Developing Renewable Power
The wind might be as unpredictable as ever, but big insurance and weather investors have gotten an appetite for taking on that risk.
This post will explore the new opportunities that are arising within revenue hedging for wind projects. In our last few posts we spent our time on the Bank Hedge fundamentals and pitfalls. The purpose of the Bank Hedge is to hedge the price risk. Here we also touched upon the three overall risks faced by a wind project. Those risks being the Price, Fuel (Wind) and operational risk. After exploring the conventional way of hedging the price risk (especially in US Tax Equity deals) and the pitfalls of doing so, this post will discuss the wind risk and the new structures around hedging, which is showing up in the market.
To create the most efficient and cheapest hedging market it is crucial that specific risks are transferred to the most competent owners of such risks. A competent owner would be a company, which has the biggest expertise in handling the risk and the best opportunities to mitigate it via diversification. The Price risk, which we touched upon in previous posts, is most suitable for a commodity trading desk, which has broad experience with navigating the relationship between the day ahead market and the real time market. Furthermore, they might also be trading across a different energy market, where supply demand effects can give rise to pricing differences, which can be exploited.
For the wind risk the commodity trading desk would not be a suitable owner. Instead this risk has become interesting for large reinsurance companies, where weather insurance has been a business for many years. Reinsurance companies are the companies, which are insuring governments etc. against hurricanes, floods and earthquakes, which can be described as event of high impact, but low likelihood. To diversify their risk, they are interested in having many risks spread out across the globe and potentially across weather events. Their competence within the space have given rise to an appetite for taking on the fuel risk of a wind project, which is slightly different as the risk can be described as low impact, high probability events.
This initial discussion of the rightful owners would give rise to more contracts. The price risk goes to the Commodity Desk, while the fuel risk goes to the reinsurance company. This leads to more complexity and more counter party risk. It would be better if you could simply find one owner for both risks, but this would unfortunately destroy the thesis of “a most competent owner for each risk”. This structural issue has been solved by market participant already as there are some interesting aspects around the reinsurance companies.
As the hedging of revenue streams creates value by securing the downside, it is a crucial element for getting debt (cheaper than equity) into the capital structure of a wind project. Debt-holders are only interested in the downside protection as they have no claim on the upside. They only get a promise of their money being paid back and an interest payment on the money borrowed. Hence, the way to get better debt financing terms is to create the most secure structure around the downside.
The hedging itself is not the only thing that could give comfort for the debt-holders as there would be a counter party risk towards the hedge provider. Therefore, the best hedge provider you can structure your risk under would be a company with a rock-solid balance sheet and a pretty credit rating to prove it. Insurance companies usually have high credit ratings as it is one of the most important quality stamps of their ability to payout when bad outcomes occur. This quality stamp would also be of high interest for the debt-holders in renewable projects, which makes it interesting to have all your risk covered by a hedge instrument from a AAA rated insurance company. The following illustrates how this is set up:
The above figure shows a Wind project receiving a fixed payment from the Reinsurer and paying the floating (leg) payment to the Reinsurer. In the above example the Reinsurer has taken on both the fuel risk and the price risk, which structures the different risks under one umbrella and the Wind Project gets both risks removed with only the insurance company as hedge provider. As the insurance company is a competent holder of the fuel risk, this will stay with the insurance company. The price risk can then be transferred towards a commodities trader with a swap deal between the Reinsurer and the Commodity Trader. This means that the Fixed-for-floating price hedge (Bank Hedge) lives on, but the hedge provider is now taking the risk.
The above-mentioned structure sounds brilliant in theory, but there are some practical aspects that would still need to be thought through. The price risk is easy to settle as the energy price is posted at specific intervals every day based on supply and demand mechanism, but we don’t have such a luxurious settlement point for the wind. Therefore, the practical challenges around the fuel/wind risk mitigation has for many years evolved around the settlement of the wind. In our next post we will look at the new ways of solving this issue and some failed attempts from the past. Furthermore, we will investigate one innovative hedging product, which has been in the market for a few years now called the Proxy Revenue Swap.
Blue Power Partners is developing and building renewable power with a dedicated focus on wind, solar and storage projects worldwide. Our core business is centered around Development, Construction and Operation, and we are partnering with globally leading developers and asset owners within the Industry.
Together we aim at pioneering a greener future.