August 3, 2011
The Energy Policy Act of 2005 established incentives to encourage private investment in innovative technologies, including advanced nuclear energy facilities. Much of the government’s support for the construction of nuclear power plants is offered in the form of federal loan guarantees. Those guarantees, which are administered by the Department of Energy (DOE), promote investment in nuclear energy by lowering the cost of borrowing and possibly increasing the availability of credit for project sponsors. In exchange, DOE is authorized to charge sponsors a fee that is meant to recoup the guarantee’s estimated budgetary cost. However, because budgetary cost estimates are not a comprehensive measure of the taxpayer resources committed, and because of concerns about the accuracy of the methods and assumptions that DOE uses to estimate expected losses, some commentators have suggested that federal loan guarantees for the construction of nuclear power plants are being systematically underpriced, whereas others believe they are being overpriced.
A CBO study, which was prepared at the request of the Ranking Member of the House Subcommittee on Regulatory Affairs, Stimulus Oversight, and Government Spending, identifies the main factors that influence the cost of federal loan guarantees for nuclear construction projects. It provides illustrative estimates of the costs of such guarantees, using both the methodology specified in the Federal Credit Reform Act of 1990 (FCRA) and a more comprehensive fair-value approach.
CBO finds the following:
- The expected cost to the federal government of guaranteeing a nuclear construction loan will vary greatly depending on a project’s characteristics and on the economic and regulatory environment in which the project will operate. Important considerations include the project’s capital structure (the mix of debt and equity used to finance the project); the sponsors’ ownership structure; whether construction costs may be passed on to utility ratepayers or local taxpayers; the degree of uncertainty about construction costs; the cost of competing generation technologies; and the demand for electricity.
- Default rates and recovery rates are likely to vary considerably, both across projects and over the lifetime of a given project. (A recovery rate measures the fraction of the present value of outstanding principal and interest that the lender receives in the event of a default.) CBO does not have enough information to independently estimate an average recovery rate; however, assigning a similar expected recovery rate as a starting point for all projects—which is DOE’s current practice—does not seem to make full use of the information available to DOE through its detailed project assessment process.
Using a single recovery rate tends to increase the variability of estimated guarantee costs relative to their true values, which increases the government’s exposure to a phenomenon known as adverse selection. Adverse selection occurs when borrowers are better able than the government to assess the value of a guarantee offer and take advantage of their superior information at the government’s expense.
- When credit ratings are used to assess default probabilities, cost estimates will vary widely with the assigned ratings category and the assumed recovery rate. They also depend on whether Treasury interest rates or estimated market interest rates are used for discounting future cash flows. As required under FCRA, budgetary estimates use Treasury interest rates for discounting future cash flows; fair-value estimates rely on estimates of the applicable market interest rates for discounting.
- Budgetary estimates of the costs of guaranteeing a hypothetical nuclear construction loan are significantly lower than the corresponding fair-value estimates, which provide a more comprehensive measure of the cost to taxpayers. Budgetary estimates do not recognize that the government’s assumption of financial risk has costs for taxpayers that exceed the average amount of losses that would be expected from defaults; those additional costs arise because a borrower is most likely to default on a loan and fail to make the promised payments of principal and interest during times of economic stress, when the losses are especially painful for taxpayers. Consequently, the budgetary cost of a guarantee is generally lower than its fair-value cost, which approximates the market price that a private guarantor would charge for an obligation with similar risk and expected returns. For hypothetical projects with low to moderate risk (specifically, with ratings in the range of “A” to “BB”) the budgetary cost, ranges from 1 percent to 6 percent of the principal loaned. In contrast, the fair value of the guarantee ranges from 9 percent to 21 percent of the principal loaned.
- It may not be possible to charge borrowers the full cost of a loan guarantee because of the high degree of uncertainty involved. When adverse selection is severe, attempts to offset expected losses with an increase in fees can backfire because the higher fees drive away creditworthy borrowers, making it impossible to provide a loan guarantee that does not involve a subsidy.
Historical experience suggests that investing in nuclear generating capacity engenders considerable risk. One study found that of the 117 privately owned plants in the United States that were started in the 1960s and 1970s and for which data were available almost all of them experienced significant cost overruns and 48 of them were cancelled. (In its analysis, CBO relied on a credit-ratings-based approach to evaluate the probability of default rather than on the historical experience of the nuclear industry, for which not enough data exist to draw quantitative inferences.)
Most of the utilities that have undertaken nuclear projects suffered ratings downgrades—sometimes several downgrades—during the construction phase. However, bondholders experienced losses from defaults in only a few instances. Losses for the most part were borne by the projects’ equity holders, the regions’ electricity ratepayers, and the government. Some analysts argue that newer plant designs and changes in the regulatory environment make nuclear investments less risky now, but recent experience abroad suggests that cost overruns and delays are still common phenomena, and concerns remain about an uncertain regulatory environment and changes in demand for electricity.
The study was written by Wendy Kiska and Deborah Lucas of CBO’s Financial Analysis Division.