A Case Study of Interest Rate Risk Management

1. Introduction

In the U.S. renewable market, Power Purchase Agreements (“PPA”) are increasingly auctioned and contracted 2 or 3 years in advance of the start of construction for assets under development. While this provides the renewable development Companies and Sponsors with flexibility on managing the project development timeline, it also exposes the project to additional interest rate risk. That is, against the backdrop of a volatile yield curve, financial sponsors and project developers become “on-risk” to increases in interest rates once the PPA is signed and the MegaWatt hour (“MWh”) price is fixed. Additionally, in a traditional PF financing the rate is not fixed until Financial Close is reached by the Project. However, if the interest rate exposure of the project is left unhedged, any incremental increases in the interest rate results in lower coverage ratios (i.e. DSCR) and reduced debt capacity. The project’s ability to raise debt in high interest rate environments creates a funding shortfall which may necessitate additional Sponsor’s equity contribution. This negatively and materially (as a result of the use of substantial financial leverage) impacts the project Internal Rate of Return (IRR) and the return on Sponsor’s equity.

The probability of a successful Financial Close for renewable projects is typically deemed high, once a PPA is signed and a project site is secured. This allows the Sponsors to consider hedging interest rate risk prior to Financial Close. Every project’s specific features and timeline require bespoke considerations to structure an appropriate and effective hedge which would ultimately stabilise the project IRR, equity return, and dividend distributions to the shareholders. In this paper, we discuss the most relevant topics related to managing interest rate risk in-line with renewable project milestones and highlight the role of a Hedge Coordinator (“HC”) in structuring, executing, and syndicating pre and post Financial Close hedges.

2. Managing rate risk in-line with project contingencies

In addition to our extensive U.S. renewable energy financing experience, HSBC has been a key player providing solutions and execution of bespoke risk management hedges on Project Finance transactions. We have paired these capabilities to develop risk management frameworks for renewable energy project sponsors. Every project’s specific features and timeline requires careful and bespoke considerations to structure an appropriate and effective hedge which would ultimately stabilise the project IRR, equity return, and dividend distributions to the shareholders. We have outlined the interest rate risk profile of renewable projects under four main categories.

2.1. Pre PPA auction: changing profile of risk

During the early stages of the project the focus will likely be PPA negotiations, permits and land acquisition. The Sponsors should begin to consider the interest rates exposures and scenario analysis impacting project NPV, IRR, DSCR, and Return on Equity. The main question here is how a stressed interest rate scenario could deplete the economic viability of the project. Additional thoughts to consider at this stage include hedge accounting, rating agency, and shareholder communications. However, at this point, sponsors have not committed to a MWh price, implying the proposed price can still be altered to reflect the economic impact of changes in interest rates.

2.2. Pre Financial Close: contingent risk period

Once a PPA is signed and the MWh price is fixed, the risk of future interest rate fluctuations is borne by the Sponsor. At this time, the Sponsors should plan for the execution of hedges to optimise the economics of the overall project. There are a number of risk management alternatives which can be used by the Sponsors to effectively manage the interest rate risk. These alternatives include, but are not limited, to Forward Starting Swaps, Deal Contingent Hedges (“DCH”), Payer Swaptions, or combination strategies.

When considering the spectrum of hedging alternatives, each product offers its own combination of advantages and disadvantages. The pay fixed forward starting swap is a simple and direct hedge that allows the Sponsor to lock in interest rates (despite using variable loan financing). However, these swaps can create credit exposures for banks, and open ended liquidity risk, as the Mark to Market (“MtM”) of these swaps can move either “for” or “against" the Sponsors which would have to be settled if the Project does not ultimately reach Financial Close.

Deal Contingent Hedges (“DCH”) are hedges which would be cancelled if the project is unable to reach Financial Close. By adding the DCH feature to a swap, the risk of not reaching Financial Close which results in open ended MTM risk, is removed. However, such products will require very specific facts and circumstance to be in place before banks will offer such a solution. Further, the DCH feature will be priced at a Premium to a Vanilla Swap.

Swaptions and other option products provide even further flexibility, as the Sponsors buy the option to benefit from an increase in rates (either from a cash payment or the ability to enter into an In-The-Money hedge), but are under no obligation to enter an Out-The-Money hedge if rates decrease. The key negative consideration for option based produces is the option premium which is typically paid upfront for purchasing the optionality.

2.3. Financial Close: optimal profile of debt

At the time of Financial Close, once the project is capitalised with equity, the final profile of debt is determined. Existence of pre Financial Close hedges act to stabilise the interest expense cash flows and protect coverage ratios helping to mitigate an adverse shortfall in the debt sizing due to higher interest rates. At this stage, the Sponsors should begin to consider optimisation of the size and tenor of the existing hedges to match the final profile of debt. Furthermore, the existing hedges may need to be distributed and syndicated to participating lenders on a pro-rata basis. A Hedge Coordinator can play a central role in structuring, executing, and syndicating pre and post Financial Close hedges to Participating Banks, in an efficient manner. Additionally, if the existing hedges have an outstanding MtM at the time of Financial Close, the Hedge Coordinator may be able to structure a solution to house the “off-market” portion of the hedge while, at the same time, re-coupon the existing hedges in preparation for the syndication to the participating lenders. At the time of closing, if DCH hedges are used additional Credit Charges may be added by the swap dealers to compensate for the now conventional credit risk of a Hedge. If the trade, at Financial Close has an existing MTM, there may be further adjustments to the Credit Charge as compensation.

2.4. Post Financial Close: M&A process

Those sponsors who intend to sell their renewable development assets after reaching a significant milestone (e.g. Financial Close) would need to understand and quantify the impact of realised interest rate fluctuations on the valuation and sale price of the project to the potential buyers. If pre Financial Close hedges have been executed and are in place, the project’s valuation would be by definition de-risked from interest rate fluctuations providing sponsors with a more stable exit scenario. In other words, the MTM and value of the hedge contracts would offset the adjustments made to the purchase price resulting from interest rate fluctuation and debt sizing. At this stage, Sponsors should begin considering monetisation of existing hedges prior to sale or transferring them to the buyer at the time of sale via Novation techniques. A Hedge Coordinator can assist with the valuation process and optimisation of the alternatives available to the Sponsors.