By Jaafar Rizvi, Fall 2016
Electricity price risk too often does not get the same thoughtful treatment as other business risks, such as those involving foreign currency or interest rate exposure. In fact, because most organizations don’t address the risk of rising electricity prices in the long-term, they are gambling that prices will go down over time – and this implicit position can cost them. There are new developments in hedging long-term electricity price risk for 10 to 25 years, going well beyond protection against short-term volatility. Organizations should rethink their status quo position and consider a strategy that Google has been using for years and that Amazon, MIT, Lockheed Martin, and others have recently adopted.
Typically, a sophisticated organization will counter short-term spikes in electricity prices with a financial product such as an option, or a fixed-price one to three year-contract set at a premium above the market price. But these hedges have to be renegotiated at the end of the contract period and therefore don’t insulate against long-term rising prices.
Enter the Power Purchase Agreement (PPA). There are several types of PPAs, but most have a common feature where an organization contracts to buy renewable power, sourced from a wind or solar energy field, at a fixed price and sell it back into the grid at the market price.
The key characteristic for generating a hedge with a PPA is having a high correlation (typically 90-99%) between where an organization is consuming electricity and where the wind or solar project is located. This correlation is typically achieved by signing a PPA with a project on the same regional grid as the purchaser. In essence, the PPA offers the same hedging benefits of a market electricity price for fixed payment swap, yet unlike a swap, it can be structured to avoid onerous derivative accounting treatment.
In addition to the risk benefit, these contracts can be structured to offer sustainability advantages, as the buyer of the energy is able to claim, through ownership of the Renewable Energy Certificates (RECs) generated by the project, that they have partly or fully neutralized their carbon emissions, else the RECs can also be sold for a profit.
To understand the hedge value of a PPA, consider the following example. In year 1, a fictitious honey jar manufacturer, Buzz, spends $10 million on the energy commodity portion of their electricity bill (as opposed to distribution charges, for example). In the unhedged scenario, if electricity prices increase 5%, Buzz will spend $10.5 million in year 2.
If Buzz had signed a 20-year indirect PPA for solar energy on the same grid for an amount equal to their annual electricity usage at a fixed amount equal to the price paid in year 1, things look different. The solar field will also generate $10.5 million (assuming perfect price correlation for simplicity’s sake) and Buzz is only paying $10 million for that energy, leaving a $500,000 benefit that can be applied to reduce the onsite electricity bill. Thus, Buzz pays the same $10 million as they paid before. Moreover, Buzz would receive the associated RECs which would allow them to be able to make the claim that they have net zero electricity emissions.
Even if prices decrease, net spending remains at $10 million. Thus, the risk to the PPA is that electricity prices go down in the long-term. While electricity prices can be volatile, they have not decreased historically and are not forecasted to do so in the future.
According to the U.S. Energy Information Administration (EIA), from 1960 to 2015, commercial retail prices for electricity grew from 2.40 to 10.59 cents per kilowatt-hour, representing a long-term compound annual growth rate of 2.7%. Even through the fracking boom, prices grew from 2006 to 2015 at a rate of 1.3%, with no two consecutive years in that timeframe showing price decreases. EIA predicts an annual growth rate of 2.1% for commercial electricity prices through 2040, and that figure doesn’t include the impact of a potential federal price carbon. At this rate, in the final year of the PPA, costs would be $14.8 million, but Buzz would still pay $10 million.
Indeed, the long-term price forecasts suggest that organizations would benefit from being net providers and not net users of electricity. If an organization were to sign an indirect PPA for more than their total usage, they would no longer be neutral toward energy prices, they would be long, benefiting on the whole when prices rise.
Energy needs can be complicated and each institution’s situation will be different. At CustomerFirst Renewables we have worked with large corporations such as Lockheed Martin, universities such as MIT, and organizations as small as Friends of Post Office Square – a small public park and underground parking garage. Each has different needs, but a deal can be structured to provide significant risk and environmental benefit for anyone.
Jaafar Rizvi works at CustomerFirst Renewables, where he helps institutions procure large amounts of renewable energy, and is a Clean Energy Leadership Institute Fellow.