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How are energy contracts affecting the transition to net zero?

Around the world, a large proportion of electricity is sold through power purchase agreements that may span decades. While these long-term contracts help to reduce risk, they can also lock countries into fossil fuels and hinder a rapid switch to renewable power, which is often cheaper.

Across the world, a vast proportion of electricity is sold from a power generator to a utility company via ‘power purchase agreements’ (PPAs). These are long-term contracts that typically span one to three decades. They specify the price and duration for which electricity will be purchased.

While these contracts play an important role in reducing risk for power generators by shielding them from the vagaries of an uncertain market, they can also, in certain circumstances, lock in uncompetitive power generation.

Electricity production has been changing steadily over the last two decades, with new renewable energy sources, such as solar and wind, growing in their share of the global power mix (see Figure 1). The growth of these technologies has been driven by the fact that their costs have declined rapidly due to efficiency improvements, accumulated experience and continuous innovation (see Figure 2).

Figure 1: Global power mix

Source: BP Statistical Review of World Energy (2022); Ember's Global and European Electricity Reviews (2022). Accessed via Our World in Data.
Note: 'Other renewables' includes waste, geothermal, wave and tidal

Figure 2: Global levelised cost of electricity by source, 2010-2022

Source: International Renewable Energy Agency (IRENA)

But when contracts are written for time periods far out into the future, dynamic efficiency gains (that is, cost reductions from switching to cheaper options) cannot be realised. Many PPAs for coal are like fossils: they reflect market conditions, expectations and prices of the past. They force a utility company to keep sourcing power from coal even when low-cost alternatives may be available and economically sensible.

For example, in the early 2000s, it may have made sense for a utility company to agree to a 25-year contract to source electricity from a coal-fired power station. At that time, renewable energy was more expensive, and a long-term contract with a coal generator might have been viewed as the stable and secure choice.

But fast forward to 2017, and suddenly, solar PV had out-performed coal in terms of cost per unit power (see Figure 3). Instead of being able to switch to the cheaper option that would benefit electricity consumers by reducing bills, the utility is legally obliged to keep sourcing from the coal generator until the PPA expires.

Figure 3: Inflection point (price of electricity from new power plants), 2009-2019

Source: Lazard Levelised Cost of Energy Analysis, version 13.0. Accessed via Our World in Data
Note: Hover to reveal percentage change

A natural consequence of this is that there is increasing pressure to exit coal PPAs prematurely to make room for cheaper renewable energy. For example, Germany is negotiating with producers of lignite – often referred to as brown coal – for early closure; and the Asian Development Bank has a pilot in Indonesia and the Philippines for the early retirement of coal through a newly developed ‘energy transition mechanism’.

Similarly, in India, there are some efforts to revive the financial health of indebted electricity distributors by allowing them to source lower-cost renewable energy rather than more expensive coal, as dictated by existing PPAs.

Another approach is to create power markets with more dynamism so that utilities can simply pick whichever is cheapest. For example, Germany’s grid sources a proportion of its power only 30 minutes before delivery. This helps the market to adjust to the fact that on sunny days, there is cheap and abundant solar power. Many other European countries – such as France, Switzerland and the UK – source a proportion of their power through these ‘day-ahead’ or ‘intra-day’ markets.

This type of near real-time adjustment is a far cry from PPAs that are revised on the basis of decades. Unfortunately, in many developing countries, PPAs dominate the power market and switching to whichever source is cheapest is often only possible when existing contracts expire.

From decades to hours, markets can adjust at different frequencies. Realising that much of the world’s power operates on slower timescales is important for policy-makers interested in a rapid low-carbon transition.

There is also a deeper question around how new PPA contracts should be written to balance considerations around risk reduction and dynamic efficiency. On the one hand, long-term contracts create security of supply: it is reassuring to know that for the next decade, a generator has agreed to supply its power and a utility is committed to buying it. This can reduce financing costs.

On the other hand, consumer bills also matter, and contracts should not be so long that they preclude the utility firm from sourcing from dramatically cheaper sources of power.

The same tension also exists for renewable energy PPAs. Long-term contracts can be written to source a particular type of clean energy, but it is entirely possible that future developments mean that new, more efficient options come along.

As consumers, electricity retailers and politicians realise that institutional lock-in is preventing the adoption of some of the cheapest power in the world, it is likely that there will be a push to ensure that power markets are made more flexible.

Further, as energy security concerns become paramount – particularly since Russia’s invasion of Ukraine – thinking about with whom you enter a multi-decade contract is just as important as whether the type of generation is cost-competitive. On the heels of today’s geopolitical crisis, many organisations are reassessing whether they should have entered into a PPA with Russian energy producers.

Whether it’s about future cost trajectories or the geopolitics of sourcing relationships, careful thought is needed before the next batch of multi-decade PPAs are signed.

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Author: Sugandha Srivastav
Picture by Pavel Babic on iStock
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