Germany Solar Power Generation Hedging Power Price Cannibalisation

Energy transition refers to the global shift from fossil fuels towards sustainable, renewable sources of energy. This transition is driven by concerns about climate change, energy security, and the growing demand for energy in developing countries. Renewable energy plays a key role in this transition, as it is generated from sources that are naturally replenished, such as sunlight, wind, and water. Renewable energy technologies include solar photovoltaics, wind turbines, hydropower, geothermal, and biomass.

Germany is one of the world's leading countries in solar power generation. Today, Germany's solar power capacity is capable of generating roughly 9% of the country's electricity needs, making it an important contributor to the country's energy mix. Solar PV expansion in Germany jumped 28 percent in 2022, with 7.2 gigawatts (GW) of new installations added to the grid. By the end of 2022, the total installed solar PV capacity was 66.5 GW.

Renewable electricity production is intermittent (wind/no wind, sun/no sun) whereas fossil fuel power generators can be controlled by the operators more easily at “the flick of a switch”. Hence, the financial risks related to this type of power generation are vastly different from what they used to be. This article will present indices that help manage solar power generation financial risks. The emphasis will be on Germany Solar Power Generation although other countries could have been considered. To start with, let us review the situation with Germany’s solar power generation installed capacity.

Germany Installed Solar Power Generation Capacity

In recent years, Germany's installed solar capacity has continued to increase, although at a slower rate than in previous years. After a peak in 2012 when the country installed over 7 GW of new solar capacity, installations declined due to changes in government policies and a reduction in feed-in tariffs. However, in 2020 and 2021, Germany's solar capacity began to rebound, with the country installing over 4 GW of new solar capacity in 2021 alone and another 7.2 GW in 2022. This growth is being driven by a combination of falling solar panel prices, improved technology, and new government incentives. Additionally, there is growing interest in community solar projects and rooftop solar installations, which are allowing more households and businesses to generate their own renewable energy. Overall, Germany's solar power sector is expected to continue growing in the coming years, as the country works to meet its ambitious renewable energy targets and transition to a low-carbon economy.

There are in excess of 2 million individual installations ranging from rooftop installations to large farms like the Krughütte solar farm:

Renewable power generation price cannibalisation

The second point that we need to introduce is power price cannibalisation. Renewable power generation price cannibalisation is a phenomenon that occurs when the increasing penetration of renewable energy sources (such as wind and solar) in the electricity grid causes the price of electricity to decrease even to a point where it may become unprofitable for renewable generators to operate. This can happen because renewable energy sources have low marginal costs, meaning that once they are installed, the cost of producing additional electricity is very low.

As more renewable energy sources are added to the grid, the overall supply of electricity increases, which can lead to a decrease in the wholesale price of electricity. This, in turn, can reduce the revenue that renewable generators receive for their electricity output, making it harder for them to cover their fixed costs and remain profitable.

Renewable power generation price cannibalisation can be a concern for policymakers and investors who want to promote the transition to renewable energy sources, as it can make it more difficult to attract investment in new renewable projects. To mitigate this risk, policymakers may implement measures such as carbon pricing, renewable energy certificates, or capacity markets to support the deployment of renewable energy sources and ensure their economic viability.

How to measure renewable power generation price cannibalisation?

For renewable power producers, asset holders, and investors, the Speedwell Climate / EPEXSpot Solar Power Quanto indices reflect both wind/solar and spot price fluctuations over a period of time (day, month, season, etc.). Designed for risk transfer, these indices are integral to risk management programs that ensure revenues' stability, resulting in increased financing and development in the renewables market.

Out of the three published indices, the Quality Factor index is of interest here. The Quality Factor (QF) is a measure of the Achieved Price divided by the baseload price. For the removal of doubt, the Quality Factor index is also known as the Capture Rate index. The formula for the QF is:

This index combines the Speedwell Modelled Solar Power Generation Index with the EPEXSpot price and is by definition a measure of cannibalisation.

A high index value means the renewable power producer is capturing a price equal to the baseload price. A low index value means that the renewable energy producer is capturing a price less than the baseload price.

Germany Monthly Quality Factor Index History

In the chart below, the Germany monthly Quality Factor index history is plotted since 2005:

We see:

·????????A degradation of the Quality Factor from 1.2 to 0.95 a reduction of ~25%!

·????????An increase in the seasonality of the Quality Factor

The reduction of the quality factor index is a direct measure of price cannibalisation. This ~25% reduction is bad news for the renewable industry and the situation will keep worsening as wind and solar power generation installed capacity is increased.

The increase in the seasonality is because the impact of solar power generation on price is not the same during the summer months as it is during the winter months. This can be better seen in the graph below:

During the summer months, more electricity can be generated during the daylight hours from solar radiation than in the winter. The impact on prices is therefore greater during that time.

Power Purchase Agreement and Quality Factor

Renewable energy companies can finance their projects using a power purchase agreement (PPA) by selling the electricity generated by their renewable energy project to a buyer, typically an energy utility or a large commercial or industrial customer, at a fixed price over a specified period of time. Here's how it typically works:

The renewable energy company develops a renewable energy project, such as a wind or solar farm, and estimates the amount of electricity it will generate over its lifetime.

The renewable energy company negotiates a PPA with a buyer for the sale of the electricity. The PPA outlines the terms and conditions of the sale, including the price, the term (usually 10-25 years), and other key provisions such as delivery and payment terms.

The buyer typically commits to purchasing all of the electricity generated by the renewable energy project at the agreed-upon price over the term of the PPA.

The renewable energy company uses the PPA to secure financing for the project from investors or lenders, who are attracted by the predictable cash flows from the sale of the electricity.

The renewable energy project is built and begins generating electricity. The buyer pays for the electricity at the agreed-upon price, and the renewable energy company uses the proceeds to pay off its financing and to fund future projects.

In summary, a PPA allows renewable energy companies to secure financing for their projects by providing a long-term revenue stream from the sale of electricity, while also providing buyers with a reliable source of renewable energy at a predictable price.

When buying or selling a PPA a Quality Factor index level is implicitly traded through the agreed power price. The PPA seller may therefore wish to hedge the trend in the Quality Factor as well as/or the volatility around that trend. Another possibility is to make the agreed price linked to the QF.

Hedging the Quality Factor via the Climate Risk Transfer Market

The over-the-counter (OTC) weather risk derivative market is a decentralized market in which participants trade weather risk derivatives privately, rather than on an exchange. The market is typically composed of financial institutions, insurance companies, energy companies, and other entities that are exposed to weather-related risks.

The market is organized around a set of standard weather indices, which are used as the basis for the derivatives contracts. These indices measure various weather-related variables, such as temperature, precipitation, and wind speed, and are designed to reflect the risks faced by different industries.

In order to trade weather risk derivatives, participants typically work with a broker or dealer who can help them find counterparties and negotiate terms. The terms of each contract will depend on the specific needs of the parties involved, and may include details such as the index to be used, the duration of the contract, and the size of the underlying exposure.

Once a contract is agreed upon, it will be recorded and settled privately between the two parties involved. Settlements may be cash-based or physically settled, depending on the terms of the contract. In the present case, the contract will be cash settled.

Hedging the Quality Factor can be done using this OTC weather risk transfer market swap or put option contract.

A Quality Factor swap option payoff is simply defined as:

Payoff = Tick * (Quality Factor – Strike)

Where the strike is agreed between the two counterparties and the Tick is a constant value. When selling the swap, the payoff function is simply:

Payoff = -Tick * (Quality Factor – Strike)

and it looks like this:

Let us go through an example to calculate the payoff of a sold quality factor swap contract.

Let us assume the agreed Strike is 0.9, the Quality Factor calculated by Speedwell Climate at the contract expiry is 0.87 and the Tick size is Euros 10 million. The payoff for this sold swap would then be:

Payoff = - 10 000 000 * (0.87 – 0.9) = 300 000 Euros

In this example, the seller of the contract will receive 300 000 Euros cash as compensation for a Quality Factor that settled to a lower value of 0.87 than the agreed strike level of 0.9.

Conclusion

The share of renewables in the power mix is rising. The renewable installed capacity will increase rapidly in coming years due to government pressure and geopolitical events. Until electricity storage solution are in place in large quantities, prices will be further cannibalised during peak hours. Both the trend and the volatility around the Quality Factor index can be hedged using the Speedwell Climate / EPEXSpot Quanto Power indices.

The Speedwell Climate / EPEXSpot Power Quanto Indices which facilitate the transfer of renewable energy generation risk can be purchased from either the EPEXSpot online webshop or Speedwell’s one.

Speedwell Climate is the leading provider of data for the climate risk transfer business. We also provide the Speedwell Environmental System for pricing and managing climate derivative contracts. Speedwell Climate also provides independent valuations of weather derivatives, quanto pricing, and portfolios of climate risks.

The header’s picture was generated using DALLE-2.

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