With a lack of traditional utility power purchase agreements available to meet demand, wind project sponsors have turned to corporate power purchase agreements (PPA) and other hedging alternatives to secure predictable cash flows. Depending on the structure, these agreements can lead to derivative accounting, trigger Dodd-Frank reporting requirements, or both. The following discusses what each of these agreements represent and the associated derivative accounting and Dodd-Frank implications.
What is a PPA?
A PPA generally refers to a contract between two parties where one party (seller) agrees to sell electricity and renewable energy credits (REC) to another party (buyer or offtaker) at a specified price. In this case, the seller is often the developer or project owner. The buyer is generally a utility or commercial and industrial (C&I) organization. With a physical PPA, the seller operates the wind farm and delivers the electricity generated from the wind farm to the buyer at the contractually specified delivery point.
Accounting Considerations: These contracts may or may not meet the definition of a derivative depending on whether the agreement includes volumetric guarantees or contains default provisions that indicate a minimum volume. If the contract meets the definition of a derivative, it may still be able to escape derivative accounting via the normal purchases and normal sales (NPNS) scope exception since the contract results in physical delivery.
Dodd-Frank Reporting Considerations: A physical PPA is not subject to Dodd-Frank reporting requirements as the contract results in physical delivery of electricity.
What is a VPPA?
A synthetic or virtual power purchase agreement (VPPA) is an alternative to a physical PPA. A VPPA is a hybrid agreement which includes a contract for differences (CFD) along with an agreement to deliver the related RECs from the project. Under a VPPA, there is no physical delivery of electricity. Rather, the agreement specifies a periodic payment to be made based on the difference between an agreed upon fixed price and a floating market price, generally at a market hub or a project node. Upon settlement, when the market price exceeds the fixed price, the seller pays an amount to the buyer equal to the difference times the agreed upon quantity. When the opposite is true and the market price is below the fixed price, the buyer pays an amount to the seller equal to the difference times the quantity.
Physical PPAs are most commonly used by organizations that have heavy, concentrated load (e.g., data centers, utilities, etc.). For companies without heavy, concentrated load, VPPAs work well, as they do not involve physical delivery of the electricity. Accordingly, VPPAs have become quite common for corporate buyers who have turned to wind energy, not only to meet their sustainability goals, but also to provide long-term electricity cost certainty.
Accounting Considerations: These contracts may or may not meet the definition of a derivative depending on whether the agreement includes volumetric guarantees or default provisions that indicate a minimum volume. A VPPA will not qualify for the NPNS scope exception as these contracts do not result in physical delivery.
Dodd-Frank Reporting Considerations: Although the regulatory requirements for VPPAs are still being formed, the prevailing view is that these contracts are “swap” agreement and thus trigger Dodd-Frank reporting requirements.
What is a Hedge?
While VPPAs are growing in popularity, there is still a lack of long-term offtakers that want to sign a PPA to meet the growing demand of wind capacity. This is where several large financial institutions have stepped in to fill the void with hedging agreements. With over 20 GW of wind capacity, Texas has been the epicenter of the hedge phenomenon. Texas’ independent system operator, Electric Reliability Council of Texas (ERCOT), has a deep and liquid spot market that provides the price transparency needed to structure workable hedges.
In ERCOT, a typical hedging arrangement is a fixed-volume price swap. With a fixed-volume price swap, the hedge provider generally receives physical delivery of a fixed volume of electricity at the market hub and pays a fixed price for this electricity.
Accounting Considerations: A fixed-volume price swap generally meets the definition of a derivative and does not qualify for the NPNS scope exception. Stakeholders generally require hedge accounting to minimize earnings volatility from the default mark-to-market derivative accounting.
Dodd-Frank Reporting Considerations: Dodd-Frank reporting requirements, if any, are generally handled by the hedge provider.
The default accounting for a derivative is to record the fair value of the derivative on the balance sheet at each reporting date. Changes in fair value of the derivative are recognized in earnings as the changes occur. PPAs often have terms extending 10 to 30 years. Determining the fair value of these contracts is challenging, and the change in fair value is a significant source of earnings volatility.
US GAAP defines a derivative as a financial instrument or other contract with all the following characteristics:
PPAs generally contain three of the four characteristics noted above. The accounting analysis and conclusion typically hinges on whether the contract contains a notional amount. In performing this assessment, it is important to look for terms that specify a minimum volume of generation or other default terms that point to a minimum volume.
It is also important to highlight that this is a judgmental area of accounting. What seems to be a straightforward for some Big-4 auditors has been met with opposition from other Big-4 auditors. Accordingly, many companies complete the accounting assessments and receive their auditors’ stamp of approval prior to execution.
NPNS Scope Exception
ASC 815 provides an elective exception to the application of fair value accounting for physically settled derivative contracts that meet the definition of normal purchases and normal sales. If a company has entered into a physically settled commodity contract that meets the definition of a derivative, it may seek to apply this exception to avoid derivative accounting and related disclosures. Below is a high-level summary of the key elements necessary to qualify for the NPNS scope exception:
- The contract must involve quantities that are expected to be used or sold by the reporting entity in the normal course of business.
- The contract pricing must be clearly and closely related to the asset being purchased or sold.
- It must be probable that the contract will gross physically settle throughout the term of the contract (no net cash settlement).
- The election and the information on the basis for the reporting entity’s conclusions that the contract qualifies for the scope exception must be documented.
- The contract must be a forward contract without volumetric optionality or be considered a “capacity contract.”
Once the election is made to apply the NPNS scope exception, it is irrevocable.
Many stakeholders require the election of hedge accounting for PPAs that meet the definition of a derivative and do not qualify for the NPNS scope exception. Hedge accounting is special accounting treatment which can help dampen the earning volatility driven by the default derivative accounting rules. It allows the effective portion of changes in fair value to flow through equity rather than earnings. Hedge accounting treatment is a privilege and not a right. Accordingly, to qualify, the hedge relationship must meet criteria relating both to the derivative instrument and the hedged item. The requirements to achieve and maintain a hedge relationship can be summarized by the following provisions: documentation, assessments of hedge effectiveness, and ineffectiveness measurement.
Documentation: It is critical that the company formally designates and documents the hedge relationship at its inception to qualify for hedge accounting. The process should include determining how to define the risk being hedged and if any elements of the derivative should be excluded from the assessment of hedge effectiveness. A well-written hedge document will maximize hedge effectiveness and minimize the amount of income statement volatility. Documentation should include:
- Date and type of hedge designation
- Risk management strategy and objective
- Nature of the hedged risk
- Hedging instrument identified
- Hedged item defined
- Effectiveness assessments and ineffectiveness measurement methods
Effectiveness Assessment Tests: Companies must perform prospective and retrospective effectiveness assessment tests to prove that a hedging relationship is “highly effective,” and it will continue to be “highly effective.” These assessments must be performed at the inception of the hedge and, at a minimum, at each quarterly reporting period until the hedging relationship is terminated.
Ineffectiveness Measurements: Hedge ineffectiveness is the amount by which the change in fair value of the derivative does not exactly offset the change in fair value of the hedged item. Potential sources of ineffectiveness include location basis differences and timing differences.
Enacted in 2010, Dodd-Frank regulates parties transacting in derivatives and contains various requirements for “swap” transactions. A transaction involving cash settlement based upon the movement of a floating price is considered a swap subject to the Commodity Futures Trading Commission’s (CFTC) Dodd-Frank rules. Accordingly, VPPAs and financial hedges are subject to Dodd-Frank reporting requirements.
The parties to a swap transaction are required to report various information at the execution of the contract and on an ongoing basis to a swap data repository (SDR). One counterparty to the swap transaction is designated the reporting party. The reporting party is responsible for the initial and ongoing reporting. Regulators have established a framework for determining which party is responsible for reporting, including the ongoing updates to the underlying data of the transaction. The hierarchy is as follows:
- Swap Dealer (SD)
- Major Swap Participant (MSP)
In the hierarchy above, SDs outrank MSPs, who outrank non-SD/MSP counterparties. When both counterparties are at the same hierarchical level, regulation calls for them to select the counterparty obligated to report. VPPAs are often between a project owner and a corporation. In this case, generally both entities are considered non-SD/MSPs. Accordingly, the VPPA generally specifies the reporting entity.
The reporting obligation is generally assigned to the seller. Some generators are intimately familiar with these Dodd-Frank reporting requirements while others are not and seek outside consultation to assist with compliance. Either way, the reporting requirements are burdensome to the reporting entity, primarily due to the requirement to report quarterly valuation data.
Developers and project owners should carefully consider the accounting and Dodd-Frank reporting challenges when negotiating PPAs.
Lead image credit: CC0 Creative Commons | Pixabay