William Wild

The CEFC and Renewable Energy Project Subsidies

2011-07-11T18:35:00.000-07:00

Introduction

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

2010-10-07T03:59:00.000-07:00

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

2010-04-22T03:31:00.001-07:00

Banks - Version 2

2010-04-05T07:29:00.000-07:00

The problem is not that commercial banks are poor or inefficient investors but the opposite, they are too good, because the fact that they lend rather than own assets outright means that high leverage was and will continue to be endemic in the economy.

It was the severe externalities or social costs of endemic leverage that actually caused the damage during the GFC, and all previous debt-driven crises, through:

the accumulated inefficiencies of agency conflict between debt holders and residual equity owners,
the extreme pro-cyclicality of leveraged equity returns,
the false precision and unrealistic expectations associated with fixed debt claims against uncertain payoff streams,
the complexity and opacity arising from the transformation of real asset payoffs into a myriad of competing fixed and residual claims, and
ultimately, the massive destruction of confidence and wealth from default and bankruptcy.

When I say that commercial banks were too good, it is not through any superior personal qualities of bankers. Rather it is that they have inherent and systematic advantages as investors in assets relative to non-banks.

First, the defining role of commercial banks is as deposit-takers, for which they have special status granted and certified by the state. This confers a substantial advantage in the availability and cost of their funding relative to non-banks.

Second, because of the size that goes with the status of authorized deposit-taking institution, commercial banks are also the largest and of necessity the most diversified investors in any market in which they operate. This diversification is enforced by internal and regulatory constraint on concentrations of exposure, in particular the prescription of fixed lending limits. Through the IRB approaches mandated under Basel II, the Basel Committee explicitly, and reasonably in my opinion, treats banks as fully diversified, and the capital requirement is calibrated to absorb systematic losses only. The fresh debate about capital regulation today is not whether banks are diversified, but the extent of systematic risk to which they are exposed.

Not having to price for diversifiable risk and enjoying privileged access to state certified (and implicitly guaranteed) deposit funding would not be of merely marginal advantage for an investor. Commercial banks, who have these advantages, should completely dominate all other classes of financial investor in fair competition to own assets.

That they do not is because they do not compete for the ownership of assets. They invest in debt and not equity. There are a number of possible reasons for this.

Investment in assets through illiquid and passive equity interests would clearly expose a bank to mismatches between the liquidity of its investment and its obligations under its liabilities, primarily interest payments. An enforceable debt claim is superior in this respect, and the requirement for a borrower to repay and match the timing of the lender’s own costs of funding is a fundamental structural feature of bank lending.

That a borrower is obliged to repay debt principal according to a schedule has a different motivation, given that a bank as a going concern must assume that its funding base is permanent. Repayment obligations reflect either the expected amortisation of the assets of the borrowing firm or, to the extent that they precede that, provide a mechanism for the lender to exert some control over the assets and mitigate the agency cost of equity control.

Investment by the bank in assets through controlling equity interests would, however, be far superior to any form of debt in matching funding and mitigating duration mismatch. The bank’s claim would be effectively on demand; as controlling owner it would be free to realize as much liquidity as the asset could generate at any time it required. The potential benefits for asset/liability management (ALM) alone, in addition to the opportunity cost of not doing so, demands an explanation as to why banks do not pursue investment in this form.

I think there are two.

First, any insiders or experts needed to manage the assets, and on whom the assumed payoffs depend, may demand a controlling equity interest as a condition and as compensation for doing so. Related to this is that insiders may have an informational advantage or much greater risk tolerance in relation to that asset which overcomes their disadvantages relative to banks as pure financial investors.

Second, banks are, or believe they are, prohibited from doing so.

I would argue that the social contract under which banks are granted their preferred status has an effective caveat. Banks are to be the direct channel for monetary policy in the economy. This requires that they invest in real assets through fixed claims, namely debt. This means they cannot compete directly with non-banks, their “customers”, for who is reserved the equity, and the legal ownership and control, of real assets.

Irrespective of the reasons, we readily observe that banks do overwhelmingly limit themselves to investment in the form of debt claims. The problem this causes for the economy is that markets will still have their way. If hyper-competitive commercial banks cannot or will not invest in equity, then the market will ensure that equity gives way to the instrument through which they can invest, debt. The result is as we have observed. Leverage is constrained only by banks’ own desire to maintain the social contract and progressive “taxes” on leverage, namely the internalized, as distinguished from externalized, share of agency and bankruptcy costs.

Furthermore, the problem is exacerbated, not mitigated, by efficiency in asset markets and competitiveness in banking markets. In the most transparent and competitive markets for assets the maximization of leverage is always observed to be the key determinant of bid price and success. We need only consider the private equity, property, project and structured finance markets as evidence.

My hypothesis is not mere argument, although it provides a real explanation for the ubiquitous observation that “debt is cheap”. I believe it is supported empirically by observing an equity premium in the cost of capital of individual assets.

Take a partially leveraged asset. Now assume that it is re-leveraged, so the original equity investment is replaced with debt and repaid in full as a special dividend. In this hypothetical scenario there would remain pinpoint equity bearing no risk but a claim on the residual payoffs after debt service. If the fixed claims of debt in this fully-leveraged scenario, determined as the minimum required by the bank’s standard pricing model, would be less than the highest value in the distribution of the firm’s payoffs, then there would be an expected windfall payoff to equity. This would represent the equity premium implicit in the price of the actual, partially levered firm.

Another way of expressing this is that the equity premium is the discount on the price paid for the asset that is attributable to the presence of non-bank equity in the capital structure.

Is there an equity premium? My own experience as a banker and my analysis of transactions, particularly in the highly competitive and highly leveraged project finance and private equity markets, shows a clear equity premium in most leveraged transactions. I urge others to conduct their own analysis, but the presence of an equity premium would also explain why, almost universally, it is equity holders who pursue higher leverage and banks that constrain it in competitive markets for assets. Maximizing leverage and minimizing equity and thus the equity premium allows a higher price to be bid by the combined bank and equity holder team. This is the opposite to what would be expected if observed levels of leverage represented an equilibrium at which cost of capital was minimized.

So I suggest that the equity premium persists, and is not competed away, because asset prices are set in a two–tiered market. Banks compete amongst themselves for the debt component on the basis of price and how close to full leverage they are willing to go. Non-banks compete among themselves for the residual equity piece allowed them by the banks, and for which they receive the equity premium to meet their relatively higher return requirements.

And so high leverage, and the damaging externalities that result, will remain a feature of our economy.

Banks - Version 1

2010-03-27T06:54:00.000-07:00

Financial Institutions Lending - Workbook

2010-03-01T23:40:00.000-08:00

This is a workbook I prepared for my undergraduate course on Financial Institutions Lending. It is only a skeleton on which the lectures build, so it does not include the case studies or extensive references to market events that I cover in class.

The Trouble with Equity

2010-02-11T23:15:00.001-08:00

This is being developed both as an article for press publication and also as the basis for a formal response to the Basel Committee consultation paper. Comments are most welcome.

Idiosyncratic Risk is Good & The Risk Free Investment is Definitely Endogenous

2009-11-05T08:47:00.000-08:00

General Portfolio Effect

2009-11-02T08:23:00.000-08:00

Following is one of my favourite ideas. It is a simple transformation of one concept into another, showing not that they are linked but that they are in fact the same thing. I think it has implications for every facet of finance, as the second paper below demonstrates.

The following paper combines my ideas of the General Portfolio Effect (above) and Asset Transformation (here). It reaches some important general conclusions, probably the most important of which is that there can be no short cuts when investing. Where parties have different utility functions they will optimize with different portfolios of risky assets, which have to be discovered in each case, and it may be that both cannot gain from a given transaction. This goes against the promise of the CAPM but is completely in line with intuition and everyday experience. It is a complex paper, and soon I will bolster it with some worked examples which show how simple and intuitive the proof (not quite a proof, I admit, but pretty close) actually is.

Modelling Risk In Syndication - Presentation and New Material

2009-10-22T04:57:00.000-07:00

These are the slides from a presentation I recently did for a Euromoney course on Syndicated Loans in London. The first half covers the same material as my chapter in Syndicated Lending 5th ed., and as reproduced in my earlier post. The second half of the presentation (slides 42 onward) is, however, all brand new material which extends and applies the basic concepts. The new topics are as follows.

Particular Problem for Syndicators
Linear and non-linear
Predicting Individual Participants
The Error of Induction
Confirmation Bias
Life is Not Fair (In the Short Run)
… But We Don’t Easily Accept It
Backtesting – Single Deal
Backtesting – Many Deals
Backtesting – A Better Approach?
Market Flex
A Bit Less Final Hold Could Mean a Lot More Risk
Oversubscription Can Represent Uncertainty, Not Quality
What Use Is Any Of This If We Can’t Predict?

Asset Transformation

2009-10-16T09:18:00.001-07:00

RAROC v. Capital Ratio

2009-09-29T07:15:00.000-07:00

Prudent Lending Practice

2009-09-19T01:19:00.000-07:00

In 2004-5 I was an expert witness for the defence in a case brought by the Australian Securities & Investments Commission in the Federal Court of Australia. My evidence went to the issue of "prudent lending practice" and I had the opportunity to offer a definition of the term and a general description of the practice that would fall within it. I also considered the nature of credit risk assessment and the value of subsidiary sources of repayment. In the end the judge preferred my evidence. Below is my full affidavit (unfortunately a version with the case identifiers blanked, but the analysis itself is still very clear). The final judgement is here (my evidence is considered at paragraphs 443-455). The underlying transaction was a "private loan" in which a firm of solicitors procured lenders for a property development. Needless to say the loan went into default.

Regulatory Capital Swap - Part 2

2009-09-15T06:52:00.000-07:00

This is the final term sheet and explanatory memorandum for a new product designed to procure new capital to support new bank lending on a transaction by transaction basis. The origination and development of the idea can be seen in Part 1.

Regulatory Capital Swap - Part 1

2009-08-28T00:27:00.000-07:00

In October 2008, the month after the collapse of Lehman and as the extent of the damage to the banking system was becoming apparent, I was trying to think of a way of structuring loans to pass through changes in the cost of the bank's capital that supported them.

I realized that the only perfect solution would be for a borrower's shareholders to actually provide the capital to support its loan, and that this not only solved the problem of the cost of the bank's capital but also the more fundamental problem of its scarcity. After all, which investors could be more incentivized to provide a bank with new capital at the height of a credit crunch than the owners of a firm whose new loan that capital would facilitate. This would directly address the problem of pro-cyclicality in bank lending. I also saw that this would provide the element of real market discipline that banks had been missing, and could be a pillar of any new capital regulation.

Since then idea developed to address theoretical and practical issues as they arose, the main ones being (i) that the bank not being seen to fund its own capital, (ii) overcoming the divide between the loan origination and capital management functions within banks, and (iii) a practical form for the capital itself. This post provides a history of that development. Part 2 sets out the final product, the Regulatory Capital Swap.

Blog/Press coverage from Felix Salmon and the Sydney Morning Herald by Michael West.

Too Many Rating Classes

2009-08-18T14:10:00.000-07:00

Implied Precision in Loan Ratings

2009-08-10T00:32:00.001-07:00

Inflating Cashflow Conundrum

2009-08-07T05:49:00.000-07:00

Time For New Underwriting Conditions

2009-08-05T06:43:00.000-07:00

The Economic Basis of Syndicated Lending

2009-08-03T15:55:00.000-07:00

This is my PhD dissertation written over the period 2001 to 2004. One area that it didn't cover fully was the assessment of syndication risk, but I have since addressed this in the work on "Modelling Risk in Syndication" (see here).

The Problem With Counter-Cyclical Capital Ratios

2009-07-31T04:48:00.001-07:00

Modelling Risk in Syndication

2009-07-30T04:59:00.000-07:00

This is the text of an article included in the 5th Edition of Syndicated Lending: Practice and Documentation (ed. Tony Rhodes, Euromoney Books 2009).