The Role of Balancing in Virtual and Physical PPAs

The discussion around the differences between virtual and physical PPAs can seem unending. Much has been written on this topic, so this post will only succinctly discuss such details. Our goal here will be to address another important element specific to physical PPAs: the role of the balancing. There is no clear industry standard regarding the role of balancing in physical PPAs, and the language around this can be tricky. This post aims to clarify the implications of the main options for balancing in physical PPAs.

In principium erat…

To better understand these implications, let’s zoom out and think about the market environment with no PPA involved at all. Market Participants (MP), both buyers and sellers of energy, may take part in the market either directly or through a representative. This entity would represent the MP when working with the system operator, and across the broader market. Buyers and sellers tend to use different names for these balancing responsibilities: On the supply side it is generally called Balance Responsible Party (BRP) while the buy side it is commonly referred to as retailer.

There are a series of costs related to any market activity that any MP will face. These can come in the form of financial guarantees or hardware investments to operate in the market, but let’s simplify and focus on just one: the balancing costs (aka deviation costs).

Balancing costs

MPs will participate in the Day-Ahead market and schedule their best expectation of power generation or consumption. For example, a generator may expect to produce 100 MWh of generation the following day, and will bid this amount in the Day-Ahead market. Conversely, a consumer may expect 100 MWh of consumption, and may likewise bid this amount in the Day-Ahead market. In this simplified scenario, the market will be balanced. 

Afterwards, all MPs will have opportunities to adjust their schedule if their expectations change through the intraday market — and even through ancillary and real-time markets. To keep the example simple, we will assume the schedule remains at 100 MWh. As accurate as this schedule may be, there are always deviations from this in reality. Generation and consumption will rarely play out exactly as scheduled. The generator may generate 102 MWh, or perhaps 97 MWh, while actual consumer demand may vary similarly. 

These deviations from planned supply/demand dynamics are where the system operator (SO) steps in to ensure the operational viability of the system. To maintain system balance, the SO has some real-time markets that allow it to re-balance the system. Logically, re-balancing the system in real time comes at a cost. Normally, these costs are passed on to MP, in proportion to their deviations. This makes full sense, as it is precisely those who deviate from their scheduled production and consumption that provoke costs for the SO. 

This all means that any MP directly participating in the market will face these costs. MPs being represented by an entity will also face these costs, but may be shielded to an extent by their representative entity, who can pass through the costs to all of the MPs they represent — creating the benefits of a portfolio effect. 

Now that we’ve established these market dynamic basics, let’s see how the introduction of virtual and physical PPAs changes things, and the impact of signing different PPA structures.

Virtual PPA

Virtual PPAs (VPPAs) provide a simpler example. As its very name already indicates, a Virtual PPA has no impact on the real-world operation of the wholesale electricity market. At its core, a virtual PPA is simply a financial agreement — an ex-post true-up (notwithstanding other tradeoffs such as accountability burdens). As nothing changes in real life operation, all MPs participating in a VPPA will face the same costs that they were facing before the PPA took place.

Physical PPA

Physical PPAs present a very different scenario, since typically the buyer already has a supply contract in place that the PPA must co-exist with. This dynamic forces a process called “sleeving,” in which the BRP and Retailer coordinate the energy flows. There are significant synergies here if the same entity is representing both MPs (the buyer and the seller) — so much so that sometimes there are requests for one MP to change representatives, so both parties have the same representative. 

These conditions open the question of how to deal with balancing costs. This is where the language used can be insufficiently precise, and where concepts need to be crystal clear. Offers — and the ways in which balancing costs are distributed in PPAs — can be read from the seller’s or buyer’s point of view. For the sake of this example, we will use the perspective of an energy seller. 

Physical PPA “with balancing costs”

The facility’s operation won’t change compared to its pre-PPA life, and both buyer and seller will face their own balancing costs. 

This Physical PPA case is the same as the virtual case, and the seller must assess anticipated balancing costs and incorporate them into their PPA offer, so it receives the desired net value after paying balancing costs to the system operator.

Physical PPA “without balancing costs”

Physical PPAs offer another alternative, which is typically as follows. 

Let’s assume an IPP is selling to a retailer or utility, who also acts as a market representative and is representing a large portfolio of assets. In this situation, the buyer can assess how the portfolio’s total balancing costs would change if the asset in question is incorporated into their portfolio. 

In this example, the buyer would likely ask the seller for an offer where balancing costs are not included. Since the seller (IPP) won’t need to add any forecasted balancing costs into their offer if they agree to this structure, the offer itself will logically be more competitive. If the buyer’s expectation is that dealing with the seller’s balancing costs will be cheaper than the difference in PPA price between the two offers, then they would be willing to contract with this cheaper structure.

Summary

The table below shows how virtual PPAs imply no changes in real-life operation, with both buyer and seller facing their own balancing costs as regular Market Participants. On the physical side, one option is completely equivalent to the virtual deal, when both parties are responsible for their balancing costs. But a new possibility arises when the buyer is ready to incorporate the seller’s balancing costs into their portfolio, allowing for reduced balancing cost overall.