Hedges for wind projects: Evaluating the options
With a dearth of traditional utility PPAs for US wind projects, project sponsors are evaluating alternative offtake arrangements.
At least three types of hedges have emerged as viable offtake structures: fixed-volume price swaps, virtual PPAs with corporate offtakers and proxy revenue swaps. It is critical for sponsors to understand the basic features of these offtake structures as they evaluate their options to finance their wind projects.
Fixed-volume price swaps
A fixed volume price swap, often called a bank hedge, is perhaps the most tested alternative offtake structure.
Numerous projects over the last five years—mostly in Texas’s ERCOT market—have used fixed-volume price swaps. The hedge provider is a bank or another strategic investor. Several large financial institutions with active ERCOT trading desks also make tax equity investments, and for these institutions it is common for fixed-volume price swap and tax equity commitments to be offered together.
At least in ERCOT, fixed-volume price swaps typically are a type of physical hedge, meaning the hedge provider purchases power as part of the transaction. The hedged transaction occurs at a trading hub agreed to by the parties. The project company purchases a fixed volume of power at the hub for the then-current hub price and immediately resells that power to the hedge provider for a pre-agreed fixed price per megawatt hour. Power produced by the project is not part of the transaction and is separately sold on a merchant basis at the grid node nearest the project. The intended result of these two distinct transactions for the project company is the sale of a fixed volume of power at a fixed price.
Basis risk is a central concern in fixed-volume price swaps and other alternative offtake structures. There is potential misalignment between actual realized revenue from merchant sales at the nodal price and the cost to purchase power at the hub at the hub price for resale to the hedge provider. This discrepancy (e.g., if the hub price is higher than the nodal price) is called basis risk.
The options for project companies looking to mitigate basis risk are relatively limited. Financial institutions have historically declined to provide financial hedges that avoid basis risk through settlement at a project node. Hedge providers are looking to settle transactions at liquid trading hubs.
One popular mechanism employed to delay the impact of (although not remove) basis risk over the term of the hedge is a “tracking account.” The tracking account is like a working capital facility. For any settlement period for which the amount the project company must pay for power at the hub exceeds the merchant revenue realized by the project, the hedge provider makes a loan to the project company in that amount by letting the project company delay payment of an amount it owes the hedge provider. The tracking account records the cumulative balance of those loans as a negative amount with accrued interest until the balance reaches a pre-negotiated floor. After any settlement period for which the realized merchant revenue exceeds the purchase obligation at the hub, the project company partially repays the loans in the amount of the excess. At the end of the hedge term, the project company repays the tracking account balance in either a lump sum or installments.
The use of a tracking account provides liquidity and frees up cash for debt service or for distribution to equity. In lieu of a tracking account, a basis risk reserve or working capital facility can provide similar protections.
There also is the possibility for projects to use financial instruments like congestion revenue rights to mitigate basis risk. However, to our knowledge, congestion revenue rights or similar instruments have not been used to support project financing.
The project company’s obligations to buy and resell power at the hub are hourly and typically match the volume of power expected to be produced by the project for the hour in a P99 scenario. Limiting the hub delivery requirement to the project’s P99 production provides predictable revenues for the project company with acceptable volumetric risk and some cushion for price-driven basis risk. The project company may also deliver renewable energy credits as part of the transaction.
A force majeure or other curtailment event affecting the project’s delivery of merchant power does not excuse the delivery obligation at the hub unless expressly excused in the hedge. The force majeure provisions in the ISDA power annex — part of the documentation for the hedge — apply to the purchase and sale of power at the hub rather than a force majeure at the project site. Project insurance programs typically reflect this feature of fixed-volume price swaps.
During construction, the project company typically must post credit support in the form of cash or a letter of credit. The amount of required credit support is negotiated and typically steps down at commercial operation.
A hedge provider also typically will require liens on project assets and equity as credit support for the hedge. It also imposes a full set of covenants on the project company to limit the universe of competing creditors and to protect the collateral.
The hedge provider does not usually post credit support in the form of cash or a letter of credit as long as a parent guaranty from a creditworthy guarantor is in effect. Sometimes the creditworthiness of the guarantor is measured in tiers: while a high credit rating means the hedge provider does not need to post cash or a letter of credit, a lower credit rating requires the hedge provider to post margin in excess of a pre-negotiated threshold. As the credit rating steps down further, so does the corresponding threshold. At any time the guarantor is not creditworthy, the hedge provider must post margin in the full amount of the hedge provider’s exposure.
Hedge providers with a lien should expect to execute a forbearance agreement with any tax equity investors and an intercreditor agreement with any lenders or other secured hedge providers.
Corporate PPAs, also known as synthetic or virtual PPAs, are financial hedges provided by corporations. The corporate PPA is accepted as a financeable offtake structure.
Unlike physical hedges, no power sales typically occur under these hedges between the project and the hedge provider. The simplest form of corporate PPA is a basic contract for differences. The project company pays the floating price per MWh for a fixed percentage of power actually produced, and the hedge provider pays a pre-agreed fixed price per MWh for the same amount of power. The floating price is either a hub price or the nodal price. The project sells its physical output on a merchant basis into the market.
Basis risk exists only if the floating price paid by the project company is the hub price. Corporate PPAs do not usually provide a tracking account.
Price floors are a negotiated point in corporate PPAs. While the offtaker will prefer not to settle the hedge when energy prices are negative, tax equity investors may require that a negative price floor be set at the grossed-up negative value of the production tax credits.
Corporate PPAs typically contain annual minimum availability requirements. Customary excused hours may include force majeure and curtailment imposed by the transmission owner.
Corporations enter into these hedges for financial benefit and for environmental attributes, which are typically transferred as part of the transaction. Offtakers may also assert that their nearby corporate facilities run in part on renewable energy based on the added-generation test: the revenue stream from the corporate PPA directly enabled the construction and operation of the wind project.
For project companies, the hedge provides unit price protection for power actually produced.
Credit support requirements vary and usually take the form of a letter of credit, cash or a parent guaranty for the project company. The hedge provider often posts a parent guaranty and may be required to post margin at any time the guarantor is not creditworthy. The credit of the offtaker will be a central concern, given the need for long-term contracts to support financings and the difficulty in taking long-term views on a corporation’s credit.
Unlike fixed-volume price swaps or proxy revenue swaps, corporate PPAs typically can start settling immediately upon project commercial operations. The other two arrangements typically have fixed starting dates for settlement.
Proxy revenue swaps
The proxy revenue swap is a new product that debuted in 2016. Three 10-year proxy revenue swaps were executed in 2016 and supported third party debt and tax equity commitments.
The hedge provider in a proxy revenue swap is a weather risk investor. Fundamentally, the hedge provider is looking to make investments that are not correlated with other parts of the economy, but instead are based on natural phenomena like the wind resource regime at a project site.
As part of the financial settlement, the hedge provider pays the project company a pre-agreed fixed price per annum (rather than providing a fixed unit price per MWh generated or sold, as is the case in corporate PPAs and fixed volume hedges respectively). In other words, the project company receives a fixed annual payment.
The project company pays the hedge provider a fixed percentage of “proxy revenue,” which is equal to the hub price multiplied by the “proxy generation” for that settlement period. “Proxy generation” is calculated under the hedge as the power that would have been produced by the project based on measured wind speeds and assuming pre-agreed fixed operational inefficiencies. The assumed operational inefficiencies include availability, performance and electrical losses.
By paying a fixed price per annum instead of per unit of output, the weather risk investor effectively hedges two variables for the project: the volume of power that the project will produce per year (removing any variation in production resulting from operational inefficiencies), and the hub price per unit.
From the project company’s perspective, the proxy revenue swap evens out revenues that would otherwise vary significantly based on wind production.
The project company must contend with basis risk when entering into a proxy revenue swap.
The proxy revenue swap does not impose delivery obligations or minimum availability requirements. Availability is one of the fixed variables in the calculation of proxy generation.
Although the transaction does not entail a sale of power, the project company may sell and deliver RECs to the hedge provider.
The credit support requirements for each party are similar to those in a fixed volume hedge.