The Economics of Curtailing Renewables pt.2

A FEW MONTHS AGO WE PUBLISHED A POST ON THE ECONOMICS OF CURTAILING RENEWABLES. AS THIS SUBJECT KEEPS GROWING IN IMPORTANCE WE'RE DOING THIS POST TO EXPLAIN A SECOND CRUCIAL FACT NAMELY THAT IT IS IMPORTANT NOT TO CONFUSE A MONTHLY REFERENCE MARKET LOGIC WITH AN HOURLY SPOT LOGIC WHEN THINKING ABOUT THE ECONOMIC CURTAILMENT OF ASSETS. WE'VE SEEN MANY MISLED DEBATES ABOUT THIS, WHICH IS WHY WE WILL TRY TO SHED SOME LIGHT ON THIS SUBJECT.

A quick disclaimer at this point: We wrote this article for internal purposes and for market partners, so if you don’t want to dive this deep, maybe it’s time to stop reading here. For the nerds: let’s go!

Catching up from where we left off

Before reading this specialized case, I highly recommend reading part 1 of this blog series, as this really explains the basics of why and when we curtail. 

The basic rule that we devised is that in order to fully compensate Ms. Solar for any curtailed power, we will need to reimburse her the lost market premium. Because of this, our marginal curtailment price (strike price) is always the negative anticipated market premium. This remains true regardless of whether we are in an hourly Spot contract or in a reference market value (RMV) contract and this article aims to show why this is true. 

Reference Market Value (RMV) Contracts vs hourly Spot Contracts

We previously made a point, why we are not big fan of reference market value contracts, however they are the norm in the market so you have to deal with them. 

To explain the difference, let's go all economist style and imagine a world where a month only consists of 3 hours instead of 720. Crazy, right, but it will make things easier and not change any of the fundamental logic. 

Now lets run with this model and say in hour 1 prices are at 200 EUR/MWh, in hour 2 prices are -50 EUR/MWh and in hour 3 the price is 100 EUR/MWh. This means that the average price over this "month" would be 83,3 EUR/MWh. Have a look at table 1 for this calculation. 

However, the production profile of our asset is not baseload and it produces 10 MW in hour 1, 15 MW in hour 2 and 10 MW in hour 3. We can simply multiply production times hourly price to get the revenues. Then we divide the spot revenues over the production in this month to arrive at an asset level average price of 64,3 EUR/MWh for this asset, which is less than baseload as it tends to produce more power during cheap hours. 

Now let us also calculate the the "monthly" average price for our reference market value (RMV) asset. This asset represents the average German renewable asset (let's say it's Solar). As this calculation is based on the production of many assets, I assumed that production is 10.000 MW in hour 1, 15.000 MW in hour 2 and 10.000 MW in hour 3. As luck will have it (and this is not usually the case) the reference market value is also exactly 64,3 EUR/MWh. I am setting the problem up with the reference market value identical to the asset level price as this will help reduce complexity later. However, the logic is the same even if the RMV differs from the asset level price.

Now let us look at the payoff of Ms. Solar in a situation in which she is not curtailed under a spot contract and a monthly reference market value contract. In the spot contract, she simply receives her production output multiplied with the hourly spot price. 

In a reference market value contract, she receives output multiplied with the monthly reference market value. Figure 1 shows us her hourly revenues under these contract schemes. Her production is represented by the grey line. Under the reference market value contract she simply gets the 64,3 EUR/MWh in each hour, which is why she won't have negative revenues. In the spot contract she always gets the hourly price, so she can get negative revenues however she also has higher revenues when prices are high. 

As this example is set up, she receives exactly 2.250 EUR in both cases, however her revenue profile from hour to hour looks quite different. 

Table 2 below shows the revenue flows for this example under a Spot contract and an RMV contract. Note how total revenues are identical, even though hourly revenues differ quite a bit. 

Adding in a curtailment decision

Now let us add in a curtailment decision. Let us assume that our asset has a subsidy level (anzulegender Wert/AZW) of 100 EUR/MWh. This means that for our "month" Ms. Solar would get a Market Premium of 35,7 EUR/MWh from Ms. DSO in each hour of production. Remember:

Market Premium = Subsidy Level/AZW - Reference Market Value

Market Premium = 100 EUR/MWh - 64,3 EUR/MWh = 35,7 EUR/MWh

So, if we curtail Ms. Solar, we would need to reimburse her these 35,7 EUR/ MWh in order to make her indifferent between being curtailed or not as she would be missing these payments from Ms. DSO.

This means that it makes sense to curtail production whenever prices fall below a level of -35,7 EUR/MWh. In our example, hour 2 has a price of -50 EUR/MWh, so this is the hour in which we curtail and production falls to 0. 

We now need to calculate the curtailment volume. This will be equal to 15 MW which Ms. Solar would have produced if no curtailment had taken place. Looking at the curtailment revenues under Spot and under RMV, you see that there are quite stark differences. 

In the case of the reference market value, the curtailment revenue is calculated by taking the production and multiplying this with the reference market value and the market premium, which needs to be reimbursed. 

Revenue_curtail_RMV = curtailed production * (reference market value + market premium)

= 15 MW * (64,3 EUR / MWh + 35,7 EUR/MWh) = 1.500 EUR

Note that this price i.e 64,3 EUR +35,7 EUR is exactly 100 EUR/MWh and it equals the subsidy level (AZW) of the plant. For this reason, you find in many route2market (Direktvermarktung) contracts a clause that says, that if a plant is curtailed, it should be reimbursed at least the "anzulegender Wert". This is correct for monthly reference market contracts but very incorrect for hourly spot contracts. 

Calculating the curtailed revenue for the spot contract follows a similar logic, however using spot prices instead of reference market prices.

Revenue_curtail_Spot = curtailed production * ( spot price + market premium)

= 15 MW * (-50 EUR/MWh +35,7 EUR/MWh) = -214,29 EUR.

As you can see, this puts Mr. Trader in the awkward position where he actually has to charge Ms. Solar for the curtailed volume, as the curtailment took place at negative spot prices. 

However, if we look at the total sums, we understand why this math works out. In the reference market value contract, Ms. Solar receives 1.285,7 EUR for her produced volume and 1.500 EUR for her curtailed volume giving her a total of 2.785,7 EUR.

In the spot contract she receives 3.000 EUR (much more than above) for her produced volume and pays negative -214,29 EUR for her curtailed volume putting her at a total of (you guessed it) 2.785,7 EUR. 

If you wonder why she makes more money now than in the non-curtailed case (2.250 EUR), look at the difference between these revenues: 2.785,7 EUR - 2.250 EUR = 535,7 EUR. If you divide that by 15 MW i.e. the curtailed volume you get 35,7 EUR/MWh which is exactly the value of the market premium which you had to reimburse Ms. Solar. Therefore, Ms. Solar is financially indifferent between being curtailed or not. 

Looking at Mr. Trader for a second, we see that in the case of curtailment he makes spot revenues only in hour 1 and hour 3 and he doesn't produce in hour 2. He therefore now has a revenue of 3.000 EUR and he pays out 2.785,7 EUR to Ms. Solar; therefore he is happy to curtail in this instance as this makes him better off. See Table 3 for these calculations.  

Looking at Figure 2 the important point to understand is that reimbursing the subsidy level, i.e. the anzulegender Wert (here 100 EUR/MWh * 15 MWh) only makes sense in a "monthly" reference market logic as here it is the sum of the market premium and the reference market value. 

We see in the market, however, that many customers are accustomed to receiving the AZW in moments of curtailments, which makes sense under a reference market construct, which customers are often used to. However, in a spot logic, one is exposed to hourly spot prices and therefore, in times of curtailment, spot prices are passed through, which can be and often are negative in these instances. This tends to cause confusion, as many a Ms. Solar does not appreciate having to pay out money when she is being curtailed. The crucial point to understand is that she would have paid out that money if her plant had been producing as well.

Her spot contract makes her at least equally well off because she also receives the higher revenues when prices are above the average which is not the case in an RMV construct. Going through the numbers one can see that overall revenues are identical (i.e. 2.785,7 EUR) under both constructs as long as only the market premium is compensated for. 

Third Party "Whitelabel" Agreement

Now a further confusion, that we have come across in so-called white-label contract agreements is a demand to receive the "Anzulegender Wert" for curtailment payments in a spot based contract. The reasoning usually goes that the white label partner (let's call them Mr. White) has a contract with Ms. Solar in which he owes her the "Anzulegender Wert" whenever a curtailment happens, and therefore he needs to be paid this amount whenever he is curtailed under the spot contract. 

To him the situation in which curtailment happens feels like the curtailment situation in Figure 2. He only "receives" i.e. needs to pay out a price of -214,29 EUR from his trading partner, however he needs to pay out 1.500 EUR (full "anzulegender Wert") to Ms. Solar. Clearly, if you only look at this one hour or instance this looks like a terrible deal. However, this is a misunderstanding, as it confuses an hourly logic with a monthly logic. Yes he pays out more than he receives in this particular hour, however he is compensated for this later on. As long as he receives the market premium for his curtailed volumes on top of the spot price, his revenues in a situation of curtailment are exactly the same as if he had not been curtailed over the course of the month. 

But let us entertain the misguided idea, in which the "anzulegender Wert" were to be paid out in a spot contract instead of paying the spot price + the market premium. 

Doing it wrong: reimbursing the AZW in a Spot contract

Now let us imagine that Mr. Trader reimburses Mr. White the full anzulegender Wert in the case of the curtailment. See table 4 for this case. 

In the (correct) Spot logic he would pay:

Curtailment revenue = Production Volume * (spot price + market premium) = 15 MW* (-50 EUR/MWh + 35,7 EUR/MWh) = -214,29 EUR.

Now he pays the anzulegender Wert:

Curtailment revenue = Production Volume * (anzulegender Wert)

= 15 MW * (100 EUR) = 1.500 EUR.

Adding the revenues, Mr. White would now receive 3.000 EUR for the produced volume and 1.500 EUR for the curtailed volume putting him at a total of 4.500 EUR, while he would only need to pay out the anzulegender Wert to Ms. Solar in the curtailed hour and the reference market value in the other hours. This means he would be receiving 4.500 EUR from Mr. Trader and paying out 2.785,7 EUR to Ms. Solar. Clearly this would be a great deal fro Mr. White, as this would increase his asset level price from 64,3 EUR/MWh to 113 EUR/MWh in this example.

However, surely Mr. Trader could never make this deal, as he would now have a spot income of 3.000 EUR and pay out 4.500 EUR to Mr. White leaving him at a big loss of 1.500 EUR. 

Figure 3 shows quite clearly, how the blue revenues are much greater than the orange revenues indicating a faulty contract design as now one party clearly benefits more from the curtailment decision.  

Summary

As we have had a few discussions, in which counterparties asked us for the so-called Anzulegender Wert in cases of curtailements it felt necessary to write a post on the subject and explain why this logic is misleading. The correct reimbursement on top of normal payments i.e. the reference market value in the case of an RMV contract and spot prices in case of a spot contract is ALWAYS the market premium. In case of an RMV contract, the addition of the market premium and the reference market value is equal to the anzulegender Wert. 

However, this is NOT the case in spot contracts. Paying the anzulegender Wert in cases of curtailments in spot contract is a gross violation of basic logic as it mixes up monthly and hourly logic and leads to outcomes, which two reasonable parties could not possibly want in a good contract design.