On the Adjustment of the Return on Capital for Off-taker Default Risk

The purpose of this paper is the evaluation of the return on capital to account for default risk in financial decisions concerning power generation investments. These investments are often based on energy sales through power purchase agreements. In this way, the investor is exposed to the credit risk of the off-taker. In particular, the agreement can be seen as an unsecured loan. Thus, this risk ought to be factored in the decision. To do so, we decompose the free cash flows (“FCFs”), in their variable and fixed portion. We derive formulas for the probability associated with the variable portion of the FCFs in the generic period, modeling the possibility of off-taker default and recovery. The risk margin is, then, obtained through a valuation equation based on a non-arbitrage argument. Since default and recovery probabilities play a major role in the methodology, we discuss different ways of obtaining numerical values for these quantities. A numerical example for an investment in the power sector is then used to illustrate these ideas. The assumption of decision-maker quadratic utility function is maintained throughout the paper.