Power purchase agreements that settle based on “proxy generation” are becoming more common for wind and solar projects.

Such power contracts are a variation on a type of hedge called a “contract for differences.” The contract has a “strike price.”

If the actual price the owner of a power project receives for any given megawatt hour of electricity sold is greater than the strike price, then the project owner pays the excess to the hedge provider. If the actual price of electricity is lower than the strike price, then the hedge provider pays the difference to the project owner.

In most renewables projects, a contract for differences settles based on the amount of power actually produced by the project during the settlement period rather than a fixed notional output quantity.

The main difference between a proxy generation PPA and a typical contract for differences is that the proxy generation PPA settles based on the “proxy generation” rather than the actual output of the project.

“Proxy generation” means the amount of power the project would have produced if the wind turbines or solar panels had operated at an assumed rate of efficiency. The rate of efficiency is negotiated between the hedge provider and developer before execution of the proxy generation PPA documents.

For example, the owner of a wind project might negotiate a proxy generation PPA with an efficiency rate per turbine of 85%. A third party, called the calculation agent — often REsurety, the company that invented the proxy revenue swap — measures the actual wind at each turbine during the settlement period and then uses this to recalculate the amount of power the turbine would have produced had the turbine been operating at 85% efficiency.

Calculations

The actual calculations are very complicated as many elements of the turbine’s operation must be assumed.

The result of the calculation is that the developer assumes the operating risk at the project. If the turbines operate ultimately at 75% efficiency rather than 85% efficiency during a given settlement period, then the developer is not entitled to a payment from the hedge provider to make up for the lower amount of power produced. The hedge will still settle as if the project had produced the amount of power that would have been produced by turbines operating at 85% efficiency. The hedge settles based on actual output as adjusted for the proxy generation.

On the other hand, if the turbines actually operate at 95% efficiency for a given settlement period, the developer is not required to give that excess to the hedge provider.

The calculations for solar projects are often less laborious (albeit still complicated) than the corresponding calculations for wind.

Often parties will rely on a weather model with granular data on the actual amount of irradiance at the project site during a given settlement period. As a result, there is no need to collect actual project data. The calculation agent uses the irradiance amount from the weather model to determine the amount of power that would have been produced had the panels operated at the assumed rate of efficiency.

Despite the similar name, proxy generation PPAs are different from proxy revenue swaps.

Both products rely on the proxy generation rather than actual generation at a project. However, proxy revenue swaps do not use a strike price per megawatt hour of power. Rather, the hedge settles based on a fixed lump sum per settlement period negotiated before execution of the hedge.

If the “proxy revenue,” or amount of revenue the project would have earned based on the proxy generation rather than actual output, exceeds the lump sum for a given settlement period, then the developer pays the excess to the hedge provider. If the proxy revenue for the settlement period is less than the lump sum, then the hedge provider pays the difference to the project.

Proxy generation PPAs are usually documented on an International Swaps and Derivatives Association form, similar to many hedges.

Key Issues

Developers should be aware of a few key items in the proxy generation PPA.

First, the hedge starts settling on a set date, regardless of whether the project has commenced commercial operation by that date. This is feasible because the contract relies on “proxy generation” rather than actual generation, and proxy generation can be calculated without actual project data. This is especially true for solar projects, where the weather model provides all of the data necessary for the settlement calculation. For wind projects, the calculation agent uses relevant wind data to determine the settlement.

This can be unsettling because the project may not have a source of revenue yet to make any required hedge payments. Developers address this problem by making sure that there is sufficient cushion between the anticipated commercial operation date and the hedge start date. If the hedge nevertheless starts settling before commercial operation, then developers may need to contribute equity to the project to make payments. Otherwise, the hedge provider will draw on the credit support.

Second, the hedge typically contains a deadline for commercial operation. If the commercial operation date does not occur by this deadline, then the hedge provider usually has a termination right. Usually the deadline is either on the date the hedge starts settling or several months after.

This can complicate raising construction debt because construction lenders count in the worst case on the project still being able to operate and earn revenue even if there is no tax equity takeout. The project can still operate and earn revenue, but without the hedge to provide a floor under the potential revenue.

Third, a force majeure event at the project does not equate to a force majeure under the hedge. Hedges typically use the ISDA definition of force majeure, meaning an event is only a force majeure event if it physically prevents a party from making a payment. An example is where a cyberattack occurs and the parties are unable to wire funds as a result. If a hurricane or other force majeure event occurs at the project, typically the hedge will continue to settle. Developers should consider purchasing business interruption insurance to ensure that funds will be available to settle the hedge in such cases.

Electricity basis risk is always borne by the developer in proxy generation PPAs. Basis risk is the difference between the price of power at the hub, where the hedge settles, and the price of power at the grid node, where the project connects to the grid and sells power.

The developer receives the nodal price for the physical electricity delivered to the grid, but the “floating price” the developer must pay under the hedge is calculated using the hub price in lieu of the nodal price. The developer bears the risk that the nodal price is lower than the hub price. If the nodal price is higher than the hub price, the developer reaps that benefit.

Developers should be prepared to post credit support to the hedge provider.

Credit support can take the form of a letter of credit, cash or a creditworthy parent guaranty. Some offtakers might be willing to take a lien on the project as credit support.