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By Richard M. Farmer
Thelen Reid Brown Raysman & Steiner LLP
Recent economic events have forced the rethinking of the business and financing models previously used for the development, financing and construction of large commercial and public infrastructure projects. In the electric power sector, the merchant power model, either without a power purchase agreement or with a short-term power purchase agreement, has resulted in the bankruptcies of a number of the largest merchant power developers, including, most recently, Calpine Corporation.
In the public sector, the development and financing of large infrastructure projects finally may be trending toward the public-private partnership model that has been used extensively in the United Kingdom and, more recently, elsewhere in Europe. It is becoming increasingly difficult, given debt loads and competing social imperatives, for municipal and state governments in the United States to finance such projects in the traditional manner with tax-exempt debt. Similarly, even the U.S. government is turning to project financing for certain of its infrastructure and other projects, as evidenced by the manner in which it has recently financed military housing facilities and an aircraft refueling facility located in the Middle East.
As a result, new and complex approaches to the project financing of infrastructure, often involving sophisticated financial architectures and hedging arrangements to properly allocate risk, are being developed. In addition, large institutions, high-yield debt funds and hedge funds have formed the backbone of the Term Loan B market, with floating rate term loans typically having 5- to 8-year maturities and lower-than-investment-grade ratings.
In the electric power sector, for example, in connection with the development and project financing of a greenfield project in the post-merchant plant era, it may become necessary, absent an appropriate power purchase agreement, for the developer to seek very early on to enter into financeable hedging arrangements covering electricity sales at commercial operation and/or fuel costs. These hedging arrangements would provide some assurances to prospective lenders before financial close concerning electricity revenues and/or fuel costs until appropriate power purchase agreements or definitive fuel arrangements could be entered into.
A further project financing complication is that many of the new projects in the electric sector involve renewable energy, which, despite the availability of tax credits, often remains a challenge to develop and finance. Similarly, much of the expected greenfield power development over the next decade in the United States is likely to be coal-fired, with longer development and construction periods and higher capital costs. This is especially likely to be the case for integrated gasification, combined-cycle projects. Despite the availability of tax credits provided by the Energy Policy Act of 2005, strong support undoubtedly will be needed from state or local governments promoting the development and use of local coal and from state public service commissions and traditional utilities to develop and finance integrated gasification projects. In addition, the project financing of transmission assets, despite the real need for new transmission capacity in certain parts of the country and the inclusion of provisions in the Energy Act facilitating their development and financing, will remain challenging.
Aside from greenfield power project development, much of the recent project financing activity in the United States has been directed toward corporate or project restructurings, either inside or outside bankruptcy proceedings, and refinancings. For example, there was the $320 million refinancing of the Crockett Cogeneration Project near San Francisco, California. In addition, there is a vibrant market in project acquisitions and divestitures, with private equity funds and, lately, hedge funds becoming major players. A good, recent example includes the successive transfers at higher prices of ownership of Texas Genco.
A complex, new area of project finance activity involves the U.S. government entering into contracts to provide it with needed infrastructure, ranging from housing and utility services on its military bases to refueling facilities for the U.S. Air Force and Navy on a military base in the Middle East. In each of these cases, the U.S. government contract served as the primary project document supporting the project financing. Not surprisingly, the complex inter-relationship of federal government contracting law and project finance provided many challenges. For example, some of the most difficult and vital government contract concepts to integrate into a project financing are those relating to the U.S. government's unilateral right to amend or terminate contracts to which it is a party and the resulting timing and amount of compensation provided the owner.
In the transportation sector, aside from the recent sales by city and state governments of the Chicago Skyway and the Indiana Toll Road, Bay Area Rapid Transit (BART) in the San Francisco area is exploring a public-private partnership to build a spur line from its system to Oakland Airport.
Thus, although a recovery now may be well under way in the electric power sector, that sector still presents many challenges to industry participants, especially given the fact that many of the new development activities are likely to be coal-fired and renewable energy projects. In the broader infrastructure sectors, there also are likely to be new project finance opportunities presenting themselves, each with its own set of issues.
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For more information about the issues covered in this report, please contact Richard M. Farmer in New York at 202-603-2240 or at rfarmer@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©2006 Thelen Reid Brown Raysman & Steiner LLP
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