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Merchant Power: When Hedging and Profits Collide

Does too much risk management mean leaving money on the table?

Fortnightly Magazine - June 2006

could generate profits far exceeding the current cost-of-capital requirements.

The key to intelligent financial analysis of an energy merchant is evaluating the impact of these three variables: expected EBITDA, upside, and risk.

The Impact of Risk Management

Within the energy industry, Calpine is not considered an aggressive energy trader. Many other energy merchants possess large trading floors with hundreds of traders and thousands of positions. Yet Calpine’s contract portfolio is made up of 145 positions intended to reduce the risk of its portfolio of plants by locking in a stream of cash flows regardless of the market prices of power and gas. These contracts are long-term in nature (a weighted average of 7 years) and can be quite complicated in structure. Recent disclosures indicate that Calpine has contractually “sold” 31 percent of its future base-load generation and 63 percent of its peakers over the coming five years for $6.3 billion. Table 2 provides a summary of the generation percentages sold over the next five years.

Naturally, this activity reduces the EBITDA distribution native to the business. In other words, Calpine has traded a set of uncertain cash flows for $6.3 billion in contractual cash flows. These “locked-in” positions thus have increased Calpine’s expected net revenue and reduced the market risk of the corresponding distributions.

On the other hand, these positions also have reduced the potential financial upside of the business. Because Calpine has locked in guaranteed returns today, it will not be able to reap the benefits of any extreme power price spikes that could occur in the future on the generation covered by these contracts. Figure 3 demonstrates the monthly financial impact of these contracts.

The primary question Calpine’s stakeholders (investors and management) will need to answer is whether or not the company’s increase in expected EBITDA plus its reduction in risk will be worth more than the foregone amount of above-market return opportunities given away.

Unfortunately, the answer to this question differs depending on what kind of stakeholder one is, and this creates a conflict of interests that must be considered during the bankruptcy reorganization process. Typically, management will pursue as much upside as possible, as long as it avoids financial distress (management failed in this case). One might argue that a better strategy would have been to pursue merchant generation without long-term contracting in order to benefit from any and all market spikes.

On the other hand, unsecured debt holders typically want to contract out as much as possible to increase the probability that their debt interest is paid. Secured debt holders, however, may be less concerned given their more advantageous place in line. They will be indifferent to the upside opportunity (as above-market returns will benefit mainly equity stakeholders), but there also exists a high probability that their investment will be covered in all cases.

Equity holders also will want to insist on eliminating all contracts to maximize their upside opportunities.

Comparing the cumulative distribution function (CDF) of the business both with and without the contracts in relation to interest costs better illuminates the decision management should make.