When it comes to fair valuation under IFRS 13, renewable energy contracts like Power Purchase Agreements (PPAs) presents unique challenges. Discounted cash flow (DCF) modelling is a common approach used to value PPAs.
In this article, our Financial Instruments team outline the 7 most critical challenges considering various factors such as market inputs, credit risk, and uncertainties to calculate the present value of future cash flows associated with the agreement.
PPAs are often long-term energy contracts—typically spanning 15 to 20 years—and are traded in illiquid markets, making it difficult to source observable market data for valuation. This necessitates the use of unobservable inputs, which require careful estimation and documentation.
To enhance reliability of the inputs used, entities may benchmark their forward curves against alternative curves in line with recent market transactions or expectations. This approach ensures that valuations robustly reflect the market-based assumptions in energy PPAs.
The capture rate represents the actual prices a project is likely to realize relative to the average market prices. Adjustments to reflect capture rates are necessary to reflect the true value of the PPA in the context of the specific market.
For example, capture rates of a solar PPA in Spain could be quite different from a solar PPA in the UK or Ireland. However, estimating the capture rate can be complex, requiring sophisticated forecasting over the PPA's duration.
This involves considering factors like the project technology, for example, whether it's a solar PPA or a wind PPA, peak and off-peak periods, the project's production profile, and geographic considerations.
PPAs often include unique terms such as caps, floors, upfront premiums or other pricing mechanisms. Also, often the price of renewable energy credits (RECs) are embedded in the fixed price of the PPA, which may be required to be excluded from the valuation. These features require additional modifications to the valuation approach to accurately reflect their impact.
Robust models are needed to ensure these contract-specific characteristics are appropriately captured. When options are involved in the PPA, sophisticated models like Monte Carlo simulations may be necessary to account for the added complexity and variability that options introduce to the pricing structure.
Inflation can significantly impact the valuation of PPAs, especially for long-term contracts. Often the fixed price on PPAs is linked to inflation indices. While the European Union consumer price index (CPI) is relatively liquid and widely used for these estimates, other country-specific indicators, such as the Irish CPI, can create difficulties due to varying levels of availability and transparency.
This increases the risk of valuation uncertainties when projecting future inflation rates for PPAs. If inflation projections are unobservable, entities could estimate future inflation using economic forecasts or historical averages.
Accurately forecasting the volume of electricity under a PPA is crucial. This involves considering the payment structure (baseload or pay-as-produced) and using benchmarks like P50 volumes for renewable energy assets. However, variability in production estimates can complicate these forecasts, requiring a diligent reassessment of volume projections by market experts on an ongoing basis.
This iterative review process helps ensure that the PPA remains aligned with the evolving market conditions and operational performance of the renewable energy asset.
The discount rate reflects the perceived risk of the PPA and significantly impacts the present value of future cash flows. Determining an appropriate discount rate involves considering factors such as creditworthiness and market conditions. Entities must select a rate that aligns with the project's risk profile and financial objectives.
Fair value measurement for PPAs with derivative features requires incorporating both the entity's own non-performance risk and the counterparty's credit risk. Credit value adjustment (CVA) and debit valuation adjustment (DVA) are essential for accurately assessing the impact of credit risk.
Navigating the fair valuation of PPAs requires a high level of judgment and expertise. Entities can enhance their fair value measurements to reflect a realistic, market-aligned view of future cash flows, in compliance with IFRS 13, by addressing the challenges outlined above.
This approach not only strengthens the accuracy of financial reporting but also supports better decision-making in the management of PPAs.
Valuing power purchase agreements (PPAs) under IFRS 13 is no easy task. From unobservable market inputs and credit risk adjustments to inflation-linked pricing and contract complexities, each element can significantly impact the fair value of renewable energy contracts.
Ready to take control of your PPA valuations? Reach our to our financial instruments specialists for an initial conversation. We look forward to hearing from you.
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