EXPLORING THE CAPITAL MARKETS AND SECURITISATION FOR RENEWABLE ENERGY PROJECTS
ETSU K/BD/00215/REP
Contractor Impax Capital Corporation Ltd
Prepared by M E Haggard M A Thompson S Colonna
The work described in this report was carried out under contract as part of the New and Renewable Energy Programme, managed by ETSU on behalf of the Department of Trade and Industry. The views and judgements expressed in this report are those of the contractor and do not necessarily reflect those of ETSU or the Department of Trade and Industry.
First published 2000 © Crown copyright 2000 Limitation of Responsibility
This document has been prepared by Imp ax Capital Corporation Ltd (“Impax Capital”) with support from CMS Cameron McKenna based on materials and information supplied by various sources believed to be reliable. Impax Capital has made limited independent investigation of such information and makes no representation or warranty (express or implied) as to the accuracy, completeness or fairness of the information, opinions or projections herein. Nevertheless, additional information is available on request.
Recipients of this report are not to construe the contents of this report as investment, legal or tax advice. Each recipient should consult its own counsel, accountant, independent adviser or other advisers as to legal, tax, business, financial and related aspects of this report.
Except where otherwise indicated, this report speaks as of the date hereof. The delivery of this report shall not under any circumstances, create any implication that there has been no change in the rules or activities of the subjects contained herein since the report’s date. In furnishing this report Impax Capital undertakes no obligation to update any of the information contained herein.
----- Acknowledgements------
Written with support from CMS Cameron McKenna
The capital markets are a large and constantly evolving arena. Without the participation and support of many highly skilled practitioners in the market, the value of this report would be significantly diminished. It is only by working closely with people actively involved in the market, that a reasonable assessment of investment potential is possible. The following companies were particularly generous with their time and support: Barclays Capital Financial Security Assurance (UK) Greenwich Natwest Fitch IBCA HSBC Investment Bank Standard & Poor’s Prudential Portfolio Managers UK J Henry Schroder & Co
ii 1. Executive Summary
> Availability of finance is a function of the renewable energy framework and commercially sound projects; > Capital markets provide a large, long term and liquid source of finance for infrastructure; > Capital markets can be flexible and offer looser covenants than commercial bank debt, however, credit quality of the sponsors in conjunction with the main agreements (EPC, fuel supply, PPA and O&M) is paramount; > Green credentials are not bankable in isolation; > Minimum transaction size for public markets is £100 million; therefore, r- Capital markets/securitisation is most appropriate for the refinancing of renewable energy portfolios owned by a single company.
1.1 Introduction The UK’s renewable energy industry has grown significantly over the last decade, due in large part to NFFO providing a long term bankable contract. As the industry grows, the need for financing also grows and like any infrastructure project, renewable energy needs to raise long term finance economically and with tenors that reflect the asset's life. This becomes even more important when the relatively high costs of renewable energy and the new support regime, which is economically less robust, are considered.
1.2 Task This study looks at the opportunities for renewable energy projects to access the bond market to finance projects or refinance existing projects, and what, if anything, is required to facilitate this. In addition, the study looks at the possible use of securitisation to group projects together as a means of dealing with some of the challenges faced by renewables, such as small size relative to most bond issues and the transaction costs.
1.3 Capital Markets and Securitisation The capital markets provide the largest global source of finance (global bond turnover is over $600 billion per day), they are generally very liquid and constantly increasing the range of deals considered. Finance is provided as debt (bonds) and equity raised in the form of tradable securities principally from non-bank sources, such as pension and life companies, insurance companies, corporate investors and private accounts. Securitisation is a process under which pools of future receivables - that is, contractual entitlements to receive amounts of money - are packaged into tradable securities, usually in the form of bonds. In economic terms, an investor buys a share of the cash flows generated by a specific pool of assets and takes the risk that the assets will not generate the expected cash flows. Diversification of the pool and credit enhancement may allow the owner of the assets to reduce their average total borrowing cost.
1.4 Risks and Constraints Capital markets financing exposes the transaction to global market risk, where appetite for certain tenors, asset classes or credits may change unpredictably, with no obvious link to a project’s specific merits. Therefore, prudent sponsors will run capital market and commercial bank financing options in parallel for as long as practicable, to provide some protection against this. When developing a project the financing options need factoring in at an early stage, particularly if a capital markets option is to remain available. This includes issues of legal structure, credit profile and disclosure requirements. Securitisation provides one potential route for a company. However, it is expensive in terms of transaction costs and management time, therefore suitable professional advice is required before embarking on this and other options considered.
1.5 Bank v. Bond In general, the capital markets are better than the commercial bank debt markets at providing: > longer tenors; > fixed and/or indexed rates; > third-party credit enhancement; > softer covenant packages; > less stringent monitoring. However, the commercial bank debt markets is usually better at: > managing construction/completion risk and post-financial close variations; > offering reasonable certainty (price and completion) when raising finance; > managing proprietary or confidential information (controlled disclosure); > dealing with complex or unusual transactions, or sub-investment grade risks.
1.6 Renewable Energy and the Capital Markets The capital markets will consider renewable energy projects, provided fundamental size and credit quality issues are met: > a liquidity minimum for public placements in the secondary market is £100 million. Less than this and the markets impose a ‘liquidity premium’. Private placements can be much smaller and are only limited by the economics of the transaction costs relative to the deal size;
IV > quality requirements are the same for any technology: a proven technology, strong EPC, bankable fuel supply, PPA and O&M agreements; > ‘green’ credentials do not translate into a pricing advantage and may even discourage investors on the basis that “fundamental economics are not viable without subsidy”. Complex deals, whether renewable energy or fossil fuel plants, may be difficult to place into the primary bond market. Few investors, including large institutional investors, maintain the resources to conduct due diligence that goes much beyond a project’s credit rating and its core report from a rating agency. This means that investors often avoid overly complex or unfamiliar transactions. The degree of sensitivity to these factors also depends on the overall level of market appetite at the time. For renewable energy, complexity may come from unfamiliar technologies, fuel supply issues, green certificates or just the number or diversity of assets to be included.
1.7 Credit Quality and the Percentage Obligation While some renewable technologies are approaching a market price based on the recent NFFO-5 bidding, such as energy from waste (2.39-2.49 p/kWh), this does not convincingly demonstrate market convergence or the ability to compete on a standalone basis with fossil fuel generators. Rather, the prices reflect NFPA’s credit strength, the market ’s comfort and understanding ofNFFO, its 15-year term, plus improvements in technology - remove NFFO and renewable electricity prices will increase for three reasons: > capital costs need covering within the shorter power contract time frames (most PPAs are too short and offtakers have little incentive to provide them for third parties); > lower gearing and higher equity is needed, with the associated cost; > higher debt coverage ratios are required in order to deal with increased risk. Renewable generators under the Percentage Obligation face four new risks that NFFO generators did not: > power market risk (price, volume and balancing charges); > term/renegotiation risk (arms length market contracts rarely exceed 10 years); > green premium risk; > off-taker credit risk. An effective and reliable legislative framework is required for a renewables market to work efficiently. Once this is established, it takes a considerable period for investors to research, understand and become comfortable with (or not, as the case may be) the new arrangements. Further legislative intervention also needs minimising, to ensure prices reflect economic drivers rather than expectations of political action. The NETA process
v has caused a material slow-down in the UK renewable energy industry and this is likely to exacerbate the process of implementing projects within the percentage obligation. The debt market invested significant effort in assessing the NFFO framework and educating credit committees on the risks involved. The new percentage obligation will require more due diligence, due to its increased complexity and lack of standardisation. This will take time and raising debt finance will be curtailed until this process is completed. It is unlikely that bond finance will be accessible for individual projects, until the new market has established a significant track record and a number of bank financed deals have proved successful. However, refinancing of a renewable energy portfolio with the support of strong corporate covenants is possible.
1.8 The Future A framework that encourages economically rational behaviour is not in itself sufficient to ensure access to long term capital. The markets will need convincing that the risks under the percentage obligation are reasonable over the long time frame required for infrastructure debt. This is particularly the case when other less risky projects are competing for capital (cash and management time), such as PFI projects, with high quality, predictable terms and contracts in excess of 20 years. Therefore, it is likely that renewable energy projects will need significantly greater levels of equity, supported by creditworthy sponsor guarantees. Necessarily this moves the market structure towards consolidation and domination by larger corporates, particularly the power utilities that have an existing generation profile that is able to manage any new variable output. A number of misconceptions exist within the renewable energy community that require correction: > merchant renewable power is not at present a bankable proposition - for the capital markets or the bank markets - well tried and reliable conventional generation has sufficient difficulty in raising finance, even when backed by large, multi-national sponsors; > there are no shortcuts when raising infrastructure finance - green credentials alone do not make a project bankable. The core commercial structure must be sound; > the main task is to look forward and encourage new renewable capacity - securitisation provides a funding method primarily for projects that would receive finance anyway. The challenge is to provide sensible instruments that will encourage future projects.
VI 1.9 Summary Bond finance and as a subset of this, securitisation, provide a source of finance for renewable energy projects. However, commercial bank debt also provides a readily available, large source of finance. The availability of finance per se is not restricting the growth of renewable energy in the UK since there is no shortage of liquidity in the bank or capital markets. Availability of finance is simply a function of the renewable energy framework and access to commercially sound projects.
VII viii 2. Contents
1. Executive Summary iii 2. Contents ix 3. Introduction 1 3.1 Outline...... 1 3.2 Objectives...... 1 3.3 Context...... 2 3.4 Securitisation...... 3 3.5 Research Methodology...... 5 3.6 The Project Team...... 5 3.7 Professional Advice...... 5 3.8 Report Structure...... 6 4. Capital Markets 7 4.1 Outline...... 7 4.2 Bond Financing Process...... 8 4.3 Supply and Demand...... 9 4.4 Rating Agencies...... 11 4.5 Monoline Insurance...... 11 4.6 Pooled Securities...... 11 4.7 Bond Pricing...... 12 4.8 Repayment...... 14 4.9 Secondary Market ...... 15 5. Financing Projects 17 5.1 Outline...... 17 5.2 On and Off Balance Sheet Summary...... 17 5.3 Sponsor Strength...... 18 5.4 Size...... 19 5.5 Gearing...... 19 5.6 Documentation...... 20 5.7 Transaction Cost...... 20 5.8 Interest Cost...... 20 5.9 Confidentiality...... 20 5.10 Replicability ...... 21 5.11 Insolvency...... 21 5.12 Presentation...... 22 5.13 Global Risk ...... 22 5.14 Bankability ...... 23 5.15 Use of Funds...... 23 5.16 Summary...... 23 6. Non Recourse Financing 25 6.1 Objective...... 25 6.2 Non-recourse Bond and Commercial Bank Debt Summary...... 25 6.3 Decision Process...... 26
IX 6.4 Sponsor Strength...... 27 6.5 Size...... 27 6.6 Documentation...... 28 6.7 Transaction Costs...... 28 6.8 Interest Cost...... 29 6.9 Transaction Risk ...... 29 6.10 Confidentiality...... 30 6.11 Insolvency...... 30 6.12 Presentation...... 30 6.13 Source ...... 31 6.14 Investor Flexibility ...... 31 6.15 Transaction Flexibility ...... 31 6.16 Ongoing Monitoring ...... 31 6.17 Tenor ...... 32 6.18 Investors ...... 32 6.19 Summary ...... 32 7. Securitisation 35 7.1 Outline ...... 35 7.2 History ...... 35 7.3 Definitions ...... 35 7.4 Securitisable Assets...... 36 7.5 Securitisation Types ...... 37 7.6 Issue ...... 37 7.7 Transaction Process ...... 38 7.8 Sponsor Process...... 40 7.9 Confidentiality ...... 41 7.10 Bond Rating...... 44 7.11 Credit Enhancement...... 48 7.12 Monoline Wraps ...... 49 7.13 Capital Market Transaction Costs...... 50 7.14 Fund Raising Options...... 50 7.15 Bridge Finance ...... 50 7.16 Impact of the Basle Accord...... 51 7.17 Private Placements...... 52 7.18 Green Premium ...... 52 7.19 Schroders PFI Fund...... 52 7.20 Recent Developments ...... 53
8. Support Mechanisms 55 8.1 Background ...... 55 8.2 Auction of Renewables Contracts...... 58 8.3 Fixed Tariff ...... 61 8.4 Net Metering...... 63 8.5 Renewable Portfolio Standard ...... 63 8.6 Voluntary Green Premium/Certificate ...... 68 8.7 Conclusion...... 68
x 9. UK Implications 71 9.1 Outline ...... 71 9.2 Capital Market Advantages...... 71 9.3 Capital Market Disadvantages...... 71 9.4 Plants Operating Under NFFO ...... 71 9.5 Pre-construction NFFO Contracts ...... 72 9.6 Ex-NFFO Plants ...... 72 9.7 New Build under the Percentage Obligation ...... 72 9.8 Conclusion ...... 72 10. Alternatives 75 10.1 Outline ...... 75 10.2 Pre-prepared Portfolio ...... 75 10.3 Capital Markets Incentive ...... 75 10.4 Securitise Green Premiums...... 76 10.5 Weather Derivatives Hedge ...... 76 10.6 Stranded Asset Approach ...... 76 10.7 Government Sponsored Wrap ...... 77 11. Conclusions and Recommendations 79 11.1 Context ...... 79 11.2 NFFO ...... 79 11.3 Percentage Obligation ...... 80 11.4 Refinancing ...... 80 11.5 Other Frameworks ...... 81 11.6 Summary ...... 81 12
12. Appendices 83 A. Glossary B. Credit Ratings C. Sovereign Credit Ratings D. UK Power Company Credit Ratings E. NFFO and the Fossil Fuel Levy F. Financial Times Bond Table G. Case Study in Bond Financing: Sutton Bridge Power H. Deal List
xi xii 3. Introduction
3.1 Outline The UK renewable energy industry has grown significantly over the last 10 years, due in large part to the Non Fossil Fuel Orders (“iVFFO”) that provided long term bankable power contracts for developers to raise finance on. Progress in other parts of Europe and the US has been equally swift, although the industry is still some way from maturity. As the industry grows, the need for financing also grows and like any infrastructure project, renewable energy needs to raise long term finance economically and with tenors that reflect the asset's life. International capital markets have played a growing role in infrastructure finance, with the City of London at the centre of this development. This report examines capital market financing routes potentially open to renewable energy projects and considers some alternatives.
3.2 Objectives This report compares on and off balance sheet methods of financing renewable energy projects before looking at ways in which securitisation through the capital markets could provide benefits for the financing (or refinancing) of these projects. The increasing use of capital market products for infrastructure deals is reviewed, before considering how renewable energy project sponsors might use these. In selecting a financing option, sponsors should consider many factors andthis report highlights the following: > The advantages, disadvantages and costs of different financing options and securitisation in particular; > The feasibility of securitisation within the legal and regulatory constraints of investors andthe London Market; > Investor requirements and the investment profile of renewable energy; > The experience of securitisation of power projects in general and renewable energy projects in particular in Europe and North America; > The possibility of grouping projects to be financed as a portfolio; > The suitability of securitisation for renewable energy in the UK and, if it is feasible and advantageous, identifying what the appropriate next steps would be. If it does not appear feasible, identifying the reasons why this is the case. This report was commissioned by ETSU to highlight the issues facing sponsors and assist the Government’s decisions for the future of renewable energy support. A by product of this work is various recommendations and suggestions for further work by ETSU, which builds on these results and may help the Government achieve its targets for renewable energy resources. These are covered in Chapters 10 and 11.
1 3.3 Context The world's electricity markets have liberalised over the last decade and many independent power producers have come into existence as a result. The privatisation of the electricity supply industry has led to large, private sector conventional generation projects and the development of innovative financing packages, both on and off balance sheet, to meet the increased need for funds. In parallel, the generation of energy from renewable resources has rapidly developed. As concerns over diversified energy supplies and global warming grow, the European Commission and Member States have introduced policies and programmes that actively support the expansion of these emerging technologies for cleaner, sustainable energy. Many of these programmes mitigate part of the commercial risk inherent in such innovative activity and provide bankable power contracts, which encourage private developers to take the lead in establishing renewable energy capacity. Countries such as Denmark have demonstrated the benefits of focused government support, which catalysed domestic projects to underpin export growth, such that Danish wind turbines now account for around half of all new turbines installed. Despite local regulatory uncertainty, growth in the renewables sector has continued across Europe as a whole. However, large-scale investment is still required if the Commission’s objective of 12% primary energy from renewables by 2010 is to be achieved. A direct consequence of the increase in project development activity is an increase in the demand for finance, both debt and equity. The Commission's White Paper on renewable energy predicted an investment requirement of approximately £100 billion between 1997 and 2010 if this target is to be met. In other words, an average of £20 million per day needs investing across Europe in renewable energy projects until 2010. With the release of the paper "Renewable Energy: Prospects for the 21st Century" by the DTI in March 1999, the UK Government reconfirmed that it is working towards a target of 5% of electricity from renewable resources, by the year 2003 and 10% hopefully by 2010. Once the target is reached, it is expected that renewable energy capacity will continue to increase, encouraged by the Kyoto Accords and the need to maintain diversity of energy supply. In the UK, energy production has changed markedly since privatisation of the electricity industry, primarily through the advent of very advanced gas-fired generation. The Electricity Act of 1989 made provision for the respective Secretaries of State to mandate that Public Electricity Suppliers obtain specified amounts of energy from renewable energy resources, in order to achieve a target of 1,500MW of new renewable energy capacity in place by 2000. This led to NFFO in England & Wales, and equivalent orders in Scotland and Northern Ireland, which in turn have resulted in approximately 3,800MW of contracts for new nameplate capacity since 1991. The NFFO process
2 achieved remarkable reductions in price, with NFFO-1 awarding contracts in the range 3.6-lOp/kWh compared to NFFO-5 with contracts in the range 2.34-4.60p/kWh. However, at the end of December 1999 only 747MW, or 20%, of that capacity was commissioned and operating. The UK currently obtains approximately 2.5% of its electricity (1998 figures) from renewable energy, mainly large hydro1 resources. To reach the target of 10% by 2010, it is estimated that approximately 8,000MW of new generating capacity will be required, at a capital cost of £5-8 billion. This represents both a considerable challenge and opportunity for developers and financiers. Long term assets need long term finance, which applies particularly to renewable energy's cost profile when compared to some alternatives. Until now, the majority of debt finance has been provided by commercial banks, which have become familiar with some of the sector’s technologies and commercial risks. However, the capital markets provide the largest source of long term debt and may also bring cost benefits to sponsors. To date, most of the UK's renewable energy projects have divided into relatively large projects2 (10MW - 50MW) or very small projects (<2MW). Most large renewable energy projects have been financed on balance sheet by large companies, or have been project financed using commercial bank debt. This report looks at securitisation as a possible means of increasing the options for project sponsors to access finance in an efficient and competitive manner.
3.4 Securitisation Securitisation is the process under which pools of receivables - that is, contractual entitlements to receive amounts of money - are packaged into marketable, transferable, investment grade securities, which are distributed to investors. The entitlements to receive money could comprise mortgage loans, credit card receivables, lease receivables, hire purchase contracts, trade receivables, project receivables or corporate loans. The securities are collateralised by, amongst other things, the assets that are being securitised. In economic terms, an investor is buying a share of the projected cash flows - both principal and income - generated by a specific pool of assets and is taking the risk that the assets will not generate the expected cash flows. The originator - that is the original owner of the receivables - is financing or refinancing the assets. Securitisation may also eliminate some of the risks of owning those assets, whilst retaining some of the economic benefits of the assets, such as fees for the provision of certain services in relation to the assets, equity participation or in the case of over-collateralisation, the
1 Considered here as greater than 50MW. 2 These are small compared to fossil-fuel stations that typically run into many hundreds of MWs.
3 residual value. However, securitisation as a means of financing should be viewed in the context of the wider capital market as shown in the diagram overleaf.
Commercial Capital Markets Bank Debt Debt
Project Corporate Project Corporate Securitisation Risk Risk Bond Bonds Issue
Private Placement; Public Placement; Bi-lateral; Club; Syndication (Domestic; Rule 144A; Eurobond)
Providers of commercial bank debt are typically the major commercial bank lenders. Borrowers can obtain commercial bank debt from: > a single bank via a ‘bilateral loan’; > a small group of banks where each bank commits a given amount via a ‘club loan’; > a large group or syndicate of banks after formal syndication following underwriting by a lead bank or lead group of banks. Capital Markets, on the other hand, is a broad term used to describe both debt and equity raised in the form of negotiable (ie easily traded) securities from pension and life companies, insurance companies, corporate investors and private accounts. Debt raised in the capital markets is evidenced by a bond, which is a legal promise by the issuer (borrower) to pay the investor (lender) on declared terms. Bonds are usually negotiable and customarily longer-term obligations (5-25 years, or over). Short-term bonds are referred to as Notes. Bonds are raised through a number of mechanisms and markets: > public listing on a stock exchange, with full disclosure and application of exchange rules; > a Rule 144A bond, which is issued in the US but not registered with the SEC and only marketed to a limited number of qualified investors; > private placement bonds which are negotiated with a small number of institutions and often held to maturity. The diagram above shows the types of debt instrument and illustrates some of the options a sponsor needs to consider, often early in a project's development. The
4 development process should consider both sides of the tree until near to financial close. Premature decisions may reduce the financing options available, which usually results in greater cost or the project becoming uneconomic. The trade-offs between each option are covered in more detail in Chapters 4 to 6, with a decision tree for commercial bank debt versus capital markets debt in Section 6.3.
3.5 Research Methodology The research was based on Impax Capital's extensive knowledge of raising finance for the renewable energy industry supported by Cameron McKenna’s wide transaction experience both inside and outside of the renewable energy field. This was supplemented by extensive discussions, both formal and informal, with a wide variety of market participants in the City of London. At the outset, a list of recent power plant securitisation deals (see Appendix H) in Europe and North America was established with particular regard to renewable energy deals or deals that were similar in nature to renewable energy, such as small embedded conventional plant. Attention was paid to the differing technology types: given the extent of the UK wind energy resource, any securitisation of intermittent and non- dispatchable plant with variable output (such as CHP) was carefully examined. The survey of “done deals” was based on historical information and used to derive conclusions on the advantages and disadvantages of different financing alternatives.
3.6 The Project Team The Project Team was led and co-ordinated by Impax Capital of the UK, Europe’s leading independent adviser to the renewable energy sector. Impax Capital has successfully raised over $330 million in debt and equity capital from third parties for a wide range of renewable energy projects. Supporting the research was Cameron McKenna a highly respected City law firm with extensive project finance and capital markets expertise that has worked with Impax Capital on a number of cutting edge transactions in the renewable energy field.
3.7 Professional Advice The content of this report derives in part from information provided voluntarily by third parties that is not in the public domain, and against a background of changing financial markets. The market is complex and little allowance is made for inexperienced investors or sponsors. As such the methods described should not be considered the only approach to securitisation, or that securitisation is the best way of freeing up equity for further projects or broadening the range of investors for renewable energy projects. Also, this report cannot provide a firm indication of how every investor, underwriter or rating agency would price the risks involved. The process and assessment of the benefits of securitisation is complex and expensive. Sponsors considering securitisation
5 as a means of raising finance are strongly advised to obtain independent advice relevant to their particular needs before undertaking substantial work or expenditure.
3.8 Report Structure The report initially compares and contrasts the differences between using on and off balance sheet financing, before moving to a more detailed consideration of the differences between the bond and commercial bank debt markets. Parts of this section apply equally to on and off balance sheet financing, although the emphasis is on the off balance sheet, or limited recourse route. Having laid the foundations for bond financing, securitisation is examined in greater detail along with some specific issues relating to bond finance. These include the rating agencies, disclosure issues and insurance products. Based on the above, a number of different renewable energy incentive schemes are examined andtheir ability to provide bankable contracts for bond financing is considered. The issues in particular for the UK market are subsequently highlighted, before a number of alternative incentive structures are briefly touched upon, before the report is concluded.
6 4. Capital Markets
4.1 Outline 'Capital Market' is a generic name that describes debt (bond) and equity raised in the form of tradable securities from non-bank sources, principally pension and life companies, insurance companies, corporate investors and private accounts. The main features of a bond are relatively simple: the issuer, (ie borrower/sponsor), promises to pay a specified percentage of par value on designated dates (the coupon payments) and to repay the par (principal) value of the bond at maturity. Bondholders, as creditors, have a prior legal claim over ordinary and preferred shareholders on the income and assets of the company for the principal and interest due to them. Bonds are customarily long-term obligations and are negotiable, that is they are easily traded. Failure to pay the principal or interest normally constitutes a legal default and investors can then go to court to enforce the contract. The obligations of the issuer and investors are set out in great detail in a bond indenture or trust deed. Generally a corporate trustee is employed to ensure the detailed stipulations of the indenture are adhered to and the indenture is made out to the trustee, who is appointed to act in a fiduciary capacity for the investors. New bonds are originated in the primary market, where the money raised flows directly to the issuers. However, most capital market trading takes place directly between investors and this is known as the secondary market, since it does not directly involve the issuer. This illustrates one of the main differences between bond finance and commercial bank finance: a bond investor can usually sell a bond even if the underlying characteristics change and can therefore adapt their portfolio’s risk profile3. A bank usually holds commercial debt4 to maturity, post syndication, although Credit Suisse First Boston (CSFB) recently securitised part of its project finance debt portfolio. The market price of a bond changes over time due to several factors: expected inflation, interest rates on competing investments and the creditworthiness of the borrower5. However, price in isolation (ie spread over the benchmark) does not guarantee saleability - this remains a function of the market ’s capacity and liquidity at the time the bond is issued, plus its appetite for: > risk and tenor; > that particular credit rating; > the sector.
3 This rarely applies in the private placement market, where trading is limited or impossible and investors usually want to hold the asset to maturity in order to cover a particular exposure. 4 There is some trading of debt between banks, but this does not provide ready access to liquidity. 5 Most bonds have a fixed rate, but some are issued with a floating rate or more recently, with index linking.
7 Bonds are issued across a wide risk spectrum ranging from sovereigns at one extreme to sub-investment grade corporate or project risks, often referred to as ‘junk bonds’ or ‘high yield bonds’, at the other. An explanation of the different risk ratings is at Appendix B, with a list of sovereign ratings at Appendix C andUK power company ratings at Appendix D. Normally a project will not receive a higher rating than its main sponsor, rather like companies usually being unable to receive a higher rating than their home country. Due to the ability to ‘ring fence’ an off balance sheet project from the sponsor it may be possible for a project to achieve a higher credit rating than its sponsor in certain circumstances and hence improve its borrowing capacity. Capital market fund raisings may be issued by: > a special purpose project company raising finance for a single activity (e g. a power station, road, hospital etc.) the revenues from which will be the sole means of meeting bond interest and principal payments as they fall due; > a borrowing entity seeking to raise finance against a pool of receivables. This is often referred to as securitisation; > large and medium sized corporate issuers requiring finance for general corporate purposes. In these cases, bondholders are secured on the corporate assets of the issuer and not just the revenues from a single activity.
4.2 Bond Financing Process The diagram overleaf outlines the main participants in a bond Global Non-Recourse Bond Issue -$bn financing and their roles are described in greater detail in 1994 3.9 subsequent sections. A bond issue can be distributed as a 1995 3.8 public issue or a private placement. Public issues are normally 1996 4.8 large liquid issues (at least £100 million), which can be easily 1997 7.5 traded. Private placements are distributed to smaller groups of 1998 9.8 institutions and are more likely to be held to maturity 1999 19.97 especially where the characteristics of the bond (an asset) have Source: IFR PFI been designed to meet the particular liability profile of an investor. The growth in non-recourse bonds is shown opposite, with the jump in 1999 due primarily to activity in the US.
8 Sponsor decides to Core Financial Model Bond v. Bank raise finance. Appoint (Cash flow, construction, (see Section 6.3) Financial Adviser operations, B/S, P&L, tax)
Review Market Conditions Structure model accordingly. ; and Investor Appetite
Select and appoint sponsor's Structure Infomation lawyers (usually on financial Memorandum, Model and advisers recommendation). Due Diligence Pack
Bank that will market the bonds, inform sponsor on price and guarantee take-up Select Lead Underwriter through the underwritingcommitment.
Independent review of risk - analysis (made public with sponsor's agreement) Select and retain Rating Required before many investors are Agency allowed to consider the bonds.
Insure payments to \ Select Monoline Insurer V bond holders. (if applicable)
Series of presentations from sponsor, rating agency, underwriter and financial Roadshow for Investors adviser to potential investors.
Complete documentation. Sell \ bonds. Sponsor receives funds. Primary market placement £££
Underwriter provides trading liquidity and undertakes always to buy/sell the bonds Market Making (not always guaranteed).
4.3 Supply and Demand The bond markets play an essential role in raising finance for Project Bonds by companies and governments. The largest sector of the market in Country ($m) 1999 1997 was dollar denominated bonds, which was worth over $11 USA 11,944 trillion, based on publicly traded debt outstanding6. Most of this Canada 1,863 is traded by institutions, and total daily bond turnover was UK 1,212 estimated to be around $600 billion in 19987 . In the US, Puerto Rico 1,000 institutional funds were worth three times the assets in the Mexico 892 banking system, which reflects a growing trend towards capital Spain 728 market financing as a cheaper, more liquid source of funds8 (see Australia 492 table opposite for the country split in project bonds). Source: IFR PFI
0 US$ bonds account for approximately 47% of the market, Euro area bonds 25%, Yen 15%, Sterling and others the remaining 13%. 7 The Economist, November 1999. 8 Financial assets held by commercial banks in the US have fallen from around 35% of total financial assets to 20%, with pension funds and mutual funds being the main recipients of the switch in assets.
9 Over the long term, bonds could increase substantially as a source of project debt from the current 10% in 1997 and 1998. This is mainly due to bonds representing funds from the largest source of capital in the world - institutionally managed funds such as pension funds, insurance companies and mutual funds. McKinsey recently estimated that in 2000, global savings would be close to $90 trillion - a large proportion of which is under institutional management and theoretically available for long term debt financing. This represents a substantial excess over the funds available for bank lending. To put this in context, in 1997 US institutional investors controlled the equivalent of 227% of US GDP, and UK institutional investors controlled the equivalent of 193% of UK GDP9. With the amount of capital involved, institutions are constantly Project Bonds by searching for new instruments that meet their investment profile. Sector ($m) 1999 This need is exacerbated by the reduction in national debt for the Power 7,270 US and UK, whose long term sovereign bonds were traditional Telecoms 5,227 cornerstones of institutional portfolios. Both countries have Infrastructure 3,676 markedly reduced the proportion of long dated bonds issued. This Oil and Gas 2,822 results in “hunting down the yield curve10” and suggests that Petrochem 672 appetite for less conventional offerings, such as single asset project Leisure 299 bonds, within the capital markets may increase. At the same time, the movement of infrastructure finance from the public to the Source: IFR PFI private sector has also increased demand for long term finance. Changes in investor demand amongst pension and life companies (in particular for higher yielding assets), the increasing availability of private equity and the emergence of large infrastructure funds suggests the need for debt instruments that will appeal to a broad range of capital market investors. These include single asset bond issues and securitisations, provided such products meet market requirements for credit, price, liquidity and size. The above table provides a snap shot of demand in this area. For private sector businesses, taking on debt can be Leading bookrunners of asset- backed Euromarket issues $bn risky. If their income fluctuates and they are unable Credit Suisse First Boston 12.7 to meet the repayments, bankruptcy can ensue. Deutsche Bank Therefore, in general the more financially sound an Lehman Brothers 39 issuer of debt is, the lower the spread achieved over Merrill Lynch 3.0 Goldman Sachs 2-6 the benchmark. Professional money managers use 2 4 HypoVereinsbank 19 various techniques to analyse information on Nomura 1.7 companies and bond issuers in order to estimate the Societe Generale L1 ability of the issuer to live up to its obligations. This Morgan Stanley JP Morgan activity is known as credit analysis. Source: Capital Data Bondware, 1-6/99
9 The Economist, November 1999. 10 A colloquialism for looking for a higher yield at the expense of accepting greater risk. This usually occurs when market sentiment is positive and sovereign risk provides insufficient return.
10 4.4 Rating Agencies Some institutional investors rely on in-house credit analysts to determine the creditworthiness of an issue; however, it is costly and time consuming for an individual to monitor all the bonds held in their portfolio. Rating agencies reduce this cost by assessing a company’s financial condition (usually by reference to its ability to repay long-term debt and the likelihood of default) and publishing their conclusions. Therefore, for most bond debt, sponsors will have to involve a rating agency and even with some private placements, pension fund trustees will require a rating. Ratings offer an independent assessment of credit risk and allow investors to compare the risk and return characteristics of any instrument across global lines. Ratings are a blend of qualitative and quantitative factors and by expressing an opinion on the future, they are necessarily subjective. Nevertheless, they have generally correlated quite well with subsequent default statistics. Ratings are usually issued for bonds, companies and countries. However, recently bank loan ratings have also occurred for specific project debt, as this may improve the potential to access the capital markets when refinancing or as a means of demonstrating to a bank the potential for refinancing. In part, this type of financing acts as a bridge to the capital markets, whereby banks recognise that a major proportion of their loan will be removed from their books within a relatively short period. This has in instances allowed the banks to hold much higher positions than they would otherwise consider. The leading internationally recognised rating companies are Standard & Poor’s, Fitch/IBCA, Moody’s andDuff & Phelps. Their rating systems use similar symbols and a description of these is in Appendix B. This report uses Standard & Poor’s nomenclature throughout.
4.5 Monoline Insurance A small number of companies offer monoline insurance, which may be used to improve the credit rating of a bond to ‘ triple A ’, which lowers the interest cost and makes it attractive to a wider or different pool of investors. Monolines are primarily active in the US, but three monolines have offices in the UK. They effectively insert themselves in the security chain between investors and the assets and guarantee the bond payments to the investors. However, they impose tight credit criteria and covenants separate to the bond holders’ trustee, in order to ensure the required credit quality. The role of monolines is discussed in more detail in Section 7.12.
4.6 Pooled Securities Issuers are now looking at pooling assets into securitised collateralised loan obligations (CLOs) or collateralised bond obligations (CBOs). Bonds are being issued for closed- end defined pools of loans made by banks and the first open-ended deals have recently
11 occurred11. Several types of structure now exist, but these remain variants of the structures already extensively used for asset-backed bonds secured by mortgage receivables, other consumer receivables and mid-market corporate loans. Under a pool structure, bonds are serviced by the cash flow generated by a pool of project loans. The credit strength of the bond should be stronger than the strength of an individual loan, which results in cheaper borrowing costs, as the pooled cash flows diversify the default risk inherent in the loans making up the pool. In addition the bonds may be strengthened by over-collateralisation of loans and loan cash flows. Typically, CLO bond issues are also issued in tranches to give different risk profiles and priority claims on cash flows.
4.7 Bond Pricing Simple bond pricing is made up of two components: a benchmark interest rate and a spread, usually quoted in basis points (one-hundredths of a percentage point), on top of the benchmark. The benchmark is either a government bond with a similar maturity12 to the expected bond financing or the appropriate LIBOR rate. In the UK, Gilts are used and in the US, the Treasury Bill rate is used, as these effectively represent a ‘risk free’ rate. The spread over the benchmark is an amalgam of factors that are primarily driven by market sentiment. The factors include the project risk (represented by the bond rating), the tenor of the bond, the repayment profile, the expected secondary market liquidity, the appetite for exposure to the underlying assets, the spread achieved by similar bonds and any special features in the bond13. The weighting of each factor varies depending on market sentiment andthe bond underwriters will be able to give an indication of the expected rates at the time. An example of the impact that market appetite can have on pricing is the spread achieved by two PFI hospital deals. In 1998 the Queen Elizabeth Hospital (Deal 24 in Appendix H) was rated BBB+ and priced at 160bp over the 2016 indexed linked Gilt. In 1999 the South Tees hospital (Deal 23 in Appendix H) was rated AAA through a monoline wrap and priced at 130bp also over the 2016 index linked Gilt. Both use the same benchmark but a spread of 30bp between AAA and BBB+ is unusually small. The South Tees deal spread was quite high due to the lack of market appetite at that time for wrapped paper, compared to the 40+bp difference seen between BBB+ and A+ bonds in
11 An open ended fund is effectively a line of credit, where a number of projects are put in the pool, but the lenders also agree to fund future, as yet undefined, projects. Typically these future projects must either pass a set of objective quality criteria before being allowed into the pool, or they must be compared to the pool ‘under stress’ to ensure the addition does not lower the overall credit quality of the pool. 12 The benchmark might have a similar ‘average life’ to the bond being issued, which takes into account different coupon sizes, rather than simply matching the tenor. 13 These features might include call options, interest payment through ‘payment in kind’ bonds (usually only a feature of highly leveraged buy-outs in the US), convertibility, index linking and the ability to change between principal repayment methods (usually lottery versus market purchase). The pricing calculation for these is complex and beyond the scope of this report.
12 Appendix D for UK Utility borrowings. Section 6.9 on capital market transaction risk gives another example of how spreads may vary due to external economic shocks, such as the Russian debt default in 1998. Appendix F shows an extract from the Financial Times with a typical daily report on the bond market andthe spreads achieved, while the graphs below were compiled by
Utilities A v BBB (Syr modified duration, bp)
BBB
Source HSBC Investment Bank
HSBC Investment Bank based on utility bonds of different credit quality and maturities. These demonstrate the significant changes in bond pricing over the last year and how
Utilities A v BBB (15yr modified duration, bp)
BBB
o o
Source: HSBC Investment Bank
13 spreads have tightened substantially for lower grade bonds in January 2000. This resulted from a general lack of bonds available in the secondary market, which increased demand for the lower grades and less popular bonds. Thus a bond issued over the last year might have achieved a difference in spread of almost 20bp, depending on when it was issued. It should be noted that the above graphs show modified duration and not tenor. Modified duration is (simplistically) a weighted average of the bond’s repayments that depends on coupon level and tenor.
4.8 Repayment There are a number of ways a bond is repaid, which are partially a function of market practise and partly of investor appetite. Typically, the coupon is paid quarterly, semi annually or annually andthe standard varies from Gilts to corporates and from country to country. The principal repayment may be by a number of methods:
> Straight Amortisation - equal repayments are made throughout the life of the bond. This is simple, common on tax-exempt infrastructure bonds in the US and gives bond holders confidence in the repayments. However, it maximises investors’ exposure to reinvestment risk.
> Limited Amortisation - This is similar to straight amortisation, but occurs typically over the last few years of the bond’s life. It is now also being seen over the initial part of a bond’s life as a method to limit exposure in conjunction with some form of credit enhancement.
> Sinking Fund - This is a fund often held by the trustee into which principal repayments are made. This is used to redeem the bond at certain pre-agreed times, sometimes only at maturity. It gives the bond holders confidence in the repayment but does not expose them to as much reinvestment risk. Typically, the sinking fund is invested in risk free bonds (ie sovereigns) and any interest rate differential (the difference between the interest rate earned on the Sinking Fund balances and the interest rate paid to bond holders) is borne by the issuer. Typically, sinking funds that redeem bonds during the bond’s life are used to purchase bonds in the open market, or by a lottery that selects bonds for redemption.
> Bullet Payment- A bullet payment refers to all the principal being repaid at the end of the bond’s term. This is frequently supported by a sinking fund and is often the preferred method for pension companies, due to the lack of reinvestment risk and ability to plan their cash flows.
> Profiled Repayment - This usually only occurs in private placements where the repayment profile is agreed on a financial base case model that reflects the anticipated revenue flows from the assets. This is particularly useful for certain renewable energy technologies (such as wind and biomass) that have seasonal
14 performance differences. A variation on the profiled repayment is the Batesville CCGT project (Deal 15 in Appendix H) where the senior bond debt had two tranches: the first bond was a straight amortisation over 14 years and the second bond with similar seniority amortised from years 14 to 26. This allowed different investor appetites to be satisfied on tenor, without sacrificing security. Issues regarding repayment are usually developed by the sponsor and their financial adviser, based on the market and cash flow profile. > Grace Period - Principal and interest payments may include grace periods and one example of this is Dam Head Creek (Deal 10 in Appendix H) where the senior debt had a 5 year grace period. This is similar to limited amortisation, but without any repayments.
4.9 Secondary Market The secondary market represents one of the main advantages for bond investors over commercial bank debt investors, as this is a mechanism that allows investors to efficiently trade their holdings14. The secondary market in bonds is primarily for listed bonds, as private placements and Rule 144 A bonds have the number of investors restricted by quantity and qualification. The secondary market operates in a similar manner to a stock exchange and allows investors to buy and sell their investment, thereby changing their risk profile with relative ease compared to commercial bank syndicated debt. To generate sufficient liquidity in the secondary market, an issue of at least £100 million is typically needed. Without this level investors in the primary market are liable to require a greater spread to compensate them for the expected difficulty in achieving a ‘fair’ price due to thin trading. Some corporates have over issued bonds to achieve this target level, and avoid penalisation in the primary market issue.
14 There is a growing secondary market in bank debt that is being assisted by increasing standardisation of documentation. However, this provides insignificant liquidity when compared to bond secondary trading.
15 16 5. Financing Projects
5.1. Outline Power projects have generally raised finance by two main methods: loans to a developer backed by the cash flow from ownership of a number of assets, or project loans backed by the revenue of individual generating plant. This section compares these two financing routes for renewable energy - on balance sheet and off balance sheet financing - as the first step in the decision process for funding a project. Both have advantages and disadvantages, and within this comparison, some of the issues between bank finance and bond finance are touched on. A more detailed analysis of off-balance sheet bonds versus commercial bank financing - the second step in the process - follows in Chapter 6, before Chapter 7 looks at securitisation and the issues it raises for renewable energy.
5.2. On and Off Balance Sheet Financing Summary The following table summarises the main differences between on balance sheet and off balance sheet financing. These differences are then amplified in the text, with specific reference to the list of deals in Appendix H. The relative importance of each item can only be judged in the context of a sponsor’s own circumstances and there is no attempt to prioritise these here. This is a matter for the sponsor and their advisers. On balance sheet financing is considered debt raised that has recourse to the sponsor’s other assets. Off balance sheet financing is considered debt raised that only has recourse to the specific assets it is financing andthere is no recourse to the sponsor, beyond the sponsor’s equity contribution. True non-recourse financing is very rare and limited recourse financing more commonly occurs, with investors looking to maximise the number of risks borne by the sponsor. The Tyseley waste to energy plant (Deal 12 in Appendix H) shows the level of guarantee and support required by investors, in this case represented by a monoline insurer, even from large, highly respectable sponsors, if an investment grade rating is to be achieved.
On Balance Sheet Off-Balance Sheet Sponsor Affects ability to raise finance on Theoretically, allows financing of Strength favourable terms. projects unrelated to sponsor strength. Size Linked to balance sheet strength and Constrained only by the economics of level of existing debt. the underlying assets. Gearing Moderate amount possible, but limited Much higher than on-balance sheet with by previous debt covenants. correspondingly higher equity returns. Documentation Comparatively limited, often able to Complex, expensive and transaction duplicate previous debt funding. specific. Transaction Relatively cheap, especially if the Relatively high, due to complexity. Costs sponsor has a good track record and Securitisation costs are substantially previous transactions can be duplicated. higher than most single asset project finance.
17 On Balance Sheet Off-Balance Sheet
Interest Cost Linked to the quality of the sponsor, size Reflects only the risk of the project and of their balance sheet, business any credit enhancement, relationship, plus existing debt level. Confidentiality Good, with limited requirement to Variable, depending on route taken. disclose sensitive project specific data. Public debt placements may require substantial disclosure. Replicability Easy and cheap if loans can be Difficult, but see Chapter 10. replicated. (Note with bonds, similar covenants are required between issues, otherwise earlier bonds are adversely affected.) Insolvency Harder to become insolvent due to the Well structured deals are designed to be variety of income generating assets and self-correcting, with numerous objective the relatively lower gearing. indicators of performance. Insolvency action is relatively simple, as priorities and values are extensively documented. Presentation Equity analysts interpret debt positively Equity market signal can be mixed. provided gearing is not excessive. May move debt off balance sheet if less Debt fully recorded on balance sheet. than 50% of the SPV is owned. Source Bank or capital markets possible, but Bank or capital markets possible. linked to existing level of debt. Avoids tripping loan covenants or ratios imposed by sponsor's other debt. Global Risk Entire business at risk if the loan Sponsor's risk limited to equity paid in defaults. and any other support, but see Chptr 9. Sponsor able to take more market risk All risks need defining and allocating - and rely on asymmetry of information. a costly and time consuming process that may impact the sponsor's returns. Bankability Not directly relevant - see sponsor Extensive work to check contracts and strength. ensuring an appropriate structure. Use of Funds Can be very flexible, with few Highly constrained with draw downs restrictions, but depends on the linked to set milestones. borrower.
5.3. Sponsor Strength Sponsor strength will always be a factor in the ability to raise finance, if only for the perceived quality, a “halo effect”, that certain names may bring, plus the potential that name recognition brings to assist the decision process. This is particularly relevant for on-balance sheet financing where a good track record will lower borrowing costs and provide a wider range of lenders competing for the business. Impax Capital has noticed changes in attitude from finance providers when small developers attract a large, well capitalised shareholder.
18 For non-recourse finance, the transaction is based purely on the economics of the assets to be financed and the amount of equity and other support, such as performance guarantees, provided. However, investors usually take comfort from having a large sponsor and the expectation that they can afford to behave ‘responsibly’ if the assets under perform. This might imply a slight shading in interest rates, of around 5-15bp.
5.4. Size Funds raised are initially a function of the cost effectiveness of the fund raising in terms of fees and time. Thereafter, the amount that can be raised, is dependent on the following factors. > The amount that can be borrowed through the balance sheet is directly linked to the size of that balance sheet andthe existing level of borrowing, which may often have covenants restricting the level of additional borrowing. For a large utility, the additional debt required for most renewable energy projects would amount to around 2% of their existing borrowing15, which may be sufficiently material to move it off balance sheet when renewable energy is not considered a ‘core business’. > Off-balance sheet funds are in theory a function of the credit quality of the underlying cash flows and the coverage ratios required, therefore size is rarely constrained per se, other than by the transaction’s cost. Minimum sizes are often required to attract investors and compete for management time with larger projects.
5.5. Gearing On-balance sheet gearing is usually kept below 60% and in many cases below 30%. This is due to the less well-defined nature of the supporting cash flows and the freedom the company has to apply those cash flows in any area of the business. In contrast, most non-recourse financing starts at 70% gearing (for merchant power type projects using state of the art technology) and may achieve up to 95% gearing. This is dueto long term contracts that match the financing tenor and provide predictable revenue flows that are only linked to operating efficiency. The result of higher gearing is improved returns to equity holders. In practice, gearing ratios are applied as a ‘rule of thumb’ assessment and the finance provider’s preference for sponsor’s cash, in the form of equity, at risk in the project vehicle. The credit quality of the underlying cash flows is directly linked to the quality of the off-take contracts: if price and volume are contracted, then the levels of gearing seen in the early ‘dash to gas’ in the UK are possible. Subsequent deals, where volume but not price was contracted saw significantly lower levels of gearing and this is touched on in the Sutton Bridge case study in Appendix G.
15 PowerGen has approximately £2.5bn of debt and an average large renewable energy project costs about £50m, hence 2%.
19 5.6. Documentation Documentation is an issue of cost and complexity. Cost is a function of the legal fees, which are directly related to transaction complexity. Complexity also impacts on the sponsor’s management time, both while negotiating the transaction and afterwards while trying to ensure that all the covenants and stipulations are adhered to. Off-balance sheet financing as a rule has far more complex documentation as it seeks to constrain and allocate risk. Some attempts have been made to standardise documentation (such as turnkey construction contracts - the Model Forms), but this has had limited success. Section 7.19 looks at Schraders’ PFI fund that uses standardised documentation to ‘shoe-horn’ sponsors into a predetermined set of contracts. On- balance sheet financing usually has simpler documentation and subsequent rounds of fund raising can often use existing documentation.
5.7. Transaction Costs Costs for on balance sheet financing are generally much lower than off-balance sheet financing due to the simpler debt structures and the ability to use more boiler plate' in the legal agreements. In the case of bonds, the underwriting cost depends on the anticipated rating, on the basis that it is easier to market a high grade security than a lower grade security. Thereafter the difference is primarily due to legal and accountancy fees, particularly as off-balance sheet transactions are more contractually intensive. In addition, raising finance for renewable energy typically faces increased costs due to the fuel supply risk inherent in most projects and the lack of market comparators. Section 7.13 gives an indication of the actual costs involved for off- balance sheet transactions.
5.8. Interest Cost On balance sheet financing is concerned with the credit standing of the entire corporate entity and as a result, this tends to favour established, large companies. A list of major UK power company ratings is at Appendix D which shows interest costs standing in the 35-60bp range today, but this was much lower before the Asian debt crisis and the Russian default. This contrasts markedly with the non-recourse transactions in Appendix H that mainly cost more than lOObp over LIBOR. In contrast, off balance sheet funding costs are strictly a function of the project’s credibility andthe availability of funds for project transactions at the time. However, there is a material difference in this regard between the capital markets and commercial bank market, which is dealt with in Chapter 6.
5.9. Confidentiality On balance sheet funding rarely requires a sponsor to divulge the detailed uses of the funds received, which may provide it with a commercial advantage. Off-balance sheet
20 funding requires a greater level of disclosure, but this varies significantly between the options selected. This is covered in more detail in Section 7.9.
5.10. Replicability Replicability refers to the ability of work from one fund raising to be readily adapted to a subsequent fund raising and thereby reduce the transaction costs. This is less applicable to the commercial bank market than the bond market. However, within the capital markets this can restrict the issuer in the type of financing raised and it is generally considered desirable that any bonds raised through the balance sheet are fundamentally similar to previous financings, otherwise it is likely to affect existing issues. The cost in management time is particularly high for any bond debut issue although there are speed and cost benefits to be derived subsequently from having established “template” documentation. Establishing the right structure for (especially) a debut corporate bond issue is important, as any subsequent variation in structure or quality will affect pricing.
5.11. Insolvency If funds raised through the balance sheet are defaulted on, the debt provider has recourse to all the issuer's balance sheet up to the value of the debt. The recent losses by MEG Micon demonstrate the risks faced by a company andMEG Micon only survived as a company due to its shareholders’ willingness to stand behind the debts and provide additional capital injections. This is one reason that the rates achieved by corporate borrowers are substantially lower than project specific debt, as there are more assets to call on. Equally, few companies have leverage much over 50%, which means that more equity is available to 'cover' the debt16. In contrast, most off balance sheet financing achieves debt in the range of 70-95% of the project's cost, which reduces the absolute amount of equity the sponsor must subscribe17 and maximises the return on equity. In theory, with non-recourse financing the sponsor is only exposed up to the amount of equity subscribed, subject to completion/performance guarantees in connection with the sub-contracts. In practice, true non-recourse financing is rare and sponsors will often find themselves under considerable pressure from their lenders to support a project, particularly if they wish to access the market again. In this context, failure of non recourse financing in the bank or capital market would restrict access to both sources of funds in the future. The support provided by Foster Wheeler for the Robbins waste to
10 This simplifies a complex issue and in practise, the level of cash, amongst other tilings, is also a vital factor. 17 In one unusual case, the sponsor raised 140% of tire project's value in debt. This was partially due to tire relationship existing, but also demonstrates the nature of non-recourse financing which is secured on tire value of future cash flows, not the project's asset value.
21 energy plant in Illinois clearly demonstrates the pressure sponsors can be under18 . Conversely, problems with wind farms built by small developers in California in the 1970s have made many investors wary of investing in wind power even today. An absolute requirement for any off-balance sheet fundraising is that it is 'bankruptcy remote' from the sponsor. This means that any problems with the sponsor cannot affect the cash flows to debt providers and other investors in the off-balance sheet vehicle and vice versa. This is a potentially complex area, depending on the SPV jurisdiction of incorporation. For the UK, where the legal concept of fixed and floating charges is well established, this is less problematical than in the US.
5.12. Presentation Within reason, equity markets look favourably at a degree of gearing and the debt is fully recorded on the balance sheet. This may have implications for future lending, as some debt covenants are linked to balance sheet ratios. Off balance sheet debt should have little or no impact, although FRS 519 may require consolidation that could trip other borrowing ratios. A strong sponsor may not wish to consolidate the debt for several reasons, even if it would still benefit from limiting liability by using a subsidiary: > the project is not in its core area of business; > a joint venture partner is exposed to a similar risk profile (such as the PowerGen renewables refinancing with Abbot - Deal 1 in Appendix H); > in politically sensitive projects, it may bring the additional support of the international finance community.
5.13. Global Risk Off balance sheet financing seeks to isolate the assets from the sponsor and ensure the funder’s only risk is linked to the underlying asset performance. Therefore, this does not expose the entire sponsor to risk. A major benefit of on-balance sheet debt financing is that it permits the sponsor to take equity type risks with debt funds. This is relevant where the sponsor believes it has a better understanding of the market risks (information asymmetry) than the banks or rating agency and is unlikely to be able to convince them that the risk is acceptable. An example of this are certain Italian CIP6 (see Section 8.2) contracts where sponsors are beginning work on balance sheet due to the complex contracting process of some of the main contracts. This approach would be virtually impossible for a bank or rating agency to accept in an off-balance sheet funding. Similarly, a number of the NFFO 1 and 2
18 The Robbins plant had its power tariff and gate fee cut significantly by the local government and as a result, Foster Wheeler paid hundreds of millions of dollars to keep the plant going until it could be sold. Walking away from the deal was, apparently, considered impossible if Foster Wheeler were to retain its reputation and ability to raise finance.
22 biomass plants were obliged to lock in a substantial portion of their fuel supply with long term contracts, although macro indicators suggested that the fuel prices would fall and remain low. This indeed proved the case and at the end of the debt period, these plants were able to purchase fuel in the spot market and switch between fuel types depending on the respective prices, in order to boost their returns.
5.14. Bankability Bankability is not directly an issue for debt issued through the balance sheet, as in this context it refers to the sponsor’s size and balance sheet strength. For projects, it refers to the creditworthiness of each party and the contractual links of those parties to the project. These are subject to individual and careful scrutiny. Debt providers also look through the contractual agreements to the underlying economic incentives, to ensure the SPV and its shareholders are incentivised to meet its debt covenants. However, all the cash traps, tight covenants and clever structuring will not work if the fundamental building blocks of a project (PPA, EPC/construction guarantees, fuel contracts) are not of the appropriate credit quality or duration. These must also inter relate, such that any risks left in the project company are acceptable. This is particularly relevant for renewable energy post META and NFFO-5. A fundamental building block remains the PPA and without it, green certificates or carbon credits will not be considered bankable.
5.15. Use of Funds As described above, on balance sheet funds usually give the management great leeway in how the funds are used. This allows greater commercial judgement to be exercised and fewer constraints on the riskiness of those investments. Off-balance sheet finance typically constrains the use of funds for strictly defined purposes. However, the recent emergence of open-ended securitisations and the Schroders PFI fund (see section 7.19), have demonstrated more funding options for sponsors. In these instances, provided projects meet certain very tight credit criteria and can comply with pre-defined documentation, they may be subsequently added to the pool.
5.16. Summary On-balance sheet financing often achieves a lower interest cost and greater flexibility. Off-balance sheet financing allows the merits of a project to drive the amount of funds raised with higher levels of gearing possible. However, this is only due to revenues being contracted and specifically committed to debt service, or the market risk for spot revenue being considered acceptable, because the product is a basic commodity and the supply/demand balance is well understood. For the UK power sector and renewables in particular, NETA may change this. Nonetheless, investors’ demand for long term debt 19
19 Financial Reporting Standard - rules governing accounting in the UK.
23 in infrastructure is growing and the investor base is increasing. Both methods provide advantages and disadvantages, which need assessrng agamstthe specific circumstances for which funds are required.
24 6. Non Recourse Financing
6.1 Objective Assuming a sponsor has decided to raise finance through a non-recourse structure, this section examines some of the issues involved in choosing between the project bond and commercial bank financing. Chapter 7 then looks in more detail at the securitisation process and some of the specific factors that apply.
6.2 Non-Recourse Bond versus Commercial Bank Debt Summary The following table summarises the main differences between capital markets debt and commercial bank debt for an off balance sheet financing. These differences are amplified in the text and referenced to the deal list in Appendix H. The relative importance of each factor should only be judgedin the context of a sponsor’s own circumstances and there is no attempt to prioritise the factors. This is a matter for the sponsor and their advisers. Commercial bank debt is self-explanatory and for the purposes of this section, capital markets debt will be primarily considered in the context of the public markets. Options such as Rule 144A or private placements are considered in Chapter 7. These provide some additional features that might benefit certain sponsors.
Commercial Bank Debt Capital Market Debt Sponsor Less important, but may influence Helps primary market placement and Strength spread achieved. may improve credit rating one notch. Size Large (no minimum) but rarely cost Very large (minimum £100+ million) effective below £10-20 million. Gearing High gearing accepted, tied to DSCR. High gearing accepted, tied to DSCR. Documentation Transaction specific but can be more Fairly standardised for public markets, flexible as a result. otherwise complexity may be an issue. Transaction Negotiable, but subject to market norms. See section 7.13. Costs Interest Cost Usually over lOObp, rarely over 250bp, Depends on market conditions. Material as higher risk projects simply not variation can occur not linked to project accepted. May step down post quality. Access to monolines and other completion. enhancement possible. Transaction Limited, as negotiated process. High, as market conditions may change. Risk Confidentiality Good - information kept within the Limited in public placements by need to lending syndicate. disclose material contracts and the level of rating agency comment. Insolvency Flexible approach to refinancing and Inflexible and more likely to initiate workouts possible. insolvency proceedings.
25 Commercial Bank Debt Capital Market Debt Presentation Limited. Demonstrates sophistication and rating may have a 'halo' effect. Source Large market with many experienced Large market. US market is more participants. complete with contiguous pricing along the risk curve - less so in Europe. Investor Flexible, able to cope with complex Inflexible once issued. Relatively Flexibility structures and deal with variations in simple story needed in primary performance once debt drawn. placement (but see Section 7.17 on private placements). Transaction Complex documentation, but some Issue follows a necessarily standardised Complexity standardisation possible. approach but is inherently more complex. Ongoing Significant. Limited, unless monoline involved. Monitoring Tenor Usually under 15 years, but some PFI Long tenors, often 20-30 years, some loans now reaching 30 years. out to 40 years. Investors Relatively small number of investors, Large number of investors with small often holding sizeable participations. investments relative to their portfolio2".
6.3 Decision Process The diagram overleaf outlines the main considerations for sponsors in deciding between a bond and commercial bank financing. Some are empirical, while others necessitate a more subjective approach, such as that taken by Enron in SuttonBridge Power (Case study in Appendix G and Deal 14 in Appendix H), when the ability to raise its corporate profile in the wider market was also significant. These factors are explained in more detail later on and in this diagram they set out in the approximate decision order. 20
20 Less so in the Eurobond primary market.
26 Amount Bank
>£60-80 m
Confidentiality Bank
Sufficient disclosure possible
Flexibility - Ease of refinancing - Additional projects (portfolio additions) - Changes to existing project - Re-negotiation of terms - Drawdown flexibility. Degree of flexibility required shades between bond and bank/private placement.
Rating Bank
Investment grade likely
Complexity Bank
Complexity shades between bond and bank/private placement.
Tenor
Longer tenor shades towards bonds.
Other - Diversify source of borrowing - Relationship with lenders
All in Cost - Wrap Final decision Market Status/ - Legals Sentiment - Spread
6.4 Sponsor Strength Sponsor strength provides similar benefits to the commercial bank debt and capital market debt routes. For capital market investors, a strong sponsor may bring ‘name recognition’ benefits that are particularly useful in the primary market. For commercial debt lenders, there may be ‘relationship benefits’ in supporting a large core client.
6.5 Size Bank financings are usually able to cope with most transaction sizes and loans are often widely syndicated. In the context of renewable energy this is unlikely to prove a barrier.
27 For the largest transactions the bond markets are often chosen, as these provide the greatest breadth and liquidity. The Orchid securitisation (Appendix H, Deal 18) of nuclear credits demonstrates the need to move outside of a relatively small domestic market, as well as the advantages of a currency that appeals to the widest variety of investors, in this case US$.
6.6 Documentation Various bond underwriters contacted believed that negotiating and structuring a bond financing is easier and quicker than a commercial debt financing. The sponsor will only deal with the bond underwriter (rather than a number of commercial bank arrangers); or, in a wrapped deal, with a monoline insurer (with reduced input from the bond underwriter). However, monolines are likely to negotiate a tougher covenant package than commercial lenders, which may work in favour of investors but against issuers. Major project loans are increasingly being structured with common documentation for PFI style projects or export credit agencies (Common Terms Agreements and Common Security Agreements) as an alternative to more cumbersome inter-creditor agreements. For these transactions, the additional flexibility also means that the question of finance from a bond or loan may be deferred until closer to launch when the market appetite is best assessed. However, this structure is yet to gain acceptance in the wider project finance market.
6.7 Transaction Costs In comparing transaction costs between the two fund raising methods it is difficult to draw meaningful conclusions for renewable energy projects, as costs are generally transaction specific and partly a function of the level of competition for business at the time. In general, bond under writing costs are higher than a bank’s equivalent charges, while the ancillary transaction costs might be lower and more open to adaptation. However, one of the largest costs, the legal fees, are a function of deal complexity. Section 7.13 provides some indication of the costs associated with a capital market transaction and where several projects are involved, for instance in a securitisation, the structuring costs will materially outweigh any differences between commercial debt and bonds. One transaction ‘cost’ unique to the capital markets is the uncertainty over the final spread achieved, until the bond is launched. Under certain market conditions, this may result in an inability to place the bond at all - an example being the withdrawal of the Dam Head Creek bond financing (Deal 10 in Appendix H) due to market problems and META uncertainty. Conversely, better terms than expected may be achieved, such as for Sutton Bridge (Deal 14 in Appendix H).
28 6.8 Interest Cost Interest rates are broadly similar for most types of deal when considered on an unwrapped basis and commercial bank financings are often hedged with fixed rate swaps, the cost of which are rarely public information. The relative market appetite in the bond market often drives the advantage of one method over another. In particular, the Treasury 6% 2028 Gilt stood at a yield of 4.52% on 4th February 2000, illustrating that fixed rate, long-term sterling is available at historically low rates and coincidentally lower than medium term rates. Monoline wrapped bonds may often have an interest cost advantage over the bank market, as the monoline will adjust its pricing to compete with the current bank market, within the monoline’s own pricing envelope, which is dictated by their need to fulfil their own capital adequacy requirements. Bonds may also offer more innovative structures, such as index linking, which fills a particular need in the market and thereby achieves a better credit rating.
6.9 Transaction Risk Access to capital markets is prone to interruption as project sponsors discovered during the second half of 1998. In the US market, for example, infrastructure bond spreads over US Treasuries widened from around 200bp to 600bp and above. Yields increased from 8-10% to 11-13%. In the UK, investors in triple A rated PFI bonds enhanced by insurance from one of the US monoline agencies have seen spreads increase from a low of 50bp in the summer of 1998 to more than lOObp over their equivalent Gilt bench mark after the Russian debt default later that year. The hiatus forced sponsors to run with both commercial debt and capital market solutions to guard against future uncertainty. A bond’s actual spread is uncertain until the bond is launched. This may be due to many factors, some economic, and others due to activity in other parts of the world or even a lack of market appetite for a certain asset class due to many similar issues having reached the market in the preceding months. Bonds typically provide fixed rates although a number of recent issues have had floating tranches (see the PECO Energy securitisation - Deal 19 in Appendix H) or the index linked bonds for PFI deals such as the Queen Elizabeth Hospital deal (Deal 24 in Appendix H) have been very well received and achieved exceptional pricing as a result. Index linked bonds would be an attractive route for NFFO based renewable generators due to the NFFO contract’s index linking and provided that the basis risk of the operating costs is not substantial.
29 6.10 Confidentiality There is little or no confidentiality in bond transactions, other than private placements. The activities of rating agencies andthe requirement of exchange listing rules ensures that there is far greater transparency of information in the bond market than with the commercial debt market. This may exclude the bond route, other than for private placements, as many key contracts in a power financing have confidentiality clauses built in. This aspect is covered in greater detail in Section 7.9. Commercial bank financing is capable of far greater confidentiality and the sponsor’s banking relationships are often included in third-party confidentiality agreements as standard.
6.11 Insolvency Default to a bond investor means that a payment has been missed and the cure provisions built into the funding structure have failed. It is then probable that the issuer will be placed in administration, as it may be difficult for a large number of bond holders to agree terms, amongst themselves or with the sponsor(s)21. In contrast, banks are usually able to take a more flexible approach for the following reasons: > there may be a relationship factor with the borrower/sponsor(s); > syndication loan participation amounts are normally larger (£5 million is at the lower end of the participation scale in a syndicated loan) than a bond investor’s final take (bonds are usually sold in lots of £10,000 or £100,000), hence a greater incentive to resolve the problem; > the role of an Agent Bank for a syndicated credit is to co-ordinate the response of other syndicate banks in such circumstances; > the number of banks in a syndicate is small relative to the individual bondholders in an issue, making agreement and action easier.
6.12 Presentation Issuing a bond and the subsequent publication of a rating can have a halo effect for the sponsor outside the capital markets. To an extent, it demonstrates that the sponsor has ‘come of age’ and even if the ‘triple A’ is due to a monoline, this may help credibility areas outside the debt market. For instance, PSEG is building a number of pure merchant power plants in Texas through the bank market, rather than issue high yield bonds that would not achieve investment grade. They plan to pool the current plant under construction (Guadalupe -
21 UK exchange rules allow a ‘cram down’ whereby once 75% of bond holders agree tire terms of a restructuring they can then force the remaining bond holders to accept them. This is not possible under US exchange rules and small bondholders are often involved in ‘greenmail’ where they negotiate an early take out of their bonds so that large bond holders can agree a restructuring.
30 1,000MW, $320 million senior debt) with a number of other assets in that region to achieve an investment grade rating22.
6.13 Source The commercial banking market is easily large enough to cope with any renewable energy based transaction. However, banks do have sector lending limits that may constrain their ability to lend to projects. In London, a number of banks have a good level of experience in certain sectors of renewable energy project finance and are willing to look at a great variety of deals. However, the level of risk accepted by commercial banks is quite low (compared to the risk of many single asset projects) and cannot be increased merely by increasing the interest rate paid. The bond market is very large, although this may also suffer from over issuance of certain types of paper. A good example of the effect of over issuance is the South Tees PFI hospital deal (Deal 23 in Appendix H). In the US andto a growing extent in Continental Europe, a high yield (junk bond) market is growing that offers financing instruments along the entire risk spectrum and certainly beyond what most commercial bank credit committees would accept.
6.14 Investor Flexibility Bond investors are usually passive and only interested in receiving their interest and principal repayments. Indeed, the large number of investors usually precludes any restructuring or adaptation of terms. It is here that the commercial banks have the greatest advantage, as a syndicate can usually come to a collective agreement on dealing with major changes in the transaction. However, the difficulty of this should still not be underestimated.
6.15 Transaction Complexity Both routes are complex dueto the nature of the non-recourse structure. To the extent that listed bonds require certain documentation, this may appear a slightly simpler route, but counteracted by the complexity of listing rules. With competent advice, neither route should provide most sponsors with an insurmountable hurdle.
6.16 Ongoing Monitoring Bond structures typically adopt a very limited level of monitoring compared to commercial bank debt and although rating agencies continue to report on a bond, the level of interaction is still relatively low. However, monoline insurers will usually adopt the same degree of monitoring as the commercial banks as do many private placement investors.
22 This also reflects the current view that in the US power market participants need large diversified portfolios to succeed in a deregulated market, which coincides with the forecasts for the UK power market made by Fitch IBCA.
31 6.17 Tenor Bonds traditionally offer long tenors and fixed rates, compared to banks that tend to offer shorter tenors and floating rates, with the option of swapping (at a cost) floating for fixed. De-mutualisation of the larger building societies andthe arrival of continental municipal lenders have brought tough new competition as these institutions can start to match bond market tenors with lending commitments of up to 30 years 23. This has helped increase the tenor offered by the commercial bank market and narrowed some of the difference between bonds and bank lending. However, the bond markets still offer consistently longer tenors and a number of financings (eg South Tees Hospital PFI (Deal 23 in Appendix H) and Sutton Bridge Power (Deal 14 in Appendix H)) have been strongly influenced by the relative ease with which these are obtained compared to the bank market.
6.18 Investors Deal complexity has a strong influence on the financing route chosen dueto the level of interaction expected or required between sponsors and investors. In this context, private placement bonds and bank financing are similar, in that with a small investor audience, it is possible to educate them on the project’s unique features. In comparison, most investors in listed bonds do not have the resources or inclination to understand the nuances of a deal, which was one reason cited for the withdrawal of the bond financing for Dam Head Creek (Deal 10 in Appendix H).
6.19 Summary Apart from any price or tenor advantages over commercial bank debt, positive features of the bond route generally include documentation with a greater degree of standardisation; a “hands-off ’ covenant package; and a less intrusive post-signature monitoring and surveillance regime. However, the greater disclosure requirements and the listing obligations plus a difficult restructuring process that tends to favour administration or insolvency in preference to a work out counters this. In addition, commercial bank debt and private placements are better able to accept complex deals or unusual technologies. There are disadvantages to the bond market for issuers regarding negative arbitrage during construction, penalties for pre-payment and less flexibility in restructuring. Similarly, the liquidity of the project bond market is still poor compared to government bonds and most corporate bonds, which means investors are not always able to exit the bonds at a price they accept as realistically reflective of the value, which implies higher pricing.
23 Some PFI deals have recently had 27 year loans from UK clearing banks as a result of this competition and the credit quality/tenor of the underlying contracts.
32 In practice, sponsors are usually recommended to retain the flexibility in choosing between bond and commercial bank finance for as long as possible, suchthat any short term capital market issues will not prevent the project going ahead. In the end, pricing is usually the absolute determining factor.
33 34 7. Securitisation
7.1. Outline This section looks specifically at the requirements of securitisation compared to single asset bond finance. It also considers some issues that are common to any capital market instrument in greater depth, such as monoline insurance and disclosure rules. Corporate finance techniques are being increasingly applied to financing power transactions, especially when buying groups of generating assets that have a greater diversity of risk. An example is the US Gen financing24 of the New England Electric System generating assets used a borrowing vehicle that had an investment grade rating to issue commercial paper supported by revolving credit commitments, which resulted in a significant saving in borrowing cost. This implies an increasing willingness of investors to look at innovative ideas and not be put off by unfamiliar asset bases.
7.2. History Securitisation first appeared in the 1880s when New York trust companies sold debenture bonds secured by groups of mortgages to the public. The large growth in securitisation began in the 1970s as the US Government sought to create liquidity in the secondary mortgage market. This allowed mortgage lenders to move large parts of their debt portfolios off balance sheet, in order to improve their central bank imposed capital adequacy ratios. This freed up lenders’ capital to make new loans, without the costs of raising new funds and still being able to retain an interest in the profits derived from the securitised assets. The growth of securitisation outside the US has been concentrated in the last 10 years and was also dictated by the economic needs of particular areas plus the ability of the local legal system to accommodate securitisation.
7.3. Definitions Securitisation is one possible route for opening the capital markets to finance renewable energy projects. In this context, securitisation is considered the financing or refinancing of income generating assets in the form of tradable debt instruments sold to investors which are secured on the assets andwhich are serviced from the cash flow the assets yield. It could also be considered to be the transformation of an illiquid asset into a tradable security with a secondary market. A securitisation typically involves the following steps: > assets are pooled;
24 US Gen is the unregulated subsidiary of PG&E, the 3rd largest utility in the US by assets and market capitalization. US Gen issued $417 million of bonds and $900 million of bank debt for this transaction. This should not be confused with National Grid Company’s purchase of the New England Electric System ’s transmission assets.
35 > a special purpose company is set up that accesses or acquires and then administers the assets; > securities are issued by the special purpose company based on the ability of the company to generate income from the pooled assets, together with any supporting insurance proceeds, guarantees or other forms of credit enhancement; > typically the special purpose company then obtains a credit rating for its securities, which facilitates trading on the secondary market and qualifies them as suitable investments for pension funds and other institutional money. One motivation for segregating assets and using them as collateral for a security offering is that it can result in lower funding costs. This is because investors look to the credit quality of the underlying pool of assets rather than the credit quality of the issuer of the asset-backed securities. The first ever asset-backed security was issued by Sperry Lease Financial Corporation and was backed by lease receivables. The issue was structured such that the cash flow from the underlying leases was clearly sufficient to satisfy the interest and principal payments for the bond and as a result, it received a AAA rating, which was substantially higher than Sperry ’s own rating. This structuring is particularly important for small companies that do not have the track record or access to sufficient capital through their balance sheet to compete with larger developers. Securitisation brings significant advantages to borrowers, capital market investors and bank lenders: > if the international capital markets are accessed, the financing of existing assets at better rates than the originator would be able to obtain through a more straightforward secured borrowing. By putting together a transaction which enables the issue of investment grade paper, it is possible to benefit from cheaper funding costs and access to a wider range of investors; and > if an off balance sheet structure is used, the removal of the underlying assets from the originator’s balance sheet and the consequent freeing up of capital for use in writing new business. This is possible through a special purpose vehicle. > bank lenders are able to liquefy one of their major illiquid assets and benefit from regulatory capital relief, as well as coping with single country, technology or sponsor limits; > investors are offered an efficient way to diversify risks and invest in potentially more liquid assets, with an attractive return;
7.4. Securitisable Assets Virtually any asset producing a fairly stable and predictable cashflow can in theory be securitised. Examples of assets which have to date been securitised in Europe include mortgage loans, lease payments, consumer loans, conditional sale and hire purchase receivables and revolving credits such as credit card receivables and corporate loans. In
36 theory any renewable energy project capable of being project financed could be grouped into an asset pool suitable for securitisation.
7.5. Securitisation Types A securitisation of the revenue streams from groups of renewable energy projects might be possible as part of a re-financing of debt in projects that had been commissioned and had achieved an operating track record. The following scenarios are theoretically possible although the first of these is the most likely from a practical standpoint, as there may be difficulties in taking security under multiple jurisdictions in a single finance and security package: > projects with a single owner in a single jurisdiction; > projects with a single owner in multiple jurisdictions; > projects with multiple owners in a single jurisdiction; > projects with multiple owners in multiple jurisdictions. Within this mix, projects might be single or multiple technologies and the benefits of diversification are discussed in Section 7.10. The re-financing of portfolios is the most likely way in which securitisation could be applied to the renewable energy sector given the small size of projects, potentially variable income stream and the technology, construction and operating risks attending such projects. However, capital markets practitioners indicated that the bond market would accept some construction risk, depending on the technology and the quality of the EPC contract.
7.6. Issues A number of issues need consideration in connection with any proposed securitisation. The solutions to the problems posed will vary for different asset types or different issuers in the same jurisdiction. A number of the issues are: > what structure is required to achieve the commercial objectives of the originator and to satisfy investor expectations? > what are the assets and what are their characteristics? > what is the most appropriate mechanism for transferring the assets (assuming a transfer is necessary)? > how do credit and securities regulations impact on the structure? > how do insolvency considerations impact on the structure? > what are the arrangements for obtaining security and for collecting the moneys?
37 7.7. Transaction Process Securitised transactions come in many forms and structures, but there are four basic elements common to all transactions:
a. Sale The owner of the assets to be securitised sells the assets25 to a special purpose vehicle (SPV) established either by the originator specifically for the purpose of acquiring those assets (ie a clean company) or by a third party as a conduit to acquire the assets of originators in general. The SPV is often ‘orphaned’, so that it need not be consolidated as a subsidiary or subsidiary undertaking under the relevant statutory regime. In the UK, FRS 5 has limited the opportunities to do this, although there may still be ‘quasi subsidiaries’, to deal with regulatory concerns or financing restrictions on risk asset ratios and the like. Although the SPV acquires the assets, the originator will normally retain a participation in the profits of the assets (approximately the income less the financing and administrative costs), particularly where the project is over-collateralised,
Typical Structure of a Securitisation
Administrator Swap/liquidity Originator Residual providers Value Services T ransfer assets / liabilities Receivables
Project Assets Security Trustee Security Purchase Price
Trust
Receivables Trust
Enhancement Investors Construction Lender (monoline etc)
such as the PECO securitisation (Deal 19 in Appendix H). There are several ways of achieving this, but in the UK the preferred method is a ‘receivables trust’ whereby a trustee holds the assets for the benefit of both the SPV and the originator, with the originator being limited to the residual profits arising. The
25 There will be tax and other issues to consider - suitable professional advice is required.
38 security trustee represents the interests of the bond holders and will not necessarily be the same as the receivables trustee.
b. Secured Borrowing The SPV raises funds to pay for the assets, usually in the form of bond financing, either public or private placement, but occasionally by syndicated loan facilities. The SPV then creates fixed and floating charges over the assets and all of the SPV’s other property, undertaking and assets to secure its obligations to repay the finance raised. This security will be granted to the bond security trustee, for the lenders, the provider of any credit enhancement and the originators.
c. Enhancement As the SPV is a shell holding only restricted assets, some enhancement is required to protect it from various risks, including: > credit risk (default by the debtor projects); > liquidity risk (receipts delayed/payments accelerated); > currency risk (movements in exchange rates where several currencies are used - see the SuttonBridge case study in Appendix G); > market risk (covers reinvestment risk and market rates moving differently to income returns). Enhancement can take many forms and might include the SPV issuing several tranches of debt (see Deal 16 in Appendix H) with different seniorities, loan facilities, letters of credit, insurance, contingency funds, swaps, guaranteed investment contracts and top slice agreements26. The type of securitised asset and its cash profile will determine the nature of the enhancement, along with the negotiating skills of the originator. Bond underwriters and monoline insurers in particular, will look to constrain the sponsor’s freedom and try to design a structure that is self-correcting if there is a problem with one of the asset cash flows. Thus the level of enhancement will be set by the expected demands of investors and this will relate to previous investment performance of similar deals and the market appetite at the time.
d. Servicing The originator will usually continue to service the assets in the portfolio as the agent of the SPV for a management fee and deal with the day to day administration. It will also transact the daily business of the SPV (which will rarely have assets of its own) and be responsible for the fulfilment of any statutory duties of the SPV.
20 A tiering of risk that allocates risk in a set order to investors. Tins is often seen indirectly in bond tranches, but for it to work effectively, there needs to be a sufficiently large deal to provide liquidity in each tranche.
39 7.8. Sponsor Process Planning, structuring and bringing a securitisation to fruition is inevitably a challenging and time consuming exercise, particularly for first time sponsors or for new assets. The process can take many months and requires considerable forward planning and commitment on the part of the originator. It requires a substantial degree of investment, both in adviser’s fees and management time, as well as modifications to the sponsor’s existing systems and procedures. Sponsors that have completed a securitisation report levels of due diligence and legal structuring that make an audit or a project financing appear simple in comparison. Therefore, sponsors may well find that timely professional advice can help achieve a similar aim in a more cost-effective manner by > straightforward asset sales; > renegotiating loan covenants; > use of hedging instruments; > refinancing existing borrowings on a different basis. If securitisation still appears an attractive alternative, a detailed feasibility study covering the economics and practicalities is then advisable. The first questions to be posed are: > are the assets genetically suitable? > are the particular originator’s assets suitable? Generic suitability refers to the degree of stability in the cash flows provided by the assets and how easy it will be for external due diligence, be it by a private placement or a rating agency or monoline insurer, to understand the risks involved. This area is of particular significance for renewable energy generators, where the capital markets are less familiar with the technology and fuel risks of renewable energy technologies. For most wind farms, hydro, land fill gas andwaste to energy plants this process is relatively easy, as there is substantial historic performance data to support underlying cash flow assumptions. Biomass based combustion may have a slightly more challenging time, depending on the technology used, the fuel risk profile and the country the project is based in27 . Technologies that are less proven, or with a more chequered track record, such as anaerobic digestion, wave power and some photo voltaics, will find it difficult to provide the level of investor comfort required. The stage that finance is raised is also an influence, as proven technologies provided by quality EPC providers and sponsors can attract financing during construction, as demonstrated by PowerGen’s recent £48 million re-financing at favourable rates for its wind farms (Deal 1 in Appendix H).
27 In the US, biomass has in many instances a better track record than waste to energy, while in Scandinavia, biomass is considered a main stream fuel source.
40 The suitability of the originator’s assets for securitisation needs establishing as early as possible. Suitability not only depends on technology, as above, but on whether the assets are capable of securitisation. This may be influenced by: > confidentiality clauses in material contracts; > existing documentation that has fundamental flaws that would render the assets unenforceable; > contractual prohibitions on transferring the assets. The asset mix is also important at this stage, depending on the power marketing strategy. Where assets are supported by a government sponsored power contract for the term of the proposed debt, this is less important and Appendix E discusses the benefits of the NFFO contract as a financeable instrument. However, if assets will be selling power into the open market, be it on a merchant basis, into the balancing market or through a mix of bilateral contracts, then sponsors will need to ensure that their mix is credit worthy. A recent report by Fitch IBCA highlighted the potential changes in credit worthiness that different generating portfolios will attract, and this will influence the financeabiltiy of the eventual portfolio. However, there are a number of uncertainties derived from the nature of project bonds, the lumpiness of the transactions and the unproven default remediation history within the capital markets, such that sponsors considering securitisation need to focus on the specific pool of assets planned to go into the pool. In assessing a pool, it is the credit profile of the receivables supporting a given asset backed debt issue rather than any generic rules or assumptions about global asset performance that counts.
7.9. Confidentiality Confidentiality concerns have prevented a number of capital market transactions, due to the need to disclose information on all material contracts. An example of this is the Salt End power plant28 sponsored by Entergy: BP as gas supplier objected to the disclosure requirements (that included its contracts) and as a result, Entergy had to cancel the bond issue. Many contracts signed in financing a renewable energy project have confidentiality clauses, be this fuel prices, turnkey contract clauses or performance guarantees that the counter-party will not wish disclosed for various commercial reasons, other than under appropriate and controlled confidentiality agreements. With a public placement, this is more difficult unless the capital market financing option is factored in to the negotiation of these contracts, or appropriate representations and warranties can be obtained from sponsors on which investors can rely 29. However, Rule 144A and private placements
28 The UK’s largest IPP merchant plant: £722 million project for a 1,200MW CCGT. Gas supply contract was 15 years and construction started -06/98. 29 This reinforces the advantage a large, reputable sponsor has over some of the smaller IPPs. Clearly tills method would only work where a reasonable number of contracts can be covered by tire proviso.
41 may still be possible, as access to information can usually be controlled appropriately. Some banks have even been prevented from pooling their project exposure to launch notes collateralised by project revenues as a result of this. Sponsors who borrowed from banks found the bank wanted their consent to a collateralised loan obligation issue using their project as part of the collateral pool. Many sponsors proved unwilling to agree to the required disclosures without some benefit to them in return. Disclosure, being the flip side of confidentiality, is particularly an issue of investor protection in the US market, which is more litigious. Market worries over bondholders accepting construction risk have been overcome using proven technologies and high quality EPC contractors. SuttonBridge 30 in the UK was the first unwrapped deal on which investors took construction risk, and the $1 billion Petrozuata Rule 144A issue in Venezuela even happened without political risk cover. But even with strong investor appetite, matters on project bonds are still largely uncharted and highly sensitive areas. Finance is still being raised on the basis of dealings with rating agencies, stock exchanges, government agencies and general commercial awareness rather than any long-term reliable precedent or legal ruling. With projects under development or construction, bank loans are heavily structured, with experienced lenders sophisticated enough to gauge and allocate risk in order to protect themselves through detailed covenants against any setbacks affecting the repayment schedule. Eurobond or Rule 144A placements are sold into a market without significant investor input or negotiation. Regulations exist to protect the potential investor, but how much suppliers or off-takers will allow to be revealed is unclear. It is difficult to objectively define what must be disclosed to satisfy regulators without divulging too much to competitors, as it remains a skill based on experience. In the absence of specific project bond regulation, sponsors and advisors need to balance confidentiality with due diligence. Rule 144A Offerings - Information provided in a US bond offering is far more detailed than a Eurobond offering, (although European market practice has been influenced by US requirements) partially as a result of US legal practices. Rule 144 A offerings are designed to avoid registration with the SEC and as such, can only be sold to approved investors. With some exceptions, there is little difference in Rule 144A requirements and those internationally reputable firms would require. There are minor differences of form, such as a Rule 144A issue usually lists risk factors as a separate heading, while the international market traditionally does not need this. This is changing as the market moves towards a ‘mid-Atlantic’ standard. However, on project bonds, risk factors are standard even when they are not going into the US. Rule 144A technical requirements require less disclosure than is customary, but due to industry practise, it is generally necessary to disclose a similar level as for public deals.
30 £285 million raised - see Deal 14 in Appendix H.
42 London Offering - When structuring a Eurobond issue, the London listing rules need considering, as this is now the preferred exchange for project debt and structured debt. The earliest deals were unrated sterling issues, but Sutton Bridge (Deal 14 in Appendix H) was an important development as the first Eurobond with a Rule 144A placement which was London-listed and where investors also bore construction risk. In this transaction bonds were placed simultaneously in the UK and US. London-listed deals need to display contracts, which is one of the peculiarities of the London exchange and a material difference from Rule 144A placements. For Rule 144A deals, issuers do not file contracts with the SEC - which would be obliged to make that information available to the public - andtherefore better confidentiality is a major advantage of this type of issue. With a listed Eurobond, the documents go on display and are available for inspection but in contrast, in the US far more detail is required in the offering circular. It is then up to the issuer if copies of contracts are distributed to prospective purchasers and if they are distributed, this can be under appropriate confidentiality restrictions. However, third party contracts may be material to the investor’s decision and contract summaries are included in Rule 144 A circulars. For Eurobonds, if a provision of the contract is material it must be disclosed in the offer document, whether or not the exchange requires its display for 14 days. If a large pool of assets is being securitised then diversity and size of the collateral pool determines the amount that must be disclosed about individual projects. Rating agencies typically expect to examine all material contracts if there are 20 or less projects in the pool, with 30 or more projects within a pool then selective sampling occurs and this approach might also be acceptable for bond prospectuses.
Exemptions from disclosure rules on the London exchange, have rarely been given. There are three possible reasons for exemption from disclosure: > the information is minor; > the information has national security implications; > disclosure is detrimental to the issuer. The third option gives the most opportunity for a sponsor, but even this has had limited success. The best example was the £165 million PFI deal issue for Road Management Consolidated. The Highways Agency was reluctant to disclose anything that would have allowed another consortium to gain a competitive advantage over the Government for subsequent deals. Given the difficulties of getting a derogation and a more flexible attitude from the Government, subsequent deals, such as the M6 Autolink Concessionaires (see Deal 22 in Appendix H) have not had waivers. Even the presence of a monoline insurer has been tried unsuccessfully as a reason for minimising, or
43 avoiding, disclosure on the basis that investors could rely on the triple A rated monoline to conduct the necessary due diligence. In summary, sponsors should consider in advance the different requirements for fundraising and ensure that when negotiating contracts there is sufficient flexibility for capital markets funding, if there is any chance of using that route. In practise, US and European bond prospectuses are identical, with only a local regulatory wrap added at the end.
7.10. Bond Rating A rating is the rating agency’s opinion about the likelihood of full and timely payment on a rated security. It is not a recommendation to buy or sell a security and gives no indication of the aptness of a given security for any investor’s portfolio. A bond rating represents the ability of a borrower to repay the principal and interest over the long term. These crudely translate into probabilities of default, with a rating of ‘B’ signifying a 30% chance of default over a 10 year period and a rating of ‘BBB-‘ a 4% chance of default over a 10 year period. In this instance default refers to a payment not being met rather than complete non-payment of funds. It is very unusual for a structured transaction to receive a bare (ie unenhanced) ‘AAA’ rating because of the nature of the risks assumed. Most bank project financed deals could qualify for a rating in the ‘BB’ to ‘A’ range, depending on the technology used and quality of the sponsor.
In bond ratings a high grade means low credit risk or conversely a high probability of future payments. Bonds rated triple A (‘AAA’) are said to be prime, double A (‘AA’) are of high quality; single A issues are upper medium grade andtriple B are medium grade. All lower grades are described as having speculative elements and are considered sub-investment grade, or more colloquially 'high yield' or 'junk bonds'. All bonds rated BBB or better are considered investment grade. The distinction has a significant effect on the marketability of the bonds to investors, as many large institutional funds are restricted to investment grade bonds. In the US there is a larger market for sub-investment grade paper that is able to absorb new issues more easily than low grade bonds issued elsewhere. The bond’s rating and the market ’s appetite are directly linked to the spread the bond will have to pay. Both factors are affected by general economic conditions, which drive the benchmark pricing for a bond and its credit spread. The benchmark is usually a highly liquid sovereign issue, such as a Gilt in the UK, with a similar tenor to the proposed bond and the bond is then priced as a number of basis points over that. However, this spread will vary depending on general economic conditions, which may cause a ‘flight to quality’ or demand from institutions ‘hunting down the yield curve’.
44 A variety of research has been undertaken to develop a series of financial ratios that objectively measure the credit risk of various businesses. The nature of the data means that these are biased primarily towards whole businesses, rather than individual projects. Nonetheless, these give a perspective on credit risk and may provide an indication for highly leveraged capital market transactions. An example of this sort of date is shown below.
Financial Ratios by Bond Rating (1990 - 1992) AAA AA A BBB BB B CCC
Pre-tax interest 17.7 7.6 4.1 2.5 1.5 0.9 0.7 (Pre-tax Income from Continuing coverage Operations + Interest Expense)/Gross Interest EBITDA* interest 21.0 10.5 6.2 4.2 2.6 1.9 1.2 EBITDA/Gross Interest coverage Funds from 120.1 65.3 37.0 26.3 15.5 9.8 5.5 (Net Income from Continuing Operations operations / debt (%) + Depreciation)/Total Debt Free operating cash 42.3 28.0 13.6 6.1 3.2 1.6 0.8 (Funds from Operations - Capital flow / Total debt (%) Expenditures - Change in Working Capital)/Total Debt Pre-tax RoC* (%) 31.9 20.6 15.6 10.9 10.9 6.9 4.6 (Pre-tax Income from Continuing Operations + Interest Expense) / (Average long & short term debt + minority interests + Shareholder Equity) Operating income / 22.2 16.3 15.1 12.6 12.7 11.9 12.1 (Sales - COGS* - Selling Expenses - Sales (%) Admin Expenses - R&D Expenses)/Sales Long-term debt / 12.5 23.3 34.7 43.8 59.3 59.9 69.3 Long Term Debt/(Long Term Debt + Capital (%) Equity) Debt / Capital (%) 21.9 32.7 40.3 48.8 66.2 71.5 71.2 Total Debt/(Total Debt + Equity)
Source:Professor Damodaran (note rounding has occurred from the original research) * EBITDA - earnings before interest tax depreciation and amortisation. RoC - return on capital. COGS - cost of goods sold.
These results have been translated into spreads over the benchmark, to provide an indication of what a different credit rating costs. The actual figures will vary depending on market conditions andthe phase of the economic cycle, plus in project finance other covenants may impact the price compared to the general corporate market, as shown overleaf:
45 Synthetic Rating Estimation: Premium over US Government bonds Large Manufacturing Firms Smaller or Riskier Firms If Interest Coverage If Interest Coverage > To Rating Spread > To Rating Spread -100 0.199 D 10.00% -100 0.499 D 10.00% 0.2 0.649 C 7.50% 0.5 0.799 C 7.50% 0.65 0.799 CC 6.00% 0.8 1.249 CC 6.00% 0.8 1.249 CCC 5.00% 1.25 1.499 CCC 5.00% 1.25 1.499 B- 4.25% 1.5 1.999 B- 4.25% 1.5 1.749 B 3.25% 2 2.499 B 3.25% 1.75 1.999 B+ 2.50% 2.5 2.999 B+ 2.50% 2 2.499 BB 2.00% 3 3.499 BB 2.00% 2.5 2.999 BBB 1.50% 3.5 4.499 BBB 1.50% 3 4.249 A- 1.25% 4.5 5.999 A- 1.25% 4.25 5.499 A 1.00% 6 7.499 A 1.00% 5.5 6.499 A+ 0.80% 7.5 9.499 A+ 0.80% 6.5 8.499 AA 0.50% 9.5 12.499 AA 0.50% 8.5 100 AAA 0.20% 12.5 100 AAA 0.20% Source^pofessorDamodaranJhoteroundinghasoccurredjromtheoriginalresearch)^
The other significant variable is the markets appetite for specific asset classes and if there have already been a number of similar bonds issued, investment managers may be restricted in taking on any further exposure to that asset class. These factors insert a substantial degree of uncertainty over a bond issue, that cannot be accurately quantified until the actual issuance. A good example of this recently was Dam Head Creek (Deal 10 in Appendix H). The rating process is based on five main components: > Credit analysis of the underlying assets and/or underlying obligors. > Payment analysis on the application of cash flows; monitoring and furnishing reports on payments. > Analysis of the characteristics of the investment pool for concentration and correlation issues; > Stress analysis of the default and loss characteristics of the portfolio. > Analysis of the transaction structure both from a legal perspective such as accessing and liquidating collateral; operational and administrative risks, and the ability of the cash cascade to protect different investor tiers. The rating process is very detailed and requires a significant amount of documentation and information to be provided to the rating agency. The actual rating is only assigned once documentation is complete, which is why a bond prospectus often states an expected rating.
46 The chart below shows some of the processes that a rating agency will go through.
Initial Contact
Feasibility Industry Analysis Review
Collateral Sovereign Risk Originator/ Legal Structure Analysis Evaluation Servicer Review
Collateral Cash Flow Analysis
Financial Credit Structure Enhancement
Preliminary Rating Final Legal Final Rating Financial Pre-Sale Monitoring Committee Review Committee Close
A portfolio is considered concentrated if the cash flows are highly reliant on a small number of investments (generally one or two) and generally considered diversified if there are 11 or more projects in the pool. An asset pool is also concentrated if a large proportion of the portfolio will be simultaneously affected by any single factor. The determination of the degree of correlation is important to the assessment of the portfolio’s weighted average cash flow credit quality. Because most portfolios anticipated under this study will typically not have a large number of investments and will all be made up of infrastructure investments, some correlation is inevitable. For portfolios with minimal correlation, the credit rating will be raised and hence the cost of borrowing lowered. It is worth noting that the rating agencies consider: > a securitisation structure in general terms is only as strong as its weakest link; > all unrated entities in the structure will become insolvent. A significant point for originators is that the better the information provided the less likely the rating agency is to make conservative assumptions. Rating agencies work from the effect of a worst-case economic scenario affecting the assets andthe effect this would have on the ability to service the securities. The higher the level of rating sought
47 the greater the stress analysis applied to the assets. By changing the credit enhancement it is possible to target a desired rating for a securitisation transaction. The initial proposal to the rating agency is likely to include: > a detailed description of the assets providing collateral, the originator’s underwriting standards and collection procedures; > a description of the originator’s views of credit and liquidity risks; > a description of how any cash flow shortfalls will be covered; > a description of how the structure ensures that investors will be paid in full and on time under all circumstances; > an explanation of the flow of funds and any liquidity shortfalls; > the legal jurisdiction of the issuer and the assets. The rating process will involve confidential discussions with the rating agencies to deal with any issues that arise on the proposal; an indication is then given of the detailed work necessary to assign a rating and the rating fee that would involve. The quality of the sponsor influences the rating attributed to the project, even though much of the financing done for renewables is on a limited-recourse basis. A sponsor’s quality is often a highly subjective judgement based on balance sheet strength, track record in projects and the quality of the management. In particular, a sponsor that is highly regarded in the market and has been rated over several years at the corporate level by one of the rating agencies, is able to lift the rating assigned to a project by several notches, compared to a less well known sponsor. Although this apparently contradicts the concept of non-recourse financing and assessing a project vehicle purely on its merits, the reality is that few large companies have let limited-recourse projects fail causing senior debt holders to suffer material losses.
7.11. Credit Enhancement The main factors in assigning a rating to a bond are the type of underlying assets, the type of loan, the leverage, the amount of seasoning and the credit quality of the contracts and counter-parties. Typically a double A or triple A rating is sought, as this gives access to the greatest pool of investors and hence the most liquid markets. The amount of credit enhancement depends on what a rating agency requires to bring the receivables pool up to that rating. This is open to limited negotiation and rating agencies are used to making subjective judgements. However, they are unlikely to move far from industry norms. There are two general types of credit enhancement: > External Credit Enhancement - This comes from third-party guarantees that provide first loss protection against losses up to a specified level. The common
48 types of external enhancement are (1) corporate guarantees; (2) letters of credit; (3) pool insurance; (4) bond insurance and (5) monoline wraps. Pool insurance typically only covers certain defined losses and may be linked to historical credit performance and the degree of seasoning. Bond insurance typically is used to supplement other forms of credit enhancement, rather than as a stand-alone enhancement. External credit enhancement is also subject to the credit risk of the third-party providing the enhancement. > Internal Credit Enhancement - This is generally more complicated than external enhancement and may alter the cash flow characteristics, even in the absence of default. The most common forms are the tranching of bonds (so that a subordinated series are issued which enables the first-ranking bonds to be rated higher), the provision of a subordinated loan facility, cash traps, or over capitalisation.
7.12. Monoline Wraps A “wrap” is credit enhancement provided by a monoline insurance company. The insurer takes the credit risk of the project in return for a fee paid by the borrower thereby enabling bond investors to look to the credit risk of the insurer (usually AAA rated) rather than the project. The wrap helps to broaden the investor base by attracting institutions that would not invest in project debt likely to carry a rating of BBB or lower. Monoline insurers will not consider an underlying risk of less than ‘BBB’, in order to avoid impairing their own ‘AAA’ status. However, they usually aim to price the wrap so that the all-in cost of the bond is competitive with the pricing of a commercial bank debt alternative. Section 7.16 covers some of the related changes to bank risk capital allowances under the Basle Accord. There are a limited number of monolines in the London market, as most concentrate solely on the US market. Investors appear to retain an appetite for monoline paper, although pricing of the wrap is a function of competition at the time and the credit quality of the main underlying asset. For instance, monolines are keen to wrap NFFO style contracts due to the government component, which reduces their capital weighting to 20%, compared to 100% (see Section 7.16 for more details). The price of wrapped paper can fluctuate considerably, despite the high credit ratings as AAA’ trades from flat to lOObp over depending on perception of the underlying credit quality.
49 7.13. Capital Market Transaction Costs
Item Cost Remarks Underwrite, structure and 62.5-75bp for AAA Success based fees payable at distribute bond (calculated on 100-125bp for BBB financial close. the face value of the bond) 200-300bp for sub-investment grade
Lawyers (issuer, monoline, >£400,000 and may easily exceed the For borrower’s account regardless underwriter and trustee) underwriting fees on small complex of transaction outcome. deals.
Rating Agency £50-100,000 For borrower’s account regardless of transaction outcome. Typically 5bp for project finance and 3bp for balance sheet debt, with a minimum absolute level.
Accountants £25-50,000 For borrower’s account regardless of transaction outcome.
Listing fees etc £10,000+ Success based Registrars £10,000+ Success based Trustees £10,000+ Success based
Typically the costs become prohibitive on a pro-rata basis when the size of the issue falls below £60-80 million, both in terms of the fixed fees and the liquidity premium charged by the market for small deals. Below this size the market is more limited and tends towards private placements, with only a small number of investors purchasing the bond. This effectively resembles the commercial bank market, with the loan differences being primarily legal, rather than financial. Some corporate bonds have been issued at £100 million even though the company required less than that, solely to achieve the round number and avoid a premium to compensate an expected lack of liquidity. Legal fees are a function of the time worked, which is based on the complexity of the deal. Most capital market transactions are completed by a small number of legal firms based in the City. Although these charge substantial fees compared to firms located outside London, the in-house experience and credibility that the name brings generally more than offsets the higher charge-out rates.
7.14. Fund Raising Options Securities placed privately are exempt from registration, because they are issued in transactions that do not involve a public offering. The private placement market in the US has grown significantly dueto the agreement of rule 144 A in 1990, which allows the trading of private placement bonds between qualified institutional investors.
7.15. Bridge Finance Bridge finance is usually provided by commercial banks or an investment bank to cover a short term financing need, such as the construction period, prior to a take-out by the main, longer term, financing through a bond issue. A good example of this was the
50 Italian Vento wind project (Deal 2 in Appendix H), where the sponsors financed their equity stake through a bridge financing during construction. In theory this allows more flexibility in financing, with covenants designed to cover the different risks that construction and operation each have. However, bridge finance can be a risky proposition for developers, as it is often time constrained or has a stepping up of interest rates31. Before entering a bridge based transaction, sponsors should take appropriate professional advice (not from the prospective finance provider) on the risks involved.
7.16. Impact of the Basle Accord The Basle Committee has recently released its proposed risk capital weightings for securitised assets held by banks. The Accord prescribes that external ratings should be used as the basis for risk weighting and for securitised tranches, the weightings are as shown overleaf.
Rating Risk Weighting32 AAA to AA- 20% A+toA- 50% BBB+ to BBB- 100% BB+ to BB- 150% B+ or below Deduction from capital
This new system differentiates between paper of different credit quality, compared to the existing system that simply requires that all asset-backed securities be risk weighted at 100%, unless they are mortgage backed, when it is 50%. This suggests that banks will become more interested in investing in the paper of other banks, especially as most banks tend to have a concentration in the exposure to a certain domicile or customer. Banks will also find it attractive to invest in highly rated securitised paper of corporates due to the lower risk weighting and this should result in increased liquidity and volume. This should also have a material impact on the way corporates raise funds, by making it more attractive to raise funds through a securitisation. This should help move European corporate borrowing closer to the US model, where over 60% of corporates raise funds via the issue of paper. This will help renewable energy, as the market will become deeper for all risk bonds.
31 One of the basic challenges of project and infrastructure debt is achieving debt terms that match the asset lives of the facilities being financed. With the exception of the US bond and bank debt markets, maturities rarely approach infrastructure asset lives. Even in the US high yield market, investors tend to prefer the pricing simplicity of interest only bullet bonds, which avoids re-investment risk. As a result, many infrastructure financings face major refinancing risk in the form of large bullet and balloon payments. Some lenders argue that refinancing reduces credit risk, because it gives lenders opportunity to reset debt terms and pricing. Elowever, maturity risk might be relatively small for established credits in relatively liquid and continuous markets, but where the sponsor is not a well known name, or the credit is less than AAA/AA, there remains a significant timing risk. 32 The amount of risk free capital required covering a particular risk that is being insured.
51 7.17. Private Placements The process of issuing bonds through a private placement in the UK is very similar to accessing the commercial bank debt market. The simplest reason that the debt is issued as a bond stems from many of the investors not being banks and thus prohibited from making loans. A further reason is that many large fund managers, such as Prudential, which invested in the SELCHP plant (Deal 11 in Appendix H), find it administratively easier to allocate bonds internally between different investment funds. The private placement market compliments commercial bank debt and often is willing to offer far longer tenors at fixed rates, particularly where these match annuity fund liabilities. This provides some potential for sponsors to negotiate a slight improvement in terms in return for tailoring the debt profile to the particular liability profile of the investor. Private investors are often more willing to look at unusual projects, they will consider smaller amounts (£10-20+ million) and prefer not to involve a monoline, as they like the improved spread. Certain private placement investors can individually take substantial amounts (around £75 million, where most banks would need to syndicate that) or for larger amounts, they are able to create a club investment with similar institutions. As with commercial bank debt, private placements can offer far higher degrees of confidentiality than the public markets. The private investors contacted expressed interest in the renewable energy sector, but the provisos on underlying contract credit strength were no different to the public markets. However, they tended to prefer well proven technologies, such as wind power and waste to energy, rather than more cutting edge developments.
7.18. Green Premium ‘Green’ marketing often figures prominently in many renewable energy investment proposals seen by the authors. Sponsors often consider this enhances the attractiveness of such investments. However, with a few minor exceptions, investors only accept the ‘greenness’ of an investment as advantageous when the fundamental economics already exist. Therefore, in the primary market the ‘green’ nature of the underlying assets might prove advantageous in marketing the bond, but it will not improve the spread over the benchmark bond. If anything, investors tend to be concerned about what they are giving up, in order to do something for the environment. This is compounded by the limitations imposed on most institutional investors by their fund trustees to invest only at market rates. Therefore, renewable energy derived bonds will be assessed purely on the quality of the supporting cash flows and assets, just like any other offering.
7.19. Schroders PFI Fund Schroders has recently constructed a template fund for a PFI portfolio. It has agreed a £1 billion wrap with FSA for an open-ended debt guarantee for pooling post construction PFI projects in conjunction with a construction period bridge facility from
52 an investment bank. The Fund is aimed at relatively small PFI projects (£5-20 million) for which it would not otherwise be economic to raise money. Projects must comply with the terms of the standardised documentation and they are financed through construction by the bank bridging loan. Once sufficient projects have reached operation, these are aggregated andthe construction finance is then refinanced via the bond market. Schroders made a substantial investment in advance to prepare the documentation templates that covers all the construction and refinancing documentation. The template and quality thresholds for a project to be admitted were agreed with FSA in advance, thereby insuring the FSA wrap would be available. The ability to take a project from pre-construction to operation through this financing mechanism is partially dependent on the project sponsor also being the contractor. Therefore, the restrictive covenants provided for the construction phase are accepted by the sponsor as a ‘cost’ of financing a relatively small project. It is unclear how well this might work with a third-party EPC provider. Schroders andthe Rotch Group own the standard template and the contract with the FSA. Their income is derived from the fees for structuring each PFI funding. The actual interest rate achieved by the bond is passed through to the individual companies, therefore, each participant benefits from the pooling of their assets with others to achieve diversification for investors. The covenants are tightly drawn, with little room for a sponsor to negotiate variations. Schroders believes this will be acceptable, as these projects would not otherwise gain finance. This application of this type of structure for the renewable energy market is considered in Chapter 10.
7.20. Recent Developments The securitisation market continues to develop and access an ever broader range of markets. For instance, in 1997 a number of transactions used notes or certificates issued out of US securitisation deals as the underlying assets for secured Euronotes, issued with a ‘AAA’ rated swap. A variation on this was the issue by Westpac of Australian mortgage-backed notes, with the transaction registered with the SEC, while using identical documentation for the Eurobond and Australian markets. While in Latin America securitisation of dollar denominated cash flows has served as a means for issuers to access the capital markets at better rates than they could achieve by borrowing on their own credits. The first transactions of this type included the monetization of tourist credit card charges by banks in Mexico and future encashment of migrant worker receivables. Recently, originators of assets that have non-credit risks have used securitisation techniques to transfer those assets along with the non-credit risk to the capital markets.
53 Risks normally underwritten by primary insurers are also being transferred to the capital markets. In this instance, a SPV raises capital in the capital markets and reinsures a catastrophic risk. Interest on the securities is funded out of the premiums paid by the ceding insurer and investment earnings on the entity’s capital. Any claims on the reinsurance causes investors to incur a loss on their investment. This is complemented by work on the development of synthetic securitisations to overcome some of the covenanted limitations that often exist on the underlying assets. Synthetic transactions are now well established for currency and interest swaps. Rather than exchanging economic assets, an agreement to exchange the economic difference at set periods in the future occurs. If the originator is unable to transfer the assets to an SPV, a synthetic securitisation might help in the form of a swap: a counter-party pays up front for the right to enter the swap, whereby he receives a stream of income generated by the inalienable assets. In an attempt to broaden the market and access more investors, Enron has securitised its dividend stream from the South Teesside power complex through a £110 million issue of sterling bonds privately placed through Barclays Capital. The inherently subordinated position of this sort of deal provides an interesting yield pick up, but the investor base for such assets still remains limited. From the above, it is unlikely that securitisation will provide a route to finance renewable energy projects other than after construction. In order to access the capital markets efficiently, a large proportion of the existing capacity built under NFFO would need to be amalgamated into the portfolio. This might point to a portfolio approach as used by Schroders in their PFI fund. Given the state of the renewables industry, it is unlikely that any one participant could afford the risk associated with starting the up front work on this approach.
54 8. Support Mechanisms
8.1 Background Across the developed world most renewable energy technologies have converged within their band in terms of cost, competitiveness and technical development, suchthat the costs for a wind farm at around £800/kW is roughly the same in California, as it is in Minnesota, Scotland or Spain. While some countries retain an exceptional expertise in certain niches for historic reasons, such as Denmark’s large-scale anaerobic digesters, market penetration by renewables is primarily a function of economics and by direct implication, the government driven incentive schemes. This is most noticeable in Europe, where countries have very different profiles for renewable energy capacity installed over the last 20 years. For instance the UK has around 2.1 GW of renewable energy capacity, three-quarters of which is large hydro; Denmark has around 0.9GW of renewable energy capacity, which is over 95% wind power; and Italy, has 22GW of renewable energy capacity, 90% of which is large hydro. Inevitably this is partly due to local peculiarities, such as the renewable resource and difficulty of getting planning permission for wind turbines in the UK, but principally it is a direct result of the form of incentive scheme available. The shape of the renewable energy market in any country reflects a government’s decisions on the political and market support provided. The one common factor amongst (almost) all incentive schemes in the EU is the reliance on tariff subsidies rather than investment grants. Unlike many other markets, where government imposes generally negative covenants on a market in order to shape its function, the renewable energy market requires positive covenants to develop. For the UK to achieve its targets in renewable energy, the Government’s decisions on the form of the incentive scheme directly impact the shape (and hence size) of the resulting market. To achieve larger renewable energy projects (both to make accessing the capital markets possible and achieve the overall quantum required by the EU) the system needs to encourage larger projects. However, this should not be at the expense of the small innovative technologies developed by entrepreneurs, who have generally demonstrated a degree of nimbleness and risk acceptance that large companies still find hard to emulate. Therefore, a balance is required between building capacity now, while encouraging technologies that create tomorrow’s market, rather like Danish support for wind power in the 1970s. While some renewable technologies are approaching a market price based on the recent NFFO-5 bidding, such as landfill gas (2.59-2.9 p/kWh), energy from waste (2.39-2.49 p/kWh) and wind (2.43-3.10 p/kWh), it is incorrect to assume this demonstrates market convergence. The market rarely, if ever, provides triple A, 15-year, index linked contracts without performance penalties. The prices reflect how bankable the contract is, not merely an improvement in technology alone - remove NFFO and power prices
55 will jump, unless an equivalent tenor and credit quality contract is available, as capital costs need covering within the power contract time frame. Therefore, this report assumes that fundamentally the sector will need some form of incentive for many years to come. This derives partially from the capital cost of renewables, but also the difficulty of relatively small projects negotiating strong enough PPAs. For instance, one of Europe’s largest biomass power stations had a construction cost of over £1200/kW compared to large CCGT power stations with a cost approaching £280/kW. In addition, some CCGTs are up and running within 14 months - hence lower construction interest cost, which makes it hard for renewable energy to compete. In many renewable energy project financings, the two largest costs are EPC followed by interest during construction. In addition, for small developers, any negotiation with a power marketer is strongly weighed against them in terms of need, cost and expertise. Large utilities that construct their own renewable capacity do not face the same problems. For them, the negotiating process is limited only to defining the off-take terms in a manner acceptable to external investors, if financing on a limited recourse basis. However, large utilities still need sufficient economic incentive, both in rates of return and absolute quantum33, for a project to compete internally for management resources against much larger fossil fuel projects. An example of the benefits that a guaranteed PPA brings is demonstrated by the NFFO-5 awards, where all the energy from waste projects bid for prices below the current average pool price34.
This section looks at the bankability of a selection of renewable energy incentive schemes being used or promoted at the moment. They are examined in the context of the ability to provide investment grade levels of security35 andwhether they are bankable for the purpose of securing long term finance. These schemes are considered in isolation, although in practise most countries offer other incentives, such as tax allowances or grants that may encourage a renewable energy market. For any PPA, the important variables are price, volume, term and off-taker credit strength:
> Electricity Price may be fixed, indexed (to RPI or another benchmark, such as average retail price), floating, or variable. The variability is usually a function of embedded benefits, availability incentives and costs associated with non-contractual
33 For example a 3MW wind project with an all in cost of £8m that generates a (attractive) 25% rate of return for shareholders will often still be too small to justify the management time required in a major utility. 34 The cost of accepting a bid below average pool price was probably offset by the ability to raise finance against a known income profile, the indexed linked nature of NFFO, the removal of electricity market risk (ie price, charges and uncertainty) and the simplification of the PPA arrangements. The tenor of the waste contract also plays a part, but this alone does not explain a bid below pool price. 35 Investment grade ratings often depend on the weakest link in security chain being able to meet the stress testing required by rating agencies or monoline insurers. Therefore, a PPA might be bankable, that is money can be raised against it, while still not meeting the security level required for an investment grade rating.
56 performance. The more confidently this can be predicted, the better the credit quality of the financing.
> Volume is self-explanatory, although the period over which it is averaged, andthe incentives for meeting that amount, strongly impact the overall credit quality of the PPA. In particular, the ability to vary volume without penalty is important, otherwise it compounds the total penalty for non-base case performance36. If the marginal cost of production is low enough the generator will almost always be able to dispatch the volume profitably, assuming that the penalties for this variability do not negate the benefit.
> Term is important when financing relatively expensive renewable energy plant. The longer the term, the more predictable the average cash flows (ie a longer averaging period) and hence, the cheaper the overall financing cost.
> Off-taker credit strength is the keystone to the Price/Volume/Term structure, as it represents the ability of the contract counter-party to fulfil the contracted terms. For most utilities, which have a published credit rating, this is a relatively straight forward assessment by investors. Where the off-taker is a small company or does not commission a credit rating, investors may never become comfortable with the risk. The above factors drive the credit risk of the PPA and these are examined in the context of the different incentive mechanisms. However, the ultimate bankability depends on the underlying reliability of the renewable technology to generate electricity. In this chapter bankability of an incentive scheme is considered in isolation, while in practise investors assess the incentive in the context of a particular technology/project. A number of these incentive schemes are being changed, or have only recently been introduced, therefore due caution is required before project specific assumptions are made on the basis of the following commentary. The incentive schemes examined are: > Auction of Renewables Contracts (ie UK NFFO or Irish AER); > Fixed Price Mechanism (ie Germany, Spain and the former Danish system); > Net Metering (ie some parts of the US); > Renewable Portfolio Standard (ie the new Danish System or UK Percentage Obligation); > Voluntary Green Premium/Certificate (ie California, the Netherlands or Philadelphia).
36 An extreme example occurred in the US mid-West during 1999, when Cinergy was unable to meet its contract obligations for a two hour period. This cost the company $79 million as a result.
57 8.2 Auction of Renewables Contracts The main examples of this type of contract are the UK NFFO, Irish AER (which are very similar to each other) and to a lesser extent, the Italian CIP6. All provide an index linked price and a known term, however under NFFO, sponsors bid for prices, while CIP6 prices are set by the government for each technology band and sponsors bid on a technical basis for these contracts.
CIP6 Contracts are funded from the Cassa di Conguaglio, a tax account maintained for all the energy companies at the government’s (Ministem del Tesoro) specific behest. All consumers pay energy taxes (environment and nuclear taxes) on their bills. These are remitted by the distributors to the generators and then into the Cassa di Conguaglio to fund the nuclear levy (see Orchid Securities - Deal 18 Appendix H - for the notes on its securitisation), government taxes and the renewable energy incentive paid through CIP6. Bids for CIP6 used to be made to Enel, but after its privatisation this is handled by MICA (Ministero dell’Industria Commercio e dell’Artigianato - the Italian equivalent of the UK’s DTI). Unlike NFFO, the CIP6 pays a very high price (around lOp/kWh) for the first eight years of its term and then a much lower price (around 3p/kWh) for the final seven years. These prices are index linked and paid fully from the Cassa di Conguaglio unlike the NFFO, which is a mix of a reference price and a green premium (albeit the difference is effectively transparent to the generator). NFFO - in its most recent guise, provided a 15-year index linked contract for a power price based on a competitive tendering process. The NFFO power price is a combination of the market clearing price (ie pool price or post NETA, it is expected to be the balancing market price) and a premium over this. However, the contract holder and the financiers have no market exposure and receive a fixed price irrespective of the actual level of pool price. The UK Government imposes a legal requirement for the public electricity suppliers to collect this premium from all consumers’ bills. In practise the percentage payment from consumers’ bills is reviewed at regular intervals and forms a fund with sufficient capacity to meet all anticipated payments until the next review. A more detailed description of the NFFO is in Appendix E. This section will concentrate on the NFFO, as it provides a stronger credit and is familiar to most readers. There are several reasons for the greater credit strength of the NFFO compared to CIP6 - the two main ones being govemment/political risk and the relatively short premium period for CIP6. The main advantages of NFFO from a financing perspective are: a known price that is index linked on an annual basis; reasonable length fixed term; very secure risk profile (refer to Appendix E where the ‘quasi sovereign risk ’ perception is discussed); a standardised contract; and a set capacity. Taking each of these in turn:
58 > Risk Profile - NFFO achieves its strong risk rating dueto the perception that the UK government will not act arbitrarily by retroactively changing the Orders and that the uplift in price is shared across all electricity consumers. This is not weakened by the pool price component that is paid by a PES, as the market believes that the regulator would not allow a PES to default, due to its national importance and they are required by the regulator to maintain an investment grade rating. The value of this risk perception is most noticeable in the way a monoline insurer allocates only a 20% risk capital weighting to a NFFO backed project compared to a project with a 'normal' PPA37 This reduction in risk weighting means the monoline is able to offer a more competitive price for a NFFO based project38 .
> Price - The price achieved by a project is set in the NFFO bidding process, such that if a bid is accepted, the bidder receives that price. When raising finance the sponsor can model with reasonable confidence the price it will achieve, as this only varies due to inflation. Income risk then becomes ‘merely ’ a function of technology performance risk, which most financiers will accept, particularly when coupled to strong performance guarantees from the contractor/O&M supplier. With a project's main income source index linked, this reduces exposure to interest rate changes and reduces the need for an interest rate swap, thereby improving overall cost effectiveness39.
> Term - As discussed earlier in this report, most infrastructure projects need long term finance, often in the 10-25+ year range. The 15-year term for NFFO is sufficient to allow a reasonable amortisation rate for the debt, while still giving a PPA 'tail' at the end of the repayment period. Generally, it is easier to raise finance if the repayment term is less than the PPA term, although some quasi-merchant plants, such as Sutton Bridge (see the case study in Appendix G) have their financing extending beyond this guaranteed term. However, these plants are usually state of the art CCGT plants with amortising debt, which means that they will still be mid merit when their original PPA expires but have a substantially reduced debt burden. It is most unlikely that a renewable energy plant would achieve a similar financing due to differences in capital cost and performance certainty. Having a PPA 'tail' at the end of the financing period provides substantial comfort to investors, as they can see guaranteed revenue (subject to technology performance) still available to fund their debt if the project under performs initially. Indeed, some financings now
37 Risk weighting in this instance would be 100% or possibly even more, depending on the level of perceived risk. 38 A quirky result of the NFFO structure is that its credit risk falls as the pool price falls, because a greater proportion of the price is borne by the NFPA/sovereign component, although in practise this is unlikely to change the credit rating. 39 The current market appetite for index linked bonds is strong, as evidenced by the new Treasury Building PFI project under PFI which went to a bond financed solution due to the ability to provide an index linked 35 year bond. Commercial debt providers also bid for the solution but were unable to match the indexing, without potentially costly index linked swaps. This appetite means a better spread will be achieved, but it should be noted that the attraction of an index linked investment is in proportion to its tenor, since inflation risk increases with time.
59 provide a grace period at the beginning and end of the financing period (such as Dam Head Creek - Deal 10 in Appendix H) to give sponsors leeway to deal with the inevitable variations in performance, without needlessly triggering default provisions.
> Standardised Contract - The NFFO PPA is standardised and as such, simplifies the due diligence that an investor needs to conduct. Once investors have researched, understood and accepted the NFFO risk, standardisation means that this work is quickly replicated for future projects, with the associated economies of scale. Therefore, uncertainty caused by the NETA process (and the delay in starting the renewable energy percentage obligation) will slow the development of renewable energy, even if it were to offer a similar credit risk to NFFO, because investors will need to become familiar with it and understand the credit implications. The removal of standardised power contracts under the percentage obligation only compounds the problem.
> Capacity - A NFFO contract covers a set quantity of generation. If this quantity is exceeded, the PES still has to purchase the excess power, but at the pool price rather than the premium price, and no penalty is payable. Similarly, if the generator does not achieve its NFFO output, it still receives the full NFFO price per kilowatt-hour generated and no penalty under the contract. This system gives generators a considerable margin for variation in their output, with no adverse consequences from the PPA, when compared with many larger conventional plants that incur substantial penalties if they cannot meet their contracted obligations. This simplifies the due diligence process and risk. In particular it is very valuable for variable output generators such as wind and CHP40. Although there are a number of flaws with the NFFO process, these affect the government’s objectives for renewable capacity rather than the credit strength of the contract41. Thus, the NFFO contract forms an essential link in any financing arrangement and would be advantageous in raising bond finance. In all the research conducted with capital market practitioners, the NFFO contract was consistently highly regarded. Its one weakness might be that infrastructure investments command longer terms and investor appetite is particularly strong at the moment for long-term money. The past 10 years demonstrate that NFFO is bankable and provides an investment grade link in any financing.
40 A major strength of NFFO is that it allows averaging over a significant period (it varies between rounds) that is long enough for variable output generators to smooth out and peaks or troughs. Conversely, this is why the balancing market will be so detrimental for variable output generators under NETA. 41 These flaws include encouragement to game the system: the longer a prospective sponsor waits to build a project, the higher the profit due to steadily falling production costs and there are no penalties for developers if they fail to install the capacity, so that unprofitable bids are made that force out realistic bids.
60 8.3 Fixed Tariff The German Renewable Energy Feed-In Tariff (REFIT) regulates public utility companies’ purchase and reimbursement of electricity generated from renewable resources. The legislation applies to hydro, wind, and solar energy, as well as landfill gas, geothermal, sewage gas and agricultural and forestry products/waste, although it excludes hydro, landfill gas, sewage gas and biomass plants with a generator rating greater than 20MW. A new version of the law was introduced at the beginning of 2000 and its full implications are not yet clear. The REFIT law obliges public utilities (operators of the grid) to purchase renewable energy generated in their respective supply area, and to reimburse the fed-in electricity at various rates depending on the technology used. Electricity generated from hydro, biomass, landfill gas or sewage gas is reimbursed at 80% of the average electricity price paid by domestic consumers, whilst wind and solar power are reimbursed at 90% of the average consumer price (approximately 5.5 pence/kWh for wind). The new law gives three ministries (environment, energy and industry) the right to re-examine the prices paid biennially to check the level of market penetration and cost effectiveness of each technology band. This may result in changes to the percentage awarded, or in the case of wind, it has limited new projects to a maximum of 5 years of payments under REFIT. The average consumer price is calculated across all Germany and recalculated biennially42. The local utility that buys the power is able to pass the additional costs of the REFIT price through to its own consumers. However, the old law included a provision that ensured any generator starting up under the REFIT scheme will not receive ‘worse terms’ if the law is subsequently changed, although this did not remove price risk due to moves in the average price. This provision has not been noticeably applied in practise yet, therefore it introduces a greater level of uncertainty. The benefit of this clause was that it removed the requirement for investors to form a view of the likelihood of the German government changing the incentive structure. Although the current political climate in Germany is unlikely to materially change the support for renewable energy, there is a risk that it might be adapted, especially as any government will find it easier to change the terms of a scheme run on a biennial basis rather than facing the political difficulties of retroactive changes. A price calculated every two years that is based on average retail prices is hard to model without the substantial expense of specialist power sector consultants, particularly in a market being restructured. This exposes the income to reasonable variation and a presumption of falling prices, which will add to investor concerns. It also exposes sponsors to interest rate risk, as the retail power price will not necessarily track a change
42 New energy taxes were introduced in spring 1999 that significantly increased the retail price of electricity, and hence, the subsidy paid to renewable energy generators. The European Commission had challenged the resulting increased subsidy and this is still being negotiated.
61 in interest rates (ie basis risk). An interest rate swap is always possible, but this adds to the cost of financing. For investors, the expectation of falling prices does not reduce the bankability of renewable energy contracts, rather it makes them conservative in their assumptions and the cover ratios required. Inevitably this biases towards the cheaper technologies in each band and hence away from capital markets financing.
The contracts are generally very simple, as the local utility is obliged to accept whatever power the renewable generator produces and there are no penalties for under or over production (top-up and spill). As a result, little due diligence is required of an investor. The lack of penalty is another advantage when it comes to modelling the investment and narrows the income risk down to technology performance, which makes the contract readily bankable. The relatively high price and short duration of the tariff biases the incentive towards proven, low cost technologies that will be able to repay their debt quickly and thereby offset any longer term uncertainty. This explains the preponderance of wind power and waste to energy renewable schemes in Germany compared to the greater diversity found elsewhere. However, biomass may achieve a flat priced 20-year contract that would be very attractive for bond style finance, assuming the 20MW limit did not preclude the scale required. It is unlikely that long term capital market financing (ie greater than 7 years) could be raised against other renewables supported solely by a REFIT type incentive, unless coverage ratios were satisfactory even with significant convergence of the incentive price towards the wholesale market price after the first few years of the financing. This sort of uncertainty is better borne by a private placement or commercial bank financing where the ability to restructure the debt is easier. Although in practise, such investors will still require significant credit protection. Fixed prices tend not to reflect the true costs of generating electricity and one of the difficulties of this system is setting the 'right' price. If wholesale power prices are expected to fall substantially below retail prices there is a credit risk if renewables grow to a material size andthe cost of support becomes excessive. In that instance the utility will pay a non-competitive price for a substantial portion of its power purchases and may then be motivated to challenge the system and try to invalidate the grandfathered rights. This has been seen to an extent in Germany with utilities in the north contesting the REFIT due to the disproportionate cost borne by their consumers due to most wind farms (approximately 3,000 MW nameplate capacity) being on the north coast. Investors will consider this risk and it may limit their willingness to provide long term finance. The Spanish incentive scheme is similar to the former REFIT law, but the government sets the price support each year. Despite this uncertainty, a substantial level of limited- recourse finance has been raised. However, the level of sponsor guarantee is significant,
62 which may explain the preponderance of large energy companies and construction companies in that market. Also, Spanish banks have dominated the financing (around 90%) as they have been more willing to take a positive view on regulatory, political and sovereign risk. However, the Xistral project (Deal 3 in Appendix H) demonstrates the benefits of a predictable power regime, not merely on price but the perception that the government will live up to the spirit of its obligations. In conclusion REFIT provides a bankable solution that may be considered Investment Grade over the short to medium term and possibly long term for biomass.
8.4 Net Metering Net metering is a system similar to the Fixed Tariff concept that is usually provided for smaller generators (typically less than 1MW). It is found in parts of the US and certain limited areas of the EU. In effect net metering allows a normal retail consumer’s electricity meter to be ‘run backwards’. This type of incentive is aimed at small generators, typically using an intermittent power source as it allows the generator to draw power from the grid when their own generator is not running, while exporting any excess power to the grid when it is running. By allowing the meter to run in reverse, it effectively provides the local retail power rate to the generator. For small generators this system has a number of important advantages, as it provides access to the grid and power contracts on fair terms by removing the negotiations with a large power company, which is often in a stronger position than a small generator. It also helps the financial due diligence process, dueto the very simple, standardised contract used and limiting credit assessment to the off-taker, which by definition in the UK is of investment grade for the retail market 43. The credit risks are similar to those for the Fixed Tariff scheme, although the size of project usually considered appropriate for net metering is generally limited suchthat it is less likely to invite legal challenge than fixed tariff schemes. This also means it is unlikely to make economic sense due to transaction costs for non-recourse finance. Overall, net metering credit risk is lower than the Fixed Tariff Scheme, therefore it may be considered bankable and investment grade.
8.5 Renewable Portfolio Standard A renewable portfolio standard aims to impose a market driven price on green power by obliging a certain proportion of all electricity generated/consumed to come from a renewable source. Typically a fungible certificate represents the green value and it can usually be separated from the underlying electricity. Two main Renewable Portfolio Standards are being introduced. The first system, in Denmark, was dueto start at the beginning of 2000, but it has been postponed without a new implementation date. The
43 Some of the smaller power marketers are able to post a bond instead of a credit rating. How tills will stand up to a credit review is currently unclear.
63 UK system is dueto start after the NETA process is complete (October 2000 in theory), but no sooner than April 2001. The features of each system are:
Denmark should have moved from a fixed price mechanism to a new incentive for renewable energy in order to ensure 20% of its power consumption is from renewable sources by 200344 A purchase obligation was to be placed on every electricity consumer - represented by their chosen supply company - that required them to buy 20% of their electricity from renewables. In parallel, rules were to be streamlined for site permitting and grid access to minimise the opportunity for development bottlenecks. The mechanism for recognising “green value” was a green certificate issued in proportion to the volume of green kilowatt hours produced. It was planned that certificates would be registered and held at a producer account with a bank or depository trust company. These could then be traded in an open market (a derivatives market was also planned45) and this should remove some of the price volatility and allow forward sales.
UK electricity market arrangements are being replaced by NETA, which is being reviewed and has undergone a number of iterations, which are not yet finalised. Current proposals assume bilateral trading, with a balancing market and cost allocated to generators out of balance against their contracted supply. Renewable resources will be encouraged by the imposition of an obligation on Suppliers to take a percentage (apparently 8%, but to be confirmed) of output from renewables, which will increase over time to meet the government's target of 10% by 2010. Green certificates are expected with a cap on green certificate prices. Trading will be based on a market delivered mechanism and the exact form is correspondingly uncertain.
Green Certificates - superficially provide a sensible, market orientated approach that will establish a clearing price for green power. A common currency for trading green power comes into being andthe supply of certificates depends on the volume of renewable energy produced. If supply exceeds demand, the price will fall and thereby discourage new entrants or penalise high cost producers. In theory a liquid market in certificates removes wholesale electricity market price risk, as the green certificate price should rise to off set any fall in wholesale price. However, this is only possible if certificates are not capped like the proposed UK and Danish systems and if the price is elastic. In an ideal market, the price of certificates plus the expected electricity price will equal the marginal cost of green power. It appears that the certificates are not linked to the source of production46, which means sufficient liquidity will be provided in the market. Generators are not necessarily tied to selling certificates to a Supplier and
44 Currently it is 14% - ie renewable energy is expected to increase approximately 50% in three years. 45 The issue of counter-party risk for trading is not yet clear - ideally central clearing and standardisation are required, where trade is facilitated and delivery guaranteed. 46 There had been discussion about issuing a greater number of certificates for the more expensive technologies - which would move the system back to a fixed tariff problem of the 'right' price, or issuing different bands of certificates, which would impact liquidity and remove a market driven system.
64 could contract with a creditworthy counter-party for its green certificates, thereby rearranging the credit risk of power sales. This does not remove the credit risk, which remains a function of the factors listed previously and the key determinant of access to long term finance. With green certificates, the cheaper technology bands will benefit initially as purchasers seek to sign them up and there is a risk that 'non-convergent' technologies (such as biomass and offshore wind) are 'squeezed out'. This risk is potentially magnified by the fragmented nature of the industry and lack of transparent market pricing for green benefits, which will be exacerbated by the needs of bilateral contracts47 introduced under NETA.
Penalties - in the UK and Denmark, a transitional mechanism was proposed to limit the cost of non-compliance. In Denmark the penalty is effectively capped at a rate close to the maximum incentive price cap, which effectively removes much of its punitive nature and turns it more into a price controlling mechanism, thereby reducing the bankability of the system. In the UK, a cap on the green premium is also proposed, that will hinder development of bankable contracts, as investors cannot form a reliable assessment of the premium while it is distorted by an artificial limit and also exposed to political risk.
Access - arrangements in the UK for renewable energy developers that wish to use the local distribution system are uncertain and characterised by long and expensive negotiations, an uncertain basis for charging and occasionally disproportionate charges. Work towards making aggregation of renewables easier as well as reducing the penalties for being out of balance is ongoing. Current proposals include measures to ensure the distribution companies, the National Grid and network planning documents consider embedded generation, obtain system security services from embedded generators and are incentivised to do so. This includes the publication of technical and commercial information, plus transparency of the principles and rules for calculating connection and DUoS48 charges. There are proposals to increase the scope and scale of non-licensed generators and Suppliers to trade electricity in local markets without having to go through the balancing market risks of NETA or the costs of licensing. These assist the process of raising finance, as investors will be more comfortable that the costs represent a true market price andthat they are able to forecast with reasonable certainty any charges. However, these do not in themselves make a project bankable.
The Climate Change Levy - will impose a tax on fossil fuel based generation supplied to non-domestic customers from April 2001, while exempting energy from renewables49. This makes the price target for convergence easier to reach, by effectively
47 The real difficulties faced by the Renewable Generators’ Consortium demonstrated the problems of getting the industry to act cohesively, as has the response to NETA. 48 Distribution Use of System Charges. 49 The Levy was announced in the March 1999 Budget statement and exemption for renewables was announced in the November 1999 pre-Budget statement.
65 raising the price of fossil fuel power by 0.43p/kWh (ignoring the offset from National Insurance rebates). It is questionable whether the difference is sufficient to compensate for the risks involved. Indeed, investors may consider that the Levy unduly susceptible to political risk, given its high profile and overt impact on all sectors of industry, such that they will only consider a portion of it in their assessment of future market prices. Therefore, the Levy cannot be considered bankable in isolation.
Financing Risks - On the basis of the information currently available, the financing risks for renewable generators under the percentage obligation are:
> Uncertainty - caused by NETA has impacted fossil fuel based projects (see Dam Head Creek, Deal 10 in Appendix H), as well as renewables. Even when NETA is implemented, the markets will take time to assess it and gain comfort in the ability to model returns, which will impact renewables, where there is a higher degree of perceived risk 50 and output variability. In addition, investors will require substantial evidence of the level of green premium achieved before committing any funds against projections - until a strong market in green premiums is operating and transparent, the premiums are probably unbankable. This suggests that only the most competitively priced technologies will succeed.
> Compliance - is a key factor in the success of a percentage obligation and the level of penalties imposed for not meeting the obligation. Unless penalties provide an incentive (ie sufficiently punitive), the percentage will not be met if it proves cheaper to ignore it. Investors need the confidence that the Government will enforce the directive effectively and consistently, such that the market for green power remains buoyant and a stable premium can be established. Equally, the assessment of what is renewable needs complete transparency and contractual rigour, otherwise the measurement of merit order51 will be impossible for investors, even assuming that they are willing to consider this risk in the first place. It is unlikely that any but the largest renewable energy projects will justify the cost of developing a merit order for renewable energy generation. A number of accreditation schemes are being advanced in the UK, but most lack the credibility to enforce the measurement of renewable output. Any verification must be able to demonstrate that the capacity existed and that the actual power produced was green. OFGEM will be given the obligation to provide verification, although it currently appears that only the Environment Agency has wherewithal to confirm compliance and measure the output of different generators.
50 Perceived risk comes from the main risks faced by any power project financing: price, volume, off-taker credit, sponsor credit, technology, political, construction and operating. 51 Merit order is refers to the competitiveness of a power plant in terms of cost and its ability to service a particular demand profile. Fossil fuelpowered merchant plants undergo substantial and costly assessment of their current and anticipated position in the merit order such that price and volume risk can be assessed by investors. The concern for investors with green certificates will also be the predictability of price and volume.
66 > Forecasting - of long term green certificate prices may be required in order to raise long term finance. Forward sales covering that period provide one method of forecasting, but the validity of these depends on sufficient purchasers being willing to contract for a known price now, compared to taking future spot market risk. This is unlikely. Alternatively, investors will need to assess the merit order of renewable generators, (see the write up on SuttonBridge in Appendix G) to be comfortable with the level of anticipated green certificate price. It is almost impossible that investors will consider this type of analysis (and associated cost) for other than the largest transactions and then only if the enforcement mechanism is considered robust enough to maintain demand. As a result, until the market establishes itself, investors are unlikely to consider it bankable beyond the minimum certificate price and the expected wholesale price. A forward market will develop, but it will be short-term initially and may never achieve sufficient liquidity beyond 18-24 months.
> PPAs - will need to be negotiated for each project and the current market is not providing the quality or duration required. In particular, under NETA the risk sharing of balancing charges appears asymmetric. The one group that can achieve good PPAs is the existing large energy companies, which can finance on-balance sheet, with a vertically integrated portfolio that can absorb any variability. However, the proviso made earlier still exists on the demands this would make on management time and if this is overcome, it suggests that renewables will not be provided at fully competitive prices. The alternative to a large energy company for most developers will be a contract with an aggregator that can manage the variability and negotiate better embedded generation provisions for its larger portfolio. However, many aggregators advertising themselves for renewables do not provide the credit strength needed for long term finance. Non-standardised PPAs will increase due diligence costs and make it more difficult for developers without non-recourse finance experience to agree bankable contracts.
In summary - a percentage obligation biases renewable generation towards large integrated power companies that have the experience and financial strength to negotiate suitable PPAs and provide some corporate support. Compared to NFFO, the percentage obligation exposes generators to: > whole sale power market risk (price, volume and balancing charges); > term/renegotiation risk (arms length market contracts rarely exceed 10 years); > green premium risk (price, volume, political and cap levels); > off-taker credit risk (power off-taker and green certificate off-taker). Even the provision of capital grants (possibly from the Climate Change Levy) as tax allowances biases towards generators with large parent companies that can use the credits elsewhere in their business. In practise, a PPA will not even be needed by the
67 large vertically integrated companies, as they can take the market risk of price and volume through their balance sheet. Small generators and independent producers of variable output generation will not achieve the quality of PPA required for long term financing, until the cost of non-compliance outweighs the difficulty of a long term obligation. As currently drafted, no renewable portfolio standard is likely to provide a bankable contract.
8.6 Voluntary Green Premium/Certificates A number of green certificate systems exist in the US based on one of three independent verification systems. One of the higher profile systems has developed in California in parallel with the Automated Power Exchange (APX). In this instance, there is no obligation for consumers to buy clean power and renewables are soldto customers on a voluntary basis. Californian renewable energy producers receive three types of payment: the commodity price of the power, a certificate and a subsidy. However, if the subsidy is removed, the price of the green certificates should rise to compensate, assuming a steady level of demand. In practise green certificate prices are unlikely to rise sufficiently (ie the market is elastic) to fully compensate for the removed subsidy. Indeed, observation suggests that the fall would be exponential, as most consumers will pay a small amount extra for environmental benefits but will balk at paying large amounts, both for affordability reasons and dislike of free-riders. Therefore, this system is unlikely to be considered bankable until sufficient market pressure exists to persuade large numbers of consumers to purchase green power. In reality this means regulatory compulsion, as marketing alone is unlikely to achieve this and investors would require suitable enforcement methods to encourage the market in green certificates in order to avoid undue free riders.
8.7 Conclusion It is clear from the above that the ideal system does not exist and it will remain a balance between economic efficiency, bankability and the encouragement of different technology bands. The UK Government has made a clear commitment to renewable energy: “Renewable sources of energy make an important contribution to secure, sustainable and diverse energy supplies and are an essential element of a cost-effective climate change programme52.” However, legislation is required for a renewables market to work properly. Once a framework has been established, legislative intervention should be minimised to ensure prices do not reflect expectations of political action rather than pure economic drivers.
52 John Battle MP, Minister for Energy in New and Renewable Energy - Prospects fertile 21st Century, March 1999.
68 However, a framework designed to encourage economically rational behaviour is not in itself sufficient to ensure access to long term capital. For the purposes of raising large amounts of long term finance through the capital markets, the ideal contract is one that provides a long term, predictable set of cash flows that only depend on the project’s operational performance and off-taker ’s effective credit rating. Other incentives may be as effective in getting capacity built and ensuring its debt is paid off, by providing relatively high, but short term payments, although this will bias renewables towards wind due to its relatively low capital costs compared to Waste to Energy. Therefore, it seems that technologies with costs converging towards a wholesale power market price are best incentivised with long term, competitively bid large contracts (ie 50 - 100+ MW) that do not penalise geographically dispersed aggregation. Non-convergent technologies need similarly reliable incentives but with less rigorous price competition but more rigorous commercial and technical assessment. Conclusions that may be drawn from the case studies in Appendix H are: > the provision of creditworthy long term power contracts greatly expands the range of renewable energy projects that can be financed; > the mitigation of power price risk for lenders, through a fixed pricing mechanism enables senior debt gearing to be increased and the amount of truly subordinated debt or equity to be decreased, with a resultant decrease in cost; > long term bond financing keeps power prices low in the early years while maintaining adequate debt service coverage ratios.
69 70 9. UK Application
9.1 Outline This chapter provides a succinct review of the main issues regarding renewable energy financing in the UK and the application of the capital markets, based on the more detailed information contained in the preceding chapters. Due appreciation of the complexity involved in any financing is required and an awareness of the often unintended consequences certain decisions may have. Therefore it is always important to obtain appropriate professional advice for the particular circumstances of the transaction under consideration. There are four elements of the UK market to consider: > existing plants that are operating under NFFO-3, 4 and 5; > the 2GW of NFFO-3, 4 and 5 capacity not yet constructed; > the ex-NFFO-1 and 2 plants de facto under the percentage obligation; > new build plants under the percentage obligation.
9.2 Capital Market Advantages The main advantages of the capital markets are tenor, price (from time to time), the ability to access a wide range of investors and the ability to benefit from innovative features, such as index linking. Whether the underlying assets are green or not does not affect in any material way the ability to raise finance - it is the underlying quality of the cash flows that matters. This applies equally to all forms and sources of finance. Grouping projects may help, as a more diversified pool of assets with some cross- collateralisation will lower the risk profile. However, it is unlikely that the benefits of grouping projects belonging to multiple owners will outweigh the associated transaction costs.
9.3 Capital Market Disadvantages For renewable energy the main disadvantage is the minimum size required for the public markets, although private placements partially get around this. However, the probable complexity of any renewables deal will make primary marketing challenging and the relatively short duration of most renewable incentives limits access to the full tenors possible in the bond markets. Other issues such as disclosure and complex structures may impact the ability to access the market, unless allowance for a possible capital markets financing was made when the project was first developed.
9.4 Plants Operating Under NFFO Plants operating under NFFO are best placed to access the capital markets through refinancing, which might release additional cash or reduce the cost of borrowing. These
71 plants have high quality power contracts, no construction risk and many have a substantial operating track record. Opportunity exists for these to be grouped into a portfolio andthereby achieve the necessary size to attract bond investors. However, given the relatively short NFFO contract time left (when compared to PFI projects with contracts of over 25 years), the advantages of the capital markets may be limited to price indexing and intermittent price competitiveness as the non-NFFO period cashflow risk will need support from strong corporate covenants. The benefit of longer tenors will not apply as both sources of capital are easily able to provide this tenor.
9.5 Pre-construction NFFO Contracts Pre-construction NFFO plants are unlikely to attract bond market finance, unless supported by strong corporate covenants. Several would need to be grouped together to achieve the requisite size. It is unlikely that the market will be interested in analysing a complex construction package, particularly for several sites andtechnologies. The inclusion of a small proportion of pre-construction projects within a portfolio has been achieved with the banking market (but limited to simple, well proven technologies) and is not ruled out for the capital markets.
9.6 Ex-NFFO Plants Ex-NFFO plants are effectively under the percentage obligation but have the advantage of good operating histories. Until the percentage obligation has established a substantial track record and several commercial bank debt financed projects have proved successful, it is unlikely that the capital markets will even consider these projects, if a green premium is required to support the debt, unless supported by strong corporate covenants. For those projects able to operate at a market price and not unduly exposed to balancing charges, there is a possibility of accessing the capital markets to refinance a large portfolio. However, this would only be possible if one company acquired a substantial proportion of the existing projects, in order to reach a reasonable size. The markets would not accept projects with multiple ownership and complex inter-creditor agreements.
9.7 New Build under the Percentage Obligation In a similar manner to the ex-NFFO generators, new build plants under the percentage obligation will find it virtually impossible to access the capital markets in the short term. The only exception is for very large single asset projects that are financed on a limited recourse basis with strong parent guarantees. This limits the market to the very largest utilities, such as Vivendi, National Power and PowerGen.
9.8 Conclusion There are opportunities for renewable energy to access the capital markets, however this will be primarily for refinancing. The intrinsically smaller size of most renewable
72 generation also limits its access to these markets, and to an extent, also the commercial bank markets. Non-recourse financing is exceptionally complex and contractually intensive, which imposes a minimum size dueto economies of scale, whatever source of funds eventually used. The most effective way for the government to open the capital markets to renewable generators would be to simplify the transfer (ownership and site) of pre-construction NFFO contracts. This will allow some contract consolidation and hence larger project sizes.
73 74 10. Alternatives
10.1 Outline This section highlights a number of alternative approaches to financing renewable energy assets and means by which the industry can be encouraged. The ideas outlined below represent a selection of some of the more innovative concepts that were discussed as part of the research process for this report, although events in the UK market may well overtake these. They are included here to stimulate discussion, rather than provide solutions. Those concepts that merit further study and assessment may be selected for subsequent development by the New andRenewable Energy Programme.
10.2 Pre-Prepared Portfolio The Schroder s’ PFI fund (see Section 7.19) with its generic documentation and bridging loan for the construction period demonstrates a market based approach to help smaller projects raise finance in a cost effective manner. However, the up-front costs of establishing this fund were very substantial and it is considered unlikely that the renewable energy sector would stimulate sufficient interest from a finance House for this type of up-front investment due to its smaller size, lack of clear commercial prospects and more uncertain future than PFI. Schroder s’ judgement on PFI was positive, but renewable energy without any clear framework available offers little commercial incentive. Further study on this approach and the actual costs involved might identify an opportunity for a portfolio structure to be created with or without Government assistance, such that it can then operate on a commercial basis.
10.3 Capital Markets Incentive Two principal attributes of the capital markets are the financing term offered and the size of funds raised. Infrastructure projects are generally long-term assets that need long term finance to maximise the economics. Renewable energy with its relatively high cost structure needs term financing to an even greater extent, but to achieve this, senior debt lenders (whether bond or bank markets) need certainty. Therefore, based on the above considerations, a new incentive scheme might be run on the following lines: > Term of 20, 25 or 30 years, depending on the technology; > A minimum contract size of 50MW and a maximum size of 100MW; > The contract would be company (one contract per company per round) specific, rather than site specific and not transferable until post-construction; > Power price will be sufficient to ensure an average DSCR of 1.1, provided that third- party senior debt is between 70-80% of the financing and that a minimum output specification is achieved (for instance in terms of capital expenditure, operating
75 expenditure, heat rate, availability and the like - ie technology performance risk remains with the debt/equity investors); > Power price will be adjusted downwards if the contracted amount is not achieved. This system would encourage larger corporate involvement, while focussing on technologies that offer scale and replicability and offer front-end economies due to the use of long-term debt. A broadly similar concept is used in the PECO Energy securitisation through the ‘Competitive Transition Charge’ mechanism (see Deal 19 in Appendix H).
10.4 Securitise Green Premiums As a market for green certificates or premiums develops, income to sponsors may come from two separate sources: power sales and green premiums; which might not necessarily be sold to the same purchaser. When a green obligation is imposed on an annual basis, this improves the opportunity for variable output generators (eg wind and CHP) to raise funds against the green premium sales. The longer averaging period provides a lower risk and the green premium purchaser might be of higher credit quality (ie an industrial customer rather than a small aggregator). Sponsors may also wish to sell forward their premiums. Areas for further study include: the direct market for green premiums (ie not through a Supplier); and the design of a trading exchange for green premiums (rules, instruments and legal position).
10.5 Weather Derivative Hedge A number of innovative capital market and derivative products have been successfully marketed over the last two years. These include a bond with repayments dependent on earthquake risk in Japan, weather derivatives traded on the Chicago Board of Trade and the development of an OTC53 market for weather derivatives. There is potential for certain technologies (such as wind power) to provide a quasi hedge for some of these instruments, in that their revenues move inversely to some weather risk that the underlying market may wish to hedge. This should probably be considered a revenue enhancement tool for green power producers, rather a core financing method.
10.6 Stranded Asset Approach Stranded assets in the power industry are typically assets that were built during government ownership or control of utilities, but when deregulation occurred the costs associated with those assets were unsustainable in an open market. A number of examples are detailed by Deals 18 and 19 in Appendix H. Stranded assets are generally funded by a set levy imposed on all consumers, agreed with the regulator for a set number of years and protected from subsequent challenge.
53 Over the Counter.
76 This concept is widely found in the US power market and in the Italian and Spanish securitisation of nuclear credits. The levy is securitised, the funds purchase the assets and their future obligations ring-fenced from the main operating company. This might provide a method of ensuring marginal assets continue to generate. The assets are grouped and funds raised in different risk tranches, with Government support for the top tranche (ie to guarantee marketability) and commercial finance raised for the remainder. The Channel Tunnel Rail Link provided a unique example of the benefits of a government guarantee in marketing the bonds, although the public sector test (the guarantee would not be called in any reasonable scenario) may be harder to achieve in this context.
10.7 Government Sponsored “Wrap” Monoline insurers impose a tough and sometimes onerous covenant package on the projects they sponsor. Given the uncertain nature of some renewable energy technologies, it is unlikely that a monoline would accept sufficient of the risks to make the insurance economic (particularly for non-NFFO projects, due to the change from quasi-sovereign risk). The Tyseley Waste to Energy plant is a good example of the credit strength required by a monoline insurer before its guarantee is committed (see Deal 12 in Appendix H). There are a number of market stimulation funds operating, such as the Photo Voltaic Market Transformation Initiative sponsored by the IFC (ie World Bank) that work on a semi-commercial basis to provide support and develop a market ahead of full scale commercial acceptance. Another example is the Aqua Fund supported by OPIC (a US Government Agency) that raises debt on the public market and lends it on to the Aqua Fund. The public debt is guaranteed by OPIC and corporate investors fund around one- third of the Aqua Fund. The fund then invests in water infrastructure projects, but due to the low debt costs, the fund is able to generate higher returns for its commercial investors than they would achieve through a straight investment and thereby allow a greater number of projects to qualify for financing. For renewable energy, the fund would be managed by a commercial organisation to provide an insurance wrap to relevant projects. A commercial return would be possible due to the fund manager’s detailed understanding of the renewable energy market (because the contract makes it economic to develop the knowledge) and the ability to accept risks that a monoline could not, due to its regulatory capital restrictions. Equity investors in projects would still be exposed to risk and the wrap manager would be incentivised through a mix of results from the number of projects supported andthe return made on the underwriting.
77 78 11. Conclusions and Recommendations
11.1 Context The sterling capital markets provide a potentially deep, liquid pool of finance for projects with a debt requirement in excess of £100 million; the underlying credit strength of the project - prior to the involvement of a monoline insurer - is usually around the BBB level; and direct or indirect support from a large corporate is often required to give the credit the requisite strength. Most renewable energy projects have not met these criteria, primarily on account of size, but also because many project sponsors under NFFO 1 to 5 are small, financially weak entities compared with companies like Vivendi and Enron whose support for Tyseley and Sutton Bridge respectively was crucial for the bond issues attaching to those transactions. In contrast, the volume of bond issues emanating out of the PFI sector54 reflects: > the availability of larger transaction sizes; > financially more robust sponsors; > agreements that provide long term, high quality contracted-for revenues streams, contingent (only) upon performance. We conclude that commercial bank debt continues to provide an effective and flexible means of financing projects across all sectors. While there are pricing andterm advantages, from time to time, in using capital markets finance, the liquidity and extended maturities available from some banks - particularly for PFI projects - continues to make commercial debt a competitive option and, for most NFFO style projects, the only option.
11.2 NFFO The NFFO framework has been responsible for securing commercial bank support for renewable energy projects. The certainty, credit quality and enhanced nature of the NFPA contracts provided an “equity substitute” for an industry most of whose early sponsors were small, undercapitalised companies. That phase of the industry’s development is almost certainly drawing to a close following the publication in February 2000 of the Government’s “Conclusions in Response to the Public Consultation on New andRenewable Energy, Prospects for the 21st Century”. The Government has announced its intention to move away from the existing NFFO arrangements and adopt a percentage obligation on all electricity suppliers, as outlined in that document. This is likely to steer future renewable energy development towards
54 In 1999, bond debt accounted for over 25% of all new PFI deals (31% if the Pay Water private placement is included) compared to 10% in 1998. Total new PFI deals in that year were £1.97 billion.
79 the larger, financially robust corporates, capable of taking the electricity market price risks inherent in the new scheme and largely absent from its NFFO predecessor. The means of financing within this new framework will also change, as financiers will place greater reliance on the credit strength and direct support from project sponsors, in the absence of the predictable contracted-for cash flows obtainable under NFFO. A limited recourse financing approach if pursued will need a greater proportion of equity and subordinated debt (ie lower gearing) in conjunction with more robust shareholder guarantees. Many of the smaller companies that originally started the UK renewables business will not have the financial strength to provide such support and may need to consider merging with larger organisations. Unless these smaller firms offer unique skills, joint ventures are unlikely. From an industrial perspective, we view this as a potentially positive development for the achievement of the Government’s renewable energy targets for 2003 and 2010. However, the flexibility, willingness to take risk and innovative approach deployed by many small companies provides a vital ingredient in the sector’s ability to become a vibrant industry. It is unlikely that the pioneering work achieved so far could be repeated under a grant based system.
11.3 Percentage Obligation It is unrealistic at this early stage to expect financiers to make long term credit decisions based on judgements of: > the likely future price level of Green Certificates; > the future supply / demand relationship for renewable energy, or > the likely cost competitive position of one renewable energy technology over another. It remains to be seen whether large corporate sponsors are willing to take these risks themselves. There is likely to be a lull in the development of renewable energy in the UK (exacerbated by the gap between NFFO-5 and the start of the percentage obligation) while all parties assess the new arrangements and this will impact all types of financing, not just the bond markets. Financial institutions will need to embark on a detailed due diligence exercise to understand the new order and to put the sunk costs of research into the NFFO framework behind them. Further discouragement of a quick take up comes from the relatively low cap on green certificates, which distorts the economic incentives.
11.4 Refinancing In the short to medium term, the bond market and securitisation provide a potential source of refinancing for NFFO based projects, which may release funds for further project development. The 2GW of NFFO-3, 4 and 5 capacity still not yet built provides ample size to access these markets, especially if additional flexibility is allowed in
80 relocating contracts. However, with a 15-year term, the capital markets provide no consistent advantage over the commercial bank debt market.
11.5 Other Frameworks Part of the remit of this study was to look at support mechanisms used in other markets to see whether they offered any guidance for an alternative support framework in the UK. We looked, therefore, at designing a scheme that maximised the advantages of using capital markets finance whilst fulfilling the principal criteria for access, in particular transaction size and credit strength. Chapter 10 looks at support frameworks from a number of markets. From the constituency of schemes described, we would recommend further study of the capital markets incentive scheme described in Chapter 10.3, if the UK were ever to consider adopting a successor to NFFO. This structure encourages the use of long term capital market debt in order to optimise electricity price economics in the early years of a project. The structure involves the recalculation of the electricity price each year to a level sufficient to provide senior lenders with acceptable debt service cover, subject to the plant meeting a minimum output specification. There are precedents for this approach and one of them, PECO Energy Transition Trust (Transaction 19 in Appendix H) incorporates a mechanism referred to as the Reconciliation of Competitive Charge.
11.6 Summary
In summary, bond finance and as a subset of this, securitisation, provide a source of finance for renewable energy projects. However, commercial bank debt also providesa readily available, large source of finance. In Impax Capital’s view, the availability of finance per se is not restricting the growth of renewable energy in the UK. Availability of finance is simply a function of the renewable energy framework and access to commercially sound projects, as there is currently no shortage of liquidity in the bank or capital markets.
81 82 12 . Appendices
A Glossary
B Credit Ratings
C Sovereign Credit Ratings D UK Power Company Credit Ratings
E NFFO and the Fossil Fuel Levy
F Financial Times Bond Table
G Case Study of a Bond Financing: Sutton Bridge Power
H Deal List
83 84 Appendix A - Glossary Some of the terms in this Glossary have different meanings in contexts other than those of the international markets and certain domestic markets.
Accrued Interest Interest earned but not collected. Interest due from the issue, or from the last coupon date to the present on an interest-bearing security, or from the last payment due date on a loan. All-in Rate An interest rate on a loan that includes the funding cost, risk margin, cost of compensating balances, commitment fees and any other charges. Allotment The allocation of a new issue of securities by the lead-manager among members of the syndicate. This normally takes place after the issue’s subscription period and after its final terms have been fixed. The syndicate members in turn allocate the securities to their investor clients. Amortisation (1) The gradual reduction of any amount over a period of time. A general term which includes practices such as depreciation depletion, write-off or intangibles, prepaid expenses, and deferred charges; or general reduction of loan principal. (2) Gradual repayment of a debt over time. (3) Repayment through the operation of a sinking or purchase fund. Annuity A level stream of cash flows for a limited number of years. Arbitrage In theory it is the simultaneous purchase and sale of an asset (usually in different markets) to take advantage of price anomalies. In practise it is far more complex, but the intention is to take advantage of discrepancies in the market. Arms Length A term referring to agreements made between unrelated parties or as if the parties were unrelated. It implies open market rates/conditions. Asset-backed Securities collateralised by a pool of assets. The process of creating securities securities backed by assets is referred to as asset securitisation. Association of An association of over 500 member firms from 30 countries. The main objective of International Bond the AIBD is to provide a basis for examining the secondary market, issue rules Dealers (AIBD) governing the markets and to maintain a close liaison between the primary and secondary markets. Balloon payment Where a term loan is amortised in equal periodic instalments except for the final payment, which is substantially larger than the other payments, the final payment is known as a balloon payment. Base Rate Floating interest rates on bank loans are sometimes quoted on the basis of the prime rate or the base rate of the lender. Basis Point (bp) One one-hundredth of a percent (ie 0.01%), typically used in expressing rate or yield differentials. Bearer Bond A bond for which the only evidence of ownership is possession. Benchmark In the context of a bond, this is typically a “risk free” bond (usually from the government) that has a similar duration to the bond being raised that provides a base interest rate, to which a risk related premium (the spread) is added to calculate the bond’s coupon. Bid and Offer Bid is the highest price a prospective buyer is prepared to pay at a given time for the tradable unit of a specific security; Offer is the lowest acceptable price to a prospective seller of the same security. Collectively, the two prices represent a quotation and the difference between them is the spread. Boiler Plate A colloquialism that refers either to standard terms and conditions in a contract, or the level of protection/armour required in order to achieve a transaction.
A-1 Bond A bond is a negotiable note or certificate, which evidences indebtedness. It is a legal contract sold by one party, the issuer, to another, the investor, promising to repay the holder the face value of the bond plus interest at future dates. Bonds are also referred to as notes or debentures. The term note usually implies a shorter maturity than bond. Some bond issues are secured by a mortgage on a specific property, plant, or piece of equipment. In certain markets the terms “bond” and “debenture” refer to different levels of security. In the UK a debenture is usually secured and a bond is unsecured, whereas in the US, this is the opposite way around. Bond House A firm which underwrites, distributes and deals in bonds as one of its primary activities. Bond Rating An appraisal by a recognised bond rating service of the soundness of a bond as an investment. Bought Deal A Eurobond issue that is fully underwritten on fixed terms and conditions by the Lead Manager. A bought deal occurs when the Lead Manager offers to launch an issue with a specified price and spread. Bridge Financing Interim financing of one sort or another. Broker Brokers are intermediaries who trade in a variety of financial instruments including foreign exchange, equities, commodities, bullion or insurance on behalf of their clients and who charge a fee-or commission-for this service and advice. Brokers fulfil an important function in the market by bringing together buyers and sellers in an efficient manner. Capital Markets A broad term used to describe both debt and equity raised in the form of tradable securities principally from non-bank sources, i.e. pension and life companies, insurance companies, corporate investors and private accounts. Cash Sweep A mechanism whereby post debt service cash flows can be redirected to pre-pay certain obligations (usually senior debt principal). Clip and Strip In this type of bond, the principal and coupon portion of the bonds may be split apart Bonds and sold separately. CLO Collateralised loan obligation. Payments to the CLO bond holders are derived from the cash flows realised from the underlying pool of loans in the securitised portfolio Co-financing Where the different lenders agree to fund under the same documentation and security packages yet may have different interest rates, repayments, profiles and terms (e.g. tranches A and B). Collateral Assets pledged as security to assure payment. Co-manager A member of the management group of a securities offering other than the lead manager(s). A second-tier participant, ranked by size of participation. Commitment Fee A per annum fee applied to the portion of the unused financing (the amount not yet drawn down) until the end of the availability period. Commercial Bank A bank that both accepts deposits and grants loans and, under certain stipulations in some countries, pays interest on current accounts. Commercial Paper An unsecured promissory note with fixed rate and fixed maturity of less than 270 days. Commercial paper is normally sold at a discount from face value. Committed Loan A legal commitment undertaken by a bank to lend to a customer. Facility Consolidate The process of combining the accounts of a group of companies onto one set of accounts. This may mean showing the combined debt of all group companies, even though most of it is actually non-recourse to the parent’s balance sheet. This is a presentation issue, rather than an economic issue.
A-2 Convertible Bond A bond containing a provision that permits conversion into other securities of the issuing entity, typically ordinary equity at some fixed exchange ratio. Convertible Debt Debt convertible to equity or debt issues of the issuer upon the happening of certain events and/or at the option of the lender. Coupon The annual rate of interest on the bond’s face value that a bond’s issuer promises to pay the bondholder. One of a series of actual certificates attached to a bond, each evidencing interest due on a payment date. Coupon Rate The rate of interest received by a bondholder on an annual, bi-annual or quarterly basis. Covenant A loan covenant is agreement by a borrower to perform certain acts, such as the timely providing of financial statements, or to refrain from certain acts such as incurring further indebtedness beyond an agreed level. A breach of a covenant is a Default. Cover The amount above unity of a Debt Service Ratio. Credit The issue of a Guarantee, L/C, or additional Collateral to reinforce the credit strength Enhancement of a Project Financing. Cross Project Participants agree to pool their Collateral (i.e. allow Recourse to each other’s Collateralisation Collateral). Cross-collaterised Pooled securities allowing recourse to other security interests in the pool. pooled financing Cure Making good a Default. Current Yield The ratio of the coupon on a security to its market price, expressed as a percentage. DCF Discounted Cash Flow where net cashflow is brought to a Present Value using a given percentage Discount Rate. Dealer A securities dealer, as opposed to a broker, acts as a principal in all transactions, buying and selling for his own account. Debt (Liability) An obligation to pay cash or other goods or to provide services to another. Debt Capacity The total amount of debt a company can prudently support, given its earnings expectations and equity base. Debenture A legal security over the Issuer’s assets. Debt Service Principal Repayments plus Interest Payable. Usually expressed as the annual dollar/currency amount per year. Default Failure to make timely payment of interest or principal on a debt security or to otherwise comply with provisions of a bond indenture or loan agreement. A Money Default means a repayment was not made on time. A Technical Default means a Project parameter is outside defined/agreed limits or a legal matter is not yet resolved. Default Premium The increased return required to compensate investors for the risk the company will default on its obligation. Deferred Coupon Bonds in which the interest payment is postponed to some date prior to maturity. Bonds Discount Rate The annual percentage applied to NPV or PV calculations. The Discount Rate may be a Weighted Average Cost of Capital. Direct Placement Selling a new issue not by offering it for sale publicly but by placing it with one or several institutional investors. Discount Bond A bond selling below par. Discount Non-interest-bearing money market instruments that are issued at a discount and Securities redeemed at maturity for full face value; for example, US Treasury bills.
A-3 Disintermediation The investing of funds that would normally have been placed with a bank or other financial intermediary directly into debt securities issued by ultimate borrowers; for example, into bills or bonds. Domestic Bonds Bonds issued by a borrower in its country’s own domestic bond market. Drawdown The Borrower obtains some of the Project Financing, usually progressively according to construction expenditures. DSCR Debt Service Cover Ratio. The ratio of cash available to service the debt in a specific period divided by that period’s debt service requirement. Dun & Bradstreet A firm that rates the creditworthiness of many borrowers and generates financial ratios for many industry groups. ECGD Exports Credits Guarantee Department of the United Kingdom. Efficient Market A market in which asset prices instantaneously reflect new information. EIB European Investment Bank. An organisation owned by the governments of the EU that lends at preferential rates to large infrastructure and similar projects that assist economic development in Europe. It accepts very limited risks, will only fund a portion of a project and often requires preference over other senior debt providers. EIB won’t take construction risk and the technology needs a good operating history and progressive release of bank guarantees. Its spread is typically flat to 5bp under commercial banks. EPC ‘Engineer Procure Construct’. A generic term used for a turnkey construction contract where the contractor takes responsibility for all aspects of the construction and provides (bankable) performance guarantees. Equity Kicker A share of ownership interest in a company, project or property in consideration for making a loan. The kicker may take the form of stock, stock warrants, purchase options, a percentage of profits, or a percentage of ultimate ownership. Eurobond A Eurobond is any bond in any currency issued outside a borrower’s domestic market and sold to international banks. Eurobonds have no domestic market and are often bearer instruments. Eurobonds are not registered in the United States and therefore can not be originally sold to a US investor. They are genuinely international instruments. Face Value The maturity value of a bond or other debt instrument. Sometimes referred to as the bond’s par value or nominal value. Fiduciary An individual, corporation, or association, such as a bank or trust company, to which assets are given to hold in trust, according to the trust agreement. Fixed Rate Bond A fixed rate bond pays the same rate of interest to investors throughout its life and has a final maturity date. Floating Interest An interest rate which fluctuates during the term of a loan and which is adjusted Rate upwards or downwards during the term of a loan in accordance with some index of short-term rates. Floating Rate A floating rate note issue has no fixed rate of interest. The coupon is set periodically Notes according to a predetermined formula tied to short-term interest rates in the appropriate market. Usually refers to floating rate notes issued in Europe, although all kinds of floating rate instruments are issued in the United States. The holder may have the right to demand redemption at par on specified dates. Gearing The level of debt to enterprise value (ie debt plus equity). Alternatively the debt to equity ratio (not used in this report). Grace Period (1) The period between a primary market offering of an issue of securities and the first operation of its sinking fund, and (2) The period which may be allowed to the borrower to remedy an event of default.
A-4 Hell-or-High-Water A requirement that an obligation, such as rent payments, be carried out “come hell- Clause or-high-water”. An unconditional, absolute obligation not subject to defence of non performance by the other party to the contract. Illiquid A financial instrument not easily traded or converted to cash. Indenture of a A legal statement spelling out the obligations of the bond issuer and the rights of the Bond bondholder. Indenture Trustee The holder of a security interest in property for the benefit of the lenders. Indexed Loan A loan with debt service repayment tied to some standard which is calculated to protect the lender against inflation and/or currency exchange risk. Information A document detailing the Project and Project Financing. Memorandum International A group which endeavours to standardise the way which new Eurobond issues are Primary Markets launched, encouraging common standards and greater disclosure. The London or Association Luxembourg stock exchanges require the issuer to comply with its relevant listings procedures. Institutions Insurance companies, pension funds, trusts, foundations, mutual funds, funds managers, bank investment departments. Investment Bank A term applied to a financial institution engaged in the issue of new securities including management and underwriting of issues as well as securities trading and distribution. Investment banks engage in buying and selling securities, such as stocks, bonds and mortgages. Investment banks also act as intermediaries between a corporation that requires funds and investors. Investment Grade For a rating, the rating value above which institutional investors have been authorised to invest. Genetically, it is instruments rated BBB or higher. IRR The Discount Rate making the NPV zero. Junk Bond A sub-investment grade bond or unrated high-yield bonds. Keep-Well Letter A form of guarantee in which the guarantor agrees to keep the recipient of the guarantee well, by injecting capital as needed. Sometimes called a maintenance of working capital guarantee. If properly worded, a keep well letter can be the equivalent to a formal guarantee. Lead Arranger The senior tier of Arranger. Lead Bank A senior bank involved in the negotiations for a Project Financing. Subordinate to an Arranger. Lead Manager. Lead Manager Senior tier of lender in a loan Syndication. Limited-Recourse Under certain conditions (legal or financial), there is access to the sponsor’s credit or other legal security for repayment, besides the Project’s cashflow. There is usually Recourse in the event of fraud or misrepresentation/non-disclosure - thus “Non recourse” is better described as “Limited Recourse”. Liquid Easily traded or converted to cash. Majority in The term typically used in loan indentures to indicate those persons that are titled to Interest instruct the indenture of the trustee to take action under the indenture. Manager A medium-level Participant established according to Final Take. Margin The amount expressed in % p.a. above the interest rate basis or cost of funds. For hedging and futures contracts, the cash collateral deposited with a trader or exchange as insurance against default. Market Risk Changes to amounts sold or the price received which impacts on gross revenue. Sometimes called sales risk. Maturity The final date a project finance loan is repayable. The end of the term.
A-5 Merchant Power A power plant that is exposed to full market risk for price and volume for its electricity sales. Mezzanine A generic term for finance subordinated to the senior debt but senior to ordinary Finance equity and possibly preference equity. Monetisation Securitisation of the gross revenues of a contract. Moody’s A credit rating agency. Mortgage A pledge or assignment of security of particular property for payment or debt or performance of some other obligation. Similar to an indenture of trust or security agreement. Mortgage Bond A bondsecured by a lien on property, equipment, or other real assets. Negative Pledge Undertaking by a borrower not to offer improved security arrangements to other lenders without offering the equivalent security to the instant lender. Negotiable Any written evidence of a payment obligation which maybe transferred by Instrument endorsement or by delivery, such as checks, bills of exchange, drafts, promissory notes and some types of bonds or securitised assets of which the transferee may become a holder in due course. NETA New electricity trading arrangements. NFFO Non Fossil Fuel Obligation Over A transaction specific term. It is the allocation of ‘more’ assets to support a liability Collateralisation than might other wise be required. Participant A party to a Funding. It usually refers to the lowest rank/smallest level of funding. Alternatively, it is one of the parties to the Project Documents. Participation The amount of loan/bond issue taken directly or from another direct lender/underwriter. Pass-through A mortgage-backed security on which payment of interest and principal on the underlying mortgages passed through to the security holder by an agent. PPA Power Purchase Agreement, a long-term power supply contract. Praecipium The amount of the front-end fee retained by the Arranger(s) and not distributed to the joining members of a Syndication. Prime Rate The rate at which banks lend to their best (prime) customers. The all-in cost of a bank loan to a prime credit equals the prime rate plus the cost of holding compensating balances. Private Debt A placement of debt securities to a limited number of sophisticated investors, as Placement opposed to a public placement. Registration requirements are simpler in a private placement and greater disclosure is often possible through the use of confidentiality agreements. However, the security might have a limited secondary market. Pro rata Shared or divided according to a ratio or in proportion to participation. Project Financing A loan structure, which relies for its repayment primarily on the project’s cashflow with the project’s assets, rights, and interests, held as secondary security or Collateral. Project The Asset constructed with or owned via a Project Financing, which is expected to produce cashflow at a debt service cover ratio sufficient to repay the Project Financing. Prospectus A formally approved document describing the business and affairs of the issuer and the terms and conditions of the security. An offering Circular in the US filed with the SEC, e.g. for an IPO or a rule 144a Bond Issue. PV Present value where a stream of cash flows or accounting flows are discounted to the present at a Discount rate.
A-6 Quality The degree of credit risk of a security or borrower. High quality borrowers are perceived to have greater than average ability to make debt service payments and hence offer less risk. Rating Agencies Agencies that study the financial status of a company then assign a quality rating to securities issued by that firm. Standard & Poors and Moody’s are leading rating agencies. Recourse In the event that the project (and its associated escrows, sinking funds, or cash reserves/standby facilities) cannot service the financing or Completion can not be achieved, then the Financiers have resource to either cash from other Sponsors/corporate sources or other non-Project security. Rule 144A A rule adopted by the US Securities and Exchange Commission that eliminates the two year holding period of privately placed securities by permitting large institutions to trade such securities among themselves without having to register them with the SEC. Less stringent documentation and disclosure is permitted than for normal securities. Running the Book The manager who has total control over a debt syndication or bond offering (usually appears on the upper left of the list of underwriters in a tombstone advertisement). Seasoning The age of a loan portfolio. It is primarily used in the mortgage market where defaults and redemption rates are a function of the age of the loans. Secondary Market After the initial distribution of bonds or securities, secondary market trading begins. New issue houses usually make a market in bonds or securities they have co managed. Other institutions, generally act as market makers in a wide range of issues and instruments by quoting two-way prices and being prepared to deal at those prices. Secured Creditor A creditor whose obligation is backed by the pledge or some other security over assets. In the event of a default, the secured creditor receives the cash from the sale of the pledged asset to the extent of their debt and they are usually able to force the sale of those assets to meet this obligation. SEC Securities and Exchange Commission. An agency in the United States created by congress to protect investors in securities transactions by administering securities laws and regulations. Security A legal right of access to value through mortgages, contracts, cash accounts, guarantees, insurance’s, pledges, or cash flow including licenses, concessions and other Assets. A negotiable certificate evidencing a debt or equity obligation/shareholding. Securitisation The process under which pools of receivables - that is, contractual entitlements to receive amounts of money - are packaged into marketable, transferable, investment grade securities that are distributed to investors. Senior Creditor Any creditor with a claim on income or assets prior to that of general creditors. Senior debt All debt, both short term and long term, which is not subordinated to any other liability. In addition, most current liabilities such as accounts payable, accrued expenses and taxes are usually considered senior debt. If the financial statements do not specify whether the debt is senior or subordinated, conservative practice is to assume it is senior. Sinking fund A reserve of the sinking fund established or set aside for the purpose of payment of a liability anticipated to become due at a later date. Indentures on corporate issues often require the issuer to make payments into a sinking fund. The proceeds are used to retire randomly selected bonds in the issue, or in some instances by market purchase. Sovereign risk The government’s part of political risk.
A-7 Special purpose An independent corporation with nominal capital which is a party to a project corporation financing for purposes of holding title as a nominee or acting as a conduit of funds. Sometimes known as an SPV - special purpose vehicle. The structure has implications for security and bankruptcy remoteness in some jurisdictions. Sponsor A party wishing to develop a Project. A developer. Spread The risk related interest premium added to the benchmark rate to calculate a bond’s coupon. This is usually measured in basis points. SPV See special purpose corporation. Strip Debt Debt arranged in tiers with different rates, maturities and amortisation to improve the borrowers cost. Syndicated Loan A commercial banking transaction in which a number of banks undertake to provide a loan or other facility to a customer on a pro rata basis under identical terms and conditions evidenced by a single credit agreement. The pricing will normally consist of a fixed spread over a short term based rate with commitment fees, agency fees, management fees, offsetting balances, security, etc, often included as well. Subordinated The subordinated party accepts a lower priority of repayment and/or security than Debt senior debt. Takeout A financing is structured to refinance of take out another loan, such as a construction loan. Tap Basis In the Euro commercial paper market, the method of issuance where by the dealer approaches the issuer for paper in direct response to particular investor demand rather than the issuer seeking bids from the dealer. Tenor The number of years a loan is made for. Term loan A loan with an original or final maturity of more than one year, repayable according to a specified schedule. Tolling Agreement A long-term contract to make periodic payments over the life of the contract in certain minimum amounts as payment for a service or a product. Tombstone An announcement placed in a financial newspaper or journal which announces a financing or performance of some financial service. Treasury Bill A non-interest-bearing discount security issued by the US Treasury to finance the national debt. Most bills are issued to mature in three months, six months or one year. Trustee An independent or nominated third party who administers corporate or financial arrangement. Underwriter A financial firm engaged in the business of underwriting securities issues. A dealer who purchases new issues from the issuer and distributes them to investors. In a Eurobond offering the Lead Managers and Co-managers act as underwriters for the issue, taking on the risk of interest rates moving against them before they have placed the bonds. Additional banks maybe invited to act as sub underwriters, so forming a larger underwriting group. Underwriting An arrangement under which a financial house agrees to buy a certain amount of securities of a new issue on a given date and price, thereby assuring the issuer the full proceeds of the financing. The commitment to fund is not contingent on Syndication. Unsecured Loan A loan made on the general credit of a borrower. The lender relies upon the borrows balance sheet and the capability of the borrower’s management to manage its assets and produce cash flows sufficient to repay the debt No assets are pledged. Yield The financial return, usually expressed as an annual percentage.
A-8 Yield Curve The relation ship between yield and current maturity is depicted in graphic form as a yield curve. This curve plots yield on the vertical axis and maturity on the horizontal axis. A normal yield curve slopes upwards from left to right, from short maturities to long maturities. Yield to Maturity The rate of return from a debt security held to maturity when interest payments and the investor’s capital gain or loss on the security are taken into account. Zero Coupon A bond that pays no interest. The security is sold at a discount and its yield is determined by a rise in value per unit of time. Its maturity value equals par.
A-9 A-10 Mainly Speculative: Speculative: Investment Grade Substantial Risk or in Default Low Creditworthiness High Creditworthiness Appendix CCC+ BBB+ ccc- BBB- AAA S&P ccc BBB AA+ BB+ AA- BB- AA cc BB A+ B+ A- Cl B- A c D B
B
Moody -
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B-2 Appendix C - Sovereign Credit Ratings
Ratings are the country’s credit rating or where applicable, the foreign currency rating.
Rating Country Long Term Outlook Short Debt Term Austria AAA Stable A-1 + Belgium AA+ Stable A-1 + Bulgaria B Positive Positive Denmark AA+ Positive A-1 + Finland AA Positive A-1 + France AAA Stable A-1 + Germany AAA Stable A-1 + Greece BBB Positive A-3 Hungary BBB Positive A-3 Iceland A+ Positive A-1 + Ireland AA+ Stable A-1 + Israel AA- Stable A-1 Italy AA Stable A-1 + Liechtenstein AAA Stable A-1 + Luxembourg AAA Stable A-1 + Malta A Negative A-1 + Norway AAA Stable A-1 + Poland BBB Positive A-3 Portugal AA Stable A-1 + Romania B- Negative C Russia SD - SD Slovak BB+ Negative B Slovenia AA Stable A-1 Spain AA+ Stable A-1 + Sweden AA+ Stable A-1 + Switzerland AAA Stable A-1 + United Kingdom AAA Stable A-1 + Source: S&P Infrastructure Finance September 1999
C-1 C-2 Appendix D - UK Power Company Credit Ratings
S&P S&P Credit Spread over LIBOR Company Rating Outlook 5 Year 10 Year
Avon Energy A- Negative +65 +80 British Energy A- Negative +57 +70 CE Electric A- Negative +55 +69 CSW Invest. A- Negative +55 +69 Hyder BBB+ Negative +79 +95 National Grid AA+ CWD +17 +25 National Power A- Stable +37 +55 PowerGen A Stable +40 +55 Scottish & Southern Energy A+ Stable +17 +27 Scottish Power A+ CWD +22 +33 Southern Invest A- Negative +60 +80 TXU Eastern BBB+ Stable +75 +89 United Utilities A Negative +45 +60 Yorkshire Power BBB+ Negative +75 +95
Source: Chase, "International Fixed Income Credit Research", 29 June 1999
Highest and lowest spread for each maturity are in bold
Ranges: A+: 17 - 33bp A-: 37 - 80bp BBB+: 75-95bp
D-1 D-2 APPENDIX E - NFFO AND THE FOSSIL FUEL LEVY The Non-Fossil Fuel Obligation (NFFO) requires public electricity suppliers (PES) to contract for renewable generating capacity. To achieve this, the Secretary of State for Trade and Industry and the Secretary of State for Scotland are empowered under the Electricity Act to ensure that each licensed supplier55 buys a certain amount of generating capacity from non-fossil fuel sources. Licensed suppliers are obliged, under the scrutiny of DTI and the Office of Electricity Regulation, to run a competition where individual projects bid for a Power Purchase Price (PPP56) within different technology bands. Each bid is examined by OF GEM on a ‘will secure’ basis57 and all projects that pass the test are included in the analysis by OFGEM to recommend the capacity set for each technology band. The Secretary of State then lays the Order before Parliament and licensed suppliers award sufficient PPAs to meet the Order on the basis of price per kilowatt-hour generated. In 1990 all the PESs set up one organisation, the Non-Fossil Purchasing Agency (NFPA) to act as their agent and pool the obligations for running the competitions and payments. To meet the NFFO, PESs have to enter into contracts with generators for an aggregate amount of electricity, which complies with the Order. There are technology bands for wind power, hydro, landfill gas, municipal and industrial waste, agricultural waste and energy crops, although these are not always represented in each competition. PESs purchase the electricity, which contributes to the NFFO through the NFPA. To meet the higher cost of renewable generating stations, licensed suppliers pay a Fossil Fuel Levy on their electricity sales revenue. The Levy is collected by OFGEM each month through the Suppliers’ electricity bills and then given to the NFPA for it to pay the renewable energy generators the difference between PPP and Contract Price. The payments are then paid as an additional sum for every kilowatt-hour of electricity generated by the generator. Renewable generators are paid according to their bid price (index linked) and not according to Pool price or any other mechanism. The Act foresaw the development of the electricity market, a general downward movement of prices (all generation) and therefore recognised a need to account for the difference between the price paid to the renewable generators and the market price of electricity. The Act and secondary legislation derived from it, permits PESs to recover the difference between the price
55 The obligation is on the distribution grid, therefore on the PES. Important when considering consequences of market supply liberalisation. Suppliers need a licence when selling >500kW and can only obtain it if they are rated at Investment Grade (no less than S&P’s BBB- or Moody’s Baa3). Some Suppliers are able to post a bond to achieve this, but the impact on a credit assessment is not yet clear. 50 Fixed indexed price an RE generator would be guaranteed with a NFFO Purchase Power Agreement. 57 Projects are examined under technical, commercial and economic viability criteria in order to ensure that they "will secure" the capacity specified in the Order.
E-1 paid to generators and the Reference Price. To date, the Reference Price has been set at the price of electricity in the Pool. Some reference price will arise from NETA (possibly the average Balancing Market price) although this is not yet certain. The additional cost is passed through to customers and this is specifically allowed for in supply price controls. At present the Levy accounts for less than 1% of a customer's bill. The Fossil Fuel Levy for 1998/99 raised £117m from licensed electricity suppliers and of this, £114m will fund renewable generation commitments with the remaining £3m added to the existing £41m surplus from 1997/98. The resultant surplus, plus the interest generated that has already been taken into account in setting the levy rate for 1999/2000, will be used to offset the amount of levy required in the next rate setting exercise in spring 2000. The 1999/2000 levy, at 0.3% on the electricity bill, is equivalent to less than £1 a year on the average domestic electricity bill of £27 558 . OFGEM has two main roles under NFFO. To advise the Secretary of State for Trade and Industry and the Secretary of State for Scotland on the means of meeting proposed Orders, and to examine the projects put forward by the RECs to ensure that they 1,1 will secure' the capacity to be specified in the Order. Contracts are awarded competitively on the price per kWh bid by generators. As the levy is spread across all consumers and is a statutory requirement on the Suppliers to collect the funds, the market treats this as a de facto sovereign level of risk. This comes from the cost being borne effectively by the whole nation and a strong perception that the UK government will not act retrospectively to change contracts that are in operation. In Scotland generators are able to bid for contracts with the two Scottish public electricity suppliers, Scottish Power and Hydro-Electric, in the same way that applicants in England and Wales are able to apply for inclusion in the Non-Fossil Fuel Obligation. Three Scottish Renewables Orders (SRO) have been made to date, the first in 1994, second in 1997 and third in March 1999. In England and Wales five Non-Fossil Fuel Orders have been made to date, in 1990, 1991, 1994, 1997 and in 1998.
58 Source: OFGEM.
E-2 Appendix F - Financial Times Bond Table EURO-ZONE BONDS Red.* S&P Bid Bid Day ’s Change Mth’s Spread v 15 December 1999 Coupon date Rating Price Yield Yield Change Yield Govts □ SOVEREIGNS UK 01/01 4.250 AAA 100.665 3.62 -0.03 +.20 -0.43 Denmark 01/02 7.750 AA+ 100.908 4.28 +0.00 +0.22 -0.01 Sweden 02/01 5.000 AA+ 101.237 3.85 -0.0.3 +0.19 -0.20 Greece osms 5.750 A- 100.524 5.66 -0.07 +0.08 +0.72 □ SUPRANATIONALS ADB“ 10/07 5.5000 AAA 101.309 5.29 -0.07 +0.07 +0.46 EIB“* 04/09 4.000 AAA 90.753 5.28 -0.05 +0.11 +0.25 Eurofima**** 12/09 5.625 AAA 100.954 5.50 -0.05 +0.12 +0.47 World Bank 04/05 7.125 AAA 110.520 4.82 -0.06 +0.06 +0.21 □ UTILITIES EDF 01/09 5.000 AA+ 97.858 5.30 -0.04 +0.09 +0.27 TEPCO 02/03 4.750 AA 100.171 469 +0.00 +0.16 +0.27 Elydro-Quebec 03/08 5.375 A+ 98.680 5.57 -0.07 +0.07 +0.63 Powergen (UK) 07/09 5.000 A 93.540 5.90 -0.03 +0.10 +0.87 □ FINANCIALS Bad Wurtt 02/10 5.375 AAA 98.744 5.54 -0.04 +0.11 +0.47 OKB 09/07 5.750 AAA 103.244 5.22 -0.05 -0.01 +0.39 Credit Local 04/09 4.750 N/A 95.381 5.39 -0.04 +0.10 +0.36 Abbey Natoional 01/09 5.000 AA- 94.323 5.82 -0.06 +0.10 +0.79 □ INDUSTRIALS Unilever 05/04 6.500 AAA 106.335 4.85 -0.01 +0.11 +0.34 McDonalds 09/07 5.125 AA 98.324 5.38 -0.06 +0.08 +0.44 Philip Morris 04/09 5.625 A 97.413 6.02 -0.06 +0.09 +1.08 Bat Int Fin 01/09 5.375 A 97.753 5.75 -0.07 +0.05 +1.03 □ PFANDBRIEFE...... Rliein Elypo 12/01 5.500 AAA 102.133 4.33 +0.01 +0.24 +0.28 Euro Elypo 01/04 5.500 AAA 100.560 4.84 +0.03 +0.18 +0.33 Bayer Elypo 01/06 6.000 AAA 104.350 5.15 +0.03 +0.15 +0.43 Depfa 01/09 3.750 N/A 88.188 5.43 +0.02 +0.02 +0.40 □ HIGH YIELD Ono Finance 05/09 13.000 CCC+ 112.055 10.67 -0.05 -1.08 +5.64 Colt Telecom 07/08 7.625 B 101.719 7.35 -0.05 +0.04 +2.41 Impress Metal 05/07 9.875 B 95.289 10.81 -0.05 +0.94 +5.98 Remy Cointreau 07/05 10.00 B+ 109.286 7.76 -0.03 -0.21 +3.15 ^Redemption; **Asian Development Bank; ***European Investment Bank; ““European Company for the Financing of Railroad Rolling Stock; “* “German Landesbank Mortgage Asset Backed Securities Source: Financial Times 16 December 1999
New International bond issues | „ Amount Coupon Borrower Price Maturity Fees Spread bp Book-runner m. % □ US Dollars Rep of the Philippines (a) 400 9.875# 98 625 Jan 2019 POOR +361(Feb29) Goldman Sachs Banco Itau SA (b) - 100 9.25# 100.432R Feb 2001 0.38R Barclays Capital (Brazilian private bank) - □ EURO (e) 3CIFJ 200 (c) 99 998 Jan 2002 0.125 Deutsche Bank TPS A Euro Finance (d) - 100 6.125 100.366 Oct 2004 0.325 +145(Jul04) Deutsche Bank/Salomon SB Polish Telco □ STERLING Merchants Trust pic (g) - 30 5.875# 97.241R Dec 2029 0.625R 175(Dec28) Warbusrg Dillon Read UK investment trust Final terms, non-callable unless stated. Yield spread (over relevant government bond) at launch supplied by lead manager. J Floating rate note. # semi-annual coupon. R: fixed re-offer price; fees shown at re-offer level., a) Fungible with $700m. Plus 157 days accrued, b) Fungible with $100m. Plus 146 days accrued, c) 3-mth Euribor +10bp. d) Fungible with €400m. Plus 56days accrued, e) Spreads relate to German govt bonds, g) Floating charge over property. Source: Financial Times 16 December 1999
F-1 F-2 Appendix G - Case Study of a Bond Financing: Sutton Bridge
Deal Summary
Capacity: 790MW CCGT with three 260MW GE 9FA+ turbines.
Senior debt: 25 year BBB bonds, fully amortising from 2002 until maturity in 2022. £195m 8.625% coupon and $150m Rule 144A 7.97% coupon. Issued May 1997.
Equity: £42 m.
PPA: 15 year capacity and tolling agreement (CTA) with synthetic tolling agreement for Eastern Electricity.
Site: South Lincolnshire, 85 miles north of London.
Introduction SuttonBridge Power (SBP) marked a ‘coming of age’ for UK IPP bond finance. Until that deal, the sector had been considered a significant potential source of sterling bonds, but one that had not fulfilled the capital market ’s expectations. SBP was a significant development in the sterling bond market for several reasons, not least of which was at that stage only two other power project bonds59 had been issued and these were for post construction projects with power contracts covering the debt tenor.
Fund Raising SBP raised finance pre-construction and against a tenor that included 8 years of merchant exposure, with 30% of the debt still outstanding at the change over. Much of the attraction of using the bond market was dueto the particular needs of the sponsor, which wanted a 25 year tenor (commercial bank debt was at that stage only achieving 18 years) andthe consequential earlier availability of dividend flows. Market indications were that institutional investors wanted to see more long-term paper to match their liabilities, which made the potential to get the bonds away successfully far more likely. Equally, the sponsor also considered that the strategic benefit of increased visibility amongst a new pool of investors - the UK institutions - was important and not available through the commercial debt route. Any sponsor the size of Enron has to regularly raise finance from the capital markets and increasing its investor base through greater visibility would assist in future approaches to the markets. Unusually, the sponsor decided to offer the bonds in parallel to the UK and US market in order to ensure there was sufficient market depth and appetite for the bonds. At the same time, the underwriters split the placement equally between themselves, rather than dividing it geographically by their home markets.
59 El98m Kilroot deal in 1994 and £4bn First Hydro acquisition in 1996.
G-1 Dividing the placement across the Atlantic introduced a further element of competition that helped narrow the spread - a technique rarely possible in such a direct manner for the commercial bank debt market. Indeed, it subsequently appeared that the full amount of debt could have been placed in either market, which suggests that the element of competition helped tighten the spread finally achieved. To deal with both markets, the covenant package was based on a mix of US and UK market practice, which investors were forced to come to terms with. A disadvantage of the split was the unusually long, dollar bond, currency swap, which was arranged through Enron's risk management unit.
Risk Summary With regard to the credit rating process of the issue, the project was considered to expose lenders to the following risks: > After 2014 or later if the CTA is extended, SBP is exposed to merchant risk until the 2022 bond maturity; > UK and European gas markets were at an early stage of liberalisation and deregulation, thus exposing SBP to an uncertain gas industry structure and its attendant pricing and supply risks; > Financial forecasts relied on natural gas supplies and transportation in the UK and Continental Europe to be adequately balanced and below 44 pence per therm (1996 price) during the merchant period; > Enron Corporation (BBB+), may own as little as 10% of the project's equity by 2014 and will therefore have limited incentive beyond its guarantees and commitments to the project to provide support if the economics seriously deteriorate; > UK electricity regulation or other public policy related activities might pass laws and regulations that would lead to coal being favoured as a fuel stock over natural gas. However, the following strengths offset the risks: > Enron Capital & Trade Resources Ltd (ECTRL) a wholly owned subsidiary of Enron Corporation, has guaranteed all fixed and most operating payments to SBP with a CTA through May 2014 in exchange for supplying gas to the project; > Enron Corporation and its subsidiary, Enron Power Corporation, substantially guaranteed construction of the power plant, thus mitigating construction risk; > Enron Engineering & Construction Services was a highly experienced contractor that supervised the construction of the plant; > General Electric (‘AAA’) supplied two frame 9 turbines and assumed virtually all operating risk for 12 years (extendable for six years at SBP’s option under the same terms and conditions). The assumption of risk was made through an Operation and
G-2 Maintenance agreement (O&M) whereby it is responsible for all O&M costs in return for a fixed management fee - thus greatly reducing technology risk; > Gas reserve risk was very low, with British North Sea supplies alone capable of providing gas at current consumption rates for almost 10 years and European supplies sufficient for almost 85 years; > CCGTs were quickly replacing coal-fired generation technology in the UK, a situation that was expected to continue until most coal and oil-fired generation was retired by 2014, thus helping CCGT technology remain competitive; > Minimum debt service coverage ratios (DSCRs) during the CTA period were 1.34 for the base case and extremely robust under sensitivity analyses; > Minimum forecast base case DSCR of over 2.50 during the merchant period, which conservatively assumed that technology and gas prices would move SBP from a base load plant to a peaker facility, and would only rely upon capacity payments from the pool for coverage of fixed and operating expenses; and > Financial covenants mirrored those typically found in most project finance transactions, but also included a two-year forward looking DSCR test on distribution60 during the merchant period. The exceptionally strong construction arrangements, contractual allocation of technology risk to General Electric, strongly supported revenue payments, which in large part are virtually guaranteed by Enron through to 2014 and fundamentally sound economics allowed a BBB rating. However, the eight-year tail merchant power period with its complete exposure to fuel and electricity price/volume risk will limit any upward ratings movement until the uncertain dynamics of the UK gas and electricity markets stabilise andbecome more transparent.
Capacity and Tolling Agreement The bonds have a three phase life: the first 19 months for construction, where risks were mitigated through a fixed price engineering services contract with General Electric, the second phase is a 15 year CTA and the final 8 years expose investors to merchant risk. At the end of the CTA, some £90 million of debt will still be outstanding, although there is an option for that phase of the contract to be extended. The arrangers argued that in the last phase the plant will only be moderately geared and the plant's efficiency will easily allow the bonds to be fully amortised. In many respects, the CTA is analogous to a conventional PPA, however, ECTRL does not directly take the electricity. ECTRL has an agreement with Eastern Electricity pic which effectively provides Eastern with a synthetic tolling plant, since for certain
o0 Distribution refers to cash paid out of the project company that is not for operating expenses or for the senior debt.
G-3 regulatory reasons, Eastern may not directly own additional IPP capacity. The CTA initially extends to 2014, after which ECTRL may elect to extend the contract in one- year increments for 10 years with at least 24 months prior notice. However, the terms of the CTA were not binding until construction was complete and the plant achieved minimum performance criteria. Bondholders were at risk in that the terms of the contract were subject to possible renegotiation if the station did not meet minimum performance criteria. However, that risk was largely mitigated by liquidated damages for delay and performance on construction of the station. The CTA mitigates much of SBP’s business risk as the agreement controls fuel expenses and eliminates electricity price andvolume risk. Functionally, the CTA is an ECTRL gas-put to SBP and ECTRL pays SBP a fixed sum and a variable sum based on every fired gas turbine hour. In return, SBP remits all pool proceeds that it may earn to ECTRL. Fuel costs largely determine SBP’s place on the merit order dispatch curve, therefore the ability to mitigate fuel supply and price risk reduces its risk relative to its competitors. SBP virtually eliminated fuel market risk in the early years of the project by transferring that risk to Enron, which was better able and willing to absorb the risk. In the latter years, several options may become available, although not as firm contractually as in the early years, thus exposing the project to fuel market risk. The CTA is a notable measure of Enron’s commitment and exposure to the SBP project, as at financial close the present value of the CTA payment until 2014, before netting out any pool proceeds, was about £500 million. In addition, the CTA insulated bondholders from most changes in the law affecting the cost of gas-fired generation in England and Wales. If SBP incurred additional costs or savings due to a change, those costs or savings pass through to ECTRL.
Financial Structure Senior creditors comprise the original bondholders and any further issues of these bonds, plus debt raised to fund required modifications or improvements and a working capital facility of up to £15 million. Subordinated secured creditors, comprised the letter of credit facilities and the dollar bond swap provider (ECT) and had no rights of acceleration, insolvency, etc. The security structure also provided for deeply subordinated creditors - mainly cost overrun facilities provided by Barclays Bank, unsecured, but guaranteed by Enron. Deeply subordinated creditors are paid out of permitted distributions but with no rights of acceleration etc. Enron structured SBP to provide as much financial flexibility as possible, particularly during the potential merchant power years. The most important feature is that approximately 70% of the senior debt will have been amortised by then, thus greatly reducing the project’s leverage. According to the base case forecasts, which conservatively assume that SBP will operate as a peaking facility, SBP should have a
G-4 minimum DSCR of 2.5 during the merchant years. During the CTA period, when Enron has taken away the merchant risk, the projects base case minimum DSCR is 1.34. The DSCR ratio does not drop below 1.0 until the station’s availability for the year drops to 66%, when the CTA would cause the fixed payments to be adjusted downward so that a DSCR of less than 1.0 would result. Given the reliability of GE gas turbines and the insurance in place, this risk was considered low. The base case pro forma below shows how Enron designed the revenue structure and bond amortisation to minimise default risk to bondholders. In the CTA period, the CTA payments provide a quality and high-certainty revenue stream. Expenses are minimised since Enron is supplying gas to the project. As a result, SBP is able to amortise its debt quickly in the CTA period and during the merchant period, the bond amortisation schedule lowers principal payment by about £6.8 million per year, reducing overall debt service by £8.1 million. Variable O&M decreases to zero by 2014, the year in which no dispatch is assumed andthe project receives only loss-of-load probability (LOLP) payments. Any dispatch, assuming that the project is bid at prices higher than gas expenses, would only increase net operating income. Hence, even at no dispatch, SBP is able to maintain a minimum DSCR of 2.48.
SBP Pro Forma -1996 £m 1999 2005 2010 2014 2019 2022 Revenues Fixed payment 57.6 68 8 68 8 22.9 0.0 0.0 Variable payment 3.7 4.7 4.6 1.8 0.0 0.0 Pool proceeds 0.0 0.0 0.0 380 64.4 65 9 Total revenue 613 715 73.4 62.7 64.4 65 9 Expenses Fixed O&M (5 2) (7.4) (8-5) (9.6) (H.l) (12.2) Variable O&M (17) (4.7) (4.6) (18) 0.0 0.0 Miscellaneous expenses (7.2) (10.2) (118) (13.2) (15.2) (16.5) Total expenses (16.1) (22.3) (24.9) (24.6) (26.3) (28.7)
Earnings Before Interest & Tax 45.2 51.2 48.5 38 1 38 1 37.2 Plus depreciation 7.2 8.7 8.7 8.7 8.7 8.7 Plus interest income 1.0 1.7 0.0 0.0 0.0 0.0 Pre-tax cash flow 53.4 616 57.2 46.8 46.8 45.9 Senior debt service Principal 0.0 (16.3) (16.3) (7.5) (11.5) (7.3) Interest (20.9) (20.4) (13.2) (7.7) (3.7) (0.3) Total senior debt (20.9) (36.7) (29.5) (15.2) (15.2) (7.6) Senior DSCR 2.56 168 1.94 3 08 3 08 6.04 Summary DSCRs Min Avg Max CTA period 1.34 1.64 2.10 Merchant period 248 248 248 Pricing At the time of the financing, the UK portion of the SBP bond was sold slightly below par at 99.523 in order to achieve a spread of 135bp over its benchmark Gilt, the 9% 2011. The yield at issue was 8.66%. Approximately three months later AES Barry was financed as a pre-construction merchant power plant through the bank market, using a
G-5 floating rate loan and interest rate at issue of 8.3%. This was based on a spread of 130bp over LIBOR, which then fell to 120bp for the first five years post-construction, before slowly increasing to 134.5bp after the eleventh year of operation. However, the loan was for 15 years and £91m. This demonstrates remarkable competitiveness in pricing, when the tenor of the bond was 50% longer than the commercial debt and on a fixed rate - the cost of a swap to fix the bank rate would have comfortably made up the difference between implied yields andEnron achieved strategic benefits on top.
Legal and Contractual Structure The following chart shows the project's structure. A more detailed explanation of it is available from Standard & Poor’s:
Enron Corp
Enron Engineering & Construction
SB Investors Enron O&M Ltd Ltd.
50% 150% Enron SB Ltd. A100%
Collateral Intercreditor Agent
Cayman Issuer (Sutton Bridge Finance)
(. .) Contract/Agreement CTA: Capacity & Tolling Agreement ECTRL: Enron Capital & Trading Resources Ltd
Participant DOI: Deed of Indemnity ESA: Engineer Service Agreement
ECT: Enron Capital & Trading Resources GEM: General Electric International Inc.
------Ownership EES: Enron Engineering Services
G-6 Appendix H - Deal List
Contents 1. Off Balance Sheet Commercial Bank Project Debt - Electricity. 2. Off Balance Sheet Bonds - Electricity. 3. Off Balance Sheet Bonds - Stranded Costs. 4. Off Balance Sheet Bonds - Infrastructure. 5. On Balance Sheet Commercial Bank Debt - Electricity. 6. On Balance Sheet Bond Debt - Electricity.
Notes:
1. Interest rates are expressed as basis points over LIBOR unless otherwise stated. 2. Exchange rates used are listed in the below table. 3. PFI Deals in Section 4 quote the debt raised, rather than total project cost.
Exchange Rates Used:
FX FX/£ £/FX € 0.632 1.582 $ 0.618 1.62 Dr 0.0018 543.8 FFr 0.096 10.42 ITL 0.000326 3,070 Pta 0.0038 263.2
H-1 H-2 (1) Off Balance Sheet Commercial Bank Project Debt - Electricity
Debt & Project Sponsor Pricing and Structure Remarks Arranger 1. PowerGen Renewables PowerGen - 50% £48m Tranches: Placed to put funding needed for current and (UK 1999) (UK power utility) projected requirements under one facility and Refinance existing loans for ABN AMRO A. £22m - 15 years: refinance operational projects and fund projects move it off balance sheet. More financial 10 operating wind farms & 2 Abbot Group - 50% under construction in 1999; 80 - 125bp; autonomy/clarity for the new company, under construction, plus the (UK oil group) B. £2m - 17 years: development costs up to 2000; 100 - 125bp; although paying a higher interest rate than if development and construction C. £24m - 17 years: projects in 2000; 100 - 125bp. financed on PowerGen’s balance sheet. costs of wind farms in 2000. Tranche C will refinance drawings under Tranche B, once the wind farms Projects financed under NFFO start construction. contracts with NFPA.
ABN AMRO brought Tranche A and B to syndication. The deal was oversubscribed.
Abbot purchased 50% of PowerGen Renewables on 31/12/98 for £5.71m. One of the attractions of the partnership being Abbot’s off-shore technology.
H-1 2. IVPC (Italian Vento IVPC Energy - 50% ITL349bn Tenor: 13 years The five tranche facility is structured in line Power Corp) 90% owned by US wind (£113m) with the construction milestones of the project (Italy 1998) developer UPC) Five loan tranches: ITL118bn (1st tranche) to refinance 59.4MW; (tranche A has already been drawn to refinance Project finance for a Greenwich ITL228bn (4 tranches) to finance construction of 108.8MW: operating sites). 169.2MW wind project to Tomen Power NatWest refinance 59.4MW operating Corporation - 50% A. ITL118bn, Years 1 to 7 - 105bp; Year 8 to 13 - increases up to 130bp; It refinanced a bridge loan on an existing asset sites and construct remaining (US subsidiary of Tomen B. ITL44.9bn, Construction 120bp; Operation to Year 7 - 105bp; Year 8 and financing construction of new plants. sites. Corporation, a Japanese to 13 - increases up to 130bp; general trading and services C. ITL105.9bn, as B; Banks derived comfort from the existing company) D. ITL62.5bn, as B; operation of 59MW, which allowed them to E. ITL15m - VAT facility, 25bp. agree stepped finance for the remainder.
Underwriting fees: Senior lead managers, ITL50bn - 40bp; lead mangers, Project uses government ITL35bn - 30bp; managers, ITL20bn - 20bp. guaranteed Renewable Energy Debt/equity - 85/15. PPAs (CIP/6).
Eleven CIP6 PPAs (each 15 years). Base Tariff: ITL195.9/kWh (6p/kWh) Proven technology supplied by Vestas Multiple - first 8 years; ITL98.3/KW (3p/kWh) - Years 8 to 15. lump sum EPC contracts.
Long term O&M contract with Vestas (turbine supplier). Tranche E finances VAT credits due from the Government to allow for timing differences.
H-2 H-3 Debt & Project Sponsor Pricing and Structure Remarks Arranger 3. Xistral Grupo Aciona - 90% Pta32bn Tenor: 19 years (3 years construction, 16 years operation) - 90bp. One of the largest wind farms deals in Europe. (Spain 1999) (Spanish construction firm) (£122m) Project finance for a 240MW Cash sweep mechanism to accelerate repayment up to year 14. No need for long-term PPA’s, as the local wind farm. NEG Micon - 10% Banco Bilbao utility (Begasa) is obliged to buy the off-take (Danish wind turbine Vizcaya Underwriting fees: senior lead managers, Pta1bn and above - 30bp; lead under Spain’s renewable energy legislation manufacturer) managers, Pta500m to Pta999m - 22.5bp; managers, Pta350m to Pta499m Chase - 15bp. The Renewable Energy tariff, which has been set by law, is Pta 11.1/kW (4.2 p), which Debt/equity - 85/15. will change each year.
PPA: 5 year rolling contract with Begasa, a local utility owned by Endesa (55%) and Union Fenosa (45%).
4. Orisane Lyonnaise des Eaux FFr305m Tenor: 20 years (1.5 years construction, 18.5 years operation). France’s largest waste-to-energy deal in 1999. (France 1999) (French utility) (£29m) Waste-to-energy plant in Interest: 60bp. The plant will burn 110,000 tonnes of waste per Mainvilliers, west of Credit annum. Chartres. Agricole EIB provided FFr140m (£86.5m). The plant will have two sources of Natexis revenue: waste tip fees and electricity sales.
EIB has contributed €1.6bn (£1bn) as part of its infrastructure/environmental programme, to waste processing plants in Europe, since 1993.
H-4 5. Rokas Rokas €70m Tenor: 11.5 years (3 years construction, 8.5 years operation). Different currencies used for refinancing and (Greece 1999) (Greek construction firm) (£46m) development. Project finance for 6 wind Three tranches for 3 construction phases: farms on three islands Paribas A. €2.9m (£1.832m) (10 MW - completed); Greek Drachma has depreciated against the totalling 104MW. B. Dr24bn (£45.6m) (50MW - in construction); Euro by 30% since debt issued (0.0027 to C. Dr597m (£1.134m) (44MW - to be started). 0.0019). High currency risk for operating projects. Interest: 150bp pre-completion; 140 - 160bp post completion. High level of grant funding allows low debt Total Funding is £230m, structured as follows: 20% Debt, 40% EU grant, ratio. Equity levels are set by grant 40% Equity. requirements.
PPA with Public Power Corporation (Greek utility). Projects use government guaranteed Renewable Energy PPAs.
H-5 H-6 Debt & Project Sponsor Pricing and Structure Remarks Arranger 6. API Energia API - 51% €648.5m €34.62m for an 18 month equity bridge: 35bp. One of Italy ’s first project finances it has been (Italy 1999) (Italian energy firm) (£410m) refinanced to increase D/E from 75/25 to 85/15. Refinancing of a project €577.6m base facility €25.31m standby facility finance for a cogeneration (to ABB - 24% ABN AMRO 0- 1 year: 130bp 130bp Difficult refinancing process (fire accident at a refinery) power plant using (Swiss engineering firm) 1- 8 years: 115bp 125bp the refinery shortly before closing the deal). tar refinery waste as fuel. BNL 9-12 years: 125bp 135bp Deal executed when 90% of the construction Texaco - 21% 13-17 years: 140bp 150bp was completed. (US energy firm) Greenwich Natwest Underwriting fees: Senior lead managers, €30m - 42.5bp; lead mangers, Major risks are the tar gasification technology €22.5m - 32.5bp; managers, €15m - 25bp. and new, stricter environmental regulations that Mediocredito could be put in place following the fire at the Centrale Debt/equity - 85/15. refinery.
20-year PPA with Enel (largest Italian utility). The PPA has an incentivised price for first eight years of generation. Remaining years API - tar supply contract guarantee. will be at market price (Italian pool price).
7. Gregory Cogeneration G&E Power $257m A. $175m, 17 years (2 years construction + 15 years operation); Guaranteed revenues (5 years) (US 1999) US power utility) (£159m) B. $10m Debt Reserve Letter of Credit (L/C); and fuel supply do not cover most Project finance for a 550MW C. $7m Revolving Debt; ING D. $65m Equity Bridge for construction period; of debt tenor. merchant cogeneration gas- Columbia Electricity fired power station. E. Small working capital facility. (US power utility) Projections for average DSCR are high, but not DSCR: 2.1 average, 1.76 minimum. unusual for merchant risk (effectively coverage ratios are moving the financing closer to on- 10 year secured fuel supply; 5 year power offtake agreement (Reynolds for balance sheet type ratios). the majority, Dynergy for the remainder) and heat (Reynolds Metals plant).
H-7 Debt & Project Sponsor Pricing and Structure Remarks Arranger 8. Milford El Paso Energy - 95% $365m Five tranches: Senior Debt facility split into 4 tranches to meet (US 1999) (US power utility) A. $156.25 bank loan (2 years construction, 15 years operation) to be different investor appetites. Project finance for a 540MW (£226m) syndicated. Construction (2 years) - 112.5bp; Years 1 to 4 - 125bp; Years merchant gas-fired power Power Development Corp 5 to 8 - 137.5bp; Years 9 to 12 - 162.5bp; Years 13 to 15 - 187.5bp. Note that two pension funds are taking station. - 5% KBC Bank Underwriting fees: $25m - 62.5bp; $20m - 50bp ; $15m - 40bp. construction risk. (US power utility) B. $30m (2 years construction, 17 years operation) commercial bank The plant takes market risk. El loan; Paso is taking fuel price and C. $35m (2 years construction, 18 years operation) funded by Trust Company of the West, a US investment fund; capacity risk. D. $50m (2 years construction, 19 years operation) funded by pension fund TIAA-CREF; F. $15m working capital facility; G. $78.75m equity bridge loan (2 years).
Cash Traps: if debt service cover ratio falls to 1:4:1, 50% of excess cash is trapped or held in escrow for four quarters and only returned to the sponsors if the project’s performance improves. The amount steps up as the DSCR falls. The deal also features sweeps if the DSCR rises above a threshold.
El Paso Natural Gas will provide fuel with 25% of fuel cost subordinated to debt service. If the plant dispatches less than75% of the time, the % of fuel subordinated to debt service increases.
The plant is scheduled for service in November 2000.
H-8 9. Tenaska Frontier Tenaska Frontier - 65% $380m Tenor: 19 years (2 years construction, 17 years operation): The plant’s market risk is dimished (US 1998) (US power utility) (£235m) A. $295m construction and term loan: 100bp (construction), up to by Peco Energy taking capacity Project finance for a 830 MW 212.5bp (operation); gas-fired, combined cycle Montana Power - 25% Credit B. $42m equity bridge loan during the 2-year construction period; risk. power station. (US power utility) Lyonnais C. $38m letters of credit; D. $5m working capital credit. The project risk (for fuel) is linked to Peco & Illinova - 10% Tenaska risk. (US power utility) Debt/equity: 85/15. Note lower interest rate in construction (100bp) Well proven GE technology. than in operation (212.5bp). This suggests either a very strong EPC or that the banks want Tenaska Frontier has the O&M, as well as the supply contract. to encourage refinancing during operation.
Power Team (a division of PECO Energy) purchased the rights to market 100% of electricity output.
H-9 H-10 (2) Off Balance Sheet Bonds - Electricity
Project Sponsor Debt & Pricing and Structure Remarks
H-11 10. Dam Head Creek Entergy Corporation £361m Rating: Senior BBB-; Subordinated debt BB-; Full electricity market price risk - currently (UK 1999) US energy group) very competitive due to gas moratorium but Refinancing an 800MW Must maintain at least 50% Warburg 3 Facilities: expected to become mid-merit by 2015. merchant gas-fired power of the equity until start of Dillon Reed A. £271m senior bonds, tenor 24 years, 5 year principal grace period, First public bond financed merchant plant in station 12 months in to a 25 commercial operations and average life 14.8 years; Europe - an indicator of market sentiment. month construction period. 25% during the following B. £54m subord. Bonds, tenor 19 years, 6 year principal grace period, The profile is based on the five years. average life 12.8 years; Low projected market risk based on estimates proposed bond, which was C. £123m ancillary credit facility (loan underwritten by banks, tenor 20 that the plant is still profitable running at 30% planned for 11/99 but years), consisting of: baseload. withdrawn. - £20m cost overrun facility; - £10m working capital facility (commissioning onwards); Complex off-shore structure for tax and - £35m gas L/C - if drawn, repayment is senior to debt service; financing purposes. - £18m National Grid Guarantee - covers equipment from NGC; A long-term (although shorter than the debt - £40m Hedging L/C for trading counterparty risk. tenor) fuel contract with price based on a basket of indices. May be rebased if market price Construction and Refinancing Fees are £14.5m (4% overall). moves by >20%.
Debt/sub debt/equity - 75/15/10 (£36m equity guaranteed by an ‘A' Minimised construction and maintenance rated bank L/C; all equity must be fully subscribed by start of risk due to robust MHI guarantee. operation). High DSCR, especially first years due to DSCR (Base Case): average 2.58, minimum 2.00; Aggregated Senior and principal repayment grace period. Subordinated Cover Ratio: average 1.95, minimum 1.54; Aggregated Gas supplier required a LC to protect against Senior and Subordinated Cover Ratio (Worst Case): 1.24. fluctuations in plant performance. Reserve Accounts (6 month senior debt; 1 year subordinated debt). S&P commented on a low equity (£36m) Fuel: 15 year index linked (50% pool price, 30% PPI, 20% gas price) take level and sponsor is having £46m of its or pay contract with Shell. Able to sell on into spot market. current finance repaid.
Construction Bonds: a) Performance (30% EPC), b) Ascending (in lieu of S&P constrained the rating due to NETA, retention of milestone payments; 10% EPC) and c) Availability and pool price and gas price risks. Defects Liability issued at take-over (25% EPC). All bonds are issued by Bank of Tokyo-Mitsubishi (Rating A-) on behalf of contractors. Partial cram-down possible with 50% of all Extraordinary Maintenance: 6 year agreement with MHI61 (provides senior creditors. operational and financial guarantees in relation to the agreement), then First attempt to raise bond funding at the start establishment of maintenance reserve account. O&M:15 year agreement of construction (—10/98) was withdrawn due to with Entergy (provides operational and financial guarantees in relation with turmoil in the market (Asia and Russian the agreement). default). Bank finance was £463m senior debt and £36m sub-debt. Senior debt priced at 115- Risk Management: agreement with Entergy for hedging activities against 145bp. power and gas future prices and for credit support on market arrangements.
H-12 61 MHI: Mitsubishi Heavy Industries
H-13 Debt & Project Sponsor Pricing and Structure Remarks Arranger
H-14 11. SELCHP Onyx £55m 22 year private placement to Prudential, that also removes some of the The plant was financed through a £95m (UK 1999) (Vivendi - French multi shareholder guarantees. recourse financing arranged by BNP and Bank Waste-to-energy plant utility) Societe of Scotland. It did not sell and had to wait for refinancing of senior and Generale Working capital facilities provided by Societe Generale. syndication once construction was completed. mezzanine debt. CNIM (Constructions Industrielles Refinancing a bank loan at 125-150bp, expiring in 2006 Outside NFFO (expired in 1998), short term de la Mediterranee - French PPA with London Electricity. Operations construction firm) PPA: 3 year deal with London Electricity. Installed capacity of 32MW. started in 1994. Project will be exposed to Fuel contracts with 7 municipalities to supply 400,000 tons p.a. merchant risk, although the main revenues are from waste incineration gate fee payments.
A private placement to only one debt provider. Structured as a bond to enable Prudential to allocate the debt among its different funds. Pru’s largest single investment in project finance to date and the sponsors wanted a private placement.
SocGen will provide ongoing working capital, but is not linked to the senior debt.
H-15 12. Tyseley Waste Disposal Onyx £95m62 Wrapped by Financial Security Assurance (FSA). Limited recourse financing. (UK 1998) (Vivendi - French multi - Rating AAA, £88m of debt at 6.675%, 2018, priced at par (spread at issue Project bond for a 28 MW utility) Paribas 80bp over 9% 2008 Gilt). Bond default risk linked to the ability of the waste-to-energy incinerator. insurer FSA (AAA) to meet the bonds Amortisation: front weighted to ensure that by the 15 year mark principal is obligations. paid down to £18.3m (designed to protect FSA from a Vivendi default and end of NFFO period). Project financed under NFFO contract with NFPA. Performance and regulatory risk guaranteed by Vivendi (BBB+), through a L/C up to the full value of debt. Credit Commercial de Level of sponsor guarantees makes it a quasi France (AA) issued £18.5m L/C designed to protect FSA in the corporate deal. event of default by Vivendi. FSA has not underwritten regulatory & 2 Reserve Accounts: both 6 months debt service coverage. One reserve performance risk (secured by Vivendi) nor fuel account can be used to pay for unforeseen maintenance costs. risk (secured by Council guarantees). FSA has recourse on both Vivendi and the City of Main revenues are municipal waste incineration fees paid by Birmingham Birmingham for these. City Council. Fees rise in line with a composite index, designed to reflect Tysley ’s costs. Electricity revenues, guaranteed with NFFO PPA and split with Council.
62 Debt only
H-16 H-17 Debt & Project Sponsor Pricing and Structure Remarks Arranger 13. Kilroot Electric NIGEN £198m Unrated. 9.50%, 17 years tenor, issue at 99.896. UK’s first non-recourse bond issue in the power (UK 1994) Joint venture formed in market. Refinancing a non recourse 1992 by AES and BZW Repayment: amortising from 2006-2010 (five equal instalments). commercial debt transaction Tractebel ) Sold to UK insurance and pension funds and by AES and Tractebel to Salomon 13 year PPA contract with Northern Ireland Electricity (transmission and apparently no rating was required. acquire the 520MW coal/oil Brothers distribution company). power station in Northern The project takes market risk. Operating Ireland. Proven and operating technology reduces generating risk. track record made financiers comfortable. 14. Sutton Bridge Power Enron - 50% $150m Rating BBB See Appendix G for more details. (UK 1997) (US energy firm) (£93m) Project bond for a 790MW and A. US$ Tranche, Rule 144a, 7.97%, 25 year tenor, issued at par; Default risk linked to two large corporate gas combined cycle power SB Investors Ltd - 50% £195m B. Sterling Tranche, Bond, 8.625%, 25 years tenor, issued at 99.523. risks. Market & fuel are Enron risk (BBB+) station. (Private Investor Vehicle) up to year 2014. BZW Debt/equity - 85/15; Equity of £42m. DSCR: 2.5 to 1.00 during the merchant period (minimum DSCR forecast O&M linked risks are effectively GE risk Merrill Lynch by S&P's analysis assuming the plant becoming a peaker). (AAA) up to 2012, or 2018 if O&M agreement renewed. Plant passed commissioning tests in May 1999; Enron guarantees Capacity & Tolling agreement for input & output. Enron Bond riskier in the last years of its tenor due to pays a fixed price for output that comprises cost of the gas supply in a tolling agreement shorter than bond terms. exchange for all market proceeds. The agreement expires in 2014, if not renewed Sutton Bridge becomes a merchant plant. Note that projections include periods where available cash is just enough to service debt. O&M Agreement: 12 year GE Agreement, where GE assumes virtually all operating risks. Extendable for 6 years at Sutton Bridges' option Swap agreements to hedge dollar payment obligation.
H-18 15. Batesville Cogentrix Energy $325m Rating BBB- Similar structure to Sutton Bridge. PPA (US 1999) (US cogeneration project (£201m) default risk is Virginia (A-) and Aquila Bond issue to refinance an developer) A. $155m tranche; 14 year amortising bond, issued at 165bp over 9 year (BBB) corporate risk. 837MW combined cycle CSFB Treasury (7.164%); power station 60% into LS Power B. $170m tranche; 26 year tenor, issued at 230bp over 30 year Treasury Tolling agreements do not cover all 2nd tranche construction period. (US power (8.16%); Amortises between 2013 and 2025 (years 14-26). tenor, projections estimate a 45% margin between available cash flow and debt service company) Debt/equity - 86/14; payments (ie effectively a DSCR of 1.8). DSCR: 1.7 (average), 1.45 (minimum). Note: tranche ‘B’ repayment is done after 2 Tolling Agreements: 13 years with Virginia Electric and Power Co (2/3 expiration of the Virginia tolling agreement and of output, with a call option to extend to year 25); 15 years and 7 months repayment of tranche ‘A’. Risk is valued at with Aquila Power Corp a subsidiary of Utilicorp United, (1/3 output, with 65bp higher than tranche ‘A’. a call option for a further 5 years).
Construction Guarantee: BVZ (Black & Veatch and Zachry JV) O&M: LS Power.
H-19 Debt & Project Sponsor Pricing and Structure Remarks Arranger
H-20 16. Pacific Klamath City of Klamath Falls $308.6m Three tranches: Default risk linked to Pacificorp Energy (Oregon) (£190) (BBB+) ability to meet its 30 year (US 1999) A. Unrated tax exempt senior - $220m: (all priced at par) - 25% placed tolling agreement (47% electricity Non recourse bond issue to Lehman to private entities and 75% placed to municipalities or non federal build a 484MW gas-fired Brothers government agencies, made up of: output, 100% gas input) and O&M cogeneration power station. 1. $22.6m, 5.5%, 2007; agreement obligations. 2. $44.9m, 5.75%, 2013; Finance cost is lowered by the use of tax 3. $28.9m, 5.875%, 2016; exempt bonds. 4. $123.6m, 6%, 2025; Taxable senior debt unrated, as placed with a B. Taxable senior, private placement to approved institutional investors - restricted number of institutional investors. no SEC registration required: $28.6m, 10%, 2025, Yield 10.19%, issued below par; Taxable subordinated debt yield lower than taxable senior debt yield due to the Pacificorp C. Taxable subordinated bond (Rating: BBB+): $60m, 8.2%, 2025, Yield guarantee (ie same credit rating). 8.34%, issued below par. DSCR: Average 2.09, Minimum 1.74; Lehman Brothers received $4.2m. Tax exempt senior debt structured to meet needs of investors - presumably a negotiated placement. Tolling agreements (30 years, 47% of total off-take) signed by Pacific Klamath Energy (subsidiary of Pacificorp). Similar to PFI deals, due to public-private “partnering”. Steam sale agreement signed with local wood industry (no minimum requirement).
Pacificorp guarantee for US$60m subordinated bond. Construction and Performance guaranteed by Black & Veatch. O&M provided by Pacificorp.
H-21 17. AES Eastern Energy AES Corp $550m Rating BBB-, $550m unsecured pass-through certificates, Rule144A Bond funds only two of the four power stations. (US 1999) (US power company) (£340m) Bonds non recourse to Two Tranches: No dividend distribution to AES unless AES for the acquisition Morgan A. 350bp over Treasuries, 2017 (12.5 years average life); coverage debt equals or exceeds 1.7. of four coal plants from Stanley B. 350bp over Treasuries, 2029 (22 years average life). New York State Electric & Division of risk between AES and the Gas. Forecasted DSCR: over 2.00; Two debt reserve accounts: 1 year. NYSEG (the off-taker): NYSEG assumes capacity risk for 2 years, while AES Eastern Two year (upto April 2001) capacity (representing ~10% of total Energy takes price risk. revenues) agreement with NYSEG at spot market prices.
Two year contract with Merchant Energy Group of the America (MEGA) to market the plants' energy.
Fuel supply: short-term contracts with 3 Pittsburgh coal suppliers.
H-22 H-23 (3) Off Balance Sheet Bonds - Stranded Costs
Debt & Project Sponsor Pricing and Structure Remarks Arranger 18. Orchid Securities Finmeccanica SpA $335m Rating AAA - Recourse on the Republic of Italy. Collateral are receivables, no fixed assets. (Italy 1996) (Italian manufacturing (£207m) SPV securitising nuclear group - Seller of nuclear Amortised secured floating-rate notes due February 2008. The SPV Issue in US Dollars in order to access a larger credits arising from the credits to SPV) Merrill Lynch incorporated in the Caymans (tax issues) and bought, with the proceeds of and more liquid market. moratorium on nuclear the bonds, Finmeccanica’s nuclear credits. Credits are reimbursed through construction in Italy. a “nuclear surcharge” paid by Italian electricity consumers, collected by the Nuclear credit agreement electricity utility Enel and then distributed to nuclear creditors. These guaranteed by Italian Government. nuclear credits form the collateral for the bond issue. A currency swap is used as payment of nuclear credits is denominated in Italian lire. The swap Achieved higher rating than the Sovereign, due also covers interest basis risk arising from the notes paying interest on to the risk being spread across the economy, three-month US dollar LIBOR and the nuclear credits paying interest at the without ‘political’ risk interposed. ABI (Italian Bank Association) prime rate.
H-24 19. PECO Energy PECO Energy $4bn Rating AAA Unlike Orchid Securities, neither Pennsylvania Transition Trust (US utility - seller of future (£2.472bn) 7 separate classes with weighted average lives (AL) ranging from 1.3 to 8.9 State, nor the Federal authorities can abrogate (US 1999) surcharge - income to SPV) years; 2 classes have floating interest rate: PECO’s rights to its transition charges; i.e. Securitisation of PECO Salomon A. 244.3m, 5.502%, AL 1.3 years; removes regulatory risk. Energy stranded cost due to Smith Barney B. 275.6m, 5.656%, AL 3.26 years; market liberalisation. C. 666.4m, 17bp over LIBOR-6m, AL 4.03 years; Credits guaranteed neither at D. 459m, 5.83%, AL 5.37 years; E. 464.2m, 23bp over LIBOR-6m, AL 6.28 years; federal level nor at the F. 993.6m, 6.073%, AL 7.28 years; Pennsylvanian state, therefore over G. 896.8m, 6.155%, AL 8.91 years. collateralisation was necessary. Electricity price risk. Stranded cost is recovered through a surcharge levied on retail electricity bills, with the surcharge as the collateral to bond holders. The proceeds will be used to recover investment made during the regulated period. Two reserve accounts: Consequently proceeds will be used to reduce Capital Account - 0.5% of principal fully funded at financial close, Over capitalisation on a pro rata basis. Collateralization Account - 2% of principal to be funded throughout the term of transaction.
Surcharge rates are variable. The Reconciliation of Competitive Transition Charge (CTC) is the name of the mechanism that re-calculates every year the necessary adjustments to the CTC rates, to recover the total CTC Revenue Requirement.
H-25 H-26 (4) Off Balance Sheet Bonds - Infrastructure
Debt & Project Sponsor Pricing and Structure Remarks Arranger 20. Stirling Water Thames Water - 49% £79m Rating AAA (Rating Fees: £18,000 pa.) Purchase of output by East (UK 1999) (UK water utility) Scotland Water Authority, a PFI linked bonds for three RBC Coupon: 5.822%, 27.5 years, yield at issue: 120bp over 8% 2015 Gilt. water projects (Seafield, MJ Gleeson - 41% Dominion creditworthy government owned Almond Valley and Esk) in (contractor) Securities Wrapped by MBIA Ambac (unconditional and irrevocable guarantee of agency, hence low cover ratios. Scotland.Two separate issues: (formerly payment of scheduled interest and principal); Wrapping fee: 45bp p.a. The projects credit profile is one for Seafield and Almond Montgomery Watson - Hambros) equivalent to £4m up-front & £39,000 commitment fee. enhanced by MBIA’s wrap. Valley, the second for Esk 10% (delayed by planning (environmental engineering Lead Arranger underwriting fee: 1.25%. Experienced and high rated sponsor (Thames permission). and construction firm) Water) supporting the project. Principal repayment grace period: 5.5 years; Interest repayment grace period: 2.5 years. EPC firm committed as O&M provider and shareholder, which is sometimes seen as a Debt/Equity: 80/20; £14.835m Subdebt, £4.95m Equity. conflict of interest. DSCR: 1.04 Minimum, 1.13 Average; Debt Service Reserve Account: 1year during construction, 6 months Predictable business cycles, with reliable cash during operation. flows. Construction guarantee (Ml Gleeson): 100% initially during construction it decreases to 50% of bonds drawn down towards completion. Guarantee Risks: cost 90bp on amount, plus 50 bp commitment fee. Uncertainty on long term water flow projections; L/D's £120,000 week (£6.24m over lyear). Change in environmental regulations; New Scottish Parliament’s level of support Trustee: Prudential - £lk pa construction and £4k pa operation + £10k if for PFI. wound up.
30-year purchase contract with the government-owned East Scotland Water Authority (ESW) and 30-year service contract, which includes a number of protective clauses against uncontrollable events (i.e. force majeure).
H-27 21. Stirling Water Thames Water - 49% £30m Bonds are part of the above issue (same documentation). Total debt issue is £108m. (UK 1999) (UK water utility) Same coupon 5.822% , but due to interest rate change bonds were issued PFI linked bonds for the Esk RBC under par at 94.308, giving an effective yield at issue of 6.376%. water projects. MJ Gleeson - 41% Dominion (contractor) Securities
Montgomery Watson - 10% (environmental engineering and construction firm)
H-28 Debt & Project Sponsor Pricing and Structure Remarks Arranger 22. M6 Road Amey Construction 19.5% £250m FSA Wrapped Bond; Rating AAA; 8.39%; tenor 25 years. Payments due are UK Government risks. (UK 1997) (UK contractor) The projects credit profile is enhanced by PFI DBFO road programme; Morgan Debt/equity - 93/7. Debt subdivided as follows: FSA’s wrap. Note shadow toll agreement . Issuer is Autolink Sir Robert McAlpine Stanley A. £125m 25-year bonds; Concessionaires with a 19.5% B. £69m EIB loan facility; Payment projections structured on the basis of concession period of 30 years. (UK construction company) C. £19m of privately placed unrated subordinated bonds; an estimated flow of cars using the road. D. £16m of sponsors equity and subordinated debt. Taylor Woodrow Volume risk. Construction 19.5% Shadow toll mechanism whereby the government pays variable fees based (UK contractor) on the level of traffic.
Barr Holdings 6.5% £230m completion guarantee (5 years) arranged by IBJ; L/C commission; private company 1.4% or 2.4% over LIBOR if L/C is exercised. investor) Part of EIB loan facility provides various backup facilities: a cost overrun facility, a maintenance reserve fund and some debt service reserves. Innisfree PFI Fund 35% (private equity investment fund for PFI projects)
H-29 23. South Tees Endeavour Consortium: £137m Rating AAA, 3.607% (first coupon), tenor 32 years, priced at 99.992, Yield Payments due are UK Government risks. (UK 1999) 3.54% (130bp over index linked Gilt 2016). The projects credit profile is enhanced by PFI linked bonds for a 32 year John Mowlem - 19% Barclays FSA’s wrap. Note quality indicators. concession to build and (contractor) Index Linked, FSA Wrapped Bond (wrapping fee: 35bp). manage a hospital near Largest UK hospital PFI deal. Middlesborough. Innisfree Partners - Senior Debt finance fees £6.6m, Arranging Fee: 65bp; Commitment Fee: 45.5% 50bp. NHS retained patient volume, revenue, medical (private equity investment technology, health provision and some building fund for PFI projects) Debt/equity - 83/17; DSCR: 1.265 Annual, 1.39 Average. risks. Risk allocation for the sponsor made easier as construction provided by the Barclays Infrastructure Expected RoE: 18.46%. Equity £7m; £5.5m equity from NHS. consortium. Fund - 35.5% Subordinated debt £20m (finance fees £630k), £10m repaid by year 10 Bond selected due to longer tenor (banks only (debt/equity ratio in year 10 will be 94/6), remaining £10m repaid as a offered 27 years) and wrapping gave certainty bullet one year after bond repayment; of execution (as just post Russian default).
Construction Period is 3.9 years, with a £42.7m performance bond backed Sponsor exposed to basis risk between by Zurich Insurance. operating cost inflation and RPI. Fee has two components: a fixed availability fee linked to Revenue is split between an availability fee (68% total revenue) and a RPI and a service fee linked to RPI but market service fee. tested every 5 years. Fees are linked to quality indicators and reduced if indicators deteriorate.
H-30 H-31 Debt & Project Sponsor Pricing and Structure Remarks Arranger 24. Queen Elizabeth Meridian Consortium: £119m Rating BBB+. Payments due are UK Government risks. No Hospital wrap to guarantee project performance. (UK 1998) Kvaerner Construction Barclays Index Linked Eurobond. Note rate (160bp for BBB+) compared to PFI linked bonds for a 32 year (Anglo-Norwegian South Tees (Deal 23 - 130bp for AAA). (renewable for another 30) engineering group) First coupon 4.1875%, tenor: 30 years, 17.5 year average life, spread at concession from Greenwich issue: 160bp over 2016 index linked Gilt. Index linking removes mismatch between Healthcare NHS Trust, under Innisfree Partners assets and liabilities. which it virtually demolishes (private equity investment Amortised Principal Repayment end weighted. the existing Queen Elizabeth fund for PFI projects) Note risk to Meridian if its costs rise faster than Hospital in Greenwich. Debt is divided between £86.2m (Original Budget - base case) and £5m the index payments they are linked to. (Contingencies). Service fee linked to quality indicators. If Equity contributions: £5m Equity, £10.09m Subordinated Debt indicators deteriorate, fee is reduced. Trust Contribution: £13.6m. Part of the hospital belongs to the MoD. DSCR: 1.31 (minimum); Debt Service Reserve Account: 6 months.
Concession for 32 years, covering building maintenance (main fee) and a service fee for laundry, catering and other soft services. Fees agreed in advanced but are index linked to PPI (Producer Price Index).
H-32 H-33 (5) On Balance Sheet Commercial Bank Debt - Electricity
H-34 Sponsor, Date and Description Principal Terms Remarks Country of Issue 25. National Grid Co Transmission system $2.75bn Rating: AA+ The purposes of the loan are: (UK 04/99) owner - total assets of (£1.7bn) £4.9bn (pre-acquisition) Four facilities: 1) To back the $3.2bn acquisition of New £250m 1. $850m 5 year credit multicurrency 57.5bp; England Electric Systems and Eastern Utilities 2. $550m 5 year multicurrency revolving 57.5bp; Associates; ABN AMRO 3. $1.35bn 364 day revolving (to be drawn no later than the 3rd 2) To refinance New England Electricity Barclays anniversary from signing) 57.5bp; System ’s debt; Chase 4. £250m 5 year multicurrency revolving credit 57.2bp. 3) Other corporate purposes. Deutsche DKB Margin over Libor: Facilities ‘A’ to ‘C’ are for both National Grid HSBC Facilities 1 to 3 can drop to 50bp and facility 4 to 45bp if less than and its subsidiaries. Facility ‘D’ is only for $2.025bn is committed; parent use (sterling currency). Facilities 1, 2, and 3 can drop to 42.5bp and facility 4 to 37.5bp if less than $1.575bn is committed. S&P quote AA risk as: capacity to repay is strong and differs from the highest quality Commitment Fees: only by a very small amount. Facilities 1 to 3 pay 25bp before the acquisition and the lower of 25bp and half the margin thereafter; Facility 4 pays 20bp before the acquisition and the lower of 22.5bp and half its margin thereafter.
26. Scottish Power Integrated Utility - total £2.6bn Rating: A+ S&P - A+ risk: has strong capacity to UK assets of £6.2bn repay; borrower is susceptible to adverse Royal Bank of Facility ‘A’ - £2bn 2 years (matures 2001) term 45bp; (UK 03/98) effects of changes in circumstances and Scotland Facility ‘B’ - £0.6bn 2 year (matures 2001) revolving 45bp. economic conditions.
CommitmentFee fixed at 17.5bp. Refinancing a 5 year facility first arranged in 1996 to support a bid for Southern Water and for other general purposes. The facility was undrawn, although the bid was successful.
Proceeds used as a bridge financing to acquire Pacificorp (US). The acquisition was done through a share swap and made Scottish Power do a $835m share buyback to support its price.
H-35 H-36 Sponsor, Date and Description Principal Terms Remarks Country of Issue 27. PowerGen UK Integrated Utility - total £2.4bn Rating: A S&P - A risk: capacity to repay is strong (UK 07/98) assets of £5.9bn and differs from the Scottish Power (A+) Deutsche Bank Three facilities: qualityonly by a very small amount. Goldman Sachs 1. £500m 364 day revolver 50bp; HSBC 2. £1bn 5 year revolver 50bp; Proceeds to: 3. £900m 5 year amortising term loan 50bp. - finance £1.9bn East Midland acquisition; - refinance previous loan arranged in 1995. Margin over Libor Margin is adjusted in a 35bp to 55bp band subject to values of the debt to EBITDA ratio.
Commitment Fees Facility one: 12.5bp; Facility two: 50% of applicable margin.
28. National Power Integrated Utility - Total £1.25bn Rating: A Same risk profile as PowerGen (UK 12/98) assets of £6.9bn Barclays Facility 'A' £500m 364 day facility 27.5bp; Working capital facility that will refinance a Chase Facility 'B' £750m five year term loan 25bp. £500m revolver. The tenor was 5 years, a Citibank margin of 17bp and a commitment fee of 8.5bp. NatWest Margin over Libor Facility ‘A’ additional 7.5bp if over 50% of facility is drawn; National Power had just undergone the Facility ‘B’ additional 5bp if more over 50% of facility is drawn. acquisitions of the supply arm of Midland Electricity (£300m) and 25% of the generating Commitment Fees assets of Spanish Union Fenosa (£400m). Facility ‘A’ 10bp; Facility 'B' 5bp. Financing done shortly after the 1998 Russian default.
H-37 29. Hyder Integrated Utility - total £450m Rating: BBB+ S&P - BBB risk: has adequate capacity to (UK 09/97) assets of £3.9bn 5 year, pricing not disclosed by the borrower. repay, but adverse economic conditions or ING Barings circumstances are more likely to lead to risk. Ten banks providing debt, margin range (varies according to bidding) over Libor between 15bp to maximum of 20bp. Facility replacing £750m revolver to finance the acquisition of South Wales Electricity.
Facility reduces borrowing cost as well as locking in a more favourable covenant package.
H-38 H-39 (6) On Balance Sheet Bond Debt - Electricity
Sponsor, Date and Description Principal Terms Remarks Country of Issue 30. National Power Integrated Utility - total £200m Rating A The issue was launched at a spread of 93bp (UK 05/97) assets of £6.9bn Tenor: 25 years (matures 08/22) Coupon: 8.125% over the 8% 08/21 Gilt, pricing it 101.201 (indicative yield of 8.02%).
31. Hyder Integrated Utility - total £140m Rating BBB+ The issue was launched at a spread of (UK 12/98) assets of £3.9bn Tenor: 22 years (matures 04/20) Coupon: 7.00% 235bp over the 8% 08/21 Gilt, pricing it at 99.151. 32. National Grid Co Transmission system owner £450m Rating: AA+ The issue was launched at a spread of (UK 01/99) - total assets of £4.9bn Tenor: 25 years (matures 12/24) Coupon: 5.875% 140bp over the 8% 08/21 Gilt, pricing it £99.076 (indicative yield of 5.9%).
33. PowerGen UK Integrated Utility - total £2 50m Rating A Marketed at 170bp over the 8% 06/21 Gilt, (UK 03/99) assets of £5.9bn Tenor: 25 years (matures 04/24) Coupon: 6.250% pricing it £97.864 (indicative yield of 6.4%). Price was based looking at National Power’s yield of its £200m 25 year bond (93bp at issue). The wider spread (opposed National Power’s £250m issue) was due to the moment of heavy supply of Sterling issues (due to the end of the Russian and Asian crisis) together with high interest swaps rates (macro-economic uncertainties).
34. Northern States Power Minnesotan utility - 33rcl $150m Rating AA Indicative spread over US Treasuries 65bp (US 03/98) largest US utility with Tenor: 30 years (matures 03/28) Coupon: 6.500% assets of $7.4bn
35. Wisconsin Electric Wisconsin utility - 41st $150m Rating AA+ Indicative spread over US Treasuries 70bp. Power largest US utility with Tenor: 30 years (matures 06/28) Coupon: 6.500% (US 05/98) assets of $5.4bn
36. Duke Energy North Carolina based 4th $3 00m Rating AA+ Indicative spread over US Treasuries 100bp. (US 12/98) largest US utility with Tenor: 30 years (matures 12/28) Coupon: 6.000% assets of $26.8bn
H-40