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By Mark P. Weitzel
Thelen Reid Brown Raysman & Steiner LLP

Many power plant owners continue to move away from traditional limited recourse project financing and to utilize corporate, portfolio and other debt structures to raise acquisition and development financing. These structures generally are less expensive from an interest rate standpoint and often result in lower transaction costs and increased operating flexibility.

However, these financing arrangements are not limited to straight borrowings. A number of companies have successfully combined full or limited recourse financing with a lease or sale-leaseback of their generating assets. Leasing can yield tax, accounting and financing advantages over the use of either bank debt or capital markets financing while still permitting the power project sponsor to control the facility for a very long period of time.

Leasing Structures

Power project leases are not new, but the structures have been evolving. Leases were used as the financing vehicle for a number of utility generating stations as well as for independent power projects. Most of the utility leases were full recourse obligations of the utility while most IPP leases were limited recourse obligations of a special purpose subsidiary of the project sponsor.

In the typical lease, a financial or industrial entity (the "owner participant") forms a grantor trust (or, more recently, a limited liability company or business trust) to serve as the lessor, which then purchases the power plant from the owner (soon to be the lessee) and leases the plant back to the lessee. The owner participant funds a portion of the purchase price with its equity contribution, and the lessor borrows the remainder of the purchase price from institutional lenders or through a capital markets or 144A financing. The lease is a "net lease" in that the lessee is responsible for all expenses in connection with the facility and fully indemnifies the lessor, owner participant and lender for all liabilities associated with their participation in the transaction.

In effect, the purchase and lease are another form of financing for the sponsor, with the owner participant and lender essentially being passive investors in the transaction. Project sponsors must recognize, however, that rights to terminate a lease before the end of its term often are very limited and usually require large additional payments to the owner participant. Therefore, in entering a lease, the project sponsors should be prepared to live with the transaction over the entirety of the lease term.

Benefits of Leasing

Leasing provides a number of attractive features. First, for a project sponsor that is not currently taxable, the owner participant, which is fully taxable, can use the tax benefits of ownership (depreciation and interest deductions) and pass along those benefits in the form of lower rent. This is particularly attractive for generating assets which have a relatively short depreciation period for tax purposes. In addition, leasing effectively provides 100 percent financing because the lessor pays the full purchase price of the facility as opposed to only part of the cost being raised in a traditional debt financing.

Moreover, the financial accounting treatment of the lease can be quite attractive to both the owner participant and the lessee. Although the accounting rules are becoming more complex, the transaction typically is structured to be a "leveraged lease" for financial accounting purposes in the hands of the owner participant and an "operating lease" in the hands of the lessee. This normally results in the participant reporting significant book income in the early years of the lease term. The lessee also can enhance its book earnings in the early years if the lease term is long enough and the rents appropriately structured. The lessee's book expense in these early years can be lower than if it had owned the plant, directly incurred the associated debt, and recorded depreciation and amortization expense.

The accounting rules have been changing over time and are particularly complex in the case of a power project, as opposed to such moveable equipment as aircraft and rail cars, where leasing is the predominant method of financing. These rules make it important to address the accounting issues early in the process because early actions may preclude the availability of leasing as a financing tool.

Key Structuring Issues

Leases bring their own set of important structuring considerations. For example:

Lease Term. For a combination of tax and accounting reasons, the lease term generally cannot extend longer than the date on which each of the following is true: (1) the facility is currently expected to have at least 20 percent (25 percent for accounting purposes) of its original useful life left on such date and (2) the facility is expected to have a residual value on such date equal to at least 20 percent of its original value, disregarding the anticipated effect of inflation. These conclusions generally are supported by an expert written appraisal delivered at the original financing.

Purchase and Renewal Options. A fixed price purchase option at the expected fair market value of the facility at lease expiration generally is permitted for tax purposes but usually is not allowed to obtain operating lease treatment for accounting purposes. Because the project sponsor wants to control the asset for a lengthy period of time, this often results in the presence of lessee renewal options using various pricing modes.

Rental Structures. The IRS has issued complex regulations (called Section 467 regulations) that restrict how rent can be allocated and paid during the lease term. However, these regulations also create planning opportunities for rent prepayments and financial optimization. Most lessors and lessees employ very sophisticated lease pricing models that test for Section 467, accounting and similar rule compliance and then fine tune the economics of the transaction.

Tax Indemnity Agreement. The lessee generally will indemnify the owner participant against the loss of expected federal income tax benefits to the extent that loss occurs because of a lessee act, omission or misrepresentation. The TIA is highly negotiated and is a mechanism for allocating income tax risk between the owner participant and the lessee. Normally, the owner participant accepts the risk that the overall lease structure works from a tax perspective, and the lessee assumes the risk of the inaccuracy of the factual information it provides and the risk relating to actions it takes as lessee of the facility.

Credit Support. In the limited recourse project financings done in the 1980s and early 1990s, the true credit support usually was a long-term power purchase agreement with a utility, whose cash flow stream provided the source of repayment of the debt and return of the owner participant's equity. Many leases done today do not follow this model but rather involve the project sponsor or its parent providing some form of guaranty of all or a portion of the rental payments as well as termination payments in the case of an early termination of the lease or a default by the lessee. Alternatively, the sponsor may have its own power marketing entity enter into a power purchase agreement with the project company, with the obligations of that entity guaranteed in whole or part by the parent. The power offtake arrangements can include utility or site host offtake agreements, portfolio power sales agreements or similar arrangements to mitigate merchant power risks to the financing parties. This hybrid approach allows the sponsor the benefits of leasing noted above while minimizing the traditional project finance-style covenants limiting the lessee's operating flexibility in dealing with the facility over time.

Leasing will continue to be a significant tool for power plant financing, bringing a variety of tax, accounting and financing benefits to project sponsors.

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For more information about the issues covered in this report, please contact Mark P. Weitzel in our San Francisco office at 415-369-7007 or at mweitzel@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction Department, click here.





©2001 Thelen Reid Brown Raysman & Steiner LLP