Understanding Credit Risk - Probability of Default

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In the search for a better understanding of credit risks surrounding the PPA market, this series will look into Expected Loss. Each part of the series will focus on 1 of the 3 factors that influence it, in this case, we will dive deeper into the Probability of Default.

Expected Loss (EL)

"Expected loss is not, as such, a calculation of risk, but it is rather a forecast of usual losses." - Moody's Analytics

EL multiplies the chance of default by what is lost in the case of default and the exposure at the default. It varies over time and it's driven by 3 main factors: 

Expected Loss = Probability of Default x Loss Given Default x Exposure at Default

For now, let's focus on the Probability of Default.

Probability of Default (PD)

In the context of PPAs

The PD is a measure of the likelihood that the counterparty, typically a power offtaker, will default on their contractual obligations to buy power from a renewable energy generator.

As the generator relies on the payments from the offtaker to finance the construction and operation of the renewable energy project, it's crucial to assess the creditworthiness of the offtaker and estimate the PD.

Assessing an offtaker's PD

The generator may assess the offtaker according to its:

• Bankability/Credit rating
• Past payment history
• Regulatory and political risks

As the PD increases, the higher the project's credit risk becomes, thus making it more expensive to finance.

Worth noting: The PPA tenor duration also plays a key role on assessing the PD since the longer it is, the higher the probability that default will occur at some point.

How to mitigate this risk?

By using the following risk mitigation strategies, the developer can minimize the risk of default and improve the bankability of the renewable energy project.

• Creditworthiness evaluation

This includes assessing the counterparty's credit history, financial strength, and other relevant factors that could impact their ability to make timely payments under the agreement.

• Termination clauses

Allowing the developer to terminate the agreement if the counterparty defaults on their payment obligations. This clause should include provisions for liquidated damages, which is a predetermined amount that the counterparty must pay in the event of default.

• Collateral requirements

Requiring collateral could include a letter of credit, a performance bond, or a cash reserve that the counterparty must deposit as security against non-payment.

• Risk sharing mechanisms

That allocate risks and rewards between the two parties. For example, the PPA could include a pricing mechanism that adjusts the price of the energy based on the counterparty's credit rating.

• Insurance

The generator can purchase insurance to mitigate the risk of default. For example, credit insurance can protect against the counterparty's inability to pay, and political risk insurance can protect against political events that could impact the counterparty's ability to make payments.

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