Long-Lived & Infrastructure Assets

How to Underwrite a Power Plant

Underwrite a power plant by separating contracted revenue (tolling agreements, capacity payments) from merchant energy margin, then stressing dispatch and spreads. The metrics that matter most are spark or dark spread versus the plant's heat rate, capacity factor and forced outage rate, contracted versus merchant share of gross margin, and DSCR or leverage on a downside price deck.

What makes power plant underwriting different

A thermal power plant earns margin by converting fuel into electricity more efficiently than competing plants. Its heat rate determines how much fuel it burns per unit of power, so the spread between power and fuel prices drives whether it runs and what it earns. Revenue may come from energy sales, capacity market payments for being available, ancillary services and tolling agreements where a buyer supplies fuel and pays a fixed fee. Value comes from location, efficiency and flexibility. Risks include compressed spreads as renewables lower power prices, forced outages, fuel supply disruption, environmental rules and the cost of major overhauls on gas turbines.

Lenders favor plants with tolling agreements or capacity revenue that covers debt service, and they size merchant exposure to a third-party price forecast with conservative cases. Term loan B and project bonds are common, often with cash sweeps tied to merchant cash flow. Equity investors underwrite upside from scarcity pricing, capacity market auctions and the option value of flexible units. They may buy plants with heavy merchant exposure at low multiples, accepting volatility that lenders mitigate through hedges, sweeps and shorter effective tenors.

Key metrics

Spark spread (or dark spread for coal)

Power price minus fuel cost at the plant's heat rate is the gross margin per megawatt hour that drives dispatch.

Heat rate

Efficiency determines position in the dispatch stack and fuel cost per MWh.

Capacity factor and forced outage rate

How often the plant runs and how often it fails when called on drives energy revenue and capacity penalties.

Contracted share of gross margin

Tolls and capacity payments provide stable cash flow; merchant energy margin is volatile.

Lenders typically want debt service substantially covered by contracted or capacity revenue before giving credit to merchant margin.

Leverage and DSCR on downside price deck

Merchant plants are sized to independent forecasts with conservative cases rather than sponsor forwards.

Major maintenance cost per run hour

Gas turbine overhauls are tied to starts and fired hours and must be reserved for.

How to underwrite it, step by step

Identify revenue streams: energy, capacity, ancillary services, tolling agreements and hedges.
Obtain an independent market consultant's price forecast with base and downside cases for power and fuel.
Have an independent engineer assess heat rate, outage history, remaining life and major maintenance schedule.
Review fuel supply and transport arrangements, LTSA with the turbine OEM and environmental permits.
Model dispatch and gross margin under each price case, layering in hedges and capacity revenue.
Size debt with contracted revenue as the base and apply cash sweeps to merchant cash flow.
Assess environmental compliance, emissions costs and regulatory risk to plant life.

Due diligence checklist

Tolling agreement or power purchase agreement
Capacity market auction results and obligations
Independent market consultant report
Independent engineer report
Long-term service agreement with turbine OEM
Fuel supply and transportation contracts
Historical generation, heat rate and outage data
Air permits and environmental compliance records
Hedge agreements and ISDA documentation
Interconnection agreement
Insurance program and loss history

Key risks and mitigants

Spread compression from renewables and new supply

Size merchant debt to downside price cases and amortize with aggressive cash sweeps.

Forced outages and capacity penalties

Review historical availability, LTSA coverage and capacity performance penalty exposure.

Fuel supply disruption

Diligence firm transport, dual fuel capability and inventory where applicable.

Environmental regulation shortening plant life

Model compliance costs and shorten tenor for plants facing emissions limits.

Hedge counterparty and collateral calls

Use first lien hedge structures sharing collateral with lenders to reduce cash collateral needs.

Typical financing and deal structure

Contracted plants with tolling agreements are financed with long-dated project bonds or bank project finance, sculpted to toll payments. Merchant or quasi-merchant plants are commonly financed with term loan B facilities that carry cash sweeps, revolvers and letter of credit facilities for collateral posting, and first lien hedge arrangements where hedge counterparties share collateral with lenders. Covenants typically include minimum DSCR or maximum leverage tests, mandatory sweeps of excess cash, restrictions on hedge book changes and major maintenance reserves. Holdco debt and preferred equity appear in portfolio acquisitions. Equity comes from infrastructure funds and independent power producers that underwrite capacity market and scarcity value.

Red flags

Debt sized on sponsor forward curves rather than an independent downside case.
Capacity revenue relied on for years beyond the auctions already cleared.
High forced outage history with no corrective maintenance plan.
Pending environmental rules that could force retirement before loan maturity.
Fuel supply relies on interruptible transport in a constrained region.

Frequently asked questions

What is a spark spread?

A spark spread is the difference between the price of electricity and the cost of the natural gas needed to generate it, calculated using a specific heat rate. It approximates gross margin per megawatt hour for a gas plant. Plants with better heat rates capture wider effective spreads and dispatch more often.

What is a tolling agreement?

In a tolling agreement, a buyer pays the plant owner a fixed capacity fee and supplies its own fuel, taking the electricity output. The owner earns stable revenue tied to availability and performance rather than market spreads. Lenders treat a toll with a creditworthy buyer as contracted revenue similar to a PPA.

How do lenders finance merchant power plants?

Lenders typically use term loan B structures sized to downside price forecasts, with mandatory cash sweeps that amortize debt faster when margins are strong. Hedges with first lien counterparties, capacity revenue and letter of credit facilities provide support. Leverage is lower than on contracted plants to absorb merchant price volatility.

What is heat rate?

Heat rate measures how much fuel energy a plant uses to produce one kilowatt hour of electricity, typically in BTU per kWh. Lower is more efficient. It determines the plant's fuel cost per MWh and therefore its place in the dispatch order, how often it runs and its margin.

Underwrite a power plant deal in minutes

Drop a deck or data room. Underridge returns a verdict, investment memo, term sheet and a live model, with every headline figure traced to a page, a formula or a labeled assumption. Ten underwrites free.

Try Underridge free

Educational content, not investment, credit, legal or tax advice. Benchmarks are common practitioner rules of thumb and vary by lender, market and cycle.