The South African energy industry is being transformed by the Department of Energy’s (DoE) Renewable Energy Independent Power Producer Procurement Programme (REIPPPP). Many power purchase agreements (PPAs) have been signed between Eskom and Independent Power Producers (IPPs) and many more are expected with the round 5 bidding process to be imminently completed. Even with this growth potential, the sector is facing unprecedented challenges as a result of extreme volatility in financial and commodity markets, which most IPPs are either directly or indirectly exposed to.
A common feature of investor loans to IPPs is that they contain terms and conditions requiring the IPP to hedge all (or the majority of) market risks. This includes interest rate, foreign exchange and commodity (fuel) price risks. Hedging of these risks is traditionally achieved through the use of derivative contracts. The rationale behind these hedging strategies is to protect IPPs in the face of unexpected economic changes. For example, foreign exchange rate movements can place the IPP under substantial cash flow pressure, particularly where a project is committed to and asset and commodity purchase prices are denominated in US dollars, whilst the IPP sells power in the local currency.
Due to the specialised nature of trading derivatives and implementing hedging strategies, IPPs are exposed to operational risks as well as valuation and accounting challenges as the trading of derivatives don’t form part of their core business. However, getting the accounting correct in the pre and post PPA phases is particularly important for IPPs, as lenders rely on the underlying accounting information contained in the financial models that are submitted to secure the funding for these projects.
The feedback from lenders is that potential IPPs should be investing more time and effort in getting the accounting correct, in particular in the financial bid models they develop for the REIPPPP. If the accounting principles are over-simplified or incorrect, this has a direct impact on the projected internal rate of return (IRR) calculated by the models. If the lenders can’t rely on the projected IRR, it will restrict their appetite for lending.
IPPs need to take into account the potential volatility in earningsIPPs need to take into account the potential volatility in earnings that can be experienced as a result of the use of derivatives for hedging purposes. Even though the IPP may have economically hedged its relevant market risks, the accounting result may not always reflect this. This is as a consequence of the mixed measurement model in IFRS that requires the measurement of financial assets and financial liabilities on different bases.
Underlying exposures, or hedged items, are either, for accounting purposes, not immediately recognised or, at minimum, only recognised on a conventional accrual basis. The derivatives entered into to hedge these exposures are, however, required to be measured at fair-value, with gains or losses accounted for immediately through profit or loss, reflecting all market movements. These timing differences will eliminate over the lifetime of the hedge, however, for financial reporting purposes, a mismatch may be reported during the life.
Consider the example of an IPP that is required to import various equipment priced in foreign currency as part of its renewable energy construction project. Due to foreign exchange volatility the IPP is generally required to hedge its foreign exchange risk using a forward exchange contract (FEC). From an earnings perspective the IPP will experience volatility in its earnings due to fair value movements on the derivative. However, as the foreign exchange risk of the probable forecast purchase of equipment is “off balance sheet” until the equipment is delivered, an accounting mismatch arises. This mismatch results in earnings volatility even though from an economic perspective the IPP is perfectly hedged.
Hedge accounting is the only solution offered under IFRS to address accounting mismatches & timing differences.Hedge accounting is the only solution offered under IFRS to address these accounting mismatches / timing differences. Under hedge accounting, an entity could selectively measure assets, liabilities and firm commitments on a different basis from that usually stipulated in the accounting standards; or could defer the recognition of gains or losses on the derivatives in equity / other comprehensive income (OCI). This removes the volatility in earnings and ensures the financial information reflects the economic results of the hedging decision which management has taken.
It is only possible to apply hedge accounting when certain IFRS technical documentation and effectiveness testing requirements are met. While seemingly onerous and somewhat technical, most of the requirements would ordinarily be considered by organisations entering into hedging programs, however, these are often not formally documented.
They include the following:
If hedge accounting is not applied or achieved, it may result in an organisation not reflecting the economic result of the hedges in their financial statements, thereby triggering volatility in their earnings.
Whilst the current hedge accounting principles provide an effective solution for IPPs embarking on hedging strategies, they will have to be cognisant of the strict application requirements. This requires specialist accounting and valuation skills to ensure the valuations of the derivatives reflect fair market value and the application of hedge accounting is appropriate in terms of IFRS.
Hedge accounting principles are undergoing further changes under IFRS 9 which has an effective date for implementation set at 1 January 2018. This new standard broadens the application of possible hedge accounting strategies and promotes a more principles based approach which is aligned to an entity’s risk management practices.
There has also been an increasing focus on reflecting credit risk in the fair value of financial instruments. Although accounting standards do not provide specific guidance on how this can be achieved or calculated, CVA and DVA have become the generally accepted methods for estimating the valuation adjustment to financial asset and liability prices for credit risk. The implementation of CVA by a company increases the transparency to be able to attribute the risk components of the financial instrument’s pricing, by allowing the credit risk component to be separated out from the pricing relating to other market risks. This in turn allows the corporate to better interrogate the pricing offered by their bankers, in particular relating to the premium charged.
These various valuation considerations, whilst also taking into account the complex credit and operational lifecycle of an IPP, may place significant strain on the IPPs financial reporting processes and resources to ensure compliance with IFRS and valuation best practices.
IPPs are required to manage their market risks using derivative hedging strategies. These strategies open them up to various operational, accounting and valuation challenges which they are not adequately resourced or equipped to manage. With the current volatility in financial markets these entities also face volatility in earnings if they are unable to apply hedge accounting.
To address this challenge, IPPs need to obtain a practical understanding of the valuation and accounting specific demands, to ensure that they manage their risks effectively and provide financial reporting that appropriately reflects this.