To understand basis risk, it is useful to first review some important aspects of US energy markets.
Understand Basis Risk
Nodes and Hubs
Within each organized wholesale electricity market, electricity prices are set at “nodes”; these nodes can be located at electrical busses, or “specific components at which generators, loads, or the transmission system are connected.” There are hundreds if not thousands of nodes within each organized wholesale market. Nodal prices are then aggregated via a weighted average formula into a handful of regional “hubs” or “zones.” These aggregated values are less subject to local fluctuations in energy markets and are therefore more stable over time.
When a power generator sells energy, it receives the local nodal price in return. However, since hub prices are less volatile, most VPPA buyers choose to negotiate their VPPA so that it settles at the hub, meaning that the revenues that the buyer receives for each MWh generated are based on the regional hub price rather than the local nodal price. Hub settlement requires that the project owner, or a third party, absorb any price discrepancies between the nodal and hub prices for each MWh. If these prices are expected to move up and down together, then it’s relatively easy for a developer to build any expected profit or loss from this hub settlement into the PPA price; this is the case illustrated in the graphic below.
Basis risk refers to the potential for the relationship between the local nodal prices and the hub prices to change over time. To illustrate this, imagine that nodal and hub prices, rather than moving together as expected (and as illustrated above), instead begin to diverge, as shown below. In this case, while the buyer is happy to still be receiving the relatively high hub prices, the project owner is forced to absorb significant losses. While this is not a risk typically borne directly by VPPA buyers, it is important to consider and understand, as developers will consider basis risk when developing their prices. Projects that are deemed highly susceptible to basis risk, such as projects that rely on a single transmission line to deliver their power to customers, may be forced to quote higher PPA prices to help the project owner insure themselves against these risks. Basis risk is likely to be a bigger concern in areas where many renewable energy projects of a single type are being built and saturating the local market; examples of areas where this might be a particular issue include northwestern Texas for wind energy and southeastern California for solar energy.