Risk Reduction for Energy Project Sponsors Through Synthetic, Revenue-Neutral Diversification

Abstract

Financial institutions and insurance companies account for 96% of the activity in the $4.8 trillion credit derivatives market while corporations account for a mere 4%. This article makes a case for? synthetic, revenue-neutral diversification? as a method for energy firms to manage the credit risk in their long-term power-purchase agreements (PPAs). Synthetic, revenue-neutral diversification involves a firm buying insurance on assets in its portfolio and paying the associated insurance premium by simultaneously selling insurance to another firm, thus enabling it to avoid any cash expense. The primary objective of synthetic, revenue-neutral diversification is implicitly to change the firm?s asset portfolio and to increase diversification without reducing the firm?s revenues. In an example, two independent power producers use credit derivatives to diversify the geographic exposures of their PPA portfolios, thereby reducing their expected losses, improving their credit ratings, and lowering their cost of borrowing.