Group 4

Arani | Saloni | Charvi | Divye | Honi | Parul

Calpine Corporation
Comment on Merchant Power opportunity and Calpine’s strategy to grab
it. Do you think it will work? Can you a draw a parallel with Reliance’s
strategy to grab the UMPP market in India?

Favourable industry dynamics

 The US electric power industry was the country’s third largest industry with annual revenues of
$296 billion and assets of $686 billion.
 Projected long-term growth rate of 2% p.a. implying a need to add 15,000 MW of new capacity
annually
 Need to replace substantial amount of installed base
 Falling reserve margin shows that demand was exceeding supply

The merchant power opportunity

 The introduction of National Energy Policy Act (NEPA) allowed IPPs to sell power at wholesale
prices over the existing transmission systems and protected them against discriminatory rates and
access.
 The PUPRA act of 1978 required cogeneration of both electricity and heat as a qualifying
factor to meet the standards requiring local authorities to buy all output. NEPA removed
the cogeneration requirement, allowing IPPs to build larger and more efficient plants. The
market price still reflected the market’s average heat rate. A larger, more efficient turbine
package capable of producing at a greater capacity would thus have a major cost advantage
in a competitive market for a commodity product.
 Most states had passed or were considering legislation to introduce retail competition
 The industry was moving to a competitive structure, with IPPs accounting for half of all power
plant construction during 1990s and representing almost 7% of total US generating capacity by
1998. This share was expected to go as high as 90% in 2002.

Calpine’s Strategy
 The goal was to become one of the largest and most profitable power generators in the United
States
 Calpine could achieve this goal by using environmentally friendly, high-efficiency gas turbines
and building a vertically integrated company with engineering, construction, operating, fuel
supply, power marketing, and financing capabilities in a single firm
 This was predicated on the belief that being the low-cost producer was the only way to win in a
business where both the primary input (natural gas) and the primary output (electricity) were
commodities.
 Calpine aimed at reducing costs in all other aspects of the value chain
 This was however, a five-year opportunity before competition reduced the average heat rate, thus
diving down prices. The company planned to enter the market rapidly, by investing in huge
capacity development and using this to create barriers to entry.
 Group 4
Arani | Saloni | Charvi | Divye | Honi | Parul

Will it work?
Yes, I do believe that the strategy can work as seen in the case of ‘Pasadena Power Plant’. The success
will however depend on the company’s ability to reduce costs while developing scale before the
competition intensifies.

Reliance and the UMPP market in India

Striking similarities can be found in Reliance’s strategy to dominate the Ultra Mega Power Projects in
India. The Power Finance Corporation has envisioned 16 UMMPs. SPVs have been formed for 12 of
these projects with Reliance Power owning three of the four SPVs, which have been awarded. Because of
the huge scale of these power plants, the cost of electricity is expected to be below INR 2. Reliance is
using super critical technology, which results in higher operating efficiency and reduces the carbon
emissions compared to the older plants. The more power projects Reliance Power wins, the greater cost
advantage it will have. This seems to be the clear goal.

Why did Calpine historically choose Project Finance to fund Power

Plants?

To develop a power plant, an independent power producer typically completed the following steps:

 Site acquisition
 Sign a long term power purchase agreement with a creditworthy public utility
 Sign construction and equipment contracts
 Long-term fuel supply contract
 Operating and maintenance contracts
 Approvals from state utility, environmental and other regulatory  agencies
 Arrange financing

The instrument of choice for financing this contractual bundle was project finance in which the company
borrowed on a non-recourse basis (i.e. parent company was not responsible for repaying subsidiary
borrowings). Popular to finance development of natural resources, this was especially lucrative to IPPs
because it offered high leverage with limited or no recourse to the sponsor’s balance sheet. Lenders
became comfortable with aggressive terms compared to bank lending as IPPs had steady stream of long-
term cash flow and were ring-fenced form other risks associated with the parent company. It yielded
greater interest tax shields because average IPP had debt-to-capital ratios of 80%-95% as compared to
40%-50% for average utility. Higher leverage could be supported because their asset, the power contract
was relatively safe. In addition, they needed little additional investment and thus did not spare any debt
capacity.

 Another reason for not resorting to alternate funding mechanisms in the past might be due to low
rating on the company’s debt, thus leading to higher cost of borrowing.
 Moreover, with time the company had become familiar with the dynamics of project financing. It
could count on the support as well as reasonable terms from a broad group of banks.
 Group 4
Arani | Saloni | Charvi | Divye | Honi | Parul

Evaluate the three funding alternatives on Feasibility, Issuance Cost and

Flexibility and decide the best

Project Finance at Subsidiary Level

Project financing has been the preferred choice for raising finance for new operations for the company.
The option had shown positive results even when it was availed by making the company’s officials and
seniors more reluctant towards it as this would be a more comfortable option; considering the fact that it
has been done previously. Moreover, terms of such projects are well-known and negotiated among the
bank and the company; the management team of the company is well-versed in such a plan’s
implementation.

Yet questions were raised by the senior finance executives about such a project’s feasibility and
flexibility; considering the fact that the company required $300 million each for 4 projects. As for now,
the company is working towards a growth strategy, seeking quick growth to be able to dominate the
market and hold dominance before this technology and tactics are availed by every competitor.

Creating and negotiating such a deal for 4 projects individually will be costly and time-consuming;
however, it is a fact that the company does not have time for such a deal.

Considering the fact that the company requires $6 billion in total over a period of 5 years and there are
only 50 or so banks that provide project loans where each bank holds a per customer limit, which will
stand at a $100 per bank making it practically impossible for such a strategy be implemented.

Raise Corporate Debt at Parent Level

Calpine had begun to retire subsidy project debt with corporate level debt 1994 onwards. The company
had also set a target of achieving investment grade by 2003 and that was possible only with a debt to
capitalization ratio of 65% or less. Based on Calpine’s previous issues, continuing with this method held
several advantages such as the market demand for 7 & 10-year bullet maturities which allowed Calpine
sufficient term. Given that Calpine was still high yield, the issue would not require a collateral, would
reduce legal fees and leave Calpine free to operate its plants as a system.
This mode of financing only restricted the company at parent level, it could not issue any secured debt
and neither could it issue unsecured debt if the ratio of EBITDA to interest expense fell below 2:1. But
there was no restriction on non-recourse debt at subsidiary level, leaving the project finance option open
for new opportunities. The note holders of corporate debt had no additional rights beyond normal SEC
filings.
The massive downside was the fact that Calpine was still traded at the high-yield market which was a lot
more volatile than the investment grade market, this massively increased the price and availability risk.
The interest spread between long-term payments and short-term receivables was at a significant 250-300
bps. Calpine would be risking both its investment rating and a huge interest payment cost. In addition to
that, it would have to issue fresh equity to maintain its debt ratios and the bear the concurrent cost
associated. All in all, corporate debt did not seem to be the most attractive choice for Calpine as it was
misaligned with its current set of strategic goals.
 Group 4
Arani | Saloni | Charvi | Divye | Honi | Parul

Hybrid Option

The hybrid option was generated by the company through discussions with Credit Suisse First Boston
(CSFB). Under this option, the corporation will incorporate a new subsidiary named Calpine Construction
Finance Company under which $1 billion finance will be borrowed in a secured revolving construction
facility whereas the company will inject equity of $430 million and any other amount required for the
completion of the 4 plants.

Under this facility, the company can focus on construction of additional power plant if the company
receives the permission accordingly as with the revolving finance is repaid and re-borrowed for further
projects making the finance not limited for a certain project with no limitations on the payment of the
principal till the maturity date.

The greatest advantage the company will receive with the option is that a single deal will ensure financing
for all four plant and any additional plant saving time, legal cost and other fees but most importantly it fits
the growth strategy and enables the company to achieve competitive advantage in the market.

The major problem concerning this option is the refinancing risk, but the finance executives are confident
that the loans will be paid back in full within the maturity date as they hold multiple options regarding the
refinancing.

Considering all the evaluations, the hybrid option seems the most beneficial for the company that makes it
a logical choice for Kelly. As option 1 cannot finance all the plants and option 2 will raise the gearing to
an alarming level; hence, option 3 is best suited for the company’s growth strategy.