When your WACC doesn't work: Transition project financing

By Werner Rehm and Abhishek Saxena?

Large companies have established methods and processes, and likely among them is a standard weighted average cost of capital, or WACC. However, return, risk, and financing profiles for transition projects can be very distinct from those of the existing business. Free cash flow projections, corporate balance sheet financing, and a single WACC definition don’t work for these projects. In this edition, we discuss the reasons for this and offer some alternatives, such as time-varying WACC, discounted cash flow (DCF), adjusted present value (APV), or cash-flow-to-equity (CFE) valuation.?

How transition investments can be different from your traditional businesses

While there are many businesses that are accustomed to project financing as the main source of capital (solar and wind utilities, for example), many large incumbents are more familiar with what is effectively balance-sheet-based financing of everything, even large investments.?

"We decide on the steel we put into the ground and value the cash flows after some risk adjustment with a WACC that we have been told to use. That's how it's always been." - Oil and gas executive.?

However, energy transition projects – from carbon capture over batteries to hydrogen – can be very different. They may have some or all of the following:?

• A different risk profile, because of factors such as government guarantees or fixed-price offtake contracts like power purchase agreements (PPA).?
• Nontraditional financing, as some investments enable or even require financing from third parties with a particular interest in sustainable investments. Examples of these include project financing, sustainability-linked financing, and loan guarantees by governments.?
• Execution risk, because, in some cases, the energy transition requires a complete or substantial overhaul of existing manufacturing or distribution processes, or indeed a start-up of an entirely new business.?

Why not standard WACC DCF??

Most companies still operate in a traditional structure with many assets at many stages of life and with corporate debt, where the discounted cash flow (DCF) approach with return on capital, WACC, and balance sheet financing works in a straightforward manner. The relationship of investment, financing, risk, and return is roughly the same for all assets in the business, and all are financed the same way. Traditional NPV is solidly established as decision criteria.?

"The project guys think in levered IRR. We think in NPV. I need to be able to compare these investments." - Oil and gas executive.?

However, this is not the case in many transition investments that these large incumbents are now facing. These projects have a risk profile that changes over time and supports some form of structured financing. Examples include:?

• Cash flow guarantees – typically PPAs that significantly reduce the project's business risk compared to its corporate parent (sponsor) and enable separate funding at lower interest rates. Examples are PPAs for wind or solar parks and carbon capture and storage projects.?
• Ownership complexities – multiple equity investors that could also change over time, creating the need for separate legal entities around partnerships and joint ventures, which carry their own capital structure. Examples are co-investments in innovative hydrogen or battery technologies with partners increasing/decreasing ownership stakes over time.?
• Government subsidies – government or third-party funding and sponsoring that provides cash inflows specifically for the investment project. Examples are government subsidies, project-specific loans, and government guarantees for commercial loans for hydrogen technology investments.?
• Transition bonds/loans – debt funding with interest rate discounts. Examples are sustainability-linked debt, which provides lower or higher interest rates, depending on whether project targets are being achieved or not. ?

All these create risk/return profiles that vary over time, creating varying capital structures because they require principal repayment and, therefore, require a different way of thinking about valuation than just “what’s the WACC?”?

Bridging the philosophies?

So, what can we do? If you really want an NPV for a project with cash flows of different risk profiles and time-variant capital structure, you can use adjusted present value, or APV. APV is based on the idea that the value of debt is the present value of the tax shield of debt. Basically, you need to 1) discount cash streams at their appropriate, unlevered, discount rate; and 2) discount the value of the tax shield of the debt. And sum it all up. ?

This week, we are talking about this idea conceptually. In a future post, we will bring some example schedules and estimates to bring these concepts to practical life.?

As usual, let’s start with some general principles for valuation of cash streams with different risk/return profiles:?

• Disaggregate cash flows (CF) into underlying components according to their risk profile. In a typical company, this would be business segments. In a transition project, you need to separate investment CF, operating CF with merchant risk/commercial pricing exposure, operating CF with (lower) PPA risk, government subsidies with no payback requirement, et cetera.?
• Estimate financing cash flows to calculate cash flow to equity. Project financing has a fundamentally changing capital structure, and you need to look at equity cash flow. This is not new. However, for investments with different tiers of structured financing (such as high-yield project debt, government-sponsored financing, or sustainability-linked financing), you need to include explicit financing cash flow projections for each source of financing. You also need to include explicit forecasted interest payments by the source to be able to apply adjusted present value instead of discounted cash flow to separate the different kinds of financing streams (for example, low-interest government bonds that might be forgiven versus a bank loan).?
• Discount the individual cash flows at their appropriate cost of capital. This is typically done using APV by discounting the cash flow with?unlevered discount rates and estimating the value of the tax shield from debt separately. You could also use equity cash flow (CFE) with a time-varying cost of equity. This results in several components of value, discounting at their individual rates, that you need to add up.?

We would love to hear from you.?

• Does your company try to force projects with government financing and changing capital structure into one WACC? How do you deal with that??
• How do you deal with the different riskiness of PPA versus a market-facing pricing mechanism in projects??
• Are there any good examples you’ve seen where this was applied??

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