Hedging against low wind: 5 things you should know about weather risk transfer structures

By Geoffrey Taunton Collins; Weather Risk Analyst
GCube Underwriting Ltd.

As the global wind sector matures, the risk profile of development and operations is changing rapidly. Once confined to more developed and secure markets, the U.S. wind industry is now facing logistical and technical challenges of building and operating projects offshore, and in testing lower-wind onshore locations.

Simultaneously, the sector is coming to terms with an overall increase in scale that has seen a considerable ramp-up in size and capacity. Towers reach over 100 meters, blades span over 80 m, and projects are hitting the 600-MW plus range — with even greater potential offshore.

Cube Gone with the Wind -- report

GCube’s Gone with the Wind report focuses on the challenges posed by weather-related underperformance of wind turbines. It was launched with the objective of fostering a greater understanding of the value that weather risk transfer or WRT mechanisms can add to a wind energy asset or portfolio.

Wind-energy stakeholders and the industry have become fairly adept at managing these challenges and the threats they pose to the profitability of their assets, thanks in large part to backing from the insurance industry. In fact, the greatest threat to wind energy profitability for today’s asset managers is no longer the risk of equipment damage or project downtime. This is good news because it shows a maturing industry.

However, the sector faces one recent challenge: the impact wind resource fluctuations will have on asset and portfolio values. High-profile low-wind speed events in established markets, coupled with the challenge of conducting reliable wind measurement campaigns in emerging markets, are now driving demand for a means of protecting project revenues.

Safeguards against the impact of weather on wind project revenues are increasingly significant, and are now known as weather risk transfer (WRT) mechanisms, are becoming increasingly significant.

Understanding WRT
In a nutshell, weather risk transfer mechanisms provide project stakeholders with a means to stabilize future cash flows and minimize the impact of unexpected and adverse weather on revenue. WRT structures, if delivered effectively, help stabilize revenues and add value to a project when it comes to finance and refinance.

Structure overview

A look at the structures. The graphs apply to one hypothetical wind farm and are for illustration only – premiums and production will vary by wind regime and time period.

WRT structures provide a financial hedge that protects against market or cash flow fluctuations by means of compensation in the eventuality of below or above-par resource availability.

A recent GCube report, Gone with the Wind: An Asset Manager’s Guide to Mitigating Wind Power Resource Risk, estimated that the global installed wind base is missing out on $56 billion in total asset value as a result of a failure to efficiently manage the financial impacts of weather risk.

For those working in the wind sector, it’s no surprise that weather is the single greatest and most significant factor influencing availability and performance. With that in mind, here are five things you need to know about protecting assets from adverse conditions.

1. Expect the unexpected. Access to high-quality wind resource data is now better than ever before. The availability and accuracy of long-term synthetic datasets continues to improve because the industry is developing increasingly advanced methods of on-site wind measurement.

However, wind-energy developers and operators still find that long-term project performance differs considerably from pre-construction estimates. In some cases, this is a result of optimistic financial forecasting. More typically, it is the result of unforeseen climatic phenomena that undermine the efficacy of 12 or 24-month measurement campaigns.

The threat posed by long-term resource fluctuations to renewable-energy asset performance and revenues is now indisputable and widespread. In the wind sector, this has been evidenced by a number of high-profile examples.

One of the most severe examples occurred in Texas back in February of ‘08 when the power grid hit a state of emergency because of lack of wind. Texas recorded a resulting fall in energy production levels of 82%. More recently, the U.S. “wind drought” of early 2015 brought record lows to key markets in California and Texas, which averaged some of the lowest wind speeds in recorded history.

In Europe, Scottish Power saw its profits tumble by around £40 million over six months due to less wind than had been anticipated in the first half of 2016. While in Australia, renewable energy developer, owner and operator Infigen saw its revenues fall 23%, again as a result of low wind speeds.

2. Plan ahead
The development of advanced weather-risk coverage means the market now has an increasingly viable response to unexpected challenges. While resource under-performance is occasionally inevitable, a WRT mechanism can safeguard asset owners against resulting drops in revenue. Simple, right?

Well, the premise may seem straightforward but true to the nature of the wind industry, it has been slow to adopt WRT as standard practice. This is not so unusual. The conventional power and agricultural sectors also took time to mull over the value of weather risk transfer.

Put structure

Under the put structure, the buyer pays a premium upfront and receives compensation in years of resource underperformance. If the trigger number is 140,000 MWh, and production turns out to be 130,000 MWh, the buyer will be compensated for that 10,000 MWh shortfall. They will be paid 10,000 times the notional payment.

The sticking points have been the capacity of risk management and insurance communities to offer an attractive WRT product, with clear advantages that asset-owners and investors can fully buy into and understand. And unlike conventional property and casualty insurance, lack of resource is not yet a standard requirement imposed by regulators, lenders, or lenders’ insurance advisors.

Until recently, the attitude of operators was typically a ‘wait and see’ approach, where asset protection was only sought after a major revenue shortfall. This reactive approach is diminishing in favor of a more proactive one. Wind operators are beginning to recognize the value of investing in their assets now and for the future.

Furthermore, improvements in data collection and analysis mean that WRT contracts can now offer structures based on actual or ideal production by using SCADA data from the generating assets. This is far more effective than relying on meteorological data from offsite devices. It significantly reduces the “basis risk” that typically occurs with data used for a WRT contract that fails to match site performance.

Additionally, increased contract lengths of around 10 years are now available, which are able to better match loan tenor lengths and sync with project lifecycles.

3. Size to fit
So, how do weather risk transfer mechanisms work? Put simply, a WRT product provides cash in years of resource under-performance. It is adjusted to suit the preferences, needs, and availability of the buyer’s resource. Three basic structures are available: the put, collar, and swap.

For a:

Collar structure

Under a collar structure, the buyer pays a negligible or no upfront premium at all. Instead, in years of resource over-performance, the insured will compensate the insurer — so whenever revenues are above the ‘call.’

  • Put, buyers pay an upfront premium and then receive compensation in years of resource under-performance. Their contract will set out what constitutes a year of under-performance and the “trigger” number for production. If production falls below this number, the insurer will pay out in proportion to just how far below it production has fallen.
  • Collar, buyers pay a negligible upfront premium, or nothing at all. So, the insured may compensate the insurer in years of over-performance, while the reverse is true during project under-performance — the insurer pays the insured. When revenues are somewhere in between the agreed upon number for under and over-performance, neither party pays.
  • Swap, the insured will pay little or no upfront premium but, in this case, there is only a single trigger so that one party will always compensate the other at the end of the settlement period. If revenues are above this trigger, the insured will compensate the insurer, and vice versa if revenues fall below the trigger.

A proper understanding of which structures best suits the risk exposure of a specific project or portfolio is critical because it determines how effectively a WRT mechanism performs long-term. One size does not fit all. Time and investment will be required from buyer and seller to determine a suitable structure and triggers.

4. Add value
Those who may benefit from a WRT product fall into one of two groups: those who are financing or refinancing, and those who are doing neither but want to balance revenue flows and secure revenue certainty.

In the first case, because WRT effectively safeguards a minimum amount of revenue for a wind farm, regardless of wind-speed variability, lenders can apply less conservative estimates for their expected revenues. This means lenders can offer more favorable debt service coverage ratios. The advantages of this enhancement to leveraging, coupled with lending rate reductions, will make projects more valuable to asset owners.

Swap structure

A swap structure is similar to a collar, in which the insured pays little or no upfront costs. The difference is that at the end of the settlement period, one party will always compensate the other. In this case, there is a single trigger point represented by the red line in this graph. When revenues are above this trigger, the insured will compensate the insurer and vice versa. This has the effect of providing stable year-on-year revenues.

GCube estimates that, for a 50-MW onshore wind farm worth $80 million, successfully mitigating or transferring weather risk could achieve a total net present value increase of $5.8 million.

WRT is still an option for those not at the financing stage, such as risk-averse entities seeking to stabilize year-on-year revenues.,. In fact, benefits include an ability to minimize the impact of weather variability on the volatility of share prices and foster investor confidence. WRT buyers can also benefit from protection against rating downgrades and are typically better able to avoid profit warnings.

5. Protect investments
Typically, more small-scale wind operators have researched the benefits of weather-resource transfer structures. WRT can provide vital protection for a single-asset owner, for whom the financial impact of below-par wind speeds in one location is proportionally far greater than it is for the owner of a large portfolio.

While a larger portfolio owner can benefit from the geographical diversification of its assets, the prevalence of region-wide wind lulls (as experienced across much of the U.S. in 2015) means that even the largest portfolios remain unprotected from the financial strife of asset under-performance.

Further, if a portfolio owner is seeking project financing through a special purpose vehicle, a WRT product can deliver project-by-project financial advantages.

And, finally, larger players typically have greater skillsets and resources to dedicate to the identification of suitable WRT mechanisms. This lets such companies access more options and make informed decisions about how insurance products can increase stability and revenue predictability across their portfolios.

Resource variability and under-performance are serious concerns for the industry, with the frequency and severity of low wind events affecting asset owners around the world. Indeed, their importance will only grow as wind and renewables make an ever-greater contribution to global electricity generation.

For single-asset and large portfolio owners, WRT mechanisms can provide invaluable protection against the financial impact of unforeseen climatic phenomena. By enabling greater revenue certainty, these mechanisms let wind-power stakeholders focus on what really matters: running a profitable business and providing a cost-effective long-term supply of clean energy, regardless of the unexpected. 

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