Developing Renewable Energy
An unfortunate relic of the past that could haunt Wind Project owners for years to come.
The bank hedge also known as a “Fixed price volume hedge” or “Fixed for floating Swap” has been the preferred hedge structure used for US tax equity deals in the past years, to decrease the variability of the wind farms cash flows to secure “tax equity” financing.
The high built out of intermittent energy generators (solar and wind) in some energy markets in the US has exposed “The bank hedge” as an unfortunate relic of the past, which is not fit for markets with high renewable penetration.
Therefore, we will be focusing on the problematic mechanics of a Bank Hedge and why in some scenarios the hedge providers will be tap dancing to the bank, while the wind project will be watching and screaming in horror.
The Bank Hedge will be covered in two parts. The first part will focus on the structure of a Bank Hedge, while the second part will focus on how the Bank Hedge performs.
The formula for the settlement of a Bank Hedge is straightforward:
Hedge Volume ∗ (Fixed Price − Floating Price)
As the name implies the hedge is a financial swap, which has been used for many years in finance to hedge interest rate risk. The companies that offer this swap are the well-known commodities desks of the big Wall Street banks (JP Morgan, Citi etc.). In the context of a Bank Hedge, used for the wind industry, the Wind Project exchanges its floating price for a fixed price for the annual P99 production volume. This annual P99 production volume is calculated based on an independent Wind Resource assessment for the area where the site will be built.
The hedge will be settled, monthly, based on the following formula:
Hedge Volume * Fixed Price > Hedge Volume * Floating Price
Hedge Revenue= Hedge Volume*Fixed Price
Hedge Obligation= Hedge Volume*Floating Price
Meaning that if the formula holds then the Hedge Revenue to the Wind Project is bigger than the Hedge Obligation to the Hedge Provider. The settlement amount will then be equal to:
Hedge Volume*Fixed Price- Hedge Volume*Floating Price
In case the formula does not hold, and the Hedge Obligation is bigger than the Hedge Revenue, then the settlement will be in favor of the Hedge Provider.
That is all there is to the simple “Bank Hedge”, which eventually is very easy to understand for the Wind Project owners, the hedge provider, the financing sources and the rest of the stakeholders in the development of a new wind farm. Unfortunately, the dynamics of the wind is not simple and therefore there are various risks associated with the simple Bank Hedge, but to understand the risks we need to dig a little deeper into the three components of the hedge settlement formula (Hedge Volume, Fixed Price, Floating Price).
The yearly Hedge Volume is the P99 MWh (Mega Watt Hour) production of the wind farms. This total yearly P99 MWh amount is fitted to best emulate the patterns of the wind. This means high production in some hour and low production in other, while also taking the seasonality into account (summer less windy than winter). This means that the Hedge Volume can change in each hour, each month and in some cases each future year. The changing volumes in each hour is called the “Hedge Shape”, which we have seen in two different formats:
This is the simplest form of Hedge Shape where there is a volume for the sixteen hours ending 07:00 to 22:00 and another volume for the other eight hours (hour ending 23:00 to 06:00). This means that each hour it will either be the “7X16” or the “7X8” volume.
This Hedge Shape is a better qualified guess of what amounts of MWh will be produced in each hour during the day to better emulate the dynamics of the wind. Instead of only two different hourly Hedge Volumes per day (as the “7×16;7×8” shape) the “12×24” has a different Hedge Volume each hour.
The fixed price is the offer toward the Wind Project and will eventually be the element, where the Hedge Provider has done their fair amount of data crunching of historical price dynamics and forecasting of future price levels. The price they offer will (of course) on average always be lower than the average of the floating price the Wind Project will be paying the hedge provider.
Therefore, the simplified pricing exercise on the Hedge Providers part, is an exercise of finding the average Floating Price taking seasonality and hour of the day into account, and then subtract the necessary USD/MWh to arrive at a fixed price. The amount subtracted will contain the contingencies and profits, which the hedge provider is requiring to offer the Bank Hedge.
The Floating Price is the hourly price, which the Wind Project will settle the hourly Hedge Volume amounts on. The Floating price is typically the Trading Hub Price nearest to the wind farm or another trading hub agreed between the Hedge provider and the Wind Project. As the Wind Project receives the Node Price for the physical produced power, there will be pricing difference between the Hub Price and the Node Price in some operational scenarios, which will be further discussed in a future post.
The Tracking Account
An important aspect of the Bank Hedge is the Tracking Account, which makes the cash flows less volatile for the wind project. A tracking account is simply a line of credit provided to the project, which gives the opportunity to postpone negative differences between the Merchant Revenue earned and the Hedge Obligations toward the hedge provider, which is also known as the Mismatch:
Mismatch = Merchant Revenue − Hedge Obligation
Merchant Revenue = MWh Production∗Node Price
And the Tracking account update each month would be:
New Tracking Account = Previous Tracking account+Mismatch
As there is a lower limit for how much can be drawn on the Tracking Account, there is a possibility that the cash flow will be variating again in the future. This will happen when the draw from the tracking account surpasses the Tracking Account Limit:
Tracking Account Limit= X mio USD
The following graphic example shows a tracking account with draws and repayments, where the Tracking account limit of 10 mio. USD is reached in year 10:The graph shows green bars in year four and nine, which means that the Merchant Revenue is higher than the Hedge Obligation for those specific years. In the 10th year the Tracking account hits the limit of 10 Mio. USD, which means that a negative Mismatch in the first month of the 11th year will require that amount to be repaid to the Hedge Provider as the Tracking Account has reached its cap. This would mean that the Cash flow for the 1st month in the 11th year would be Hedge Revenue – (Tracking Account – Tracking Account Limit). Therefore, the cash flow is no longer just the well-known Hedge Revenue.
When the Tracking Account limit is surpassed, it will require a payment of the difference between the Lower Limit and the total Tracking Account Draw from the Wind Project to the Hedge Provider:
Tracking Account repayment = Tracking Account − Tracking Account limit
As the tracking account is a line of credit it will of course accrue interest when the balance is negative, which would be in line with the following formula:
Tracking Account interest = Tracking Account ∗ (Libor rate + X Basis Point)LIBOR, which stands for London Interbank Offered Rate, serves as a globally accepted key benchmark interest rate that indicates borrowing costs between banks, but the usage also expands into the consumer finance world.
When the Bank Hedge contract runs out, which is often after 10-20 years, the total Tracking Account debt will have to be settled and paid back.
The monthly cash settlement could be based on the following calculation:
Settlement Amount = Hedge Volume * (Fixed Price – Floating Price) – Mismatch
Where a positive amount would be paid by the Hedge Provider to the Wind Project and vice versa. In the case of a negative mismatch, which often would be the case, the negative figure will become positive and the Mismatch will be a positive cash flow towards the Wind Project. As the Mismatch eventually is the difference between the Merchant Revenue and the Hedge Obligation this can seems wrong if the mismatch is negative, which would imply that our Merchant Revenue cannot cover our Hedge Obligation. This is exactly the case and therefore we borrow/draw that from the Tracking Account (credit line).
When the full formula is written out it looks like the following:
Settlement Amount = Hedge Volume * Fixed Price – Hedge Volume * Floating Price – MWh Production * Node Price + Hedge Volume * Floating Price
Where the minus in front of the Mismatch in the settlement formula, has reversed the signs in front of the mismatch components. By eliminating the Hedge Obligation, which is now included as both a negative component and a positive component we get to the following:
Settlement Amount = Hedge Volume * Fixed Price – MWh Production * Node Price
Which can further be boiled down to:
Settlement Amount = Hedge Revenue – Merchant Revenue
This means that the settlement amount is simply the Hedge Revenue minus the Merchant Revenue, which makes a lot of sense. This means that a lower Merchant Revenue leads to a higher Cash Flow (Settlement Amount) to the Wind Project, which then stabilizes the cash flow available for expenses. Here it is important to remember that the positive effect on the Settlement Amount due to a low Merchant Revenue, will have the opposite effect on the Tracking Account (Credit Line), as the mismatch obviously will be higher.
The purpose of this blog post was to give a brief introduction to the Bank Hedge and the dynamics behind it. Therefore, all the elements in the Bank Hedge were dissected and explained to better understand each element. This hopefully gave a good foundation for further investigations of the Bank Hedge.
The next blog post will dig into the performance aspects of the Bank Hedge and the overarching theme will be the risks associated with the Bank Hedge. With the purpose of sharing our experiences while supporting clients regarding this specific product.
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