A non-merchant independent power project is defined as a privately-owned energy generation project with no exposure to the spot price of electricity. An independent power producer (IPP) removes that exposure by entering into a long-term, fixed rate, power purchase agreement (PPA) with a creditworthy entity, such as a regulated power utility. In Canada, most power utilities are provincially owned and regulated and procure power from IPPs through specific calls for power or standard offer programs in which successful proponents enter into a long-term PPA with the utility. Depending on the source of fuel, the term of the PPA may range from 20 to 40 years.
A Canadian IPP project can either be financed through a bank loan, a rated bond issue or through a privately placed loan (private placement or private debt). The most appropriate source generally depends on the size of the required financing. Transactions requiring less than $150 million in long-term financing are generally done in the private debt market, which is currently dominated by life insurance companies. While these transactions are rarely rated by a rating agency, they are considered investment grade (BBB or higher) as the federal government regulator (Office of the Superintendent for Financial Institutions) requires life insurance companies to take a BBB capital charge against private IPP debt transactions.
Given the similarities between the liabilities of a life insurance company and that of a defined benefit pension plan, pension plans should consider lending into non-merchant IPP projects because the investment grade private debt market offers significant opportunities to extend duration and enhance yield without significantly increasing fixed income portfolio risk. Private IPP debt transactions offer investors:
- Predictable, long-term cash flows;
- A good match for plan liabilities, with durations ranging from nine to 15 years;
- An alternative source of investment grade transactions (i.e. portfolio diversification);
- Premium yield over comparable social infrastructure bonds and loans;
- A wide variety of covenants providing early warning signals and enhanced credit protection.
Private debt transactions are generally buy-and-hold investments and the lack of external rating considerably reduces the pool of investors. As such, investors are able to extract premium returns for a given level of risk. Private IPP debt transactions also offer premium returns over the private social infrastructure debt market because the pool of buyers has expanded beyond the life insurance companies, which caused bond market spreads to tighten and drove down the “private debt” premium.
The underwriting considerations and the terms and conditions included in IPP transactions are generally similar to what most investors would find in social infrastructure loans. For example:
- The borrower is a non-recourse special purpose vehicle (“SPV”);
- The financing term must match the term of the underlying contracts (20 – 40 years);
- There should be first charge on all of the project assets, including assignment of material project documents;
- Leverage and debt service coverage ratios should reflect the resource availability under various stress tests;
- Distribution restrictions are required;
- Reserve accounts are also key (debt service, major maintenance, etc.);
- Cost overrun support can be provided by one or more of the following: letter of credit, budgeted contingencies, profit retention and/or corporate guarantees;
- Lenders require third-party consultants (independent engineer, legal counsel, cost consultant, insurance consultant) to review the project prior to closing.
Because these transactions have long lead times and are generally heavily negotiated, it is difficult for most pension funds to access this market, save and except for those pension funds with in-house expertise. The recent launch of dedicated infrastructure debt funds will help pension plans to access this market, where long-term, predictable cash flows are available at a premium over social infrastructure bonds and loans.
Louis Bélanger, CFA, FRM is Managing director, Stonebridge Infrastructure Debt Fund