Renewable energy assets (for example wind, solar, hydro or biomass power plants) can be in the feed-in regime (where the state guarantees a fixed price for each MWh of electricity produced) or the electricity is being sold on the market (which is then called a “merchant” project or we say that the project has “merchant” exposure). The merchant projects can be fully or partially hedged through PPAs (Power Purchase Agreements).  If part of the production is still being sold on the market, then the investors need to assume future electricity market prices.

Electricity market prices become perhaps the main topline driver (and correspondingly assumptions regarding future electricity market prices become one of the key valuation drivers). The decision each renewable energy investor needs to take is what electricity prices to assume for the future. There are several possibilities how this can be handled

1. Buy ready-made deterministic price forecast from some of the providers (such forecast are normally based on cost minimization fundamental models)
2. Rely on own fundamental model for electricity price forecasting (such model can be purchased from third party – it is just operated in-house)

The first approach is without much effort – investors simply purchase the ready-made electricity price curves. The second approach offers significantly more flexibility and transparency in what the underlying optimization inputs and constrains are. However, it can be quite tedious for the financial investors to run the own fundamental price forecasting models. Furthermore, assumptions regarding model inputs have to be taken (gas prices, new-built power plants, added renewable energy capacities, etc.). Not all investors have the necessary know-how to set this all up… As a result, they stick with the first approach – buying the ready-made electricity price forecast.

However, what is the main issue with both of the approaches mentioned? Well, deterministic electricity price forecasts never materialize. If you did an ex-post back-testing of electricity price forecast by comparing the future scenarios even from industry standard electricity price forecast providers with realized electricity prices, you would see how massively off the forecast were. Simply, it’s impossible to forecast the electricity market prices ten or twenty years ahead.

What’s the solution then? We believe if it is not possible to forecast the future, we could describe it probabilistically. This means to switch from deterministic to stochastic models. That is required in order to account for the uncertainty in the price forecasts. To make it correctly, though, is not a trivial task but it requires good stochastic models and also a tool which is able to value the particular renewable energy project for each scenario. In the upcoming articles, we will try to walk you through how this can be done and how Blue Yellow can help you with that. If you have any questions in the meantime, please do not hesitate to contact us.