Last month, we touched on basis risk as an advantage for solar compared to other energy technologies Although basis risk needs to be addressed, and is a natural starting point, we find other potential risks are often overlooked by host customers and developers.
If basis risk is new to your vernacular, it might be helpful to know that it’s a term borrowed from the hedging world where a hedge contract and commodity price don’t move in sync. It’s used in the energy space to refer to the long-term energy price differences between generation and demand, and within the renewable energy space to refer to nodal risk and congestion issues. Fundamentally, it means that over time, the price that the customer is paying for energy does not move together with the price that the offsite project is receiving from the grid. As those prices move away from each other, the hedge becomes “dirtier” or unconnected from the underlying price exposure (utility prices in this case).
Corporations are procuring energy from offsite solar on the scale of 800MW in 2016, and basis risk is the first and most obvious risk identified. However, there are other risks that customers need to address before entering these transactions, and developers should be highlighting these up front in order to work with customers to mitigate them as effectively as possible.
1. Merchant Risk
Merchant risk is the inherent risk that a customer is taking on when entering into one of these contracts. It is the floating side of a fixed-for-floating swap. By entering into this contract, the customer is exposed to the merchant energy market. It is the obligation of developers and financiers to ensure projects are at or near the current merchant costs so as to minimize the potential downside risk faced by customers. While merchant risk is inherent in the transaction, setting up the fixed-for-floating swap is an effective long-term hedge for other merchant exposure. It is important to sell the hedge aspect of merchant risk when concerns of long-term price exposure enter the conversation.
2. Negative Pricing Event Risk
Energy assets may encounter negative pricing in the market, and this market may impact a corporation’s contract for differences (CFD). A negative price signal in the electricity markets occurs when there is sufficient generation (supply) on the electrical grid, and the independent grid operators “signal” to energy producers to reduce their output by charging them for producing energy (instead of paying them). It is usually represented as negative locational marginal price, and is designed to disincentive additional energy production. When supply is high and demand is low, spot prices generally fall. This is even more common in markets with a significant amount of renewable energy and other production sources that can’t be shut down and restarted in a quick and cost-efficient manner to balance supply to the grid.
This is less often the case with solar than with wind, which is incentivized to produce even with negative energy pricing. Wind farms also tend to be concentrated in specific regions (ie. West Texas), that will run a negative price in response. It is important to highlight non-settlement terms like this that solar can offer as a benefit over wind assets.
3. Delivery or Execution Risk:
Like any project, onsite or offsite, a customer is often banking on the developer completing their project. Yet, the developer faces delivery risks every step of the way. To mitigate these risks, we recommend utilizing an assurance or surety as a guarantor to protect the customer against losses resulting from failure to fulfill project execution.
Experienced developers know and preempt many of the potential risks before they arise. In any case, it is important to be up front with customers about the risks and communicate clearly about how they can and will be resolved during the development process.
This is an excerpt from the December 2016 edition of The SOL SOURCE, a monthly electronic newsletter analyzing the latest trends in renewable energy based on our unique position in the solar financing space. To view the full Journal, please subscribe or e-mail email@example.com.
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