When US transport secretary Pete Buttigieg was providing a breakdown of President Joe Biden’s $2 trillion infrastructure plan in April, he pointed to February’s storms in Texas, which killed 111 people, and described them as “an example of a resilience problem”.
That, it must be said, was an understatement. Primarily, there was a resilience problem with the state’s energy infrastructure, which left citizens without power for days in below-freezing temperatures. Yet it was also a resilience problem with the regulatory system underpinning this infrastructure and with some of the financial structures upon which certain projects had been built.
The hedge contracts that are entered into as part of the tax equity arrangements crucial to the development of many renewable energy projects in the US exposed their drawbacks when many wind farms were unable to provide power to the financial institutions to which they had agreed to supply power. This forced tax equity investors to turn to the open-power market, where the uniquely regulated Electric Reliability Council of Texas – operating separately from other US power grids – saw prices reach as high as $9,000/MWh. In the most high-profile example, JPMorgan Chase is suing the Canadian Breaks wind farm, owned by Northleaf Capital Partners. The banking group claims it is owed $79 million since it was forced to buy power for $8,980.45/MWh as Canadian Breaks could not fulfil the contracted swaps. According to court documents, Canadian Breaks was projected to make about $15 million in revenues during 2021 and the project is claiming a force majeure event.
However, a joint letter to ERCOT from a group of eight utilities and GPs – including Capital Dynamics, Copenhagen Infrastructure Partners and Fengate Asset Management – summed up the feelings of many in the wake of the deadly storm.
“It appears that at least 46 mostly wind projects totalling 9GW would suffer severe financial losses as a result of the $9,000/MWh prices during the power market crisis,” they wrote. “It does not serve any public policy goals for any of these projects, or any companies in the energy industry, to be severely financially harmed as a result of an unforeseeable administrative change to ERCOT’s pricing structure and the operation of ERCOT’s Protocols on a moment’s notice. The impacts that are reverberating throughout the power and financial industries will have serious and long-lasting effects on the economy of Texas.
ERCOT will be seen as an unstable electric power market, potentially creating a very unfavourable environment for investment in the energy industry as well as other sectors of the Texas economy.”
The letter’s signatories are indeed correct: there will be long-term consequences for the wind industry as a result of the freak weather incident. However, there are also significant near-term concerns that are still being dealt with.
“I am an optimist and believe that we will see investors focusing on [winterisation] and as a result the market will undergo significant change for the better”
“For those projects we’ve worked on in the past, the sponsors of those facing unexpected challenges are looking to find some financing solution to help them get through some working capital issues they’re experiencing,” says Gary Durden, managing director at CohnReznick Capital, who provides transaction management and advisory services on wind and solar projects. “That’s a combination of doing some work with their hedge provider and seeking financing solutions to help fund whatever amounts are owed under that contract. There are a few projects facing more serious difficulty, where they are at risk of foreclosure. If that were to happen, they would likely be quickly sold as a distressed asset.”
As well as human resources in the aftermath being diverted to picking up the pieces of this crisis, Durden adds that Texas, one of the most popular destinations for wind investment in the US, has seen a slowdown in new projects as tax equity investors and lenders assess the situation.
“This has scared many banks,” says Sven Wellock, co-lead of energy at ING Capital in New York, which he says did not have significant exposure to fixed-shaped hedges. “The risk departments have become much more critical about all sorts of hedges and what risks they contain. There is a heightened scrutiny.
“Certainly, some banks are on hold when it comes to new project financings in ERCOT. We were sceptical of some of these hedges, but we didn’t believe they could turn upside down the way they did and wipe out an entire financing.”
Gone with the wind
Durden’s and Wellock’s words may seem at times dramatic, but it would be no exaggeration to say that Texas’s two-week power crisis might well have changed how wind projects in the state, and other parts of the US, are financed forever. This might require some substantial changes in projects, with tax equity investment in wind and solar sites expected to have reached about $15 billion last year, according to law firm Norton Rose Fulbright.
“Most banks are going to recalibrate their risk analysis to be a little bit more conservative about these financial hedges,” argues Wellock. “I think we are going to see fewer hedges that have similar risk. If they do get transacted in the market, there’s going to be a higher risk premium tied to those hedges to reflect the real risk you’re taking on when accepting these kinds of hedges.”
Durden also predicts changes to the hedging structures and believes this might herald the return of the power purchase agreement market in Texas. The state signed 5.5GW of wind and solar corporate PPAs in 2019, but this fell significantly last year, according to BloombergNEF.
“This whole event has made people focus a lot more closely on the types of offtake contracts that they’re willing to accept,” says Durden. “We’re seeing more of a shift from fixed volume hedges to virtual PPAs or other financially settled contracts with as-delivered volumes. I wouldn’t say hedges are completely out, but I think right now it might be difficult to get a tax equity investor to finance that. If you were to do a hedge, you are much likelier to have it at a much lower volume.”
The security-first approach was taken by the Finland-based Taaleri SolarWind II fund, which last year was part of a consortium that acquired a 93 percent stake in a 336MW Texas wind farm. “We opted for a proxy revenue swap for our offtake as it provides a much better risk profile for the wind farm than an hourly financial hedge,” says Kai Rintala, managing director at Taaleri Energia. “This does not change the fact that your wind farm needs to be producing when it should be producing.”
This consequence of the storm may well have inadvertent benefits for the future of merchant power projects, according to Wellock. “With merchant projects you wouldn’t find yourself in a similar situation where the hedge is upside down and you’re unable to operate,” he explains. “The worst thing to happen when you’re in a merchant deal and you have an outage, you’re not benefitting from high prices but you’re also not losing your shirt. That is a reasonable downside to take.”
Not everyone sees February’s events as a great catalyst for change. Michael Cembalest, chairman of market and investment strategy for JPMorgan Asset Management and a member of its investment committee, says long-term investment decisions should be able to withstand events like these.
“I don’t see why there would need to be any changes,” he says. “This wasn’t really a wind issue. I think there’s going to be zero consequences for wind. People who own power are basing their decisions on a year’s worth of energy. So, if a couple of days the turbines are offline, it doesn’t change your underwriting approach. What would be a bigger change is if the state decides it’s going to prioritise which electricity it uses if the load goes down.”
A crisis in waiting?
The crisis in Texas raised the spectre of what have so far been extremely rare weather events happening more frequently as the risks of climate change become more apparent. The outages occurred during the state’s coldest winter in more than 30 years.
“At the time it was seen as something of a black swan event,” says Rintala. “But it is entirely possible that we will see such events in the future.”
Indeed, the past 18 months have provided a warning against underestimating rare, unforeseen events. “If you imagine having a polar vortex in Florida for four days, you’d probably see the same impact,” explains Wellock. “Right now, nobody believes that to be possible. If you start seeing atypical, harsh weather, the electricity and gas supply systems are not prepared to deal with extended cold weather. Texas is unique and is known to have extreme events like hurricanes and hailstorms, which have been outliers. But I think that will now become a more standard phenomenon.”
“Connections between [higher] temperatures and… whether tornadoes and floods are a consequence of that are still being studied”
JPMorgan Asset Management
Some were already prepared. The winterisation of wind projects, while costing extra, can mitigate some of the effects of storms, and was being employed by Taaleri, not only because the firm originates from Finland’s colder climate. “I think winterisation will be a major theme in the ERCOT market over the next two to five years,” Rintala says. “I am an optimist and believe that we will see investors focusing on this point and, as a result, the market will undergo significant change for the better. It is not only about ERCOT, however. This is an issue for all markets.”
ERCOT’s unique failings
Others, though, are a little more circumspect when it comes to the possibility of the Texas storm becoming a more regular feature. “There’s a lot of conjecture in the climate scientist community that global warming isn’t just warming and leads to more volatile swings in temperature patterns overall,” maintains Cembalest. “I think the science is still in process on that. The climate, biological and geological scientists that I pay most attention to say it’s possible, but to make a conclusion like that, you need a really long period of time.
“It is clear 13 of the warmest years have been in the last 17 years and we see indisputable evidence about temperatures. Connections between those temperatures and the swings in the weather patterns and whether tornadoes and floods are a consequence of that are still being studied.”
Winterisation and climate risks aside, at the heart of this episode was the unique nature of ERCOT’s isolated grid, which stands alone from other networks in the US.
February’s events, Cembalest believes, are one of the prices paid for not having national oversight. The hedging structures, while prevalent in other states, are also more common in Texas than elsewhere.
Then there is the additional factor, revealed to Texan legislators, that many gas facility owners had failed to register their sites to a list of critical power projects to be kept online, whatever the circumstances. There were 35 gas facilities on the list at the storm’s outset, but a further 168 by the following week.
“We were sceptical of some of these hedges but we didn’t believe they could turn upside down the way they did and wipe out an entire financing”
“The notion that all these operators were supposed to sign up for a ‘don’t cut me off’ list and, between the people that just didn’t bother and the people that didn’t know it existed, those are the kinds of things that the US says you usually find in emerging countries,” says an exasperated Cembalest.
Work is underway to mend parts of ERCOT’s irregularities, with the Southern Cross transmission project set to allow ERCOT to access power from other south-eastern grids. Yet James Wright, managing director of renewables at CIBC Capital Markets, says there is an irony that the failure of fixed-shape hedges to provide revenue security could be a boon for the next chapter of the “home of wind” in the US.
“A lot of sponsors will be much happier running merchant deals,” he says. “The question is whether the financing markets can get there. There is more merchant risk coming into renewables. It’s showing the maturity of renewables more broadly and the market is playing catch-up on where the gas markets have been.”
In the calm after the storm, the events of February might just be a coming-of-age episode in the Texas energy saga.