Is Tax Deductibility of Interest Really the Problem?

Felix Salmon has run a long campaign against the tax deductibility of interest creating a perverse incentive for firms and individuals to finance with debt rather than equity capital. And I certainly can't disagree with him. However I think that there is another, greater reason for the excessive build up of leverage in our economy. I have written about it previously, here and here, but the gist of the idea is as follows.

Commercial banks have tremendous advantages over all other investors. They are massive and so are massively - almost perfectly - diversified, they usually carry mispriced or implicit state guarantees, they can take deposits without prospectus, much of their funding has no effective cost, much of their investment is cross-subsidized by the sale of other products and services, etc, etc.  As pure investors they should, and they do, outcompete everyone else.

But banks, to a good approximation, invest only in the form of debt - simply, they only make loans. I have considered why in those previous articles, but the fact of it is obvious. And so, as banks can outcompete all other investors, then the form of investment that banks make, debt, is going to outcompete the form of investment they cannot or will not make, equity.

Debt - in the form of bank debt - really is cheap relative to equity.

That doesn't, of course, make endemically high leverage good. The contrary, in fact. It suggests we need to revisit the idea that commercial banks - the dominant force in capital allocation in the economy - should invest in a way that makes our economy maximally fragile.

The CEFC and Renewable Energy Project Subsidies

The Gillard Government in Australia has introduced its carbon tax, and there is to be a Clean Energy Finance Corporation to subsidize renewal energy projects and technology. A few months ago I proposed a market driven structure under which such subsidies might be granted, and it is timely to revisit that now.

I am no free-market ideologue, but if there is one role to which government is least suited it is funding the development and commercialization of technology. Simply handing out large-scale research funding might easily create a bureaucracy that, far from enhancing development of the implementable technology, actually crowded out real commercially driven development.

The alternative is to directly subsidize individual renewable generation projects that might not otherwise, even with the effect of the tax, be competitive with carbon-emitting generation. The subsidy would meet the difference between a project’s actual capital cost and the amount of capital it could raise on purely commercial terms.

The problem with this, of course, is that government would again be in the business of picking winners, but with the further problem that private project developers could make excessive returns from the scheme without contributing to the objective of maximizing the renewable energy base.

The purpose of this note is to propose a general framework for capital subsidies that draws on the lessons of project finance to ensure that maximum societal benefit, in terms of increased renewable generating capacity, is gained from that investment.

Proposed capital subsidy framework

I suggest that there should be two requirements for renewable generation projects to receive government capital subsidies.

First, the rate of return to the project’s commercial capital should capped but with excess returns allowed to be reinvested as private equity in expanding the existing project or in new, eligible, renewable generation projects.

Second, that at least 70% of the project’s commercial capital (excluding the subsidy) should be in the form of non-recourse commercial bank debt.

Capped rate of return

One very interesting development in infrastructure finance over the last few years has been the privatization by some governments of monopoly infrastructure assets. Control is maintained over these "regulated" assets by various means, one of which is that the rate of return to the private owners is capped.

The allowed return is calculated by applying the capped rate of return to the "regulatory asset base", which is value of the assets assessed for the purpose. What is interesting is the behaviour this has encouraged.

With a capped rate of return the incentive for the private owners of the regulated assets is to expand the regulatory asset base on which their return is calculated. If the rate of return on assets is capped, the absolute return can only be increased by increasing the value of assets. Thus the incentive is for the private owners of regulated assets to expand those assets, and this has been observed.

I would suggest that similarly capping the rate of return on renewable projects that receive government subsidy, but allowing the private owners to reinvest any excess returns in expanding the asset base on which the capped rate of return is applied, would perfectly align the incentives of the private project owners and society. Say, for example, that the owners of a subsidized renewable project were only allowed to take home a return from their investment in the project of 15%. However any excess return in that particular project could be reinvested by them as new equity into project expansion or into a new project or projects, which would themselves be subject to a capped return of 15%.

The private investors could then maximize the returns on their initial investment almost without limit, creating proper market incentives, but only by creating and reinvesting in project expansions or in new projects. They could not benefit from excess returns on a single subsidized project, which would discourage the gaming of the subsidy system.

Recall that society's objective is to maximize renewable generating capacity. Under this scheme the initial government subsidy to a project might be leveraged into an increase in renewable generating capacity which is much larger than the increase represented by the original project.

In fact the growth in the renewable asset base would be further multiplied by the compulsory use of debt finance for the projects. Each $1 in excess return applied as new equity in project expansion or new projects would also support several times that amount in new commercial bank debt. This is also consistent with the observed behaviour of the owners of regulated infrastructure assets. And so this leads to the second criteria.

Minimum 70% commercial bank non-recourse debt

It is well known in the project finance industry that where the challenge is maximizing the amount of capital available to finance a project or sector, the mobilization of debt capital is key. Unlike in the world of finance theory, real capital does indeed care about the form of its investment. The vast amounts of capital controlled by commercial banks can, effectively, only be invested in the form of debt. If it is not utilized in that form, substantially all of that commercial bank capital would be wasted to the renewable sector.

Projects that are funded only or substantially by equity will be limited in size or will be inefficiently using scarce equity capital - including subsidies - that, from the societal perspective, could otherwise be leveraged into much larger base of renewable assets. It is true that the equity in projects would now be leveraged, and higher risk. Experience again shows us, however, that this will not lead to any material difference in the amount of equity capital available. Again contrary to finance theory, the providers of project equity are not just comfortable with leverage but they seek it almost without limit, and are constrained ultimately by the risk tolerance of the lenders.

If a project cannot achieve 70% commercial bank leverage then this requirement will also have served another purpose, to certify properly structured projects. Electricity generation projects have a whole suite of risks; construction/completion risk, financing risk, market price risk and operating risk are the major categories of risk in addition to technology risk.

It would be a very inefficient use of the available funds to subsidize projects that are taking on material non-technology risks. If so the subsidy would provide, in effect, a free option on these risks to project equity holders. Risk seekers would develop projects as a way to gain cheap exposure to market or completion risks, not to expand the renewable generation base. The 70% minimum commercial bank leverage requirement should ensure that these risks are hedged or otherwise allocated away from the project, as they would be in any properly structured project financing.

Conclusion

The compounding returns from reinvestment and leverage would mean that the approach I have suggested could lead to a geometric rate of increase in the renewable-generation asset base. Exactly the result we are seeking as a society and, under this structure, it would be one pursued by project equity-holders in their own self-interest.

I have only outlined the general principles here, and obviously there would be much work to be done in implementing it. Nevertheless, I think it would be a good basis for starting a discussion about the most effective means of providing capital subsidies to renewable projects.

The Project Finance Bank Market

I am quoted extensively in this article. It is from a new group providing news and intelligence for the infrastructure market, Inspiratia.com.

Inspiratia.com 

Basel III – from the other side of the table

Having last week looked at Basel III from the banking sector’s perspective, this time we are switching sides and representing opinions of the global banking regulation from those who will have been less influenced by the Institute for International Finance.

Last Friday’s market view focused on match funding and the requirement for banks to hold sufficient capital to absorb losses. To refresh your memories, the key points from Basel III are:

· tighter definitions of Tier 1 capital – 4.5% by January 2015, and a further 2.5% taking it up to 7%

· introduction of a leverage ratio

· framework for counter-cyclical capital buffers

· measures to limit counterparty credit risk

· short- and medium-term quantitative liquidity ratios

This week, sees a response from everyone but the bankers – infrastructure professionals who are not so convinced by the banks’ fears that these global banking regulations will have such a negative impact on business, pricing long-term lending out of the market.

Talking this week to players in construction, financial advisory and third party equity, there is a widely-held belief that Basel III will not be the bugbear some fear it to be.

For a start, many believe the price of debt issue has been over-hyped. One of this week’s interviewees echoes a point made by one of the PF bankers over the all-in cost of debt. “To the argument that if you increase bank capital requirements they won’t be able to lend any more or it will make lending far too expensive – you have to say: ‘relative to what?’ What we are doing today is still cheap relative to 20 years ago.

“The banks have demonstrated that they are very hard to kill. I can’t see that a few basis points on pricing will kill the infrastructure sector.”

It goes without saying that the price of debt has been pivotal to project finance and infrastructure finance over the years. It also goes without saying that when the banks have had the whip hand, they have used it with gusto… as did the sponsors when they were riding the price of debt down to historic lows.

At the very apex of the market – when monoline insurance (and hence the bond solution) was still in play – banks were squeezed until the pips squeaked. Competition drove down PPP pricing to 50bp, plumbing a depth that should never have been permitted and that many banks drew a line far north of. But still deals made it over the line… too many according to the banks (with 20:20 hindsight) that are stuck with this uncomfortably cheap debt on their books for the next 20 or so years.

However, one issue that was not broached last week in discussions with the bankers is that higher capital requirements will make banks less risky and hence bank equity will not be called on to generate such a high return. It’s not simply a case that double the capital requirements equals double the capital charge.

The market generally agrees that it will be difficult to arrange the really long tenors because of liquidity pressure. Fair enough, but that should not be fatal to project finance as this can be dealt with by amortising out more quickly, which in turn reduces the risk of the loan and thus the credit spread. Alternatively there’s always the option of mini-perms and allocating the refi risk elsewhere [hello Australia].

The hard-of-thinking have long insisted that a rising price of debt will kill off long-term investments into infra. This is patently wrong as it is a pass-through cost to the awarding authority.

“If you are a project sponsor and your debt is more expensive, then you just bid more,” says another senior PF source. “Where it becomes difficult is when governments look at the value for money issue. The more expensive the bank debt becomes relative to the cost of government funding, people start accusing PPP of not offering VFM and saying that the government should be financing these projects itself.

“But that has not been the motivation for PPP for a long time. Governments have not been doing PPPs – in Europe at least – because they think it was good value. They did it to get the expense off balance sheet.”

Here we have two glorious contradictions – the VFM stick with which the industry is regularly beaten, and the reality that the private sector is needed to finance that which the public purse cannot.

Truth is, if you want a realistic view on the price of long-term debt, better look at what’s being arranged in the Power and Oil & Gas sectors, rather than PPP and Transport which are so heavily influenced by home governments.

All about returns

Everyone should have read Andrew Haldane’s paper “Banking on The State” in which he looks at the increase in leverage in banks' balance sheets over the last century and identifies a dramatic increase in recent years. Even with Basel III we will still be far above historical bank leverage ratios.

As one source says: “The idea that banks need to generate a 20-30% return on equity is one that people got conditioned to over the last few years. But if you think about it, it makes no sense at all.

“The long term equity premium – the return generated by stock markets overall relative to the risk-free rate – is probably in the order of 3-8% over the last century. Since the 1990s banks have been trying to generate an equity premium of 20-25%.”

As Haldane observes in his fascinating paper, the banks can only achieve this sort of return by taking massive business risk (risk in their operations) and financial risk (by leveraging up their balance sheets). Of course, with this risk inevitably comes bank failure.

The source continues: “People have observed that banks are meant to be the safest of institutions, not the riskiest. The Volker Rule in the US is designed to remove a major source of business risk – trading.

“Basel III goes some way to reducing financial risk with its focus on leverage on bank balance sheets. What disinterested people – those not employed by banks – really want to see is Boring Banking, banks generating only 5-10% returns on equity, the sort of investment for the widows and orphans of old.”

That’s all about the wider banking picture, though. But how this will impact on project finance?

PF business is low risk, but the tenors are long – just like prime mortgage lending which is staple business for a bank. The liquidity costs of long tenors may be slightly higher than they used to be.

“Although we have had big funding premia built into project finance pricing since 2008, deals are still being done,” says another learned source. “But if that liquidity cost is fatal to PF then it is also going to be fatal to mortgage lending. I can't see that being the case.”

Eliminating Inefficiencies in Bank Funding of PPPs