How can understanding merchant risk help you make better wind investments?

In this guest blog, Prajeev Rasiah, Executive Vice President and Regional Manager, Northern Europe, Middle East & Africa, DNV GL, explains how understanding the risks of the market can help investors make wise choices.

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Why the loss of subsidies changes the nature of merchant risk

Environmental concerns and falling costs of renewable technology have made renewable energy projects a much bigger part of the energy market, as countries strive to reduce emissions in line with the Paris Agreement.

Driven by the increased popularity of renewables, the landscape for investing in wind projects has changed radically in recent years. The players, the technologies, the market forces have all evolved considerably. As the adoption of renewables has grown, maturing technologies and increasing economies of scale have dramatically cut the cost of installing renewable energy projects.

Consequently, governments are now looking to reduce or even eliminate renewable energy subsidies. We’re already seeing several subsidy-free bids for developing renewable energy projects in northwest Europe.

This fundamentally changes the nature of the risks such projects face.

Previously, subsidies offered a guaranteed level of income, but today, projects and their investors are fully exposed to the dynamics of the energy market, including competition and consequent price pressure.

As a result, energy projects now face a much higher level of merchant risk due to uncertainties about price developments and pay-back periods. This means that accurately determining the risk associated with investing in an energy project, through trustworthy long-term power price projections, is essential.

Of course, investors can mitigate some or all the risk by sharing it with utilities through power purchase agreements (PPAs). However, the risk still needs to be considered, and a consensus on future power price evolution is required to set the level of the PPA in the first place. What’s more, current low wholesale prices and the long-term impact of low marginal cost renewables will increase pressure on PPA pricing levels.

Price forecasting or crystal ball gazing?

We can all agree that forecasting wholesale power price development is extremely complicated and must take into consideration a huge number of influencing factors – technical, economic, environmental, political, legal and social.

Typically, power price forecasters today handle that complexity by developing multiple scenarios and producing power price curves for each one. This usually means each forecast includes a low, central (or ‘business as usual’) and high forward price curve.

However, this multiple-scenario approach can lead to wildly differing valuations of the same project as each stakeholder uses the curve that best suits their own interest.

Specifically, investors who are trying to identify their maximum exposure to risk will use the lowest curve (worst-case scenario), while project developers who want to present their project in the best possible light will naturally base their valuation on the highest price curve. This can lead to significant delays in negotiations and the realization of the project.

What’s worse, the approach gives users of the curves very little insight into the assumptions behind those curves or the factors that could influence actual power prices within a given scenario. This makes it very difficult for potential investors to really understand the risks they are taking on and thus assess whether they are comfortable with the project’s risk profile.

A single specific forecast, regularly updated

Rather than follow the standard multi-scenario forecasting methodology, predictions should be based on a single forecast that provides complete transparency on the assumptions that underpin any resulting power price curves.

At DNV GL we take a different approach, which is why we’ve developed our Energy Transition Outlook, a high-level, global forecast. Our ETO does not present different scenarios, unlike for example the IEA’s World Energy Outlook. Instead it presents one “most likely” energy future, based largely on cost comparisons and the assumption that over time prices will follow the same trend as costs.

The forecast is unique because we predict that energy demand will peak in the mid-2030s, despite continued growth of the global economy and population. This is a very distinct characteristic we have not seen since the dawn of the industrial revolution and presents quite a different picture from most of the projections coming out of the energy industry, where many popular scenarios project higher growth in energy use.

In contrast, we believe that with constrained demand, there will be an abundance of energy supply. This means the energy sector will become much more competitive and cost-driven.

We use our forecast to create a quantitative, European market model, by adding detail about the various generation and storage technologies installed in each country within the region being modelled, as well as parameters such as fuel and CO2 prices and other factors that could influence the actual power price evolution in that market.

Having a single curve per country or price region helps to standardise investment bidding, giving all stakeholders the same base point for negotiations to ensure that investors have the information and insight necessary to fully understand the risk landscape they are operating in.