What’s the difference between Physical and Virtual PPAs?

Knowing the difference between PPAs and vPPAs is integral to anybody looking to fully grasp the complexities of the energy market. We go over these two main categories, and have also enclosed a handy vPPA calculator where you can switch between participant perspectives and explore risk profiles to really help the concepts stick.

What are Physical Power Purchase Agreements (PPAs)?

Physical PPAs involve the actual delivery of electricity from a specific generator to the buyer, nearly always through the grid, by an intermediary supplier. In certain markets, the buyer can contract directly with a generator, but this depends on regulations and protocols on direct connections and grid access points. Like all grid connections, energy delivered via physical PPAs is indistinguishable from other grid power at the electron level.

Virtual Power Purchase Agreements (vPPAs)?

vPPAs are frequently structured as renewable, but we’ll get onto that towards the end of the article. First, we have to cover the basics: vPPAs are financial contracts built on a framework known as a Contract for Difference (CfD) that are usually intended for hedging real-world energy production and consumption. No physical energy delivery is coordinated, and producers may simply sell electricity into the grid at the market rate, or the “floating” or “spot” rate, although they are not obliged to do so.

This market price of the node or hub where the production device (PD) injects power into the grid (the price the generator is able to sell at) is typically used as the ideal settlement price in the contract. This is because only the generator has the ability to hedge their risk with production revenues.

However, the buyer doesn’t pay this price, instead, they settle against a pre-agreed fixed price, known as a “strike price”, which is the backbone of the contract.

• If the market price is above the strike price, the generator pays the buyer the difference.
• If the market price is below this, the buyer pays the generator the difference.

This way, wholesale price exposure remains predictable for both parties, and price stability doesn’t rely on counterparties being connected for physical energy delivery.

What is basis risk and why do you need to think about it?

The settlement market price (index price, or reference price) is the authority on price data that is established in the contract and is compared against the strike price at set intervals (typically monthly, though it depends on the contract). These financial settlement intervals are distinct from the underlying price calculations, which are usually tracked at finer resolutions (e.g. hourly or daily), aggregating over the settlement period.

However, if either counterparty is actually using vPPAs to hedge real-world energy sales or consumption, and not purely as a financial tool (remember, the vPPA is just a CfD), then this can be risky, as the settlement price can deviate from their local energy market price.

This deviation is known as basis risk and occurs when a local retail rate (and associated delivery costs) differ from the reference price, causing an inability to transact energy in alignment with the contract. This risk is therefore dependant on whether counterparties are

• using vPPAs to hedge real-world consumption or production
• and transact energy in a different market to the “settlement price” market

In an extreme scenario, it’s possible that the buyer could be paying more than for their actual electricity consumption AND may also owe payments under the vPPA, or a generator may earn less than the settlement price while also being liable under the contract.

How is basis risk managed in a vPPA?

In a well-structured vPPA, the reference price is aligned with the market where the generator sells electricity, minimising basis risk. Where total alignment is not possible, sellers usually only accept quantifiable and bounded basis risk within the same market. Therefore, the vPPA does not impose unlimited risk to either party, as:

• The generator's downside is constrained, as there is no obligation to physically deliver energy. If market prices fall below operating costs, it can reduce generation to limit losses.
• The buyer's exposure is bounded, as market prices cannot go to negative infinity. Moreover, the buyer only pays the difference between the settlement market price and the strike price.

Want to really integrate the concept and test out extreme edge cases? Have a play with our vPPA Basis Risk calculator below: