A convexity framework for merchant power diligence.
Every merchant or hybrid power asset in an infrastructure book carries a payoff that is non-linear in price, yet the standard underwriting screen, "what percentage is contracted," measures the wrong thing. It treats convexity as a risk to be minimized when, for flexible assets, convexity is the asset. This note applies two of Sheephill's standing pillars to merchant power:
It reframes the position in option terms, locates where its value is mispriced, and closes with the questions that decide whether a long-gamma thesis survives contact with a real ERCOT or PJM tail.
The contracted-% screen fails because it is blind to both of the things Sheephill underwrites for. This note is organized around the two pillars it violates. Each section below advances one of them.
Applying option pricing to assets where bond-like investors see only risk. The merchant payoff is convex and the models that set PPA terms cannot see it, so the scarcity tail is cheap to own and expensive to surrender. The edge is an arbitrage of valuation frameworks, not a directional call on price.
Prioritizing assets that hold multiple unpriced paths to value. The flexible residual is a long-gamma position; curtailable load is a scarcity call held at no premium; a book long generation and short load is internally hedged. These options exist before any desk is involved — they need only to be recognized, netted, and underwritten.
Two mechanics make a merchant power payoff convex, and a third leaves that convexity systematically underpriced.
The edge here is an arbitrage of valuation frameworks, not a directional view on price — Sheephill's first pillar, applied to a payoff the market prices off models that omit the tail.
Structuring sets the shape of the curve; dispatch and bidding determine how much of the open upside is actually realized. Lever 1 is the investor's mandate and the subject of §02 and §05; Lever 2 is the trading function's execution. A correct structure with passive DA-block bidding leaves convexity on the table; aggressive bidding on a structure that already sold its upside has nothing left to capture. Both are required, and they are distinct seats.
Sources: the mispricing claim draws on Haugen et al., "Power market models for the clean energy transition," Applied Energy 357 (2024), a review of the modeling literature rather than primary price data. The 22-hour figure comes from the 2024 ERCOT State of the Market Report (Potomac Economics, ERCOT's Independent Market Monitor), as reported by Habitat Energy. LMP decomposes into energy, congestion, and losses; the tail lives in the first two.
When a developer signs a fixed-price PPA, they hand the offtaker a floor and a ceiling in a single instrument. They are paid for the floor but surrender the ceiling for nothing. In option terms the seller now holds short gamma: a steady contracted margin collected against an uncapped loss should they be forced to buy replacement power during an outage at a scarcity price. Contracting beyond the level required to service debt is not de-risking at all; it is the disposal of convexity at a price set by a model that cannot see the tail.
The discipline is to contract to the debt, not beyond it. The logic runs in three steps:
PPA pricing as of early 2026, with both ERCOT and PJM up roughly 9% year-over-year. The split shown is illustrative; the rule beneath it is not. Contract to debt service, floor the next slice with a revenue put where more bankable cash flow is needed, and keep the flexible slice convex. The tighter the grid and the more flexible the asset, the smaller the contracted share should be.
The generator is long the scarcity spike; the data-center load is short it. They are two sides of one contract, and the consequence for a fund holding both is rarely measured:
The practical consequence is a question every owner of both exposures should put to their own book: at a $2,000/MWh price, what does the generation sleeve earn, what does the load sleeve owe, and what is the net? Run on real positions rather than assumed weights, that number reframes how much scarcity risk the portfolio actually carries. A developer that owns both generation and load, increasingly common as hyperscalers buy developers outright, is already internally hedged and should price the tail explicitly rather than let it net out by accident.
The data-center short is not monolithic. A facility willing to curtail at a 0.5% annual rate, roughly 177 hours a year and concentrated in the most stressed intervals, sheds the bulk of the scarcity cost and can monetize the flexibility as demand response. Nor is it full shedding: across most of that window, at least half the load keeps running. That curtailment willingness is a long-gamma position held without paying premium — embedded optionality in the literal sense, a path to value already sitting in the load sleeve. Underwrite the interruptible share, not merely the nameplate.
Training load is more interruptible than most procurement plans assume; inference and customer-facing load is the firm base that genuinely needs BTM or a tight PPA. The split between them sets how much of the load sleeve's short-tail exposure is real versus optically conservative.
Sources: curtailment headroom and the 0.5% / 177-hour figure come from the Duke Nicholas Institute, "Rethinking Load Growth" (2025), via Utility Dive. The training-versus-inference interruptibility distinction draws on Data Center Dynamics (Dec 2025, citing McKinsey) and former DOE Loan Programs Office director Jigar Shah, via Data Center Knowledge.
The reframe above is necessary but not sufficient. A long-gamma thesis can be correct on direction and still lose money, and the four failure modes below are where it happens. None appear in a contracted-% screen. Each is a line item an IC should require in the model before underwriting scarcity value as bankable.
Long-gamma positions and the hedges around them generate margin calls in the same tight market that proves the thesis right. You can be correct on the price and still be forced out of the position by a variation-margin call before settlement. Winter Storm Uri bankrupted counterparties who were directionally correct; the failure was funding, not the view.
The scarcity tail is overwhelmingly a nodal congestion phenomenon rather than a hub-level one. Hedging local exposure with a liquid hub contract rests on a behavioral (fair-weather) relationship that decouples in precisely the congestion event you were relying on it for. CRR/FTR cover is itself fair-weather; the auctions clear below realized congestion at exactly the moment it spikes.
Buying a scarcity call protects you only if the writer survives the event. In a genuine ERCOT crisis, the entities short that tail are the ones defaulting, so off-exchange protection turns partly illusory at the very moment it is exercised. The implication for price is material: investment-grade-backed or cleared protection costs more than the bilateral quote, and that difference is the true cost of certainty.
Scarcity adders are an administrative parameter, not a market price. ERCOT has already cut the real-time offer cap from $5,000 to $2,000/MWh under RTC+B. After the next event and the political backlash it brings, a regulator can truncate the convexity you underwrote by fiat, after you have paid for it. A long-gamma owner is, in effect, short regulatory optionality.
A note on register: what follows is a set of structuring principles an asset owner sets as policy and directs a risk, treasury, or trading function to execute. It is a framework for governing how a book is shaped, written from the infrastructure-owner's seat, not a trading manual. The mechanics that implement each principle belong with a desk; the decisions below belong with the investor.
The four risks in the prior section are the ways a correct view fails to pay. Each has a structuring answer, and together they describe a book deliberately shaped so that uncertainty is a source of return rather than a threat to survival. The governing idea is simple: pay a small, known, recurring cost to keep the right tail open, and refuse to sit in the unhedged middle where the left tail is unbounded.
| Principle | What the owner mandates | The risk it answers |
|---|---|---|
| Contract to debt, not to comfort | Set a policy ceiling on contracted volume at the level that clears debt service and fixed costs at the lender's coverage ratio. Treat any contracting beyond it as a deliberate sale of upside requiring its own justification, not a default. | The contracted-% trap |
| Buy the floor, keep the ceiling | Where more bankable cash flow is needed, prefer a revenue put or floor over additional fixed-price volume. A floor raises the financeable base while leaving the scarcity upside with the owner; a fixed PPA surrenders both sides. | Convexity disposal |
| Pre-fund the event you are betting on | Size and commit liquidity to the margin posting a scarcity-priced hour demands, in advance, as a condition of holding the position. The capital that funds variation margin in the spike is part of the position's cost, not an afterthought. | Liquidity & variation margin |
| Match the hedge to the node, and the writer to the event | Require that hedges settle where the asset actually sits (nodal, not hub) and that scarcity protection is cleared or investment-grade-backed. Price fair-weather cover (hub proxies, sub-IG counterparties, CRR/FTR) as the partial protection it is. | Nodal basis & counterparty |
No one reliably forecasts the next spike, and the posture doesn't require it. Shape the book so a quiet year costs a known premium and a violent year pays a multiple of it: most capital beyond a crisis's reach, a small budgeted slice convex, nothing in the unhedged middle. That converts uncertainty from a threat into the thing you are paid to carry.
Set, in advance, how much premium the book may spend each year keeping the tail open, and treat it as a hard budget, not a forecast input. Spend it deliberately; let the desk pick the cheapest instruments. A position capped at that budget can expire worthless without consequence and pay a multiple when the regime turns.
These are governance principles, not trade recommendations, and they are not investment advice. The instruments that implement each, the choice of put structure, the form of scarcity protection, the mechanics of margin facilities, belong with a qualified risk or trading function. Pricing and availability vary by market and counterparty and change over time.
The standard screen asks one question: how much is contracted? These six replace it. They apply to any merchant or hybrid power asset, whether owned, underwritten, or sitting in a platform's pipeline, and each maps to a risk the contracted-% number cannot surface. Each question carries a diagnostic an owner's own analytical team can run this quarter, before any desk is involved, with the specific figure to compute. Print this page; it is the deliverable.
Where this comes from: the option framing follows Taleb's Dynamic Hedging; the mispricing claim draws on the power-market modeling literature; the empirical anchors are the ERCOT Independent Market Monitor and the Duke Nicholas Institute. The contract-to-debt rule, portfolio-symmetry netting, and the four-risk underwriting overlay are Sheephill's application. Full citations below.
Contracted percentage measures how much upside an asset has sold, not how much risk it has removed. For flexible, scarcity-exposed assets in a tightening grid, the two move in opposite directions. Read the four rules below as the two pillars in operation: the first and last price the tail others discount (Valuation Framework Arbitrage); the middle two surface the optionality already in the book (Embedded Optionality).
The portfolio-level offset between generation and load is a structural observation, not a modeled result; it should be quantified on real positions before being relied upon. Figures current as of early 2026 and subject to revision. Illustrative, not investment advice.