- Investors should carefully consider the effectiveness of a floor price when structuring optimisation agreements for their flexible assets
- Whilst floor prices can limit downside risk, the level of protection may not come at a fair cost to asset owners
- There is not yet a consensus within the industry on the best use of floor prices, with some asset owners preferring full market exposure and high levels of flexibility in their contracts with route-to-market providers
These were the outcomes of a discussion between energy and finance experts at a recent roundtable hosted by Aurora Energy Research and Osborne Clarke.
Floor prices provide a method of securing fixed income for flexible assets, such as batteries, in a market where long term contracted revenues are increasingly unavailable. However, there is not yet a consensus within the industry on the best use of these arrangements. Whilst floor prices can provide a limit to downside risk, it is key to understand if they come at a fair cost and the impact on overall project economics.
The roundtable brought together senior personnel from developers and investors of flexible assets, including battery storage, to discuss the approach to structuring optimisation agreements. Here, we explore some of the themes discussed.
Why are floor prices being considered?
As the UK’s power sector becomes increasingly dominated by renewables, there is a huge investment opportunity in flexible energy to earn value resolving price volatility and system stability issues. Installed battery capacity in GB hit over 1GW in 2020, representing a 30% year on year growth.
However, the revenue stack for batteries is moving away from long-term grid service contracts towards close-to-real time optimisation across multiple energy, balancing and ancillary markets. This adds both complexity and uncertainty to the stability of future revenues.
Many investment committees who are not comfortable with this risk profile have sought to manage this through including fixed income floor prices in their bilateral arrangements with route to market providers. This typically comes at a cost of reduced upside, through a revenue share with the optimiser.
These structures may be a natural progression from the renewable industry, which has become used to subsidies and long term, stable revenue. Replicating these risk profiles is perfectly understandable approach and may be the route to attracting institutional capital and the deployment of multiple GWs.
However, to date, many investors have rejected floor revenues and believe batteries should be considered as a fundamentally different asset class to renewables, one that thrives on full exposure to market price volatility. Peak prices over the 20/21 winter showed there is value in this approach.
Floor prices as a stepping stone
Taking a merchant approach to batteries requires an understanding of the fundamental drivers of value. The energy system is undergoing profound change, and a multitude of factors including renewable deployment and gas prices will determine future price volatility. Appreciating how these interact is crucial to build an investment thesis for batteries, and for gaining a competitive advantage.
This is not easy, and before investment committees can go on this journey, floor agreements may provide a level of reassurance. Batteries are a relatively new investment class, and it will take time to build up a track record of performance to build confidence.
How do floors impact project economics?
Floor agreements may enable getting debt into a project, which can reduce the cost of capital and boost equity returns. However, this depends on the level of the floor. If a floor is set too low, the risk is that investor is giving away upside for only a small debt ratio and limited downside protection.
Indeed, recent modelling by Aurora Energy Research showed that a battery ‘P90’ revenue case, which provides a guide to a natural market floor, is above the value of many floor prices signed in the market. Essentially, this means that it is extremely unlikely that these floors would be enacted, questioning whether they represent good value for money.
Investors should be armed with the knowledge of what a realistic downside case for their asset could be when structuring their contracts with route to market providers.
Getting the contract right
Whether to use a floor price is not the only contract consideration. Osborne Clarke have found that it is also important to consider contract flexibility, defining how long projects are fixed with a single optimiser. With optimisers lacking a long track record of performance, it is hard to know which optimiser will generate the greatest value for the project. Long term contracts may not be optimal compared to the ability to switch between providers based on performance or changes to market conditions.
The level of transparency and oversight over optimiser performance is also a key consideration. The discussion revealed some investors were happy to leave the optimisation decision making to the optimiser, recognising the value of their expertise and advanced algorithms. Others were concerned that without close scrutiny from the investment team, their asset could be missing out on value, such as from new emerging revenue streams.
The consensus view was that a balance between these two approaches was required, allowing the optimiser to prove their value, whilst aligning periodically on the asset strategy.
More questions than answers
The roundtable revealed that there is clearly a divergence of opinion within the industry over whether to use floor prices and how to engage with route to market providers. The nascent nature of the sector means there is no established right or wrong way to structure these projects, and there is much still to learn. With 573MW of battery capacity winning contracts in the recent T-4 capacity market auction, there is no sign the sector is slowing down, so expect new approaches to emerge as the market expands.
If you would like to speak to Aurora’s market experts about these themes please get in touch.