Project companies are not always able to find a creditworthy counter party with a desire to enter into a long-term power contract. Even if a power purchaser is willing to sign a long-term contract to buy power, there are many markets where that price is too low to create appealing economics for investors.
As we mentioned in part 1 of our Hedging Strategies series, various types of hedges can provide a relatively stable stream of revenue for project companies, and can make the project financeable, even if that stream is not necessarily as robust as that offered by a traditional PPA.
In a Synthetic PPA, the project company sells its power on a merchant basis, but enters into an agreement with a hedging counter party (typically a financial institution), which provides a relatively stable stream of revenue. Power prices are set to a benchmark, either to a set amount, or more commonly, a price range. As long as the power from the project is sold for price inside this range, or collar, nothing happens. If the price rises above the range, the owner of the project pays an additional amount (typically, some share of the excess) to the Synthetic PPA provider. If the price falls below the range, the project company gets paid the difference to the benchmark price under the Synthetic PPA.
This type of hedge provides insurance against declines in power prices – which is a fundamental purpose of any hedge – and allows investors and lenders more clarity on project revenues than they would have with a pure merchant project (i.e., a position where the project owner will only be able to collect revenue based on electricity sold into the spot market). One of the benefits of the Synthetic PPA is that it provides some upside benefit to the provider of the Synthetic PPA, and with that additional value the cost of this hedge should be less than with another hedge that only provides a price floor.
While Synthetic PPAs might seem like a no-brainer, in practice, there are a limited number of potential willing hedging counter parties for Synthetic PPAs. Therefore, the cost reduction isn’t as significant compared to traditional hedges as the shared upside might suggest.
Synthetic PPAs should to be entered into with a healthy dose of caution because, on a spectrum of cash-flow certainty, with traditional PPAs on the far left side of the spectrum and pure merchant projects on the opposite end, Synthetic PPAs fall somewhere in the middle.
While Synthetic PPAs are not for the faint-at-heart, they are also not for participants in all power markets. Synthetic PPAs are limited to deregulated markets with liquid spot markets for the sale of power – i.e. the Electric Reliability Council of Texas (ERCOT), PJM Interconnection, Southwest Power Pool (SPP), New England Power Pool (NEPOOL), and the New York Independent System Operator (NYISO).