Pedestrians pass by the Federal Reserve building in New York. The Fed is expected for the time being to continue its series of short-term interest rate hikes, marking a shift in monetary policy that would make borrowing more expensive in the years ahead.
Interest rate hikes in the U.S. and abundant, cheap credit available to finance power generation projects could compel borrowers to secure loans in the near term as a way to help mitigate rising costs overall, market participants said.
With the U.S. Federal Reserve's June 13 decision to lift short-term interest rates by 25 basis points, the implications on U.S. power sector project financing and leveraged lending appear largely muted, at least in the near term, given what power sector banking executives see as a lending environment making ample credit available.
Two broad factors have contributed to a market environment likely to remain favorable to power sector borrowers as an offset to rising investment costs: lenders' requirements to hedge against interest rate risk using swap contracts; and the willingness of equity sponsors to accept marginally lower returns because of a deluge of institutional credit from abroad.
Capital costs rising
Rising rates certainly contribute to making project economics more expensive, as debt financing experiences an uptick in base rates. Still, the availability of credit to North American power and renewables project financing is likely to maintain robust loan volumes in the near term, market participants said. According to data provided by MUFG Union Bank NA, power projects saw approximately $34 billion in loan volume in 2017, compared to $28 billion in 2016. Of that 2017 figure, some $22 billion in project loans were allocated to conventional thermal projects, with the remainder going to renewables projects, which experienced a slight decline year-over-year owing to uncertainty from federal tax reform legislation.
The implementation of federal tariffs on imported steel, aluminum and solar modules is likely to raise costs for renewables developers in particular, which could induce cost cuts elsewhere and make a modest uptick in interest rates a secondary concern.
"All-in costs are starting to go up," Elizabeth Waters, managing director for project finance investment banking at MUFG, told S&P Global Market Intelligence. "But sponsors are constantly looking for ways to be more efficient and look for ways to offset costs."
In the PJM Interconnection market, for example, rising projected borrowing costs for new-build projects may have contributed to an increase in capacity prices in the most recent auction, which experienced an 83% increase in most zone prices for power generators for the 2021/2022 forward year. Most early-stage, new-build projects will not typically obtain financing until permitting and regulatory matters are resolved, meaning the prospect of higher borrowing costs down the road could induce higher bids.
"It's making investments more expensive," Adil Sener, director of power, energy and infrastructure investment banking at Cantor Fitzgerald, said, pointing to the immediate impact of interest rate hikes. "To some extent, it's reflected in these auction prices."
The liquidity currently available in debt capital markets has created an environment where many lenders are willing to re-calibrate and notch down their return thresholds to remain competitive. Indeed, for contracted generation assets, spread premiums above the London Interbank Offered Rate have fallen as low as 135.5 basis points to 150 basis points, a marked decline from the 200-basis-point spread commonplace in the market not long ago, Ralph Cho, co-head of North America power and infrastructure finance at Investec Securities in New York, said. This steady compression on spreads may help offset the marginal increase from short-term Fed rate hikes.
"Right now, with compression of the margins coming in tighter, but a base rate that is rising, you're kind of left, for right now, a little bit net neutral," Cho said, pointing to the additional requirement of interest rate swaps used to hedge against increases to base rates. "What does happen is that as rates start to continue to move up, then that swap that you've entered into does become more valuable."
Similar liquidity offered in term loan markets has also helped large generators like Vistra Energy Corp., NRG Energy Inc. and Calpine Corp., as well as smaller portfolio companies like Atlantic Power Corp. and Lonestar Generation LLC, chip away at their credit spreads, through refinancing existing bank loans or opportunistic new issuance, according to S&P Global Market Intelligence data from Leveraged Commentary & Data. With such liquidity, against a backdrop of higher longer-term interest rates, the result has been an acceleration of teams coming to market looking to lock in loans for projects or larger transactions.
"Everybody is in a hurry to try to lock in interest rates right now and get projects done by entering into a swap-type contract before the fact, like say if they know they're going to do an M&A deal in a few months from now and there's certainty, they'll enter into a contract with banks to lock it in," Waters added.
But with the availability of lower credit spreads, the incentive for additional new-build investments in PJM, however, is more likely to be driven by that market's fundamental power price trajectory, as well as regulatory outcomes aimed at reforming its capacity market structure.
"Going forward, [rising rates] will have implications on investment decisions, but it's not the only one," Sener said. "There are still some investors with big checks and mandates to invest in PJM, so it will continue, but we may also see some diminishing appetite on new-builds."
Large institutional investor and sovereign funds, particularly players from Asia who are yield-constrained in their own markets, are likely to continue eyeing investments in a smaller pool of quality North American power assets, while bank lenders continue to compete to put their money to work, Mark Smith, MUFG's head of loan origination for project finance, said.
"There's a lot of competition for deals," Smith said. "There's a lot of liquidity and, at least from our institution, I'm not sure what disrupts that other than some kind of macro event that probably no one is going to foresee."