Project sponsors and corporate electricity purchasers are entering into two new types of arrangements to mitigate risk in existing offtake contracts.

The product used by project sponsors is called a “balance of hedge.”

This might be used by a project company that owns a wind or solar project to mitigate against weather and covariance risk. Covariance risk is the risk that when the wind blows or sun shines in a particular area, all the wind or solar facilities in that area generate electricity at the same time, causing the market price for electricity to fall.

A balance of hedge is most likely to be used when a project sells its electricity on a merchant basis into the local grid and enters into a fixed-volume swap. The project company has no long-term power purchase agreement with a utility or other customer. Instead, it sells to the local grid and is paid the spot price at the nearest “node” on the grid for electricity produced. It enters into a fixed-volume swap to put a floor under the electricity price so that the project can be financed.

One problem with the arrangement is that the project may generate less electricity in a given hour than has been promised under the fixed-volume swap for that hour.

A balance of hedge addresses this problem as well as the covariance risk. The project company supplements the fixed-volume swap by also entering into a balance of hedge. How this works is discussed in more detail below.

The other product is called a “firming swap,” and it is being used by corporations to protect against weather risk when they have entered into “virtual” power purchase agreements.

In a virtual PPA, the project owner sells the electricity to the grid for whatever market price applies at the time of sale. The project owner then pays the electricity revenue (or deemed revenue if priced at the hub) to a corporation with which it has signed a virtual PPA in exchange for fixed payments back from the corporation.

Cutting through everything, the project owner receives fixed payments for the electricity it generates. The corporate offtaker receives floating payments that match what it has to pay at any given time to buy electricity from the local utility. The problem for the corporate offtaker is the pattern of electricity output during the day may not match the pattern of electricity usage by the corporation. That leaves the corporation either over- or under-hedged.

Fixed-volume contract risks

More and more project companies are entering into fixed-volume offtake arrangements.

Fixed-volume offtake arrangements can be “physical” or “financial.”

A physical arrangement requires the project company to deliver a predetermined fixed amount of power each hour to the offtaker.

A “financial” arrangement requires the offtake contract to settle with respect to a predetermined fixed notional volume of power each hour, regardless of how much power is produced by the project that hour.

In either case, the hourly volumes tend to be shaped roughly to mirror expectations for P99 production.

The project company retains many risks if its offtake involves fixed-volume hourly quantities.

One of these risks is volume risk, or a mismatch between the annual volumes produced by the project and the annual volumes required to be delivered under the hedge. Another is shape risk, or the risk that those volumes may not be produced on schedule; the project company may produce more power when the delivery requirements under the hedge are low, or produce less power when the delivery requirements under the hedge are high.

These two risks together are weather risk, as they are correlated with the amount and timing of the wind or irradiation, as applicable.

Project companies enter into fixed-volume hedges to offload price risk, but financial risks borne of weather-related factors may end up eating into the price-risk relief.

Project companies with existing fixed-volume offtake arrangements at operating projects may also find that, in addition to weather risk (represented by volume and shape risk), they face increasing covariance risk.

Projects with fixed-volume offtakes looking to bank some of the upside when the project is exceeding hourly requirements under the hedge may find that the upside is lower than originally modeled if other generators have come online in the area.

Balance of hedge

To manage these risks without modifying the existing offtake arrangement, the project company (or a higher-level entity in the project company’s ownership chain) can enter in a balance of hedge that will de-risk the project on volume, shape and covariance, while the existing offtake agreement continues to de-risk the project on the price of power.

The balance of hedge was first offered by Nephila Climate, Allianz Risk Transfer (Bermuda) Limited and REsurety, the same entities that designed another product called a proxy revenue swap, which is a weather hedge that can serve as an offtake for wind or solar projects.

The balance of hedge is a financial hedge that is a form of contract for differences, with a quarterly settlement amount that is the net amount owed in one direction or the other after a “fixed payment” made by the hedge provider is netted against a “floating payment” made by the sponsor entity.

The fixed payment (made by the hedge provider) is a predetermined lump-sum payment; it does not vary in accordance with the energy produced by the project. Because the fixed payment is not linked to production, the project is guaranteed revenue even if the amount of wind or irradiation during the settlement period is low. This is how the weather risk and covariance risk are transferred to the hedge counterparty.

The floating payment (made by the project company) consists of the project company’s “proxy revenue,” which is the hub price multiplied by the “proxy generation” in megawatts. The proxy generation is the amount of power the project would have produced assuming fixed operational inefficiencies.

Because the project’s operational inefficiencies reflect a pre-agreed formula rather than actual operational losses, the project company retains the risk that the turbines or panels malfunction or become unavailable to a greater degree than is reflected in the formula.

The total floating payment is the sum of the proxy revenue plus the settlement received (or minus the settlement paid) under the existing fixed-volume hedge, without taking into account any tracking account settlements. (For existing hedges that are physical, meaning power is sold physically for a contract price in lieu of financial settlements on notional quantities of power, the “settlement” for the existing hedge is treated as the contract price minus the hub price for the contracted quantity for each hour.)  Therefore, the balance of hedge settlement reflects a project revenue stream that is already at least partly de-risked on price.

The fixed payment and floating payment are then netted out, such that the sponsor entity receives downside protection to the extent the floating payment is below the fixed payment or forfeits the upside to the extent the floating payment exceeds the fixed payment.

Because the operational risk (retained by the sponsor entity) and price risk (already hedged under an existing offtake arrangement) have each largely been removed from the floating payment, the balance of hedge ultimately reflects a hedge of weather risk and covariance risk.

The balance of hedge settles at the hub, so the sponsor entity retains “basis risk.” “Basis risk” is the risk that the electricity price at the node where the electricity is sold into the grid will differ from the price at the “hub” where the electricity price is determined for swap payments under a financial fixed-volume swap or where the project repurchases electricity to supply to a hedge counterparty under a physical fixed-volume swap.

Sponsor issues

Sponsors should consider which entity in the project company’s ownership chain should execute the balance of hedge. If the balance of hedge is executed by the project company, then any tax equity investor will benefit from the reduction in risk. Some tax equity investors may prefer this.

Another consideration for the sponsor is the type of credit support provided by the sponsor entity to the balance of hedge provider.

If the sponsor wants to offer a lien on the assets of and equity interests in the project company as credit support when the existing offtaker already has such a lien, then the sponsor will need to get the existing offtaker comfortable with sharing the lien and manage the negotiation of intercreditor arrangements between the two offtakers.

In the alternative, the sponsor could provide a letter of credit as credit support, which would require the sponsor to pay letter-of-credit fees.

The sponsor could also provide cash collateral, although that is not generally viewed as an optimal use for cash.

Lastly, sponsors should consider building flexibility into their debt, tax equity and price hedge documents expressly to permit the project company to enter into a balance of hedge, as the financing documents or price hedge would not typically permit this without consent. Clearing this with counterparties upfront may reduce future delays resulting from counterparty negotiations or withholding of counterparty consent.

Firming swap

Corporate power purchase agreements in their simplest form are financial hedges that are contracts for differences. The notional volumes on which the hedge settles are the volumes actually produced by the project.

Corporate offtakers use corporate power purchase agreements to manage their energy prices and encourage development of renewables projects, but under traditional corporate power purchase agreement structures, the corporation ends up with risk that the total amount and shape of electricity supplied does not align with the corporation’s energy usage. While corporate power purchase agreements usually shift some operational risk on to the project company, the corporate offtaker often ends up absorbing some degree of operational risk as well.

Corporate offtakers can mitigate some of these risks by entering into a firming swap with a weather-risk investor. While weather-risk investors are not necessarily interested in price risk, they can offer protection on volume risk and some shape risk by functionally re-aligning the contracted volumes with the corporate offtaker’s predicted usage.

Microsoft recently adopted this model by pioneering a new form of corporate power purchase agreement that shifts operational risk to the sponsor by settling on proxy revenue rather than actual revenue and can be executed concurrently with a firming swap. The firming swap allows Microsoft to offload some of the volume and shape risk.

Microsoft makes fixed payments that are a dollar amount per megawatt-hour of proxy generation. This means that the Microsoft power purchase agreement in many ways looks similar to a typical corporate power purchase agreement except that, because the contract volume consists of proxy generation rather than actual generation, the project company retains operational risks.

Upon executing the corporate power purchase agreement, Microsoft then enters into a firming swap with a weather-risk investor. Under the firming swap, the weather-risk investor gives Microsoft downside protection to the extent the project’s proxy generation is below a predetermined megawatt-hour volume for each month and retains any upside above that volume. In this way, Microsoft is able to pass on some of the volume and shape risk to the weather-risk investor. The operational risks are still retained by the project company.

The weather-risk investor charges a premium for the firming swap. Microsoft attempts to pass through this premium to the project company.