As part of the continuing series looking at PPA’s, we build upon the first post and start to look at the available hedging products, who is in the market, how they are traded and where the market may develop. In the final post, I’ll break down the main contract structures – forwards, options, collars, weather hedges and swaps.
Available hedging products
The market for hedging tools is mainly comprised of swaps, derivatives and (re)insurance products. While the electricity hedge market is mature, it is still relatively new for wind and solar projects. As a result of the project specific nature of the market, these are almost exclusively over-the-counter (OTC) instruments and tailored to each project. Exchange traded electricity futures, forwards and swaps are mainly used as hedges for natural gas plants; nevertheless, these are crucial for price discovery.
Primary hedging structures
A range of products have emerged to manage spot and volume risk. A summary of the contracts used to hedge wind and solar products with forwards, swaps and options being the most commonly used is shown below.
How are hedges priced?
The hedge providers calculate the pricing for hedging contracts based on contract type, project location and term structure. As an indicative strike price for a swap or forward in each region, the price can be estimated by discounting the forward curve for the credit risk of the counterparty and any other risks. The discount rates are typically 10% but may hit 15-20% in ERCOT.
When determining the option price for a wind project the primary drivers are the wholesale power price, money-ness, tenor and location which (with the exception of liquidity) have a positive correlation with the price of the hedging instrument. Thus, as the market price increases the value of the hedge commensurately increases.
Liquidity, on the other hand, has a negative relationship with hedge value, meaning that if liquidity increases the transaction should get cheaper but in the absence of an active trading market, a higher liquidity premium will be applied, increasing the hedge price.
How are they traded?
Contracts for hedging power price and volume risk are primarily (89%) traded Over-the-Counter (OTC), but some standardized contracts are also exchange traded. For North America, these exchanges include Nasdaq Futures Exchange, NYMEX Clearport and NYMEX Exchange. The OTC market is over eight times the size of the exchange market.
Exchange-traded products are critical for hedge providers to mitigate the new risks carried on their balance sheet. It is unlikely that all risk can be mitigated but the market liquidity will be used to offset the exposures introduced to the hedge provider.
Regionally, ERCOT is primarily OTC while the majority of PJM is exchange traded and CA and MISO are also exchange traded.
Who is in the hedging market?
Buyers of hedges are primarily generation companies, power marketers and load serving entities. The decision to hedge is mainly driven by subjective views on power price and volatility. The hedge strategy depends on how much a generator is willing to spend on the hedge arrangement and how much risk they can tolerate.
The pool of hedge providers is more diverse, but the level of engagement of different players varies. Active players include banks that have a power sector presence with brokers and energy traders also making up a large share of the market. Smaller hedge providers are often willing to take more risks the some large banks. Weather related hedging is usually provided by weather insurance companies and (re)insurance firms like Swiss Re and Nephila Capital.Many existing US projects with a PPA are facing contract expiration in 2017. Naturally, they are looking to renew their contracts or find new counter-parties to secure a stable cash flow. These facilities have an advantage over new projects in that they have many years of performance history and the capacity factor is known.
Corporate renewable energy purchases have spiked in recent years primarily driven by sustainability mandates. About one-third of wind PPA’s and 50% of solar contracts in 2015 involved corporate engagement. Corporates are also starting to show more interest in offsite projects as the emergence of virtual PPA’s enables them to contract larger projects, typically located outside of their major consumption locations. This is turn makes it faster for them to report that they’ve met their corporate sustainability goals. Finally, corporates typically procure from developers or utilities, usually with the assistance of a third-party advisor, consultant, broker or bank.
The future of power hedging
Power hedging products gained traction roughly a decade ago, but the sector has slowed down since the heydays of the 2007 to 2009. The corporate virtual PPA’s are driving a large chunk of the demand for non-traditional power offtake products. How the PPA contract market will evolve depends upon on (1) the risk appetite for projects where existing plants and (2) the risk appetite of hedge providers.
Corporate demand for PPA’s grew steadily through 2015 and it can be expected to continue whilst the structure of these contracts will becoming more bespoke; whilst developers do not want to split a project across multiple offtakers, project size can hold-back many corporates.
As for hedges other than corporate offtake arrangements, more standardization will be necessary for the market to become more liquid and to support the future of renewable energy financing. Standardization will reduce transaction costs, increase liquidity and improve transparency.
Although standardization would help the market develop, a recent survey by PwC revealed that the corporate appetite is still focused on bespoke terms. Thus, this suggests that the market for these hedges will stay concentrated in the OTC space. Regardless, new hedging arrangements are likely to keep cropping up as providers create bespoke products to address the carious risks a diverse pool of hedge seekers are trying to mitigate.
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- Bloomberg – US renewable energy offtake options