Flex assets to reduce renewable portfolio risk

There has been a huge expansion in renewable power portfolios across Europe over the last 5 years.  This has been supported by rapidly declining costs, good access to capital and an improving policy environment. Growth is set to continue across the 2020s, but with a very new set of challenges.

“And size does matter. Optimal sizing of flex vs RES volumes evolves over time with changes in market pricing dynamics and the underlying renewables portfolio.”

Renewable investors have historically been insulated from wholesale power price exposure.  But this is changing as existing policy support measures (e.g. FiTs and ROCs) start to roll off and merchant exposure is becoming more common (either as a way to increase returns or due to the paring back of policy support for more mature technologies).

The impacts of Covid-19 in pulling forward higher renewable penetration have sharpened investor focus on market price risks going forward. These risks include falling wholesale prices, increasing price cannibalisation and higher balancing cost exposure.

Flexible ‘peaking’ asset returns such as batteries and gas engines have stood up relatively well to the Covid crisis. Flex assets also benefit from characteristics that diversify and offset renewable portfolio exposures.  This is driving a surge in investor interest in adding storage and engines to wind and solar portfolios.

In today’s article, the first in a series, we set out how the price exposures of renewables and flex assets can complement each other to manage portfolio risk and improve returns.

The renewables risk challenge

There is a wide range of Renewable Energy Sources (RES) across European power markets.  But for the purposes of this article we focus on wind and solar, as the key sources of incremental RES power asset volumes.

The wholesale market price risk of wind & solar assets can be grouped into 3 sources:

1. Commodity price: exposure to movements in power prices, driven primarily by underlying gas & carbon price movements (e.g. falling gas prices across 2019-20)
2. Cannibalisation: as system renewables volumes grow, correlated wind & solar output profiles increasingly erode asset capture prices (vs baseload or time weighted average prices)
3. Balancing: Balancing price exposure which increases over time as renewable volumes grow and balancing (or cashout) prices become more volatile.

These sources of market price risk have historically been mitigated by policy support mechanisms. The extent of risk mitigation depends on whether support is paid as a premium on top of wholesale prices (e.g. UK ROCs and premium FiTs in Continental markets) or at a fixed price level (e.g. UK FiT/CfDs).

Corporate PPAs are another market risk mitigation route for RES asset owners, allowing transfer or sharing of risk with a corporate counterparty.  PPAs are becoming more common in Europe, although aggregate volumes are still relatively small.

RES assets receiving a premium on top of wholesale prices are significantly more exposed to commodity price risk and cannibalisation than assets receiving fixed price support (e.g. under CfDs or PPAs).

Regardless of the support mechanism in place, the market exposure of RES assets is increasing over time due to:

• The approaching roll-off of existing support mechanisms (e.g. German FiTs from 2021, UK ROCs from 2022)
• Tranches of merchant exposure being introduced into RES projects to support investment cases and increase returns (e.g. increasing market exposure in UK offshore wind projects)
• The rise of pure merchant renewables projects e.g. onshore wind in the UK and Germany and solar PV in Spain and Italy.

These factors are set to increase the market price exposure of RES portfolios as the 2020s progresses.  Recognising this structural trend, RES investors are looking to define portfolio risk mitigation strategies in response.

Why flex assets complement renewables

RES portfolios can be relied on to deliver relatively stable average energy volumes, regardless of market conditions. However the ‘must run’ nature of RES assets means that portfolio owners are price takers, exposed to prevailing market prices during periods of output (and therefore price declines and cannibalisation).

Flex assets on the other hand can be tactically dispatched into market periods with advantageous prices and benefit from increased power price volatility. However flex assets carry significant volume risk e.g. lower output & returns in periods of high RES output.

The addition of flexible assets, such as storage or engines, to a renewable portfolio can provide substantial risk diversification benefits. The complementary nature of flex asset classes is driven by uncorrelated or negatively correlated returns relative to wind and solar assets as summarised in Diagram 1.

There are broadly three ways that flex assets can add value to a RES portfolio via risk diversification:

1. Dilute power price risk: Flex asset returns are largely uncorrelated to wholesale power price levels i.e. returns are driven by prompt price shape & volatility, not absolute price levels. Negative prices which can harm RES revenues via curtailment, actually benefit batteries. These impacts are summarised in the top two rows of Diagram 1.
2. RES volume ‘hedge’: RES portfolio cannibalisation & balancing risks increase over time as system RES volumes grow, reducing captured returns. But higher system RES volumes act to increase power price shape & volatility, increasing flex asset returns. These impacts are summarised in the bottom two rows of Diagram 1.
3. Anti-correlated returns: Flex assets can act to ‘smooth out’ or stabilise portfolio returns, for example:
   • Periods with low wind/solar output & returns, typically coincide with higher flex asset returns (given this drives a tighter market with higher & more volatile prices)
   • Periods with high wind/solar output & returns typically coincide with lower flex asset returns (given a well supplied market with lower prices & volatility)

While the complementary nature of these asset classes is compelling, effective practical implementation means tackling a number of important details.

The challenge: which asset combinations and how much?

We have seen a strong pick up in 2020 of large renewable portfolio investors engaging us to analyse the impact of adding batteries and engines to RES portfolios.

In our view this is a challenge that can only be tackled using stochastic simulation based market and asset dispatch models to quantify:

• The benefit of adding flex assets to RES portfolios
• Optimal type or combinations of flex asset technology vs RES
• Optimal sizing of flex to RES volumes & how this evolves over time

Robust analysis is underpinned by the ability to effectively simulate multiple (e.g. 500+) correlated profiles for the evolution of renewable output, system demand and market prices and model the impact of these on asset margin distributions over an investment horizon.

This allows the analysis of standalone margin distributions of renewable assets and flex assets.  Standalone distributions can then be compared with combined portfolio margin distributions of renewables plus flex assets to quantify benefits.

We will return in subsequent articles to set out analysis and conclusions on the benefits of combining flex and renewables. But we finish today with a taster of two high level principles:

1. Batteries complement solar: PV output profiles are relatively predictable (vs wind), with risk driven by price cannibalisation and low price periods. Batteries benefit from charging at low prices and often discharge at times of low RES output, providing a natural hedge for solar.
2. Engines complement wind: Wind output profiles are much less predictable, but also face a key risk from price cannibalisation. High engine returns tend to occur in low wind output & revenue periods, stabilising portfolio returns with this negative correlation creating a hedge.

And size does matter. Optimal sizing of flex vs RES volumes evolves over time with changes in market pricing dynamics and the underlying renewables portfolio.