TODAY’S STUDY: Connecting Big Business With New Energy

Choosing Off-Site Renewable PPAs For Environmental And Social Impact; A Case Study On Cummins Virtual Power Purchase Agreement In Indiana

Roberto Zanchi and Rachit Kansal, October 2018 (Rocky Mountain Institute and World Resources Institute)

Introduction

An increasing number of corporate renewables buyers are venturing into the virtual power purchase agreement (VPPA) market. They are driven by their environmental and social sustainability goals and the desire to achieve them by enabling new large-scale renewable energy projects.

This case study offers insight into the renewables strategy and procurement process of Cummins, a global power equipment manufacturer that announced its first VPPA in August 2017. The VPPA is for 75 megawatts (MW) of wind power from Meadow Lake, a wind farm located in Indiana.

The Cummins case offers valuable lessons to renewables buyers that are considering VPPAs to meet their sustainability goals and might need a framework to guide the selection of a renewable energy project that offers the greatest opportunities for environmental and social impact.

The case study consists of two main sections:

• A discussion of the VPPA as a high-impact renewables procurement option, which looks at why Cummins selected the VPPA as its preferred off-site renewables procurement option in Indiana to meet its environmental and social sustainability goals, and the approach it took in comparing the VPPA to two alternatives: renewable energy certificates (RECs) and utility contracts.

• A cost-benefit framework to select high-impact renewable projects, which presents the analytical framework the Cummins team used to find its preferred renewable energy project in Indiana, which may be of interest to other buyers that are strongly focused on sustainability impact and considering different VPPA project options.

To develop this case study, we interviewed the Cummins team and the project developer, EDP Renewables North America, in November 2017.

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HOW THE VPPA EMERGED AS THE HIGHEST-IMPACT OPTION

Cummins identified and evaluated four off-site renewables procurement options: unbundled RECs, procurement through the local utility, direct PPAs, and VPPAs. Faced with the challenge of picking one approach, Cummins looked to the Corporate Renewable Energy Buyers’ Principles—an initiative led by World Resources Institute (WRI) and World Wildlife Fund (WWF)—for guidance. The Buyers’ Principles provide six renewable energy procurement criteria that are widely recognized and endorsed by corporate buyers.

Cummins adopted two of the criteria for corporate renewable transactions recommended by the Buyers’ Principles initiative:

• Additionality: the transaction should enable access to, or help drive the development of, new renewable energy projects.

• Cost-effectiveness: the project should minimize the total cost to the company so that it can achieve the largest possible impact for its investment.

To ensure its renewables procurement would be fully consistent with the company’s values, Cummins then formulated two additional principles of its own:

• Tangible impact: the transaction should be clearly understood and accepted by stakeholders as having significant environmental and social impact.

• Transparency: the transaction should be openly communicated via public disclosures and be properly accounted for in the company’s financial statements. With these procurement principles in mind, the sustainability team initiated a discussion involving the company’s CEO and senior leadership that led to the selection of the off-site procurement option that best met the company’s needs.

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How a VPPA works

The virtual power purchase agreement is the form of large-scale renewables procurement chosen by the majority of corporate buyers (55+ companies) in the United States. More than 80 nonutility off-site VPPA deals with new renewable projects—wind and solar, for the most part—have been signed and publicly announced in the United States over the past 10 years. A VPPA is financial contract whereby an energy project developer and a buyer exchange cash, but the buyer never actually receives electricity from the project.

This is how a VPPA works:

1. The buyer pays a fixed price for the electricity generated by the project for the duration of the contract, typically 15 to 20 years, without taking title to, or physically consuming, the electricity generated by the project.

2.Instead, the electricity is sold into the wholesale market at real-time or day-ahead prices. The buyer is entitled to the money made from that sale and is therefore exposed to market price variability.

3.The buyer and the project developer settle the cumulative difference between the fixed price and the market price periodically. This is why VPPAs are also known as contracts for differences.

4.Usually, buyers have the option to acquire the renewable energy attributes (i.e., the RECs) associated with the electricity generated by the project, which they can sell or retain and use for their environmental claims.

5.The buyer needs to have a separate electricity contract with a utility or other retailer in place to supply power to its load. The VPPA does not provide physical supply of electricity or impact existing electricity supply contracts.

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UNBUNDLED RECS

In the United States, renewable energy facilities generate a renewable energy certificate, or REC, for every megawatt-hour that a facility produces. While RECs can be included in a power purchase agreement, RECs can also be purchased independently on an open market, in which case they are known as unbundled RECs because they are sold separately from the electricity. Cummins’ leadership rejected the idea of managing the company’s GHG footprint through unbundled RECs even though unbundled RECs have a number of attractive characteristics. In particular, unbundled RECs are a cost-effective means to offset GHG emissions, as RECs are relatively inexpensive and can be purchased easily and at a large scale. Moreover, RECs in any form provide the basis for emissions reduction accounting based on the GHG Protocol, the most widely recognized corporate GHG accounting standard. However, unbundled RECs failed to meet the additionality and tangible impact principles, which the company considered essential. Cummins took the view that the purchase of RECs alone was not sufficient for a buyer to credibly claim to have enabled a new renewable energy project in a way that would be understood and accepted by all of the relevant stakeholders.

UTILITY CONTRACT

Procurement of renewable electricity through a contract with the local Indiana electric utility was also considered, but was also ultimately rejected. On one hand, the Cummins team was convinced that the premium paid to the utility would enable the installation of more renewable generation capacity, and therefore meet the additionality principle. However, because Indiana utilities retain all RECs by law, Cummins would not have been able to acquire the RECs from a new project through a transaction with a utility in Indiana. The resulting lack of a credible claim to GHG emissions reduction meant procuring renewable energy through a utility contract would fail to meet the cost-effectiveness and tangible impact principles.

DIRECT PPA

Cummins also considered a direct PPA, a procurement option where the electricity produced by a specific renewable project is delivered to its load via a special arrangement with the local utility. This option would also meet additionality and create tangible impact by enabling new renewable generation capacity. In a direct PPA the electricity produced needs to be physically used by the buyer, so the project size needs to be tailored to the load, which places an upper limit on GHG impact. Additionally, the additional cost of the special arrangement with the utility would have diminished cost-effectiveness. For these reasons, the direct PPA was not selected.

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VPPA

The VPPA emerged as the off-site renewables procurement option that met all of Cummins’ procurement principles. Cummins determined that VPPAs provide significant GHG impacts as well as a number of other environmental and social benefits for an acceptable net financial cost. A VPPA met Cummins’ additionality criterion in the sense that it would enable the financing and construction of a new renewable energy project. A VPPA contract provides a project with a fixed-price guarantee and, therefore, greater revenue stability. This, in turn, allows developers to secure the thirdparty financing required to build and operate the project. Through consultation and engagement with stakeholders, Cummins established that the VPPA would allow the company to establish a tangible connection with the environmental and social impact of the project. These environmental and social benefits will be explored in detail in the following section of the case study. Finally, the VPPA proved cost-effective in the sense that it comes with acceptable financial cost and risk relative to the expected (high) impact. As will be discussed in the following section, achieving confidence in the company’s ability to manage the downside risk presented by market electricity prices was the key challenge in winning internal support and approval for the VPPA…

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Conclusion

This case study offers insight into the renewable energy strategy and deal process Cummins used to secure its first VPPA in 2017. To conclude, we present a summary of insights that may be useful to other corporate renewables buyers exploring or undertaking VPPA procurement:

1. On the role for renewables procurement in corporate GHG strategy Cummins’ first step in reducing its GHG emissions was to invest in energy efficiency, which provided both emissions reductions and an economic payback. The company then moved to on-site projects, and then to off-site renewables procurement once cost-effective efficiency projects became harder to find. Cummins found that the potential scale of off-site options offered the largest GHG impact opportunities in renewables procurement.

2. On the selection of the best off-site renewable procurement option To select the best form of off-site renewables procurement, Cummins developed clear procurement principles, which were supported by senior leadership. Cummins started developing its principles by adopting concepts from environmental NGOs and then added on its own requirements to tailor its requirements to the company’s needs.

3. On the net cost and financial risk of the VPPA to the company For the VPPA to be approved by the treasury, finance, tax, and legal departments, the extent and likelihood of the worst-case financial scenario had to be understood and deemed acceptable. Because VPPA values are subject to wholesale price risk, which is a function of a large number of variables, Cummins relied on historical prices, third-party price forecasts and, ultimately, statistical forecasting via Monte Carlo simulations to evaluate the potential financial downside.

4. On the social and environmental benefits of the renewable VPPA Cummins considered a wide range of environmental and social factors. In addition to GHG emissions reductions, Cummins identified a number of important social and economic variables that informed its project selection, including water and land usages, wildlife protection, acceptance by local communities, and local economic impact.

Virtual power purchase agreements are complex and are unfamiliar to most corporates. But Cummins’ experience shows that they are a valuable tool, and can provide the most cost-effective and, in the end, easiest option for even a major player in heavy industry to achieve environmental and sustainability goals.

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