Derivative & Dodd-Frank Considerations for Wind Farm Owners

By Shane Randolph and Matt Smith

Wind farm owners and project sponsors have increasingly turned to corporate power purchase agreements (PPAs) and other hedging alternatives to secure predictable cash flows. Depending on the structure of these agreements, they can lead to derivative accounting or trigger Dodd-Frank reporting requirements.

PPA Considerations

A PPA generally refers to a contract between two parties where one party (seller) agrees to sell electricity and renewable energy credits (RECs) to another party (buyer or offtaker) at a specified price. In this case, the seller is often the developer or project owner. The buyer is generally a utility or commercial and industrial (C&I) organization. With a physical PPA, the seller operates the wind farm and delivers the electricity generated from the wind farm to the buyer at the contractually specified delivery point. Traditional PPAs are typically scoped out of derivative accounting for U.S. Generally Accepted Accounting Principles (GAAP) purposes and Dodd-Frank reporting due to these contracts resulting in physical delivery of the underlying electricity generated.

VPPA Considerations

A synthetic or virtual power purchase agreement (VPPA) is an alternative to a physical PPA. A VPPA is a hybrid agreement that includes a contract for differences (CFD) along with an agreement to deliver the related RECs from the project. Under a VPPA, there is no physical delivery of electricity. Rather, the agreement specifies a periodic payment to be made based on the difference between an agreed upon fixed price and a floating market price, generally at a market hub or a project node. Upon settlement, when the market price exceeds the fixed price, the seller pays an amount to the buyer equal to the difference times the agreed upon quantity. When the opposite is true and the market price is below the fixed price, the buyer pays an amount to the seller equal to the difference times the quantity.

  • Accounting Considerations: These contracts may or may not meet the definition of a derivative depending on whether the agreement includes volumetric guarantees or default provisions that indicate a minimum volume. A VPPA will not qualify for the normal purchases normal sales (NPNS) scope exception as these contracts do not result in physical delivery.
  • Dodd-Frank Reporting Considerations: Although the regulatory requirements for VPPAs are still being formed, the prevailing view is that these contracts are “swap” agreements and thus trigger Dodd-Frank reporting requirements.
Fixed-Volume Hedge Considerations

While VPPAs are growing in popularity, there is still a lack of long-term offtakers that want to sign a PPA to meet the growing demand of wind capacity. This is where several large financial institutions have stepped in to fill the void with hedging arrangements. A typical hedging arrangement is a fixed-volume price swap with a 10 to 20-year duration.

  • Accounting Considerations: A fixed-volume price swap generally meets the definition of a derivative and may or may not qualify for the NPNS scope exception. Stakeholders generally require hedge accounting to minimize earnings volatility from the default mark-to-market derivative accounting.
  • Dodd-Frank Reporting Considerations: Dodd-Frank reporting requirements, if any, are generally handled by the hedge provider.
Derivative Accounting Overview

The default accounting for a derivative is to record the fair value of the derivative on the balance sheet at each reporting date. Changes in fair value of the derivative are recognized in earnings as the changes occur. PPAs often have terms extending 10 to 30 years. Determining the fair value of these contracts is challenging, and the change in fair value is a significant source of earnings volatility. Many stakeholders require the election of hedge accounting for offtake agreements that meet the definition of a derivative and do not qualify for the NPNS scope exception in an effort to dampen or remove the earnings volatility caused by periodic changes in fair value.

Dodd-Frank Reporting Overview

Enacted in 2010, Dodd-Frank regulates parties transacting in derivatives and contains various requirements for “swap” transactions. A transaction involving a cash settlement based upon the movement of a floating price is considered a swap subject to the Commodity Futures Trading Commission’s (CFTC) Dodd-Frank rules. Accordingly, VPPAs and financial hedges are subject to Dodd-Frank reporting requirements.

The parties to a swap transaction are required to report various information at the execution of the contract and on an ongoing basis to a swap data repository. One counterparty to the swap transaction is designated as the reporting party. When both counterparties are Non-Swap Dealers/Major Swap Participants, the seller is generally selected as the reporting party.

Join Shane Randolph, Managing Director, and Matt Smith, Director, in Opportune’s Derivative Valuation and Hedge Accounting practice and other industry leaders as they discuss these topics and more at the Wind Power Finance & Investment Summit on February 5-7, 2019 in San Diego, California. Opportune LLP is a proud sponsor of the event.

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About the Authors:

As a Managing Director at Opportune LLP, Shane Randolph assists companies and financial institutions throughout North America, South America, Europe and Asia-Pacific in their understanding of what is possible as they deal with the challenges of implementing risk management programs and highly technical accounting pronouncements. He assists clients with the entire risk management life cycle, including strategy, execution, compliance, valuation and hedge accounting. He has undergraduate and graduate degrees in accounting from Oklahoma State University. He is also a member of the American Institute of Certified Public Accountants and holds a Series 3 License with the National Futures Association.

Matt Smith is a Director in Opportune’s Derivative Valuation and Hedge Accounting practice. Matt assists companies with their derivative valuation, hedge accounting, documentation, and disclosure requirements. His background includes extensive experience in technical accounting research, SEC financial reporting, derivative valuation, and hedge accounting. He gained this experience from his various positions in the commodity space as a technical consultant and from his experience as an audit manager with EY. Matt has an undergraduate degree in accounting from Oral Roberts University. He is also a member of the American Institute of Certified Public Accountants.

Shane Randolph

Managing DirectorOpportune LLP

Matt Smith

DirectorOpportune LLP

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