The nuclear industry in the UK, and beyond, will warmly welcome EDFs final investment decision for Hinkley Point C. However, as the UK government mulls over the project fundamentals one last time before committing, it is worth reflecting that, if and when the project finally goes ahead, EDF and its Chinese partners will proceed on the basis of on-balance sheet corporate funding; not limited-recourse project financing, as originally touted.
This is not surprising. A project of the size and complexity of Hinkley Point C faces a range of challenges that lessen the availability of third party limited-recourse finance. However, the well-documented construction issues encountered by EDFs other European Pressurised Reactor projects, against the backdrop of construction delays which have blighted so many other nuclear projects globally, seemingly acted as the biggest barrier to accessing third party debt-finance. The unpredictability of project costs and schedule that characterizes nuclear plant construction violates the basic precepts of project finance. Yet, for the industry to flourish, even in the presence of strong government policy support, the ability to finance is critical. This article examines some of the basic issues on which lenders focus in assessing bankability and the possibility that new technology and new construction techniques, in the form of small modular reactors (SMRs), may hold the key to overcoming these issues.
Political and Regulatory Risk
Nuclear projects inevitably require a comprehensive package of regulatory approvals. In the UK, the key approvals include the Nuclear Site Licence (for design, construction, commissioning, operation, maintenance and decommissioning), the Generic Design Assessment (not mandatory, but widely considered as a pre-requisite to a successful Nuclear Site Licence application), a Development Consent Order (permitting construction) and EU State Aid approvals (for government support offered to a project), each subject to their own application procedures as well as challenges and appeals. Nuclear projects in most other countries will require similar approvals. To avoid exposure to delays in procurement of regulatory delays, lenders will require a developer to have procured all relevant approvals (and exhausted all possible appeals or challenges) prior to disbursing debt.
However, in a controversial field like nuclear power, there remains a risk that political or public sentiment could change during the life a project; as happened in Germany, which effectively ended its nuclear power industry in the wake of the Fukushima disaster. Lenders will require assurances that changes in policy will not adversely affect their exposure. For Hinkley Point C, the UK government agreed to enter into a so-called Secretary of State Agreement with the project sponsors, which will grant the sponsors a put-option against the government in the event of a political shutdown of the project, effectively requiring the government to compensate the sponsors for their loss of investment project lenders would no doubt expect such put-option to cover the cost of repayment of all outstanding project debt.
Security and Sufficiency of Revenue
An essential requirement for the project financing of any power project is a secure, stable revenue stream over a sufficient period of time to match or exceed debt tenor. Commercial contracts supporting the revenue stream must yield an acceptable minimum return to the project throughout the term of the debt facility, regardless of market prices for the commodity. The capital requirements and construction periods of large nuclear projects necessarily require significant levels of debt to be held over untypically long tenors; this combination leaves nuclear projects particularly vulnerable to long-term market price fluctuations. This in turn makes a long-term, minimum-price, power purchase agreement (or equivalent) a fundamental bankability requirement. In the UK it was widely perceived that the limited pool of large utility off-takers would not collectively create enough demand to guarantee the off-take of an entire nuclear fleet and, in any event, that it would not be cost-effective to require off-takers to fix minimum prices over 20 to 30 year periods.
The UK governments electricity market reform initiatives, including the flagship Contract-for-Difference (a fixed term contract between a qualifying generator and a government counterparty with a two-way payment mechanism guaranteeing a minimum price-per MWh of electricity), have shored up the bankability of nuclear power projects. Nevertheless, even the Hinkley Point C Contract-for-Difference (which guarantees a power price of more than double the prevailing market price over a 35 year term) was not enough to satisfy prospective lenders or bond underwriters that the project represented a bankable proposal. The problem lurked elsewhere construction risk.
Arguably the single biggest consideration for EDF in making its final investment decision, and generally for any investor or potential financier of a nuclear project, is the magnitude of construction risk, i.e., the risk that the construction of a project will be more time-consuming or more costly than originally anticipated. Traditional nuclear plants are massive civil engineering works, each practically unique. The power island is not an easily isolated unit separate from those works. They thus often face design and construction issues not experienced on other superficially similar projects. In such situations, the standard approach of requiring construction contractors to bear the brunt of construction risk has limited application; general contracting companies do not have the expertise to design and build the reactor core and the specialist nuclear technology providers typically do not wish to take on responsibility for the broader civil and non-specialist construction activities interface risk is extremely difficult to avoid, and onsite complications abound in the construction process. Moreover, most contractors simply do not have the balance sheet strength to underwrite the construction risk for an entire project.
In project financing, lenders want assurances that such risks will not present themselves in the first place, rather than taking comfort in contractual protections if they do. Sadly, large nuclear reactors have a poor track record in this regard; the predicted cost of the as-yet unfinished Olkiluoto-3 facility in Finland (which utilises the same European Pressurised Reactor technology as planned for Hinkley Point C) currently stands at nearly 5.5 billion -- over an initial 3 billion budget -- and the sponsors anticipate an eight-year delay in achieving commercial operation 1[http://www.world-nuclear-news.org/NN-Olkiluoto-3-begins-instrumentation-and-control-tests-1401164.html. EDFs Flamanville project in France has experienced cost overruns and delays of a similar scale. In fact, a 2014 study found that, of 180 large nuclear reactors worldwide, overruns afflicted more than 97 percent2http://www.sciencedirect.com/science/article/pii/S2214629614000942. Delays and cost overruns are not confined to the nuclear sector; three quarters of large infrastructure projects experience construction delays 3http://www.mega-project.eu/assets/exp/docs/Risk_in_the_Front_End_of_Megaprojects_-_2nd_ed.pdf. Nevertheless, the complex and highly regulated nature of nuclear power generation enhances the risk beyond that experienced by other large projects; there is more scope for error, but less margin for it. Minor snags during construction cannot be accepted in a nuclear plant; rework ordered by nuclear regulators during construction accounted for a significant portion of the delays to Olkiluoto-3 and Flamanville. Whilst the Hinkley Point C sponsors will hope that the UKs Generic Design Assessment (which encourages early regulator involvement in the design of a nuclear plant) will help mitigate construction risk, many commentators and stakeholders perceive high levels of construction risk as an unavoidable fact of life for large nuclear power projects.
Delays and cost overruns present fundamental issues for project financing, in which the borrower (the special purpose company established to construct, own and operate a project) repays debt solely from firmly contracted or dependably forecasted revenues and lenders have limited or no recourse to the project sponsors. A delayed, incomplete project cannot earn the revenue required to repay project debt. The longer construction takes, the longer the lenders capital remains tied-up and at risk, and the more stress is placed on project economics. All the while, cost-overruns (which typically come hand-in-hand with construction delays), create a hole in the project companys finances and ultimately may threaten its solvency. While project sponsors will likely be required to provide significant sponsor support commitments to cover cost-overruns and potential debt service deficiencies, they will not write blank cheques, and the lenders will want to know that the completion of construction will occur before the sponsors reach their limit. Uncertainty about completion is a deal-killer: lenders know it would be very difficult to recover capital out of a half-finished nuclear reactor.
Small Modular Reactors
SMRs are nuclear reactors typically offering 300 MW, or less, of generating capacity and comprising one or more individual integrated modules comprising pre-fabricated ready-to-install components (nuclear core, steam generators, pressurisers and instrumentation equipment). The modules can be manufactured on a production-line basis; adhering to a standard design, fabricated within a factory and delivered to site (in most cases by truck or rail) in an almost turn-key state. On-site construction activities are limited to the construction of a seismically designed building to house the modules and the installation of the modules upon delivery to site.
No civil-nuclear SMR has achieved commercial operations; but a number of facilities, including a facility to be located in the US State of Idaho schedule for commercial operations in 2024, are in advance stages of development. While the first SMRs to be installed will doubtless surface interesting construction risk issues, it is not difficult to imagine that the construction risk profile of a SMR project is significantly better than that of large facilities such as Flamanville and Hinkley Point C. The design of the entire facility is standardized, meaning the bespoke element is reduced. The self-contained, non-mechanical cooling water systems of designs like that of NuScale Power mean fewer interface issues, resulting in less contracting complexity. The smaller capital costs and shorter construction periods alone should make a small nuclear project better suited for project finance; most construction problems will be resolved at the factory in a controlled environment. Site assembly should be relatively straightforward, and the reactor should start generating revenue sooner so investors and lenders should see returns more quickly. The production-line approach to manufacturing is a stark contrast to the complexity of the large projects, some of which have been described as unconstructable and the scalable nature of SMR technology means that additional units can be installed after initial commercial operations, which opens up the possibility of financing in tranches (which, of itself, mitigates construction risk exposure because the lender(s) only face a small portion of the overall construction risk during any financing tranche).
Of course, construction risk alone is not the only issue that makes project financing a challenge for nuclear projects the highly regulated nature of nuclear power, particularly the requirement for a designated licensee to construct and at all times operate a nuclear site, does not fit easily with many standard project financing instruments and techniques such as lenders direct agreements and security packages. But the fact is that SMRs are no longer just pie in the sky billions of dollars investment have been committed to the development of this technology (including more than $200 million by the US Department of Energy and up to 250 million by the UK government) and, in the UK at least, the possibility of Contracts-for-Difference, and other government-backed credit enhancements, create an attractive framework for investment and financing. As Hinkley Point C has again shown, discussions around the feasibility and mechanics of project finance for nuclear projects have often stalled with construction risk; SMRs may just change that.