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Trusting Capacity Markets

Does the lack of long-term pricing undermine the financing of new power plants?

Fortnightly Magazine - December 2011

for a number of years, buyers interested in long-term contracts won’t be willing to sign long-term contracts priced at the full cost of new power plants. Thus, developers of new power plants will be unwilling to offer long-term contracts at prices acceptable to buyers. Second, even owners of existing generating capacity will be unwilling to sign long-term contracts at prices equal to current market prices if they anticipate that RPM prices will increase over time. It’s likely, however, that buyers’ and existing generators’ interest in longer-term contracting will increase during the next several years as excess capacity diminishes and capacity market prices rise to the cost of new generation.

Financing Power Plants

Without a need for new plants, financing for such plants won’t be available unless supported by above-market long-term contracts. 4 However, this doesn’t mean that financing is unavailable for sound investments at costs that are consistent with market fundamentals. In fact, there’s been keen interest in plant acquisition. Several major transactions of power plants in eastern PJM demonstrate the availability of financing for generation investments.

A notable example in eastern PJM is Calpine’s 2010 acquisition of 4,490 MW of Conectiv Energy power plants from Pepco Holdings. The $1.63 billion purchase included some existing forward capacity and energy sales commitments as well as a six-year tolling agreement with Constellation Power for the Delta power plant that was under construction at the time. Importantly, it was financed with $1.3 billion of seven-year debt and $100 million of three-year debt.

Many generation developers prefer to build new power plants through highly leveraged project finance arrangements, which require long-term power purchase agreements. Project finance refers to the use of project-specific debt, also called “non-recourse” debt that isn’t backed by a guarantee from a larger parent company. Project finance often is the only available option for small project development companies that don’t have a significant portfolio of other assets or for companies with weak balance sheets and poor credit ratings.

Such non-recourse debt is secured solely by the revenues and asset value of the specific power plant. It’s more risky to the lender and consequently more expensive than corporate debt, which is secured by the more diversified revenues and assets of the parent company. However, while more expensive than corporate debt of companies with investment-grade credit ratings, non-recourse debt is still attractive to developers because it’s less expensive than equity and reduces the potential liability to the parent company if the project proves to be a bad investment. Non-recourse debt also can be less expensive than the corporate debt of companies with poor credit ratings.

To reduce financing costs, project developers also will prefer to lever up their investments by using higher levels of debt and less equity. However, such reductions in financing costs are possible only if project risks are reduced through long-term power purchase agreements that shift market risks from the generation owner to the buyer of the power. In fact, by assuming project risks through a long-term contract, the buyer is reducing (and essentially subsidizing) the financing cost of the new plant. Financing projects