Aneesh Prabhu, S&P global ratings’ director, considers how shifting market dynamics are affecting hedging strategies and management.
American power generators are facing a changing operational landscape. Indeed, a raft of factors has contributed to prevailing market dislocation throughout the industry.
These are namely: the largest fuel switch in the industry’s history towards natural gas; less than expected demand growth; the proliferation of renewables; and the advent of disruptive technologies.
As a result, many U.S. power generators are adjusting their hedging strategies in an effort to reduce risk exposure.
However, this has led to a subsequent disconnect between generators’ hedging strategies and the market pricing of power commodities.
In turn, there has been a widening of the “bid-spread-ask” across the broader energy market landscape.
That is, the amount by which the ask-price exceeds the bid-price for energy commodities on the market has increased.
And with this being indicative of reduced liquidity in the market, concerns are rising.
A new breed of hedging products
Indeed – in response to growing market volatility – offtakers or hedging counterparties are becoming more reluctant to take on long-term contracts given backwardation (where prompt prices are higher than future) in power prices.
Instead, they are increasingly looking towards medium-term hedges in order to reduce exposure to price risk and weather the current state of market dislocation.
However, while shorter-term hedges can help, they are not akin to a silver bullet.
It is the effective management of these hedges – which relies on acute market insight – that is crucial to success.
A revenue put option is an example of such a mechanism. By setting a revenue floor for a predefined number of years (usually around 5), investors can be assured of certain guaranteed revenue.
This, in turn, helps power generators to secure up to 7-year financing from lenders, thereby reducing financial risk.
Crucially, however, both the fuel risk and the risk of power prices declining to the predetermined floor level remain with the generator.
Therefore it is essential that the revenue floor is set high enough to protect cash flow and cover fixed costs.
Panda Temple I power station in Texas, is a case-in-point where a revenue floor was set too low, leading to its default: a fatal case of mishedging.
Effective hedging is essential
Clearly, these new hedges can incur negative implications for credit risk – especially when compared to long-term options, such as tolling arrangements and purchase power agreements (PPAs) where long-term guarantees are generally easily met and so the pricing risk is usually low.
Of course, mishedging isn’t the only potential peril. Hedging too much, or using the wrong hedging instrument, can also have a detrimental effect for generating companies.
Ultimately, from a credit perspective, adopting the most appropriate hedging instrument hinges upon the availability options – and this requires a responsive market.
As such, for both diversified companies and independent power producers, listening to the markets will proffer the most accurate indication of future pricing.
Certainly, “knowledge speaks but wisdom listens”.
Aneesh Prabu is S&P’s global ratings’ director
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