CALPINE CORPORATION

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CALPINE CORPORATION: THE EVOLUTION FROM PROJECT TO CORPORATE FINANCE /
THE OPERATION OF MERCHANT POWER GENERATING PLANTS

By Bruce Egsieker

Calpine Corporation's Senior Vice President of Finance (S.V.P.) Bob Kelly and Vice President (V.P.) of Finance Robin Crabtree knew 1999 was going to be a difficult year. Chief Executive Officer (C.E.O.) Pete Cartwright had recently announced a bold ramp-up in Calpine's growth strategy, raising the 5-year target for generating capacity from 6,300 to 15,000 megawatts (MW).

The financial requirements were formidable. Adding 12,000 MW to Calpine's current 3,000 MW electric generating portfolio would mean building or acquiring 25 new electric power generating plants, or an average of five per year compared to one or two plants per year in recent years. Moreover, at a cost of roughly $500,000 per Megawatt (MW) for a BB rated company with total assets of only $1.7 billion and a debt-to-capitalization ratio of 79%, financing would not be easy.

Calpine would need an additional $5.0 billion dollars…so they needed creative solutions.

With annual revenues of $296 billion, and assets of $686 billion, the U.S. electric power industry was the country's third largest after automobiles and health care. Segregated into three principal functions: generation, bulk transmission, and distribution. Approximately 170 investor-owned utilities controlled 72% of the industry's total generating capacity of 733,000MW; the federal government, municipal and cooperative electric companies and other kinds of producers controlled the remaining 28%.

Despite the increasing demand for new power plants, capital spending had declined sharply. As a result, the benchmark "reserve margin" between peak electricity demand and generating capacity had declined from 35% in 1985 to under 12% in mid 1999. Industry experts generally believed a reserve margin of 15% to 20% was a comfort zone. (pre-September 11).

Federal regulation dating back to the 1930's created restrictions on multi-state operations, which meant the power industry became a collection of regional markets rather than a single national market and state regulators set retail prices.

During the 1970's and 1980's deregulation eliminated or weakened the monopoly service rights and fixed-price systems that defined the industry. The new Public Utilities Regulatory Policies Act (PURPA) in 1978 also promoted the use of geothermal, solar and wind power generating facilities.

Calpine had to move to project finance for such an aggressive building schedule for new plants. Project finance lenders became comfortable with terms that were aggressive by the standards of conventional bank lending because IPP's had steady streams of long-term cash flow and were ring-fenced from other risks associated with the parent company.

Independent power producers (IPP) had a debt to capital ratio of 80% to 95% compared to 40% to 50% for the average utility. IPP's could support higher leverage without a large penalty in funding cost because, the power contract, was relatively safe.

For example: combined-cycle gas turbines (CCGT) were capable of generating power at significantly lower cost and in an environmentally cleaner way than existing technologies. The marginal cost of operating a CCGT plant, as determined by its heat rate, was 25% to 35% lower than existing technologies and they cost less to build.

In 1992 Congress passed the National Energy Policy Act (NEPA), an act that allowed IPP's to sell power at wholesale prices over the existing transmission systems and protected them against discriminatory rates and access. But it did leave the issue of retail competition in distribution up to the individual states.

In fact, IPP's accounted for half of all power plant construction during the 1990's and represented almost 7.0% of total U.S. generating capacity by 1998. Forecasters predicted that by 2002, these merchant or competitive transactions would account for anywhere from 0% to 90% of wholesale transactions depending on the region.

CALPINE CORPORATION

Headquartered in San Jose, California, Calpine was founded in 1984, as a wholly-owned subsidiary of Electrowatt, a Swiss industrial corporation affiliated with Credit Suisse Banking Group. The name Calpine reflected its California location and its Swiss parentage (California + Alpine = Calpine). From 1984 through 1998, Calpine pursued the construction and operation of QF power plants on the IPP model, creating a new subsidiary to finance each plant, as well as acquisitions of other IPP's. As of March 1999, it had 22 plants with a combined capacity of 2,729 MW operating in seven states, and another 12 plants in various stages of development.

Between 1994 and 1998, consolidated assets increased from $421 million to $1,712 million.

In 1994, Calpine began a policy of retiring old project debt with parent-level corporate debt issues. The first issue, $105 million of unsecured senior notes, was followed by four more issues between 1996 and 1999, as Calpine's debt rating improved from B1/B to Ba2/BB. Credit Suisse First Boston (CSFB) led an initial public offering (IPO) in September 1996, which raised $317 million at a price of $16.000 per share of common stock.

In 1996, Phillips Petroleum requested bids for a 20 year fixed price contract on 90 MW of power for a chemical plant in Pasadena, Texas. Calpine was committed to win this contract. Their bid was successful and in February of 1997, financed a $152 million project loan from ING (US) Capital. Although it was the first loan to a U.S. power plant with merchant risk, the syndication was oversubscribed in the bank market.

At this time Pete Cartwright (CEO) sensed that the world was going towards large, gas-fired generating units selling power into competitive markets. He also believed that this strategy was exportable as well yielding environmentally friendly, high efficiency gas turbines and building a vertically integrated company with engineering, construction, operating, fuel supply power marketing, and financing capabilities in a single firm.

Rather than relying on outside general contractors and turnkey contracts, Calpine would manage construction itself under the "Calpine Construct" method. Besides eliminating costly and time-consuming negotiations with contractors, this approach eliminated the cost of the general contractor's margin and contingency reserves. In October 1998, Calpine acquired the Walsh Construction Power Division of the Guy Atkinson Corporation, a Sacramento based construction management firm, and folded it into a new subsidiary named Calpine Construction Corporation to manage plant construction.

So Calpine would build its own plants and do its on in-house maintenance of those plants. These new Merchant plants would be the wave of the future, combined-cycle gas turbine plants. Calpine was to increase the number of these plants from six in 1998 to 60 or more over the next five to six years at a total cost for the turbines of $3.0 billion.

To get to 15,000 MW in five years, they needed to raise at least $4.5 billion from debt and equity markets assuming Calpine generated $1.5 billion of cash from operations as projected. In the near term, however, they needed to finance four merchant plants with a total capacity of 2,265 MW at a cost of $300 million each.

The problem is that banks put these project financing packages together one at a time and lend on a single plant basis but the company needed to move forward with more than one at a time. They could do a public offering of senior notes which would put them on the upper end of the sub-investment grade high yield market.

Also these notes would have 7 to 10 year bullet maturities…which could hurt them so what do they do?

However, in a meeting with Credit Suisse First Boston they believed they could arrange a financing package that met Calpine's needs. They suggested that they set up a new subsidiary named Calpine Construction Finance Company (CCFC) and it would borrow $1.0 billion dollars (enough to get several plants going at once) in a secured revolving construction facility with a four year maturity. Calpine would invest $430 million of equity and guarantee completion of the four plants by investing as much additional equity as needed to finish the plants by a certain date. CCFC would also be able to use the funds to build additional power plants subject to approval by a committee comprised of lending banks. As a revolving facility, amounts borrowed and repaid could be re-borrowed for these additional plants, with no required repayment of principal due until 2003. Financing the four plants in one transaction was appealing from process standpoint and would save legal and other fees.

In traditional project finance when you pay down the loan, that's it. But here, we can borrow as we pay down the loan and bring in the next plant. So we are basically constructing plants in a circle. We can use the $1.0 billion of capital to finance eight or twelve plants instead of just a few. This increases the velocity of money and allows us to develop regardless of what's going on in the bond markets we have pre-approval to build plants. So it combines elements of both project and corporate finance.

This gave Calpine the flexibility to build plants using its in-house resources and manage them as part of a power system. The cost is competitive with project financing. The interest rate they pay for this revolving credit is a floating rate at 150 basis points (1.5%) to 212.5 basis points (2.13 %) over the LIBOR (London Interbank Overseas Rate).

If they went to the bank for $1.0 billion, they would have to go to 20 different banks to get that much money. That is just not feasible. This new financing form has been a great success for them.