What are Physical and Virtual Power Purchase Agreements (PPAs)?

Assumption of Production Risk

A key characteristic of renewable electricity generation is its dependence on the weather. In practice, this means that a PV or wind power plant almost never produces exactly the amount of electricity that the consumer needs at any given moment.

For this reason—with the exception of Merchant PPAs—a central element of every PPA is the allocation of responsibility for balancing these deviations, in other words: who accounts for the trading difference. While the supplier usually handles the trading itself, the additional costs arising from imbalances are often borne by the offtaker.

Examples of Production Risk

Let’s look at the two cases of the automotive supplier with its onsite PV PPA and its offsite wind PPA with physical delivery.

Underproduction

On a given day, both the PV system and the wind farm under the physical PPA deliver too little electricity in the morning. To keep production running as planned, the company’s energy buyer must purchase additional electricity on the spot market.

If luck is on their side, the supplier’s PPAs are linked to locations that happen to be among the few not generating renewable power at that moment. In this case, if many other renewable plants are producing strongly, spot market prices will be comparatively low, making the shortfall cheap to cover. Over the course of the day, they might pay only €50 per MWh for the missing electricity instead of the €75 they would normally owe under their PPAs—if the plants had been producing.

If unlucky, however, all other renewables may also be generating little electricity at the same time. In that case, according to the merit order, spot market prices can climb well into the triple-digit range.

Overproduction

In the afternoon, the weather shifts. Both PPAs deliver so much electricity that the factory cannot consume the entire volume. Under the contract terms, however, the company is obliged to pay for all the electricity from both plants.

For the wind PPA, the arrangement follows a pay-as-produced model, meaning the automotive supplier at least receives the proceeds from selling the surplus power on the exchange. The PV PPA, by contrast, is structured under a take-or-pay clause. This requires the buyer to pay for the electricity regardless of actual consumption—and without any claim to the revenues from selling the excess.

At this point, both the supplier and the PV operator can only hope that elsewhere in Germany the wind is weaker and skies are cloudier. If so, they stand a good chance of selling the surplus at favorable prices. If not, the PV operator may actually benefit from curtailing the system to avoid negative prices. The automotive supplier has no such option for its wind power. The operator will not reduce output, since they continue to receive €75/MWh. In some cases, such distortions are corrected through PPA clauses stipulating that no delivery takes place during periods of negative prices.

How do virtual PPAs work?

The basic mechanism of a virtual PPA works as follows: the power producer sells its electricity at the market price on the exchange (e.g., EPEX Spot), while the electricity consumer also procures power at the market price.

Contract for Difference (CfD)

Through the PPA, the two parties agree on a Contract for Difference (CfD). The central element of a CfD is a fixed price, known as the strike price. If the market price falls below the strike price, the consumer pays the producer the difference between the two. If the market price rises above the strike price, the producer pays the consumer the difference.

As with physical PPAs, CfDs can also include price corridors, within which the market price applies. This way, the contracting parties protect themselves against extreme price movements while still retaining the opportunity to benefit from favorable price conditions. For large consumers with some operational flexibility, this can be particularly useful. For example, an automotive supplier might choose to carry out less energy-intensive production steps on days with high power prices, shifting heavier energy use to days when spot market prices are lower.

How are Settlement Payments calculated?

Because electricity is not delivered physically under a virtual PPA, another question arises: for which exact volumes do the agreed settlement mechanisms apply?

The formula is: Settlement Payment = (Strike Price – Market Price) × Volume

In most cases, the approach mirrors that of physical PPAs: the decisive factor is the actual amount of electricity generated by the plant. This output is measured at the injection point, just as in physical offsite PPAs, and verified by an independent metering operator.

Alternatively, a fixed volume can be agreed upon, based on the site-specific capacity factor. However, this still leaves open the question of which market prices apply to which volumes.

One option is a baseload PPA that uses the day-ahead price as the market reference. In this arrangement, it is assumed that a constant amount of electricity flows continuously. For monthly settlement, the average power price of the month is subtracted from the strike price and multiplied by the number of hours. The result of such a contract is that the agreed supply volume is effectively delivered at a fixed price, since the differences between market price and strike price are balanced out through the CfD.

Another option is to use indices such as the Energy Weather Indices (enwex) as the basis for determining volumes. These indices forecast the hourly output of an average plant in a given power grid, measured against the plant’s rated capacity—in essence, a market-wide, hourly, technology-specific capacity factor. The day-ahead forecast can then serve as the basis for calculating the virtual delivery volume of the PPA facility.

Example: Calculating Settlement Payments

Let’s assume the following: our automotive supplier has signed a virtual baseload PPA for 10 MW with a strike price of €80/MWh. Suppose the average day-ahead price in a given month is €50/MWh. The settlement payment is then calculated as follows:

Settlement Payment = (80 – 50) EUR/MWh × 10 MW × 30 T × 24 h = 30 EUR/MWh × 7.200 MWh = 216.000 EUR

The automotive supplier would therefore owe the producer €216,000 for the month of July. In addition, its electricity procurement costs on the market amounted to:

Electricity Payment = (50) EUR/MWh × 10 MW × 30 T × 24 h = 50 EUR/MWh × 7.200 MWh = 360.000 EUR

In total, the company’s electricity costs amounted to €360,000 + €216,000 for 7,200 MWh. This results in an effective electricity price of €80/MWh (€576,000 ÷ 7,200 MWh). Thanks to the CfD, the buyer ends up paying exactly the planned €80/MWh. If, for example, the market price in January were €110/MWh, the same mechanism would apply in the opposite direction, again bringing the total electricity price back to €80/MWh.

The calculation based on an hourly delivery volume determined by an index works in essentially the same way—the only difference being that it must be carried out for each individual hour.

What are the Advantages and Disadvantages of virtual PPAs?

In many respects, hedging through a PPA always works in much the same way—regardless of the type of delivery. The settlement payments via CfD, even those based on indices, can just as easily be applied to physical deliveries. Still, virtual electricity supply comes with its own set of advantages and disadvantages. From an economic perspective, the most notable effect lies in allocation efficiency.

Operational Differences

At first glance, virtual electricity deliveries may seem more complex, since not only prices but also the reference volumes must be defined contractually, rather than relying on physical deliveries. In practice, however, just as many time periods and delivery volumes need to be reconciled under physical PPAs.

A similar situation arises with balancing group management. Here, virtual PPAs can even offer an advantage, since the balancing groups of supplier and offtaker are managed completely independently. By decoupling the contract from physical delivery, the structuring of risks is simplified while still meeting the buyer’s hedging needs. In this sense, virtual PPAs can be seen as an elegant solution to satisfy an offtaker’s requirements.

Site Independence

Virtual PPAs were originally designed for situations where physical delivery is either not possible (for example, due to different price zones) or simply not desired. They allow companies to reduce their carbon footprint even at sites where sufficient renewable electricity is not available locally. At the same time, they make it possible to hedge risks without a physical supply contract.

Conversely, this model enables projects in countries with excellent conditions for renewable generation to move forward, even if local demand for green electricity is insufficient to finance new capacity.

Perhaps the most prominent example is Google’s approach: the tech giant has signed numerous virtual PPAs worldwide, enabling it to account for wind and solar electricity in its balance sheets independently of where its facilities are located.

Grid Friendliness

Virtual electricity deliveries offer—at least in theory—greater flexibility in terms of injection and withdrawal of power, particularly when compared with onsite PPAs.

Because onsite PPAs exempt participants from grid fees, surcharges, and taxes, they create clear distortions in consumption incentives. On windy summer days, when market prices fall into unprofitable territory—even for renewables—this price signal normally encourages producers to curtail or shut down their plants. But the parties to an onsite PPA often do not receive this signal, or only weakly. As a result, the incentive to operate or market electricity from such generation and consumption facilities in a grid-friendly way is much lower than for grid-connected assets.

Onsite PPAs often make economic sense only due to regulatory arbitrage (see above). While such incentives may be politically intentional to encourage specific outcomes, in the case of behind-the-meter supplies they are questionable. Here, companies or households effectively avoid paying grid fees and surcharges—meant to finance the electricity network collectively—without actually providing systematic relief to the physical infrastructure.

Example

By sourcing electricity directly, the automotive supplier does ease pressure on the local grid at times when its own plant is generating. However, when solar irradiation is high and output is abundant, it would actually be more grid-friendly to curtail the plant and draw electricity from the grid instead. The typically low market prices during such periods send exactly this signal. Yet for the automotive supplier, it remains cheaper to consume the onsite-produced electricity, since no additional charges apply.

This problem does not exist for grid-connected PPAs with physical delivery. That said, PPAs with fixed-price mechanisms can also create distortions for both producers and consumers: in times of scarcity, consumers have no incentive to adjust demand, while certain PPA structures also remove the incentive for producers to reduce generation, even when there is an oversupply of renewable electricity.

An exception are settlement mechanisms tied to indices. In these cases, payments are made independently of the individual behavior of the contracting parties. This preserves incentives for both sides to adjust consumption or generation in line with market price signals.

Green Image

Although virtual PPAs may offer advantages in terms of resource allocation and grid friendliness, physical deliveries often enjoy greater public recognition. Paradoxically, this applies especially to onsite PPAs: a PV system installed directly on a factory site serves as a visible symbol that green electricity is being produced there. A claim such as “We manufacture with 100% renewable power” carries more credibility in this context—even though, in practice, additional grid electricity is usually consumed alongside.

In short: virtual PPAs provide maximum geographical and contractual flexibility but are essentially a financial instrument rather than a physical supply solution. Physical PPAs, by contrast, are more closely tied to actual electricity flows and can offer cost advantages through avoided grid charges, but they come with less freedom in terms of location.

Conclusion: Physical PPAs deliver Electricity, virtual PPAs deliver Security

Whether physical or virtual, both forms of PPAs serve the same purpose: hedging market risks related to price and volume. Physical PPAs are more immediate, reflecting a direct supply relationship, while virtual PPAs offer greater flexibility—both geographically and contractually.

Which model suits a market participant best depends on the consumption profile, market position, and objectives of the contracting parties. From a cross-border economic perspective, virtual PPAs generally hold advantages over physical delivery—particularly when compared to onsite models, which often provide less grid-friendly outcomes than grid-connected arrangements.