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A market emerges when buyers and sellers share the same interest

A market emerges

Treasury and Accounting are sometimes faced with unexpected demands as a result of the rapidly changing energy markets.

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Treasury and Accounting are sometimes faced with unexpected demands as a result of the rapidly changing energy markets due to the transition to renewable energies. This generally relates to whether or not embedded derivatives exist, the observance of the own use exemption and the valuation of the resulting financial instruments or provisions for contingent losses.  Fixed-price contracts for the purchase of renewable energies is one such case.

After many years of subsidisation by the German Renewable Energies Act [EEG], as reflected in the guarantee of a fixed sales price amongst other things, this will increasingly come to an end in the coming years. The installations, which were set up at the start of the new millennium, are thus losing the legal protection provided by their priority feed-in status and are reliant on the market price when it comes to the energy marketing. Apart from the difference in price, the EEG remuneration for many wind farms that are still receiving subsidies is slightly over EUR 60/MWh, there is also the added uncertainty that the price will no longer be known in advance as it is reset on a daily basis at the day-ahead-auction of the electricity exchange.

This price uncertainty also impacts new installations. Although these also receive subsidies under the EEG and thus are entitled to feed-in priority, the subsidy received what is known as "zero-bids" in the auction for offshore capacity meaning that the installations that are still to be set up do not receive a fixed price. The expectations for the profitability of the projects are composed of the anticipated efficiency gains when setting up the installations together with the assumption that wholesale electricity prices will rise, whereby electricity will then be sold without being bound to a fixed price.

In order to be able to leverage the maximum level of flexibility from these projects, investors have shown a great deal of interest in having revenue streams for financing that are as secure as possible, meaning that efforts are being made to agree bilateral agreements for a fixed price over an extended period.

As a transaction or market always involves at least two stakeholders it is good that initiatives such as RE100 have been set up in recent times, in which in this case "the world’s most influential companies, committed to 100% renewable power“ are loosely organised. In this way there are these and other renowned companies, which owing to their sustainability strategy are extremely interested in obtaining electricity from renewable sources at a fixed price – and now there are not only suppliers but also consumers.

There is currently a market developing in Germany for these long-term agreements from renewable sources (power purchase agreements – PPA), after the initial experience of this in Scandinavia. In order to have security for both partners a range of very specific questions need to be agreed, which quickly complicates the contractual framework: a) amount and term of the fixed price, b) is there a link to a price index, general inflation or a right to renegotiation, as was the case with long-term gas purchase agreements, c) special content of force majeure clauses due to off-shore installations, d) will only the amount produced daily, which fluctuates greatly, be delivered and the price secured or will the customer's consumption profile or a pre-agreed profile be delivered and the price secured and what additional costs will this lead to, e) change of control agreement, f) credit requirements etc.

Alongside the accounting treatment of these contracts, their valuation also poses a particular challenge. This is dependent on the agreed payment flows of the compensation payments (agreement on up-front portion, continuous compensation payments etc.). When planning the overall electricity purchase costs it should be assumed that the less electricity produced at a given point in time from renewable sources, the higher the price of any replacement procurement of electricity that takes place must. This interrelationship is not linear and thus has to be adequately accounted for and followed up in risk management. The strong levels of fluctuation in the replacement procurement of missing quantities of electricity also require a professional energy procurement system, which is capable of displaying updates to forecasts by automatically trading on the short-term market (intra-day algo trading) with minimal levels of expense, for example. As an additional product, the purchaser of the PPA should also simultaneously be entitled to the green certificates that are generated, which also need to be displayed and managed in the systems.

Therefore this also raises some accounting issues. Does the reference to a price index mean that there is a separable derivative? How is the acquisition of green certificates as part of the price agreement for the electricity to be treated? If the electricity purchased is resold, do these transactions need to be valued and recognised as derivatives as the criteria for the own use exemption would no longer be met? How should possible hedging transactions be dealt with as part of risk management for the electricity price?

Owing to the increasing levels of electricity produced from renewable installations, which no longer receive remuneration under the EEG, and other "zero-bids" for new installations, coupled with market prices being geared towards procuring emission-free energy, we expect that a domestic market will develop. Both buyers and sellers will reap the benefits from this and at the same time renewable energies are being fully launched on the market. And this does not only pose additional challenges for energy trading but also possibly for Accounting and Treasury.

Source: KPMG Corporate Treasury News, Edition 78, March 2018
Author: Malte Neuendorff, Senior Manager, Finance Advisory, mneuendorff@kpmg.com 

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