How should a large corporate buyer assess the economics and risks of renewable energy?
Sponsored by CustomerFirst Renewables.
A crucial step in any large organization’s renewable energy sourcing journey is assessing the expected savings over the life of the contract, which can often last 10 years or more.
Sustainability benefits are increasingly important to organizations, but to gain approval to move forward with a specific renewable energy (RE) option, each organization’s CFO must feel comfortable with expected economics and potential financial risk.
How should large energy buyers think about evaluating the economy? While there are general rules of the road for all situations, each buyer’s specific approach will depend on the answers to two key questions:
- What are your organization’s financial priorities for RE projects?
- What type of ER solution is available and is your organization interested in?
What are your organization’s financial priorities?
Most of today’s renewable energy solutions are third-party financed, require no upfront capital outlay from the commercial and industrial buyer, and are structured on “pay-as-you-go” models. “. This may make them more palatable to the finance team, however, there will always be concerns about the potential financial impact of signing on to be the long-term buyer of power from a power project renewable. Three high-level financial priorities tend to get the most attention when evaluating your organization’s renewable energy options.
- Maximize potential savings: Simply put, find a solution that can maximize the expected savings for your organization (offers the highest net present value, or NPV, opportunity) over the term of the contract.
- Minimize downside risk: Prioritize solutions less likely to produce losses (even if it means giving up some potential economic benefits).
- Minimize volatility: Choose solutions that provide more predictable cash flows, since energy can be one of the most volatile commodities and may not be core to an organization’s business.
While these three priorities may not always conflict with each other (for example, an option that minimizes downside risk might also minimize volatility), they often can and therefore require early prioritization. Talking to the finance team about their priorities can help your organization determine how to assess its options.
Which solution is available and interesting for your organization?
Reflecting the significant and growing interest of large corporate buyers in RE supply – and to their potential benefit – many types of renewable energy solutions are available today more than in the past, including Virtual Power Purchase Agreements (VPPAs), retail renewable energy, green tariffs, on-site solar and community solar. The availability of each solution depends on the location of an organization’s facilities. The first step should therefore be to understand what solutions are potentially available given your organization’s physical footprint.
Although an increase in available solutions makes it difficult to understand the nuanced differences and trade-offs, there are three basic business structures for purchasing renewable energy:
- Flat rate price for delivered electricity: The buyer agrees to pay a single fixed price for all electricity delivered or consumed. Examples include some green tariffs and retail renewable energy.
- Fixed discount at a specific electricity rate: For each unit of electricity, the buyer receives a constant discount at an underlying fluctuating rate (electricity rate). Examples include community solar power.
- Fixed for floating structure: The buyer agrees to pay a fixed price for the generated electricity in exchange for a deemed floating price (whether a local market price or a price determined by the utility). Examples include VPPAs, some green tariffs, onsite solar, and some retail renewable energy options.
Each structure carries a different risk profile, both in isolation and when viewed in the context of an organization’s current energy portfolio and purchasing strategy. By matching the finance team’s priorities to the solutions available to your organization, you can identify the right renewable energy solution(s) and kick off the “fun” part of economy modeling.
The Basics of Renewable Energy Economics Assessment
To get started, your organization needs to have a good understanding of its current electricity costs, answering questions such as:
- How does your organization buy electricity today? For how long? At fixed or indexed market prices?
- How much do we spend today per unit of electricity consumed?
- What would the organization’s current BAU strategy look like if projected into the future, taking into account expected growth?
After gaining a solid understanding of your organization’s BAU electricity profile, it’s time to compare it to specific renewable energy options. Map the cash flow for BAU against the selected renewable energy solution or project and assess the savings potential.
Since each evaluated renewable energy solution or project may look slightly different, it is essential to standardize them on a metric that allows easy comparison with other project options (e.g. savings per unit of electricity over the duration of the contract). Comparing only the NPVs of two contracts with different durations or sizes (in terms of electricity consumption or production quantities) does not facilitate decision making between apples.
This comparison should be a relatively simple exercise when evaluating renewable energy solutions that use a fixed lump sum price for the commercial structure of the electricity delivered. However, for other structures (such as fixed or floating), the assessment of the economic performance will depend on the future evolution of the floating price and the interaction of the structure with the current energy purchasing strategy of the organization. The evaluation of this data can complicate the analysis, given the uncertainty and volatility of market prices. But the knowledge gained from analysis is worth it.
Assess the economics of renewables when there is market price exposure
Frankly, it is virtually impossible to predict future prices. That being said, large energy buyers can adopt informed modeling approaches to better assess market price risks over time.
- Use multiple data points to inform future price predictions. Use both market-based curves (such as futures market curves) and professional price predictions that derive future prices by modeling expected supply and demand to develop a range of potential future price scenarios .
- Consider the timing of renewable energy generation in the analysis.Where there is market price exposure, the timing of actual renewable energy generation is important. Markets with high renewable energy penetration, for example, can cause significant downward pressure on prices at specific times of the day (or seasons). Match expected future prices to expected renewable energy production.
- Run numerous sensitivity analyses. Being armed with the best information today may still not predict future results. For this reason, it is important to perform various downside sensitivity analyzes to test the basic assumptions. These analyzes should be based on various supply and demand shocks that could have a negative impact on prices. For example, what if renewable energy adoption is growing faster than expected in your market of interest? How would expected electricity prices change if natural gas prices crash to a decade low?
- Layer in available contractual risk mitigators. For some renewable energy solutions such as VPPAs, suppliers can offer creative risk sharing structures (price floors, upside sharing structures and others). Buyers should evaluate these options to find the right fit, as they can make the end result very different in terms of potential savings, downside risk, and volatility.
Bring it all together
While assessing the economics of renewable energy can seem daunting as a buyer, the first step to success is understanding the financial priorities and renewable energy solutions at stake for your organization.
With this information in hand, you can see which renewable energy solution may be best suited for your organization and begin to assess the economic potential. You can leverage the expertise of the finance team and other relevant internal stakeholders, as well as external renewable energy advisors, to help assess the economics and demystify the problem analysis/resolution process . With the right planning and the right team, approval from your CFO is within reach.