As we stated yesterday in the first post in our series on hedging strategies for power contracts, one of the more popular hedging strategies is the Revenue Put Option.
Revenue Puts have been a key component of the financing for gas-fired projects, including Panda Power’s Sherman, Temple I and Temple II projects. Similarly, Revenue Puts can be a part of the financing structure for wind projects, such as Pattern Energy’s Panhandle wind farm, Airtricity’s Champion wind farm and, most recently, Starwood Energy’s Stephens Ranch wind farm.
A Revenue Put sets a guaranteed floor for revenue from the sale of electricity during the term of the hedge. This provides a baseline for a project to have guaranteed (or at least more certain) revenue during the hedge period, which is necessary for securing financing for the project.
How Revenue Puts Work
In a Revenue Put, the project owner will enter into what is essentially an option contract with the hedging counterparty (the option seller). The hedging counterparty will pay the project company (the option buyer) the difference between the hedge-specified floor revenue and the power plant’s actual revenue from power sales in the event that actual revenue from power sales are smaller than the option-specified (or hedge) floor.
Traditionally, the term of these hedges was fairly short compared to the useful life of a power plant, with hedges difficult to secure for more than 5 years, but we are now seeing some 12- and 13-year options available in the market, which greatly enhances the investment appeal of new power projects.
Hedging counterparties are often sophisticated financial institutions that do not have an interest in receiving actual electricity, but are associated with the project elsewhere in the financing (i.e. an institutional bank that also serves as an arranger in the deal). Under certain circumstances, the hedging counterparty may be an unrelated third party. For example, the hedging counterparty for the Panda Power Temple project was the 3M Pension Plan, which caused excitement in the industry that a new type of investor has entered the power hedging space.
Arrangements Vary Considerably
The arrangement for the contracted floor revenue can vary. For example, the floor can either be fixed, or floating, on a quarterly or annual basis.
Also, the revenue can be calculated or estimated in different ways. In one method, the calculation is based off of actual revenue, which is measured at the actual dispatch at the hourly marginal price. Alternatively, revenue can be measured using a contracted formula that may take into account various factors, including transmission congestion or other power generation sources. A formula approach may also factor in fuel costs – either actual fuel costs, or fuel indexed at a point of injection that does not necessarily correspond to the injection point used for the power facility’s fuel.
During the Polar Vortexes of Winter 2014, several gas-fired power plants in the U.S. Northeast were on the short-end of a bad hedging arrangement because they had indexed their hedge at an injection point further down stream from their actual supply. When the differential in prices between the actual price of fuel and the indexed price exceeded projections due to unexpected fuel scarcity on the pipeline, the hedge went sideways and fixing the issue became an eight-figure problem for investors.