Privatesector P U B L I C P O L I C Y F O R T H E The World Bank October 1995 Note No. 56 Private Power Financing—From Project Finance to Corporate Finance Karl G. Jechoutek Limited recourse project financing of power consumers, and thus increase demand uncer- and generation projects has been widely promoted tainty, balance sheet support by IPPs will play Ranjit Lamech as a solution to the intractable problem of get- an important role in sharing demand risk among ting private credit to a sector dominated by key participants. noncreditworthy borrowers and public agen- cies—from the point of view of both those sup- Project finance is more expensive plying capital and those needing it. When the for an IPP lights are going out, incumbent power enter- prises are financially unviable, and the public Project finance implies that the lenders to a purse is nearly empty, project financing of in- project have recourse (or claim) only to the dependent power producers (IPPs) may seem project’s cash flows and assets. In effect, then, the only way to get new capacity fast. In the the project is financed “off the balance sheet” developing world, however, the public-private of the project sponsors. Such project finance is partnership in project-financed IPP ventures has termed nonrecourse and is at one extreme of been disappointingly slow to produce results. the project finance–corporate finance con- tinuum of financing possibilities. In practice, This Note argues that, to achieve substantive project finance in developing countries is progress in IPP financing, limited recourse backed by sponsor or government guarantees project financing will have to evolve toward provided to give lenders extra comfort. This is structures with greater balance sheet support. limited recourse project financing, involving at The need for corporate balance sheet support least a small degree of corporate or balance for private power sector investments is gradu- sheet support. ally being recognized, and the benefits of this shift in financing structure are worth reflecting In traditional corporate financing, at the other on. First, balance sheet support by the main extreme of the financing continuum, lenders partners in an IPP financing offers greater se- rely on the overall creditworthiness of the en- curity to lenders and provides easier (and per- terprise financing a new project to provide them haps cheaper) access to long-term debt—critical security. If the enterprise is publicly held, in- to sustainable power sector financing given that formation on its performance and viability is IPPs typically depend on debt for 60 to 75 per- usually available through stock markets, rating cent of their financing requirements. Second, agencies, and other market-making institutions. while equity in limited recourse project finance This combination of security, liquidity, and in- is almost exclusively private, balance sheet sup- formation availability allows debt to be issued port by IPP sponsors can open access to pub- at a lower cost than through project finance. lic equity markets, which are deeper and Further, because the enterprise’s overall risk is generally cheaper. Third, increased corporate diversified over all the activities that it is en- balance sheet support is a corollary to the re- gaged in, the cost of equity is also usually lower. structuring in the world’s power sectors. As sec- The financing advantage for both debt and tor unbundling and self-generation expand equity makes the overall cost of capital lower choice for wholesale and (potentially) retail for corporate finance. Industry and Energy Department ▪ Vice Presidency for Finance and Private Sector Development Private Power Financing—From Project Finance to Corporate Finance Systematic empirical evidence specific to the find financing at the lowest cost, as differences power sector in the developing world is lack- in technical and operating abilities become ing, but anecdotal evidence suggests that cor- virtually indistinguishable among the front- porate finance is indeed cheaper than project runners. (Other attributes may, however, pre- finance. Corporate financing also has signifi- dominate in negotiated, noncompetitive IPP cant transaction cost advantages because it deals.) In the competitive international IPP avoids the high cost of negotiating the web of market, several trends indicate that balance carefully structured legal contracts with pur- sheet support is the preferred means for achiev- chasers and commercial lenders necessary un- ing this cost-of-capital advantage. der project financing.1 Raising capital using a parent’s balance sheet The IPP experience in the United States offers useful insights, and indicates that the project- Project developers are putting their own bal- financed independent generation model may ance sheets at risk—or those of their parent not necessarily be the most efficient mode for companies—to raise cheaper debt for projects capital formation in generation. Nor is it the and to finance their equity contribution. Projects dominant mode in other countries. The United in which sponsors have used their own bal- States pioneered generation by independent ance sheets to raise finance include the Puerto operators on a merchant basis, and it is where Quetzal project in Guatemala (Enron), the the now ubiquitous term independent power Puerto Plata project in the Dominican Repub- producer, or IPP, originated. Project-financed lic (Enron), and the Upper Mahaiao and independent generators have thrived in the Mahanagdong projects in the Philippines (Cali- United States, contributing more than half the fornia Energy). Chinese IPP developers, such additions to generation capacity in recent years. as Huaneng Power and Xinli (Sunburst Energy), It has been shown that the cost of capital for a an affiliate of CITIC, have also used this strat- purchasing U.S. utility may be higher if it egy. California Energy pioneered the largest cor- chooses to build its own generation capacity porate financing in the independent power rather than purchase power from an IPP. 2 But business, raising US$530 million through ten- much of the advantage is due to the adversarial year securitized bonds in March 1994. regulatory environment in the United States, which favors IPPs. Purchasing utilities weigh Creating consolidated balance sheets the risk that state regulators will disallow in- vestment costs against the perceived lower risk Developers are pooling projects into entities (and lower profits) of purchasing electricity that are then able to raise capital on the strength from an IPP, an arrangement in which all costs of a combined balance sheet comprising the can be passed through or expensed. The pref- “pooled” assets of the different projects. Pro- erence for purchasing power from IPPs is eas- viders of equity and debt then finance the busi- ily rationalized when one notes how many ness of building and operating private utilities and their bondholders were hurt in the generation facilities rather than an individual 1970s and 1980s, when regulators disallowed power plant. Pooling spreads project risk. For cost recovery for large investments in capacity. a multinational developer, it also reduces country-specific risk. And for a developer with Increasing balance sheet support a few projects already under commercial op- for IPPs—The evidence eration, pooling offers the advantage of an immediate revenue stream for repaying debt Project developers operate in a fiercely com- and paying dividends. petitive market for international projects. As- suming competitive bidding, the primary source Pooling has two other benefits. First, it enables of competitive advantage lies in the ability to project developers to tap public equity mar- kets—most private project developers finance Core generation, transmission, and distribution the equity component of a project privately. functions are being separated, competition is Second, it enables developers to raise cheaper being introduced in wholesale and retail mar- debt on a corporate finance basis. IPP spon- kets, and technological progress is rapidly in- sors that have used this approach include Con- creasing the number of cost-effective options solidated Electric Power Asia (CEPA), the San for decentralized self-generation or coopera- Francisco–based Bicoastal Energy Investors tive generation. This restructuring will require Fund (EIF), and Huaneng Power International a redefinition of the underlying assumptions (HPI) of China. CEPA raised debt and equity in in power sector financing. the capital markets on the basis of its corpo- rate strategy of building multiple power plants The financial challenge will be to find ways to in Asia. EIF securitized its equity interests in provide lenders with adequate long-term rev- sixteen independent power projects in the enue security when the new industry structure United States, creating a synthetic balance sheet might not allow utilities to guarantee demand and issuing US$125 million of seventeen-year risk and price risk for the maturities required. bonds. And HPI, which owns 2,900 megawatts Traditional project finance is based on allocat- of capacity under commercial operation and ing demand risk to the purchaser, whether an has another 5,900 megawatts under construc- integrated utility, a central generator and pur- tion, raised US$332 million by listing its IPP chaser, a distribution utility, or a large consumer. business on the New York Stock Exchange in This risk allocation works well because purchas- October 1994.3 ers have a monopoly franchise area, which they are obliged to serve. But as direct access to con- Pursuing mergers and acquisitions sumers is encouraged—whether or not the sec- tor is broken up—purchasing utilities will face Industry consolidation has become a steady increased demand risk as the loss of retail cus- trend in the IPP business. Notable transactions tomers becomes a greater possibility. among international players include the pur- chase of CMS Generation by HYDRA-CO En- The key to any debt-based financing is the terprises, the purchase of Magma Energy by ability to provide adequate security through a California Energy Inc. (creating an enterprise contract or other credible evidence of future with annual revenues exceeding US$400 mil- revenue streams. Innovative sharing of demand lion), and the acquisition of J. Makowski Co. risk between market players—the power seller, Ltd. by PG&E Enterprises and Bechtel Enter- the power purchaser, and the financier—will prises to form International Generating Co. Ltd. become necessary. An IPP developer’s ability It has been argued that the increasing size and to bear any of the demand risk will depend in scope of projects is the main factor driving this part on its willingness to provide corporate as- change. Smaller companies are at an impor- sets and revenues as a backstop for lenders. tant disadvantage in international capital mar- kets compared with larger players, with their The view that well-capitalized corporate enti- greater experience, capitalization, and track ties will be the ones able to meet financial records. Although these mergers and acquisi- markets’ requirements in a competitive envi- tions could be driven by a number of strategic ronment seems to be confirmed by market re- objectives, increased balance sheet support in sponses. Most recent additions to generation project development is clearly one of them. capacity in the United Kingdom—the model of sector unbundling—have been corporate- The IPP financing challenge financed IPPs. And witness the efforts by in- dustry players in the United States to create Private financing needs to be tailored to the highly capitalized enterprises as competition changing structural relationships in the sector. for final consumers looms on the horizon. The Private Power Financing—From Project Finance to Corporate Finance recently announced US$1.26 billion merger of strategy would ease the overall financing costs Public Service Co. of Colorado and Southwest- of projects and could be a transitional strat- ern Public Service Co. is a reaction to the per- egy for meeting the huge financing needs for ceived increase in demand risk stemming from IPPs in developing countries. plans for wider retail competition—the utili- ties are noncontiguous and plan to build a con- 1 See Anthony A. Churchill, “Beyond Project Finance,” Electricity Jour- necting transmission line to share generating nal 8(5): 36–44, 1995. 2 resources. For the only systematic presentation of information on this issue, see Edward Kahn, Steven Stoft, and Timothy Belden, “Impact of Power Purchased from Non-Utilities on the Utility Cost of Capital,” Conclusion Utilities Policy 5(1): 3–11, 1995. 3 The proclaimed success of this transaction is controversial, as the share price of Huaneng dropped from US$14.25 at listing (October Greater corporate finance support will make it 1994) to about US$9 in mid-1995. possible to raise private capital for indepen- dent power financing from wider, deeper, and Karl G. Jechoutek, Division Chief, Power cheaper sources. But innovative strategies will Development, Efficiency, and Household Fuels be required from governments, lenders, inves- Division (email: kjechoutek@worldbank.org), tors, and power sector enterprises alike. The and Ranjit Lamech, Restructuring Specialist following strategies are worth considering: (email: rlamech@worldbank.org), Industry and ▪ Encourage the formation of large, well- Energy Department capitalized independent generation compa- nies. Purely private and quasi-private variants of the Huaneng merchant generation model in China might be workable in large power systems. Healthy competition should be en- gendered through prudent regulatory reviews This series is published of the market power of the IPP in a particu- to share ideas and invite lar system. discussion. It covers financial and private ▪ Encourage divestiture of commercially oper- sector development as ating (and perhaps underperforming) gen- well as industry and eration plants by incumbent utilities to IPP energy. The views expressed are those of developers. These sales should be conditional the authors and are not on the purchaser’s commitment to making intended to represent specified investments. By making positive an official statement of Bank policy or strategy. revenue streams available to IPP developers immediately, such transactions would give Comments are welcome. them the financial base to invest in multiple Please call the FPD Note line to leave a plants. message (202-458-1111) ▪ In IPP prequalification under competitive or contact Suzanne bidding, give greater weighting to IPP de- Smith, editor, Room G8105, The World Bank, velopers with businesses listed on a stock 1818 H Street, NW, exchange and to those with well-capitalized Washington, D.C. 20433, balance sheets. The strategic goals of pub- or Internet address ssmith7@worldbank.org. licly held entities are likely to be more trans- parent and longer term because of these 9 Printed on recycled entities’ obligations to public shareholders. paper. ▪ Encourage project sponsors to use balance sheet support for subordinated debt and quasi- equity portions of the project financing plan in order to increase corporate financing. This