Renewables hedging evolves swiftly as banks crowd in
A fuse has been lit on renewables hedging. In offshore wind alone, a wall of investment is set to hit the industry over the next two decades, one that will take many project sponsors into cross-border investments. Those prospects are already deepening hedging markets, writes Ross Lancaster
Developers in the offshore wind sector are looking forward to rich growth. The sector represents only 0.3% of global power supply but is predicted to grow by 13% a year and have increased 15 times over by 2040, according to the International Energy Agency.
The IEA says that this growth, forecast using existing investment plans and policies, will require $840bn of investment. Adjust the model to account for global climate and sustainability goals and faster growth, and the number will surpass $1.2tr.
That surge of investment will demand hedges. In countries with more advanced offshore wind markets, such as the UK, sophisticated and competitive hedging is already established for rates and inflation risk. UK project developers no longer have to rely solely on commercial banks for their loans and hedges.
Investment banks are also now involved. Firms that won hedging business on the back of providing loans now compete with houses that offer only swaps. That has driven the price of hedging down.
“At present the banking market is extremely strong and if you are doing swaps or cross-currency swaps you can win spreads that are relatively low, not as low as 2006/07 but not at all bad,” says François Jarrosson, director, hedging and derivatives, global advisory at Rothschild & Co in London. “The iTraxx crossover index illustrates the same trend. Risk is demanding a lot less remuneration than it used to.”
Increasing competition for hedging mandates is set to push into FX as well. More jurisdictions, such as Vietnam, are devising roadmaps for their offshore wind industries. The potential for offshore wind capacity is high in Asia and Latin America.
Those factors are in play against a backdrop of US, European and Japanese central banks renewing loose monetary policy. That is set to keep the wheel spinning on the global search for yield, and banks reaching to achieve their returns with hedges.
“We are in a QE environment where infrastructure projects benefit, especially those with government support,” says Marios Paparistodemou, head of rates and risk solutions structuring at Nomura in London. “So despite the pricing pressure that we have seen, given the wider economic environment we expect a continued healthy hedging market in renewables.”
Markets such as the UK’s benefit from a secure regulatory environment and eager competition from banks. But those conditions are setting in throughout the world, including in many emerging market regions. Vietnam is a notable example, having introduced wind-friendly policies in recent years and attracted foreign banks keen to provide financing for its projects. Taiwan has already built a robust hedging market for its offshore wind sector.
Cross-border ambitions fuel FX demand
That has created a need for more FX hedging. As sponsors eye cross-border opportunities they have to assess how to manage the mismatch between the denominated currency of their fund and that of the revenues flowing from the project they invest in.
“Some 18-24 months ago, FX risk was lower down the list of our sponsor clients,” says Rishin Patel, director at JCRA (now part of Chatham Financial), an advisory firm in London. “But we are now bringing our FX team on to every transaction. It has been a noticeable trend.
“More clients are looking at cross-border activity, and into EM. FX risk management has been a key focus area for a lot of these clients and we can only see that trend continuing with a series of funds announcing new EM mandates.”
Hedging in these circumstances involves trade-offs, though. Sponsors have to decide which part of their investment they want to hedge. Investing in an EM project will often mean having to weigh up whether to hedge FX risk on the value of the asset being invested in or the cashflows — usually biannual or quarterly dividends — that flow out of that asset. Sponsors can’t hedge both.
“Funds can either hedge value, and then spot trade dividends as transactions when they come, and keep on rolling the value hedge,” says Chris Towner, director at JCRA. “Or they can just look at forecast dividends as the cashflows coming out of the asset and hedge the total of those. But if you hedge value and cashflow it can give rise to over-hedging where you are basically transacting too much. So funds need to be careful.”
Competition heats up
With FX hedging relatively new in offshore wind, the pace of innovation lags rates. But more sophisticated products are being used. While deal-contingent hedging has long been used by private equity funds, it has also increasingly been employed by infrastructure funds and sponsors. This form of pre-hedging is mainly used to manage the — usually — FX risk of a cross-border acquisition. It allows an acquirer to lock in the price of a deal for a premium and walk away with no unwinding cost if the transaction fails.
As renewable energy became more accepted by banks, deal‑contingent hedging began to seep into their toolkit.
“Five to six years ago, deal-contingent hedging in renewable space was embryonic, but over the last two to three years we have had more data points, seen more projects delivered on time and brought to the market as expected, so we see them used more regularly” says Jean-Philippe Castellani, head of structured finance hedging at Société Générale in London.
“We have done a number of such trades in Europe, Asia and the US. It has become a regular feature of the market that is interesting for both sponsors and banks. Sponsors got to offload the risk and have also benefited because the cost, which is a function of the underlying implied volatility of rates and FX, especially in euro/dollar volatility, has been low versus historical standards. So the contingent hedge has not been very costly for the sponsors.”
In the more established rates market, innovation has been running at an even faster pace, says JCRA’s Patel. The developed offshore wind markets are not always the engine room of this creativity either. Structurers in more nascent jurisdictions are often just as innovative and 2020 should bring new hedging solutions in offshore wind financing.
“You would expect the European and US markets to be setting the tone on risk management innovation,” says Patel. “But we are actually finding some of the foreign branches of US/European banks coming up with neat risk management solutions.
“The level of innovation going into these deals from the banks is phenomenal, as they try and create the next neat solution to take out the risk. In Taiwan, the market can usually absorb most project hedging. But offshore wind deals are often €2bn-€3bn equivalent, a multiple of the daily trading volume in the market. That is quite a lot of risk being taken down on the rates side, so you need to find new ways to do that.”
Regulation can still surprise
While momentum firmly favours offshore wind and other renewable sectors, investors still have to consider the risk of disrupted regulatory frameworks or hostile politics. While the arc of development is generally moving towards green policies, there are notable exceptions, such as the world’s largest economy.
US president Donald Trump’s stance on renewable energy has had a marked effect on those markets, says Bryant Lee, director of commodity risk management from Chatham Financial in Pennsylvania.
Developers’ ability to guarantee the price they sell energy for, in power purchase agreements, has become significantly more difficult. The market for PPAs beyond 10 years has dried up, with mainly short-term agreements being available — introducing uncertainty into the market.
“There will always be uncertainty about climate regulation,” says Lee. “And it can impact the level of development. In 2016, a large number of projects that had been in development came on line ahead of the potential expiration of the Investment Tax Credit. The credits had been renewed in late 2015, but were re-examined as part of President Trump’s Tax Reform plan in 2017, so the development pipeline took some time to ramp back up.”
But the political and regulatory trend is mostly supportive to renewable development. That will continue to give banks the security and desire to compete on hedges for the sector — maybe to the extent that even a withdrawal of government support would matter less in the future.
“In the western and, increasingly, in the emerging world, a positive for renewables is that they have government support,” says Paparistodemou. “That makes them very attractive to investors and has been a key part of these transactions’ success.
“As the market evolves, we may see that support weaken. That is something we as banks will be watching out for.
“But it is important to note that when we started doing renewable transactions there were a lot more questions from hedgers about the technologies being used, technical and engineering expertise and wider project risk. As the market becomes more mature, the sensitivity to these risks goes down and maybe that could compensate to some extent for a reduction in government support.”GC