Renewable energy is booming. Power generation from renewable sources, such as solar and wind, is projected to grow from its current share of about 25 percent of total US generation, to about 45 percent, by 2030. Although this new renewable capacity will help meet net-zero climate policy goals, it’s also contributing to power price volatility—an impact that many energy players didn’t plan for.
The intermittent nature of solar and wind power often creates a mismatch between energy supply and demand. The sun isn’t always shining, or the wind blowing, when energy demand is highest. This volatility exacerbates the risks that arise from investing in renewable-energy sources (RES). Energy players with substantial, primarily RES, portfolios—many of the new, nontraditional entrants in the US power market—are particularly susceptible to these risks.
What’s an energy player to do? One way to manage risk in a RES-heavy portfolio is to diversify risk exposures, adding flexible assets such as gas and batteries. These assets can, by definition, be ramped up or down as needed and help smooth out price fluctuations. Incorporating flexible-asset exposures into RES-centric plans allows energy players to construct more efficient portfolios, with higher projected returns per unit of projected risk.
In this article, we explore the dramatic growth in RES generation and its effects on power pricing. We then outline a structured approach to assessing—and diversifying—RES portfolios.
Four ways RES penetration is driving price volatility
More than two terawatts of solar and wind power are in the queue in the United States—an outpouring of planned clean-energy projects that is bigger than today’s grid itself—and are awaiting approval from regulators to be built and connected. Yet even with the current levels of RES generation, market-based indicators illustrate that RES additions to the grid are causing price volatility that will only continue as more renewable power comes online.
The extent of RES penetration today varies widely across the United States (Exhibit 1). The California Independent System Operator (CAISO), the Southwest Power Pool (SPP), and the Electric Reliability Council of Texas (ERCOT) have the highest relative levels of in-place RES generation compared with load—approximately 35 to 45 percent—primarily from solar and wind. Far lower levels of RES generation exist in the Midcontinent ISO (MISO) and the Northeastern ISOs (the Pennsylvania–New Jersey–Maryland Interconnection, New York ISO, and ISO New England).
Focusing on the ISOs with a higher share of RES generation today, we see that volatility has already increased across four power price dimensions.
Day-ahead/real-time spreads. The difference between the day-ahead (DA) market price and real-time (RT) market price of one hour of electricity is the DA/RT spread. The two prices tend to be very close in a traditional non-RES market because all generators understand the cost and capacity of their power, and bid accordingly. But when RES assets are in the picture, the variability across generators can result in periods of acute over- and undersupply, creating large DA/RT gaps. As RES generation has increased in ERCOT, so has the DA/RT spread (Exhibit 2). For any generation asset owner, the bidding strategy between DA and RT versus its expected energy production directly affects how much money it makes from selling electricity at market prices.
Daily peak-to-trough spreads. Similarly, the power price difference between the highest- and lowest-demand hours of the day is much wider at higher RES penetration rates. RES generation happens when the sun is shining (typically midday) or the wind is blowing (typically overnight). This means there is often an excess generation during times of low demand (because fewer people are at home using electric appliances and heat or air-conditioning at midday) and a deficit when demand is highest (typically early to late evening). Merchant RES asset owners, which sell power to the market at a variable price in real time, will only be compensated for trough price hours if generation doesn’t align with peak pricing periods.
Node-to-hub basis. For RES asset owners in particular, node-to-hub basis volatility is a major risk to manage, and one that is expected to compound over time. A significant portion of RES generation is contracted via node-to-hub power purchase agreements (PPAs). The node-to-hub basis is the difference in price between a generation node (where an asset is producing energy) and the hub (a proxy for where electricity is transferred to the buyer or consumer) and is a component of the PPA price. An increasing basis indicates a traffic jam between where power is generated and where it is used—and reduces the price paid to RES asset owners by the contracted buyer. RES assets are typically concentrated in specific parts of the transmission network, far from where the demand lies. This crowding exacerbates the node-to-hub basis, further dropping prices of RES assets. Merchant RES generators face similar losses resulting from location-specific pricing and the long distances between where RES is generated and power is used.
Inverse correlation between prices and renewable generation. Within a given region (for example, parts of ISOs such as ERCOT West or SPP North) and for a given technology (for example, solar or wind), RES assets tend to all generate at the same time, meaning that for RES owners, the volume of their product goes up as the price goes down. Traditional asset owners can curtail production during sunny or windy periods when local power prices are low. Inversely, when it is neither sunny nor windy, traditional assets have sole supply and an opportunity to operate more profitably than they have in the past.
Three types of flexible exposures to manage volatility
Because RES asset generators can’t control the sun or wind, they are often stuck selling at low prices, whereas flexible power sources can capture the value of peak pricing during periods of high demand. The price gap between these two types of sources will only get larger as more RES generation comes online. By incorporating flexible-asset exposures—such as the three discussed below—into their portfolios, RES generators can bridge or eliminate this gap.
Batteries
Batteries at the grid level are relatively new. They gained prominence over the last ten years and are projected to increase rapidly over the remainder of the current decade, with total capacity of approximately 13 gigawatts across ISOs in 2023 and growing to as much as 110 gigawatts by 2030 (assuming all planned projects are completed) (Exhibit 3). They can dispatch more flexibly than any other form of generation—in five- or 15-minute increments—and require little physical footprint. However, they are expensive and limited by the need to recharge, typically in one-, two-, or four-hour cycles.
Battery owners can take advantage of both sides of widening price spreads during the day, buying low-priced power and selling high-priced power. They can also participate in ancillary-services markets—specialized submarkets that help maintain the reliability and stability of the grid—to obtain a premium for their ability to balance power flow needs. When there is a need to balance loads, battery owners are paid by ISOs to charge their batteries with power they will then sell back into the market.
Gas
Gas generation has been a staple of power generation for decades, increasing in share since 2000 as coal plants have been retired. Today, gas generation is 43 percent of US power generation—with capacity to meet up to 60 to 70 percent of peak load. Asset owners can target the hours of the day during which they choose to generate and can ramp up or down quickly in response to pricing.
Given that gas is a fossil fuel, we recognize that some players will refrain from adding gas-generation assets to their renewable portfolios, whether because of their core mission or because of environmental, social, and governance (ESG)–specific conditions on their financing. For others, however, gas generation offers an option for capturing value from flexible generation in which owners can choose to play a passive or active role. They can take an active role by, for example, constantly adjusting their risk strategies—particularly by using delta hedging (which involves taking actions to optimize the plant’s profitability in response to varying market conditions).
Demand response/price-responsive load
Demand response services (DRS) describe a range of programs in which a utility or other service provider pays consumers to reduce consumption during high-demand periods—effectively adding generation to the grid. DRS providers can monetize this flexible asset by selling in wholesale markets or, in some regions, participating in capacity markets, where they sell the ability to produce energy instead of the energy itself.
The types and amount of flexible assets to target depend on an organization’s existing portfolio and capabilities.
Why challengers need flexible assets
The ownership of US energy generation is about to look very different. Assets being built and planned involve drastically different players from those in operation today. Incumbents—domestic utilities, traditional-generation independent power producers (IPPs), and private investors—represent about 86 percent of today’s generation. Their portfolios are primarily gas, coal, nuclear, and hydropower. By contrast, 73 percent of planned generation is owned by challengers—a group comprising RES IPPs, RES asset developers, and global utility companies entering or expanding in the United States (Exhibit 4). Nearly all of what is planned is solar, wind, and energy storage (Exhibit 5).
Global energy and utility companies seeking a foothold in US markets represent 40 percent of planned generation. Many of these players are accustomed to trading and using energy markets to maximize their profitability. They will require access to the assets held by incumbents to balance their risk and realize benefits through trading. These challengers therefore have the most to gain by incorporating the right balance of flexible assets into their portfolios.
Toward optimized portfolios
The frenetic pace of development over the past several years has led energy players to invest in individual assets on their merits—and perhaps with geographic or technology-driven targets in mind—but not with the goal of balancing assets and optimizing returns within a portfolio. This is true of RES IPPs and global energy players that have acquired major US pipelines. To optimize these portfolios, we recommend a structured approach that identifies key levers for diversification.
Take a portfolio-wide view. Players should evaluate their entire portfolio to understand trade-offs across a collection of assets rather than focus on individual holdings. This assessment requires integrated financial simulations that isolate drivers of profitability, such as potential returns from node/hub pricing, capacity payments, or the conditions of existing contracts. Incorporating potential portfolio changes—including adding flexible-asset exposures—into these simulations allows an energy player to identify an optimized portfolio.
The modeling process should be designed to answer the question, “What are the best potential moves at both the micro and macro levels?” At the micro level, players should quantify the potential benefits of net capacity additions within a region, such as adding wind to a solar portfolio (Exhibit 6). These moves could increase returns for the same amount of risk. At the macro level, players should seek to understand where additional RES or flexible-generation exposure would drive the most diversification benefits irrespective of location.
Understand the tools available. An energy player can optimize its portfolio’s risk/return profile using a range of levers, but at the broadest level, it should consider whether to buy assets through M&A, grow its “book of business” through trading and origination, or use both approaches.
- M&A. Successful M&A requires identifying not only which exposures would maximize returns but also which party those assets might be available from. This requires figuring out which assets already serve a strategic benefit to those that own them, and which would be more valuable to a player’s portfolio. Players should be prepared for any opportunistic purchasing opportunities with a clearly defined evaluation mechanism and value trade-off for assets coming to market. Some of the factors that drive these asset values are not well recognized by the market, which could allow purchasers to obtain assets at highly favorable prices.
- Trading/origination. Incorporating flexibility into a portfolio doesn’t necessarily mean owning assets. For example, the hedging offered by heat rate call options1 can provide a diversification benefit that is similar to that of owning gas generation. High-low price swaps2 can serve the same purpose as owning battery assets. Tolling agreements3 provide an opportunity to diversify power sources in a portfolio without owning them. Core to deciding which of these to add to a portfolio is a clear idea of what exposures are needed to balance it and how to appropriately value these nonownership exposures. An energy player’s financial models must therefore be able to dynamically assess changes in dispatch and risk and provide clarity on what adjustments to make to create an optimized portfolio.
Challengers in US energy markets looking to capitalize on the rapid growth of RES should answer a series of questions:
- How will we identify and quantify the risks in our portfolio?
- How will that risk change over time?
- What risk mitigation and value capture strategy will best help us achieve a higher risk-adjusted return?
- How can we build our portfolio over time given this strategy?
Companies that fail to consider the volatility facing RES assets will risk losing out to those that take a broader and more forward-looking view. By taking thoughtful but bold action on their answers to the above questions, RES players can begin to build more balanced portfolios, strengthening their ability to compete in the rapidly changing energy landscape.
