Federal Loan Guarantees for the Construction of Nuclear Power Plants
Administered by the Department of Energy (DOE), the loan guarantee program encourages private investment in nuclear energy by lowering the cost of borrowing and possibly increasing the availability of credit for project sponsors—usually an individual utility, a consortium of utilities, or a merchant power producer. In exchange for providing a loan guarantee, DOE is authorized to charge sponsors a fee that is meant to recover the guarantee's estimated budgetary cost.
However, budgetary cost estimates—which are calculated as required under the Federal Credit Reform Act of 1990 (FCRA)—are not a comprehensive measure of the cost to taxpayers of those guarantee commitments. Specifically, FCRA 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 estimated budgetary cost of a guarantee is generally lower than its estimated "fair-value" cost, which approximates the market price that a private guarantor would charge for an obligation with similar risk and expected returns.
CBO does not have enough information to independently estimate an average recovery rate for nuclear construction loans. However, assigning a similar expected recovery rate as a starting point for all projects—which is DOE's current practice—does not appear to make full use of the information available to DOE through its detailed project assessment process. For example, when sponsors of stand-alone projects cannot pass on construction costs to rate-payers, very low recoveries may result if bankruptcy occurs during the construction phase. By contrast, recovery rates may be considerably higher once projects become operational.
CBO's findings are as follows:
- 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 capital structure (the mix of debt and equity used to finance the project); ownership structure (whether it is a stand-alone project or part of a diversified company); whether construction costs may be passed on to utility ratepayers or local taxpayers; the regulatory environment; the degree of uncertainty about construction costs; the cost of competing generation technologies; and the demand for electricity. Although a serious nuclear accident could entail extremely large costs to investors and society, that risk has a small effect on the direct cost to the government of providing a guarantee because liability under the guarantee is limited to the amount of the debt, and the probability that such an accident will occur is low.
- Default rates and recovery rates are likely to vary considerably, both across projects and over the lifetime of a given project. CBO does not have enough information to independently estimate an average recovery rate for nuclear construction loans. However, assigning a similar expected recovery rate as a starting point for all projects—which is DOE's current practice—does not appear to make full use of the information available to DOE through its detailed project assessment process. For example, when sponsors of stand-alone projects cannot pass on construction costs to rate-payers, very low recoveries may result if bankruptcy occurs during the construction phase. By contrast, recovery rates may be considerably higher once projects become operational.
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. For nuclear construction loans, borrowers will tend to turn down a guarantee if they believe the fee set by DOE is too high but go forward if they consider it fair or underpriced, which increases the likelihood that DOE's portfolio will include more projects for which the subsidy fee has been underestimated than overestimated.
- When credit ratings are used to assess default probabilities, cost estimates will vary widely with the assigned ratings category, the assumed recovery rate, and whether Treasury interest rates or estimated market interest rates are used for discounting. CBO relied on the information in historical credit ratings to impute default probabilities (as does DOE) and considered a range of recovery rates that might apply to different projects depending on their characteristics. 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 guarantee costs are significantly lower than the corresponding fair-value estimates, which provide a more comprehensive measure of the cost to taxpayers. CBO used the credit rating associated with a project to derive the discount rate the market would most likely assign to the loan cash flows. For example, if the risks associated with a guaranteed loan are in the range of those posed by bonds rated A (less risky) and bonds rated BB (riskier), and if 55 percent of the amount owed is expected to be recovered in the event of a default, the budgetary cost, measured on a FCRA basis, 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.
- Because of the high degree of uncertainty involved, it may not be possible to charge borrowers the full cost of a loan guarantee. 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.