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Pricing risk in the wholesale markets

For wind plant owners, hedging their bets on price fluctuations in the wholesale markets by paying others to take on that risk can be a winning strategy for increasing returns compared with signing a long term power purchase contract at a generally lower price. But it all depends

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Wind power developers in the United States are increasingly shunning the security of traditional long term power purchase agreements (PPAs), dissatisfied with the contract terms on offer. Instead, they are finding other routes to maximize earnings on sales of electricity and on the environmental benefits their projects produce. One option is to sell electricity directly into competitive wholesale markets, but hedge the risk of doing so by paying a financial institution to take it on.

Forward prices are higher in wholesale markets than producers can expect to achieve in a PPA, but with a hedge contract in place they can still have protection against price volatility. Essentially, the hedge provider pays if prices drop below a floor value and take any upside if rates rise above a set ceiling. Selling the power directly into the market also allows developers to hang on to potentially valuable renewable energy credits (RECs), rather than relinquish them to the PPA counterparty.

"It creates much more flexibility for the developer. Instead of selling everything to the utility and locking in so it is gone for 15, 20, 25 years, the developer can sell just the power for ten years and after that enter into a PPA or another financial hedge, and in the meantime still have the upside of the RECs," said Floris Lyppens of Fortis Capital Corporation, speaking at the recent Infocast Wind Power Finance and Investment Summit in San Diego. In fact, said Brian Falik of Credit Suisse, a hedge can be unwound at any point should an attractive PPA opportunity come along.

That flexibility is important in other ways as well, particularly in today's tight turbine market, where developers either have a turbine inventory they need to use or have to wait for delivery. "If you don't have a PPA, you don't have an in-service date deadline, you don't have a mandate to deliver minimum energy at certain times of the year and things like that, so you have greater flexibility in constructing the facility to time it relative to your availability of turbines," said Michael Storch of Enel America.

For the most part, said Lyppens, both the equity investors in projects, who as owners gain tax credit benefits, and the project loan providers, have grown comfortable with the idea of financing wind farms that have hedges in place to provide future security rather than tried and trusted long-term PPAs. "The big advantage of the hedge is that you have a high investment grade counter party. That is what the lenders and the tax equity parties really like," he explained.

For lenders there is risk associated with the so-called "merchant tail," which is the period between when the hedge expires and the debt matures and the project is fully exposed to market prices. But even that is not insurmountable, Lyppens said. "You get comfortable with the merchant tail by consultant reports, good market studies and a good quality sponsor. And it is proven the market is absolutely willing to take that risk. We have seen it in the last year a lot." Gisela Kroess of UniCredit/HVB cautions, though, that much depends on how long the merchant tail is. "I think it would be hard to get a ten-year merchant tail done in this market."

On the tax equity side, Falik is not as convinced that comfort with hedging is universal. "You have very different tax equity participants out there. Some are very conservative and don't understand fully all the intricacies of what is going on in these hedges so they will sometimes pull away from a deal. We've seen that often."

Like many equity players, Wachovia Securities wants to see prices hedged for ten years on projects they invest in. "We looked at one transaction and closed on it that had a shorter hedge, but it was part of a broader portfolio where you could justify taking a little more risk on a single project because you had another project in the portfolio that had a long-term fixed price PPA. So we kind of looked at the blend," said Wachovia's Robert Capps.

The comfort zone

There are equity players, though, who are ready to go further and take full-on merchant risk, without even a hedge agreement in place. GE Energy Financial Services has done it with both wind and other generation technologies, but the company's Timothy Howell said it is vital to have a clear view of where power and REC prices are going. "GE has a forward curve. It is a little bit scary if you go into a merchant deal where you are not relying on your own forward view of power markets. The other thing that makes merchant quite complex is the REC market," he said. "The REC market is very uncertain and volatile right now. We'll get a model from a developer with a REC forecast and then in a month or two get a revised model with a much higher forecast. Why did it go up? Well that's what the market has done in short term. But it is trying to make a projection that is long term on that."

The amount of risk developers are ready to take also varies. Shell has traditionally preferred PPAs but "in the future would tend to lean more towards the merchant side" so it can keep the RECs against emissions in its own operations, said the company's Jeff Carter. "We are comfortable with merchant risk, but the main constraint is what the project lenders are comfortable with. Do they require a near term hedge to offset that risk?" said Carter. "We're fine with that because we don't want the project to go under water on day one either. But long term we're comfortable."

The conservative types

Other developers would rather stick with the tried-and-true PPA. "We're not fully comfortable with merchant risk in general. It doesn't mean we're not looking into it, and we also have some small merchant or quasi-merchant projects. But in general the volatility of the merchant market, even though it has played very well for those in it over the last two or three years, is something we want to keep within reasonable risk. We're not taking a huge merchant risk right now. We prefer the PPA," said Tristan Grimbert of enXco.

Eurus Energy America Corporation also likes to fix its revenue stream with a PPA, said the company's Mark Anderson. But it also likes to develop projects in markets where wholesale and merchant possibilities are available. "We find the wholesale market is one of the best tools for us to keep the utilities honest in negotiating a power purchase agreement," he said.

One of those markets, run by the Electric Reliability Council of Texas (ERCOT), covers most of the state and has been a very popular place to hedge wind. Among the deals, Fortis Merchant Banking recently provided a 1.1 million MWh, ten year, fixed price hedge agreement to provide revenue stability to Enel's 63 MW Snyder Wind Project, which came on line earlier this year in Scurry County between Abilene and Lubbock and is selling its output into the ERCOT market. The hedge was provided by Fortis Energy Marketing and Trading, an entity set up after Fortis acquired Cinergy Marketing and Trading from Duke Energy in late 2006.

But the popularity of the ERCOT marketplace for hedges seems to be changing since it decided to transition from a system where price was set in one of five zones to one where it will be set at one of more than 4000 so-called nodes, beginning December 1.

Eurus is building a wind plant in Texas and is still in the process of deciding whether to contract the output or go fully merchant, said Anderson. It decided against the hedge option after seeing what was available. "I think there is some discomfort with hedging down to the node in Texas. So we're seeing the market thin out a little bit on the hedge side and I'm not sure we're getting the value for the hedge that we were really looking for," Anderson said.

Falik agreed that things in Texas have changed. "As people have had to go in and check the box of getting a hedge or PPA out in West Texas to get their deals done for either their tax equity or for their lending group, they have come in and hedged a lot of their pipeline through 2010," he said. "But in that market specifically there has been almost too much hedging. What you've seen is a lot of the banks drop out of that market."

Part of the issue is transmission constraints coming out of West Texas, where there has been a huge build out of wind. While electricity prices in ERCOT have historically tracked natural gas prices, the amount of wind on the system is changing that. "There is a disconnect between market prices and gas. We're seeing negative prices in areas of ERCOT not be infrequent, particularly when the wind is blowing hard and the load is modest, because the amount of wind generation is becoming material," said Storch.

Price just one factor

Chris Stecklein of Direct Energy, an electricity retailer that has 813 MW of wind under contract in the ERCOT market, cautioned that it is important to look beyond price when deciding between a PPA and a hedge. "These two types of structures underwrite different risks, and sometimes they get used interchangeably as if they are analogous," he said. "The financial hedge is used to hedge out commodity price risk and, to my mind anyway, commodity price risk only. As a PPA provider we like to sell what we see as a more full service product. Yes, it doesn't leave you with the upside, perhaps, but doesn't leave you the downside either."

Wind output variability and the difficulty of not always being able to meet production schedules is a risk buyers can take on under a PPA, while projects with hedges either have to do it themselves or handle the scheduling problem through other third-party agreements. Direct Energy schedules customer load through its retail business every day, said Stecklein, as well as its contracted wind and 140 MW of combined cycle gas generation. "That is something we are pretty comfortable with. In fact, we try to make that part of our standard package."

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