Fulfilling the climate commitments to keep temperatures from rising too far above pre-industrial levels made at the 2015 Paris Agreement puts the onus on energy infrastructure to transition from fossil fuels towards greener renewable energy alternatives. To pursue this goal, investors need to understand renewable energy markets.
Energy markets are characterised by long-term transition-friendly trends tempered by short term shocks, according to Barney Coles, Managing Director and Co-head of Capital Dynamics’ Clean Energy team. “Long-term trends take place on a macro-scale where governments aim to set lasting policies committed to the green transition. Short term shocks are more idiosyncratic and reflective of the spill over of external issues onto energy markets,” Coles explains.
Long Term Commitments to Carbon Neutrality by 2050
“Long term dynamics continue to enhance and support significant renewable energy project deployment globally. The last substantial development in this trend was last year’s COP26 in Glasgow, which was meant to super-charge renewables and support the phasing out of fossil-fuels. Whilst there was disappointment that countries only agreed to ‘phasing-down’, rather than ‘phasing-out’ the use of fossil fuels, it still represented a major step in the right direction. We should celebrate the fact that for the first time there was a global consensus to endorse such a commitment,” Coles says.
“This decision should continue to build momentum towards achieving net-zero carbon emissions by 2050 or earlier. That political commitment trickles down into policy change and government support that facilitates the roll out of clean renewables and decarbonisation. Overall, the long-term trend remains supportive and consistent with the continued appreciation of renewable energy assets,” Coles adds.
Short Term Dynamics
“The shorter-term dynamics involve both the tail end of the impacts of the COVID 19 restrictions, and the fallout from the ongoing conflict in the Ukraine. The Omicron variant wave in December 2021 caused renewed lockdowns across Europe that extended the strain on industry supply chains and infrastructure; increasing commodity costs and rippling negatively through to businesses costs. From March 2022 onwards, the Ukraine conflict, the sanctions imposed on Russia, and their knock-on effect on energy prices have further rocked markets,” Coles adds.
“Energy market prices clear on the marginal cost of electricity generation where supply meets demand, which in Europe remains typically from gas-fired power stations. Given the limitations imposed on gas imports from Russia, supply has decreased across Europe, increasing wholesale prices across the Continent,” Coles continues.
“In liberalised markets, power prices act as the market signal for new entrants, so a higher price dynamic incentivises new players to enter the market, which is favourable for low-cost renewables energy projects. At the present price, many previously unviable renewable projects could now have a sound business case, which if then delivered, over a longer term horizon should act to reduce and stabilise power prices whilst accelerating security of supply. In theory, therefore, the war in Ukraine could and should facilitate a faster rollout of cheap renewable energy projects than was previously expected,” Coles argues.
Merchant Market and PPAs
According to Coles, investors should be aware of differing revenue risk approaches to investing into European energy markets. A renewable energy plant can either sell its output on the highly volatile spot market, or sell its output under a long term power purchase agreement (PPA) to a counterparty energy ‘off-taker’ for a fixed price (at a discount to the spot price), often times a corporate with specific energy needs.
“In the early days of the sector, governments provided direct subsidies to support the development of renewable energy infrastructure. Energy generators would get a fixed and generous price and that would support low-cost financing of these early projects. As the cost of the technology has fallen with time, renewables can now increasingly compete directly with fossil fuels in fully unsubsidized market settings, and the necessity of subsidies has faded away,” Coles recalls.
With a solar park or a wind park able to profitably generate electricity in unsubsidised markets, the choice for revenue-earning is narrowed down to selling power in the wholesale markets, or contract under PPAs. “Our approach is to de-risk that volatility as much as possible in every single asset. The degree to which that is possible varies across European countries because every market is different, but Capital Dynamics’ focus on additionality, sustainability, stability and de-risking means we have a preference for PPAs,” Coles explains.
Front Ending Profits
Returning to ongoing market conditions, Coles warns that renewable energy investors who avoid PPAs and instead seek to make new investments underpinned by today’s record high spot merchant energy prices should be aware of the potential future risks. “The recent spike in energy prices and asset profitability is expected to be temporary and largely dependent on the conditions facilitated by the present crisis,” Coles warns.
“Investors with a longer-term investment horizon should be aware that they may be capturing the upside today, but they may also be exposing themselves to potential down-side later. Eventually, when the ongoing geopolitical upheaval passes, prices could fall faster than expected because of the rollout of more and lower-cost renewable projects,” Coles argues.
Political Responses to the Crisis
This is not a criticism of the faster rollout of renewable energy projects per se. Coles merely suggests investors ought to be mindful of unintended consequences of investing “fully merchant” as opposed to strategies underpinned by PPAs, including in terms of the policy responses. “It’s natural that high prices should lead investors to enter this market. Demand for energy is fundamentally inelastic, which is appealing to investors. But it also burdens consumers, particularly those with lower incomes, which creates an incentive for government interventions,” Coles says.
Political interventions vary across Europe but there is a degree of harmonisation happening according to Coles. “The initial response has generally been the same, with governments across Europe imposing packages including ‘windfall taxes’ on the profits of (fossil fuel) energy companies to smooth out the effect of the crisis,” Coles explains.
Drivers of Renewable Energy Prices in Europe
Diversity is not limited to government action. It extends into market dynamics where different regulations, heterogeneous levels of renewable energy penetration, interconnection between markets and other supply and demand motivations can shift the bargaining power between energy ‘generators’ and ‘off-takers’.
“The differences in prices across Europe are due to a multitude of reasons,” Coles says. “The UK, for example, is an island nation that continues to lack large interconnection capacity with mainland Europe, whilst remaining undersupplied in renewables. The market expects the UK to be undersupplied for a long time, in part due to planning regulations limiting land use for renewables. This postponement in the rollout of renewable energy delays the displacement of higher marginal-cost gas-dependent generators, thereby pushing up the expected long-term power price in the UK,” Coles explains.
“A long-term fixed PPA price is a function of the expectation of where long-term merchant prices will be. As a result, when you overlay a PPA onto this undersupply dynamic prices are inevitably higher in the UK than in the rest of Europe,” Coles adds.
‘Take or Pay’ Versus ‘Base-Load’ PPA Contracts
At the same time, renewable contracts in most of Europe, burden the ‘off-taker’ with more risk than the power ‘generator’, contrarily to the prevailing conditions in the USA and in the Nordics. “The PPAs signed in the UK are normally ‘pay-as-produced’ contracts, where the purchaser of the power output, normally a corporate, agrees to pay the generator the agreed fixed price, regardless of when the energy is produced,” Coles says.
This is because of supply and demand dynamics. “Although the UK presents a more extreme case than Spain or Italy, those countries also currently suffer from undersupply of renewables in the context of huge corporate demand for the green power. In this environment, the renewable energy project, as a scarce resource, has more bargaining power than the ‘off taker’. This dynamic will last for a while but not forever as the experience of Nordic countries shows,” Coles continues.
“In the Nordics the dominant contract is a ‘Base-Load PPA’ contract, where the weather risks are more equitably shared between the ‘generator’ and the ‘off-taker’. In those contracts, the ‘generator’ is typically bound to deliver a certain volume of electricity within a specific timeframe, sometimes with binding floors and ceilings. Should there be unusually weak wind generation for an extended period of time such that the ‘generator’ is unable to meet the minimum amount of agreed-upon power, it is the ‘generator’ who has to go to the volatile merchant market and source the shortfall necessary to meet its obligations to the ‘off-taker’,” Coles continues.
The Nordic Market
Supply and demand dynamics also help explain why generators take more of the risk burden in the Nordics. “The integrated energy market for the whole Nordic region, Nord Pool, is one of the biggest and most liquid energy markets in the world. Because it is so liquid, a number of power trading counterparties, be that utilities, corporates or investment banks, trade there, creating a lot of options for generators,” Coles explains.
“Broader industry confidence in Nord Pool make it also one of the lesser volatile energy markets in Europe. This price stability erodes some of the appeal of the ‘as-produced’ fixed-price PPAs, that are often priced at quite a large discount to prevailing wholesale market prices” Coles concludes.