Calpine Corporation: The Evolution from Project to Corporate Finance

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To develop a power plant, an IPP typically had to complete the following steps: (1) acquire the site; (2) sign a long-term power purchase agreement with a creditworthy public utility; (3) sign construction and equipment contracts, usually on a fixed-price, turnkey basis with an experienced contractor; (4) sign a long-term fuel supply contract; (5) sign operating and maintenance contracts, if needed; (6) obtain the necessary approvals from state utility, environmental, and other regulatory agencies; and (7) arrange financing. Exhibit 1a illustrates a representative project structure used by Calpine and other developers.

The instrument of choice for financing this “contractual bundle” was project finance, in which the project company borrowed on a non-recourse basis (i.e., the parent corporation was not responsible for repaying subsidiary borrowings, see Exhibit 1b). Prior to the 1970s, project financing was used primarily to finance the development of natural resources including mines and oil fields. It was particularly attractive to IPPs because it offered high leverage with limited or no recourse to the sponsor’s balance sheet. Project finance lenders became comfortable with terms that were aggressive

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This document is authorized for use only in FM-II, BME 2014-17 by Kanagaraj Ayyalusamy, Xavier Labour Relations Institute (XLRI) from August 2015 to February 2016.

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For exclusive use at Xavier Labour Relations Institute (XLRI), 2015

Calpine Corporation: The Evolution from Project to Corporate Finance

201-098

by the standards of conventional bank lending because IPPs had steady streams of long-term cash flow and were ring-fenced from other risks associated with the parent company. Bob Kelly summarized the IPP project finance world this way:

If you look at the old business model, the IPP, you were basically financing long-term power contracts. It was an arbitrage in financing that yielded greater interest tax shields because the average IPP had a debt-to-capital ratio of 80% to 95% compared to 40% to 50% for the average utility. IPPs could support higher leverage without a large penalty in funding cost because the asset, the power contract, was relatively safe. And since IPPs had little need for additional investment, they did not need spare debt capacity.

Deregulation combined with technological advances in power generation spurred the growth of IPPs. For example, combined-cycle gas turbines (CCGT) were capable of generating power at significantly lower cost and in an environmentally cleaner way than existing technologies. In fact, the marginal cost of operating a CCGT plant, as determined by its heat rate,b was 25% to 35% lower than existing technologies, and they cost less to build: approximately $500,000 per MW compared to $750,000 per MW or more for coal and nuclear plants.

In 1992, fourteen years later after PURPA, Congress introduced further competition by passing the National Energy Policy Act (NEPA), an Act that allowed IPPs to sell power at wholesale prices over the existing transmission systems and protected them against discriminatory rates and access. NEPA also removed the cogeneration requirement, thereby allowing IPPs to build larger and more efficient plants, but left the issue of retail competition in distribution up to individual states. By early 1999, over 30 states had passed or were considering legislation to introduce retail competition.

As these changes took effect, it became clear that the industry was transitioning to a competitive structure in which IPPs and unregulated utility affiliates would have to build power plants without the benefit of long-term power purchase agreements. In fact, IPPs accounted for half of all power plant construction during the 1990s and represented almost 7% of total U.S. generating capacity by 1998.5 Forecasters predicted that by 2002, these merchant—or competitive transactions—would account for anywhere from 0% to 90% of wholesale transactions depending on the region. Forecasters also predicted increases in generating capacity, though the predictions on the amount of new generating capacity varied widely (see Exhibit 2).

Calpine Corporation

Headquartered in San Jose, California, Calpine was founded in 1984 as a wholly-owned subsidiary of Electrowatt, a Swiss industrial corporation affiliated with Credit Suisse Banking Group. The name Calpine reflected its California location and its Swiss parentage (California + Alpine = Calpine). From 1984 through 1998, Calpine pursued the construction and operation of QF power plants on the IPP model, creating a new subsidiary to finance each plant, as well as acquisitions of other IPPs. As of March 31, 1999, it had 22 plants with a combined capacity of 2,729 MW operating in seven states, and another 12 plants in various stages of development. In recent years, Calpine had gradually been increasing its growth rate. Between 1994 and 1998, consolidated assets increased from $421 million to $1,712 million, revenues grew from $94 million to $556 million, and net income from

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b The heat rate was the key industry measure of generating efficiency and referred to the quantity of fuel, expressed in British Thermal Units (BTUs), required to generate one kilowatt-hour (kWh) of electricity. Because the fuel cost was roughly equal to the marginal operating cost of a power plant, the difference between the cost of fuel and the price of power, known as the spark spread, served as a proxy for the gross margin. The US industry average heat rate was a little over 10,000 though in several regions such as New England and in states like California and Texas, the average heat rate approached 12,000 or more.

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This document is authorized for use only in FM-II, BME 2014-17 by Kanagaraj Ayyalusamy, Xavier Labour Relations Institute (XLRI) from August 2015 to February 2016.

---------------------------------------------------------------

For exclusive use at Xavier Labour Relations Institute (XLRI), 2015

201-098 Calpine Corporation: The Evolution from Project to Corporate Finance

$6 million to $46 million (see Exhibits 3a). The company’s goal was to

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