The EC’s Electricity Market Reform Proposal
The European Commission (EU) has proposed a reform to its electricity market design. The idea behind the reform is to accelerate the transition to renewables and reduce the dependency on Russian gas before next winter (1). The reform also aims to make consumer bills less dependent on volatile fossil fuel prices, protect consumers from future price spikes, and make the EU’s industry both clean and more competitive.
Power Purchase Agreements (PPAs) and Contracts for Difference (CfDs) are possible mechanisms proposed in the Reform to help companies switch to renewable electricity sources and reduce their electricity bills at the same time. But how do these complex mechanisms work in practice?
Power Purchase Agreements (PPAs)
In general, PPAs are long-term private contracts between electricity producers (typically renewable or low-carbon) and consumers, aimed at establishing their own terms for the supply of energy. This typically includes the quantity of electricity to be provided over a fixed period of time, the agreed-upon price, risk allocation, and eventually early termination fees. These agreements provide power producers with revenue stability and shield the industry from price volatility.
PPAs are becoming increasingly popular because they allow companies to secure long-term, fixed-price contracts for renewable energy, which can be cheaper and more stable than traditional energy sources. However, PPAs are currently mostly available only to large energy consumers in only a handful of Member States. The aim of the ‘Electricity Market Reform’ for PPAs is to address this issue and encourage the broader implementation of PPAs in the EU market. The proposed measures include:
- Financial risks mitigation:
One of the barriers to a wider adoption of PPAs involves credit risks for buyers, as they require a commitment to purchase a fixed amount of electricity at a predetermined price for an extended period of time. To address this issue, the EU Reform obliges Member States to ensure the availability of market-based guarantees that will reduce the financial risks associated with off-taker payment default, leaving the energy producer without a source of revenues..
- Public tenders rules:
To promote the market for PPAs, renewable energy project developers should be allowed to reserve a share of the generation for sale through a PPA when participating in public support tenders. Additionally, Member States should incentivize customers to have access to the PPA market. One way to stimulate this is by adapting the evaluation criteria in some tenders to allow the participation of projects which reserve part of the electricity that will become for sale for customers that face entry barriers through a PPA.
Contracts for Difference (CfDs)
On the other hand, CfDs are financial instruments that provide revenue support to renewable energy projects by guaranteeing a fixed price for the electricity produced over a certain period of time. These contracts are signed between renewable energy producers and a counterparty (usually a government agency or energy supplier) who agrees to pay a fixed price for the electricity generated by the renewable energy project, known as the strike price:
- If the market price of electricity is below the strike price, the power producer receives a payment from the counterparty for the difference.
- Conversely, if the market price of electricity is above the strike price, the power producer pays the counterparty for the difference.
CfDs can incentivize new investments in renewable energy infrastructure by providing revenue certainty and reducing the risks associated with volatile electricity prices.
In the context of the EU Electricity Market Reform, all public support for new investments in renewable electricity generation will have to be in the form of CfDs, which can help to shield the industry from price volatility whilst ensuring the channeling of excess revenues to final consumers.
Overall, PPAs and CfDs provide revenue stability and support the development of renewable energy infrastructure. In addition, they can help companies reduce their exposure to volatile energy prices and achieve their sustainability goals.
If you want to get more insights in this developing regulatory framework, and by extension the possible implications on your investment projects, please reach out to Alexis De Méyère (firstname.lastname@example.org), Tom Wallyn (email@example.com), Willem Gruyters (firstname.lastname@example.org) and Lorenzo E. Costa (email@example.com). We are happy to guide you every step of the way!
(1) This goal was mentioned by the Swedish Minister of Energy during the last Energy Council that took place on 28 March 2023: https://video.consilium.europa.eu/event/en/26746.