Merchant Power Models
Executive Summary
Key Takeaways
- ✓ Merchant power revenue carries genuine, undetermined market price risk, and should be modelled through an explicit forward price curve and sensitivity range rather than a single static price assumption.
- ✓ The forward price curve should be sourced from an independent market price forecast, not an internally assumed flat or escalated price, since the model's credibility depends on the forecast's independent basis.
- ✓ Any hedging arrangement — a financial hedge, tolling agreement, or partial contract — should be modelled explicitly as its own component, separate from the underlying unhedged merchant exposure it offsets.
- ✓ The merchant tail, the period following PPA or contract expiry during which an asset sells at merchant price, should be modelled as its own explicit period with its own price assumption, not an extension of the prior contracted price.
- ✓ Sensitivity analysis on merchant price assumptions should be a standard, not optional, part of a merchant power model, given how directly this assumption drives project economics once contracted revenue ends.
Objective¶
This guide covers how to model merchant power revenue within Energy Financial Modelling: the forward price curve, sensitivity range, hedging treatment, and merchant tail mechanics.
Building the Forward Price Curve¶
Merchant revenue should be built from a forward electricity price curve sourced from an independent market price forecast specific to the asset's market and node, not an internally assumed flat or escalated price. Using an independently sourced forecast, clearly referenced in the model's assumptions, is what gives a merchant revenue assumption credibility to a lender or investment committee reviewing the model.
Sensitivity Range, Not a Single Point Estimate¶
Because merchant price is genuinely uncertain, the model should test an explicit sensitivity range around the central forward price forecast — not simply present a single point estimate as if it were as reliable as a contracted price. This range should be wide enough to reflect actual observed market price volatility for the relevant market, and downside scenarios should flow through to coverage ratio and return calculations to show their actual effect on project economics.
Hedging Arrangements¶
Where a project has a financial hedge, tolling agreement, or partial contract covering some portion of its output, this should be modelled as its own explicit component, separate from the underlying unhedged merchant exposure it offsets. This lets the model show both the gross merchant exposure the asset would face unhedged and the net position after the hedging arrangement, rather than presenting only a blended net figure that obscures the underlying exposure.
The Merchant Tail¶
The merchant tail — the period following PPA or other contract expiry during which the asset sells at merchant price — should be modelled as its own explicit period, with its own price assumption and, typically, its own discount rate reflecting the materially higher revenue risk of this period compared to the contracted period that precedes it. Extending the contracted price across the merchant tail, rather than building an explicit merchant price assumption for it, is one of the most consequential construction shortcuts in this domain — see Financial Modelling Best Practices for Renewable Energy for the construction discipline this builds on.
Common Construction Pitfalls¶
Flat or internally assumed price curve. Using an internally assumed flat or simply escalated merchant price, rather than an independently sourced forward price forecast, understates the basis for the model's most uncertain revenue assumption.
No sensitivity range tested. Presenting a single merchant price point estimate without a tested sensitivity range understates how exposed project economics actually are to this assumption.
Contracted price extended into the merchant tail. Carrying the PPA or contracted price forward across the merchant tail period, rather than building an explicit, independently sourced merchant price assumption for it, materially overstates long-run revenue.
Hedging blended into gross exposure. Presenting only a net, post-hedge revenue figure without separately showing the underlying gross merchant exposure conceals the project's actual exposure should the hedge lapse or counterparty default.
Recommended Practices¶
- Source the forward price curve from an independent market price forecast specific to the asset's market and node.
- Test an explicit sensitivity range around the central price forecast, flowing downside scenarios through to coverage and returns.
- Model any hedging arrangement as its own component, separate from the underlying gross merchant exposure.
- Build the merchant tail as an explicit period with its own price assumption and discount rate.
Continue Reading¶
Related Pillars¶
Related Technical Guides¶
Related Glossary¶
Related Industries¶
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Frequently Asked Questions
What makes merchant power revenue different from contracted revenue?
Merchant power is sold at prevailing market price with no fixed contract, meaning the price actually realized is genuinely uncertain and depends on future market conditions, whereas contracted (PPA) revenue is set by an agreed formula largely insulated from market price movements.
How should the forward price curve be sourced?
From an independent market price forecast appropriate to the asset's specific market and node, rather than an internally assumed flat or escalated price — the model's credibility on this assumption depends on using a sourced, independent forecast rather than an in-house estimate.
How should hedging arrangements be represented in a merchant power model?
As their own explicit component — a financial hedge, tolling agreement, or partial contract — modelled separately from the underlying unhedged merchant exposure it offsets, so the model shows both the gross merchant exposure and the net position after hedging.
What is the merchant tail, and how should it be modelled?
The revenue period following PPA or other contract expiry during which the asset sells at prevailing merchant price. It should be modelled as its own explicit period with its own price assumption and, typically, its own discount rate reflecting its higher revenue risk, rather than an extension of the prior contracted price.
Why is sensitivity analysis particularly important for merchant power models?
Because merchant price is the assumption most directly exposed to genuine market uncertainty in this asset class, and a model that does not test a meaningful range around its central price forecast understates how sensitive project economics actually are to that single assumption.
References
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