Assessing Risk in the CHPSOP 2.0 Program

November 2014

• Careful planning, and risk identification and management are necessary in order to fully realize the opportunity offered by CHPSOP 2.0.
• Considerations for dispatching a plant are more complex than contemplated in the CHPSOP contract. The differences between what the contract assumes and the reality of an actual project represent an economic risk for the project proponent.
• Aegent recommends taking an enterprise view – identify risks during the proposal stage and distribute them over the contractual framework to ensure the project is profitable by design.

The Ontario Power Authority (OPA) began accepting applications for the Combined Heat and Power Standard Offer Program (CHPSOP 2.0) on November 3. The CHPSOP program is a great opportunity for those with the ability to make use of the waste heat produced from engines or turbines that turn power generators. While the program provides revenue to the Combined Heat and Power (CHP) project operator over 20 years, careful planning and risk identification and management are necessary to fully realize this opportunity.

Like previous iterations of OPA energy purchase agreements for natural gas-fired power plants, the CHPSOP 2.0 works on a “deemed dispatch” model. The contract starts with a fixed monthly revenue stream the project needs to be economic. Each month the OPA subtracts from the fixed payment, revenue that ought to have been earned by the project by selling power in the Ontario electricity market, based on certain plant parameters and the plant dispatching itself economically.

Characteristics of a theoretical Virtual Power Plant (VPP) form the basis for determining when the CHPSOP project ought to have run. Amongst the assumptions in this model are: heat rate, marginal operating and maintenance costs, and gas commodity costs. If a CHP project identically matches the characteristics of the VPP – and operates according to the deemed dispatch model – then the project’s actual market revenue will match its deemed revenue.

However, no physical plant will identically match the VPP and considerations for dispatching a plant are more complex than contemplated in the CHPSOP contract. The differences between what the CHPSOP contract assumes and the reality of an actual project represent an economic risk for the project proponent. Managing these risks is key.

Some prospective proponents take a functional view – they concentrate on receiving a contract, assume it will be profitable, then try to optimise the economics after contract execution. Aegent recommends taking an enterprise view – identify risks during the proposal stage and distribute them over the contractual framework to ensure the project is profitable by design.

Heat rates vary depending on the plant’s physical characteristics, ambient conditions, and useful heat output. If the physical plant has a higher heat rate than the VPP, then the plant won’t be able to run profitably during some of the hours where the CHPSOP contract assumes the plant ran profitably. The project will earn less than its expected monthly revenue, hurting its profitability.

Marginal operating and maintenance costs depend on the condition of the physical equipment, the actual amount of run-hours, and the maintenance agreement for the plant. Volumetric gas charges should also be included here. If actual operating and maintenance costs exceed the costs assumed for the VPP, then the plant will earn less than its expected monthly payment.

The CHPSOP contract assumes that all gas commodity cost equals the Dawn day-ahead index. If the operator purchases gas at another point or index, or some purchases are hedged, then the plant’s marginal operating costs will diverge from the VPP. This mismatch creates another risk that the proponent’s revenue will not equal the revenue anticipated upon entering the contract.

By identifying these risks early, the proponent can shape their proposal to narrow the gaps and pass more risk onto the OPA. To the extent that risk is not transferrable to the OPA, the proponent can develop alternative strategies for dealing with the residual risk. This allows proponents to build an accurate risk-adjusted view of the project’s economics and determine the acceptable amount of “bid-down” resulting in a more competitive proposal that will be profitable by design. They will submit their proposal with a better sense of what the risks are and a better confidence that the risk they are taking is commensurate with the rewards they expect to earn.

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