Power Market Turmoil and Financial PPAs in Southeast Europe from Feb 2021 to Oct 2022

By chance, these considerations may be like some real-life cases.

In the last 20 years, there have been 3 major trend cycles in power prices, the 1st 2000-2008 (bullish), the 2nd 2009-2016 (bearish), and the 3rd 2017-2022 (bullish, to present times). Even before 2000, it was volatile in the business of energy trade and supply. There have been major trends driven by oil prices since its exploration and application began some 160 years ago. Hedging the price of future power products in the financial markets is the primary insurance for utilities, and generators to stay in business during difficult power market cycles. Although it was practiced even before 2008, it became very clear and strict in the form of intensive use of risk management tools during and after the world financial crisis (where power prices fall to a few tens of EUR/MWh for years, bringing unprotected utility companies to the brink of bankruptcy). This system of selling futures on power works well for the hedged parties because they will start receiving cash income in their accounts if market prices happen to start falling. Well, something is different during bullish market trends.

Renewable power purchase agreements (PPAs) and the demand for hedging

Renewable energy production, like conventional energy sources, has significant requirements to protect production even in the longer term. Renewable energy projects are financed by banks and creditors and are traditionally required to pre-sell (hedge) electricity production for at least 10 years. This indirectly creates an even greater demand on the part of power offtakers (utilities, traders, suppliers) to hedge their new position with financial instruments available on the electricity exchange. This implies that the quality (especially in terms of length and price) of PPA offers from power offtakers to renewable project owners will depend mostly on the price and availability (liquidity) of the specified power futures.

Margin calls and power utilities in the EU in the period between February 2021 and October 2022

A company (power producer) hedges its future power production by selling financial futures with a base-load profile for several years ahead (perhaps at least 3 to 5 or even up to 7 years if possible) at the organized power exchange. Sometime in Q1 2021, a new sort of energy event will strike, this time with the power prices going up. Power prices on European exchanges start to rise stronger as of Q2 2021, slowly at first and then rapidly as time goes. On a daily basis, margin calls (an exchange instrument) begin to play a major role for generators and utilities to put additional money on their losing financial positions (due to significant positions on the sales side).

These were really well-thought-out hedges, just a difficult mechanism to maintain in an uptrend market because they have to load cash. Conversely, in the opposite direction cash is paid to their accounts. In any case, even though producers and utilities will one day in the future sell physical power on the spot market and probably successfully cover their financial obligations, it still has to be settled daily for years before physical delivery is made. Lack of own money necessitated the same famous bailout and the new (old) ownership is back in play (at least for a while, before the shares are sold again on the market, I like to believe).

Exposure of Utilities to renewables PPAs

Utilities and similar power offtakers engaged in long-term (10 or more years) PPAs with renewable energy generation have created additional credit exposure by entering PPAs. By doing this on the one hand and selling (back-to-back) power futures on the margin on the other, they created an obligation to settle the position financially with the power exchange daily. This creates the same financial expectations for utility (offtaker) as with long-term hedging of own power production. The risk they took, which in some cases materialized, was to run out of liquidity.

Market turmoil in the EU and the consequent decline in the quality of offered PPAs in the SEE Region

It is too early to draw conclusions about the consequences of the latest "Armageddon" uptrend, especially since it is not yet confirmed to be over. However, in terms of conclusions for financial PPAs, something can be gleaned from the last year and a half as a fact valid at least for the Southeast European region:

• Price levels of fix-price PPAs have risen significantly (at least during the trend) and have started to decline since the changes in the trend took place.
• The total number of power offtakers willing to execute financial PPAs is at least the same or slightly less (mostly the offtakers’ credit lines have been exhausted by the signed PPA, especially with the rise in power prices).
• The total duration (tenor) of financial PPAs, in terms of years offtakers are willing to give, lengthened during the uptrend and started to shorten after the market direction changed.
• Price discounts in financial PPAs to power exchange futures, which are typically applied due to offtaker side illiquidity risk, increased during the uptrend and even more so during the downtrend, suggesting that they were (maybe) volatility driven.
• Offers with embedded options (such as floors) were more likely to be part of physical PPAs compared to financial PPA offers in the SEE Region. Physical PPA options linked to utilities seem to offer much more lucrative and creative options for developers, and the costs of these compared to financial PPAs are also significant.

Although power prices have increased during the uptrend and the returns on investment in renewables have potentially increased, at least in the SEE region, this "Armageddon" event (electricity price turmoil) could potentially have a short-term negative effect on the quality of financial PPAs. Furthermore, it may have a long-term negative impact on the renewable energy industry financed by PPA-linked projects, and it remains to be seen how the risks of power market volatility will be assessed by offtakers and lenders in the coming years.

For additional readings on Southeast European PPAs related subjects: