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October 15, 2019

Leveraging Innovative Contract Structuring to Reduce Price Risk in Renewable Energy Procurement

Americans who buy Honda cars manufactured in Ohio, Indiana, and Alabama may appreciate knowing that Honda just bought enough electricity from wind and solar projects to offset 100% of the energy used at these manufacturing facilities.

It’s done with a Virtual Power Purchase Agreement, or VPPA, that lets Honda buy renewable power across state lines to meet its commitments to cut carbon. In this case, the electrons will be generated in Oklahoma and Texas.

The number of such deals is increasing, and increasing in sophistication. Edison Energy has used a variety of methods to help buyers reduce their risk of future energy price volatility, including retail-delivery structures, volume-firming agreements, revenue-upside sharing, floors and collars, which limit energy price fluctuations to a range.

The collar structure provides greater contract settlement certainty for the buyer over the contract term and allows the seller to participate in potential upside if prices exceed the upper bounds of the collar.

Energy markets are changing at an unprecedented pace. Renewable energy build-out, electrification, continued low natural gas prices, policy uncertainty and technology advancements – all create both major risks and opportunities for companies looking to achieve sustainability goals while managing energy price risk.

As recently published in the BRC Risk Mitigation Report, the renewable energy market in particular shows how market leaders can control costs while demonstrating their environmental stewardship.

Rapid growth in the industry has caught the attention of internal and external stakeholders, and dialogue between the sustainability team, executives, treasury, and finance has increased 10-fold in the past year, as corporate leaders apply their skills to the decision making.

At Edison Energy, we take a measured and unique approach to the identification, quantification and mitigation of long-term risk for energy buyers, particularly for renewables contracts. Helping clients achieve their carbon reduction goals without putting shareholder value at risk is vital for the long-term, sustained growth of the market. Over the past year, we have continued to push the market to offer more risk-mitigation and risk-sharing structures for buyers, including many unique commercial structures.

Collar Risk and Mitigation

Recently, Edison helped Honda enter into two long-term virtual power purchase agreements for 320 megawatts of renewable power capacity from Oklahoma and Texas, including an innovative “collar” structure that shields Honda from energy price fluctuations.

For the Oklahoma wind energy deal, the collar sets upper and lower bounds on Honda’s exposure to energy market price fluctuations in any given quarter, while ensuring strong and stable revenue for the project owner and operator. Innovative deals like this help expand the market for renewable energy.

A collar requires a project to assume more wholesale energy price risk than in a traditional PPA; however, it provides upside when energy prices are high. The result is more risk (and more potential benefits) than a traditional PPA, but less than a fully merchant project.

The below illustrates how the structure works for the buyer and seller:

For illustrative purposes, and not a specific Edison client transaction, below is a graphic that shows how a collar would settle relative to a probabilistic view on future energy prices for a particular hub in ERCOT. Edison’s monthly simple average market price from a probabilistic analysis in ERCOT (created using a production cost model of the electricity grid) would exceed the ceiling price starting with the p50 scenario. The value above the ceiling is retained by the seller. Collars can be symmetrical on upside and downside risk or non-symmetrical depending on buyer, seller and market dynamics.

Financing parties, especially tax equity investors, are typically more concerned with downside risk and ability to recover invested capital. As such, the collar structure has to adequately address certain risks for successful financing. Here are the considerations for both seller and buyer to enter into a collar deal:

Seller Risk Mitigations

• Structure of collar offer should provide appropriate upside potential to offset additional risk for project; certain wholesale markets are better suited for this structure
• Tax equity may require a higher return, or indemnification from the project owner
• Additional instruments can be used to address downside risk (e.g. put option), but may not be available for full PPA term
• Project owners may ultimately bear downside risk below the floor, if sufficiently motivated by project economics

Buyer Risk Mitigations

• Selection of strong project counterparty with a track record of successful collar transactions, or capability to balance sheet finance construction
• Appropriately balanced collar structure to mitigate downside risk, and expected high probabilities of positive cash flow to buyer and project
• Credit support provisions, once PPA is executed, that place financing and development risk on seller, and if project fails, ensure damages to buyer

Honda Partners with Edison Energy to Reduce Price Risk as Well as Carbon

Market leaders such as Honda are paving the way for other companies to adopt VPPAs as a method to procure renewable power and reduce climate-altering carbon emissions. With the largest renewable PPA announcement in the automotive industry, Honda leads the industry in slashing CO2 emissions — buying enough wind and solar energy to cover over 60% of the electricity Honda uses in North America.

The Edison team is honored to have facilitated such a historic and innovative deal, showcasing one of many emerging and unique risk mitigation solutions in a rapidly diversifying corporate market. We applaud Honda for being a market leader and believe this further paves the way for other companies to adopt VPPAs as a method of energy procurement that minimizes risk while achieving ambitious carbon reduction goals.

To learn more about the largest automotive renewable procurement deal in history, read the release here. And to learn more about how Edison Energy can help your company achieve its carbon reduction goals with renewable energy, while managing energy price risk, please contact us.