Synthetic Power Contracts
By John Frenki
Renewable energy projects traditionally attract financing only after securing a long-term contract to sell the electricity to a creditworthy offtaker at a relatively fixed price. The project development is hard enough, but in today’s market, finding a power contract is becoming exceedingly difficult. A developer can ordinarily expect a financier to lend or invest only against “contracted revenues.”
At the same time, developers are sometimes reluctant to sign PPAs if it means locking in a price for power for the next 20 years that may be below projected electricity prices. As natural gas prices plummeted in the last few years, so have the prices at which utilities are willing to buy power.
A synthetic power contract may provide an answer.
However, such contracts should be entered into with caution, as parties can literally lose the wind farm, solar or other power project, or their investment in it, if their interests are not adequately protected.
Project owners traditionally generate revenue through either long-term power contracts or “PPAs” or through open market — merchant — sales. Long-term PPAs, typically 10 to 20 years, guarantee the project a stream of revenue for an extended period of time by selling the electricity output at a fixed price to a creditworthy purchaser, such as a utility. PPAs distinguish between capacity and energy. Capacity payments are payments for the ability of the utility to call on the project for power. The energy price is a per-mWh charge for the electricity actually delivered. Capacity payments were common in large thermal power projects in the distant past, but it is becoming harder to find them. All PPAs cover energy.
The energy price generally covers operating costs, payment of principal and interest on long tenor debt and recovery of capital with a reasonable return. Another approach for projects to generate revenue is to sell the electricity into the open market. These sales, which are not subject to a fixed term, provide projects with a significantly lower degree of cash flow certainty than traditional PPAs due to variable, market-based pricing and, depending on the dynamics of the project, potentially a greater possibility of curtailment. Curtailment means being shut down temporarily, for example during a period when transmission lines in the area are full so that there is no way to get electricity to the grid.
A synthetic PPA is basically a form of hedge. In one form of synthetic PPA, the project sells its electricity on a merchant basis, but enters into a contract with a third party that provides a floor under the electricity price.
A hedge works both ways. The project pays the counterparty if electricity prices are above a benchmark price. The counterparty pays the project the difference if they fall below the benchmark.
The payments may be calculated around a notional quantity of electricity regardless of what the project actually produces or they may be paid based on actual output.
In some cases, the benchmark prices are the same for each side of the arrangement. In others, there is a range between the two targets in which neither party pays. Essentially, there is a zone of indifference. The hedge provides insurance against declines in electricity prices and, depending on how it is structured, it may also allow the project owner to earn more if electricity prices rise.
On a spectrum measured by cash flow certainty, a synthetic PPA falls somewhere between the relative predictability of traditional PPAs and the less certain (and in the eyes of financiers, risky) method of selling power on the open market.
Synthetic PPAs are generally limited to locations where hedging counterparties can be found –- therefore, areas that are deregulated and that have liquid spot markets for energy sales that permit the sale of the electricity output into a day-ahead or real-time market. These markets include the New England Power Pool (NEPOOL), New York Independent System Operator (NYISO), the Electric Reliability Council of Texas (ERCOT), the PJM Interconnection (PJM) and the Southwest Power Pool (SPP), among others.
Also, synthetic PPAs may be appropriate under certain circumstances in markets such as California, where the California Public Utilities Commission has required certain projects to set the commercial start date under a PPA several years into the future to better match anticipated load growth in the California market. For such projects that have been fully permitted and are ready for operation before the PPA starts, a synthetic PPA may let the project generate revenue in the meantime with a floor under the interim revenue so that the project can be financed.
Electricity price forecasts are for a recovery in prices to pre-crisis levels in the next three to five years. Synthetic PPAs may provide a useful stopgap for project companies that do not want to be locked into current power prices for the long term.
There are several ways to structure a synthetic PPA. The hedging counterparty is typically a financial institution. At a basic level, the main structures are contracts for differences, options — put options, call options and collars — and pure commodity hedges.
In a contract for differences, there is no physical exchange of power between the buyer and seller because the power project sells the electricity into the open market, not to the hedging counterparty. The counterparty, which may be a factory, computer company or other user of large amounts of electricity, independently buys power from the spot market to meet its own needs. However, both parties have an interest in a hedge. The power project would like to sell at fixed prices but can only sell on a merchant basis. The counterparty would like to buy at fixed prices, but can only buy at floating prices. They enter into a swap. The counterparty pays the power project a fixed price, and the power project gives the counterparty back the floating price it receives in the merchant market. Rather than pay the full amount, they net, and there is a payment in only one direction.
The parties agree on a “strike price” for energy. This price is subject to escalation over the term of the contact for differences, which is typically three to five years. If the spot market sale is greater than the strike price, then the power project pays the difference to its hedge counterparty, and vice versa.
Contracts for differences are usually contracts around a notional quantity of electricity.
The project may enter into a literal fixed-for-floating swap instead, where the owner swaps the hourly clearing price when it sells its power into the market. This price floats every hour and is used as the index for the swap.
There are two types of options: physical options, involving the power produced by the project, and financial options, involving future revenue derived by the project.
In a physical option, a party has the right to sell or “put” or to purchase or “call” electricity in the future, while in a financial option, the parties have the right to put or call the future cash flows from an actual or hypothetical sale of electricity. The term of these options can range from days to several years, and the option may cover only a portion of the output or the entire output from a project.
Under both types of transactions, prices are pre-set with an additional cost associated with the option. The price of the option is determined by the proximity of the strike price to forward price forecasts in the power markets and the length of the option term.
Put options are a physical hedge in which the option buyer purchases the right to sell electricity at a certain strike price. If the price of the electricity drops below the strike price, then the option buyer will exercise the option to sell its power for more than the market price. Conversely, if the price per kilowatt hour rises above the strike price, then the option buyer will let the option expire and earn the market price of the electricity.
Call options are the inverse of put options where the option buyer purchases the right to buy electricity at a certain strike price. If the price of the electricity rises above the strike price, then the option buyer will exercise the call option and, if not, then it will let the option expire. A collar is a hybrid approach in which the buyer sells a call option and buys a put option, or vice versa. This places a cap on gains and a floor on losses, while also eliminating the cost of the option.
Alternatively, the parties can choose to hedge the price of underlying commodities, such as the price of natural gas or unbundled renewable energy certificates that are sold separately from the generated electricity.
Lenders have been willing to finance projects with synthetic PPAs, provided key issues are addressed in the agreement.
Due to the large value at risk created by the amount of the settlement exposure, the hedging counterparty will generally seek to share rights in the collateral package, which are traditionally held by lenders in a project financing. This is the most significant area of tension in negotiating a synthetic PPA because the project owner is likely to have already pledged its assets — such as project revenues, contractual rights, physical assets and equity — to senior lenders. Therefore, the pool of collateral available to secure the hedge agreement may not be large enough to protect the counterparty without creating overlapping claims between the counterparty and existing lenders.
Accordingly, the counterparty will seek a senior lien on specific collateral and step-in rights in order to secure its exposure on the hedge, while lenders will want to ensure that the provisions in the hedge agreement do not prejudice their rights under the intercreditor agreements or otherwise cause their protections to fail. For example, the counterparty will prefer that the payments associated with settlement of the hedge be treated on the same level as operation and maintenance expenses in the project waterfall, which are typically paid out at a priority over the senior debt. However, lenders will argue against such treatment for the counterparty’s payments, while also requiring that their consent to any material modifications to the project owner’s obligations. Also, the lenders may push back on various provisions negotiated by the counterparty, including an obligation by the project owner to post liquid collateral with the counterparty upon the occurrence of certain trigger events.
Termination rights are another issue of focus in negotiating a synthetic PPA. In order to ensure that the project owner is not subject to differing standards, lenders will want to see the termination rights, as well as termination events under the hedge, as closely aligned as possible with the events of default under the loan and intercreditor agreements. Also, lenders may ask for a brief cure period after an event of default under the hedge agreement in order to give the lenders a chance to cure any default and thus preserve the value of the hedge.
The short term of a synthetic PPA, typically 10 or fewer years, is a concern for lenders because it creates a period of unhedged merchant tail and will require the debt to be amortized in a relatively short amount of time. Nevertheless, lenders will finance projects using a synthetic PPA if there is sufficient price protection.
While traditional long-term PPAs rarely have index-based escalation factors because of the uncertainty caused by shifts in the power markets over time, parties to a synthetic PPA may be able to negotiate for an escalation factor because the term of the agreement is typically less the half that of a traditional PPA. By setting an escalation factor for the strike price over a relatively short period of time lasting fewer than ten years, the synthetic PPA will more accurately align the price of the agreement with that of electricity in the power markets, thereby reducing the exposure of all parties to volatile pricing movements.
Under a project financing associated with a traditional long-term PPA, lenders vote on a weighted basis, according to their exposure to the transaction. Under a synthetic PPA, the lenders and hedging counterparty can choose to arrange voting rights in one of several ways. The counterparty may defer to the lenders and is not entitled to voting rights. The voting may be based on the exposure of the counterparty. Alternatively, the voting rights may be based on the occurrence of a particular event, such as acceleration of the senior debt.
Synthetic PPAs face some regulatory uncertainty. The Commodity Futures Trading Commission, which is implementing the Dodd-Frank Act, has not said yet to what extent parties to synthetic PPAs will be subject to CFTC regulation, but it is clear that parties to hedges will face new limits on positions and capital exposure, as well as record-keeping and reporting requirements. There is a limited exemption for “end users.” The scope of the exemption is still being debated. Parties will need to factor these potential new regulatory requirements into their modeling for projects using synthetic PPAs.