Understanding Credit Risk - Exposure at 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 Exposure at 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 Exposure at Default.

Exposure at Default (EAD)

In the context of PPAs, it refers to the predicted amount of money that's at risk in case of a default by either a generator or an offtaker.

The calculation of EAD for a PPA depends on several factors, such as:

• the size and duration of the contract,
• the current market price of electricity,
• the creditworthiness of the parties.

Worth noting: The longer the term of the contract and the higher the price of electricity, the higher the EAD.

Types of exposure in EAD - Replacement Risk (RR)

RR can be seen as the difference between the value for the undelivered volumes under the current market prices and the price settled under the PPA.

Depending on the movement of the prices after the execution of the PPA, either the buyer or the seller may be exposed to RR.

RR is therefore the loss experienced by the impacted party while engaging in a replacement transaction at market rates.

Replacement Risk Example - Exposing the offtaker

• Offtaker A bought electricity from Generator A at 53 €/MWh to be sold to Offtaker B in 2023.

• Generator A defaults the agreement for the 53 €/MWh electricity delivery in 2023.
• Offtaker A is still obliged to deliver electricity to Offtaker B.
• Forced to go to the market to buy the missing amount of electricity, which is now priced at 56 €/MWh.

Offtaker A has a Replacement Loss of 3 €/MWh

Replacement Risk Example - Exposing the generator

• Offtaker A bought electricity from Generator A at 53 €/MWh to be sold to Offtaker B in 2023.

• Offtaker A defaults the agreement for the 53 €/MWh electricity delivery in 2023.
• Generator A is left with amounts of unsold electricity.
• Forced to go to the market to sell the surplus, which is now priced at 49 €/MWh.

Generator A has a Replacement Loss of 4 €/MWh

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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