Pitfalls in the valuation

Power purchase agreements (PPAs) are a key component of the energy transition and allow companies to use renewable energies and hedge energy price risks. By the same token, these long-term electricity supply contracts present companies with new challenges, which is why the impact on areas such as accounting and risk management must be examined before such a contract is concluded.

The International Accounting Standard Board (IASB) is currently looking into the accounting treatment of PPAs and published a staff paper on this in March 2024. Many companies are hoping that the relevant paragraphs of the standard will be amended to allow them to more easily avoid fair value accounting and the associated fluctuations in the income statement in future. In particular, this concerns the questions of when the own use exemption under IFRS 9.2.4 applies and whether the contracts are accounted for as derivatives and must be measured accordingly. But regardless of whether a valuation of PPAs is required as part of the quarterly and annual financial statements, a fair value should be determined before the contract is concluded to enable more informed negotiations. All of this aside, the valuation of PPAs is a challenge in and of itself due to the individual contract structures, long terms and variable electricity production.

The structure of the contract forms the basis for its subsequent accounting treatment and therefore also influences the valuation method to be applied. Depending on the contract, the following options are available for accounting for PPAs:

• Applying the own use exemption in accordance with IFRS 9.2.4 and 9.2.6
• Recognizing individual contract components as embedded derivatives in accordance with IFRS 9.4.3.1
• Recognizing the entire contract as a derivative in accordance with IFRS 9
• Making use of hedge accounting
• Classifying the contract as a lease in accordance with IFRS 16
• Full consolidation in accordance with IFRS 10

If an (embedded) derivative is recognized in the balance sheet, this will have an effect on the reporting date to be used for model calibration and the recognition of a so-called day one gain or loss (IFRS 13.64, IFRS 9.B4.3.3). Additionally, embedded derivatives require separate consideration, particularly if a unit price for electricity and guarantees of origin have been contractually agreed and no separately defined individual prices have been defined.

Alongside the contract prices, other contract-specific factors such as technology, settlement (physical/financial), delivery profile, term, availability and location of the plants, handling of guarantees of origin, remuneration clauses and the counterparty must be taken into account when evaluating PPAs. This means, for example, that the defined remuneration clauses may require a simulation-based valuation instead of a deterministic approach or an increased granularity of the model in order to map the expected cash flows. As a result, all valuation-relevant parameters and clauses contained in the contract must first be identified so that they can then be properly modeled.

In many cases, power purchase agreements are concluded for comparatively long contract periods of several years or decades. To be able to value the contract, the associated cash flows must be estimated for the entire delivery period. Accordingly, this requires a price forward curve that extends sufficiently far into the future. For this reason, the data basis used for the valuation often varies between the liquid phase, i.e. the period in which electricity futures are traded on a liquid exchange, and the illiquid phase. During the liquid phase, the prices quoted on the exchange can be used as the best estimate for the development of the electricity price. As no such quoted prices are available for the illiquid phase, corresponding electricity price modeling is required. Forecasting electricity prices is complex, as a wide range of assumptions need to be incorporated into the model, including with regard to generation capacities and the expansion of renewable energies, weather data and regulatory requirements. This is why it is crucial to choose an established provider with suitable model assumptions and sufficient granularity in the output data in order to obtain a suitable forecast of electricity prices. Another decisive factor for the evaluation of PPAs is the extent to which inflation assumptions are taken into account in the fundamental models and the electricity price reports. In addition, the fundamental model's electricity price forecasts can be used to bring the quoted prices of the liquid phase to the required level of granularity. In many cases, providers also offer similar reports for the price development of guarantees of origin.

When using a fundamental model as part of the measurement, the fair value hierarchy of IFRS 13 requires unobservable data to be allocated to Level 3 inputs. Pursuant to IFRS 13.93, the electricity price sensitivities of the fair values must therefore be reported in the notes and further disclosures made. It is therefore advisable to include the calculation of sensitivities directly in the valuation model.

A further special feature of renewable energy plants is that their electricity production is variable depending on the weather. In PPAs, electricity is often supplied on a "pay as forecasted" or "pay as produced" basis. Unlike a baseload delivery, in these cases the individual delivery profile must be taken into account when estimating future cash flows and any balancing energy costs incurred.

Fluctuations in production volumes during the year can be reflected in the model either by a sufficiently high granularity of the cash flows (at least hourly) or by using capture prices when calculating the expected cash flows. Capture prices are the volume-weighted average prices that an investment is expected to achieve over a certain period of time. They are usually either provided directly by the providers of the fundamental models or can be calculated from the baseload prices using so-called capture rates.

Both approaches first require a plant-specific production forecast. Several system operators already provide a yield forecast as part of the contract negotiations. In case the plant operator does not provide a production forecast with sufficient granularity, an own forecast can be derived from historical production and weather data. In doing so, it is essential to take into account the location and type of plant and to use a sufficient history length. If obtainable, it is advisable to use the production data of the plant specified in the contract. This time series can then also be used for backtesting your own forecast as soon as a sufficient history of production data is available. It is also important to take degradation into account when forecasting electricity production, i.e. a reduction in the plant's output over the term of the contract. As with the fundamental models, the production forecasts are Level 3 data in accordance with the fair value hierarchy of IFRS 13, which means that they must also be disclosed accordingly in the notes.

Power purchase agreements offer companies an effective instrument to achieve their sustainability goals and hedge against electricity price risks. The considerable freedom in the structuring of power purchase agreements allows the contracts to be adapted to the company's specific needs. On the other hand, it also makes it more complex to assess and analyze the effects of contract design on accounting and the associated valuation. This is why the employees responsible for concluding power purchase agreements must be made aware of the far-reaching effects on the balance sheet. In addition, a comprehensive and cross-departmental analysis of the individual clauses must be carried out during the contract negotiations. It is necessary to identify the contract sections pertinent to the valuation of power purchase agreements and to design the valuation model used accordingly, which can provide valuable insights from as early as the negotiation phase. What's more, a large amount of input data and parameters are required, all of which must be entered into the model as at the reporting date. In doing so, sufficient data quality is essential, both for the initial calibration of the model and for subsequent valuations. In conclusion, the valuation of power purchase agreements is a complex and interdisciplinary computation that is driven both by accounting estimates and by the special features of renewable energies.

Source: KPMG Corporate Treasury News, Edition 142, April 2024
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Yannic Diefenbach, Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Jeannine Widawski, Assistant Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG