Benchmarks for Investment Grade Power Projects

Author: Goldsmith, Deborah; Brooks, Andrew; Chew, William; Moulton , Curtis

There are no set guidelines for investment grade power project financings. Each individual financing is approached in light of the particular credit profiles of participants, the different structural and contractual arrangements, and the unique characteristics of each regulatory and market environment. However, S&P has identified some benchmarks that are important in establishing investment grade strength for each of the more crucial rating factors. The weighting of each of these rating factors will depend on each project's unique characteristics.

1. Output sales contract.
Capacity payments should cover debt service and other fixed project costs. Availability minimum requirements should not raise material risk to project revenue given the technology.

• Energy: Load factor guarantees if certain availability factors are met, and if payment is divided between a variable and fixed energy rate component, with the fixed component based on availability, not generation. The fixed energy rate should be able o cover minimum inventory charges, as well as other fixed charges, like minimum fuel takes.
• Dispatch: If under utility control, the expected mode of dispatch should be economic. This is not a concern if project costs economics are sound compared to the utility's embedded cost. Ideal project arrangements would have a guarantee of a minimum number of hours for which a project can be dispatched.
• No "regulatory out" clause, unless the underrecovery of the buyer is deferred until the end of the debt term. Exceptions may be made only where S&P is extremely comfortable with the future rate-making environment.
• Thermal sales: The host for a qualifying facility project should be investment grade status. Exceptions may be considered, depending on circumstances. The plant should be an integral part of the host's operations.

2. Power costs
Power costs should not only be below avoided cost of the buying utility, but should also be reasonable when compared to the regional embedded cost of power. Avoided cost should not be at risk of being unusually high prospectively due to limited fuel protection or known changes in market supply demand conditions in the intermediate term (such as known large capacity additions in the region that could create surplus supply conditions over the intermediate term). The project should also be economically priced for the seller, so that the seller is not at risk of significant margin squeeze in the event of a potential change in external conditions.

5. Technology

• The operator's experience record should be sound. If there is a third party O&M contractor, proper incentives and penalties should be written into the agreement, particularly if the contract calls for a straight pass-through of costs.
• The operator should have extensive experience and a solid performance record with the technology being used.
• Availability requirements in output sales agreements should not be unreasonable for the technology given expected scheduled and unscheduled outages.
• Warranties for key operating equipment should exist for at least the first year of operation.
• The contracting engineer should guarantee performance standards at operation. If initial testing fails below required capacity utilization levels, liquidated damages should be set at levels that would pay down debt in an amount that would still allow for the same required coverage levels.
• A project feasibility review must be made by an independent engineer experienced in the technology being employed.

6. The purchaser should be at least investment grade.
How far the project's rating would be below this credit rating would depend upon the economics. Sound economics and adequate transmission could allow the project's debt to be rated close to, if not equal to, the buying utility's senior debt rating. In very rare cases, if the power could easily be sold elsewhere, the credit rating could be placed above the utility's senior debt rating.

CREDIT BENCHMARKS
To achieve investment-grade or near-investment-grade ratings, projects will need compelling credit strength in each of the key analytical areas. For most projects, this will include:

• Very low-risk technology and low site risk: In most cases, this can be established by ample record of comparable projects on similar sites being completed with few or no cost overruns and construction delays.
• Conservative construction schedule. Projects with longer construction schedules will only be able to achieve investment-grade or near-investment-grade ratings when vendors and contractors are able to demonstrate overwhelming capacity to manage the accompanying risk. Construction budgets also should include schedule cushions and reserves to cover worst-case delays and cost overruns.
• Strong turnkey construction contracts. The contract should shift substantially all construction risk to contractors and vendors.
• Adequate capacity to perform on contract obligations. This will be demonstrated by a rating or financial guarantee in the form of an LOC or surety bond providing for payment of contract damages and penalties in sufficient time to maintain cash flow required for debt service.
• Contractors and vendors should be able to show extensive experience building comparable projects at or ahead of budget and schedule. Power project construction also should be a major part of the long-term business strategy of key contractors and equipment suppliers.
• Strong third-party trustee structure for management of construction funds. The trustee should be experienced in administration and management of power project construction, preferably as a lender, and should retain an experienced engineer independent of any other interest on the project.
• The process of obtaining permits should be as free as possible from the potential for significant changes in law or regulation. This is best accomplished where project and site have support from both surrounding community and all other affected parties, including output purchasers and environmental interests. In addition, acceptance standards should incorporate the emission levels approved under the project's environmental permits.