McKinsey&Company published an article on how the expansion of subsidy-free renewables projects requires asset developers and investors to find new strategic approaches to manage the risk from merchant price exposure. We have made a summary of this article, which we have shared below.Summary of article written by Sven Heiligtag, Florian Küster, Florian Kühn and Joscha Schabram from McKinsey&Company. First published in November 2018.
The Three Phases of Market Integration
In the last three decades, subsidies played in important role in accelerating renewable energy investments. In the first phase of market integration, policy mechanisms like feed-in tariffs facilitated the rapid growth of renewable energy generation while technology advances caused a constant decrease of construction and operating costs and risk.
The introduction of auctions which entailed fierce competition for subsidies heralded a second phase characterized by price droppings of 50 to 80 percent during the last three years and a limited merchant risk undertaken by developers.
However, “zero bid” auctions which no longer guarantee a minimum electricity price and the recent development of subsidy-free projects in Spain, Germany and the Netherlands give rise to a new phase of market integration in which governments will abandon subsidies and developers will be fully exposed to wholesale prices. Hence, the strategic management of merchant risk will be of growing importance to developers and renewables investors.
Managing Long-Term Merchant Risk Markets - New Solutions and Strategic Positioning
One approach for asset owners and investors could be to consider additional risk buffers, such as an increased minimum expected rate of return. For example, an increase in the minimum expected rate of return of 150 to 250 basis points translates to an additional risk buffer of approximately 20 to 30 percent of capital expenditure. This could be a key enabler for offering competitive bids and allow to manage the long-term merchant risk efficiently.
However, the most popular transaction type for dealing with long-term merchant risk has been the corporate power-purchase agreement (PPA). Several companies, most notably Google, have fulfilled their pledges to become carbon neutral by securing numerous long-term PPAs lasting more than ten years.
Yet there is likely to be a blockage in demand if renewables grow at the pace currently forecast. If we assume, for example, that the bid-winning projects are fully subsidy free in the future, 40 percent of the total B2B consumption in Germany would need to be covered by long-term PPAs.
As industrial and B2B counterparties will only be able to absorb a limited amount of the expected long-term merchant risk volume, the participation of traders and intermediaries, financial institutions, and long-term investors as well as the strategic positioning of renewables players is needed.
There are several archetypes to consider, which can be grouped along two main axes: merchant risk appetite and merchant risk-management sophistication.
Given that the long-term renewables-merchant risk market is highly illiquid, and the pricing is non-transparent, players can use commercial capabilities and a sophisticated risk-management setup to differentiate themselves from their competitors.
Consequently, players that have sophisticated commercial capabilities but have not previously engaged in asset-development activities are starting to move into renewables development by using their commercial focus to profit from and deal with merchant risk effectively. Experienced asset-development players, on the other hand, are investing in expanding commercial capabilities to increase their options for handling merchant risk exposure.
Before making a strategic decision on their own positioning, players should answer the following questions:
- What are the likely scenarios of future merchant risk-exposure development, considering the current portfolio and future renewables projects?
- What is the player’s ability to absorb risk—in balance-sheet strength, credit rating, and the impact of merchant risk exposure on the company valuation?
- What are viable solutions to off-load long-term merchant risk and its costs, and how well developed are the player’s commercial capabilities?
- Are there strategic alternatives to avoid risk, such as focusing on regulated markets? What would be the impact on the player’s growth ambitions?
The Investor's Perspective: An Opportunity to Create Value
Apart from renewables developers, players with a place in the merchant risk value chain such as financial investors will also need to develop strategies to create value.
To date, financial investors have mainly invested in renewables via direct equity investments and have benefited from stable returns. While the introduction of merchant risk means stable returns are no longer guaranteed, it does offer the opportunity to increase returns. Investors need to develop basic views on whether to take on merchant risk, how merchant risk will impact portfolio risk and return expectations, and how to invest in renewables projects with merchant risk—for example, via new asset classes or risk-mitigation requirements.
A comparison of the volatility of merchant risk with the volatility of equities (German power prices versus DAX 30) indicates that renewables projects with merchant risk could be attractive for investors since the volatility is lower than the volatility of equities. This correlation indicates that investors can benefit from the portfolio-diversification effect.
All in all, merchant risk, as the new and vital ingredient of renewable energy investments has a great potential to thrive the industry. Success will be determined by players finding their place, based on their strengths, competition, and the needs of different actors.