27 April 2017
The growing penetration of renewables is introducing ever-greater amounts of weather risk into energy markets – making its management a priority for renewable and thermal generators alike, say Daniel Stilwell of Nephila Advisors and Richard Oduntan of Nephila Capital Ltd
Every company in the energy industry is affected by the weather, and the rapid growth of renewable energy is magnifying its impact. As the penetration of renewable energy increases, managing the clear risks associated with weather, on both the supply and demand sides, becomes increasingly important. These exposures are inherent in the development, financing and operation of renewable energy assets, especially wind, solar and hydro. The economics of these assets are driven by both volumetric risk (driven by wind speed, solar radiation and rainfall) and interdependency between production and market price (where more production does not always mean more revenue). The traditional approach of financing these assets, including finding an off-taker for the electricity generated, typically leaves one or more weather-related risks with parties that do not desire it, whether that is the off-taker, lender or developer.
Individual renewable assets have this exposure and, from a top-down perspective, entire power markets with medium to high renewable energy penetration are therefore also exposed to the volatility associated with the intermittency of associated weather variables. With the retirement of traditional (polluting) base load generators in many markets, a greater portion of generation is subject to intermittent weather. On particularly windy or sunny days, power markets with high renewables penetration such as Germany, UK, Texas and California have seen power prices turn negative. There are examples of gas plant bankruptcies in California driven partly by the rise of renewable generation resources in the state. This new reality, combined with a world with increasing occurrences of extreme temperatures affecting power demand means weather risk can no longer be ignored.
The weather risk transfer market has evolved
Historically, the weather risk transfer market has focused on temperature-linked products for thermal generators and retailers. "Vanilla" weather derivatives – products like CDD/HDD (Cooling Degree Days/Heating Degree Days) puts and swaps – have been available since they were developed by Enron and others in the late 1990s, and futures contracts linked to these indexes trade on the Chicago Mercantile Exchange. These tools have helped generators protect against mild weather and reduced demand, and power retailers from extreme weather and price spikes. Similarly, "quanto" products, whose payouts are linked to more than one variable, have gained popularity in recent years, allowing end-users to hedge against both weather risk and a commodity price (such as power or gas).
On the other hand, until recently wind, solar, and hydro risk management products have been less common, less standardised and often imperfect for buyers' needs. Stakeholders and market participants have had to manage these weather risks with non-weather tools, creating inefficient outcomes. For example, a developer might prefer a larger loan to a smaller one because debt is less expensive than equity. A lender might want to maximize the amount of money it puts to work, provided it's not exposing itself to undesired risks. However, the shadow of bad weather looms large in the actual financial structure: to address the risk of a solar or wind farm producing less electricity because of poor weather conditions, a very blunt solution is generally implemented, such as a conservative debt-service coverage ratio, assuming poor weather will occur, which helps ensure that a project will be able to repay its obligations.
New weather-linked products now exist to address these inefficiencies directly. A put option on wind volume can be utilised to ensure a minimum level of production, eliminating downside below the strike level, and giving a lender the comfort to advance more capital. Similarly, a swap can be used to remove all weather variability. In exchange for giving up the value of the excess generation above a specified level, the project owner can eliminate downside by receiving guaranteed revenues. In addition to improving the terms of a project finance loan, solutions like these ensure that equity investors have more predictable, less volatile and thus more desirable returns.
For example, consider the performance of an investment in a wind farm that chooses not to hedge its weather risk, and experiences a 1-in-25 year level of wind generation in its first year of existence. Such an occurrence is expected to occur at some point during the life of the asset, but its timing is unpredictable, and an early event can severely impair the lifetime internal rate of return of the investment. Furthermore, this unpredictability makes planning for core business activities, such as developing or acquiring new assets, much more difficult and may require an entity to hold excess cash. A weather hedge doesn't just improve the risk-adjusted return of assets; it enables companies to transfer risks that they don't want or need to manage.
The Proxy Revenue Swap
One specific example of these new generation of weather-linked products targeting the reality of power markets is the Proxy Revenue Swap, an innovative alternative to the traditional Power Purchase Agreement ('PPA'), which protects developers against both price and wind risks. The first-of-its-kind product was developed to help project owners manage the revenue volatility associated with the wind resource variability and is an alternative to securing a traditional contracted off-taker through a PPA.
Unlike a typical PPA, where the counterparty makes a fixed payment per megawatt hour of power generated, the Proxy Revenue Swap is quoted as a fixed dollar payment per year, backed by high credit security, for a term of up to 10 years. If the project generates less revenue than the strike, the project is made whole up to the revenue strike. The coverage addresses volumetric risks (i.e. the risk that annual output is more or less than average), price risks (i.e. that prices go down over time), and covariance risks. Covariance risk includes the risk that when hourly production is particularly high, market prices may also be low or even negative because similar forms of generation may also be producing more than normal. This might occur if the sun is shining more than average in Southern California, and all of the solar generation in the region is generating more than normal and prices are low or negative as a result of the excess supply in the market.
The first Proxy Revenue Swap, with Capital Power's Bloom Wind Farm, was recently recognised by IJ Global as North American Wind Deal of the Year. "We're proud to pioneer the use of this innovative risk-management solution for hedging potentially volatile revenues of wind farms at Bloom Wind," said Paul Wendelgass, Capital Power's director of business development. "The agreement secures long-term predictable revenues for investors, which provided an opportunity for Capital Power to secure a renewable energy tax-equity investment for Bloom Wind with Goldman Sachs Alternative Energy Group in December 2016."
Weather products can be structured at a project-level, like the Proxy Revenue Swap, or on a portfolio of projects, with a production put. They can also be structured at the regional or market-wide level as well. An example would be a dual-trigger option that would pay out if wind generation across, for example, the Electric Reliability Council of Texas (ERCOT) power market was high in a given hour and power prices fell or became negative.
Products like these could help renewable projects with merchant exposure, or thermal generators such as gas, coal, biomass or nuclear plants whose revenues are vulnerable to the effects of growing penetration of renewable power generation. Similarly, power prices may be more likely to spike during hours where renewable generation is low. As renewable penetration increases, hourly prices are often lower on average but more volatile than before, and wind-contingent power options may be a more cost-effective solution to manage this volatility than traditional products.
Weather is a key economic driver in today's power market, and more so than ever. Market participants and other stakeholders can use better data and tools to understand how weather variability can influence the economic performance of power assets and markets. Each stakeholder then has to decide between making weather risk management a core business, or transferring weather risk to others who are better suited to manage and hold this risk.
A dedicated weather risk capacity provider will typically have a large diversified portfolio of weather exposures and a strong appetite for more, making such a portfolio the logical home for individual project or market risks. Backed by strong credit ratings, and a competitive cost of capital, they have the potential to underwrite wind, solar, and hydro risks more cost-effectively than most counterparties. Renewable energy buyers no longer have to bear these risks, and they can use these products when looking for a PPA, looking to finance their projects, or looking to improve their risk-adjusted returns on their operating portfolio. Other market participants can also make use of tailored weather-linked products to manage financial risks associated with the high penetration of renewable energy.
Daniel Stilwell is a Portfolio Originator at Nephila Advisors, and Richard Oduntan is a Portfolio Manager at Nephila Capital Ltd. For more information, email firstname.lastname@example.org.