Why do capacity payments exist

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Pivotal180 is excited to share a Spanish subtitled extract from our Renewable Energy Project Finance Modeling course. This video is titled “Why Do Capacity Payments Exist”.

Participants in our renewable energy project finance modeling course build a renewable energy project finance model from scratch and gain insights into the key terms of the main Agreements used in deals.

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Video Transcript 

When we speak about the different sources of revenue under a power purchase agreement, we mention a capacity price and an energy price, but for a lot of people, the idea of why we need a capacity payment is somewhat elusive.

The real driver comes from the need within an energy system to have what’s called reserve margin. For the reliability of the grid, there’s a certain amount of capacity which needs to be on standby in the event there’s a sudden surge in demand or loss of supply.

When a power plant goes down for maintenance and the reserve margin is typically recommended to be about 15% of the maximum load on the grid. So the system needs what’s called peaker power plants, which are very rarely or maybe even never dispatched. Basically, unless something is on standby, our grid won’t be able to meet its obligation to serve the load and now the trouble is that power plant won’t get built unless someone is going to pay for it. And a plant that never runs, still needs to be paid for its existence or for its availability to deliver power if and when it does need to be dispatched.

Okay, I think I get it. So we have power plants that exist only to cover a reserve margin of 15% of the maximum load on the grid and these power plants receive a fixed capacity payment every month.

How do I work out the capacity payment that they should deserve then?

That’s a great question. Essentially you’re asking what’s the right price to pay for something that doesn’t ever run and if you think about that as a matter of what you would demand as an investor, the answer starts to present itself. That power plant needs to be paid an amount that is sufficient to cover all of its fixed costs. You need to cover labor, you need to cover fixed maintenance, you need to cover debt service and you need to cover some kind of return on equity. If those items don’t get paid, the plant won’t get built, and for the duration of the PPA, as long as that power plant is available to deliver power, the utility must pay for capacity.

Okay. So if the investors get their equity return from just the fixed capacity payment, what would the energy payment itself cover? Assuming they actually get one?

The energy payment is simply a means of covering the cost from operating the plant. So the energy payment is designed to be sufficient to cover all of the variable costs. So the costs of fuel, if we’re talking about biomass or a nonrenewable power plant that needs fuel or the costs of consumables or of other variable operations and maintenance.

Now in some markets, particularly in the developing world, many utilities and governments are incredibly uncomfortable with the idea of a capacity payment. I mean, it seems sort of outrageous to be paying a private company money just to exist, even if it never delivers power.

So if you are in an environment where capacity payments are not the norm or capacity payments are completely unacceptable, there are other ways that you could get an investor comfortable in building a power plant even without a capacity payment. One way would be to charge only for energy. Basically you set a price per megawatt hour just like the energy charge, but you take all of your annual fixed costs plus all of your variable costs and divide that sum by the anticipated number of megawatt hours per year and that becomes your all in energy price and that will work perfectly as long as the off taker is obligated to dispatch the power plant for the right number of hours per year.

Given that we can’t perfectly estimate when the wind will blow or the sun will shine. I kind of imagine that off takers would be willing to provide a capacity payment for wind and solar projects. I mean, why wouldn’t an offtaker agree to this?

That’s a good insight with wind and solar PPA is it can be quite common to have only an energy payment even in markets where capacity payments are the norm. I mean, how can I provide reserve margin if I don’t even know whether I’m going to be available when the grid actually needs power? So the very nature of renewable as an intermittent resource makes them somewhat incompatible with capacity payments.

Now remember as the equity investor, I was the one who chose to build that wind project or that solar project in a particular place. So I should absolutely be prepared to take the risk of how much energy is going to be produced, but it’s not really my fault if the off-taker doesn’t need the power at the precise time that the energy is produced. Once I’ve taken all of my fixed costs and all of my variable charges and I’ve converted them into an energy only payment,

I need to be absolutely certain that the utility is going to buy a sufficient quantity of energy from my power plant. It’s the only way I’m ever going to recover the amount of cash that I need to recover. So if there’s a PPA with only an energy payment and no capacity payment, the agreement will specify a minimum purchase quantity, which is a minimum number of megawatt hours per year that the off-taker must buy and this is why renewable energy.

PPAs are typically structured as take or pay contracts. The project must be paid for energy generated regardless of whether or not the off-taker actually takes it and if for whatever reason, the off-taker does not take the energy, the project company is going to be entitled to receive what are called deemed energy payments and that’s what keeps the investors economically whole, even in the absence of a capacity charge.

Just to make sure I get this, wind and solar projects normally get an energy only PPA because they’re not dispatchable. Sure. But as the grid needs reserve margin, other technologies such as gas fired power plants may need a capacity payment such that investors are willing to build them so they’re available in emergencies or when the wind isn’t blowing or the sun isn’t shining, it seems like both. Makes sense.

That’s it. You got it. My job is done here.

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