Stumbling blocks in the valuation

Power purchase agreements (PPAs) are an important part of the energy transition and enable companies to utilise renewable energies and hedge against energy price risks. At the same time, these long-term electricity supply contracts present companies with new challenges, which is why the impact on areas such as accounting and risk management should be considered before such a contract is concluded.

The International Accounting Standard Board (IASB) is currently addressing the accounting treatment of PPAs and published a staff paper on this in March 2024. Many companies are hoping for an amendment to the relevant paragraphs in the standard to make it easier to avoid fair value accounting and the associated fluctuations in the income statement in future. This relates in particular to the questions of when the own use exemption under IFRS 9.2.4 applies and whether the contracts must be recognised as derivatives and measured accordingly. However, regardless of whether a valuation of the PPAs is required as part of the quarterly and annual financial statements, a fair price should be determined before the contract is concluded so that negotiations can be more informed. However, the valuation of PPAs can present companies with challenges due to the individual contract structures, long terms and variable electricity production.

The contract design lays the foundation for the subsequent accounting treatment of the contract and therefore also influences the valuation method to be applied. The following options are available for recognising PPAs, depending on the contract:

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

If a contract is recognised as an (embedded) derivative, this affects, for example, 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). In addition, embedded derivatives must be analysed separately, particularly if a uniform price for electricity and guarantees of origin and no separately defined individual prices have been contractually agreed.

In addition to 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. For example, 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. It is therefore first necessary to identify all valuation-relevant parameters and clauses contained in the contract so that these can then be properly modelled.

Power purchase agreements are often accompanied by a comparatively long contract term of several years or decades. In order to value the contract, the associated cash flows must be estimated for the entire delivery period. This requires a price forward curve that extends sufficiently far into the future. For this reason, the data basis used for the valuation often differs between the liquid phase, i.e. the period in which electricity futures are traded on a liquid exchange, and the illiquid phase. For the liquid phase, the prices quoted on the exchange can be used as the best estimate for the development of the electricity price. As such quoted prices are not available for the illiquid phase, corresponding electricity price modelling is required. Forecasting electricity prices is complex, as a wide range of assumptions, including regarding generation capacities and the expansion of renewable energies, weather data and regulatory requirements, must be incorporated into the model. It is therefore crucial to choose an established provider with suitable modelling assumptions and sufficient granularity in the output data in order to obtain a suitable forecast of electricity prices. The extent to which inflation assumptions are taken into account in the fundamental models and the electricity price reports is also crucial for the assessment of PPAs. The electricity price forecasts of the fundamental model can also be used to bring the quoted prices of the liquid phase to the required granularity. Providers often also offer analogue reports for the price development of guarantees of origin.

According to the fair value hierarchy of IFRS 13, the use of a fundamental model as part of the measurement involves unobservable data that is to be allocated to Level 3 inputs. In accordance with 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.

Another special feature of renewable energy plants is that electricity production varies depending on the weather. In PPAs, electricity is often supplied on a "pay as forecasted" or "pay as produced" basis. In contrast to 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.

The fluctuating production volumes during the year can be modelled 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 realise over a certain period of time. As a rule, they are 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 initially require a plant-specific production forecast. Some plant operators already provide a yield forecast as part of the contract negotiations. If the plant operator does not provide a production forecast with sufficient granularity, a separate forecast can be derived from historical production and weather data. Here it is essential to take into account the location of the plant and the type of plant and to use a sufficient length of history. If available, it is advisable to use the production data of the plant specified in the contract. This time series can also be used for backtesting your own forecast as soon as a sufficient history of production data is available. When forecasting electricity production, degradation, i.e. a reduction in the plant's output over its lifetime, must also be taken into account. Similar to the fundamental models, the production forecasts are Level 3 data in accordance with the fair value hierarchy of IFRS 13, meaning that they must also be recognised accordingly in the notes.

Power purchase agreements are an effective instrument for companies to achieve their sustainability goals and hedge against electricity price risks. The great freedom in the design of power purchase agreements also offers the opportunity to customise the contracts to the company's own needs. At the same time, this makes it more complex to assess and analyse the effects of the contract design on accounting and the associated valuation. It is therefore important to sensitise the employees responsible for concluding power purchase agreements to the far-reaching effects on the balance sheet and to carry out a comprehensive, cross-departmental analysis of the individual clauses during the contract negotiations. The contract sections relevant to the valuation of power purchase agreements must be identified and the valuation model used must be set up accordingly, which can provide valuable insights as early as the negotiation phase. In addition, a large amount of input data and parameters are required, which must be entered into the model as at the reporting date. Sufficient data quality must be ensured, both for the initial calibration of the model and for subsequent valuations. The valuation of power purchase agreements is therefore a complex and interdisciplinary calculation that is driven both by the accounting assessment and by the special features of renewable energies.

Source: KPMG Corporate Treasury News, Issue 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 Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG