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EDP Renewables 2013 Annual Report

Internal Control and Risk Management I

50. INTERNAL AUDIT

EDPR has Internal Audit Department composed by five people. The function of EDPR’s Internal Audit is to carry out an objective and independent assessment of the Group’s activities and of its internal control situation, in order to make recommendations to improve the internal control mechanisms over systems and management processes in accordance with the Group’s objectives.

Additionally, EDPR has a Responsibilities Model and a SCIRF Manual (Internal Control System over Financial Reporting), in which individuals, governing bodies and commissions responsible for implementing and managing the internal control system are indicated.

The Responsibilities Model includes the functions and main activities in the management and maintenance of the system at all levels of the organization including monitoring activities related to the annual cycle, the implementation of controls and documentation of evidence and supervision activities.

The SCIRF Manual incorporates the general principles of the Internal Control System over Financial Reporting are established, as well as the methodology used, the procedures for ensuring the effectiveness of internal control and design of models, documentation, evaluation and reporting.

In line with the general principles of the model adopted by EDPR for the management of the SCIRF, the COSO framework (Committee of Sponsoring Organizations of the Treadway Commission), the responsibility for overseeing the Internal Control System lies in the Board of Directors and the Audit and Control Committee. The CEO is accountable before the Board, must ensure the proper functioning and effectiveness of the SCIRF, promoting its design, implementation and maintenance. The Executive Committee must support the CEO in this task, guiding the development of the Entity Level Controls of the Company and the controls in their areas of responsibility, relying when necessary on other levels of the organization. Also, the Senior Managers are responsible for evaluating any deficiencies and implementing appropriate improvement opportunities.

To fulfil these responsibilities, EDPR’s Internal Audit offers support and advice to the management and development of the SCIRF.

Additionally, in 2013 the EDPR Group decided to have its SCIRF audited by the external auditor. As a result of its evaluation, the external auditor issued a report with a favourable opinion on SCIRF of the EDPR Group, according to ISAE 3000 (International Standard on Assurance Engagements 3000).

51. ORGANIZATIONAL STRUCTURE OF INTERNAL AUDIT

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52. RISK MANAGEMENT

EDPR’s Risk Management is as an integrating element of all organizational processes and decisions and not a stand-alone activity separated from the main activities of the Company. It includes from strategic planning to evaluation of new investments and contracts.

Risk Management at EDPR is supported by three distinct organizational functions, each one with a different role: Strategy (Risk Profiler), Management (Risk Manager) and Controlling (Risk Controller).

Market, credit and operational risks are identified and assessed and, following the result of the assessment, Risk Policies are defined and implemented across the Company. These policies are aimed to mitigate risks without compromising potential opportunities, thus, optimizing return versus risk exposure.

During 2013, EDPR defined or reviewed four new Global Risk Policies: Energy Price Hedging Policy, Counterparty Credit Risk Policy, Country Risk Policy and FX Risk Policy. These policies are already implemented or in the process to be implemented next year.

53. RISK AREAS AND RISK FACTORS

Risk Management at EDPR is focused on covering all market, credit and operational risks of the Company. In order to have a holistic view of risks, they were grouped in Risk Areas converting all the value chain of EDPR’s business. The following list summarizes Risk Areas defined within EDPR:

  • Countries & regulations – Changes in regulations may impact EDPR’s business in a given country;
  • Revenues – Revenues received by EDPR’s projects may diverge from what is expected;
  • Financing – EDPR may not be able to raise enough cash to finance its planned Capex or to fulfil its financial obligations due to changes in exchange rates or bankruptcy of counterparties;
  • Wind turbine contracts – Changes in turbine prices may impact projects’ profitability; Contracts should take into account the pipeline development risk;
  • Pipeline development – EDPR may deliver an installed capacity different from its targets or suffer delays and/or anticipations in its installation;
  • Operations – Projects may deliver a volume different from expected.

Within each Risk Area, risks are classified in Risk Groups and finally into Risk Factors. Risk factors are the source of the risk and the purpose of Risk Management at EDPR is to measure, control and eventually mitigate all risk factors that affect the Company.

From  Risk  Areas  to  Risk  Factors

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1. COUNTRIES AND REGULATIONS

I.I. COUNTRY RISK

Country Risk is defined as the probability of occurrence of a financial loss in a given country due to macroeconomics, political or natural disasters. During 2013, EDPR has defined a new Country Risk Policy that assesses country risk through an internal scoring based on publicly available data. This internal scoring is compared with external assessments from renowned parties. Each risk factor affecting country risk is evaluated independently to decide on potential mitigating actions:

Macroeconomic Risk: Risks from the country ́s economic evolution, affecting revenue or cost time of the investments

Political Risk: All possible damaging actions or factors for the business of foreign firms that emanate from any political authority, governmental body or social group in the host country

Natural disaster risk: Natural phenomena (seismicity, weather) that may impact negatively in the business conditions.

MANAGEMENT OF COUNTRY RISK

Before approving a new project in a new geography, EDPR analyses the risk of the new country and compares it to our existing portfolio. Mitigation measures may be decided when this risk is above a certain threshold.

I.II. REGULATORY RISK

The development and profitability of renewable energy projects are subject to policies and regulatory frameworks. The jurisdictions in which EDPR operates provide different types of incentives supporting energy generated from renewable sources.

Although the European Union and various US federal and state bodies have regularly reaffirmed their desire to continue strengthening support for renewable energy sources, remuneration schemes have become less competitive in some countries due to the financial crisis. Thus, it cannot be guaranteed that current support will be maintained in all EDPR’s geographies or that the electricity produced by future renewable energy projects will benefit from purchase obligations, tax incentives or other support measures. Regulation promoting green energy has been revised or is under revision in some countries where EDPR is present.

In particular, during 2013 there were regulatory changes in Spain that reduced incentives for existing and future projects. In Romania, the number of green certificates for new wind projects was reduced.

In the US, renewable generation was incentivized through Production Tax Credits (PTC) at a Federal level till December 2013 and is still incentivized through State RPS Programs that allow receiving RECs (Renewable Energy Credit) for each MWh of renewable generation. As a general rule, EDPR focuses on developing in states which have an RPS program in place and are undersupplied of renewable generation. As aforementioned, in December 2013, PTC scheme for wind expired and all projects that will be built in the future will not receive PTC, except for those that qualified during 2013. EDPR was able to secure around 1 GW of PPA projects with PTC qualification that will be mainly built during 2014 and 2015.

MANAGEMENT OF REGULATORY RISK

EDPR is managing its exposure to regulatory risks through diversification (being present in several countries) and by being an active member in several wind associations. Regulatory Risk in each of EDPR’s countries is monitored continuously, considering current regulation, potential drafts of new laws, feedback from associations, evolution of installed renewable generation capacity and other inputs.

Additionally, a high level analysis is performed for each country considering the meaningfulness of renewable generation from a strategic and financial standpoint. Among others, EDPR analyses the following for each country: existing and future generation mix, electricity prices, remuneration incentives for renewables, renewable generation target and energy autonomy.

Finally, Regulatory Risk is also considered ex-ante at the moment of the investment, through sensitivity analyses that are performed to evaluate its impact in project profitability.

2. REVENUES

I.III. ELECTRICITY PRICE RISK

EDPR faces limited electricity price risk as it pursues a strategy of being present in countries or regions with long term visibility on revenues. In most countries where EDPR is present, prices are determined through regulated framework mechanisms. In those countries with no regulated tariffs, power purchase agreements are negotiated with different offtakers to eliminate electricity price risk.

Despite EDPR’s strategy of eliminating electricity price risk, EDPR still has some wind farms that have merchant exposure.

In Europe, EDPR operates in countries where the selling price is defined by a feed-in-tariff (Portugal, France and Italy) or in markets where, on top of the electricity price, EDPR receives either a pre-defined regulated premium or a green certificate, whose price is achieved on a regulated market (Spain, Belgium, Poland, and Romania). EDPR is also developing investment activity in the UK, where current incentive system is based on green certificates but will change to a feed in tariff.

In countries with a pre-defined regulated premium or a green certificate scheme, EDPR is exposed to electricity price fluctuations. Considering current PPAs in place, EDPR is exposed to electricity price risk in Romania, in Poland and partially in Spain.

The US market does not provide a regulated framework system for the electricity price. However, most of EDPR’s capacity in the US has predefined prices determined by long-term contracts with local utilities in line with the Company’s policy of avoiding electricity price risk. Despite existing long term contracts, some EDPR’s wind farms in the US do not have PPA and are selling merchant with exposure to electricity price risk. Some others with existing PPAs do not sell their energy where it is produced are exposed to basis risk.

In Ontario (Canada), the selling price is defined by a long term feed-in-tariff, thus, there is no electricity price exposure.

In Brazilian operations, the selling price is defined through a public auction which is later translated into a long- term contract. Electricity price exposure is almost null, with some exposure for the production above or below the contracted production.

MANAGEMENT OF RISKS RELATED TO EXPOSURE TO MARKET ELECTRICITY PRICES

Under EDPR’s global approach to minimize the exposure to market electricity prices, the Company evaluates on a permanent basis if there are any deviations to the pre-defined limits (measured through EBITDA at risk and total merchant exposure).

EDPR seeks to eliminate electricity price risk through PPAs with private offtakers. In 2013, EDPR secured long term agreements in Europe for 60 MW, in Brazil for 116MW, and in the US for 1,000 MW.

In those geographies with remaining merchant exposure, EDPR uses various financial and commodity hedging instruments in order to minimize the exposure to fluctuating electricity prices. In some cases, due to the lack of liquidity of financial derivatives, it may not be possible to successfully hedge all merchant exposure.

In 2013, EDPR financially hedged part of its generation in Poland and Romania. In Spain, hedges in place at the beginning of 2013 were unwound when new regulation eliminated the merchant exposure that included the previous legal framework (RD661).

As mentioned above, some US wind farms have exposure to electricity price risk or basis risk (difference in electricity price between locations). EDPR hedges electricity price and basis exposures through financial swaps or FTR buys (Financial Transmission Rights).

I.IV. GREEN CERTIFICATE OR REC PRICE RISK

In Europe, EDPR operates in countries where, on top of the electricity price, EDPR receives a green certificate whose price is achieved on a regulated market (Poland and Romania).

In these European countries with a green certificate scheme, EDPR is exposed to fluctuation on the price of green certificates.

In the US, renewable generation is incentivized through State RPS Programs that allow receiving RECs (Renewable Energy Credit) for each MWh of renewable generation. REC prices are very volatile and depend on the supply/demand equilibrium in the market.

MANAGEMENT OF RISKS RELATED TO EXPOSURE TO GREEN CERTIFICATES OR REC PRICES

EDPR intends to eliminate Green Certificates and REC price risk with the signing of bundled PPAs, which include the sale of the electricity and the Green Certificate or REC. In some cases, the offtaker may be interested in contracting only the Green Certificate or the REC, thus a GCPA (Green Certificate Purchase Agreement) or a RECPA (REC Purchase Agreement) is signed.

The market of GCPA or RECPA is very illiquid and no financial derivatives exist for Green Certificates or RECs. Therefore, all exposure to Green Certificates or REC prices cannot be eliminated.

I.V. ENERGY PRODUCTION RISK

The amount of electricity generated by EDPR’s wind farms is dependent on weather conditions, which vary across locations, from season to season and from year to year. Variation on the amount of electricity that is generated affects EDPR’s operating results and efficiency.

Wind at different locations may be independent from each other or may be correlated (positively or negatively). A negative correlation implies a natural hedge of production fluctuations of the portfolio.
Other risk factors that affect production are turbine availability and curtailment, which are considered as operation risks and are explained in the corresponding section.

MANAGEMENT OF RISKS RELATED TO VOLATILITY OF ENERGY PRODUCTION

EDPR mitigates wind resource volatility and seasonality by having a strong knowledge in the design of its wind farms and through geographical diversification of its asset base in different countries and regions. EDPR has analysed correlation between different wind farms in its portfolio and this geographical diversification enables EDPR to partially offset wind variations in each area and to keep the total energy generation relatively steady. Currently, EDPR is present in 11 countries: Spain, Portugal, France, Belgium, Poland, Romania, UK, Italy, US, Canada, and Brazil.

EDPR has analysed in detail the potential use of financial products to hedge wind risk, and this product might be used to mitigate risk in specific cases.