Managing RtM risk under the intermittent CfD
Managing RtM risk under the intermittent CfD
Electricity Market Reform (EMR) has been under development for over three years and is now rapidly moving into implementation. Contract for Difference (CfD) strike prices were confirmed alongside the final EMR delivery plan which set out an indication of the (limited) budget available for renewables being contracted under CfDs. The coming months will continue to be busy, with a number of shortlisted projects to be issued with Investment Contracts under the FID enabling scheme in March 2014, and the rules for management of budget and allocation of CfDs also being published.
Identifying the Issues One of the key changes with a move from the Renewables Obligation (RO) mechanism to the CfD will be the altered market risk profile. The CfD will stabilise revenues for a generator by insulating it from long term price risk over the first 15 years of operation. It does, however, still leave investors
in intermittent renewable assets (eg offshore and wind and solar) with the residual challenge of accessing the day-ahead reference price and managing the cost of any change in forecast output from that day-ahead stage through to actual delivery as set out in more detail in Figure 1.
A key challenge for investors will therefore be assessing how this residual market risk is best managed and the cost to the project of doing so. A long term power purchase agreement (PPA), that provides a degree of certainty to investors as to the long term impact that this residual market risk will have on project economics, will no doubt
Figure 1: Route-to-market risk under an intermittent CfD Intra-day forecast error
B
The risk that a generator cannot access liquidity in the intra-day market to trade out its position or can, but at large bid offer spreads
The risk that a generator’s delivered volumes differ from its final contracted position as submitted at gate closure
Imbalance Volumes
C
A
B
Managing RtM risk under the intermittent CfD
Volumes Intra-day
Volumes sold DAH
Time
2
Imbalance risk
Delivery
Day-ahead auction
Wind forecast for delivery time
The risk that a generator’s forecast output changes intra-day and it has to sell/buy in the intra-day market at a different price to the DAH price
C
Intra-day liquidity risk
Gate closure
A
Volumes
continue to play an important role in providing a financeable route-tomarket for non-balance sheet players, as it has under the RO - particularly for lower risk investors or those looking to maximise leverage. However, liquidity in the long term PPA market is currently poor, with independent generators struggling to secure financeable offers from the relatively small pool of offtakers considered sufficiently creditworthy to support long term limited recourse finance. While this market is expected to improve with the move to a CfD, as the PPA will no longer need to provide long term wholesale price protection or take away ROC liquidity risk, residual concerns remain as to whether long term financeable PPAs will be available in the volumes required to deliver the governments deployment objectives. In view of this, the Department for Energy and Climate Change (DECC) has committed to implement an offtaker of last resort (OLR) that will guarantee renewable generators access to market at a fixed discount to the day-ahead market reference price. DECC is consulting on the level of this discount but it is likely to be around ÂŁ25/MWh. This is not enough to be a viable route to market in its own right, but enough to floor the route-to-market risk for a generator by effectively providing a fixed feed-in tariff (FIT) against which lower cost capital can be raised.
An investor under the CfD will therefore be left with a choice: c ontinue to pay a creditworthy counterparty to provide long term certainty as to the cost of accessing the MRP under a long term PPA, or pt to contract with less credit o worthy counterparties, in the shorter term market (or even develop inhouse trading capability that will dispense with the need for a PPA altogether), but in all cases accepting greater route-to-market risk within the project itself in the return for greater value capture against the market reference price. In assessing the merits of these two extremes, investors will need to understand which of these two options, or any option in between, provides the optimal mix of risk and reward given their available financing strategies and/or investment criteria.
Baringa’s offerings As a leading regulatory, market and commercial advisor for over a decade, Baringa can help market participants from all segments of the energy sector navigate these new challenges.
Risk allocation and commercial structuring Building on our established PPA commercial advisory practice, Baringa can help both PPA providers and investors to actively shape the nature of route-to-market offerings under CfDs and start to flesh out the principle commercial building blocks of a principal PPA. For example:
hat is the most appropriate pricing w structure for a long term PPA and should this vary at different points of the PPA tenor? a percentage discount to the market is reference price likely to continue to be a good predictor of imbalance cost in the future or could this relationship break down with high penetrations of winds and other intermittents? ow should negative price risk be h allocated and priced? how might curtailment rights be built into the agreement to allow the offtaker to respond to price signals in the day-ahead market, intra-day market and balancing mechanism either on its own behalf or on behalf of the generator? how should change-in-law be treated, in particular those which result in an adjustment to the strike price in relation to a risk or benefit being partially or totally assumed by an offtaker?
Pricing RtM risk Having established an appropriate allocation of risk, Baringa can also help developers, investors and PPA providers establish a ground up assessment of long term PPA pricing. We have been providing independent market due diligence to support asset financing cases for many years and have been at the forefront of the policy development process, both for EMR and wider cash out and market reform.
Managing RtM risk under the intermittent CfD
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Figure 2: Key components of long term PPA pricing
Intra-day forecast error Intra-day liquidity cost
Pricing uncertaincy of cost evolution over tenor
Imbalance cost Trading cost Risk Premium
Archieved MRP
One of the most material aspects of that pricing methodology is pricing the uncertainty inherent in fixing route-to-market costs over a 10 or 15 year period. Baringa can help clients to simulate this pricing process by generating both expected routeto-market cost evolution scenarios together with downside scenarios against which a risk premium can be calculated (see Figure 3).
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Figure 3: Pricing long term route-to-market cost uncertainty Scenario development
Develop a range of RtM cost evolution
pathways to establish how key cost drivers might evolve in the future.
K ey assumptions are: Levels of wind/solar development - Correlation in forecast error across different classes of intermittents - Levels of interconnection and impact of demand side response in the case of high cash out prices - Impact of market coupling on DAH and Intra-day liquidity - Gas/wholesale prices
With this analytical understanding of PPA pricing, Baringa can help clients understand, appropriately manage and accurately price long term RtM risk for renewable assets under the intermittent CfD, enabling:
Managing RtM risk under the intermittent CfD
Pricing of uncertaincy Cost included in PPA discount
Building on our existing, trusted modelling framework, we have developed capabilities to model the route-to-market costs that would normally be priced into a PPA on an asset specific basis (as set out in Figure 2). This includes, for example, estimating the imbalance costs and the intra-day trading costs that we would expect a particular generator to incur in securing a route-to-market.
Net PPA price
sk r ri
ital
cap
e tak on Off jecti t pro s o c tive’ er va
s
‘Con
Expected costs
time (years)
c areful calibration of CfD bidding strategies in what is likely to be an increasingly competitive allocation framework, and a strengthened and informed negotiating position relative to both offtakers and lenders alike.
Exploring the short term... As explained overleaf, the offtaker of last resort will allow investors to opt for a shorter term contracting strategy and trading a loss of leverage for potentially improved short term pricing. Baringa is uniquely positioned to help investors to navigate that trade-off, having been at the forefront of the reform of cash out rules, the route-to-market debate around CfDs and the development of the OLR mechanism itself.
In the same way as Baringa can help investors understand the risk premium priced into a long term PPA discount, we can model equity returns under different route-to-market strategies, helping investors understand and price tail risk inherent in shorter term PPA strategies or relying on in-house trading capabilities. By benchmarking an investor’s equity premium for accepting merchant imbalance risk
above the OLR discount against the prevailing discounts in the long term market, we can help our clients select an appropriate RtM market strategy that genuinely optimises returns against a given capital provider’s risk envelope.
Managing RtM risk under the intermittent CfD
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For more information please contact: Ilesh Patel +44 (0) 7887 795924 Ilesh.Patel@baringa.com Ed Crosthwaite-Eyre +44 (0) 7734 956487 Edward.Crosthwaite.Eyre@baringa.com
About Baringa Partners Baringa Partners LLP is an award-winning management consultancy that specialises in the energy, financial services and utilities markets in the UK and continental Europe. It partners with organisations when they are developing and delivering key elements of their business strategy, as well as working extensively with government and regulators to provide policy and advisory services. Baringa works with its clients either to implement new or optimise existing business capabilities that relate to their people, processes and technology. Baringa is recognised both in the UK and internationally for its unique culture, which has been acknowledged by a number of awards and accolades and continues to reaffirm Baringa’s status as a leading people-centred organisation.
Baringa Partners LLP, 3rd Floor, Dominican Court, 17 Hatfields, London SE1 8DJ T +44 (0)203 327 4220 F +44 (0)203 327 4221 E info@baringa.com W www.baringa.com Š Copyright Baringa Partners LLP 2013. All rights reserved. This document is subject to contract and contains confidential and proprietary information.