Financial Hedges in Merchant Power Project Finance

Abstract

The authors explain the elements of financial hedges used by generators in merchant power markets. The revenue put and the heat-rate call option (HRCO) are two hedge contracts frequently employed as an element of market risk mitigation in project financings for merchant power plants. The revenue put is a financial contract that effectively provides the generator with a floor on variable cash flows, while the HRCO is a swap of variable cash flows for a fixed payment stream. These hedges induce project finance lenders to provide more non-recourse leverage in financings by limiting the variability of a merchant generator’s energy margin. The authors use a hypothetical example of a combined-cycle power plant in the PJM power market to illustrate how a merchant plant’s energy margin may vary in a particular market based on natural gas prices, weather, and supply of generation in the market. They analyze the counterparty risk presented by these contracts for the generator and its financial counterpart, how counterparty exposure is measured and secured, and the factors that drive premiums for these hedges and their availability.