With a lack of traditional utility power purchase agreements available to meet demand, wind project sponsors have turned to corporate PPAs and other hedging alternatives to secure predictable cash flows. Depending on the structure, these agreements can lead to derivative accounting, trigger Dodd-Frank reporting requirements, or both. The following discusses what each of these agreements represent and the associated derivative accounting and Dodd-Frank implications.
What is a PPA?
A power purchase agreement (“PPA”) generally refers to a contract between two parties where one party (“seller”) agrees to sell electricity and renewable energy credits (“RECs”) to another party (“buyer” or “offtaker”) at a specified price. In this case, the seller is often the developer or project owner. The buyer is generally a utility or commercial and industrial (“C&I”) organization. With a physical PPA, the seller operates the wind farm and delivers the electricity generated from the wind farm to the buyer at the contractually specified delivery point.
- Accounting Considerations: These contracts may or may not meet the definition of a derivative depending on whether the agreement includes volumetric guarantees or contains default provisions that indicate a minimum volume. If the contract meets the definition of a derivative, it may still be able to escape derivative accounting via the normal purchases normal sales (“NPNS”) scope exception since the contract results in physical delivery.
- Dodd-Frank Reporting Considerations: A physical PPA is not subject to Dodd-Frank reporting requirements as the contract results in physical delivery of electricity.
What is a VPPA?
A synthetic or virtual power purchase agreement (“VPPA”) is an alternative to a physical PPA. A VPPA is a hybrid agreement which includes a contract for differences (“CFD”) along with an agreement to deliver the related RECs from the project. Under a VPPA, there is no physical delivery of electricity. Rather, the agreement specifies a periodic payment to be made based on the difference between an agreed upon fixed price and a floating market price, generally at a market hub or a project node. Upon settlement, when the market price exceeds the fixed price, the seller pays an amount to the buyer equal to the difference times the agreed upon quantity. When the opposite is true and the market price is below the fixed price, the buyer pays an amount to the seller equal to the difference times the quantity.
Physical PPAs are most commonly used by organizations that have heavy, concentrated load (e.g., data centers, utilities, etc.). For companies without heavy, concentrated load, VPPAs work well, as they do not involve physical delivery of the electricity. Accordingly, VPPAs have become quite common for corporate buyers who have turned to wind energy, not only to meet their sustainability goals, but also provide long-term electricity cost certainty.
- Accounting Considerations: These contracts may or may not meet the definition of a derivative depending on whether the agreement includes volumetric guarantees or default provisions that indicate a minimum volume. A VPPA will not qualify for the NPNS scope exception as these contracts do not result in physical delivery.
- Dodd-Frank Reporting Considerations: Although the regulatory requirements for VPPAs are still being formed, the prevailing view is that these contracts are “swap” agreement and thus trigger Dodd-Frank reporting requirements.
What is a Hedge?
While VPPAs are growing in popularity, there is still a lack of long-term offtakers that want to sign a PPA to meet the growing demand of wind capacity. This is where several large financial institutions have stepped in to fill the void with hedging agreements. With over 20 gigawatts of wind capacity, Texas has been the epicenter of the hedge phenomenon. Texas’ independent system operator, ERCOT, has a deep and liquid spot market that provides the price transparency needed to structure workable hedges.
In ERCOT, a typical hedging arrangement is a fixed-volume price swap. With a fixed-volume price swap, the hedge provider generally receives physical delivery of a fixed volume of electricity at the market hub and pays a fixed price for this electricity.