Credit where it's due: de-risking off-take deals amid market volatility

What’s your credit score? Anyone who has bought a house, an expensive car, or entered into any long-term financial commitment knows just how important a good credit rating is to getting the nod of approval from the bank.

Signing a 15-, 20- or 25-year power purchase agreement (PPA) should be no different for a commercial or utility off-taker.

However, renewable energy sellers often don’t take enough action to examine and manage potential buyers’ credit risk, or the risk that they default on their contractual payment obligations.

In less volatile market conditions, renewable energy sellers could afford a more relaxed attitude toward off-taker credit. But in the post-Covid, post-subsidy environment, certainty around credit is now key to ensuring that PPAs don’t end up costing more than the seller bargained for.

What is the impact of bad off-taker credit?

In the event of off-taker default, sellers will have to look for alternative buyers.

Given substantial market volatility, available prices may be a far cry from where they were under the initial off-take contract, with potentially catastrophic impact on the economic viability of a project – a risk fittingly referred to as 'replacement risk'. Correctly assessing the magnitude of this risk requires understanding the main drivers:

Probability of default: This is driven by the financial strength of the off-taker and is part of standard credit risk assessment procedures. Over the course of the pandemic, a wave of downgrades and downgrade warnings of a magnitude last seen during the sub-prime crisis was issued, and this must be taken into account when assessing the probability that the off-taker will default.

Volatility: The extent to which the seller might be worse off after finding a replacement off-taker depends on price volatility. The more volatile prices are, the more they might move to the detriment of the seller.

Covid-19 has brought about a brief episode of unprecedented volatility. Fears about potential further flare-ups of the virus and price volatility due to waning energy demand might lead to a more defensive volatility assessment of PPA off-takers, thus resulting in higher costs for credit protection.

Mitigating credit risk for a post-Covid recovery

As the market has begun to stabilise, we have seen more and more off-take deals signed with large multinational firms, who are, in theory, less likely to default on their PPAs. However, in order to open up opportunities to engage with a wider pool of offtakers, effective credit risk mitigation is called for:

Third party guarantees: A guarantor obliges to indemnify the affected party for their losses up to a pre-agreed amount. This means that default only results in loss to the seller, where both the off-taker and the guarantor default; or where the difference between the original and post-default off-take prices results in a loss greater than the guarantee amount. Such guarantees may be issued by state entities (e.g. GIEK in Norway and SID in Slovenia) or banks.

Collateralisation mechanisms: This is when a contract includes clauses that require collateral deposits (e.g. cash, liquid securities) to the benefit of the exposed party. If default occurs, the credit-affected party is entitled to liquidating collateral to indemnify itself.

PPAs can act as a strategic prerequisite to be successful in non-subsidy renewable investment and especially in times of price volatility – but sellers need to carefully assess financial risks due to counterparty default. This feat can be performed with a carefully calibrated simulation approach, which takes into account both price volatility and the probability of counterparty default.

Creating transparency around this risk will help avoid credit events, foster trust in PPAs as a viable means for long-term energy sourcing and ultimately keep renewable capacity expansion on track also during times of crisis.

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Join Customer First Renewables, DNV GL, REsurety, Switch and Holland & Hart to discuss PPAs at Financing Wind North America at 10.35am EDT on Thursday 3rd September. You can still register here to catch this session