When it comes to financing new energy facilities, somebody has to take risk. It usually comes down to the developer or the consumer. If neither is willing, the project's plan is shelved.
Historically, most gas and electric projects were hedged against the state. Under this arrangement, state regulators guaranteed debt holders they would recover their loans and interest expense. Regulators also guaranteed equity holders revenues high enough to assure them a margin.
The art of project financing was optimizing the debt and equity ratio. If interests were low, states and utilities would seek higher debt levels and lower gross returns on equity. Depending on rates, most projects could justify 60% debt and 40% equity. Some sought higher ratios; up near 80% debt and 20% equity.
The state passed the project's risks on to their consumers through the state's system of tariffs. State-approved tariffs would require consumers to pay investors expected returns through utility rates. In the end, consumers assumed almost all financial risks to build natural gas pipelines, electric transmission lines, gas and electric distribution systems and power plants.
In fact, every commercial nuclear power plant built in the U.S. had government guarantees. The same is true with all utility-owned coal-fired power plants, oil-fired plants and most gas-fired power plants.
However, a decade ago, several states reconsidered their role as hedge managers. One by one, they decided the market was a better tool to manage certain gas and electric assets. Many of these states restructured their utilities. They unwound their hedges. They no longer guarantee returns for large energy projects.
With an important hedge gone, restructured utilities looked elsewhere to offset their market risks. Larger projects found few willing to assume market risks. In fact, most project developers could not find a single party willing to speculate on an obvious energy projects.
There are short-term power purchase agreements available. Some grids offer capacity payments on a year-to-year basis. However, none of these arrangements will work for project financing, because the commitment is too short.
To attract low cost debt, projects need bankable third parties to hedge production for as long as any ratable debt remains in place. Most debt has terms of 20 or 30 years. Therefore, developers must find buyers willing to commit to buy power for 20 or 30 years.
In the private sector, those buyers are difficult to find. The only entity willing to take long-term risk positions are state governments. Most state governments are only interested in renewable energy.
The state of California has been one of the nation's largest sources of power purchase agreements. They reverted to the old model. California assumed the risk and transferred it to PG&E's (PCG) Pacific Gas and Electric utility, Sempra Energy's (SRE) San Diego Gas & Electric and Edison International's (EIX) Southern California Edison. In return, these utilities had state permission to pass on their costs to customers. In the end, the customers are assuming most of the risk.
At least 22 other states authorized power purchase arrangements directed at renewable energy (six states specifically disallow or restrict such agreements). Most of these agreements do not cover traditional power production.
This means many large and important projects are on the shelf. Most of these projects offer reliable sources of power. They are compliant and relatively clean. They are economic in the traditional sense. They provide a balance in the grid's merit order. They just cannot be financed.
Some may ask, why not shift the risk from the consumer to the developer?
Some have. There are small gas turbines and upradedes that have or will go forward. Two or three speculative large-scale gas turbine projects may go forward. In all likelihood, these projects will have their debt holders in firm control of the cash flows. However, these larger projects have yet to seriously commit.
The lack of financing and the magic of debt and equity ratios help Exelon (EXC), NRG Energy (NRG) and Calpine (CPN). It may even help Entergy (ETR). Project financing has become a barrier to competition. Existing fleets may be depleting, but they need not fear new entrants, particularly for base load.
In the end, something has to give. Some expect the power and natural gas markets will break, high prices will become norm and investors will rush in. Others believe market rules will have to change. In the meantime, and it could be a long time, incumbents' hands are becoming incrementally stronger.