Sponsored by Coho.
A crucial step in any large organization’s renewable energy procurement journey is the assessment of expected economics over the life of the contract, which can often run 10 years or longer.
Sustainability benefits are increasingly important to organizations, but to secure approval to move forward with a specific renewable energy (RE) option, each organization’s CFO needs to feel comfortable with the expected economics and potential financial risk.
How should large energy buyers think about evaluating economics? Although general rules of the road exist for any situation, each buyer’s specific approach will depend on answers to two key questions:
- What are your organization’s financial priorities for RE projects?
- Which RE solution type is available and of interest to your organization?
What are your organization’s financial priorities?
Most of today’s renewable energy solutions are financed by third parties, require zero upfront capital outlay by the commercial and industrial buyer and are structured under "pay as you go" models. This can make them more palatable to the finance team, however, there will still be concerns about the potential financial impact of signing up to be the long-term offtaker of power from a renewable energy project. Three high-level financial priorities tend to get the most attention when it comes to evaluating your organization’s renewable energy options.
- Maximizing potential savings: Simply put, finding a solution that can maximize expected savings for your organization (offers the highest net present value, or NPV, opportunity) over the life of the contract.
- Minimizing downside risk: Prioritizing solutions less likely to produce losses (even if that means forgoing some potential economic upside).
- Minimizing volatility: Selecting solutions that bring more predictable cashflows, given 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 be in conflict with one another (for example, an option that minimizes downside risk also might minimize volatility), they often can be and therefore require early prioritization. Chatting with the finance team about its priorities can help your organization sort through how to evaluate its options.
Which solution Is available and of interest to your organization?
Reflecting the significant and growing interest of large corporate buyers in RE supply — and to their potential benefit — many more renewable energy solution types are available today than in the past, including virtual power purchase agreements (VPPAs), retail renewable energy, green tariffs, onsite solar and community solar. The availability of each solution depends on where an organization’s facilities are, so the first step should be to understand which solutions are potentially available given your organization’s physical footprint.
Although an increase in available solutions creates complexity in understanding the nuanced differences and trade-offs, three basic commercial structures exist for purchasing renewable energy:
- Fixed all-in price for delivered electricity: The buyer agrees to pay a single fixed price for any delivered or consumed electricity. Examples include certain green tariffs and retail renewable energy.
- Fixed discount to a specific electric rate: For each unit of electricity, the buyer receives a constant discount to an underlying fluctuating rate (utility rate). Examples include community solar.
- Fixed for floating structure: The buyer agrees to pay a fixed price for electricity generated in return for a deemed floating price (whether a local market price or a utility-determined price). Examples include VPPAs, certain green tariffs, onsite solar and certain retail renewable energy options.
Each structure carries a different risk profile, both in isolation and when considered in the context of an organization’s current energy portfolio and purchasing strategy. By matching the finance team’s priorities to which solutions are available to your organization, you can identify the right renewable energy solution(s) and kick off the "fun" part of modeling the economics.
The basics of evaluating renewable energy economics
In getting started, your organization must have a good grasp of its current business as usual (BAU) electricity costs, answering questions such as:
- How does your organization purchase electricity today? For how long? At fixed or index market prices?
- What is being spent per unit of electricity consumption today?
- What would the organization’s current BAU strategy look like if projected into the future, accounting for expected growth?
After building a strong understanding of your organization’s BAU electricity profile, it is time to compare that against specific renewable energy options. Map out cash flows for BAU against the selected renewable energy solution or project and assess the savings potential.
Given that each renewable energy solution or project evaluated may look slightly different, normalizing them on a metric that allows easy comparison to other project options is vital (for example, savings per unit of electricity over the contract term). Comparing just the NPVs of two contracts with different term lengths or sizes (in terms of electricity consumption or production amounts) does not facilitate apples-to-apples decision making.
This comparison should be a relatively straightforward exercise when assessing renewable energy solutions that use a fixed all-in price for delivered electricity commercial structure. However, for other structures (such as fixed for floating), evaluating economic performance will depend on how the floating price evolves in the future and how the structure interplays with the organization’s current energy purchasing strategy. Assessing this input can complicate the analysis, given the market price uncertainty and volatility. But the insights gained through the analysis make the extra effort worth it.
Evaluating renewable energy economics when market price exposure exists
Candidly, it is all but impossible to predict future prices. That being said, large energy buyers can take informed modeling approaches to better assess market price risks over time.
- Use multiple data points to inform predictions of future prices. Use both market-based curves (such as forward market curves) and professional price forecasts that derive future prices by modeling expected supply and demand to develop a range of potential future price scenarios.
- Consider timing of renewable energy production in the analysis.When market price exposure exists, the timing of actual renewable energy production matters. Markets with high penetration of renewable energy, for example, can result in significant downward pressure for prices at specific times of day (or seasons). Match expected future prices according to expected renewable energy production.
- Run plenty of sensitivity analyses. Being armed with the best information today may still fail to predict future outcomes. For this reason, it is important to run various downside sensitivity analyses to test base assumptions. These analyses should be based on various supply and demand shocks that could negatively impact prices. For example, what happens if renewable energy adoption grows more quickly than expected in the market of interest? How would expected electric prices change if natural gas prices crashed to a decade low?
- Layer in available contractual risk mitigants. For some renewable energy solutions such as VPPAs, suppliers may offer creative risk sharing structures (price floors, upside share structures and others). Buyers should assess 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.
Bringing it all together
Although evaluating renewable energy economics can seem daunting as a buyer, the first step to success is understanding the financial priorities and renewable energy solutions in play for your organization.
With that information in hand, you can see which renewable energy solution may be in your organization’s best fit and begin to assess the economic potential. You can leverage the expertise of the finance team and other internal relevant stakeholders, as well as external renewable energy advisors, to help evaluate economics and demystify the analytical/problem solving process. With the right planning and team, your CFO’s approval is in reach.