Tracking accounts in hedges
Tracking accounts are used in many fixed-volume hedges to mitigate electricity basis risk.
Basis risk is the risk that the price at which electricity is sold at the grid node is less than the price at the hub.
Some wind and solar projects without long-term contracts to sell electricity enter into physical or financial fixed-volume hedges.
While the hedge settles at the hub, the project is still producing power that is sold into the grid at the node for the spot price. The project company uses these merchant revenues to cover amounts owed under the hedge.
For example, in fixed-volume hedges with physical settlement, the project company is required to purchase the required hourly volumes of power at the hub price and then immediately resell those volumes to the hedge provider at the fixed price. The purchase at the hub is funded by merchant revenues. In fixed-volume hedges with financial settlement, the merchant revenues would be used to pay the settlement owed to the hedge provider, if any, which is typically calculated on a monthly basis.
When the nodal price (meaning the spot price at the project’s node) is less than the hub price, the merchant revenues might not be enough to cover the purchase requirement at the hub (in physical hedges) or the settlement amount owed to the hedge provider (in financial hedges). This delta between the hub price and the nodal price is called basis risk.
A tracking account is a way to mitigate basis risk.
It is essentially a working capital loan provided by the hedge provider to the project company as part of the hedge.
The amount required to be borrowed or repaid monthly by the project is determined based on the difference between the “floating amount,” which is the amount owed by the project company under the hedge (in both physical and financial hedges, the sum across all hours of the hub price multiplied by the fixed volume of power for that hour) and the “realized revenue” (the merchant revenue earned during the same period).
The realized revenue calculation includes all power sold by the project, even power in excess of the volume of power required under the hedge.
The difference between the floating amount and realized revenue is called the “mismatch.”
If during any settlement period the realized revenue is less than the floating amount, then the hedge provider is required to lend funds to the project in that amount.
If during any settlement period the realized revenue is greater than the floating amount, then the project company is required to pay down the loan balance in that amount.
Because the mismatch is calculated based on not only the difference between the price at the hub and node, but also the difference between the volume of power required under the hedge and the volume of power sold into the grid by the project, the tracking account ends up mitigating volume risk (the risk that the project produces less power overall than the amount required under the hedge) and shape risk (the risk that times of high production at the project do not align with the hours for which high-volume delivery is required under the hedge) in addition to basis risk.
However, because sponsors and financing parties tend to focus more on basis risk issues as opposed to volume risk and shape risk, the tracking account is thought of primarily as a way to mitigate basis risk.
The tracking account balance is usually documented as a negative number with a maximum “limit” that is also a negative number. For example, the tracking account limit might be negative $10 million, meaning that the hedge provider will not lend more than $10 million in the aggregate to the project company.
At the commencement of the hedge term, the tracking account balance is zero. If during the first settlement period the mismatch is $100,000, meaning the floating amount exceeded the realized revenue by $100,000, then the hedge provider lends that amount to the project company, and the tracking account balance then becomes negative $100,000. If, in the subsequent settlement period, the realized revenue exceeds the floating amount by $25,000, the project company is required to pay down the outstanding tracking account balance with that excess amount, resulting in a tracking account balance of negative $75,000. This simple example does not account for interest, which typically accrues on the outstanding balance at a pre-agreed margin over LIBOR. Accrued interest is added to the tracking account balance monthly.
If, in the example, the tracking account were to reach the limit of negative $10 million, then the project company would no longer be permitted to draw on the tracking account unless the project company pays down all or part of the tracking account balance. Furthermore, once the tracking account limit is reached, all interest on the outstanding balance must be paid currently going forward on a monthly basis, since there is no room left for the interest to be added to the outstanding balance. Financing parties may require cash sweeps once the tracking account balance reaches a certain level (before reaching the limit), as this is indicative of a basis risk problem at the project.
The tracking account cap is usually set at zero, meaning the balance cannot become positive. A positive balance would indicate a loan was made by the project company to the hedge provider.
The tracking account typically settles monthly. In a physical hedge where the hedge provider pays the project company for power daily, the tracking account settlement is determined separately from amounts owed for power. In financial hedges, which usually settle monthly, or in physical hedges for which the hedge provider pays for power monthly, the tracking account settlement is often netted out with the settlement for power.
The tracking account is only a temporary solution for basis risk. As the tracking account is a form of loan, a negative balance must be repaid at the end of the term of the hedge. Often the hedge provider will permit the project company to repay the balance either in one lump sum or in a structured repayment over the course of two or three years. If the project company opts for a structured repayment, then the hedge provider will usually require that credit support remain in place until the tracking account balance has been repaid in full. A project company that has granted a lien on the project to the hedge provider as credit support might have the option to replace this lien with a letter of credit during the repayment period.
Not all hedge providers offer tracking accounts as part of a fixed-volume hedge. Sponsors that find themselves across the table from a hedge provider that is unable to offer a tracking account have four options: provide for member loans in the project’s capital structure, obtain a working capital facility, “sleeve” the hedge or go without a tracking account (or any similar facility).
Member loans are a common way for project owners to provide working capital to projects.
Typically, the owners agree among themselves that some or all of the owners can make loans to the project company for working capital needs. The loans typically are unsecured and are repaid to the extent of available cash, after payment of operating expenses but before distributions. Common points of negotiation include the interest rate, whether any of the members are obligated to provide member loans and the cap on aggregate outstanding member loans. In the context of a tracking account alternative, at a minimum the cap would need to be sized to accommodate reasonably anticipated liquidity shortfalls resulting from negative basis.
The second option — obtaining a working capital facility — involves the project company entering into a working capital facility arrangement with either an affiliate or a third-party financial institution.
These arrangements are uncommon; the price of such a facility can be prohibitive. Furthermore, if the working capital facility provider requires a lien on the project as credit support, then the sponsor will find itself in the middle of an inter-creditor negotiation among the back-levered lenders, tax equity investor and, if the hedge provider has a lien, the hedge provider. Another point to address is the priority of payments between principal and interest repayments under the working capital facility, on one hand, and settlement payments and termination payments owed under the hedge, on the other hand. Such negotiations can be time-consuming and expensive.
The third option is to “sleeve” the hedge.
This involves two simultaneous transactions: first, a different hedge provider that can provide a tracking account executes a hedge with the project company and second, this new hedge provider executes a back-to-back hedge with the original hedge provider that cannot provide the tracking account, passing through all of the economics except a premium. This route is more expensive because the amount the project will receive under the project-facing hedge will be lower to account for the hedge provider’s premium.
It is rare for all of these elements to come together in a transaction such that a sleeve would be the best path forward or even a viable option. First, the project company would usually already be negotiating with at least two potential hedge providers concurrently, as it would be difficult to bring in another hedge provider at the last minute. Second, the potential hedge provider offering a tracking account would have to be willing to sleeve the hedge with the potential hedge provider that is not providing a tracking account. Third, the hedge provider that is not providing a tracking account would have to offer a high enough price such that even with the sleeving premium, a sleeve would be a better economic option for the project than executing a hedge directly with the hedge provider offering a tracking account.
The last option — forgoing the tracking account or similar facility — is usually only viable for sponsors that are building on balance sheet and do not require debt or tax equity financing. Financing parties usually prefer that the hedge have a tracking account because a tracking account offers relief on basis risk during the term of the financing. A sponsor might consider this route if the sponsor anticipates positive basis and is comfortable with contributing equity to the project in the event that basis is worse than expected.