Managing financial risk tradeoffs for hydropower generation using
snowpack-based index contracts
Abstract
Hydrologic variability poses an important source of financial risk for
hydropower-reliant electric utilities, particularly in snow-dominated
regions. Drought-related reductions in hydropower production can lead to
decreased electricity sales or increased procurement costs to meet firm
contractual obligations. This research contributes a methodology for
characterizing the tradeoffs between cash flows and debt burden for
alternative financial risk management portfolios, and applies it to a
hydropower producer in the Sierra Nevada mountains (San Francisco Public
Utilities Commission). A newly designed financial contract, based on a
snow water equivalent depth (SWE) index, provides payouts to hydropower
producers in dry years in return for the producers making payments in
wet years. This contract, called a capped contract for differences
(CFD), is found to significantly reduce cash flow volatility and is
considered within a broader risk management portfolio that also includes
reserve funds and debt issuance. Our results show that solutions relying
primarily on a reserve fund can manage risk at low cost, but may require
a utility to take on significant debt during severe droughts. More
risk-averse utilities with less access to debt should combine a reserve
fund with the proposed CFD instrument in order to better manage the
financial losses associated with extreme droughts. Our results show that
the optimal risk management strategies and resulting outcomes are
strongly influenced by the utility’s fixed cost burden and by CFD
pricing, while interest rates are found to be less important. These
results are broadly transferable to hydropower systems in snow-dominated
regions facing significant revenue volatility.