Banking on Predictability

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

A renewed capital investment structure is required for long-term investment in power infrastructure.

The bank markets and the long-term fixed income markets, or institutional investors, have long memories, and their pain is still fresh. Over the last few years, they have had to watch their investments in power infrastructure become distressed, bankrupted, or reorganized.

Even as we argue that the infrastructure financing markets may have stabilized for the time being, both from a financial and a fundamental standpoint, the undeniable fact is that investors still remember what's happened in the United States, and they remember privatizations in foreign countries where they experienced similar losses. In short, investors are wary.

Without mention, the ability to attract investment is central to developing new infrastructure that will help resolve many of the power issues we face today.

Yet, given the recent power markets, and investor sentiment, many utilities could not be blamed for believing that sources of funding have dried up.

Because of our extensive activity in the market, Lehman Brothers has a different perspective. There is money and there are opportunities that lie in the infrastructure financing market today-but only with the right capital investment structure.

Finding Asset-based Solutions

In the last few years, many investors have experimented with a number of capital investment structures, whether unregulated, regulated, or diversified hybrid models, with mixed results. Today, the question from investors is, how do you then come and participate in the next asset-based solution?

That is quite a difficult question to navigate, but we believe, with respect to infrastructure policies, the employment of a financing mechanism similar to that used with Public Utility Regulatory Policies Act (PURPA) contracts would be extremely well received by infrastructure investors.

If you look at the construction of bilateral PURPA contracts, they generally separated fixed and variable components, not unlike gas pipelines. The fixed component was meant to cover certain items, and the variable component was meant to cover-off certain items. The financing markets generally viewed that as a rate base and financed it as such, but it favored an arbitrage of debt over equity.

The total composition of debt in the capital structure showed numbers that were higher than those for the utilities that were the obligors on the power purchase agreements. That worked, and it still works. Those contracts are still valid. In fact, investors are buying assets to get to those contracts and leveraging them again. Furthermore, these contracts would mitigate the unknown risks.

These PURPA contracts are old and cold at this point, but the fact remains they are long-term contracts. Many of those contracts are still operative in nature. In fact, many of the projects that were financed using these contracts have been gobbled up in the merger and acquisition market over the past two years, as financially distressed parties have looked to raise capital in the most efficient way. In some cases, the value of these assets backed up by these contracts were more valuable to them in a sale context than selling their own corporate securities, either debt or equity, to the extent 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 minds of debt investors as they think about new investments.

There also was a perception among the market participants-both the people building infrastructure and those financing it-that there would be some nature of self-regulation to capital flowing into infrastructure investments. Industry players repeatedly said that the capital markets would never allow an infrastructure bubble in merchant gas-fired generation. Clearly, that was not the case. There was a lack of self-discipline in merchant investments. There was a further assumption that bankruptcy in the utility sector was a far-off concept, one that could not actually be realized.

The comparison of non-recourse versus recourse debt is clear. What we learned post-crisis is that non-recourse really means that debt owners can now be equity owners upon a bankruptcy type situation. Under these circumstances, people invested non-recourse debt and possibly thought there might be some future infusions of capital, although none were required or mandated. They now know that all parties are going to act in their economic best interests when tested under duress. Under these circumstances, these debt investors are now, in the case of merchant power plants in particular, asset owners. That's a new transition within the sector, creating a new owner base within the power sector. Clearly, those investors are not meant to be long-term owners of infrastructure capital, at least not by that method of acquisition.

This is really more of a financial mechanism that poses risk. One of the lessons learned is that there is really no good substitute for financial liquidity in the event that additional cash is required to be injected into systems.

How Investors See the Power Industry

It's important to understand the complexity of what an investor may see in something like a load pocket, especially a wholesale load pocket. Considerations include:

  • A wide degree of generation participants in that market, both the fuel type and the nature of their assets and how they meet load-serving needs;
  • Peaking generation, whether it's market-based or just built by an incumbent, and whether that incumbent might have the advantage of tax-exempt debt;
  • Distributed generation, and combined heat and power, renewables, which are somewhat social programs, but valid; and
  • On the transmission side, there are intra-grid and intergrid situations, meaning the connection of grids to make regionality greater, or the concept of super regions.

From a financing market standpoint, all of these assets are in play right now. Whether there are existing assets suitable for the M&A market (which would involve somebody needing to finance that M&A transaction) or they are new-build assets requiring new construction within the pocket, or they are going to be contributed to some greater whole (possibly in the case of transmission)-all of those have financial implications to the current asset owners and to the new asset owners. They affect how the capital structures of the various participants in that pool are constructed and how the capital will then behave. Some parties are clear entrepreneurs and profit-incented. Some parties are not necessarily profit-incented, but reliability-incented and subsidized with cheaper capital. There are four basic financial regimes that provide 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, and that's certain.

Lessons Learned: Four Capital Structures

  • Vertically Integrated Utility: Demonstrates the composition of a traditional utility, cost of service, capital structure. Concerned investors perceive this regime as the lowest-risk regime because of its capital structure. Roughly 50 percent (give or take) is represented as debt. That debt would be considered recourse and corporate in nature. Around five percent of the capital structure, plus or minus, is preferred, and around 45 percent of the capital structure is common equity
  • Contracted Power: The PURPA Contracted Power Project regime relies upon the strength of a contract-a ratable contract that is viewed by the markets as a creditworthy instrument-to keep relative risk fairly low. Roughly 80 to 90 percent of the capital structure of a project financed with this type of revenue contract could be debt. That debt is non-recourse and project finance. This is different from the recourse and corporate debt you find in a vertically integrated utility. Used for highly specific infrastructure situations, this debt's payback or return on the capital is wholly dependent upon the operations of the project and the revenue that the contract generates. The remainder of the capital structure in these circumstances is typically equity.
  • Merchant Power: This is the highest relative risk, meant to illustrate the EWG Merchant Power Projects-largely gas-fired generators, green-field, and construction in nature-that were financed during the boom times of the power market, leading up to the energy crisis. Typically, these projects did not involve long-term contracts; they involved merchant revenue streams that the market, both debt and equity, needed to gain comfort with respect to the composition of those streams.
  • The Future Capital Model: What might capital investment look like today in a post-energy-crisis environment? Where will the capital markets draw the line with respect to a capital structure and/or any capital flowing into new infrastructure investment? Most decisions will be based on the lessons learned.-F.N.

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