Calpine Corporation

The Evolution from Project to Corporate Finance Part I

Team Members Hrishikesh Pathak (42) Yashaswi Priyadarshi (43) Sahil Rawat (45) Anoop Teja (46) Paramjeet (31) Muthu Narayan S (38)

Question 1
Calpines strategy of using Project Finance prior to 1998 Good or Bad?

 Calpine Corporation pursued the construction and operation of power plants on the IPP model, taking the leverage of PURPA Act, 1978
Exhibit 1b: Typical Project Finance Structure (Cash and collateral Flows)

 Calpines strategy of using Project Finance was a good strategy because:-

Non Recourse to the parent corporation

The subsidiary, being an IPP (Independent Power Producer), had a high leverage with limited or no recourse to the sponsors balance sheet

Parent company was ring-fenced from any risks associated with the project

 Greater Tax Shield

IPPs had a high Debt to Capital ratio of 80-95% which yielded greater interest tax shields

The company could support higher leverage from the steady cash flows from the asset. Till 1998 it had constructed 22 plants with a combined capacity of 2729 MW. Project Finance was suitable for construction of fewer number of such plants.

Question 2
What are the benefits of using Project Finance for power plants with long-term Power Purchase Agreements (PPA)?

 A long term PPA is done with a creditworthy public utility, which ensures a steady stream of cash flows. These cash flows will be used to service the project debt Default risk gets mitigated since PPAs are signed with public utilities PPAs act as collateral throughout the life of the project to the lenders who provide project finance Financing technologically superior CCGT reduces the cost of construction, which is an incentive to the lenders

Question 3
If you are the Calpine CEO, would you embark on the high growth strategy?

 Calpines heat rate was much lower at 7500, while the market average heat rate was 11000

Calpine could derive a fuel cost advantage- In case of Pasadena contract, the additional 150 MW had an annual fuel cost of $29.6 mil, while the market cost was $43.4 mil. This helped Calpine to bid aggressively, finally winning the deal. This decision changed the companys strategy dramatically, and they wanted to be proactive and re-power America

 Increasing gap between demand and supply, and the rapid fall of reserve margins from 35% in 1985 to 12% in 1999

High growth strategy would involve making a vertically integrated power system, which would lower the overall cost structure (Construction cost, Operating and Maintenance Cost, Fuel Supply Cost, Power, Marketing Cost)
Creating entry barriers would deter new competition

Enjoy the benefits of economies of scale (from 3000 MW to 15000 MW)

Question 4 How big are the potential returns?

Question 5 What are the most significant risks?

 Construction & Completion

Getting permits for site location was a complicated affair CCGT: Only two suppliers with limited production capacity Number of technically sound personnel for such an aggressive strategy They knew the opportunity to re-power America is at best 5 year opportunity

Operating
Locking in long term customers (No long term PPAs)

Technological
The strategy will likely be under pressure if high margins attract other new entrants, or if more efficient technology erodes Calpine's market share, or margin, or both, specially if this happens within the next 10-12 yrs.

 Financial
Extensive negotiations are required for approving finances which included rising debt and equity worth 4.5 bn, assuming they generate 1.5 bn cash as projected Project Finance Corporate Finance Revolving Credit

Price
No long term power purchase agreements, so a fixed long term price cannot be locked Market price expected to fall to $24/MWh from existing $31/MWh New competition in retail distribution Calpine's relatively small presence in each of its markets will limit its ability to set prices, forcing it to be a price taker most of the time.