FINANCING NUCLEAR | POLICY & FINANCE
contributions. The advantages of project financing are the availability of non-traditional loan sources, off-balance sheet treatment, and the ability to prevent recourse to an affiliate (including the parent company) in the event of a project’s default. The disadvantage of project financing is that the lenders only look to the cash flow of the project to service the loan which limits the pool of projects that can satisfy the loan covenants. Non-regulated electric power projects cannot use balance-sheet financing, and it was balance-sheet financing that was used to obtain the financing to build every nuclear plant everywhere around the world.
A primary task for lenders is to determine whether the
project will generate enough cash flow to cover the debt and pay dividends to the equity participants, and this determination considers all project risks and uncertainties, including the changes in revenue (price and output quantity) risks discussed previously. Based on the risks of a power plant project, the lender(s) will establish a minimum debt coverage ratio (DCR) and then calculate whether the project’s cash flow meets this minimum. The DCR is the primary tool used by lenders to account for such risk. Increasing the interest rate offered to a project is also a method used to account for risk, however, a change in the interest rate is captured in the calculation of the DCR and, thus, ultimately, the DCR remains the primary tool. If the project’s pro forma financial statements indicate that there may be instances where the minimum DCR will not be satisfied, the lender will either impose a new, lower debt:equity (D:E) ratio that will satisfy the minimum DCR requirement, or choose not to participate as a lender to the project. Therefore, an increase in any risk, including revenue risk, affects the willingness to lend. Moreover, a lender’s insistence on imposing a higher minimum DCR, while holding the project’s capital costs, revenue, and all other non-debt expenses constant will, by definition, lower the D:E ratio and thus require an increase in the quantity of equity. This creates a problem for the equity investors: it reduces their return on equity (ROE). The above financial concepts (DCR and D:E ratio) and their relationship to an increase in risk have been tested extensively and supported by financial research for over four decades.
Impact on equity The impact of risk on the valuation of equity has also been well-studied for many decades. The financial marketplace demands that assets with identical risk have the same rate of return on equity, and assets with higher risks require higher returns. In addition, the financial marketplace will adjust equity valuations due to an adjustment of the imputed cost of equity upon the arrival of new risk information. This includes information regarding the deregulation of electric markets and, as such, changes in revenue risk arising from deregulation will get reflected in the minimum required ROEs of electric projects. This creates a double whammy for equity investors: increases in risk increase the minimum DCR, which results in a lower ROE. At the same time these increases in risk lead to a higher minimum required ROE. Both of these factors, individually and/or jointly, work to reduce the availability of equity. Moreover, baseload power projects such as nuclear should be affected by the exposure to output quantity risk greater than a technology that is designed for peaking or
intermediate dispatch. While research has shown that every electric generating project faces increased revenue risk from deregulation, baseload projects such as nuclear with their high fixed cost/low variable cost structure that are vitally dependent on maintaining a high Q to ensure a low ATC, face an even greater revenue risk and thus further affect the availability of debt and equity financing.
Impact on the cost of capital and the availability of funds As already discussed, revenue risk affects the D:E ratio and the minimum required ROE, and both of these are inputs to the calculation of a project’s weighted average cost of capital (WACC). Thus, as risk increases, so does the WACC. For those investments that make use of project-financing, such as every power plant in a deregulated market, research has conclusively demonstrated that investors will provide funding sequentially in accordance with the ratio of each project’s internal rate of return (IRR) to its WACC. New power plants with high IRR:WACC ratios will get funded first and so forth down the line until either: a) the electric market demand is satisfied and there is no longer a need for the projects with lower IRR:WACC ratios, or b) investors have expended all of the funds in their energy portfolios. Those technologies with high IRR:WACC ratios attract funding. Those technologies with lower IRR:WACC ratios are unlikely to attract funding. Ratios less than unity have no chance of obtaining investment. The IRR:WACC ratio forms a straightforward metric for understanding which power plant technologies will obtain financing within deregulated electricity markets. High fixed cost/low variable cost projects, such
as nuclear, will have a higher WACC relative to other technologies due to the change in dispatch risk caused by deregulation. Everything else being equal, this higher WACC in the denominator of the IRR:WACC ratio will lessen the availability of investment funds for nuclear. In deregulated markets, all power plants selling into the grid within an ISO receive the same P at the same time, and thus the primary drivers affecting IRR are the capital cost of the power plant and its fuel cost. A quick comparison based on US Energy Information Agency data between several high fixed cost/low variable cost technologies shows the capital costs of wind and solar to be much less than the estimates for the new advanced modular designs, and this lower capital cost is what drives a higher IRR for wind and solar. The higher IRR in the numerator of the IRR:WACC ratio will increase the availability of investments funds for these projects and lessen the availability of investment funds for nuclear. To date, funds for nuclear within deregulated markets have been unavailable because there have been more than enough projects with higher IRR:WACC ratios to satisfy market demand. So long as there are projects seeking investment having higher IRR:WACC ratios, nuclear power will be crowded-out of the financial marketplace within deregulated markets.
Regulated vs. deregulated markets The key distinction regarding the availability of financing for nuclear plants is regulated markets versus deregulated markets. For example, the recently completed Vogtle nuclear units were constructed within the one-third of the US market that remained regulated. The units are owned by a regulated utility and thus were able to use
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