Energy Finance Report

Hedging Strategies for Power Contracts – Part Four: Structuring Synthetic PPAs

Posted by Elias Hinckley on 9/11/14 4:42 AM

Co-author John Frenkil

As we mentioned last week in Part 3 of our series on Hedging Strategies in Power Contracts, project companies are not always able to find a creditworthy counter party with a desire to enter into a long-term power contract. Even if a power purchaser is willing to sign a long-term contract to buy power, there are many markets where that price is too low to create appealing economics for investors.

In a Synthetic PPA, the project company sells its power on a merchant basis, but enters into an agreement, usually with a financial institution that provides a relatively stable stream of revenue. There are various structures for arranging Synthetic PPAs.

1. Contract for Differences

In a Contract for Differences (CfD), the project company enters into a swap with the hedge counter party, which agrees to pay the project company a fixed price. In exchange, the project company agrees to pay the counter party the actual price it receives in the merchant market. Essentially the project company is swapping variable revenue for fixed revenue. In practice, rather than paying the full amount, the two parties net the difference and either the project company or the counter party is paid, depending on how the CfD is structured and the market price.

This arrangement is made in a futures contract and paid through cash payments, rather than buying or selling the physical electricity commodity.

2. Put Options – purchasing the option to sell power

Under a Put Option, prices are pre-set and are based on the proximity of the strike price to forward price forecasts in the power markets, and the term of the option. The project company, or option buyer, purchases the right to sell physical power at a certain strike price. If the price falls below the strike price, then the option buyer will exercise the option to sell its power for more than the market price. However, if the electricity price rises above the strike price, then the option buyer will let the option expire and earn the market price of the electricity.

3. Call Options – purchasing the option to buy power

As with Put Options, Call Options are pre-set and they are priced based on the same mechanics as a Put Option (i.e. the proximity of the strike price to the forward price, and length of the option term). However, Call Options work in the opposite way – the option buyer pays for the right to buy power at a certain strike price or let the option expire and buy at the market price.

In the next post in our Hedging Strategies series, we will explore Heat Rate Call Options, a popular type of hedge in power contracts for gas-fired generating facilities.

Topics: Power Generation, Energy Finance, Hedging

Hedging Strategies for Power Contracts – Part Three: Synthetic PPAs

Posted by Elias Hinckley on 9/5/14 4:52 AM

Hedging_PPA.jpg

Co-author John Frenkil

Project companies are not always able to find a creditworthy counter party with a desire to enter into a long-term power contract. Even if a power purchaser is willing to sign a long-term contract to buy power, there are many markets where that price is too low to create appealing economics for investors.

As we mentioned in part 1 of our Hedging Strategies series, various types of hedges can provide a relatively stable stream of revenue for project companies, and can make the project financeable, even if that stream is not necessarily as robust as that offered by a traditional PPA.

In a Synthetic PPA, the project company sells its power on a merchant basis, but enters into an agreement with a hedging counter party (typically a financial institution), which provides a relatively stable stream of revenue. Power prices are set to a benchmark, either to a set amount, or more commonly, a price range. As long as the power from the project is sold for price inside this range, or collar, nothing happens. If the price rises above the range, the owner of the project pays an additional amount (typically, some share of the excess) to the Synthetic PPA provider. If the price falls below the range, the project company gets paid the difference to the benchmark price under the Synthetic PPA.

This type of hedge provides insurance against declines in power prices – which is a fundamental purpose of any hedge – and allows investors and lenders more clarity on project revenues than they would have with a pure merchant project (i.e., a position where the project owner will only be able to collect revenue based on electricity sold into the spot market). One of the benefits of the Synthetic PPA is that it provides some upside benefit to the provider of the Synthetic PPA, and with that additional value the cost of this hedge should be less than with another hedge that only provides a price floor.

While Synthetic PPAs might seem like a no-brainer, in practice, there are a limited number of potential willing hedging counter parties for Synthetic PPAs. Therefore, the cost reduction isn’t as significant compared to traditional hedges as the shared upside might suggest.

Synthetic PPAs should to be entered into with a healthy dose of caution because, on a spectrum of cash-flow certainty, with traditional PPAs on the far left side of the spectrum and pure merchant projects on the opposite end, Synthetic PPAs fall somewhere in the middle.

While Synthetic PPAs are not for the faint-at-heart, they are also not for participants in all power markets. Synthetic PPAs are limited to deregulated markets with liquid spot markets for the sale of power – i.e. the Electric Reliability Council of Texas (ERCOT), PJM Interconnection, Southwest Power Pool (SPP), New England Power Pool (NEPOOL), and the New York Independent System Operator (NYISO).

In the next post in our Hedging Strategies series, we will explore various structures for arranging Synthetic PPAs.

Topics: Structured Transactions & Tax, Power Generation, Energy Finance, Hedging, Renewable Energy

Hedging Strategies for Power Contracts - Part Two: Revenue Put Options

Posted by John Frenkil on 8/27/14 10:30 AM

Hedging_PPA.jpgAs we stated yesterday in the first post in our series on hedging strategies for power contracts, one of the more popular hedging strategies is the Revenue Put Option.

Revenue Puts have been a key component of the financing for gas-fired projects, including Panda Power's Sherman, Temple I and Temple II projects. Similarly, Revenue Puts can be a part of the financing structure for wind projects, such as Pattern Energy’s Panhandle wind farm, and Airtricity’s Champion wind farm.

A Revenue Put sets a guaranteed floor for revenue from the sale of electricity during the term of the hedge. This provides a baseline for a project to have guaranteed (or at least more certain) revenue during the hedge period, which is necessary for securing financing for the project.

How Revenue Puts Work

In a Revenue Put, the project owner will enter into what is essentially an option contract with the hedging counterparty (the option seller). The hedging counterparty will pay the project company (the option buyer) the difference between the hedge-specified floor revenue and the power plant’s actual revenue from power sales in the event that actual revenue from power sales are smaller than the option-specified (or hedge) floor.

Traditionally, the term of these hedges was fairly short compared to the useful life of a power plant, with hedges difficult to secure for more than 5 years, but we are now seeing some 12- and 13-year options available in the market, which greatly enhances the investment appeal of new power projects.

Who Participates?

Hedging counterparties are often sophisticated financial institutions that do not have an interest in receiving actual electricity, but are associated with the project elsewhere in the financing (i.e. an institutional bank that also serves as an arranger in the deal). Under certain circumstances, the hedging counterparty may be an unrelated third party. For example, the hedging counterparty for the Panda Power Temple project was the 3M Pension Plan, which caused excitement in the industry that a new type of investor has entered the power hedging space.

Arrangements Vary Considerably

The arrangement for the contracted floor revenue can vary. For example, the floor can either be fixed, or floating, on a quarterly or annual basis.

Also, the revenue can be calculated or estimated in different ways. In one method, the calculation is based off of actual revenue, which is measured at the actual dispatch at the hourly marginal price. Alternatively, revenue can be measured using a contracted formula that may take into account various factors, including transmission congestion or other power generation sources. A formula approach may also factor in fuel costs - either actual fuel costs, or fuel indexed at a point of injection that does not necessarily correspond to the injection point used for the power facility's fuel.

Tread Carefully

During the Polar Vortexes of Winter 2014, several gas-fired power plants in the U.S. Northeast were on the short-end of a bad hedging arrangement because they had indexed their hedge at an injection point further down stream from their actual supply. When the differential in prices between the actual price of fuel and the indexed price exceeded projections due to unexpected fuel scarcity on the pipeline, the hedge went sideways and fixing the issue became an eight-figure problem for investors.

Topics: Structured Transactions & Tax, Power Generation, Energy Finance, Hedging, Renewable Energy, Wind

Hedging Strategies for Power Contracts - Part One: Introduction

Posted by John Frenkil on 8/26/14 12:38 PM

Hedging_PPA.jpg

Financings of merchant power projects – power projects without power purchase agreements (PPA) for the sale of power – have made a resurgence in recent years. Today’s market for power hedges has become more effective and robust than the hedging market for merchant projects in the 1990s and early 2000s.

Most power projects are built with PPAs. In a PPA, the project owner or developer will find one or more buyers to agree to take the electricity generated from the project at a set price over some significant portion of the project’s life. With a long term contract in place, an investor or lender can look at project revenue with a high degree of certainty. As long as the plant and offtake party (or parties) operate as they should, the project will collect a predetermined amount of revenue under the PPA.

In a pure merchant setting – a position where the project owner will only be able to collect revenue based on electricity sold into the spot market – it is very difficult to estimate the amount of revenue that will be available because collections are entirely dependent on the price available in the market when the project’s electricity is ready for sale.

Today's merchant projects have a number of options for pursuing non-traditional revenue streams. We will provide an overview of the more popular options through a multi-part series on hedging in power contracts.

In tomorrow’s post, we will explain how the Revenue Put Option is used in practice. Understanding the available options and how to select and properly structure a hedge will be vital for successfully financing most wind and gas generation projects in the U.S., and it is quite likely that we will see the first hedged solar project within the next year.

 

Topics: Power Generation, Energy Finance, Hedging, Renewable Energy, Wind

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