As the supply of PPA’s fails to keep pace with the surging renewables growth, market participants are structuring new financial products that replicate the impact of a traditional offtake arrangements.

In a multi-part blog post we look at the current market for ‘non-traditional’ offtake arrangements (focusing on the US market), explain why different players might want to hedge, cover the existing contract types and how power offtake strategies may change.

In part one we start by considering PPAs, hedging and look at their use in Solar and Wind contracts. Whilst we focus on the US market, the PPA market is global and – especially in part two – the material is high level enough to be applicable to most markets. Finally, we will look at the market and delve into the structured products in part three.

Introduction

Power purchase agreements (PPAs) have traditionally been the primary structure use to provide revenue certainty to wind and solar projects, allowing them to raise finance and fund development. These projects need the assurance of steady revenues in order to secure favourable financing terms; the prevailing environment of low power prices makes operating as a merchant generator (ie without an offtake contract) a risky – and potentially money-losing – venture even with falling costs and subsidy support.

Long-term contracts with traditional utility offtakers have supported most renewable build to date. But most financiers of renewable energy projects (especially debt lenders) are unwilling to bear exposure to wholesale power prices, and thus, developers are forced to find long-term ‘hedges’ to lock in future revenue streams.

Basic PPA structure
Basic PPA structure

Against this backdrop there is an emerging universe of ‘exotic’ financial hedges, backed by new-entrant energy buyers, all designed to minimise project risk while offering energy price upside for offtakers. Using tools developed for corporate finance, so called ‘synthetic PPAs’ are popular with banks, (re)insurance companies and brokers who offer a wealth of products

Getting started with PPA’s

With low wholesale power prices and flat or only marginally increasing price forecasts, a reluctance to sign long-term physical PPAs is natural. This is especially true in “restructured” electricity markets such as ERCOT (Texas) , CAISO (California) and PJM (Mid-Atlantic states), where slowing load growth, low gas prices, and increasing renewable penetration have conspired to depress wholesale market prices. Projects that have been unable (or unwilling) to secure traditional PPAs have been increasingly turning to synthetic PPAs as a measure to reduce merchant exposure and mitigate risk.

US PPA arrangements (2013)
US PPA arrangements (2013)

Why Hedge?

The simple aim of providing “revenue certainty” masks a number of other risks and concerns which renewable energy hedges seek to address. Conceptually, the hedge exists to reallocate these risks, typically away from the developer and onto a counterparty. Due to the unique nature of each project numerous intricacies exist within each arrangement but there are broad trends characterise each PPA.

Risk allocation

An important element of synthetic PPAs is how the major risks are allocated. These risks and who bears them are the determinants of the cost of the contract. These risks – going beyond the scope of this post include Bid, Production, Shape, Tenor and Bankruptcy amongst others. While most contracts address price risk, and more and more contracts are starting to tackle volume risk, basis risk constitutes the largest potential residual risk that project retain.

Hedging for project’s investors

Hedging matters for project’s investors as well: it is a bridge to obtain financing by demonstrating to potential investors that the project will yield profit by having a locked-in, fixed income stream.

All investors look for expected revenue from projects, but their risk appetite varies. Tax equity investors require sufficient revenue certainty from the project to make sure they can cover the principle and interest payments for lenders. Based upon the published data, investors typically want 1.25 – 1.5 times the amount of revenue compared to the amount of debt.

Types of PPA
Types of PPA

Can you hedge any wind and solar project?

Banks, brokers and corporations alike have additional criteria when they look for projects to underwrite. Two critical areas of focus are (1) location and (2) size

Location – location matters for liquidity reasons; hedge provides prefer areas with a liquid price market. The most liquid market is PJM which features an active two-way market out for 5-7 years. In New York and New England, 10-year contracts can be arranged without the large bid-offer spreads seen in less liquid markets.

Size – Structuring a large or small project takes the same amount of effort, so larger projects are preferred. Among the small hedge providers, the minimum project is typically 20MW of install capacity.

Whilst hedge providers are concerned with location and size of a project, they are also concerned with diversifying their overall portfolio. The appetite and interest to underwrite in each region will vary for each hedge provider based upon their position, existing portfolio and exposure.

If a hedge provider has contracts with multiple wind farms in the same state, they will need offsetting call options to hedge against the exposure they acquired be serving as a hedge counterparty.

Main factors explaining solar and wind contracts in US PPA’s

Wind and Solar PPA contracts
Wind and Solar PPA contracts

Solar output is considered less volatile and the output shape in friendlier from a risk management perspective because it has less volume variation. Wind, on the other hand, tends to be heavy during off-peak hours but does have the advantage of being a more mature and understood market.

Merchant wind plants tend to have better capitalised developers than solar and their hedge market is well established. This is due in part to the rush to secure the PTC, which brought many wind plants on-line without PPA’s. With increasing losses in the spot market, many of them have been open to hedging the price risk even with short-duration hedge arrangements.

Where next?

Having covering the basics of the PPA, we’re going to start to look at the market for hedging tool – swaps, derivatives and (re)insurance products – in the next post. We will cover the individual instruments, look at the volumes and structures traded and how they are priced and the pay-off structures. Finally, in the last post in this mini-tutorial series, we will consider what the future has in store for power hedging.

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References
  1. http://g.foolcdn.com/editorial/images/72625/ppa-us-map_092013_large.jpg
  2. Bloomberg – US renewable energy offtake options
  3. http://www.investopedia.com/articles/basics/03/080103.asp

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