Not all power purchase agreements look alike: as more companies seek renewable supply, more credit risk complicates deals.
For solar developers, this upwelling risk creates a choice: stick with what you know, or experiment?
Seeking safety in numbers, some solar developers are diversifying their PPAs to include clubs or contracts with communities.
The Solar Energy Industries Association estimates that 324 GW of solar projects will come online in the United States over the next decade. Who will purchase all of the power generated? Project developers are looking beyond traditional utility partners to find buyers. A recent BloombergNEF report indicated an 18% annual increase in new corporate power purchase agreement (PPA) volumes for 2020, suggesting a wider field. These corporate contracts can come with increased risk of default, so developers are learning about other structures that may offer more palatable credit risk. These include community solar, in which households sign up to purchase power sourced from smaller-scale solar projects.
Under law firm Norton Rose Fulbright’s definition, a corporate PPA serves as “a contract governing the purchase by a corporate buyer of all or part of the energy produced by an off-site renewable energy project built, owned and/or operated by an independent or affiliated entity.” These contracts hedge against merchant risk to guarantee future cashflows for the asset owner, and are often required in order to secure project financing. The buyer’s usually a company of some kind, but needn’t be.
Historically the PPA buyer was a utility, but there is an increasing appetite for PPAs in the US from corporate entities which want to procure renewable energy themselves. This has mainly flowed from large technology companies, but interest is growing among smaller corporations grappling with the ramifications of climate change and focusing on decarbonizing their operations. A report from IHS Markit suggests that up to 20% of new renewable generation in the US through 2030 could be contracted directly with corporations. Corporations, though, depend on sometimes-fickle customers for cash, and so bring higher credit risk than some utilities do.
Credit risk is the risk that a person or company cannot repay its obligations. Credit risk appears in almost all debt deals, and agencies like S&P and Moody’s will evaluate the financials and economics of a particular company and provide a credit rating to indicate how likely the company is to pay its debts. These ratings help investors and lenders make sound decisions related to credit risk. When dealing with corporate credit risk, people will often speak of “investment grade” credits, which corresponds to a credit rating of BBB- or better.
Since a PPA amounts to an agreement that someone is going to buy the future power generated by a project, any project developer signing a corporate PPA takes on credit risk of the corporate buyer. Project developers typically seek an investment grade rated PPA buyer, such as a utility or a large technology company. However, renewable project development may be growing even faster than demand for corporate PPAs. This can lead to a “buyer’s market”, where the amount of power being added through renewables projects is greater than the amount of power demanded by investment grade corporate PPA buyers. This can cause issues for developers: if they cannot find a PPA buyer, they will not be able to finance their project.
Shah Imran, then of EDP Renewables, agrees: “The market is getting saturated with developers, and smaller developers might be willing to stomach more credit risk in order to get the project done”. In other words, some renewable developers are unable to find investment grade corporate off-takers for their projects. To secure project financing, they may instead look to sub-investment grade buyers who look more likely to miss PPA payments.
Bryan Eckstein of Forefront Power agrees that there are issues with finding quality off-takers in the corporate space. “PPA deals with investment grade companies and utilities have largely been picked over”. Developers like Forefront see an opportunity at the opposite end of the size spectrum: instead of targeting utilities and corporates for offtake, they focus on community and municipal solar.
The benefit of this strategy is diversification. Community and municipal scale solar projects, sized up to 5MW, consider the offtake market as a whole. Rather than load all the credit risk onto a single corporate, these projects can spread the credit risk across many households in different towns and employment bases. A project considering community market penetration and churn (people moving in and out of neighborhoods) can effectively mitigate their default risk, short of a complete community exodus. Diversification also makes it more attractive to target underserved low-income offtake markets.
This diversification doesn’t come with easy customer acquisition. Eckstein says “the biggest challenge of these projects is getting 100% subscription on the front end”. Even where the customer would save money, customers may need to see savings as high as 20% to overcome the nuisance cost of switching electricity providers. These issues are compounded in low-income markets, where greater education of the community may be required to get it onboard with the idea of an outsider selling them something.
Community solar developers also often have to offer customers the same flexibility in billing and contractual periods that a large utility can boast, which means that individual customers can cancel their contracts with limited notice. This can make it more difficult to find financing in a world where lenders are used to long-term PPA contracts which guarantee payments. One way that developers can mitigate this risk is to oversubscribe the project, so that a customer leaving their contract can be replaced with another customer from the project waitlist. Another potential mitigant is to allocate a certain percentage of the project’s power to a traditional long-term PPA contract with a corporate off-taker (also called an “anchor tenant”), but this reduces the project’s diversification benefit.
In addition to Forefront Power, several other developers are active in the community solar sector, including Nexamp, Community Energy, and Distributed Solar. NREL data from June 2020 suggests that there are roughly 2.6 GW of installed community solar projects in the United States, heavily concentrated in Minnesota, Florida, and Massachusetts.
With major ratings agencies expecting corporate default rates to increase through 2021, credit risk should remain top of mind for developers and asset owners looking to enter into long term contracts with corporate counterparties. Developers looking to expand without dipping deep into the well of corporate credit risk may set their sights on community solar instead.