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For wind, basis risk and demand gaps replace tax credit uncertainty as market matures

Withthe wind industry at ease on federal production tax credits, developers andfinanciers are now grappling with the same economic risks from power pricevolatility and slowing load growth that have long plagued fossil generators, a signthat the market has reached a new level of maturity.

In2015, a record numberof corporate power purchase agreements, or PPAs, were executed betweendevelopers and big names in technology, to include , , and That boon, driven inpart by uncertainty around extension of the federal production tax credits headinginto late 2015, was viewed as a transition point where prices spelled out inlong-term PPAs, typically between 15 and 20 years, presented an attractive andtidy fixed cost expense to those technology titans and introduced a new layerof demand into the wind market.

Butas corporate off-takers have become more familiar with regional energy markets,the long term PPA may now be presenting challenges that, in fact, pose morerisk than they initially sought to mitigate, namely in the form of basis risk.

Thatrisk, which is essentially the price differential between where a wind farmsends power into the grid and where that power is ultimately settled on at thetrading hub, has had an adverse effect on demand, panelists at the AmericanWind Energy Association Finance and Investment Conference 2016 said this week.

"Whatwe are having a bigger challenge with is that most of these PPAs come with alot of basis differential risk, and that is what we are beginning to worry a lotmore about," John Eber, managing director of energy investments at J.P.Morgan, said on Oct. 5. "In certain parts of the country where there isexcessive build, the difference between the hub and the node can besignificant."

Withtechnology companies staffing up their energy management personnel to morerigorously assess potential projects, and tax equity providers becoming moreaverse to basis risk overall, the effect could be one wherein the market from smallerbuyers with potentially less-than-investment-grade credit are precluded fromentering into PPAs in the near term, as major corporate buyers hash out detailsin hedging contracts.

"Oncethey start realizing they have a lot of risk in their books they cannot manage,and they are stuck with this risk for 10-15 years, that will slow down themarket, and we are seeing a major slowdown in that market," CitigroupEnergy Inc. Managing Director for structured products Roxana Popovici said Oct.6. "For small buyers that [risk] is going to be even more prevalent,because they cannot absorb losses as well as a Google or Microsoft can."

Somemarket participants, however, are optimistic that, so long as major corporatebuyers are patient, and development capital can be assembled in the low- tomid-teens returns, then proper hedging strategies will be developed forcorporate PPAs, similar to the five-year energy hedge used by merchantgenerators.

"Ithink there is a lot more innovation potential in the way things are hedged,particularly with basis products, because that is clearly a risk that peopleare concerned about," First Reserve Managing Director James Berner said Oct.6, referring to "revenue proxy swaps" offeredby a division of insurance company Allianz Group.

Butfor investments to make sense, both to project investors and corporate buyers,a move away from oversupplied regions, namely Texas, where wind dispatch has attimes weighed on hubprices, appears to be among the more likely prospects to buoyindustry growth.

Thatmakes wind a more likely candidate in the "replacement cycle" inmarkets such as PJMInterconnection LLC and the U.S. Southeast, where coal retirementsand weak gas prices challenge new build economics, Goldman Sachs ManagingDirector Brian Bolster said Oct. 5.

"Itwill get harder to build gas on an economic basis, setting aside regulation, sorenewables are going to be a big part of the replacement cycle that isoccurring because of age and the price of natural gas," Bolster observed.

Thesentiment was echoed by other bankers, who suggested that public marketsthrough yieldco vehicles could emerge as a chief source of capital to developwind projects, particularly as private funds appear to favor projects in late-stagedevelopment over greenfield projects.

"Largebaseload centralized power stations are not being built with great frequency,so this is the growth story for power generation, and the yieldcos are wellpositioned," J.P. Morgan Executive Director Neil Davids said Oct. 6."Whether they have one sponsor or multiple sponsors … I think the growthis there, it is the equity markets acceptance to eventually fund that growth."