The wind market in Texas is leading the way. Traditional long-term power purchase agreements (PPA) are becoming much tougher to find, while intense competition is driving down their price, but American wind power developers are finding new ways to lock in enough revenue certainty to drive projects forward.
Of the 4.8GW of wind capacity that came on line in the US last year, about one-third had no PPA in place. They relied instead on financial hedges, a mechanism that finds a middle ground between the security of a traditional fixed-price PPA and the risks of riding the ups and downs of selling power into volatile short-term spot markets on a merchant basis. Although there are a number of ways to structure hedge contracts, the basic idea is to stabilise cash flows enough to attract project financing by guaranteeing a price for at least a portion of the project's output.
"A hedge is really a market enabler," says Daniel Shurey, an analyst with Bloomberg New Energy Finance (BNEF). Shurey expects hedges to play a significant role in the US wind market over the next couple of years at least, as developers work to bring projects to commercial operation in time to qualify for the $0.023/kWh production tax credit (PTC).
"Almost all of the hedge deals have been done in Texas so far, and we're still expecting a lot of build-out in the state," he says. "So I think, by default, we will continue to see growth in the use of hedges."
BNEF's forecast calls for 6-6.5GW of new wind capacity to be built in Texas this year and next, with as much as 4GW of that backed by hedges instead of PPAs. There are several reasons why Texas has been the epicentre of the hedge phenomenon. It has a deep and liquid spot market that provides the price transparency needed to structure workable hedges. A $7 billion transmission build-out to bring wind from West Texas to market was completed last year, which has significantly reduced the risk of curtailment and negative market pricing, which can turn a hedge from a benefit to a liability for project owners. Net capacity factors that can range beyond 50% also make it easier for hedge deals to make economic sense even at a time when wholesale power prices, and therefore hedge prices, are being driven down by low natural gas prices. But perhaps the biggest factor is that for many projects, there is simply no other choice.
Filling the void
"The punchline is that there are not 20GW of long-term offtakers Texas that want to sign a PPA, and probably, when all is said and done, you'll have that much wind capacity in the state," Mark Egan, managing director of commodities origination at Bank of America Merrill Lynch, told delegates at Infocast's recent wind power finance and investment summit in San Diego. "What Merrill Lynch Commodities and some of the other dealers have been able to do is basically fill that void in a way that feels reasonable and do so in a way that is financeable. So we've effectively been able to allow the continued development of the market."
Both hedge providers and project developers are looking to expand the use of hedges into other competitive power markets in the US. The PJM Interconnection, the country's largest wholesale market, is high on the list.
"I think one of the reasons for that is there are very few PPAs available in PJM at the moment," says Shurey. At the same time, he notes, electricity retailers need a supply of renewable energy credits (REC) to meet state green power mandates.
"It could become a little bit more profitable to enter into financial hedges in the near future, particularly if long-term PPAs remain scarce and PJM REC prices continue to rise," he says. "And the more people who do it, there could be a bit of a knock-on effect that opens the door for others to get in there as well."
There is little doubt that opting for a hedge is not for the faint of heart, as one Infocast speaker put it. Hedging requires careful market projections, the analytical capability to understand what risks a project faces, and the operational experience to manage the asset in the marketplace in a way that allows it to meet the hedge requirements.
Hedges are also often shorter term - in the 10-13 year range compared to a 20-year PPA — and usually do not cover the full output of the facility, leaving the project exposed to significant market risk. But that can also be an opportunity to earn higher returns as market prices rise. Hedge prices being offered are typically 30-40% below where forecasts show wholesale power prices are heading, said Michael Storch, executive vice-president at Enel Green Power North America. "You give away an enormous amount of value in terms of the price you can get under a hedge as compared to what the merchant price curve is showing."
Some developers would like to find ways to capture more of that upside, Infocast delegates heard, by actively managing their wholesale electricity sales.
"I think the ability of the big balance sheet players to be market participants and take some risk will be key to the growth of our industry," said Tristan Grimbert, CEO of EDF Renewable Energy. "We are looking to have a trading desk within our group so we can leverage that."
While some developers at Infocast expressed a preference for the security of a PPA, Grimbert questioned whether it is always a better choice. Price competition has pushed PPA prices in the US down into the mid-$20/MWh range, with some landing at less than $20/MWh for the first year of the contract. "You can have a two-cent PPA for 25 years or a levelised price of merchant electricity you can sell at four cents. I can tell you that doubling the revenue is really worth the risk," Grimbert said.
HOW DO HEDGES WORK?
Hedges are financial agreements designed to smooth-out price volatility in wholesale power markets and deliver stable cash flows to a project so lenders and tax equity investors feel comfortable providing financing. The actual structure of a hedge can vary from project to project as developers balance the risk they want to take with the price they want to receive, but most share the same basic features.
Strike price The hedge provider, usually a bank or commodity trading house, guarantees a minimum sales price for a negotiated quantity of produced energy. If the market price is lower than the strike price, the hedge provider pays the difference to the project. If the market price is higher, the project developer pays the difference to the hedge provider.
Point of settlement This is a key area of risk for wind projects. The market price a project receives is calculated at its point of interconnection, or node. But most hedge providers will only guarantee the price at a larger trading hub, which is the average of several different nodes in the market. If there is a significant difference between the two, usually caused by transmission congestion, it can cost the project owner. Take the case of a project with a $50/MWh strike price as an example. If the nodal price and hub price are both $20, the project receives $20 from the market and $30 from the hedge provider to bring it to $50.
But if the nodal price is zero and the hub price is $40, the project receives nothing from the market and only $10 from the hedge provider.
Fixed shape The hedge provider's trading desk takes the hedged power from the project and tries to match it with potential buyers, so it will require the wind producer to provide a fixed quantity of power over a fixed period. This can be difficult for an intermittent generation source, and costs for wind producers who might be forced to go into the market to buy power to meet their obligations when wholesale prices are high. They mitigate that risk by hedging only the portion of their output they feel they can reliably provide.
Tracking account This is basically a loan from the hedge provider designed to cushion the impacts when actual production and market pricing deviate from what was expected, ensuring the project still receives its guaranteed minimum payments. The owner pays back the account from excess cash flows when generation is higher than expected, with the idea that things will even out over time.