PROXY GENERATION PPAs The Next Evolution of PPAs for the Corporate & Industrial Buyer

Kenneth Davies, Microsoft Giji M. John, Orrick Lee Taylor, REsurety AUTHORS

Kenneth Davies is Director of Energy Portfolio Management at Microsoft Corporation where he is responsible for structuring long term renewable energy PPAs in order that they serve as an effective offset to the company’s long term energy cashflow-at-. Prior to joining Microsoft, Kenneth was Managing Director at Altenex where he helped introduce the vPPA to the C&I market. Kenneth previously worked at Google where he was responsible for creating Google Energy, LLC and executing the company’s first wholesale renewable energy transactions. Kenneth is an investor in, and advisor to the Board of Directors of, REsurety, Inc.

Giji M. John is a partner in the Houston office of Orrick, Herrington & SutcliffeLLP . Giji has represented project developers and long-term offtakers in renewable energy power purchase agreements (both physical and financial) since 2008, negotiating over 3,000 MW of nameplate capacity for wind and solar projects. Giji recently helped to develop the earliest Proxy Generation PPAs as well as proxy revenue-based Volume Firming Agreements to help C&I buyers their weather-related exposure under existing PPAs.

Lee Taylor is the co-founder and CEO of REsurety, Inc. REsurety provides information and risk management products to the renewable energy industry. In collaboration with clean energy buyers and sellers and (re)insurers, REsurety has developed innovative risk management products, including the Proxy Revenue Swap and Volume Firming Agreement and to date has supported more than 4,000 MW of transactions across the US and Australia.

DISCLOSURES In the interests of transparency, the reader is advised that REsurety may benefit from the adoption of the Proxy Generation PPA as against the traditional vPPA since (1) REsurety is, and may often be, appointed to perform the role of the independent calculation agent under Proxy Generation PPAs, and (2) REsurety’s Volume Firming Agreements, which are cited in various portions of this paper, are most efficient at hedging C&I buyers’ Fuel when hedging volumes under a Proxy Generation PPA. Beginning as novelty transactions dominated by socially conscious “tech” companies, corporate & industrial (C&I) renewable energy purchases now exert tremendous pull in the electricity market. Since 2013 and in the United States alone, C&I buyers have contracted for approximately 14,000 MW of renewable energy1, continuing to make headlines with every purchase.

C&I buyers’ appetites for renewable energy have unleashed tremendous creativity in structuring new products. As a result, C&I buyers benefit from state-of-the-art offerings, including: direct purchases of renewable energy by C&I buyers; “green tariffs”2; and intermediated deals allowing C&I buyers with smaller purchasing requirements to piggy back onto larger deals originated by financial institutions3 or by other C&I buyers.

This paper turns a lens onto direct purchases4, the predominant form of renewable energy transaction. And, this paper further narrows its focus onto the preferred structuring tool for those direct purchases—the long-term power purchase agreement (PPA)—by exploring methods for re-tooling the PPA (1) to simplify the contracting and negotiation process, (2) to better align the interests of green power buyers and power sellers, and (3) to empower C&I buyers to use the latest risk management tools being made available to them from insurance and commodity markets.

1 The Business Renewables Center maintains an up to the date tracker, available at: http://businessrenewables.org/corporate-transactions/.

2 World Resources Institute tracks existing green tariffs at: https://www.wri.org/publication/emerging- green-tariffs-us-regulated-electricity-markets.

3 Citi’s 10 year agreement with QTS Realty Trust serves as a recent example of such an intermediated deal. See “Citi to Power QTS Data Center in Irving, TX with Clean, Renewable Energy,” BusinessWire (April 2, 2018).

4 “Direct purchases” here include those transactions in which the C&I buyer and the project are in a direct contractual relationship; and this paper therefore includes both the purchase of physical electricity as well as swaps. 1 The Evolving PPA the C&I vPPA remains stubbornly And while the Proxy Generation entrenched in its utility origins. PPA is a new evolution of the C&I Originally designed to manage The C&I vPPA treats a project’s vPPA, it builds upon the learned the relationship between electric fuel, operational and price risks— experience of more than 4,000 utilities and independent power the core drivers for each project’s MW of Proxy Generation-linked producers (IPPs) for fossil fuel- economics—the same as those contracts that have been signed powered projects, the PPA was risks would be treated under a fossil by (re)insurance firms over the adapted in the early 2000s to fuel-powered PPA by allocating past four years. Combined with manage the relationship between most of these risks to the C&I buyer. recently available Proxy Generation- electric utilities and IPPs for That treatment, however, ignores based Volume Firming and PPA renewable energy projects. In the the reality that the operation of Settlement Guarantee agreements, early 2010s, the PPA evolved again. a renewable energy project is the Proxy Generation PPA provides Given the regulatory impediments fundamentally different from the a powerful tool for C&I buyers to to direct contracting between operation of a fossil fuel-powered pursue sustainability goals through C&I buyers and renewable energy project. Further, this treatment the acquisition of renewable projects, this evolution re-purposed thwarts C&I buyers’ ability to use energy, while avoiding the risks the infrequently used PPA financial the tools available to manage that they may be unwilling or contracts-for-differences structure the risks taken on through the unable to absorb. into the preferred tool for C&I buyer execution of a vPPA. contracting—now referred to as the Part I of this paper defines the Virtual PPA, or “vPPA.” To correct this misallocation of risks involved in buying power risks, the traditional C&I vPPA from a renewable energy project, But despite its evolution to date, needs to evolve. and the allocation of those risks under the traditional C&I vPPA Short Summary structure. Part II introduces the Proxy Generation calculation as well This paper introduces that newest as the main features of the Proxy evolution to the C&I vPPA—the Generation PPA. Part III concludes “Proxy Generation PPA.” Recently by presenting a case study that deployed in a handful of C&I explores the first deployment of the transactions, the Proxy Generation Proxy Generation PPA by one of the PPA is specifically designed to both leading C&I buyers in the market (1) re-allocate the risks associated today: Microsoft. with a project’s operations back onto the project and (2) enable the C&I buyer to effectively manage the risks associated with uncertain future vPPA settlement payments by using the available and expanding vPPA risk management tools offered by insurance and commodity markets. The Proxy Generation PPA also has the added benefit of reducing contractual complexity in the C&I vPPA.

2 CORE RISKS

Defining the Allocation of Core Risks Core Risks Under PPAs The economics of purchasing In both fossil fuel PPAs and C&I energy from a renewable energy vPPAs, the default allocation of project is subject to three main Core Risks is as follows. drivers of risk: fuel, operations and ALLOCATION price (collectively, the “Core Risks”). CORE RISK The Core Risks are5: SHARED7 • Fuel Risk: The availability FUEL RISK and price of fuel to power the project. For fossil fuel projects, Fuel Risk comprises the price of obtaining the commodity that SHARED will be burned (e.g., natural gas, coal, diesel or fuel oil). Wind and sunlight have no cost; so Fuel Risk PRICE RISK in the renewable energy context C&I BUYER is solely dependent upon supply— i.e., how much of the free fuel shows up at any given time and In the fossil fuel PPA, Core Risks in total. are allocated consistent with • Operational Risk: The project’s operational reality. In the fossil fuel operational performance, PPA, dispatch is controlled by the energy buyer, enabling mitigation 5 One risk that is often discussed in the context meaning the efficiency with which of C&I vPPAs is “shape risk.” Shape risk is the a generation facility converts of the Core Risks. Simplistically, covariance of Price Risk and one of the other the buyer decides to dispatch the two Core Risks (Fuel Risk or Operational Risk) fuel into energy. Components of and is therefore covered as part of the Core Operational Risk generally include project (Operational Risk) when Risks. the cost of fossil fuel to power the equipment performance (power 6 We note here the distinction between price risk curve for wind, I-V for solar), project (Fuel Risk) is less than the at both the interconnection point and at liquid prevailing market price for electricity settlement points. We note the pre-dominance equipment and grid availability of “hub-settled” C&I vPPAs, in which the parties generated by the project (Price Risk). settle on the basis of the price at a liquid hub as (maintenance, curtailment, etc.) compared to the price at the project’s bus bar. In and collection system losses. By contrast, in the wind and solar that case, while the Buyer is allocated Price Risk at the liquid hub, it is actually the project that • Price Risk: The price for the energy context with a C&I buyer, bears the Price Risk between the bus bar price dispatch is controlled by the and the liquid hub price (i.e., the project’s “basis project’s electricity. Under the risk”). However, for purposes of this paper, we 8 C&I vPPA, that price has two project. As such, the C&I buyer focus solely on Price Risk that results when the hub is used as the settlement point price. components—the price that does not have a mechanism to the project receives from the mitigate the Core Risks. Even if 7 Fuel Risk and Operational Risk are shared the C&I buyer attempts to use between the project and the buyer. In a PPA, electricity grid and the fixed price energy is sold on a price per unit volume agreed to under the C&I vPPA. hedging products available in the ($/MWh) basis. As such, should a lack of fuel or an operational issue cause a project to Whether or not the C&I buyer commodity and insurance markets generate fewer MWh, the project’s revenue will to hedge a subset of the Core Risks be reduced accordingly. Whereas a buyer does makes a payment to the project not pay for energy not produced, the under or or receives a payment from the (namely Price Risk and Fuel Risk, over-generation will lead to the buyer paying respectively), its hedging strategies for fewer or more renewable energy credits project is dependent upon the and energy than it anticipated. The uncertainty relationship between these two can be frustrated or negated of the energy volumes can be particularly 6 because it does not actually challenging for a buyer as it can lead to the price components. buyer unexpectedly being long or short the operate the project. This interjects energy market. Operational Risk outside of the C&I 8 The contracts-for-differences structure available buyer’s control, which hampers to C&I buyers is a purely financial instrument the C&I buyer’s ability to “cleanly” that is not generally concerned with dispatch. Instead, it assumes the swap of fixed and hedge the other Core Risks. floating revenues. 3 Operational Risk: No example illustrates the race The Clear Case for to the bottom between projects and C&I buyers better than Re-Allocation the frequency and timing of While being allocated Operational maintenance outages. The project Risk, C&I buyers have attempted to and the C&I buyer typically have push some of this risk back onto the competing concerns—the project project. This has inevitably resulted desires to conduct maintenance at in a tit-for-tat between projects and any time the fuel resource (the wind C&I buyers—from the perspective speed) is low, when power prices of the projects, to allow operational tend to be high, while the C&I buyer flexibility and from the prospective desires that maintenance occur of the C&I buyers, to both maximize when power prices are low, when generation during periods of high wind speeds tend to be high. electricity prices and increase In the opening salvo of negotiations, certainty in the amount of power C&I buyers restrict the performance they are expecting to buy. In order of any maintenance during summer to manage the various covenants, months. Pushing back, projects exceptions and exclusions require exceptions to allow for necessary to govern this competing maintenance during periods of dynamic between the project and lower wind speeds. C&I buyers the C&I buyer, operations-related push back again, requiring not-to- clauses have become exceedingly exceed thresholds in those same complex, bordering on the months. Projects then retaliate with labyrinthine. exceptions to preserve equipment Two examples illustrate the point. warranties, to which C&I buyers First, C&I wind vPPAs have robust restrict maintenance events that provisions measuring the actual cannot be performed during mechanical availability of the project non-summer months. It is easy as compared to a pre-agreed enough to see how a one paragraph required availability. These covenant easily becomes a multi- provisions are designed to ensure page tome. that the project is able to produce As a result, most modern C&I vPPAs electricity during productive still allocate much of a project’s weather conditions. However, the Operational Risk onto the C&I availability guaranty is replete with buyer, despite pages of terms and negotiated exceptions including, conditions intended to accomplish for example: curtailments by the the opposite. That is a mis-allocated transmission provider or electric risk. The C&I buyer has little to grid operator; periods when no control over what turbines are locational marginal prices drop purchased, how they are maintained below a pre-set floor; substation or upgraded, or what terms and failure; serial defect of equipment; conditions are negotiated into and curtailments required to protect warranties and services agreements, environmentally endangered or yet the C&I buyer generally bears the threatened species. As a result, financial impacts and risks of those the availability guarantee language decisions. The Proxy Generation in vPPA contracts is often highly PPA correctly re-allocates the bespoke, limited in the protection it Operational Risk of a project away offers C&I buyers and difficult from the C&I buyer and back onto to enforce. the project. 4 Reallocating the Other However, while it is true that many Core Risks C&I buyers enter into C&I vPPAs in order to hedge the cost of their The Operational Risk is simply electricity consumption, many misallocated to the C&I buyer. others still do not actually have a We now also consider the others. market-based energy consumption cost risk to offset. This can occur Fuel Risk for many reasons—but as one In the context of wind and solar example, let us assume a C&I buyer energy, neither the project nor the enters into a 15 year vPPA but has C&I buyer can control Fuel Risk—i.e., already agreed to buy power at a the weather. So, Fuel Risk should fixed price from its utility for the be allocated to the party that is next 5 years. As such—for the first best positioned to hold or hedge 5 years of the 15 year vPPA, the this risk. That decision can, in turn, C&I buyer has no energy cost risk be influenced by the risk tolerance to offset and as such the vPPA of the party exposed to the Fuel becomes a speculative 5-year bet Risk, and the cost of hedging or on the value of power generated transferring that risk. by the relevant wind farm. In cases It is also important here to consider like this, the C&I buyer may look the fact that C&I buyers may in to hedge or sell their exposure to fact be highly attracted to Fuel Price Risk to a Commodity for accounting reasons. The Counterparty—such as a bank, intermittency of wind and solar commodity trading firm or energy fuel resources result in an inability retailer. to know how much power will be The reallocated Core Risks then produced and when—invoking re-balance as follows: the “no known notional quantity” exemption that avoids having PROXY GENERATION TRADITIONAL PROXY GENERATION to account for a C&I vPPA as a PPA (or after vPPA ALLOCATION PPA ALLOCATION derivative.9 CORE RISK optional hedging)

PROJECT & Price Risk PROJECT & PROJECT & C&I BUYER FUEL RISK C&I BUYER C&I BUYER Together with the desire to achieve (OR INSURER) sustainability goals, Price Risk is the sine qua non as to why many OPERATIONAL PROJECT & C&I buyers enter into C&I vPPAs— PROJECT PROJECT as the C&I vPPA creates a hedge RISK C&I BUYER on the cost of their electricity consumption costs. And as such, C&I BUYER (OR PRICE RISK COMMODITY Price Risk is properly allocated to C&I BUYER C&I BUYER the C&I buyer.10 In the ideal (but MARKET often not realized) scenario, the COUNTERPARTY) purchase price of renewable energy at the liquid trading point specified How then to come to a solution that 9 See FASB 133 ¶ 6(a). under the C&I vPPA will be fixed and will implement this re-allocation? below the forward price curve for Again, we introduce 10 We take note of the creative solutions in the comparable electricity purchases, market to further shift Price Risk to the seller the Proxy Generation PPA. through the form of price collars. enabling such C&I buyer to lock in energy prices at a discount to the expected future market cost. 5 PROXY GENERATION PPA

The Proxy Generation PPA is, In short—by calculating the interests between the project in many ways, a fundamental settlement of a Proxy Generation and the C&I buyer. Third, the re- rethinking of what constitutes a PPA based on the measured allocation of Operational Risk to the PPA. The PPA is, and has been, input (fuel) as opposed to the project empowers the C&I buyer a construct that is calculated measured output (energy) the to pursue hedging strategies—if based on the actual generation Proxy Generation PPA buyer avoids and as it deems necessary—to of a project, as measured by the taking on exposure to the project’s mitigate Fuel Risk and Price Risk, project’s electrical meter. The Proxy Operational Risk. each of which can separately be Generation PPA, by contrast, re- hedged through contracts with orients the PPA towards settlement Value Proposition insurance and commodity market measuring the expected generation participants, respectively. In reorienting the PPA away from of the project given a specific the actual metered generation, volume of fuel (e.g. the wind speed the Proxy Generation PPA re- Calculation Basics at each turbine) as measured allocates Operational Risk squarely At its core, Proxy Generation is a by the project’s operational and to the project. Operational Risk straight forward calculation. Every meteorological measurement is captured by the EOE which, ten minutes, the average wind equipment. as a single number, replaces the speed at each turbine is measured For a wind farm, Proxy Generation labyrinth of operational covenants and adjusted for air density and calculates this expected generation and their exceptions that have blade interference. That wind speed quantity profile as a function of: become standard in traditional is applied to the turbine’s power (1) measured weather conditions C&I vPPAs. Prior to signing the curve to yield an amount of implied at each individual turbine; (2) the Proxy Generation PPA, a project energy. Finally, that quantity of turbines’ expected fuel-to-power determines and commits to the energy is then multiplied by the conversion efficiency (also known EOE. Once operational, if the EOE (a percentage always less as the “power curve”) and (3) the project out-performs its EOE, that than 100% and typically greater project’s expected operational outcome is to the project’s benefit. than 85%). The resulting volume efficiency (“EOE”). If the project under-performs of energy (in MWh per turbine) is its EOE, that outcome is to its then summed across all turbines detriment. The C&I buyer has no comprising the project, and all risk—neither upside nor downside— time intervals within each hour, to the project’s operational yielding a project-level, hourly performance, as intended. Proxy Generation value that can be applied to the settlement In re-allocating Operational Risk point price. in this way, the Proxy Generation PPA achieves three ends. First, it simplifies the contracting process, allowing the Proxy Generation PPA to be stripped of complex and difficult-to-enforce contractual provisions around mechanical availability, turbine selection or limitations on maintenance outages. Second, by re-allocating the Operational Risk to the project, the Proxy Generation PPA aligns

6 Additional complexity comes project, the C&I buyer, and the into play in order to handle designated calculation agent. abnormal conditions. For example: The independent calculation what happens if the project’s agent makes the Proxy Generation anemometers break, or if a calculations on a standard hurricane knocks the whole project schedule—typically quarterly, with ever and so it no longer reports any interim reports issued monthly. wind speeds? Standard provisions exist to handle these conditions, Covenants and data quality tracking and – if Since the Proxy Generation PPA necessary – data replacement, is a is predicated upon a calculated large part of the service performed quantity of energy, rather than by the independent calculation an observed quantity, the Proxy agent to a Proxy Generation PPA. Generation PPA renders obsolete the complex operational covenants Independent in a traditional C&I vPPA. In their Calculation Agent place are covenants covering Given that Proxy Generation is a data reporting and quality. As calculation of idealized production to data reporting, under a Proxy rather than actual generation, Generation PPA the project will prior to entering into a Proxy be required to deliver to the Generation PPA, the C&I buyer independent calculation agent and the project will need to agree detailed operational data on the upon a third party with the requisite project, including meteorological expertise to provide the Proxy observations as well as operational Generation calculation service. The conditions. As to data quality, the independent calculation agent, project will be required to submit then, becomes a crucial third party to covenants that ensure the to the Proxy Generation PPA. The data measurement equipment downside to adding a third party to are regularly maintained and the traditional C&I vPPA process in operational. order to settle on Proxy Generation is cost. Calculation of Proxy 11 As an example: if a $20 per MWh Proxy Generation PPA is executed with a 100 MW Generation as a service typically Project with a P50 generation of 350,000 MWh, costs 0.5% of contract value11, the expected value of that agreement would be 350,000MWh * $20.00/MWh = $7,000,000. The and requires a new contract—a cost of Proxy Generation calculation services Calculation Services Agreement— would be $7MM * 0.05% = $35,000. to be entered into between the

7 CASE STUDY: MICROSOFT

As Microsoft’s business shifts certainty in energy consumption The reason given was fairly from being primarily software- costs—that we have embraced the simple: Microsoft’s partners on based to being primarily cloud- Proxy Generation PPA. the traditional vPPAs, the projects based, the energy consumption themselves, directly or indirectly As background, Microsoft’s first of our operations has increased controlled the Operational Risk; traditional vPPAs began producing significantly, and is expected and holding risk exposure to a third clean energy in the summer to continue increasing with the party’s decisions is expensive, at of 2015. Watching those first success of our energy-intensive, best, and impossible, at worst. In transactions begin to perform, we cloud-based products. With response to that market feedback, were delighted by the contribution our current global operations Microsoft changed the way we they made to our sustainability consuming more electricity than purchase clean energy, exclusively goals but were frustrated by the some small U.S. states, we face two buying power via Proxy Generation financial volatility of the settlement challenges: (1) the environmental PPAs with the goal of leaving the payments and the limited ability footprint of our operations is Operational Risks with the party we had to predict or manage expanding and (2) Microsoft’s that controls them—the project. that volatility. Project generation financial performance is increasingly Having identified a solution, we changed dramatically month-to- sensitive to a volatile commodity— changed our contracting strategy month and quarter-to-quarter; and electricity price. quickly, and as of today Microsoft we often found ourselves buying has signed agreements to buy Microsoft was an early pioneer of an excess of power when we did clean power from over 1,300 MW the traditional C&I vPPA, viewing it not need it (when energy prices of wind and solar projects across as an excellent tool in addressing were relatively low) and receiving the U.S., with nearly 1,000 MW of our first challenge: environmental a shortfall of power when we did those agreements using the Proxy sustainability. Through the direct need it (when energy prices were Generation PPA structure. purchase of energy from wind and relatively high). For an organization solar projects, we are on a path like Microsoft that values These Proxy Generation PPA to eliminate the carbon footprint predictable financial performance, structures, coupled with the of our data centers’ energy having the efficacy of our vPPAs Volume Firming Agreements we consumption. With respect to as tools to manage energy costs recently announced (https:// our second goal of energy price be dependent on the weather was blogs.microsoft.com/on-the- certainty, however, the traditional not ideal, so we began to work with issues/?p=61905), enable Microsoft vPPA has proven a partial but commodity markets and insurance to succeed in its win-win strategy incomplete tool. This is because our firms to craft a solution. of renewable energy procurement, data centers consume power 24 achieving both our sustainability What became clear was that hours a day, regardless of whether and financial goals in parallel. We Microsoft had good options to the wind is blowing, the sun is hope that the model Microsoft manage all of the risks associated shining, or the project with which has pioneered provides a useful with our traditional vPPAs except for we have signed a vPPA is available template for other C&I buyers who one-- the Operational Risk. Banks to produce energy. It is through are similarly aiming to achieve and commodity trading firms were our pursuit of this second goal— aggressive sustainability targets eager to work with us to manage without having to sacrifice financial the Price Risk on any expected performance or flexibility. excess or shortfalls in generation as compared to our load and (re) insurance firms were eager to work with us to manage Fuel Risk; but nobody wanted to take on the Operational Risk.

8 CONCLUSION

While retaining much of the vPPA architecture that has been successfully utilized to contract for approximately 14,000 MW of C&I renewable energy transactions since 2013, the Proxy Generation PPA represents a conscious evolution of the vPPA. That evolution is first towards simplicity. By replacing the C&I vPPA’s couplet of an as-generated energy construct and operational covenants with a single Proxy Generation calculation based on weather conditions and the EOE, the Proxy Generation PPA removes the back and forth negotiation over operational covenants and the need to police those covenants. That evolution is also towards the complementary goals of aligning green power buyers and sellers’ interests in the operation of projects and empowering C&I buyers to fully utilize the latest risk management tools available in the insurance and commodity markets. The Proxy Generation reverses the traditional utility PPA assumption of bluntly pushing Core Risks onto the buyer. Instead, the Proxy Generation recognizes that (1) the C&I buyer has different objectives and capacities from its utility counterpart and (2) the C&I buyer simply cannot bear the same risks as effectively as its utility counterpart, By re-allocating the Core Risks between the project and the C&I buyer in relation to which party can best bear or hedge these risks, the Proxy Generation PPA disaggregates unhedgeable Operational Risk from hedgeable Fuel Risk and Price Risk.

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