Suppose a business was paid €100 by the government to produce a product. What would happen if that company went away and had to compete to sell said product at a dropping and unknown market price of around €35?
This is not an unfair description of how the European wind market is evolving. The wind power production industry has been supported by government schemes designed to nurture and encourage the growth of young businesses, and it has worked - producing electricity from wind is now competitive with producing electricity from almost every other source, particularly fossil fuels. As public policy efforts go, this has to be judged a highly successful one.
Now, however, the industry is being asked to graduate from being taken care of, to going out and making it in the harsh environment of market-based pricing. To date, the response has been to do this by driving down costs, which has been very effective. New auction sales of production licences, where the price is set by competitive bidding, are the best evidence yet of the industry's ability to make electricity at prices of €50/MWh or even less. But this innovation curve can only take us so far, and the pressure on economics has already had an impact.
A new study by WindEurope, supported by Swiss Re Corporate Solutions, puts all this into perspective, and points out that the industry may be missing a trick by not taking advantage of the market tools that permit wind farm operators to manage the risk of wind uncertainty. In the study, researchers reviewed the growth forecast for wind power development in Europe from now to 2020, and on to 2030. They then looked at the history of wind variability, which developers and owners have generally absorbed in the economics of their project rather than hedging. Finally, using an estimate of value that can be created when hedging wind increases debt capacity, it concluded that wind investors are leaving a good deal of value on the table by choosing not to hedge wind: it estimates that potential to be €2.5 billion between now and 2020, and €7.6 billion by 2030.
According to the study, industry plans are to create another 44GW of wind power, on and offshore, by the end of 2020, bringing Europe's total to an estimated 204GW, and that could grow to 323GW by 2030.
But the economics of the business may get in the way of that growth. In 2005, 80% of new wind capacity was supported by feed-in tariff arrangements, where a generous fixed price was paid by a low-risk counterparty to a wind producer for whatever the farm could generate. But feed-in tariffs are disappearing rapidly. They supported only half of the new capacity by 2015 and, by 2020, they will be gone as a support for new development.
They are rapidly being replaced by market-based premium schemes, where governments still support - in part - the payment of the price for power, but at a price that is determined not by fiat, but by competitive auction. Market-based premiums will dominate the production support by 2030, and the market will be increasingly pushed towards taking pure merchant price risk - making the MWh and selling them for whatever the market will pay at the time. That kind of price risk, which is new to the wind power industry, makes projects very difficult to finance with debt and, without that leverage, financial returns are harder to deliver. For the past three years, 60-70% of new wind farm investment has been supported by project finances with non-recourse debt representing a large part of that.
Non-recourse debt needs predictable cash flows. If the price of the product and the quality of the buyer is known, that cash flow certainty makes leverage possible. When that certainty was the order of the day in wind development, the only real uncertainty was the wind variability. A wind farm in Europe's wind resource fluctuates 10% more or less than the average production from year to year; the shorter the period, the higher that variability. If the power price is fixed, and high, wind variability does not affect revenue uncertainty enough to hurt a project's ability to service its debt.
For this reason, using financial instruments - wind index swaps or options - has been rare in wind project financing and development. Lenders have not demanded the certainty, so the market has been able to grow rapidly without owners needing to hedge the wind risk.
But what happens if price and counterparty certainty is replaced by merchant risk? That puts the value of getting rid of the resource variability in a new light. If the price is no longer fixed, then something else has to be fixed to deliver equally safe cash flows - and that something else is wind uncertainty.
In a wind hedge, a hedge provider agrees to take the underproduction risk. The wind producer fixes a level of wind production based on the tolerance of the project stakeholders, and then the hedge contract compensates the producer for MWh that is not produced because the wind was below that threshold. With this, lenders don't have to worry about severe downsides, and equity investors protect a minimum level of financial return.
Using the analysis provided by Swiss Re Corporate Solutions, the WindEurope study looks at a typical project-financed wind farm, and the impact of increased leverage and reduced lending costs on that project. On a 120MW project, the hedge increases the net present value of the cash flows from €20 million to €24 million. Different project lenders will assign different values to projects but, as deals get harder to do in the more-merchant- price energy world, the industry is moving towards, and hedging the wind risk can go a long way towards easing the stress in the system.
By simply mapping the potential for added value across the anticipated growth in the industry, WindEurope sees hedging as a potential €2-million to €3-billion solution in the next few years, with another €7 billion to €8 billion by 2030.
Meanwhile, the hedging industry is developing new tools to manage a more subtle risk in wind production: when does the wind actually arrive? When feed-in tariffs were a reality, it didn't matter. In a merchant energy regime, where spot prices change by the hour and forward prices can only be fixed to a limited degree, it matters a great deal. Hedgers are creating products that pay for underproduction based on the market price when the underproduction occurs. That can address what the industry calls the 'shape' risk of wind power production - a key feature of enabling corporate buyers to enter power-purchase agreements.
So, as the market risk increases in wind power development, the industry is moving to meet the challenge. According to WindEurope's new study, supported by Swiss Re Corporate Solutions, that could create quite a lot of value for fuelling the continued growth of the business.
Hedging solutions to protect low profits against low winds are increasingly available and offer a cost-effective way to manage the biggest risk that every wind producer faces.