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Loan Guarantees and the Economics of Electricity Generating Technologies |
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The loan guarantee program authorized in Title XVII of EPACT2005 is not included in AEO2007, because the Federal Credit Reform Act of 1990 requires congressional authorization of loan guarantees in an appropriations act before a Federal agency can make a binding loan guarantee agreement. As of October 2006, Congress had not provided the legislation necessary for DOE to implement the loan guarantee program (see “Legislation and Regulations”). In August 2006, however, DOE invited firms to submit “pre applications” for the first $2 billion in potential loan guarantees. The EPACT2005 loan guarantee program could provide incentives for a wide array of new energy technologies. Technologies potentially eligible for loan guarantees include renewable energy systems, advanced fossil energy technologies, hydrogen fuel cell technologies, advanced nuclear energy facilities, CCS technologies, efficient generation, transmission, and distribution technologies for electric power, efficient end-use technologies, production facilities for fuel-efficient vehicles, pollution control technologies, and new refineries. In the electric power sector, the loan guarantee program could substantially affect the economics of new power plants, for three reasons. First, Federal loan guarantees would allow lenders to be reimbursed in cases of default, but only for certain electric power sector technologies. Consequently, they would be willing to provide loans for power plant construction at lower interest rates, which would reduce borrowing costs. For example, a number of private companies guarantee loans made by State and local governments. Such insured loans typically are rated AAA (very low risk) and therefore have relatively low yields. Indeed, municipalities purchase such insurance because the decrease in interest rate is greater than the insurance premiums. Second, firms typically finance construction projects by using a capital structure that consists of a mix of debt (loans) and equity (funds supplied from the owners of the firm). Debt financing usually is less expensive than equity financing, and up to some point, the average cost of capital (the weighted average cost of debt and equity financing) can be reduced by substituting debt for equity financing. (The substitution of debt for equity is called leveraging.) After that point, however, projects financed with large amounts of debt can be very risky, and additional debt financing can increase the average cost of capital rather than lower it. Thus, there are constraints on the use of leverage. In many industries, capital structures tend to include 40 to 60 percent debt. With loan guarantees, however, the risks of highly leveraged projects are shifted to the guarantor, and more leveraging can be used to reduce the average cost of capital for construction projects. Federal loan guarantees also can allow potential sponsors to participate in one or more major projects while avoiding the risk of possible failure, which might be caused by factors such as construction cost overruns or lower than expected electricity prices and, potentially, could threaten the financial viability of the sponsoring firm. To avoid this problem, beginning in the 1990s, many firms used project financing to build electric power plants, including a number of merchant natural-gas-fired plants that were built in the late 1990s and early 2000s. Under project financing, a power plant under construction is treated as if it were owned by a separate entity whose sole asset is that new power plant. Thus, the loan is secured only by the new plant. This is also referred to as non-recourse financing. Because lenders for the plant’s construction have claims only on the power plant in case of default, the project’s risk is quarantined. That is, the lenders have no claims on the firm’s other assets in case of default, and the project’s failure will have only limited effect on the firm’s creditworthiness and overall financial health. From the firm’s perspective, there are clear advantages to using project financing. From the lender’s perspective, however, project (non-recourse) financing can be very risky, especially if the project is highly leveraged. If the project fails and the firm defaults on its loans, the power plant will be sold; but if market electricity prices and thus the value of the asset are depressed at the time of the sale, the lender may not be able to recover all its costs. In addition, the administrative costs associated with bond default can be substantial. Consequently, given the inherent risk of large-scale projects, it could be very difficult to obtain project financing for a multi-billion-dollar power plant at a cost that would allow the project to remain economical. Federal loan guarantees would thus provide an incentive program for potential lenders. To examine the potential impacts of DOE’s loan guarantee program on the economics of various capital-intensive electricity generating technologies, the levelized costs of electricity generation from newly built power plants financed with and without loan guarantees were computed, using plant cost and performance assumptions from the AEO2007 reference case. In the case without guarantees, financial assumptions from the reference case were also used, including average equity financing costs of about 14 percent over the 2006-2030 period, average debt financing costs of about 8.0 percent, capital structures consisting of 55 percent equity and 45 percent debt, and a capital recovery period of 20 years. In the case with loan guarantees, capital structures of 20 percent equity and 80 percent debt were assumed. The capital structure assumption in the loan guarantees case is typical of the financing for construction projects for some merchant natural-gas-fired power plant that have been built by companies with long-term power purchase contracts. In addition, DOE has stated that its loan guarantees under the new program will cover no more than 80 percent of the debt for any project. It was assumed that the yields on such guaranteed debt would be halfway between risk-free 10-year Treasury bonds and very low but not riskless AAA corporate bonds. Based on average yields over the past 25 years, this assumption implies that, with the loan guarantees, the cost of the insured portion of the debt would fall by about 1.5 percentage points, to about 6.5 percent on average over the 2006-2030 period. The uninsured portion of the debt (20 percent of 80 percent) would be relatively risky, however, and probably would be rated below investment grade. Thus, it was assumed that the cost of the uninsured debt would be at the lower end of the yields to high-yield (fairly risky) corporate bonds, or about 1.5 percentage points higher than the 8.0 percent assumed in the case without guarantees. In total, the cost of debt averaged over the insured and uninsured portions of project debt financing in the case with loan guarantees would be 7.1 percent—about 0.9 percentage point below the 8.0 percent assumed in the case without loan guarantees.
Projections from the two alternative cases are shown in Table 9 for the levelized costs of generating electricity from various technologies at power plants becoming operational in 2015. The results show that loan guarantees would significantly lower the levelized costs for eligible generating technologies. (Conventional coal-fired and combined-cycle natural-gas-fired plants do not qualify for the loan guarantee program.) In addition, because the loan guarantee program reduces financing costs, the greater a technology’s capital intensity, the greater would be the percentage reduction in total generation costs. For a (capital-intensive) new nuclear power plant or wind farm that received a loan guarantee, the levelized cost of its electricity production is reduced by about 25 percent under the assumptions outlined above.
Contact: James Hewlett |
