[Aribba is a student at Amity University, Kolkata.]
In India's evolving power market, power purchase agreements (PPAs) have transformed into financial instruments with derivative-like features.
Long-term power contracts dominate the Indian electricity sector with 88% of the overall traded volumes consisting of PPA with 25 years of tenure. Although PPAs liberate investors from price-volatility risk and ensure long-term certainty, their proliferating ramifications must be dealt with to facilitate the financial viability of distribution companies (DISCOMs) or state DISCOMs.
The Indian Energy Exchange initiated the Cross Border Electricity Trade in April 2021 to create a unified South Asian regional power market for supporting the One World One Sun One Grid ambition of the Indian Government, establishing a green electricity export market. To ease their economic burden, DISCOMs need to be unshackled from expensive long-term PPAs with old, inefficient plants. The long-term PPAs are fixed contracts that underwrite the old plants’ capital cost (financing and depreciation) without providing value to the customers. Now, India must proceed toward expanding financial products in the derivative (or financial) electricity market whose developers want to avert risk without signing long-term PPAs for projects’ financial closure.
Considering the conundrum mentioned above, the exchanges may soon open the power sector derivatives market, allowing generators and consumers to enter into futures contracts and use them as a new hedging tool to mitigate price volatility and other associated risks. A decade-long dispute between the Central Electricity Regulatory Commission (CERC), the power regulator, and the Securities and Exchange Board of India (SEBI), the market regulator, was resolved by the Supreme Court (SC) order and the Ministry of Power (MoP) memo. The SC order, in conjunction with the MoP memo, has laid the groundwork for consumers to trade electricity as a commodity on the CERC and the SEBI-recognized platforms, giving them more options for meeting their short and long term power needs.
An Understanding of PPAs, Commodity Derivatives, Contracts for Differences, and Everything in Between
PPAs are frequently required to fund renewable energy projects. As a result, they play a critical role in developing new renewable energy technologies. Lower rates and the green credentials of having their power supply come entirely from renewable sources entice buyers. Most PPAs are settled financially, which means the price is decided between the generator and the off-taker, but the actual power produced is sold on the spot market. This, in turn, creates price risk.
Derivatives, on the other hand, according to clause (ac) of Section 2 of the Securities Contracts (Regulation) Act 1956, include financial instruments whose value is determined by the value of an underlying asset such as stocks, currencies, or other financial assets or commodities. These underlying assets can be anything and include commodities. This legislation not only defines derivatives but also includes commodity derivatives.
Notably, contracts for differences (CfDs) are encompassed, instruments reflecting the value of underlying assets, such as barrels of oil, tons of wheat, or megawatts of electricity. This inclusion significantly shapes the regulatory landscape, providing a clear legal framework for the trading and functioning of derivatives related to commodities. The inclusion of CfDs further adds flexibility to the market, allowing participants to speculate or hedge on the price movements of various commodities without the physical exchange of these assets.
The Blend of Commodity Derivative Contracts in a PPA
The MoP sanctioned the introduction of an electricity forward contract and derivatives market in India in July 2020. The long-awaited reform came from the settlement of a dispute between the CERC and the SEBI. Apart from adding electricity as a commodity in the financial market, this is an essential incremental step in expanding the overall structure of the physical delivery market.
As per this statement by the Indian Government, this would bring newer products to the power/commodity exchanges and attract increased participation from generating companies, DISCOMs, and large consumers, eventually deepening the power market.
According to the proposed structure, physical and financial markets will operate on different exchanges and be regulated by the CERC and the SEBI, respectively. The existing physical delivery contracts and non-transferable specific delivery (NTSD) contracts in electricity will be regulated by the CERC, while commodity derivatives in electricity (other than NTSD contracts) will be regulated by the SEBI. Following this order from MoP, in July 2020, the CERC issued a draft on power market regulation addressing some pressing concerns. While PPAs provide long-term revenue certainty for renewable energy projects by fixing the price of electricity generated, CfDs and other derivatives can further enhance their effectiveness.
CfDs act as a risk mitigation tool, compensating developers for the difference between a pre-determined strike price and the volatile market price of electricity. This shields developers from financial losses due to price fluctuations, incentivizing greater investment in renewable energy.
Beyond CfDs, other derivatives like options and futures contracts contribute to the success of PPAs. Options offer flexibility, allowing developers to hedge against price fluctuations or capitalize on potential upside. Conversely, futures contracts lock in future electricity prices, enhancing revenue certainty and facilitating project financing.
Way Forward: Risk in PPAs Paving the Way for Derivatives
DISCOMs are suffering huge losses and have not signed long-term PPAs with power developers in recent years; this is turn has put the future development of additional renewable energy capacity at risk. The introduction of financial instruments in the derivatives market will aid in hedging off-taker risk and providing flexibility and certainty of supply to both DISCOMs and developers for power sales in the futures market, as well as in developing the price signal required to incentivize supply during peak demand periods – the key to enabling battery deployments and demand response management.
According to the Institute for Energy Economics and Financial Analysis, the derivatives market will benefit renewable energy developers, both for current projects with untied PPAs and those in the development phase for sale in the financial market. Further, stranded gas-peaking power plants may find buyers in the financial market if a different derivative product for gas-powered plants were created, linking the time of delivery price, possibly with the input price of gas, to help resolve the financial stranding of much of India’s gas-based electricity capacity.
Thus, DISCOMs, large commercial and industrial consumers, and generators can use electricity derivatives for effective price risk management, which can be combined for several months to form a close match with the long-term load or generation profile. Further, such instruments will provide merchant-generating stations in India with longer-term visibility of guaranteed prices, allowing them to formulate long-term fuel sourcing strategies better. As a result, stable price visibility for buyers and sellers encourages trade reliability and contributes to the deepening of the Power Market.
The derivatives market will also provide more diverse supply avenues, greater visibility of a more reliable forward price curve, and greater transparency in power pricing. Market players can transfer risk to willing participants, enabling increased activity. Further, derivatives market prices will reflect the collective perception of market participants about the future.
A Shifting Paradigm: PPAs to VPPAs
With the introduction of the virtual power purchase agreement (VPPA), an instrument that closely follows the financial settlement terms of a CfD, there is more flexibility (than a traditional PPA) which has led to an increased popularity for these agreements in the broader market.
The legal status and applicable regulatory framework related to VPPAs in India are still uncertain. VPPAs operate on the principle of a CfD between independent power producers (IPPs) and off-takers. Under the terms of the CfD, any profits exceeding the strike price specified in the contract are transferred to the off-taker. If, the market price falls below the strike price, the off-taker supports the difference.
The fundamental question surrounding VPPAs is whether they fall under the jurisdiction of regulatory bodies such as the CERC or the SEBI. The CERC held that VPPAs do not involve the physical delivery of electricity, nor are they tradable contracts, placing them outside the regulatory oversight of both agencies.
In conclusion, the Indian electricity market is evolving, and hence, the need arises for clarity to navigate the complexities of evolving energy landscapes. Clarity in regulatory guidelines will not only facilitate a smoother transition for IPPs and off-takers but also encourage a more robust and competitive renewable energy sector. By providing a clear roadmap and regulatory support for VPPAs, India can pave the way for enhanced sustainability, energy security, and the realization of ambitious goals in clean and efficient power generation. A forward-looking legislative approach is key to unlocking the full potential of renewable energy sources and ensuring a sustainable and resilient energy future for the nation.