An approximation of counterparty credit risk in long term power purchase agreements (PPAs)

A power purchase agreement (PPA) is a contractual mechanism used by energy suppliers and consumers to manage long term price and volume risk. The contract has value once an agreement on price and volume has been made. The value of the contact is stochastic and based on the current and future expectations of the underlying electricity price. The total contract value can be positive for the producer if realized market prices are lower than originally expected or positive for the purchaser if prices are higher than expected. These contracts typically are uncollateralized and therefore pose a credit risk to both counterparties. Assessing the value of this credit risk can be slow and computationally burdensome requiring Monte Carlo calculations, so this paper proposes an approximation to the problem that yields a closed form solution.