For many years, the recipe for a successful and bankable investment in the power generation space called for one main ingredient; the long-term Power Purchase Agreement (PPA). The PPA was, and still is in many cases, the primary factor determining the bankability and feasibility of a project. However, in most of the deregulated US power markets, long-term fixed price PPAs, with double-digit returns, are a thing of the past. Most investors are facing some amount of exposure to the power spot markets – which really requires a change of mentality and risk profile.
Given the capital expenses required for most investments in the power sector, infrastructure funds deploying pension or insurance money have always played a major role in the development of power plants. By nature, these funds are looking to deploy large amounts of money, often hundreds of millions of dollars, per investment and are looking for low-risk bond-like returns. Traditionally, long-term agreements such as PPAs or tolling agreements (an agreement where an asset owner gets paid to convert fuel to electricity) have provided investors very predictable returns on power assets.
The current market is awash in capital chasing these types of projects. New players, such as the YieldCos (with very low cost of capital), and overseas funds, have joined the traditional US players in the hunt for contracted assets. On the other hand, the number of attractive PPAs is declining related to slow load growth and protracted low commodity prices, which eliminate any incentive for load serving entities to sign long-term, above-market contracts.
So what are some of the options for the infrastructure players looking to deploy their hundreds of millions – or billions – of dollars in the power generation space? One solution, we advocate, is taking on some amount of merchant risk – while closely monitoring and managing these risks. For many funds this poses a challenge both on the valuation side, on structuring hedges or other contracts to mitigate some of the risk, as well as on the asset management and risk management side.
Over many years, InventivEnergy has developed a proprietary spread option model for the market valuation of a given asset. We recognize that power plant assets can be decomposed into a portfolio of daily spread options between fuel and power. Our spread option model basically infuses financial option pricing techniques onto physical assets and therefore offers more insightful valuation fundamentals and hedging methods, as compared to the many “dispatch model” or “black box” methods employed by others. By taking into consideration multiple factors at the local node – ranging from congestion over fuel mix to environmental regulation – we base our valuation of a given asset on regional pricing levels and differentials for power and fuels. Our model also considers volatility in the markets as well the correlation between e.g. natural gas and power. Taking into consideration all the local dynamics for the given asset, and our view on potential opportunities for optimization of the asset, we develop assumptions for a valuation base case, within a band of a low and high case, which we are 95% confident is an accurate indication of the present value of the asset.
Once an owner decides to acquire an asset with some level of market exposure, an inherent advantage of our valuation model, is its importance in negotiating hedges in liquid markets for the shares of the output that are not contracted. Indeed, the model will indicate at what price and at which volumes it is advisable to hedge the merchant output.
Combining hedges with e.g. PPAs on a plant is not the same as having a fully contracted asset – far from it. In order to achieve pro forma returns, owners must manage assets proactively, with an increased focus on energy and risk management. Here again, the spread option model’s usefulness cannot be understated, as it also allows for a constant monitoring of value-at-risk and portfolio mark-to-market. Managing merchant assets requires significant rigor on behalf of the owners/managers. We often recommend to our clients that they set up risk committees with very well defined policies and procedures. Simply put, we recommend defining a “box” within which risk and exposure are acceptable, and once an asset trends toward the edges of the box, this should immediately be brought to management’s attention in order to evaluate the best course of action.
Going from managing plants with PPAs to plants with hedges or selling power into the spot markets, really is a transformation from managing contracts to managing energy and risk. This transition represents a paradigm-shift on how an organization manages its power assets, but if carried out right and managed well, this transition will allow further deployment of funds in the power generation space and potentially higher returns, at risk levels commensurate with the PPAs of the past.
John R. Keller is CEO and Founder of InventivEnergy, LLC.
Opinion: The Move From Contracted Assets to Managing Merchant Risk – Are You Ready to Capture the Upside?
By John R. Keller on May 08, 2015 at 4:00 PMFor many years, the recipe for a successful and bankable investment in the power generation space called for one main ingredient; the long-term Power Purchase Agreement (PPA). The PPA was, and still is in many cases, the primary factor determining the bankability and feasibility of a project. However, in most of the deregulated US power markets, long-term fixed price PPAs, with double-digit returns, are a thing of the past. Most investors are facing some amount of exposure to the power spot markets – which really requires a change of mentality and risk profile.
Given the capital expenses required for most investments in the power sector, infrastructure funds deploying pension or insurance money have always played a major role in the development of power plants. By nature, these funds are looking to deploy large amounts of money, often hundreds of millions of dollars, per investment and are looking for low-risk bond-like returns. Traditionally, long-term agreements such as PPAs or tolling agreements (an agreement where an asset owner gets paid to convert fuel to electricity) have provided investors very predictable returns on power assets.
The current market is awash in capital chasing these types of projects. New players, such as the YieldCos (with very low cost of capital), and overseas funds, have joined the traditional US players in the hunt for contracted assets. On the other hand, the number of attractive PPAs is declining related to slow load growth and protracted low commodity prices, which eliminate any incentive for load serving entities to sign long-term, above-market contracts.
So what are some of the options for the infrastructure players looking to deploy their hundreds of millions – or billions – of dollars in the power generation space? One solution, we advocate, is taking on some amount of merchant risk – while closely monitoring and managing these risks. For many funds this poses a challenge both on the valuation side, on structuring hedges or other contracts to mitigate some of the risk, as well as on the asset management and risk management side.
Over many years, InventivEnergy has developed a proprietary spread option model for the market valuation of a given asset. We recognize that power plant assets can be decomposed into a portfolio of daily spread options between fuel and power. Our spread option model basically infuses financial option pricing techniques onto physical assets and therefore offers more insightful valuation fundamentals and hedging methods, as compared to the many “dispatch model” or “black box” methods employed by others. By taking into consideration multiple factors at the local node – ranging from congestion over fuel mix to environmental regulation – we base our valuation of a given asset on regional pricing levels and differentials for power and fuels. Our model also considers volatility in the markets as well the correlation between e.g. natural gas and power. Taking into consideration all the local dynamics for the given asset, and our view on potential opportunities for optimization of the asset, we develop assumptions for a valuation base case, within a band of a low and high case, which we are 95% confident is an accurate indication of the present value of the asset.
Once an owner decides to acquire an asset with some level of market exposure, an inherent advantage of our valuation model, is its importance in negotiating hedges in liquid markets for the shares of the output that are not contracted. Indeed, the model will indicate at what price and at which volumes it is advisable to hedge the merchant output.
Combining hedges with e.g. PPAs on a plant is not the same as having a fully contracted asset – far from it. In order to achieve pro forma returns, owners must manage assets proactively, with an increased focus on energy and risk management. Here again, the spread option model’s usefulness cannot be understated, as it also allows for a constant monitoring of value-at-risk and portfolio mark-to-market. Managing merchant assets requires significant rigor on behalf of the owners/managers. We often recommend to our clients that they set up risk committees with very well defined policies and procedures. Simply put, we recommend defining a “box” within which risk and exposure are acceptable, and once an asset trends toward the edges of the box, this should immediately be brought to management’s attention in order to evaluate the best course of action.
Going from managing plants with PPAs to plants with hedges or selling power into the spot markets, really is a transformation from managing contracts to managing energy and risk. This transition represents a paradigm-shift on how an organization manages its power assets, but if carried out right and managed well, this transition will allow further deployment of funds in the power generation space and potentially higher returns, at risk levels commensurate with the PPAs of the past.
John R. Keller is CEO and Founder of InventivEnergy, LLC.
Topics: Comment, Hedging, Hedging Strategy, Power Purchase Agreement, PPA, Risk Management