Author: Kourtney Nelson

As head of the 3Degrees Transaction Center of Excellence, Kourtney Nelson works with clients to determine the best product structure to meet their renewable energy needs including physical and virtual power purchase agreements.

VPPAs: Four surprises for first time buyers

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Power purchase agreements (PPAs) – and virtual power purchase agreements (VPPAs) in particular – have become a popular and valuable way for companies to meet renewable energy and greenhouse gas (GHG) reduction goals. As many of our clients have experienced, there is a significant learning curve that comes with executing your first PPA–and one that should not be underestimated. 3Degrees has helped a number of organizations execute their first PPA or VPPA and have found that many of them are surprised by or unaware of certain key components for success.

Four important keys to success are:

  1. Advisor selection
  2. Defining the value of a PPA to your organization
  3. Stakeholder education and engagement
  4. Understanding that price and value are not the same

This article provides advice on how to successfully address each of these common stumbling blocks. If you are looking to execute your first deal, understanding and carefully thinking through these areas ahead of time will help ensure you have a smooth PPA procurement and implementation process.

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1. Advisor selection: be skeptical of deals that sound too good

Some advisors pitch VPPAs as money makers with no upfront costs for your company. These claims should be viewed with skepticism and examined closely. We recommend the following considerations when you are evaluating and selecting an advisor:

  • Know how your advisor is getting paid. Some advisors are making windfall profits based on a success fee pricing model. With this model, the advisor receives payment from the project developer upon contract execution and the fee is based on the long-term project revenue ($/MWh) or the size of the selected project ($/MW). The buyer benefits by avoiding upfront costs but this method is more costly over the long term. As important, it can also create a misalignment of incentives–the advisor gets paid more with a longer term and/or a larger sized deal. See our article on VPPA transaction fees for more details on how to make an informed pick for your advisor.
  • Be cautious of easy money. VPPAs are sometimes advertised as positive cash flow for buyers–meaning that buyers will actually make money by entering into the contract. If a VPPA truly provided easy money, then we would expect to see project developers or investment bankers (who always follow the money) building projects on spec to reap the rewards. Ensure you understand the underlying modeling assumptions that result in a VPPA with positive net present value.
  • Don’t bank on increasing wholesale power prices. Natural gas prices, which are highly correlated to wholesale power prices, are at historic lows due to the shale gas boom. We see no sign of a slowdown in US natural gas production [Source: EIA Annual Energy Outlook 2018], so be wary of price forecasts that show significant increases in wholesale power prices over time (and therefore increase the potential value of a VPPA for a buyer).

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2. Defining the value: creating a PPA “mission statement”

When the sponsor of the PPA or VPPA initiative sits within the sustainability team, the “why” behind procuring renewable energy is often so obvious to them, it goes unsaid. Consequently, they may be surprised when they face resistance from others in the organization. For example, a facility manager might be more focused on keeping the electricity bill low. Or an energy buyer might view renewable energy as an unnecessary and frivolous use of company resources. Or maybe the company attorney resists dedicating time to learning a new contract structure.

Stakeholder engagement (more below) is a key part of working with these naysayers. But before launching stakeholder engagement activities, it is important to define why the company is heading down this path. Your PPA initiative needs a mission statement.

The mission (or purpose) of your PPA initiative provides the foundation for all internal and external discussions. For example, your company’s values may align with procuring renewable energy. There might be public goals that need to be met. Or you may be facing shareholder, customer or competitive pressure to act on climate change. Understanding and being able to explain why a PPA is well-suited to meet your needs provides the proper context for internal discussions.

In addition, a clearly defined purpose provides guiding principles for assessing the many trade-offs that come with the PPA selection process. Some common VPPA trade-offs include:

  • A project located in the same state as your corporate headquarters versus a project in a less expensive part of the country
  • The desire for additionality versus preference a shorter contract commitment
  • Executing a single transaction to meet goals versus multiple contracts to diversify risk

When a company has a clearly articulated mission for their PPA initiative, the answers to these questions become simpler and the best-fit PPA can readily emerge.

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3. Stakeholder engagement: ignore at your peril

PPAs are complex contracts that require significant buy-in from across the organization. You will be introducing people to a lot of new concepts – concepts that are typically not part of the organization’s core business and outside people’s comfort zone. This leaves many stakeholders feeling uncertain and afraid to ask a “stupid” question. As a result, we’ve seen stakeholders avoid asking questions and internal deal champions that assume this lack of questions equals support for moving forward with a PPA. Unfortunately, the silence is often indicative of continued confusion and can create last minute project roadblocks.

So how do you get meaningful engagement with your stakeholders (and avoid unpleasant surprises later)?

  • Stakeholder mapping: Think carefully about all of the different departments that may be impacted by a PPA and/or may have decision-making authority. It can be useful to look at other major initiatives that required multi-departmental buy-in to ensure that a complete list is created.
  • Outreach: After the stakeholder map is complete, find the decision maker in each department. Build the relationship by telling them the renewable energy story, the PPA “mission statement” and the importance of their department’s role in the overall decision-making process.
  • Education: Renewable energy, wholesale power markets and the mechanics of the “contract-for-differences” are key topics for the stakeholder group to understand when pursuing a VPPA. These concepts are usually new to stakeholders and have very little to do with their day-to-day responsibilities. People do not need to be experts — that’s what advisors are for — but they do need to understand the value drivers and risks. Be very intentional about setting the tone for stakeholder meetings. Simple statements such as “we are all here to learn” and “please ask questions” can create an environment where real questions will emerge.
  • Follow-up: Individual follow-up goes a long way. This can be a simple email or a small group discussion on the specific topics that correspond to an individual and their role. This kind of targeted follow-up can create a comfortable environment for asking detailed questions, thus giving stakeholders the ability to confidently support your initiative.
  • Repeat: True stakeholder engagement requires building trust over the term of the PPA initiative. Stakeholders need to be given regular progress updates and provided with opportunities to ask further questions.

If you are working with an advisor, they should be able to provide some tools and resources to guide the stakeholder engagement process.

4. Evaluating offers: VPPA value is not just about price

We all like a good deal. There’s a reason why retailers run special promotions for items at $9.99 instead of $10 – we like paying the perceived “lower” price. So while our natural instinct is to select the lowest price, for VPPAs, the lowest price offer is often not the best value for the buyer.

Instead, consider: What is the long-term value of the VPPA for our company? And how can I ensure I’m making an apples-to-apples comparison between projects?

For example, how do you compare:

  • A wind project against a solar project given that these technologies have different generation profiles?
  • Projects with different start dates or different contract lengths?
  • Projects in different states or regions?

There are no simple answers, but a comprehensive quantitative analysis can provide insights that will allow a buyer to make a clear-eyed selection. Some of the most common approaches to the quantitative analysis include:

  • Using multiple forecasts of the floating wholesale power price and comparing these to the fixed contract price, resulting in a range of expected implied REC values
  • Stress-testing wholesale power price forecasts to understand potential value under a range of market conditions
  • Using a historical look-back to see how the contract would have performed if it had been executed three-to-five years ago

Executing a PPA is an incredibly powerful tool for meeting your corporate sustainability, renewable energy and GHG reduction goals. We encourage you to think critically about the early steps you can take to set yourself up for the successful execution of a well-understood and risk-mitigated contract.

If you are looking for help with an upcoming PPA or VPPA transaction, learn more about our renewable energy procurement services or contact us.

 

Is the success fee model working for our industry?

Transaction: Success Fee Model

Your company has taken the bold move to set renewable energy and carbon emissions goals.  You have done the work to get the key stakeholders to consider a virtual power purchase agreement (VPPA). Now you’re wondering if you need an advisor to help you navigate the procurement process. Experienced advisors can help you avoid many of the pitfalls inherent in participating in the wholesale energy market. But how much do they—and should they—charge for the value they offer clients?

A trusted advisor can add significant value, helping with everything from building stakeholder support, navigating derivative accounting concerns, to running financial analyses and leading contract negotiations. The market for advisors offering their services has grown along with the appetite by corporate buyers for VPPAs. But clients’ understanding of advisory services costs under the widely accepted success fee model remains murky. Peeling back the layers of this business model can add greater clarity and transparency to the market.

The success fee model is the most common pricing model currently offered by renewable energy advisors. This model is akin to commodity brokerage services: advisory services are provided to the buyer “free” of charge because the seller “covers” the cost. In the case of a VPPA, the advisor provides support throughout the term of the engagement at no cost to the client and then receives payment at contract signing (or other key milestones) from the project developer. This fee can take the form of a payment based on project size (dollars per MW), an ongoing royalty (percentage of the long-term revenue from the project) or a combination of the two. In this scenario, a client avoids paying consulting fees in favor of ongoing payments levied on top of the VPPA price, paid over the life of the offtake agreement.

The success fee model has emerged as a favored pricing structure for good reason. Many VPPA initiatives are led by budget-constrained departments that have climate change or renewable energy goals, while the ongoing VPPA costs will be paid out of a larger facilities, operations, or treasury budget. In addition, even if a client fully intends to execute a deal, they can walk away with no money out-of-pocket if they decide not to execute a contract or if they are unable to find a project that meets their requirements. The success fee approach also helps ensure that the advisor works diligently to overcome any obstacles to bring the client an acceptable project and contract—or else they won’t get paid!

Unfortunately, this model can also create a misalignment of incentives. The advisor gets paid more for a longer term, larger sized and/or higher priced deal. Even though the advisory services required (i.e. stakeholder engagement, solicitation and contract analyses and negotiation) are the same whether the VPPA is for 10 MW or 200 MW, the advisor’s fees can increase materially for the latter. Additionally, since the advisor only gets paid if a contract is executed, this model can cause the advisor to focus more on getting a contract signed than on the nuances of the client’s best interests. This is a natural, human response to the incentives in place. Whether these potential conflicts are perceived or real does not diminish their impact on the client and points to the importance of trust and transparency in this relationship.

The chart below shows the fees which result from representative success fee engagements. As highlighted in the chart, seemingly modest differences in a VPPA can have a dramatic impact on the fees paid to the advisor. The chart assumes a simple combination success fee: $10,000 per MW paid upon contract execution and a 1% annual royalty from the developer’s VPPA revenue.

 

*All examples assume a 15-year contract; solar projects assume 25% net capacity factor (NCF) and wind projects assume 45% NCF

As these examples show, a simple change in technology from solar to wind, with a higher capacity factor, can significantly increase the payment to the advisor. VPPA advisory services can be highly lucrative, hence the reason why several advisors have been acquired by large energy companies.

It’s important to evaluate these fees in the context of cost and risk to the advisor. Typical time and materials VPPA advisory services that include stakeholder engagement, solicitation, analyses, negotiation, approval and execution of a VPPA may cost a buyer approximately $250,000 to $400,000. Even taking time-value of money into account, success fees come at a premium.  Whether the premium is excessive in light of the ‘at risk’ nature of the services can only be determined by the client.

In addition to the potential misalignment that this fee structure creates, there are some other aspects of advisory offerings that deserve greater transparency. The royalty component of the success fee model is often marketed by the advisor as sharing project risk with the client because they are to be paid out over time by the developer. In reality, some advisors are paid in a single, upfront lump sum payment by the developer (based on expected project revenue) or by syndicating those royalty streams—thus, the advisor can buy their way out of project risk. Also, agreements between advisors and developers may include non-circumvent clauses which prevent the developer from working directly with that client and/or prevent the client from engaging in a subsequent VPPA, without paying the advisor—whether they provide support for that transaction or not. Finally, some advisors exclusively source projects from their proprietary project database. The databases are often “pay-to-play,” resulting in some developers reducing the number of projects they make available via the database, thus limiting the client’s true access to the marketplace.

While there is no doubt that advisors are an important part of the corporate renewable energy ecosystem, corporate buyers should understand the true cost of these services under a variety of scenarios and weigh their corresponding value.

So are success fees a bad idea? Not necessarily.

If you have full insight on the range of potential fees and believe you are receiving equivalent value, then a success fee can serve you well. However, it is important that you have a clear-eyed view of the advisor’s incentive structure.

You can push for full transparency by asking the following questions during the hiring process (or even asking your current advisor):

  • What are your total potential fees (not just percentage of VPPA price or $/MWh) for a specific sized VPPA and what assumptions make up those fees?
  • Will you show me the VPPA financial results both with and without the advisor’s fee embedded in the price?
  • When will you be paid by the developer and will you tell me if these milestone payments change?
  • Is there a cap on the total success fee amount? If not, why not?
  • What contract terms do you require between you and the chosen developer and how could those terms impact me now and into the future?
  • Will you provide advisory services on fixed-fee or time and materials basis and if so, what are the estimated costs for those services?

As an advisory firm that supports renewable energy procurement and offers a success fee model along with other payment structures to our clients, 3Degrees welcome these questions. We believe transparency creates a more efficient marketplace, enables educated buyers and improves decision making. Increased transparency naturally occurs in maturing markets, but further clarity is needed to ensure that cost equals value—with the value to be defined by you, the buyer. Advisors in the sustainability industry need to foster sustainable pricing models that serve the clients, fairly compensate the advisors and ultimately, promote more renewable energy being built to combat climate change.

Interested in learning more? Get in touch with us. Contact Us Here