With a lack of attractive solar power purchase agreements (PPAs) available in the market, project owners have been seeking alternative arrangements to secure long-term revenue certainty. One alternative is a fixed-volume hedge, which is available in deregulated power markets.
Under a physically settled fixed-volume hedge, the project company purchases a fixed volume of power at the “hub” for the then-prevailing market price, and delivers the power to the hedge provider for a fixed price. The price for the power and volume of power, or shape, to be delivered is agreed upon at execution of the transaction. The actual power the project generates and delivers to its node is sold separately at the then-prevailing nodal price. The project company uses the revenue it receives from the nodal sales to purchase the “hub” power delivered to the hedge provider.
Price and Risk Factors
Fixed-volume hedges also may be settled based on notional amounts of fixed and floating amounts. For the fixed amount, the fixed price is multiplied by the notional amount of power for the applicable hours. The floating amount is determined by multiplying the hub price and the notional amount for the applicable hours. If the fixed amount exceeds the floating amount, the hedge provider pays the project company an amount equal to the excess. When the floating amount exceeds the fixed amount, the project company pays the excess to the hedge provider.
With these transactions settled at the hub based on a fixed price and shape, the project company is exposed to price basis risk and volumetric, or shape, risk. Price basis risk arises when there is a mismatch between the nodal price the project company received and the hub price it paid. Shape risk occurs if the project is not producing power in a manner that matches the agreed-upon shape.
Some transactions rely on tracking accounts, ostensibly a working capital facility, to mitigate or defer risk. If the project company’s realized revenues (not just those related to the hedged volumes) in a given settlement period (usually monthly) are less than the project company had to pay out in that month, the hedge provider will advance the project company the shortfall, up to a cap. If the realized revenues exceed the amount the project company had to pay out, the excess is applied to reduce the tracking account balance, including interest. At the end of the term, the project company either pays any outstanding tracking account balance in a lump sum, or during an agreed-upon term (typically not more than 36 months). If the transaction does not have a tracking account, tax equity investors may seek price basis and shape risk mitigation in the tax equity transaction.
The collateral package for hedges usually includes letters of credit, cash, or a credit-worthy parent guarantee during the construction period. Upon achievement of commercial operations, solar project companies often grant the hedge provider a first priority lien on the project assets, and a pledge of the membership interests in the project company and the sponsor’s ownership in the tax equity partnership (a “Class B” membership interest).
First-lien solar transactions raise financing issues for the tax equity investors and back-leverage lenders. To monetize the investment tax credit (ITC) and avoid recapture of the ITC, among other things, the original tax owner must place the project in service for federal tax purposes and remain the owner for at least five years. If the hedge provider foreclosed on the project assets or project company membership interests prior to the end of the 5-year recapture period, all or a portion of the ITC would be recaptured.
One solution to avoid recapture has been to have the hedge provider and tax equity investor execute a forbearance agreement. The hedge provider can then foreclose on the Class B membership interests, but not the project assets or membership interests unless specified events occur during the recapture period. With the forbearance, tax equity investors guard against recapture, and the hedge provider may still gain operational control of the asset by foreclosing on the Class B membership interests.
Back-leverage lenders have a further concern because their main collateral is the equity above the Class B member. The lenders do not want the hedge provider to foreclose and eliminate their collateral and source of repayment, and will seek cure rights to avoid foreclosures.
Sponsors may choose to forgo the lien collateral package and leave the construction period collateral in place for the transaction’s term, but this also has financing challenges. For instance, the hedge provider may require credit downgrade protection with the right to terminate the transaction if, for example, the guarantor is not replaced. Tax equity investors will require additional structural protections to mitigate the risk of termination.
It’s likely the use of the fixed-volume hedge will grow as the amount of attractive PPAs remains low, and corporate credits are an unknown in the ongoing pandemic. The hedge market will continue to evolve beyond the fixed-volume transaction. Parties are employing other novel products using puts, calls, swaps, and collars to mitigate price and/or volume risk, as well as mixing asset classes such as solar and battery storage, and solar and wind. ■
—John Leonti is a partner at Troutman Pepper and leader of the firm’s Capital Projects and Infrastructure Practice. Xuan Li is an associate with the firm’s Capital Projects and Infrastructure Practice.