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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

the framework for contract discussion ().

The market is probing for workable models of the past, with a call for "back to basics," particularly in the investment paradigm of capital flowing into infrastructure. You hear it from the management of companies that reside in the sector and the owners of the assets in the sector. And you hear the market's call for back to basics phrase: "I want to understand how this market works. Is it transparent enough to observe this market working in the way you're saying that it's working, so that I can monitor the performance of my investment, either a physical investment or a financial investment?"

Moreover, there are new players and some non-traditional players. On the street, they may call this "smart" or "hot" money. These are private equity players, hedge funds, and other forms of private capital-opportunistic investors with liquidity. They have a desire to play where there's an opportunity, such as a need for something as fundamental as infrastructure, combined with a lack of willing capital or capital that is priced for the large-risk premium to flow into those circumstances. As they think about making their next investments, their advantage is the hindsight of things that recently went wrong.

That new money is able to evaluate risk and return right now. Where does it feel most comfortable? Where will its costs be released with respect to financing? Clearly, where things are most certain. That's why we need to resolve issues about disparate markets and jurisdictional imbalances. The left side of the spectrum wants full cost-of-service re-regulation, while the free market camp on the right wants open and competitive markets. The answer will be resolved in time. The sooner we have certainty, the more quickly capital will flow in a rateable fashion-and possibly, the sooner some of these fundamental technical issues, and these asset issues, can be resolved.

To the extent that the markets, as designed today, will continue to have an implied level of risk that's not necessarily clear and transparent, capital will eventually flow. But it may cost more than it should for a certainty that may be reached at some future point in time. This involves optionality-when capital feels comfortable with the prospects of investing in an asset that displays characteristics of a deep-in-the-money intrinsic option. Optionality can either be:

  • Extrinsic, which is volatile and, less certain; and
  • Market-based and intrinsic, which is certainty.

As mentioned earlier, the most certain form of a revenue stream is that which can raise the most debt, which is in turn very cheap cost-of-capital in today's market. That's a contract.

Some assets resemble contracts in nature, such as a low-cost coal plant in a gas marginal region. That is not as good as a contract, but can look like one as it is evaluated. An example includes a cost-of-service rate base that might have some performance-based up sides. That looks something like a contract.

Better yet, most attractive today are jurisdictionally undisputed, bilateral contracts where there is no argument to the validity of the contract. That's a contract,