Lesson 7 Overview

As Energy Market Professionals, we run across many different types of risk that we will need to manage going forward. Certain of these risks are very obvious - like the cost of the natural gas commodity increasing as the weather gets colder leading into October. Other risks may be less obvious - like the long term cost of the natural gas commodity remaining at long term historically low levels and thereby placing the value proposition of your utility scale solar power plant at risk. Other risks are seemingly less direct - such as the potential for the US Legislature to reduce or eliminate the Investment Tax Credit for a solar project or the imposition of tariffs on certain components. In this lesson, we will talk about identifying risks and ways to mitigate (or exacerbate) them through market-based and non-market-based instruments. We will further our understanding of risk management and how certain instruments can be used to de-risk our projects.

Learning Outcomes

By the end of this lesson, you should be able to:

• Explain the simple risk management financial derivatives;
• Develop risk management solutions for each identified risk in your project;
• Develop Pxx values for a typical solar project;
• Explain how contracts work to mitigate certain risks but introduce other risks;
• Develop a holistic risk mitigation strategy for your project.

Reading Materials

• Risk.net (2022) Editorial: How Energy Risk Managers are Responding to Extreme Volatility [1]
• kWh Analytics (2023): Solar Risk Assessment 2023 [2]

• Video interview with Jayson Kaminsky, CEO of kWh Analytics. If this video is slow to load here on this page, you can always access it and all course videos in the Media Gallery in Canvas.

Video: Interview with Jayson Kaminsky (32:44)

Once the video begins to play, you can access the transcript for this video by choosing the transcript icon, to the right of the magnifying glass icon, in the upper right corner of the video player.

Registered students can also access videos in the Media Gallery in Canvas.

What is due for Lesson 7?

This lesson will take us one week to complete. Please refer to the Course Calendar in Canvas for specific due dates. Specific directions and grading rubrics for assignment submissions can be found in the Lesson 7 module in Canvas.

• Complete the assigned readings and viewings for Lesson 7
• Complete Quiz 5
• Project work - Risk Management Measures

Questions?

If you have any questions, please post them to our Questions? discussion forum (not email). I will not be reviewing these. I encourage you to work as a cohort in that space. If you do require assistance, please reach out to me directly after you have worked with your cohort --- I am always happy to get on a one-on-one call, or even better, with a group of you.

What is Financial Risk?

I typed "financial risk" into the search engine (Google.com search for "types of finanical risk") as I was putting this module together, and this is the list that confronted me: 

Woah! Well yes, the management of each of these risks is important in your energy project. But don’t fret, many of these can be mitigated with simple measures and others might be ignored. First, let's get a definition (or two):

We'll take a look first at market risk.

The factors that affect the overall market are things like demographics, the overall inflation and interest rates, and a very recent and obvious one: the COVID 19 pandemic. All investments are subject to these kinds of factors and our energy projects will certainly have their returns affected by these macroeconomic parameters. Some of these parameters can be mitigated or “hedged” while others may not be able to be covered. For instance, if a developer were worried about rising inflation causing his returns to erode in the upcoming years, they might decide to include an escalator in the price of the output of the project. A more subtle form of risk mitigation for long term projects is to borrow money (take on debt) at a fixed interest rate for the term of the loan. This will shield the project developer against the potentiality of an increase in interest rates that might be catastrophic for returns in the future. Of course, when the developer decided to do a deal for debt at a fixed interest rate, they also removed the potential upside of a decrease in interest rates in the future, which could cause returns to be significantly higher than expected.

Doing a deal that removes pricing volatility for a period of time and for a known quantity is what is known in the financial community as a fixed for float swap. We will see this again as we move through the commodity markets as well as markets for other inputs into our project.

What is Commodity Price Risk?

Let us think about some examples of commodity price risk. Think, for example, about a natural gas consumer in the month of October. This company is thinking about how there is a heating season coming up and how natural gas might be trading at $3.00 per MMBtu and how he knows that natural gas prices can go up significantly during the winter months because demand for natural gas increases significantly in the heating season. Now the natural gas consumer in this situation is what is called a “natural short” - meaning that the consumer has a requirement that has not been contracted for or fulfilled. This natural short position places them at significant budgetary risk should prices increase, as they can, in the winter period. Should prices rise from $3.00 per MMBtu to $4.50 per MMBtu, the commodity portion of their natural gas exposure would rise 50%.

Figure 7.2: Daily Henry Hub natural gas spot prices (Jan 1997 - Mar 2021)

Click for a text description of this figure

This graph shows natural gas spot prices in dollars per million British thermal units (MMBtu). The graph indicates that the natural gas market was volatile between Jan of 1997 and March of 2021. For instance, the graph shows a spike on Feb 25, 2003 ($26.40/MMBtu (real) but generally indicates that prices stay below $20. Another spike occurred on Feb 17, 2021 ($23.86/MMBtu) but was followed by a dip, on March 2, 2021, to $2.87/MMBtu.

Source: U.S. Energy Information Administration [8] (EIA) (public domain)

As you can see from the graph above, the volatility of the natural gas market could definitely produce this kind of risk for the consumer.

Another example of commodity price risk is that which might be experienced by a producer of a commodity. Imagine, for instance, if one were a solar developer. The solar developer wants to sell his electricity into the market to be able to pay his creditors and earn a return. If the revenue (which is equal to the quantity of electricity times the price of the electricity for the period in question) is subject to large swings in the price, the entire value proposition of the project could be at risk. This is one of the most important risks to any energy project and one that the savvy project developer (you, in this course) will want to mitigate.

Figure 7.3: Real-time Load-weighted Average PJM Power Prices: January through June

Click for a text description of this image.

This graph shows significant electric price volatility over a 20-year period -- from 2000 through 2020.

Dollars per MWh from 2000 to 2020

Year	Dollars per MWh
2000	20
2007	about 75
2015	about 28
2020	just under 70

Source: PJM IMM [9]

Above is some significant electric price volatility over a 20 year period (remember - your project is likely 25-30 years). Mitigating this risk would be very important for investors in your project. Mitigating Commodity price risk can take on many forms (and we will go into more detail at the end of this lesson), but probably the simplest form would be to engage in a transaction to fix the price. The natural gas consumer above would likely estimate their usage (or burn) for the volatile period and fix the price for that volume in $/MMBtu. This consumer would then have much less heartburn over the winter period, since the indigestion of worrying about gas prices would not arise. The consumer simply buys a contract for delivery of natural gas at the current price. Similarly, the power developer would want to fix the price for its output for the term of the contract in $/MWh. Both of these simple strategies allow for more stable cash flows over a season or a project life.

Basis Risk and Counterparty Risk

This type of risk takes place when the risk manager is not able to buy or sell a financial product that is an exact match for the product he needs to buy or sell. For instance, the gas purchaser in the example on the last page might not have enough load to buy a contract for each month in the winter. So he might buy just a January contract. If the other contracts were to settle differently than the January contract, this purchaser would have the basis risk associated with the mismatched purchases. In the energy market, there is a very specific basis risk that we call “locational bass risk.” This risk comes from the fact that a commodity may be produced or consumed at a point on the energy transportation network that is different from where the commodity is typically traded. In the second example on the previous page, where the developer is producing electrical energy, the price he would receive at his delivery point into the grid might be less (or more) than is paid at a liquid trading point. This potential differential is called “location” or "transportation” basis risk. (insert diagram here)

In our example from the previous page, the seller of the natural gas or the buyer of the developer’s solar output could default on the obligation it has taken on to sell or buy the product in each transaction. This means that when looking at mitigating these risks, it is very important to ensure that the party on the other side of the transaction is credit worthy and will perform their obligations. This phenomenon was of particular concern in late 2001 when Enron started to default on its many obligations to the energy market as it could no longer maintain liquidity. If you’ve never read or seen “The Smartest Guys in the Room” - It is highly recommended. Here's a trailer:

Please watch the following video (2 min):

Operational Risk

There are two specific types of operational risk that should accounted for in your project or in an energy enterprise: Production Risk and Expense Risk.

Production Risk

Production risk is the uncertainty associated with the energy production of your project. In renewable energy projects like wind and solar projects, the variability and intermittency of wind and sunlight can significantly affect the amount of energy produced. In oil and gas production, hydrocarbon reservoirs can produce more or less petroleum than expected. These uncertainties create uncertainty in the revenue profile for the project. If revenue is uncertain, then returns will be as well.

The operational risk faced by projects due to the uncertainty of the intermittent resource is significant, and without understanding and accounting for this risk, project stakeholders will not invest in the project. To account for the variation in the resource, the industry utilizes a probabilistic approach. The analyst cannot predict with 100% certainty what the output will be. The analyst can, however, use past data to predict with a level of certainty that an array will produce at least a certain amount of power. The analyst does this by developing P-values. For instance, a P50 value is that level of production that would expect to be exceeded annually at least 50% of the time. For a P90 value, we have a level of production that we expect to exceed 90% of the time or 9 out of 10 years.

Typically, lenders are interested in P90 or P95 values because they want to make sure that the debt payment will be made without interruption every year that the loan is outstanding. Developer and equity investors tend to look at the rosier P50 values, as these values are what should give the best estimates for equity returns.

For a really great exposition of how to account for variation in the solar resource, please read the blog by Solar GIS entitled How to Calculate P90 (or Other Pxx) PV Energy Yield Estimates [14], where there are a number of techniques to develop Pxx values discussed.

Expense Risk

Expense risk is the risk that input values like fuel or maintenance costs will be different than projected. Obviously, unexpected increases in expenses will put pressure on the returns of a project.

Risk Mitigation Measures

One can mitigate risks through a number of different measures:

1. Contracting (for physical commodities or services)
2. Buying or selling futures contracts
3. Buying or selling options

It is always important to understand that as the developer or operator moves to reduce risk in certain areas, they may be taking on unidentified risk in another area. Please keep this in mind as you work to de-risk your projects in this class and in your career. As Stephen Covey has said, “When you pick up one end of the stick, you pick up the other.”

Contracting (for physical commodities or services)

One of the simplest ways to remove price and performance risk is to enter into a contract for services or a commodity. These types of arrangements take on many forms and can be very simple and also very complex. Natural gas and power purchase arrangements can be 50-100 pages in length, as many different terms and conditions need to be agreed upon. Typical terms that are covered in energy contracts include:

1. Term (how long?)
2. Quantity (how many?)
3. Price (how much does it cost?)
4. Credit (how much do I trust you will perform?)
5. Termination (how do we end the deal?)
6. Payment terms
7. Force Majeure (when can the parties be excused from performance?)
8. Liability
9. Confidentiality
10. Governing Law

Contracts for services can include many other provisions as well, such as:

1. Non-discrimination (who to hire)
2. Prevailing wage (how much to pay people working on the job)
3. Safety
4. Limitations on performance
5. Project Timelines

The general idea of a commodity or performance contract is to remove certain risks that one counterparty has to another counterparty who is better able to mitigate that risk. For instance, I would probably hire a plumber if my garbage disposal were clogged. This would allow me to remove the risk of flooding my kitchen and/or injuring my hand. The plumber gets paid to take on that risk, which he or she is much better at mitigating because he or she is a trained professional. These types of arrangements occur all the time even though we may not be aware that they are risk management measures. It is important, though, to make sure that when one mitigates risk with a contract that one is confident in the performance of the counterparty. The best contract doesn’t mitigate any risk if the party on the other side can’t or won’t perform.

Buying or Selling Futures Contracts

A futures contract [15] is an agreement traded on an organized exchange to buy or sell assets, especially commodities or shares, at a fixed price but to be delivered and paid for later. The most relevant futures contract that the North American energy market deals with is the NYMEX Natural Gas Futures Contract. One can trade natural gas on the New York Mercantile Exchange in contracts of 10,000 MMBtu per month on a fairly liquid basis out about 3 years and in less liquid manner about 10 years beyond that. Buying a futures contract obligates one to take delivery of that gas in the month specified for the price agreed to. Selling a futures contract obligates one to deliver gas in the month specified for the price agreed to.

Buying or Selling Forward Contracts and Options

A forward contract is an informal agreement traded through a broker-dealer [16] network to buy and sell specified assets or commodities.

There are two basic options (and many other options) in the energy markets. The put and the call. The put allows but does not obligate the owner to deliver energy in a certain quantity at a certain price for a certain period. This type of contract is very helpful to a generator or producer because they can lay off the risk of prices falling below a certain level and not having enough revenue for the project.

The call allows but does not obligate the owner to receive energy in a certain quantity at a certain price for a certain period. This type of contract is very helpful to a consumer because they can lay off the risk of prices rising above a certain level and not having enough revenue for the project.

When one sells a put and buys a call, they are then a buyer in a forward contract. When one sells a call and buys a put, they are then a seller in a forward contract.

Lesson 7 Summary and Final Tasks

I hope you enjoyed the exploration of risk in the energy markets. Please remember to:

1. Watch the interview with Jason Kaminsky
2. Complete the risk management assignment
3. Take the Quiz.

Reminder - Complete all of the Lesson 7 tasks!

You have reached the end of Lesson 7! Double check the What is Due for Lesson 7? list on the first page of this lesson to make sure you have completed all of the activities listed there before you begin Lesson 8.