Loan guarantees: investments, not subsidies

1 September 2009

A recent study conducted by the Wall Street Journal suggested that the public is growing wary of government intervention in business affairs. Backstopping or subsidizing "risky" businesses has developed a negative connotation as taxpayers have become increasingly concerned about the manner in which their tax dollars are used. Consequently, the loan guarantees created by Title XVII of the Energy Policy Act of 2005 are sure to encounter skepticism.

Through the Loan Guarantee Program, the Department of Energy ("DOE") has been entrusted with up to $90 billion in guarantee authority to facilitate the development of clean energy technologies. Before considering the ideals the program seeks to promote, the sheer magnitude of the authorization alone warrants consideration. The prudence of a $90 billion program should be assessed with impartial analysis of the risks and rewards. A simple analysis that treats the loan guarantee as an investment made by the government in exchange for future tax revenue can enable these risks and rewards to be evaluated in the same objective manner as any investment decision. Although the initial inclination may be to classify the loan guarantees as a subsidy, the analysis detailed herein reveals a mutually beneficial arrangement. The loan guarantee differentiates itself from a standard subsidy in that it is likely to result in a positive return on investment for the U.S. government.

Typically, a subsidy is defined as a grant by the government to assist an enterprise deemed advantageous to the public. That is, subsidies are extended without any expectation of direct monetary return. In contrast, the Title XVII Loan Guarantee Program requires recipients to pay for the guarantee through a Credit Subsidy Cost ("CSC"). The term CSC is an oxymoron, however, in that if the loan guarantee were a true subsidy, the government would not require this compensation. Through the CSC, recipients are required to pay the net present value of the anticipated cost of default. This framework is similar to that used by insurance companies to calculate premiums.

Congress established the loan guarantee to support up to 80% of the costs dedicated to the construction, commissioning, and startup of clean energy projects. In the case of a hypothetical nuclear project, with estimated all-in costs of $10 billion, 80% of those costs can equate to the government having a potential exposure of $8 billion per project. Opponents of the loan guarantee program have deemed this potential exposure irresponsible and unnecessary for taxpayers. Conversely, advocates of the program believe the risks are remote and can be justified by zero-emission power generation and job creation. The assertions made by both sides overlook an additional benefit from the government's perspective: tax revenue.

In addition to the CSC payment itself, the government receives compensation in the form of future tax revenue generated by the project. It is essential to point out that this revenue is wholly dependent on the provision of the guarantee. In a July 2007 letter, six investment banks made it known to the DOE that nuclear projects would have difficulty accessing the capital markets without the support of a federal loan guarantee. Two years later, much of the financial sector remains in disarray and banks are no less risk-averse. The loan guarantees are therefore critical for nuclear power projects, which require an investment comparable to the GDP of a small nation. Since the tax revenue received by the government is contingent upon the loan guarantee offered by the government, the engagement should be evaluated in the context of risk vs. reward. Do the tax revenues of the project warrant the exposure associated with the loan guarantee?

The potential loss of $8 billion on a single project may seem staggering, but not when compared to the tax revenue generated by a nuclear plant over its 40-plus year life. To demonstrate this, DAI Management Consultants performed a simple cost-benefit analysis for one of the project's applying for a loan guarantee. We compared the government's risk of loss against the tax revenues received. To be conservative, we ignored the CSC payment to the government (which by definition must already compensate the government for an expected default). Instead, the intent of our analysis was to determine the probability of default that produces a breakeven point between the present value of the tax revenues and the losses incurred by the government during a default event. In short: how high would default probabilities have to get in order for this not to be a good investment for the government?

The loss rate given default for a new nuclear project has been estimated to be between 10% and 40% by Standard & Poor's. In other words, in the event of a default, lenders (or guarantors) are likely to recover 60% to 90% of their loan. Even in the extreme case of a 40% loss rate, the results of our analysis showed that the net present value to the government of providing a loan guarantee is positive unless the probability of default exceeds 75%. Further, in the unlikely event that a project suffers a complete loss upon default (a 100% loss rate) by expending its entire capital budget and realizing no recovery through eventual operation, the probability of default would need to exceed 30% before the loan guarantee would be imprudent from an investment perspective.

Considering that the DOE has based as much as half of the screening process on an applicant's creditworthiness, it is improbable that those projects considered the most eligible have a 30% to 75% chance of default. Therefore, the loan guarantees appear to be reasonable – and well-compensated – investment opportunities for the U.S. government.

Few matters are as passionately debated as nuclear power. The prospects of global climate change and rising fossil fuel prices, however, are much too serious for one's passion to supplant sober, objective assessment. In fact, it is precisely because of the seriousness and import of the decision that data must be collected and analysis performed dispassionately and objectively. Such analysis of the loan guarantees is not only possible, but also the reasonable thing to do. It's an investment, after all, not a subsidy. The government should treat it like one.

Author Info:

Budd Shaffer, P.E., David Rode, and Steve Dean, ASA, P.E. are all of DAI Management Consultants, Inc.

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