Risky Business—How Power Contracts Allocate Uncertainty
Risk consists of exposure and uncertainty. Market participants operating in the energy industry are exposed to significant uncertainty ...
by Tanya Bodell, FTI Consulting
Risk consists of exposure and uncertainty. Market participants operating in the energy industry are exposed to significant uncertainty and, therefore, risk.
Exposure to such risks often changes with industry events. When one party is in a better position than another to absorb risk, a potential business relationship can ensue. Contracts define such business relationships, allocating rights, obligations and risks between parties. A selection of risks often allocated under power contracts is summarized below.
Demand Risk. Demand risk is exposure to uncertainty in power requirements. Given the long life, large capital costs and construction times associated with power plants, utilities must anticipate and plan for long-term load requirements. Independent power producers also must anticipate how those requirements will translate into prices to decide whether to build or buy. Overestimating capacity requirements can result in financial distress and potential bankruptcy; underestimating capacity requirements can lead to lost opportunity and increased price volatility, outages or both. Power purchase agreements implicitly allocate demand risk to the utility.
Quantity Risk. Quantity risk occurs when the amount of energy required to be hedged is uncertain. Variation in daily and hourly load obligations create quantity risk for utilities. Fixed-quantity contracts establish the amount to be purchased or sold under the contract, mitigating quantity risk for the seller. In contrast, all-requirements contracts allocate quantity risk to the seller.
Price Risk. Price risk is created by sensitivity to volatility in market prices for capacity and energy. Fixed-price contracts can mitigate uncertainty for both parties, although the mark-to-market value of the contract will vary according to the value of the underlying product (i.e., market risk). Merchant plants are exposed to price risk unless they hedge through fixed-price bilateral agreements or a contract for differences.
Operational Risk. Operational risk represents variability in outcomes associated with execution of business functions such as power plant outages and inoperability of other assets. Power contracts that set minimum delivery requirements and prioritize rights, specify outage rates or both allocate operational risk.
Curtailment Risk. Curtailment risk is exposure to operational constraints tied to dispatch decisions resulting from constrained transmission lines. Wind projects in western Texas and in the Pacific Northwest have been exposed to significant curtailment risk, suffering revenue losses because of lower energy production, fewer renewable energy credits and inability to maximize production tax credits. Sellers have attempted to shift such risk to the off-taker, negotiating to require the buyer to pay for the lost tax credit plus the curtailed energy that was not produced.
Compliance Risk. Compliance risk is the risk that a company can experience negative consequences from not complying with regulatory or legal requirements. Power contracts may mitigate compliance risk with respect to the Federal Energy Regulatory Commission, North American Electric Reliability Corp., accounting standards and other legal and regulatory requirements. Counterparties also may contractually agree to indemnify the other against potential repercussions of a violation.
Financial Risk. Consequences of financial risk include uncertain cash flow, variable interest rates and volatile returns on investment. An extreme outcome of financial risk is insolvency, bankruptcy or both. A contract may specify remedies in the event of default.
Credit Risk. Credit risk relates to changes to the financial ability to meet obligations. Contracts protect against credit risk by requiring maintenance of a minimum credit rating and recovery mechanisms in the event of default (e.g., collateral payments). A seller may require a municipality or electric cooperative to ensure sufficient rate recovery to cover contractual obligations.
Counterparty Risk. Counterparty risk is the uncertainty faced by each party to a contract regarding whether the counterparty will honor its contractual obligations. Contracts mitigate such risk through default provisions and termination rights.
Strategic Risk. Strategic risk derives from changes in the competitive environment because of new competitors, mergers, acquisitions or both, and entry into new markets. Counterparties to power contracts are facing increased strategic risk associated with uncertainty surrounding market fundamentals such as penetration of renewable resources, demand response, plant retirements and acquisition and divestiture activities.
Risk in a power contract is like water in a water balloon; shifting risk simply squeezes it to the other side. As the industry faces greater uncertainty, more water is being injected into the balloon, increasing total risk allocated under power contracts.
Re-examine your contracts and monitor changes to your exposure given industry events. Too much risk sent your way might end up bursting your balloon.
Tanya Bodell is a managing director at FTI Consulting and co-founder of the Electricity Consulting Group. Reach her at email@example.com.
“Risk comes from not knowing what you’re doing.”