Power Market Liberalization:

The Cost of Capital
and
Risk Mitigation Planning

By Katia Karpova
Regional Coordinator,
Europe and the NIS
Institute for Public-Private Partnerships

About the Author...

Katia Karpova is the Regional Coordinator for Central and Eastern Europe for IP3. She is a frequent trainer in IP3 courses on topics such as financial analysis, tariff structuring, and financial modeling for private sector investment in infrastructure projects.

Introduction

Governments worldwide are restructuring/liberalizing their power generation, transmission, and distribution markets to introduce competition, improve service delivery, and lower costs for the consumer. In liberalized markets, utilities (public or private) are expected to perform more efficiently to achieve cost savings and greater profit margins due to reduced operations and maintenance costs, better managed fuel pricing, improved application of generation capacity and technical design, and greater labor productivity¹. The net impact of the effectiveness of power market liberalization on investment risks and the resulting cost of capital, however, is contingent on a number of related factors, including market trends, country conditions, and existing regulatory and institutional arrangements. Greater risks translate into higher cost of capital, which of course means generally higher risks to government through direct or indirect subsidies and higher tariffs for consumers.

This article provides an overview of enhanced financial planning and management for both investors and consumers in a liberalized (or liberalizing) power market, with focused discussion on the risks and risk mitigation strategies for effectively managing the cost of capital.

Cost of Capital

The "cost of capital" to the project is simply characterized as the cost of acquiring debt ("cost of debt") and equity investment ("cost of equity") to finance the project. A project's cost of capital is calculated using the Weighted Average Cost of Capital (WACC) formula. When computed, the cost of capital is compared to the financial internal rate of return on the project (FIRR) to determine profitability and merit of the project and the consequent investment decision.

If the cost of financing the project were less that the expected return on the project, all else being equal, the investor would accept the project. The cost of debt is the interest to be paid to the lender. The cost of equity is the rate of return on the equity holdings expected by shareholders (based on a number of risk factors) and is calculated using the Capital Asset Pricing Model (CAPM) discussed below. Return on the equity portion of the capital structure sometimes includes return on equity plus recourse/limited recourse loans. The figure above illustrates a typical "Cost of Capital" structure for a project.

Weighted Average Cost of Capital (WACC)

One important tool to utilize in the initial stages of a project opportunity pre-feasibility analysis is to calculate the Weighted Average Cost of Capital. Using the WACC formula, the cost of capital to the project is estimated, which is then compared to the financial internal rate of return on the project. In determining the merit of the project, a FIRR in excess of WACC (again, all else being equal) is used as a threshold for accepting the project for investment.

The cost of each capital component is "weighted" by its proportion in the overall capital structure of the project, which is determined by the debt/equity ratio, otherwise known as "leverage ratio" of a project. To illustrate, the weight on debt in a 60/40 leveraged ratio would be 0.6, multiplied by the interest rate on the cost of debt (i.e. loan) for a project. The cost of equity component is calculated similarly: the "weight" on the equity portion is multiplied by the return on equity derived through the application of CAPM. The formula for WACC calculation is provided below:

WACC = we*re + wd(1-T)*rd

Where re is the cost of or required rate of return on equity, rd is the cost of debt, we is the amount (weight) of equity, wd is the weight on debt, and T is the tax rate for tax-free debt environments.

While it is easy to determine the cost of debt represented by the interest on the loan, it is more challenging to calculate the cost of equity. The CAPM model is used to estimate the cost of equity.

Capital Asset Pricing Model (CAPM)

CAPM is used to calculate the cost of equity or the required rate of return on equity stock. Components of the CAPM include the risk free rate, which is usually represented by the least risky financial instrument in the market (for example, the Treasury Bill is used as the benchmark in the United States) and the market risk premium or the difference between the risk free rate and the overall risk on a well diversified market portfolio, which is multiplied by the beta coefficient. The risk-free rate can represent the yields on short-term deposits or government bonds, anywhere between 1 and 5 years in maturity.

Beta is the correlation between returns on the stock and those of the entire market and is referred to as a risk indicator of the stock. CAPM assumes that there is a direct relationship between the risk of a stock and the market risk. Beta of 1 indicates that the stock moves identically with the overall market, i.e. the risks of the stock and the market are the same, while a beta greater than 1 implies a riskier asset relative to the market. Below formula is used to calculate the CAPM.

Re = Risk-free rate + (Market Risk - Risk Free Rate)*b

In countries with less developed capital markets, however, it is difficult to use the CAPM and estimate its components. For these environments, the "rule of thumb" is to estimate the risk free rate based on the returns on the least risky government security, and estimate the market risk premium using other criteria, such as average industry returns with similar environments, other utility returns within the sector, market proxies, or credit ratings.

Implications for Liberalized Power Markets

In liberalized markets, power project cost of capital may increase due to the greater uncertainties and risks perceived by the investors, making it more expensive to raise both debt and equity for utility companies. However, utilities may decide to use a number of solutions to offset and mitigate the increased cost of capital, including the following:

Consider adjusting the leverage ratio to reduce the overall cost of capital to the project. Lenders ultimately determine the amount of leveraged debt in the financing of a project, which is normally less costly than equity. Lenders will demand that there is adequate equity component in the capital structure of the project, which serves as insurance and an indication of commitment on part of the project sponsors in the outcome of the project. In most cases, lenders favor more equity investments on part of the project developers, governments, and international finance organizations (such as the International Finance Corporation).

Allocate risks to the parties most suitable to manage/control the risk. In competitive markets, it is crucial to identify and allocate risks to the relevant parties in the project. For example, due to the nature of liberalized markets and the introduction of market-pricing mechanisms, tariff increases that may be necessary to cover the costs may have to be increased on a gradual basis and not all at once. This may escalate the risks associated with potential cost overruns and construction financing delays, including lower electricity sales, loss of customers to other providers, lower power sales price, and higher O&M costs, which have to be accounted for and efficiently allocated to responsible parties.

Utilities and government must demonstrate a commitment to cost reduction and cost recovery programs. Power market liberalization should provide incentives for utilities to minimize their costs in order to be able to successfully compete in the market and make sufficient margins. Utilities are likely to seek more favorable fuel arrangements, labor management strategies, cost effective O&M planning, etc. It is important for utilities to be able to demonstrate to potential investors and lenders that they have a viable plan in place to reduce the costs and achieve cost recovery under all scenarios and that the government will fully support such reform initiatives

Reduce regulatory risks. One of the goals of market liberalization should be reduced regulatory risks faced by utilities. However, according to the International Energy Agency report, "there has been increased business risk in recent years from unexpected regulatory actions. Some regulatory authorities and governments have more critically evaluated costs incurred by monopoly supply utilities."² It is important for governments and regulatory bodies to clearly delineate the regulatory functions and manage/rule in a consistent and effective manner. This will only increase the confidence of all stakeholders in the regulatory processes and allow the consumers to reap the benefits of liberalization.

Ensure sufficient regulation in the transition stage. Simultaneously, it is critical to ensure strong regulation during transition to the liberalized power market. Successful market liberalization efforts will depend on the emergence of competitive and reliable domestic power utilities. Adequate regulation will safeguard the interests of new investors and encourage the much-needed investment into the power sector.

Consider less capital-intensive technologies. Finally, in the process of reducing costs and becoming competitive and reliable service providers, power utilities will be forced to consider new fuel and technology options, giving preference to the choices with least cost and shorter construction periods³ . New long-term investors will favor environmentally sound technologies in renewable energy resources, which will become more of practice than innovation in the years to come.

Conclusion

In some environments, liberalization of power markets may result in greater costs of capital to the projects. To mitigate the potential increases in cost of capital, countries should consider the options for reducing risks and costs as discussed above. This will enable them to build competitive, reliable, and cost-effective power supply while placing downward pressure on prices for consumers in increasingly competitive and liberalizing power markets.

¹ "Electricity Reform," International Energy Agency, 1999, OECD

² Ibid.

³Ibid