As we argued in our last blog, a healthy corporate power purchase agreement (CPPA) market is vital to cost-effectively decarbonise power systems. However, there are a number of barriers to creating such markets, not least of which is the credit risk developers face from long-term contracts with corporate offtakers.
The good news is that solutions exist to CPPA credit risk – whether from government guarantees or from private sector innovation. Below, we consider which might be most appropriate for the UK power market.
A credit crunch?
One of the appeals to both buyers and sellers of CPPAs is their long-term nature. A corporate buyer can lock-in its power costs for up to 10-15 years. Equally, a developer can match the tenor of its debt with a long-term revenue stream. However, both parties to the contract are at risk of the other defaulting.
For the corporate buyer, that risk tends to be minimal. If the seller stops generating power, the buyer can usually expect to replace the contract without too much difficulty, albeit with the risk that it might be forced to pay a higher price for its power, depending on where the market is at that point.
In some cases, CPPA contracts can be structured where the buyer has recourse to the project’s assets in case of default. Probably the most important factor is that the project has limited operating costs once it’s operational, so project SPVs – the buyers typical counterparty for the transaction – very rarely default on CPPAs.
The seller, however, faces greater credit risk. If the buyer defaults, the project operator also becomes exposed to wholesale power market prices, and may not earn enough to cover its debt payments. Moreover, by the time its buyer goes bankrupt, it is likely to have lost weeks or months of revenue from power supplied but not paid for.
Credit risk is not front of mind for developers in the UK market who have previously relied on government support schemes. Entering into contracts-for-difference with the government-owned Low Carbon Contracts Company exposes them to the credit of the UK Government, which – despite the best efforts of some recent prime ministers – retains an AA-rating.
However, those raising debt secured against CPPAs will face careful scrutiny from their lenders. Their bankers will consider the credit risk of the CPPA counterparty when pricing their debt, and would likely refuse to lend against those struck with sub-investment grade offtakers.
Solutions are at hand
There are a variety of possible solutions at hand.
An obvious solution is for the government to step in, providing risk guarantees in ways that are analogous to the export credit guarantee model. Here, government agencies provide guarantees to help their exporters manage the risk of selling goods and services overseas.
Indeed, in Norway, the country’s export finance agency has been offering a product aimed at the CPPA market since 2011. Its power purchase guarantee is available to counterparties based in Norway (with no requirement to export power). The guarantee can either safeguard the power seller against default by its buyer, or the lending bank against non-repayment of any loans that the buyer has taken out to purchase power in advance.
It is a targeted programme, restricted to companies involved in wood processing, metal production and chemicals production.
The Spanish government established a similar programme in 2020, allocating €600m to provide guarantees to energy-intensive companies signing renewable energy PPAs. These are also available through Spain’s export credit agency, Cesce, and the first such guarantee was made last April, to power supplied under a 12-year PPA to steel maker Sidenor Aceros Especiales from a Sonnedix solar plant.
France followed suit with state-owned investment bank Bpifrance launching a PPA guarantee fund last year, with capacity to support up to 500MW of generation, which would double the size of France’s corporate PPA market. The first CPPA supported by the fund was struck last October, between Arkolia Energies and food company Bonduelle.
Such initiatives are likely to become more common in the EU following the agreement by the Council of Ministers in December on proposals for electricity market reforms. Among other things, the reform package will allow member states to set up guarantee schemes “at market prices, if private guarantees are not accessible”.
As a variation on this theme, there have been calls for development finance institutions to step in with such a product. Indeed, the Spanish government has called for the European Investment Bank (EIB) to offer financial guarantees to CPPAs. Again, the development bank could provide a guarantee to the project owner or lender to make them good if the seller defaulted.
Project finance insurance
An option for project finance banks is to take out non-payment insurance to protect themselves from the failure, refusal and/or inability of their counterparties to repay debt on its scheduled due date. Whilst this is one step removed from the CPPA off-taker and is typically limited to 50% of the borrowing, such insurance provides a useful source of investment-grade, unfunded risk capacity, and protection for project finance lenders. Insurers offering non-payment insurance are typically rated A or above, providing additional security to the lenders.
Another possible way to manage the credit risk of the buyer is the provision of guarantees by monoline insurers. These are specialist insurance companies which focus on one line of business, using particular sector expertise and portfolio diversification to manage risk more efficiently – and therefore at a lower cost – than non-specialists.
Essentially, the monoline insurer is able to lend its – typically triple-A – credit rating to the cash flows from the PPA buyer, using an over-capitalised special purpose vehicle to turn them into a bankable revenue stream for the project developer.
An alternative to a specialist monoline insurer would be a generalist credit insurer that was willing to insure the default risk of the offtaker. Like the monoline insurer, it would lend its credit rating to the cash flows from the buyer, but here there wouldn’t be a special purpose vehicle and the insurer would pay out under the policy in the event of a default of the buyer if, and only if, the seller suffers a loss.
The actual loss would have to be settled in a transparent way by establishing the replacement price of a new offtake agreement with a similar buyer credit for the remaining term of the CPPA. Because of the uncorrelated relationship between the default risk of the buyer and the power price, this insurance product is effectively a structured credit product and, as such, should cost less than a simple credit default swap.
A government-backed intermediary
A more ambitious proposal is to create an entity to manage credit and long-term price risk, or use an existing one, such as the Low Carbon Contracts Company. Such an entity would aggregate end-user demand, manage market risk on behalf of end-users, and execute large, long-term contracts with generators. This model assumes that the entity is provided with either low-cost capital from a development bank or government, or has a government guarantee.
Probably the most obvious market solution is the aggregation of buyers into a single CPPA. This spreads the credit risk over a number of corporate credits which reduces the impact of credit default; if there are five buyers in the CPPA with 20% of the offtake each, then a single default has less impact on the seller.
Options for the UK?
So, which might be most attractive in the UK context? The government was looking at the question of guarantees as part of its Review of Electricity Market Arrangements (REMA), which it launched in 2022. We are still waiting for visibility as to what the government is likely to propose in its response to the consultation it carried out, and it may be that the process is slowed by the election due later this year. Whatever the government decides, the CPPA market will be watching closely.