Despite the boom in renewable industry, declining power prices and decreasing PPA terms are making it difficult for power producers to grow their business – and do so profitably.

The energy industry today is on the verge of a major tipping point, where for the first time, renewables are reaching significant capacity additions and setting record-low electricity costs that are rivaling those of fossil fuels. This is largely credited towards the continual decrease in the hard and soft costs of renewable energy project development, construction and operation are declining. However, these changing market forces are creating unprecedented challenges for power producers, as their purchasers, who are seeing steadily decreasing costs, are becoming less willing to enter into long-term power purchasing agreements, known as PPAs. The power producer’s business model, which traditionally relies on securing these agreements, is becoming outdated as they are unequipped to keep up with the steady rate of decline in power prices. The consequences of the power purchaser’s unwillingness to sign long term contracts at fixed price, paired with the existing inefficiencies of the power producer’s business model have dire consequences – mainly, unprofitable growth.

Every power producer – from the independent provider up to the utility – is focused on growth and generating profits. This is planned for in a number of ways:

  • Augmenting their project portfolios with diverse technologies in multiple regions
  • Improving customer acquisition and retention (through up selling projects)
  • And finally, acquiring or merging with other companies with renewable strong portfolios

In the minds of today’s power producer, growth equates to profitability. While these three methods are certainly aimed at doing just that, external market forces such as low power prices and the declining PPAs rates are hindering business’ profitability.

 

Power Pricing is in Continual Decline  

The cost of building solar and wind projects are declining rapidly. Declines in technology, installation, and EPC costs, paired with abundant supply have brought power prices to unprecedented lows; as low as $0.049/KWh in some regions (PV Magazine). Solar PV module prices have come down from $82/W in 1976 (current dollar value) to $0.41/W at the end of 2016; representing a learning factor of 28% (Source: BNEF NEO 2017). This translates to how the cost of new build wind and solar is becoming cheaper than the cost of new build coal or natural gas (BNEF NEO 2017); a true tipping point in the history of power generation.

 

U.S. Unsubsidized Levelized Cost of Energy (LCOE)

The levelized cost of wind and utility scale solar power have undercut that of coal and natural gas, even at their highest estimate. The average price for wind hits under $30/MWh, while solar PV averages just over $40/MWh.

Source: Lazard/ Cleantechnica

 

While consumers are benefitting from low electricity costs, power producers, on the other hand, are running into trouble. In such a competitive market, where the lowest project bidder wins, their profit margins are squeezing tighter. Developers today are trying to produce power at the lowest cost, but their pricing ability continues to decline.

 

As Off-take Rates Decline, Power Producer’s Business Model is at Risk

Sensing the continued trend of decreasing prices, many power purchasers are feeling less urgency to lock in their rates with long-term contracts, known as power purchase agreements (PPAs). As a result, off-take, or PPA rates have declined rapidly. In just the past couple years, wind and solar PPA rates have dropped across all major regions, with the exception of relatively flat-lined growth in North America (source, Mercatus Energy Insights Report Vol. V). At their lowest, solar and wind PPA rates are averaging below $25/MWh (PV Magazine). As this trend continues without any foreseeable stop in sight, this poses significant challenges to the power producer, whose pricing ability is dwindling down to zero.

 

Average Off-take Rates by Region (2015-2016)

Over the last year, there were notable drops in Asia, Europe and South America and a relatively minor change in North America. This trend reaffirms how the relationship between competition and subsequent declining power prices impact project returns.

Source: Mercatus Energy Insights Report Vol. V

 

Wind and Solar Levelized PPA Prices by Contract Year

This graph shows how the levelized PPA prices for both wind and solar have fluctuated over the past decade. While the learning factor for solar power is steeper, wind PPA rates have reached the lowest at just under $25/MWh.

Source: “Introduction to Virtual Power Purchase Agreements” from EPA Green Power Partnership, originally LBNL, “Utility Scale Solar 2015” and “2015 Wind Technologies Market Report”

 

The power producer’s business model is fundamentally driven by historical assumptions rather than forward looking ones. With power prices continuing to decline, the current model, which is dependent on locking in long-term PPAs, is becoming less viable. But as the demand for clean, cheap power continues to fuel new development, the power producer’s reaction has been to grow, with more projects, in more regions, and with more employees. This presents problems since the way businesses structured their overhead costs were originally based on the former high costs of renewable power production. So, while technology costs have declined, overhead costs have remained the same.

 

The consequences of power purchaser’s unwillingness to sign long term contracts at fixed price, paired with the existing inefficiencies of the power producer’s business model have dire consequences – unprofitable growth.

 

Growth in the distributed generation market has put power producers under a strain like never before. To achieve the same MW output as conventional generation, distributed generation requires between 5-7x the project development overhead. However, adding more employees contributes to an increase in operational expenditure.

 

Employee per Megawatt by Generation Type

The number of employees per megawatt has increased roughly 6.5x by with distributed generation, while PPA prices are in steep decline. This trend reaffirms that as power pricing margins decrease, and employee count increases, businesses are increasingly at risk for profit loss.

Source: Mercatus analysis based on customer data

 

This is taking a serious toll on businesses’ profitability, so much so that some are deeming the independent power producer’s business model to be “obsolete” and “unable to generate value over the long term” (GTM). Findings from a recent study by Ernst and Young affirm this, as EBITDA of independent power producers has gradually decreased over time, both in North America and Europe.

 

Average EV/EBITDA trading multiples for select IPPs (2011–Q4 2016)

EBITDA isdecreasing over time for EU IPPs. 

Source: Power transactions and trends, Q4 2016 , EY

 

Average EV/EBITDA trading multiples for select North American Utilities, IPPs included (2013–Q1 2017) 

A study by Ernst and Young shows that the EBITDA of North American IPPs is significantly decreasing over time 

Source: Americas Power transactions and trends | Q1 2017, EY

 

In order to survive and thrive in today’s hyper- competitive energy market, power producers need to get back on the path towards profitable growth. This means that CEOs of power producing companies need to take a fresh look at their current operating model for their capacity growth. So while low power prices and shorter PPAs are external factors outside of your control, it’s time to focus on what you can control; optimizing your operational efficiency. This means doing more with the same or fewer resources, which includes placing more bids, building more projects, and optimizing plant performance; all without adding overhead costs. For businesses that want to remain competitive and take advantage of the ever-growing opportunities that distributed generation presents, a renewed focus on operational efficiency is key.