As millions of Texans exit a week without electricity or potable water, commentators across the country are trying to make sense of what went wrong and how to avoid such disasters in the future. Many pundits have blamed either fossil fuel-based generators or renewable ones, while experts have highlighted poor market structure and inadequate regulations. What’s missing from the conversation is an understanding of the dynamics between buyers and sellers of wholesale renewable energy, particularly in the Electric Reliability Council of Texas (“ERCOT”). The crisis exposed contracting pressures that create the wrong incentives for renewable energy deals, with some sellers forced to cut corners to remain competitive and some buyers unable to properly assess risk. To avoid such negative outcomes in the future, renewable energy market participants need better information and contracting tools.
The renewables sector has benefitted from ERCOT’s deregulated, energy-only wholesale power market. The liquidity and transparency of the system allow renewable sellers to compete with fossil fuel-based sellers without political interference. ERCOT achieves this level playing field in part by attracting ample market participants, particularly in Houston – the energy capital of America. The result is that renewables in Texas have generated nearly three times more electricity than in neighboring states – Louisiana, Arkansas, Oklahoma, and New Mexico – combined since 1990. On a size-adjusted basis, Texas significantly outpaces Arkansas and Louisiana, where solar and wind account for effectively 0% of electricity, but still lags Oklahoma and New Mexico.
Relatively speaking, Texas has been welcoming to the renewable energy sector.
But to compete in this market, renewable energy sellers must hedge their future revenues against potential power price volatility. ERCOT’s open wholesale market enables renewable sellers to relatively quickly find long-term revenue contracts – known as offtake agreements – typically via power purchase agreement (“PPA”) or structured hedge. These offtake agreements aim to provide assurances that future cash flows will be stable despite inevitable fluctuations in power supply and demand. They are supposed to provide a strong foundation. Two weeks ago, that foundation cracked.
That crack will likely force some renewable sellers into contract default and result in billions of lost revenues for buyers. How could this have happened to some of the most sophisticated energy market participants in the world? For starters, a key hedging risk known as “shape risk” was not managed correctly.
Renewables are inherently intermittent resources, generating when the sun shines and the wind blows. However, some offtake agreements known as “fixed shape” contracts include hourly guarantees, obligating the seller to deliver a fixed amount of electricity according to a pre-set schedule, regardless of whether the facility generates during those intervals. Shape risk is the spread between the amount of electricity the seller has committed to deliver and the amount of electricity the seller actually generates. Sellers manage shape risk by generating more electricity than they are obligated to deliver, creating a financial “buffer.” The revenue generated by the buffer should cover the rare events when they are unable to deliver on their own and need to turn to the spot market to meet their contract obligations. Typically, the seller aims to over-generate 95% to 99% of the time, compensating for losses incurred from the 5% to 1% exception.
Most of the time, sellers generate more electricity than they are committed to deliver. The revenue from this “buffer” covers instances when they are unable to deliver and resort to replacing their shortfall by buying on the spot market to fulfill their obligations.
Source: RenewaFi (FKA NewPartner Energy LLC)
Fixed shape contracts are especially valuable to buyers in ERCOT where power prices are volatile and PPA performance is difficult to predict. Depending on PPA parameters, buyers often make over 100% of their expected profits from just 2.5% of the most extreme events, when power prices spike to extreme highs that are more than two standard deviations from the historic mean. While buyers can generate significant returns from ERCOT PPAs, they stand to incur significant losses if sellers don’t show up during extreme events such as this recent winter crisis. When that happens, the entire PPA value risks going very quickly into the red. Deep red.
This graph shows back-casted, generation weighted profit for a buyer based on 5 years of real-time prices in ERCOT and P50 renewable energy shapes. Swap value ($/MWh) is the difference between the shape-adjusted value of electricity and the fixed PPA price. (Offtaker = buyer.) As you can see, buyers are poised to make nearly all of their profit during extreme events.
Sources: ERCOT and RenewaFi (FKA NewPartner Energy LLC).
The financial buffer failed during this winter crisis. Because the wind turbines were not winterized, sellers were unable to deliver at the exact moment when prices spiked and buyers were poised to make their greatest gains. As a result, many sellers will be forced to default on their obligations. The buyers on the other side of these trades will be entitled to financial damages. We may see enormous insurance claims and even bankruptcy declarations. Contract damages compound when wholesale electricity prices hit the $9,000/MWh upper limit allowed by ERCOT. By the time sellers’ force majeure claims are resolved (perhaps in court), contract credit mechanisms will force many into extreme financial strain. Some may not survive.
This winter shock will force renewable energy buyers and sellers to reconsider PPA risk mitigation. These “fixed shape” contracts would likely have performed extremely well had the wind turbines been properly winterized. Given the immense outages from fossil fuel-based assets, headlines around the world may have read ‘Renewables to the Rescue.’ This is an opportunity to hit ‘reset’ and address key pain points for renewable energy buyers and sellers, particularly with regards to energy contracting.
For perspective, it was only relatively recently that the levelized cost of energy for solar and wind allowed renewables to compete with fossil fuel-based assets in ERCOT. Before that, renewables, especially solar, were heavily subsidized, enjoying seller-friendly offtake terms and prices, particularly in states like California. But when renewables entered deregulated and unsubsidized markets on their merits, they became subject to “standard” contracting mechanisms, forcing them to learn how to manage new contract risks.
Renewables are now learning to stand on their own two feet. But the learning curve has been steep. And the combination of managing new contracting risks that were not intended for renewables, navigating tariffs from the previous federal administration, and being subject to conventional procurement methods such as hyper aggressive PPA price auctions has put enormous financial pressure on sellers to deliver for their customers. These challenging dynamics have made it difficult for renewable energy sellers to prepare for every possible outcome. Going forward, these factors need to be considered in market and auction design.
To do this, we need to reconsider one of the root causes of financial stress for sellers: finding high-quality offtake via conventional contracting and price auctions.
In general, there is very little liquidity in most forward markets for electricity past two to three years, making hedging out for 12 to 20 years — the typical contract duration for a renewable PPA/hedge — especially difficult. Additionally, forward contracts typically trade in standard block format, not according to the intermittent solar or wind shape. So there just aren’t that many buyers willing to take the risk of purchasing renewable energy at a fixed price that far into the future. In the rare case when a buyer is willing to put in a large order for non-standard power generation years out (a.k.a. a PPA), sellers will swarm that buyer in desperation. Such RFPs are often 1,000x oversubscribed. Considering these dynamics, it’s no surprise that buyers expect steep discounts to the spot price of electricity. And in exchange for taking on such significant risk, buyers also gain the negotiation leverage to dictate contract terms.
But some buyers have so many options that they cannot possibly compare them rationally and accurately, and instead resort to the cheapest offer. A core problem is that PPA price auctions assume that offers can be easily compared, when in reality each offer is bespoke with its own risk and value profile. To have a chance at success within the framework of a price auction, desperate sellers feel compelled to offer at rock bottom, eliminating all ‘superfluous’ costs from their pricing models. Often, the end results are buyer-friendly deals with prices so low that ERCOT sellers who win price auctions actually expect to lose money during the contracted period. Some PPA brokers and advisors representing well-intentioned and novice buyers have knowingly taken advantage of sellers’ desperation while charging exorbitant fees for their services, ironically harming the renewable energy market participants that they are supposed to be supporting. While the use of price auctions is understandable given conventional procurement methods, it often results in low quality deals with a significant price to risk mismatch.
Instead, buyers should run sophisticated auctions based on risk and value, not on price alone. While healthy competition is vital for market stability, cutthroat competition that leads to cutting corners can actually harm electrical and energy infrastructure. The goal should be to enable smoother, more stable, and more nuanced contracting processes for renewable energy PPAs so that contract commitments can be upheld, financial performance can be optimized, and the electrons can keep flowing, especially during emergencies. This is good for buyers and sellers. RFP winners should not have to sacrifice extra costs (for things like weatherization and cyber security hardening) to be competitive, especially if there’s little or no market-based financial incentive to make the upfront investment. Sadly, PPA price auctions may inadvertently be slowing the renewable transition that we are trying to foster. We cannot afford that. Renewable development needs to be accelerating to hit our aggressive carbon reduction targets. But it needs to be done responsibly.
What we are seeing is an extreme example of the fact that there are PPA attributes besides price that really matter. We should re-consider and challenge the cutthroat nature of the conventional renewables auction and use innovation to improve results for everyone.
What we should care about is finding and selecting the best deals based on low risk and high value. We want power plants to deliver in ERCOT when power prices spike. So instead of sourcing PPAs conventionally and optimizing for lowest price, we should allow innovative technologies to help us sort for high value deals that can withstand shocks and more consistently deliver strong cash flows. Smart auctions can help optimize for that result.
Implementing technology will not magically stabilize the grid. The problems are far more systemic. But smart technology is certainly part of the solution. Innovation helps humans make better decisions and reduces financial burdens, allowing market participants to spend more time and resources on safety and efficiency. Together we can, and should, do our part to improve market dynamics that make our grids and contracts more resilient.
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Notes and sources:
 Buyers are “offtakers” that can include, but are not limited to, utilities, corporations, investment banks, load serving entities, merchant power shops.
 Sellers are typically, but not always, solar and wind power plant developers.
 US EIA, https://www.eia.gov/tools/faqs/faq.php?id=74&t=11,“Net Generation by State by Type of Producer by Energy Source.”
 This type of contract historically demanded a $1/MWh to $3/MWh premium price over “as-generated” or “unit-contingent” contracts, in which the buyer agrees to purchase electricity and RECs from the seller only when generated.
 68% of occurrences is the range for 1 standard deviation in a normal or Gaussian distribution. 95% represents 2 standard deviations. 68th and 95th percentile ranges are sufficient representations of confidence intervals for most data sets of typically non-Gaussian renewable energy shape-adjusted power price distributions in ERCOT.
 Inability to deliver triggers a seller event of default, which often gives the buyer the right to terminate the PPA.
 Buyers will collect collateral, typically by draining letters of credit or forcing margin calls.
 Over the last few years, renewable energy sellers in ERCOT have accepted and executed PPAs that would result in IRRs during the contracted period that can be negative 5% or lower.
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