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.