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Study: Gas futures can help with wind revenue risk

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Study: Gas futures can help with wind revenue risk

Natural gas futures contracts can serve as a hedge for wind generation revenue risk over mid- to long-term horizons, a new study issued by The Brattle Group said, but industry observers differ about the novelty and usefulness of this approach.

As weather-dependent renewable generation has proliferated across the U.S., more states have met or exceeded their renewable portfolio standards, the report states. "Accordingly, there is increasing interest in developing renewables as merchant assets not secured under a long-term [power purchase agreement] for their energy or renewable energy credits," Brattle said in a news release issued Jan. 20.

Asked how the model for renewable generation might evolve under the new Trump administration, Frank Felder, director of the Rutgers University Center for Energy, Economic and Environmental Policy, said "state policy, not federal policies," has driven much of wind generation's development over the years, through renewable portfolio standards.

"That being said, any remaining federal tax credits for wind may be less likely to continue given the new administration and the Republican-controlled Congress," Felder said in an email Jan. 23.

Merchant wind projects face "substantial market risk due to price fluctuations, which could impact developers' ability to fulfill debt obligations and the level of investment returns," according to the Brattle study, prepared by C. Onur Aydin, Frank Graves and Bente Villadsen. "Price risk may also affect willingness, size, or timing of market entry."

Ayden is a Brattle senior associate, while Graves and Villadsen are Brattle principals.

Standardized forwards 'more cost-effective'

Some market participants have established customized bilateral hedging arrangements, called "synthetic PPAs," the Brattle study said, but these "can be offered at prices with heavy discounts compared to forward prices, which can be detrimental to the value captured by developers."

Therefore, the study discusses how one might use standardized forward contracts as "a more cost-effective way to manage market risk and achieve the level of revenue certainty needed."

The researchers explored the relationship between spot and forward electricity prices, but found that "the uncertainty in the total amount and timing of wind output creates a forecasting problem with some degree of irreducible volume risk," which means that "this hedge would intrinsically be imperfect."

The researchers then evaluated how natural gas swap contracts might be used as a hedging strategy for wind resource spot revenues over longer time horizons, which must take into account market heat rates, which cannot be reliably observed in the forward markets "due to limited trading," which means they must be forecast.

However, such a forecast is "a tractable and familiar exercise that can be conducted with historical market data or with a structure model of projected prices," the study states.

"Overall, we show that gas-based hedging, with dynamic adjustments over time, can be effective as a wind value hedge," the study states.

The study uses power prices data for the ERCOT North Hub and spot power prices at the Henry Hub in its modeling, where "average real-time LMPs and spot Henry Hub gas prices have often moved together over the past five years."

'Nothing new' in Brattle study: consultant

Jim Carson, principal of RisQuant Energy, an energy market consultancy based in St. Paul, Minn., said he sees "nothing new" in The Brattle Group study.

"I've been recommending these approaches for over a decade for a wide variety of generation resources, including wind," Carson said in an email Jan. 23. "However, the use of natgas futures contracts for hedging power exposure requires considerable continuing analysis and understanding."

In particular, a market participant needs to know the relevant heat rate for a wind farm's output.

"That is the delta and is not easily found, and it is not constant," Carson said. "It is different from month to month and changes in response to market conditions."

Also, a market participant needs to understand when such hedges work and when they fail, Carson said.

"Generally speaking, hedging practices for non-PPA output has been astoundingly poor," Carson said. "There is a pervasive, but wrong, perception that wind output can't be effectively hedged. Forward price risk is tractable, while delivery period risk remains vexing."

Eric Smith, associate director of the Tulane Energy Institute, said the concept of using derivative markets to hedge exposure is well-established.

"However, the authors seem to break new ground when it comes to the relative duration of their proposed contracts," Smith said in an email Jan. 23. "By extending the life, they hope to smooth out the intermittent nature of wind and solar power generation."

Mark Watson is a reporter for S&P Global Platts which, like S&P Global Market Intelligence, is owned by S&P Global Inc.