MILAN -- As wind power's share of electricity generation has increased, so have the financial consequences of risks associated with its inherently high variability - risks which don't just affect wind power producers but reverberate vertically through the value chain and horizontally to affect a range of electricity market players. Large utilities can manage risk with a combination of all three basic risk management strategies: limiting exposure to specific energy sources, diversifying, and engaging in extensive trading activities to hedge several types of risks across their operations.
But what options are available specifically for hedging risk from wind variability, i.e. weather-related 'volume' risk? How much risk can realistically be hedged through financial risk transfer mechanisms? What instruments are used? Which counterparties perceive rewards in shouldering this risk?
A Lack of Awareness
Wind power now accounts for a high proportion of generation capacity in many regions. For example, in the Texan transmission region managed by ERCOT (85 percent of Texas' load), wind's share of the 84 GW electricity generation capacity is 13 percent. Wind accounted for 17 percent of Germany's 167.8 GW of installed generation capacity in 2011 - but only 8 percent of total power generation (579.3 TWh).
A 2011 survey by the Economist Intelligence Unit and Swiss Re estimates that though 60 percent and 48 percent of respondents used insurance and financial derivatives to manage financial risk within the renewable energy sector, only 4 percent of wind power-focused respondents bought insurance to protect against volume risk. Yet 18 percent of wind sector survey respondents described volume risk as a “high” risk (in contrast to 7 percent of respondents from the solar sector) and 47 percent described it as a “medium” risk. Lack of awareness of weather-based hedging instruments was cited as one of the top three barriers to effective risk management with only 1 percent of all respondents using derivatives to manage volume risk.
CelsiusPro AG, a Zurich-based originator of over-the-counter (OTC) weather derivatives, offers Low Wind Day and Low Wind Season certificates in addition to products for temperature, rain, snow and solar radiation. Founder and CEO Mark Rueegg says that wind hasn't been a significant growth sector. “Wind is the only production factor for a wind power company,” he says laconically, “so I'm a bit puzzled as to why there hasn't been more of an uptake.” While these certificates, which offer a payout in the event of below average wind speeds, have found a handful of customers in Northern Europe, unlikely candidates such as crane or ski-lift operators have instead expressed interest in protection against high wind.
Wind speed variability has many financial consequences. Low wind speeds reduce generation and revenues for wind power generators and may adversely affect the ability to meet debt payments, creating credit risks for the financier. In the U.S., with incentives like the Production Tax Credit (a federal tax incentive of US2.2 cents/kWh of electricity produced, recently renewed until the end of 2013) and Renewable Energy Credits, reduced production reduces revenue.
Conversely, excessively high wind speeds may temporarily halt generation or delay wind farm construction. Long periods of high wind speeds increase costs for baseload generators, for example, when they coincide with off-peak demand or, as recently happened in Germany, when reserve power plants had to be activated to stabilize the grid. When wind has priority access to the grid, thermal power plants have to balance generation regardless of whether wind is above or below forecasted levels. Wind speed variability may also compound price risk for other market players through its influence on wholesale electricity market clearing prices in competitive day-ahead and intraday markets. In some U.S. regions, wind generators sometimes bid zero or negative power prices in wholesale power markets to ensure electricity dispatch.
The Strategies: Derivatives and (Re)insurance
Hedging solutions for wind volume risk can be executed in either derivative or (re)insurance formats; the underlying mechanism is similar. Derivatives (options, swaps, futures) derive value from underlying assets. With wind derivatives, the “underlying” used in pricing and structuring, is often an index which models a wind farm's output based on turbine power curves and historical wind speed data. Contracts pay out if wind speed is above or below a pre-specified trigger or strike. Index guarantees can be structured as put or call options which protect against unexpected outcomes.
Puts pay out if the wind index falls below the agreed strike, whereas a call structure might be used during construction to mitigate risks from high winds that halt construction. In this case calls pay out if the wind speed exceeds the strike value. With index exchange products such as swaps and collars, either party could pay the other depending on the direction in which the index moves. In swaps, any move away from the strike requires a payout from one party to the other, depending on the direction. A collar is a form of a swap with a low and high strike at either end of a range in which no payments are made. It could be used to limit the downside risk at little or no cost, in exchange for loss of the upside.
Lars Deckert, managing partner at 4initia GmbH, which provides consulting and asset management services on all aspects of wind project development (including risk management and derivative structuring) explains that currently, wind derivatives are most likely to be structured as puts, in that they pay out if wind speed drops below a certain level. “With swaps, counterparty risk is too high given that wind farms are usually non-recourse financed with a limited amount of equity,” he adds.
CelsiusPro's certificates are indexed to wind data from a weather station of the buyer's choice. However, Rueegg speculates that potential clients may be deterred by the basis risk that actual wind speed at the generation site varies from the speed as measured at the met station, thereby affecting the potential payout.
The alternative is a customized product. 4initia is currently involved in structuring its first derivative deal for a client and hopes to make an announcement within a few months. Deckert says, “We're looking for way to make the product more durable for investors, i.e. reducing or even taking away the basis risk. Currently the market is for bespoke or highly customized products since there are so many input factors specific to a wind micro-site.”
Pricing and Structuring
While the underlying logic is simple, the devil is in the details when it comes to pricing and structuring the derivative: identifying the strike, the payout, maximum limit, the calculation period, and so forth. Reducing basis risk requires site-specific long-term wind data - which isn't usually available. Derivative pricing is all about the price volatility of the underlying assets: standard option pricing models make several simplifying assumptions about expected volatility like that of geometric Brownian motion.
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