Physical fixed-volume hedges
Norton Rose Fulbright holds internal training sessions for lawyers in its projects group. The following is from a session in mid-June about physical fixed-volume hedges.
Such hedges might be used in an organized power market, like ERCOT in Texas, where a project sells its actual output to the grid at the current market price at time of sale, and then buys back a fixed quantity of electricity at the market price and redelivers it to a counterparty under a fixed-volume hedge. The project receives a fixed electricity price under the hedge. The arrangement has the effect of converting floating revenue into fixed revenue so that the project can be financed.
A physical fixed-volume hedge is entered in place of a power purchase agreement.
It helps to mitigate the risk that power prices will fluctuate by offloading some of the price risk to a hedge provider.
The hedge provider makes a bet on power prices for the next 10 or so years. A “physical” hedge means that the hedge provider is actually purchasing power as part of the transaction, and a “fixed-volume” hedge means the hedge settles with respect to a predetermined volume of power, regardless of the amount of power actually produced by the project.
The terms of these transactions are usually spread over five separate documents using ISDA, or International Swap and Derivatives Association, forms.
The “Confirmation” has the main commercial terms, including what is sold and for what price. The “Master Agreement” has all the legal terms, such as events of default and representations. The Master Agreement cannot be revised directly; instead, it is revised through a “Schedule,” which is a separate document in which the parties make certain choices or elections and also list any amendments to the Master Agreement. Finally, a “Credit Support Annex” governs credit support and, like the Master Agreement, is not negotiated. The parties can make elections under and amend the Credit Support Annex in a separate document called “Paragraph 13 to the Credit Support Annex.”
The Confirmation has a general description of the commercial transaction.
One key element in the Confirmation is the “shape.”
The shape is the fixed-volume part of the physical fixed-volume hedge. The hedge settles with respect to a fixed predetermined quantity of megawatt hours of power, regardless of how much power the project produces that hour. Production at the project is separate from the quantity settled under the hedge.
The granularity of the shape varies. A 12 x 24 shape, for example, is a grid with one column for each month and one row for each hour of the day. For the entire life of the hedge, every midnight to 1:00 a.m. in January, the hedge will settle with respect to the quantity of power in the first column (January) and first row (the hour ending at 1:00 a.m.), regardless of the amount of power produced by the project that hour.
The shape is designed to reflect projected P99 volumes at the project. P99 is a very conservative estimate of production. It means that there is 99% chance that the project will produce those volumes. A less granular shape might show, for example, January and February in a single column, or midnight through 4:00 a.m. in a single row. Often a project company will push to do a 12 x 24 matrix because that allows it to tailor the shape more closely to the expected fluctuation in wind.
The Confirmation also describes the terms of the “physical settlement.”
Physical settlement means there is physical delivery of electricity to the hedge provider under the hedge. The power sold under the hedge is not the same as the power produced by the project, which is produced and sold into the spot market at a “node” where the project connects with the grid. The project company buys back power at a “hub” for the current market hub price and then immediately resells that power to the hedge provider for the agreed fixed price.
The price that the project receives for power at the node reflects the supply and demand at that time and also reflects conditions at the node such as grid congestion.
A concern that many hedge providers have about the node is the node does not reflect the true market value of power because of congestion-related and region-specific variations that may have nothing to do with the value of power. In response to this concern and to encourage trading, some grid operators created “hubs.”
A hub is an artificial mechanism to establish a market price for power over a large area without fluctuations due to congestion and other factors unrelated to the value of power. It is designed to mimic liquid trading hubs for commodities like the Henry Hub for natural gas. There are different ways to design and organize a hub; for example, a grid operator might take several nodes that are relatively uncongested and then average those nodal prices, with the average then becoming the hub price. Hedge providers are comfortable using the hub price because it reflects the market price of power and is hopefully liquid enough that other parties will enter into back-to-back trades.
The project company uses merchant revenues received at the node to buy power at the hub. The project company is required to buy the hourly quantity of power at the hub shown for that hour in the shape attached to the Confirmation. For example, for the hour between midnight and 1:00 a.m. in January, the project company would be required to purchase the megawatt hours of power set for that hour in the shape, regardless of what the project produced. The project company pays the hub price for that power and then immediately resells that power to the hedge provider for the agreed fixed price per megawatt hour.
This type of transaction gives rise to basis risk.
Basis risk is the risk that the nodal price per megawatt hour, representing actual project revenue, is lower than the hub price per megawatt, which is what the project company pays to buy back the power it needs to sell under the hedge.
ERCOT has had significant basis issues for the past few years. Project owners usually end up taking basis risk. The owner can manage basis in the short term with congestion revenue rights, but the market has yet to offer any long-term solutions, likely because nodal prices are so unpredictable.
One temporary solution is a “tracking account.”
Recall that there are two main mismatches between what happens at the project and what happens under the hedge. There is a price mismatch, also known as basis risk. The second mismatch is the volume and shape mismatch.
Production at the project will not always line up with the required hourly quantity in the shape. The hope on the sponsor side is that the project will generate more electricity than the amount shown in the hedge shape, since the shape reflects P99 output. For example, in wind projects, wind speeds vary from one hour to the next, so there is also a good chance in any given hour that the project will underperform or overperform.
One solution the market has settled on to offer temporary relief is a tracking account. The tracking account is documented in the Confirmation and functions as a working-capital loan from the hedge provider to the project company in the amount of these mismatches. As shorthand, the “mismatch” is usually defined as the difference between project company revenues at the node for a given month and the amount that the project company had to pay out under the hedge in a given month. Hedge providers will lend the project company the amount of the mismatch, up to a limit. In a given month, if the project company revenues exceed what the project company was required to pay under the hedge, then the project company must apply the extra funds to pay down the tracking account. The project company must repay any outstanding loan balance at the end of the term. Often the sponsor negotiates for a structured repayment over the course of two or three years.
The following are a few of the commonly negotiated points in the Schedule.
One is “additional termination events.”
These are some of the most highly negotiated provisions in the Schedule and are the events that allow one party to terminate the hedge. Often these end up being project-specific events that give rise to a termination right for the hedge provider. For example, the parties might agree to include a failure by the project to reach commercial operation by a specific date.
Another area for negotiation is “incremental hedging.”
The sponsor may want to have the project company enter into additional hedge agreements to cover other types of exposure. For example, the project company could enter into a supplemental hedge called a “balance of hedge” to address covariance risk or another arrangement called a “unit-contingent option” to cover price risk on volumes produced at the project in excess of P99 volumes.
Sponsors interested in pursuing these options should consider building the flexibility to do so directly into the Schedule.
Typically the hedge provider will add boundaries around the permitted additional hedges. If the sponsor anticipates that it may want to grant a lien as credit support under any incremental hedges, then a lien cap for the incremental hedges should be negotiated before signing the fixed volume hedge. The sponsor should also consider attaching a form of inter-creditor agreement to the hedge to be entered into by the hedge provider and any incremental hedge providers.
Another area for negotiation is called a “supplemental collateral condition.”
It is a feature in many renewable energy hedges where the project company negotiates for the right to avoid termination of the hedge after certain defaults or termination events by posting extra collateral. The extra collateral is the amount of the hedge provider’s exposure, meaning how much the hedge provider would be owed if the hedge were terminated at that point in time.
The theory is that if the project company is posting a letter of credit to cover the hedge provider’s exposure, then the hedge provider would not need to rely on the collateral in the event the hedge were terminated, so safeguards are no longer needed in the hedge to protect the collateral. The parties end up negotiating what specific events of default and termination events can be cured by the project company electing a supplemental collateral condition. Some hedge providers will require that, in addition to posting collateral in the amount of its exposure, the project company post a small independent amount to cover any fluctuation in its exposure between valuation dates.
Another negotiated term is a “partial unwind.”
A partial unwind is a partial termination of the hedge. The theory behind this is that the hedge should cover P99 output at the project, so if at any time the project shrinks, the volumes in the shape will be greater than P99 and the project will be overhedged.
An overhedged project poses a liquidity issue for the project company and a credit issue for the hedge provider.
The solution is to reduce the volumes in the shape proportionally with the reduction in nameplate capacity of the project: this is called a partial unwind.
For example, if a casualty occurs and reduces the project’s nameplate capacity from 100 megawatts to 80 megawatts, and the project company chooses not to rebuild, then the project is 20% smaller than originally planned. Because the shape no longer represents P99 output at a project that is 20% smaller, the parties can partly unwind the hedge by reducing each of the hourly quantities in the shape by 20.
Because a partial unwind is a form of partial termination of the hedge, one party will owe the other party a termination payment on account of the reduction in the hourly quantities.
Many different facets of the partial unwind are negotiated by the parties, including the following: (1) under what circumstances a partial unwind can be elected, (2) which party has the right to elect the partial unwind, (3) whether the elections are temporary or permanent, (4) whether the tracking account limit is reduced as part of the unwind, and (5) whether a partial unwind termination payment owed by the project company can be paid over a period of time.
The parties also usually end up negotiating to what extent the hedge provider has approval rights over whether and how the project is rebuilt after a casualty event.
Project company covenants also are negotiated.
The project company covenants in the hedge are in many ways similar to the ones found in a loan agreement, but they are fewer and less stringent.
They are sometimes attached in a separate annex and sometimes inserted directly into the body of the Schedule. They may include permitted liens, asset sales, investments and similar items.
How stringent they are will depend in part on what type of credit support the hedge provider receives under the hedge. If the hedge provider has a lien on the project, then the hedge provider cares more about what happens at the project, how it is maintained and who else may have a claim on the project assets or revenue, and additional covenants may be included in the hedge as protection. Sometimes the parties negotiate to have these additional covenants apply (and in some cases, have all covenants apply) only after the lien is granted to the hedge provider. Negotiated points include which covenant breaches, if any, are additional termination events, allowing the hedge provider to terminate immediately. Often the parties compromise and list only negative covenants as additional termination events, similar to how a loan agreement is structured. The parties may also negotiate which covenant breaches may be cured by electing the supplemental collateral condition.
Several few key points are addressed in Paragraph 13 of the Credit Support Annex.
One is the hedge provider credit support.
If the hedge provider is not an investment-grade or creditworthy entity, its obligations will usually be backed by a guaranty. If the guarantor is downgraded, there may be some additional collateral provided to the project company.
Typically, if the hedge provider or its guarantor is not investment grade, then the hedge provider will be required to post the amount of the project company’s exposure.
Project company credit support is also addressed in Paragraph 13 of the Credit Support Annex.
Typically the project company will provide a letter of credit as credit support during construction. Some sponsors prefer to provide a parent guaranty in place of a letter of credit. Whether a hedge provider will accept this usually depends on the creditworthiness of the guarantor. Frequently the project company will then have the right to substitute that letter of credit with a first priority lien upon commercial operation.
The project company often negotiates a form of letter of credit before execution and attaches the form to the hedge. Other negotiated points include letter of credit defaults that allow the hedge provider either to draw down on the letter of credit or to require the letter of credit to be replaced. Cure periods for letter-of-credit defaults are likewise negotiated.
Project companies should try to avoid agreeing to post variable margin (other than when the supplemental collateral condition comes into play as discussed earlier). “Variable margin” means posting an amount that varies with the counterparty’s exposure. Even if sponsors have letter-of-credit facilities that allow them to post variable margin, financing parties often resist this as they usually do not have the means to post variable margin and will not be able to satisfy this requirement in the event they replace the project company as counterparty to the hedge. The supplemental collateral condition is looked at in a different light, as it is thought of as the last resort to prevent the project company from losing the hedge.
Sponsors that intend to finance projects with tax equity or debt should consider building key inter-party points directly into the hedge.
Tax equity will require forbearance arrangements to be in place with the hedge provider. Some sponsors include these directly in the Schedule rather than wait for these to be negotiated with the tax equity investor later in the process.
The lenders may want cure periods even after the loan facility flips to back-leverage, so sometimes the consent to collateral assignment will stay in effect even after term conversion.
Sponsors may want to require that the hedge provider deliver a consent to collateral assignment, forbearance agreement, estoppel and any required opinions to the financing parties upon request.
On the other hand, a sponsor should make sure that any debt or tax equity deliverables required by the hedge provider are reasonable. For example, hedge providers may want to see a copy of the financing agreement with the lenders or equity capital contribution agreement with tax equity. Sponsors should consider expressly noting in the hedge that these agreements may be redacted for confidentiality reasons before being shared with the hedge provider.