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I-SEM Delay, Changing PPA provider & I-SEM Balancing Products (Part 2) 10 May 2018

Following on from last week’s blog post on timelines and opportunities around switching PPAs; in this blog, the second part of our two-part series, we delve a little deeper into the products we are actively offering our clients.

It is an inevitable consequence of a fundamental market re-design that trading businesses and utilities are offering varying commercial structures and products around trading and importantly, balancing risk (or imbalance risk). The product offering can be a consequence of the readiness or capability of that business or equally its attitude to risk

If we consider the different investment vehicles and structures used to finance generator units alone, we see that it is difficult, if not impossible, to say one product is the most suitable or indeed that one product is unsuitable for all counterparties (with one exception below!). It follows that we then need to cater for a wide array of preferences, and in line with that thinking, we at ElectroRoute are constantly developing our product offerings to meet the prevailing demands of our clients; current and future.

With that in mind, let’s break the various products down into three broad categories;

  1. Physical Balancing: The trader will act as intermediary for the unit and take all imbalance risk from forecast error into its account. This is achieved by trading primarily in the ex-ante markets (think Day Ahead) with residual volumes (forecast error) being traded in the balancing market on the account of the trader.
  2. Financial Balancing: Often this occurs where the unit is not trading in the ex-ante market, but instead spilling into the balancing market via an intermediary agreement with an offtaker. A separate trader will offer a mitigation for balancing risk by way of financially guaranteeing that the unit will receive the Day Ahead price (less the trader’s fee).
  3. Spill (No active balancing): Akin to category two, however with no financial product to provide even a synthetic balancing structure. The unit will spill into the balancing market with all financial losses/gains going to the generator.

An important point to note at this point is that a REFIT generator unit is very likely to need access to the ex-ante markets either via a physical or financial product in order to achieve the REFIT Blended Reference Price [1]. REFIT generators’ PSO top-up will be marked against this reference price. 

This reference price discussion above is of course subject to final decision by the DCCAE, however given the above we do not recommend or offer category 3 (Spill) to REFIT clients in ElectroRoute. This is the one exception where we believe we can say that a category of trading structure is unsuitable for a generator unit.

So, three categories, two balancing products; what do we focus on in ElectroRoute?

In the last blog we mentioned a preference and focus on physical structures- the reason for this is that spilling into the balancing market results in a loss of constraint revenue. We are always particularly keen to explain to potential clients that whilst we will offer a financial product, the result of their existing offtaker physically spilling all volumes into the balancing market is that they will lose entitlement to constraint payments [2]. These will not be recouped by bolting on a financial balancing product as it does not interact with the market. It is therefore a less efficient model in our view. This is outlined by the graphic below;

Equally, it is clear to us that in order to preserve optimum revenues and cashflows, it is imperative that a unit has access to the liquid Day Ahead market. Even where a generator wants an ElectroRoute service but is happy to assume balancing risk themselves, we will always ensure they have Day Ahead market access.

So, with that explanation, we present a little more below on the two balancing structures.

Physical Balancing Products

A physical balancing product can be achieved within either a PPA or a Supplier Lite structure.

From a contract perspective, ElectroRoute enters into a PPA/ Supplier Lite services agreement, with an agreed fixed balancing fee. In return for this fee, ElectroRoute guarantees that the REFIT generator will receive the REFIT Blended Reference Price (or for a merchant/ROC generator, the Day Ahead price) less the balancing fee (the “Guaranteed ElectroRoute Contract Price” in the diagram below).

In this structure, all imbalance risk is taken by ElectroRoute, i.e. where forecast error arises or balancing market prices are volatile, this is for ElectroRoute’s account and the generator unit is entirely insulated from the effect of this.

In terms of popularity, this is the product which keeps us busiest at the moment. In particular, projects with debt finance tend to go this route, limiting risk whilst providing as much certainty to project revenues as possible.

 

Financial Balancing Products 

We see that financial balancing products are predominantly characterised by a unit which is physically spilling into the balancing market with no Day Ahead participation, but who require protection against imbalance prices. For one reason or another, the generator will decide to remain in the existing offtake relationship and seek a financial product elsewhere which replicates the effect of a physical balancing product.

The premise with this product is that the trader and generator enter into a Contract for Difference (CfD) referencing the Day Ahead price or REFIT Blended Reference Price less the trader’s fee (the “CfD Strike Price” in the diagram below). This means that “difference payments” are made between the CfD counterparties to make the generator whole to the agreed reference price. The CfD is likely to be specific to the unit output and delivery characteristics. For discussion with the generator therefore will be whether the provider of the financial product has direct control over the trading strategy (which can be difficult to achieve given they are not the market intermediary) or where the generator has a fixed trading strategy, as this provides the basis for which the CfD is priced and the risk which the CfD provider is taking on.

As we have noted above, if the unit is spilling into the balancing market, a pure financial product will not support the unit in receiving revenue for its constrained volumes. This is something that the unit will need to consider.

Another point of note is that a financial product as outlined above can often result in a pancaking of fees (the offtaker will have their fee and the provider of the financial product will also have theirs). This can be exacerbated by the fact that financially trading results in higher collateral costs for the trader in the I-SEM markets compared to direct physical trading, which will likely be passed on to the generator.

It will be for the generator to weigh up the pros and cons once these are considered.

Conclusion

It’s clear that there is no “one-size fits all” approach here, however we are equally seeing that the market is largely converging on fixed price physical balancing products, especially given the uncertainly of a new market. The financial balancing offers a less attractive fall-back approach where, for whatever reason, the preferable physical option is not available to the generator.

Our focus to date has therefore been on physical structures whilst we also engage pro-actively on financial products where the situations requires this.

Indeed, as we find ourselves getting closer to agreement on contracts for I-SEM with our current counterparties, it’s immediately back to the drawing board to see how we can continue to develop these further for the next round of contracting. ElectroRoute is well positioned to adapt and support our clients in this dynamic market and tailor a solution that best fits their needs under these conditions.

If you would like to discuss your PPA / Supplier Lite options ahead of I-SEM, please get in touch at clientservices@electroroute.com.

 

[1]: The Blended REFIT Reference Price means, in any trading period, the lesser of the Day Ahead price or {(Day Ahead * 0.8) + (Balancing Price *0.2)}

[2]: Relevant for firm generation only

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