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Banking on Predictability

A renewed capital investment structure is required for long-term investment in power infrastructure.
Fortnightly Magazine - April 2004

they had liquidity in the markets to sell those corporate securities.

Therefore, the equity capital that will flow against a debt to round out the capital structure will inherently have less risk. Theoretically, this leads to a lower charge on return. That may not be the preferred way of attracting capital to finance infrastructure, but it certainly is a way of bringing low-cost resources and assets into the marketplace. Of course, different investments have required different capital structures, but investors have found bilateral contracts to be much more effective and less risky than investments in merchant generation, which relied on market revenues. Moreover, a fair amount of expertise was brought to bear in the financing of merchant projects through the use of consulting reports and other types of measures to educate the investor base regarding a reasonable view of revenue.

However, the key point was that no underlying contracts provided a floor to those estimations, so the risk was real in merchant investments. Ironically, a fair amount of non-recourse and project debt was available in the market at that time to finance merchant projects of this nature. We saw about 60 to 80 percent debt against merchant power plants during those time periods. The remainder of the capital structure was equity.

This showed that investors were willing to buy into market development through the merchant stratification of the markets, opening of markets, and many concepts that were seeking to be employed from a policy perspective. However, the credit crisis involved a turn, and people learned what the nature of merchant versus contract really meant. The people who learned the most in that story were the debt providers.

The Merchant Bust: Lessons Investors Learned

During the merchant investment boom, the risky part of the market could be very long and very pointed. Several assumptions and parameters were assumed to be balanced and transparent by investors, but when tested under duress, they were found to be flawed. Take for instance, consulting reports on commodity price dynamics. If an investor looked at the scope of some of these reports, he or she often believed that the scope encompassed every risk they should be knowledgeable about, and that it possibly provided mitigants and an understanding of those risks. That wasn't necessarily the case. So it could be argued that the universe of investors did not have a full and transparent view of market development risk at the onset of many of these financings.

Furthermore, many of the various markets, both regionally and nationally, were at their incipient stages. They had not been tested under duress. There had not been a long track record of workability under those markets. And, as we have learned in California and other places, market development risk was a real investment risk.

The composition of the capital structure for a typical merchant power plant under investment showed all non-recourse project financed debt. We've learned post credit-crisis what risk that debt really took-that debt holder assumed an equity level of business risk within the capital structure. That lesson will certainly be on the