Utility-Scale Solar vs. Distributed Solar: Business Model for Utility-Scale Projects (Part 3)

Introduction

Solar PV technology, which converts light into electricity using the photovoltaic phenomenon, has a long history of invention and discovery dating back to almost two centuries ago. However, it was only in the last few decades that solar PV became a viable option for large-scale power generation, thanks to the mass production and cost reduction driven by China and other countries. To achieve widespread adoption and use of solar PV, a suitable business model is essential. A business model defines how a business can deliver value to its customers, in terms of a product or service, at a cost acceptable to the customers and a return acceptable to the investors. For solar PV, there are two main options: utility-scale and distributed systems. Each option has its own business model, challenges, and examples of successful implementation.

In Part 1 (https://www.dhirubhai.net/pulse/utility-scale-solar-vs-distributed-overview-aftab-raza-gizfe/?trackingId=87bA9sRRR26wg8ffd1rHNA%3D%3D) of this series of articles, I introduced the two options of using solar PV – namely, utility-scale and distributed solar PV systems - with an overview of their business models, challenges, and some examples of countries that have a large amount of each option. Part 2 (https://www.dhirubhai.net/pulse/utility-scale-solar-vs-distributed-advantages-part-2-aftab-raza-nyorc%3FtrackingId=vnSGtnlqQx2qlvAXgbSU8Q%253D%253D/?trackingId=vnSGtnlqQx2qlvAXgbSU8Q%3D%3D) compared the two options by describing their differences in detail and their advantages and disadvantages from the consumer’s and system’s perspectives.

It is now time to delve into the business models that are used around the world for solar PV. In this Part 3, I will describe the main business model for the utility-scale solar PV projects. The model would need to be adapted and tailored to different situations and needs.

Utility-scale solar PV

Power Purchase Agreements (PPAs)

The main business model for utility-scale solar PV projects is based on Power or Energy Purchase Agreements (PPAs / EPAs). These are long-term contracts between the producers (or sellers) of electricity from solar PV plants and the consumers (or buyers) of electricity, such as utilities, governments, or corporations. The PPAs specify the terms and conditions of the electricity supply, such as the price, quantity, quality, duration, payment mechanism, and risk allocation. The PPAs provide a stable and predictable revenue stream for the producers, who can recover their capital and operational costs and earn a reasonable return on their investment. The PPAs also provide a reliable and low-cost electricity supply for the consumers, who can benefit from the environmental and social advantages of renewable energy.

Key Provisions of PPAs

The PPA defines all of the commercial terms for the sale of electricity between the two parties, including when the project will begin commercial operation, schedule for delivery of electricity, penalties for under delivery, payment terms, and termination1. The PPA structure and provisions may vary depending on the type of PPA (physical or financial), the type of consumer (utility or corporate), and the market conditions (regulated or deregulated).

The detailed description of the PPA provisions is beyond the scope of this article, but some of the key provisions are as follows:

Price: The price is usually expressed as a fixed or variable rate per unit of electricity (e.g., $/MWh or cents/kWh) that is agreed by the parties at the outset of the contract. The price may be subject to escalation or indexation clauses to account for inflation or changes in market prices. The price may also include incentives or penalties for meeting or failing to meet certain performance criteria (e.g., availability or output).

Quantity: The quantity is usually expressed as a minimum or maximum amount of electricity that the producer agrees to deliver and the buyer agrees to purchase over a certain period (e.g., monthly or annually). The quantity may be subject to adjustment mechanisms to account for variations in demand or supply (e.g., curtailment or dispatch rights).

Term or Duration: The duration is usually expressed as a fixed term that starts from the commercial operation date (COD) of the project and ends at a specified date or upon occurrence of certain events (e.g., expiry, termination, force majeure). The duration may be subject to extension or renewal options that are exercisable by one or both parties.

Payment: The payment is usually expressed as a frequency and method of invoicing and payment that are agreed by the parties. The payment may be subject to deductions or adjustments for taxes, fees, charges, penalties, etc. The payment may also be subject to security mechanisms such as letters of credit, escrow accounts, guarantees, etc.

Risk Allocation: The risk allocation is usually expressed as a set of rights and obligations that are assigned to each party in relation to various risks that may affect the performance of the contract. These risks may include market risk (e.g., changes in prices or demand), operational risk (e.g., breakdowns or outages), regulatory risk (e.g., changes in laws or policies), political risk (e.g., expropriation or nationalization), environmental risk (e.g., natural disasters or climate change), etc. The risk allocation may also include remedies and compensation mechanisms such as liquidated damages, indemnities, insurance, etc.

Therefore, utility-scale solar PV projects need to carefully draft and negotiate their PPA terms and conditions to reflect their specific circumstances and objectives.

Energy-only price with take-or-pay arrangements

One of the key features of the PPAs for utility-scale solar PV projects is that they have an energy-only price with take-or-pay arrangements. This means that the producers are paid for each unit of electricity they generate and deliver to the grid or directly to the consumers, regardless of whether the electricity is consumed or not. This reflects the characteristics of solar energy, which is intermittent, non-dispatchable, available during certain hours of the day, and has very low or zero marginal cost of production. The energy-only price with take-or-pay arrangements ensures that the producers have an incentive to maximize their output when solar energy is available and that they are not penalized for fluctuations in demand or supply. This also simplifies the payment structure and reduces the complexity of metering and billing.

Types of PPAs

PPAs can be classified into different types depending on the market structure and regulation, as well as the location and size of the consumers or buyers. Some of the common types are:

Physical PPA: This is a type of PPA where the electricity generated by the producer is physically delivered through a direct line (physical on-site PPA) or through the grid (physical off-site PPA) to the consumer or off-taker for an agreed price. The producer is responsible for ensuring that the electricity meets the quality standards and complies with the grid codes. The consumer or off-taker is responsible for paying for the electricity according to the agreed price and quantity (as well as transmission or wheeling charges for the use of the gird in case of off-site PPA). Consumer also buys from the producer the Guarantees of origin (GO) or green or renewable energy certificates (RECs) provide the customer with the assurance that it is contributing to the development of renewables or that it is buying renewable energy.

Financial PPA: This is a type of PPA where the electricity generated by the producer is sold to the wholesale market at the market price and the consumer purchases electricity from the wholesale market at the market price. However, both parties agree on a fixed price (or strike price) for each unit of electricity and settle the difference between this price and the market price through a financial contract, also called a Contract for Difference (CfD). This way, both parties hedge against price volatility and guarantee a certain level of revenue or payment. While the consumer buys electricity from the wholesale market, it can buy GO or REC directly from the producer.

Corporate PPA: This is a type of PPA where the consumer is a large commercial or industrial entity that has high electricity demand and sustainability goals. A corporate PPA can be either physical or financial, depending on the preference and regulation of the parties. A corporate PPA can help the consumer reduce its electricity costs, improve its environmental performance, and enhance its reputation.

Virtual PPA: This is a type of financial PPA where the consumer does not need to be located in the same market or region as the producer. The producer sells the electricity to the wholesale market where it is located and the consumer buys electricity from the wholesale market where it is located. Both parties agree on a fixed price for each unit of electricity and settle the difference between this price and the market price in their respective markets. A virtual PPA can help the consumer access renewable energy from distant locations and diversify its energy portfolio. Both electricity and GO or REC certificates are sold by producer into (and bought by the consumer from) the wholesale markets.

Challenges

PPAs can help utility-scale solar PV projects overcome some of the challenges they face, such as regulatory hurdles, financial risks, and price competition. However, the PPAs themselves can face some challenges, particularly they often require complex and lengthy negotiations and involve legal, financial, and technical issues. Given the size of the project and complexity of risk allocation, arranging financing or financial closing is usually the focus in developing a utility-scale power project (which increases the complexity further and requirement to allocate risks optimally between various parties). Nevertheless, standardized templates of PPAs with take-or-pay structures have emerged as the best practices and optimal risk allocation which can be tailored to specific situations.

Focus

Companies that align more towards wholesale markets will typically try to develop and invest in large-scale power plants and maximize their return on equity invested. Often, the companies build these projects using construction or EPC contractors and operate them for the 20 to 25 year term of the PPA or sell them to other energy companies, investors or utilities who then own and operate these plants. Again, the focus is investing as little equity as possible and arranging debt financing.

Financing

One of the key challenges for utility-scale solar PV projects is securing adequate and affordable financing. Since these projects involve large upfront capital costs and long payback periods, they require long-term debt financing with favorable interest rates and tenors.

Utility-scale solar PV projects often use limited recourse project financing, which is a form of non-recourse or partial recourse financing that relies primarily on the project’s cash flows and assets for debt repayment, rather than on the creditworthiness of the sponsors. In this way, the sponsors can limit their liability and exposure to the project risks, while also achieving a higher leverage ratio (or gearing) and lower cost of capital.

However, limited recourse project financing also entails some trade-offs and complexities. For example, the sponsors may have to provide equity contributions, guarantees, or other forms of credit support to enhance the project’s credit rating and attract lenders. The lenders may also impose certain conditions or covenants on the project company, such as minimum debt service coverage ratios, reserve accounts, restrictions on dividends or additional borrowings, or performance milestones. Moreover, the project company may have to deal with multiple lenders with different requirements and interests, which may increase the transaction costs and time.

Therefore, utility-scale solar PV projects need to carefully plan and structure their financing arrangements to balance the needs and expectations of the sponsors and the lenders, as well as to optimize the risk-return profile of the project.

Conclusion

In conclusion, utility-scale solar PV projects have a well-established business model based on PPAs that provide long-term and fixed revenue streams for the producers and low-cost and reliable electricity supply for the consumers or off-takers. The PPAs have evolved and adapted to different market structures and regulations, as well as different types of consumers. The PPAs have also helped utility-scale solar PV projects overcome some of the challenges they face in terms of regulatory hurdles, financial risks, and price competition. However, the PPAs are not without their own challenges, such as complex and lengthy negotiations, legal, financial, and technical issues, and optimal risk allocation. To ensure best value to the consumers and investors, utility-scale solar PV projects use limited recourse project financing to secure adequate and affordable financing which bring in its own requirements including optimal risk allocation. Therefore, utility-scale solar PV projects require careful planning, design, implementation, and operation to ensure their success and sustainability.

If you are interested in learning more about the business models for distributed solar PV systems, which may not necessarily involve PPAs but other mechanisms such as feed-in tariff, net metering or net billing, etc., then please stay tuned for our next part 4 of the article series, where we will compare and contrast these mechanisms and their advantages and disadvantages. Thank you for reading! ??

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