì  The more func5onal and reliable the wholesale market is the less risks the

buyer has to take over – buyers in liberalised market gained more bargaining power – the net effect should be that the end-‐consumers will be happier as the prices should go down or at least not go higher than they could have been should the market not have been liberalised

Key Contractual Issues (1) Outline

ì  Contract Charge (Pricing)

ì  Dispatching

ì  Volume

ì  Underperformance

ì  Take of Pay (ToP)

ì  Exchange Rate (currency risk)

ì  Opera5on

Key Contractual Issues (2) Contract Charge – Energy Charge

ì  Pricing principle = pass through costs legi5mately incurred and pay the G an appropriate profit for the service ì  Energy charge – designed to pay for variable costs (eg: fuel price) ì  Capacity (or availability charge) – designed to pay for the fixed costs of the power

plant

ì  Energy charge = € / kWh = price paid per unit of incremental output ì  Price Formula = breakdown based on the costs of the fuel and the efficiency rate (ie:

rate of conversa5on of a thermal unit into electricity) ì  VC = AE/ TE ì  VC = variable costs, ie: fuel, other variable costs ì  AE = Actual Efficiency (expressed in kWh) ì  TE = Targeted Efficiency

ì  Just a single price per kWh – different prices at different stages of opera5on (eg: start-‐up price, different levels of output price, seasonal price) ì  Implies a certain efficiency level

ì  Can include a penalty element – if the G fail to generate as instructed by the dispatcher to encourage to keep the market balanced

Key Contractual Issues (3) Contract Charge – Availability Charge

ì  Capacity/ Availability Charge – 2 main roles ì  Provide extra revenue to the G to cover the capital and other fixed costs which are not covered by the

energy price per kWh ì  Provide incen5ves for the G to be available at 5mes when the system needs genera5on capacity ì  Availability is measured in MWh, ie: a MW of availability for an hour

ì  Steps to nego5ate availability payments: ì  Step 1: agree on a Target Level of Availability (T) in terms of MW level and number of hours per year, Ty

= Target per year and Th = Target per hour in a year ì  Step 2: Fixed Annual Payment (F) – to be paid if the G achieves the target level of availability, but it

should cover the fixed costs for one year + normal rate of profit ì  Step 3: Availability Bonuses and PenalAes above or below the target level (Ah) – meant to keep the G

under a con5nuous pressure to ensure that the capacity is maintained and available, but the buyer should not pay more than the capacity is worth to the system

ì  How much is the capacity of a G worth to the system? = the value of the G’s output to the system – price paid for the G’s output under the PPA ì  The value of the G’s output to the system in any hour = the cost incurred by the whole system if the

generator decreases its output ì  the G’s lack of output will be replaced by output from another G – if this output is more expensive the

value if called System Marginal Cost

Key Contractual Issues (4) Dispatching

ì  Energy charge is a key determinant of the paaern of dispatching – ideally generators should run in merit order, ie: only the generators with the lowest variable costs should be genera5ng to meet demand = golden rule of dispatching in a liberalised market

ì  If the energy price is above the variable costs of the power plant the incen5ve for efficient dispatching is lost

ì  Naturally a G wants to run at all 5mes regardless of the costs of the other generators on the system and even if the power plant displaces other cheaper generators

ì  BUT to keep the prices for the end consumer lower the dispatcher (SO/MO) needs to dispatch according to the merit order, ie: star5ng with the cheapest capacity for any given hour and going upwards 5ll it meets the demand

ì  So for efficient dispatching the dispatcher needs to know the actual variable cost of genera5on – Energy Charge in a PPA needs to be set as close as possible to the actual cost of the fuel burnt for genera5ng 1 KWh + some allowance for O & M

Key Contractual Issues (5) Volume

ì  Either all produc5on of a plant or specified calcula5on of volume

ì  BUT a minimum volume under a long-‐term PPA is established by a provision guaranteeing ì  a minimum number of running hours (most PPAs link the volume provision to

availability rather than actual running – but the laaer is equally possible), and ì  that number will be paid for – even if the plant is called on for a shorter 5me

ì  Obtaining a guarantee of availability from the plant builder would insulate the G – but in prac5ce it is unlikely for a full guarantee to be given due to the insurance premium the builder itself would have to pay

ì  Aaen5on must be paid for those jurisdic5ons where full unbundling of the generator and the dispatcher has not been done yet ì  Why? In 5mes of low demand the dispatcher is faced with the choice

between running the output of the G and switching off his own plant

Key Contractual Issues (6) Underperformance

ì  Technically each power plant is built to provide a certain capacity, but if it is not able to produce that capacity the PPA will have to deal with the alloca5on of underperformance

ì  if Volume clause says “all output” the buyer is taking the full risk of underperformance

ì  in reality the buyer is unlikely to take 100% of the risk under all circumstances, especially not all technical failure risks: the plant is unavailable because the turbine does not work – the buyer will want some degree of recourse to the manufacturer

ì  if there is a cap on the liability of the manufacturer – since the buyer is not a party to that contract and if it agrees to take over 100% of the underperformance risk-‐ seller should expect a lower rate of profit under the Fixed Annual Payment

Key Contractual Issues (7) ToP

ì  the buyer agrees to purchase over specified period a minimum volume of the output at an agreed price, and it is expected to pay for it regardless of taking it or not (but usually only if the G had available capacity to deliver and was willing to do so)

ì  Typically a 100% ToP is jus5fiable only when there is no wholesale market (spot or OTC) where the G can sell the excess not taken by the buyer – hence such a clause would not be commercially arguable in preay much any of the MSs

ì  Careful with the enforceability of the ToP – in those jurisdicitons where adequate considera5on is an essen5al contractual element (if the PPA is under English law – no prob: basic principle of common law the courts are not concerned with the adequacy of considera5on, it is totally acceptable that the par5es are “smart” enough to enter into a “bad bargain”)

Key Contractual Issues (8) ToP – Flexibility Mechanisms

ì  2 essen5al flexibility mechanisms: allow for a Buyer’s ToP obliga5on to be averaged over the life of the PPA ì  Make-‐Up ì  Carry forward

ì  Make-‐up: ì  once a buyer has made a payment in one year (and taken less) the volumes

will go into a “Make-‐up bank” ì  If in the next year the Buyer has taken the amount of that year before the

year end he can then start to take for free if he needs to up to the amount of the outstanding “Make-‐up bank”

ì  Carry-‐forward: ì  if the buyer takes more than the ToP amount in one year – receives a credit

for the overtake ì  If he then takes less in another year this is set-‐off against the “Carry Forward

Balance” from the previous year

Key Contractual Issues (9) Exchange Rate Risk

ì  This exists in almost all new built power plants projects outside the Eurozone

ì  Depending on the par5es the project costs are in one or more currencies whilst the revenues of the plant is in the local currency

ì  Problem is the issue can appear over 5me, ie: 3-‐5 years along the line

ì  Role of the PPA is to make sure the generator receives the same value of considera5on irrespec5ve of movements in the exchange rate

ì  Achieved by compelling the buyer to pay in the same currency as the costs

ì  Another problem: if the local currency deteriorates the price of power under the PPA rises – making alterna5ve local sources more aarac5ve for the buyer

ì  In prac5ce this risk is shared between the seller and the buyer (if the buyer is not a state owned company – that can afford to produce a Gov guarantee – and here we aface State aid rules)

Key Contractual Issues (10) Operation

ì  To keep the lights on PPAs have to fit within the market architecture and the Grid Code arrangements of the market they operate in

ì  The G needs to know when to switch on and off the plant

ì  The MO / TSO needs to know in advance what the available capacity will be

ì  Reserve capacity needs to be considered for transmission and distribu5on constrains

ì  Conclusion: across MSs market designs and Grid Codes are different – be comfortable that the par5es and the advisors understand them before nego5a5ng a PPA

Qs Time!

ì  Many Thanks!

Documents

Power Purchase Agreement Workshop