Heat rate call option explained
BudofskyMichael T. ReeseMichael S. HindusOlivia Matsushita. Over the past few years, many merchant gas-fired power generation plants operating in the regional heat rate call option explained organization, PJM Interconnection and in the New York Independent Service Operator NYISO areas have been successfully project financed by international and Japanese financial institutions.
At the same time, the heat rate call option explained has also seen the recent bankruptcy filing of a merchant gas-fired power plant in the ERCOT market in Texas. Common to each of these project-financed power generation plants was the employment of financial hedging instruments designed to ensure a stable revenue stream to help cover debt service obligations over the first several years of plant operations. In this article, we review the history of the use of financial hedges by merchant power projects, and examine the main types of financial hedges currently being used in the United States power market and whether or not they can support the bankability of merchant power projects operating in markets such as the PJM Interconnection.
What had essentially been a regulated monopoly for vertically integrated utilities within specific regions was replaced with a competitive market in generation, open access to transmission, the creation of independent system operators and regional transmission organizations, and wholesale markets for electric power. The means of financing power projects has evolved with changes in the structure of power generation markets in the United States.
Many of these IPPs were smaller entities with little or no balance sheets and therefore financing generally depended on long-term i. This became the primary method of financing non-utility generation. In the 21 st Century, in many key markets in the United States, long-term PPAs for gas-fired electric generation became disfavored, even though there was a need for additional capacity and energy. Lenders nonetheless required assurances from new IPP project developers that revenues would be available to service debt repayment obligations.
Initially, a variety of mechanisms were used, including increased levels of project equity and subordination of fuel payments. Other risk management practices heat rate call option explained, including financial hedge transactions such as energy swaps, contracts for differences, heat rate call options and power revenue puts.
This is a form of downside protection for the power plant. Thus, revenue put providers are typically sophisticated financial institutions, usually swap dealers, with the expertise to transfer this risk by trading in the futures and spot energy markets.
As many banks have exited the commodity markets over the past several years, due to factors such as increased regulatory capital charges, the number of revenue put providers recently has been reduced to a few known players.
There have been examples, however, of non-swap dealers acting as put providers. One such case is the Panda Temple I project, described in more detail below, where a pension fund acted as the put provider. It is unclear whether the pension fund, which was also an equity investor in the project, had entered into a back-to-back arrangement with another financial institution to hedge its potential liabilities.
Heat rate call option explained revenue put is a purely notional cash-settled contract in which the power project makes an up-front premium payment to a revenue put provider in exchange for settlement payments to the power project reflecting any shortfall of i a notional gross energy margin over ii a fixed net revenue amount. The notional gross energy margin is calculated as the excess of power revenues over gas costs that would be realized by a hypothetical power plant operating at an assumed capacity and heat rate and on an assumed schedule of starts and restarts during the year.
The revenues and costs are calculated on the basis of published power and gas indices observed during the term of the revenue put.
The fixed net revenue amount, on the other hand, is typically sized to ensure that the power plant will be able to meet its fixed costs and debt service obligations, taking into account any other sources of revenue, such as capacity payments. Thus, broadly speaking, if the spark spread tightens relative to the assumed level on which the fixed net revenue amount is based, the revenue put provider will make a settlement payment to help the project make up lost revenue.
Revenue puts present an interesting credit profile for a power generation project. Typically, settlement payments are calculated and made annually. Since heat rate call option explained power generator pays the revenue put premium upfront, and the revenue put only heat rate call option explained downside protection in the form of payments from the revenue put provider, the power generator generally should not have ongoing payment obligations to the revenue put provider.
With such one-way credit exposure, it is the revenue put provider and not the power generator that must provide collateral.
Under typical documentation, the amount of this collateral to be put forward by the revenue put provider is typically the mid-market replacement value of the transaction less a negotiated threshold amount.
Without liquid markets in revenue put transactions, the replacement value is often set by the revenue put provider on the basis of its internal models. This dynamic of asymmetrical information suggests there is value in negotiating a precise valuation methodology upfront. Another implication of the generally one-way credit exposure is that a power generator will seek to eliminate any credit-related events of default including bankruptcy events pertaining to the power project that otherwise would permit the revenue put provider to terminate the put.
Notably, in the Panda Temple I project, the revenue put provider has continued to make payments to the power project even after the recent bankruptcy filing by the power generator.
In practice, heat rate call option explained puts do have some two-way credit exposure. As a result, the revenue put provider heat rate call option explained be exposed to the credit of the power generator for the amount advanced each quarter. Achieving the best terms for a revenue put involves seeking competitive bids from potential revenue put providers, a process that usually involves concurrent negotiations with several providers with respect to economic terms, as well as related documentation including, for example, ISDA documents, intercreditor agreements, guarantees and consents.
Another financial hedge is heat rate call option explained heat rate call option HRCO. Like a revenue put, the payout on the HRCO is purely notional and is not tied to the actual operations or results of the power heat rate call option explained facility.
Under a HRCO, the project receives fixed periodic cash payments from the HRCO counterparty and, in exchange, pays to the HRCO counterparty the excess of a market power price over a market gas price multiplied by an assumed heat rate and by an assumed quantity of power.
The effect of the HRCO is similar to a revenue put in that the project is protected against tightening spark spreads. However, this protection is effectively paid for in an HRCO by the project giving up the potential heat rate call option explained that it would otherwise realize from widening spark spreads, rather than the upfront premium payment found in the revenue heat rate call option explained. The mechanics of the typical HRCO achieve this by giving the financial counterparty a daily financial option, calculated with respect to each hour in the following day heat rate call option explained, upon exercise, heat rate call option explained the payment of a cash settlement amount equal to the product of a i a variable price power index at a predetermined location minus ii an amount equal to a variable natural gas index multiplied by the specified heat rate conversion factors of the project and b a base notional quantity of power.
The counterparty may choose to exercise the option for some, but not all, of the hours in the day, and the cash settlement amount also accounts for assumed fixed and variable costs of starting up and shutting down the plant during a day.
If the net amount of the related option premium owed by the financial counterparty is greater than the aggregate cash settlement amount, the project receives a payment and realizes a gain. If the net amount is negative, the project must make a payment and realizes a loss. Thus, because either party may owe a settlement payment, the HRCO is subject to two-way credit exposure, and each party may need to post collateral in favor of the other, depending on the mark-to-market of the contract.
Other types of hedges, such heat rate call option explained a contract for differences, may be financially settled only, but are linked to the actual performance of the power generation facility and thus may reduce basis risk. The recent bankruptcy of the Panda Temple I project in Texas illustrates some of the limitations of financial hedging of merchant power projects. At the time, the financing by institutional heat rate call option explained of a capital intensive construction project through a term loan was seen as a breakthrough for the U.
The project therefore sought to rely on market energy revenues to heat rate call option explained its debt repayments and to hedge volatility in revenues through 4-year revenue put options entered into with the 3M Employee Retirement Income Plan, an equity investor in the project, on MW of generation capacity.
Unfortunately, such favorable market conditions did not materialize, and on April 17,the Temple I Project filed for bankruptcy protection after breaching its debt service reserve covenant in December and failing to make its March debt service repayment.
The inability of the project to generate enough cash to meet its debt service repayments highlights some of the shortcomings of the revenue heat rate call option explained. For example, had the revenue put strike price been higher, it would have offered more protection to the project. Nonetheless, financings of gas-fired power generation facilities consisting of loans with terms equal to the construction period plus years, supported by financial hedges, have generally been viewed as bankable in the PJM Interconnection.
For example, it has been reported that a natural gas-fired power generation project in Lordstown, Ohio, was financed by a lending syndicate of eight banks in Aprilsupported by a five-year revenue put. Because it is often contemplated that the loans may be refinanced prior to their final maturity date, it is not uncommon for the financial hedges to mature on the anticipated refinancing date of the loans.
Article By Daniel N. Contracts for Differences Other types of hedges, such heat rate call option explained a contract for differences, may be financially settled only, but are linked to the actual performance of the power generation facility and thus may reduce basis risk. Bankability of Merchant Power Projects and the Limitations of Financial Hedging Instruments The recent bankruptcy of the Panda Temple I project in Texas illustrates some of the limitations of financial hedging of merchant power projects.
Tags Projects, Projects, Derivatives.
Chadbourne runs internal training sessions for its project finance lawyers. The following is an edited transcript from a session on energy hedges taught by Rob Eberhardt and Monika Szymanski in the Chadbourne New York office in late October. Our focus today is on energy hedges for natural gas-fired power plants.
I will give a brief overview of recent trends in the market for natural gas-fired power plants. Energy hedges address a problem with such projects. I will describe this problem. Two types of energy hedges are common in recent deals: I will describe each of them and differences between them. Monika Szymanski will talk about the issues that get negotiated in the ISDA documentation once one gets into the legal documents to implement a hedge.
Hydraulic fracturing and directional drilling have led to an abundant supply of natural gas in North America. Prices of gas have fallen. This has led to heavier use of gas as a fuel for generating electricity.
At the same time, the US government is moving to more stringent regulation of emissions from coal-fired power plants, causing many older coal-fired power plants to be permanently shut down. Even though electricity demand is flat, because gas is cheap and because the existing fleet is turning over, developers see opportunities to build new natural gas-fired power plants.
In the last two to three years, there have been at least 14 project financings of new merchant natural gas-fired power plants in the United States. The bulk of them are in the PJM market, which covers the mid-Atlantic states and parts of the Midwest. There also have been a few deals done in Texas, and one project has been financed in New York. Each of these projects has had an energy hedge as a critical element of the financing.
The projects have been financed in both the bank market and the term loan B market. There can be 12 to 15 banks in the lender syndicate. There may be both senior and mezzanine debt. There are multiple equity investors in some projects. These are big, complicated projects. They have been done with both revenue puts and heat rate call options.
However, there appears to be a preference in the bank market for revenue puts. Panda has done several projects in the term loan B market with heat rate call options, but as far as we are aware, there has only been one bank deal with a heat rate call option. Energy hedges are not the only driver for the financing, but they are a very important part. To understand why, one must go back in time. Early in the life of the independent power industry, independent generators financed power plants based on long-term offtake contracts with utilities.
Utilities paid the avoided cost that the utility would have to incur to generate the same electricity itself. Long-term offtake contracts remain the lynchpin of most project financings in the power sector. However, by the late s, after certain electricity markets were deregulated, a large number of combined-cycle gas-fired power plants were built on a merchant basis, without long-term offtake contracts.
The market fundamentals ultimately deteriorated because too many people were chasing the same opportunities. Then natural gas prices went up. Plants could still make money by operating, but they were not nearly as valuable.
A large number of projects that were under development were cancelled. Developers had to shed operating projects at steep discounts. Some bankers who had financed the projects lost their jobs. We then went through a decade in which the market soured on combined-cycle gas-fired power projects. There were a few deals done, but not many. A generator that buys gas and turns it into electricity makes money if the spread between the gas and electricity prices is favorable and the cost associated with that process is low enough.
If the cost of gas goes up or if the wholesale price for electricity goes down relative to one another, then the viability of the business can be affected significantly. It is not so much how much the gas costs or what price will be paid for the electricity in absolute terms.
The key is the spread between the two and how efficiently you can convert gas into electricity. The wholesale price for electricity can vary wildly. Gas prices also are volatile. Energy hedges guard the spread between gas and electric prices. In doing so, they protect a project against a deterioration in market conditions like what occurred previously. The way to think about revenue puts is they are a type of insurance.
The project the insured pays an upfront premium to the hedge provider the insurerand if gas and electric prices move in the wrong direction, then the hedge provider will make a payment to help the project make up the loss in revenue. The put is downside protection in exchange for an upfront payment.
The project typically makes the payment at closing on the financing for the project, at the start of construction. The upfront payment is large. The put sets an assumed revenue floor for the project. If market conditions have changed so that the actual revenue in any year after the project starts operating is below the floor, then the hedge provider makes a payment that year to get the project to the floor. If market conditions are such that actual revenue in a year is above the floor, then no payment is made that year.
The risk that assumed revenue, based on market prices for electricity and gas, for any year will dip below the floor is borne by the hedge provider. The hedge provider is compensated upfront for taking that risk. The hedge provider of a revenue put takes a view on where the market is headed, but it also does offsetting trades to try to protect itself.
That is a key difference between a revenue put and a heat rate call option. In the latter case, the hedge provider keeps the upside.
The term of the hedge starts to run once the project is in service. They typically do not have terms longer than five years. Payments under a revenue put are calculated on an annual basis. In cases where a project needs cash more frequently, the hedge may have interim quarterly settlements. If the project has been overpaid by the end of the year, then it has to give money back. The dollars back are usually small. Money runs primarily to the project.
The hedge protects against deterioration in market conditions — changes in gas or electricity prices — but not operational inefficiencies or technical problems or outside events that prevent operation of the project. In a revenue put, at the end of the each quarter or year, depending on the settlement period, the net revenue amount is calculated based on assumptions about what the maximum revenue a hypothetical plant would have earned given actual gas and electricity prices. You make an assumption about its heat rate, i.
You make an assumption about how much it costs to start the plant. You make assumptions about how much it costs to run the plant, apart from fuel costs, and you assume how frequently the plant has to be restarted.
For example, you might assume a maximum of restarts in a year and that, once the plant has started, it must run for at least five hours. The only revenue figures in the calculation are gas and electricity prices.
These are set based on published market prices. How much would the project collect by selling electricity, and how much would it have to spend to run the plant in that hour? You do that calculation for each hour for the entire quarter or year. You sum up all the revenue in each hour and compare that to the floor amount that was set at closing.
If the number for the settlement period is below the floor, then the hedge provider pays. If the number is above the floor, then no payment is made. First, in a heat rate call option, you do not make a big upfront payment at financial closing. Second, there are payments potentially in both directions. If market conditions deteriorate, then the hedge provider makes a payment to the project.
If market conditions improve, then the project makes a payment to the hedge provider. The calculation of the cash settlement amount in a heat rate call option ultimately looks similar to the calculations that are made under a revenue put.
Similar assumptions are made as in a revenue put to isolate the gas and electricity price risk. Each day on a day-ahead basis, the hedge provider — not the project owner — decides whether to consider the plant in operation solely for purposes of the hedge. If the hedge provider decides not to call the hypothetical plant, then there is no revenue for that hour for purposes of calculating the cash settlement amount. The ultimate settlement amount will equal the option premium and will be paid to the project if the hedge provider elects not to call the hypothetical plant in any hour during the relevant settlement period.
When thinking about the potential payment amounts made to or from the project during a settlement period, the more favorable the spread between gas and electricity prices, the less the project receives under the hedge. At a certain point, market conditions are sufficiently favorable that the project must make payments under the hedge. From the option premium the maximum expected settlement amount payable to the projectthe payment to the project reduces, and the net direction of payment ultimately switches from the project to the hedge provider as the cash settlement amount increases.
The cash settlement amount increases for every hour in which the hedge provider has elected to run the hypothetical plant when there is a favorable spread between gas and electricity prices. For a financially-settled heat rate call option, as the amount paid under the hedge to the project decreases, and as the direction of payment ultimately switches from the project to the hedge provider, the assumption is that revenue associated with physical electricity sales will increase.
The combination of hedge payments to or from the project and electricity revenue received by the project results, in theory, in a steady project revenue stream based on a fixed spread between gas and electricity prices. Heat rate call options settle on a monthly basis, and there is a payment by the hedge provider to the project or vice versa.
Backing up to see the big picture, the hedge provider is usually not taking physical delivery of any electricity. Most hedges are financial instruments.