Chapter 17 Use of Lien-Supported Financial Derivatives
B. Case Study Example of a Lien-Supported
This section discusses an example of how lien-supported financial derivatives can work in project finance, using the hypothetical project participants referenced above.
This example involves a project financing where the project company seeks a lien- supported financial derivative in the form of a commodity swap for the development and construction of a wind farm (i.e., multiple wind turbines located at a strategic site known for its plentiful wind resource, each of which generates electricity using the available wind resource to rotate propeller blades attached to a turbine and a generator that produces electric energy).
While the example is based on a hypothetical project development of a wind farm, lien-supported financial derivatives can be used to support project financing for any type of energy project. In fact, some of the more common lien-supported financial derivatives in project financing are interest rate swaps and fuel (e.g., natural gas)
LIEN-SUPPORTED FINANCIAL DERIVATIVES
commodity price swaps. As renewable energy projects grow in number and capacity, the use of lien-based financial derivatives for project financing of energy projects could become as common as the use of oil and gas commodity price swaps to support financing of oil and natural gas drilling programs.
1. Critical Wind Farm Technical Background At most geographic sites where a wind farm is to be developed, the wind farm is only able to generate electricity on an
“intermittent” basis, because of the intermittent availability of the wind resource it relies on as the input for its generation of electric energy. If there is no wind, then the wind farm produces no electricity. Each wind turbine will typically have the capacity (i.e., potential ability) to generate 2.0 megawatts (MW) of electricity (some higher and some lower), but the output of each wind turbine at any moment, and therefore the ability to produce its full capacity, will also depend on how strong the wind is blowing at that moment.
In addition, wind typically blows strongest after sunset, which coincides with off- peak hours (hours during which the demand for the consumption of electricity is lower). Wholesale electricity prices are much higher during on-peak hours (hours during which the demand for the consumption of electricity is higher) than the off-peak hours.
Prior to construction of a wind farm, the project company will conduct numerous studies of the wind resource at that proposed geographic site to measure the available wind resource and determine the likely levels of electric energy output to be generated by the proposed wind farm at different times of the day and different times of the year.
Wind farms also differ from fossil-fuel-fired electric generation sources in several regards that are relevant to the use of financial derivatives.
First, a fossil-fuel-fired electric generation facility can be dispatched (turned on and caused to generate electric energy) whenever consumers demand additional electricity.
As a result, the operator of a fossil-fuel-fired power plant can choose to operate the facility when the market price for electric energy is equal to or higher than the price necessary to achieve profitable operations, thereby maximizing the profitability of that fossil-fuel-fired power plant.
In contrast, a wind farm can only wait for the wind to blow and must take the price that happens to be available in the marketplace when the wind resource is blowing and capable of generating electric energy, no matter how low the demand may be among consumers at that moment and, concomitantly, no matter how low the market price for electric energy may be at that moment.
The availability of the wind resource is offset by the fact that the wind energy resource, or input, utilized by a wind farm is cost free and environmentally beneficial.
Second, a 100 MW fossil-fuel-fired power plant, which purchases natural gas or another fossil fuel at prevailing market prices as the fuel to generate electricity and sells electricity at prevailing market prices, will be affected by changes in the market price for that fuel if the relationship of fuel prices to electric energy prices (referred to as
“spark spread”) is not preserved. For example, if the market price of purchasing natural gas input increases, while the market price for sales of electric energy output remains the same or decreases, then there is significant risk that the electric energy sales prices
will not produce sufficient revenues to pay the project company’s cost of purchasing the natural gas required to generate the electric energy sold in the marketplace.
This spark spread risk is a significant risk that any fossil-fuel-fired power plant must manage by utilizing such risk-management tools as tolling agreements (in which the electricity purchaser supplies the fuel required to produce the electricity being pur- chased), long-term power sales agreements with power pricing that tracks the market price for the fuel, or a combination of long-term fuel sales agreements and power sales agreements with prices that preserve a financially viable spark spread. Alternatively, the owner of a fossil-fuel-fired power plant may use one or more commodity swap transactions to manage its spark spread volatility. Fortunately, the project company does not have to address the spark spread risk for its wind farm.
Accordingly, in this wind farm example, only the energy output commodity will be hedged with a financial derivative, but the intermittent nature of the wind-resource input must be addressed in designing an appropriate output-related commodity hedge transaction.
2. Hypothetical Wind Farm Project Facts The example is based on the following assumed facts:
• A large energy corporation, Electric Future, Inc. (Project Developer), has formed a subsidiary, Windy Hill, LLC (Project Company), as a special purpose entity, to develop a wind farm with an installed capacity of 100 MW.
• Project Company is negotiating a loan agreement with Private Bank, Inc. (Lender) to provide construction financing, convertible to permanent financing upon comple- tion of construction and commencement of commercial operations (COD), for the debt portion of the project capitalization with an expected repayment term of ten years.
• Project Company will provide to Lender a first priority lien on all its assets as col- lateral to support its obligation to repay the loan, including: (1) a security interest in the wind farm and all of Project Company’s personal property, including any bank accounts or accounts receivable; (2) a mortgage on the site on which the wind farm will be located; and (3) a collateral assignment of all third-party contracts entered into by Project Company, including the EPC Contract (defined below), any agree- ments for the physical sale of the energy output, renewable energy credits, or other environmental attributes of the wind farm, and any financial derivatives transactions entered into by Project Company.
• Project Developer will contribute the equity portion of the capitalization of the wind farm and will provide to Lender a pledge of all of Project Developer’s ownership interests in the Project Company, which will include all of the related governmental permits and authorizations which will have been issued in the name of the Project Company.
• Project Company is negotiating an engineering, procurement, and construction contract (EPC Contract) with a third party to engineer, procure, and install the wind turbines, towers, and related equipment to be executed simultaneously with its execution of the loan agreement.
LIEN-SUPPORTED FINANCIAL DERIVATIVES
• Project Company does not presently have a long-term power sales agreement for the sale of the electric energy output of the wind farm and will instead be selling its energy output in the available short-term market for electric energy (i.e., the wind farm is a merchant power plant selling its output at prevailing market prices).
• Project Company is negotiating a swap transaction with Big Energy Trader, Inc., (Swap Provider) to be executed prior to its execution of the loan agreement with Lender, in order to manage the risk of price volatility in the available short-term markets for electric energy.
• Project Company will provide a letter of credit to Swap Provider as collateral to sup- port Project Company’s payment obligations under the swap transaction, to be deliv- ered to Swap Provider upon execution of the swap transaction documents, which will be replaced by a first priority lien on all of Project Company’s assets after the completion of construction and the commencement of commercial operations of the wind farm.
• Project Company and Swap Provider are also negotiating the terms of an intercredi- tor agreement, which will be executed by and among Project Company, Swap Provider, and Lender simultaneously with the closing of the project financing (i.e., upon execution of the loan agreement between Project Company and Lender).
In this example, the Project Developer understands that a major risk of the project is electricity prices falling below an average price per megawatt-hour (MWh) that will yield sufficient revenues for the Project Company to meet its debt-service obligations to the Lender and produce sufficient additional revenues for the Project Developer to earn a return on its equity investment in the wind farm. If prices fall below that level for an extended period of time, the Project Company will likely be unable to meet its debt service obligations and will default on its loan agreement with Lender.
If the revenues available to the Project Company from sales of electric energy that float with the available market price could somehow be fixed at a sufficiently high price, then one of the primary risks to financing the project will have been mitigated.
This risk can be mitigated by the Project Company and a Swap Provider agreeing to swap the Project Company’s floating price revenues for certain fixed price revenues to be paid by the Swap Provider under a swap transaction.