Waste Advantage Magazine

Second of two parts - A project finance alternative: The Bond Market

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Courtesy of Waste Advantage Magazine

Part one of this article (Waste Advantage Magazine, September 2011) outlined an alternative, but growing source of non-recourse project finance debt capital for waste-to-energy (WTE) projects— the institutional bond market. Participants in the bond market (including pension funds, insurance companies, mutual funds and high yield investors) look for opportunities to deploy their capital on a risk-adjusted basis. Unlike banks, which often face regulatory or funding constraints and are unwilling to move too far down the credit ladder, bond investors are willing and able to fund projects that may be considered low or below investment grade. Bond investors routinely accept the operating risk of alternative energy projects with contracted cash flows, but if asked to absorb other risks, they will seek additional compensation through higher interest rates and/or additional covenants. These higher rates may quickly erode the financing’s economics and drive down equity returns. The art and science of project finance is to allocate risks to parties willing and able to bear those risks at the lowest cost.

For example, participants in the bond market are generally reluctant to bear construction risk. Many are trying to match long-term liabilities (e.g., life insurance policies) with long-term assets (the bonds they purchase as investments). They do not have the technical skill set or resources to resolve unforeseen construction related issues. If not resolved satisfactorily, underperforming assets will impact their portfolio management and profitability. In order to ensure that the project is built on time and on budget, bond investors generally prefer projects be built under a turn-key lump-sum Engineering Procurement and Construction (EPC) contract with liquidated damages backed by a surety. The EPC contractor, with arguably more knowledge about building a WTE project compared to an insurance company, essentially absorbs the construction risk and is compensated for that risk through a higher contract price.

Currently, the average alternative energy project reviewed by the rating agencies finds itself hovering at the low end of investment grade (BBB) or moving below investment grade (BBB- and lower) based on the credit rating of the off-take counterparty. WTE projects with their feedstock risk (will the waste be made available at the proper economics for the full term of the financing to ensure timely payment of principal and interest?) have additional credit risk relative to wind or solar projects. Mother Nature, their feedstock supplier, doesn’t have a credit rating and has no financial incentives to change her behavior. As you move further down the credit ladder your cost of debt increases. The difference in interest rate for a BBB credit relative to a BBBcredit is real and grows substantially with each step down the ladder. When a specific risk cannot be allocated to one of the direct stakeholders in a WTE project at a cost that facilitates the capital formation process (including equity), profit-motivated and other third parties can be brought in to absorb those risks at lower cost.

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