Geothermal clearout deals to dead rats

As it prepares for its big open home, Mighty River Power is busy cleaning out, scrubbing up, dusting down and shoving bread in the oven.

When you're going for top dollar you don't want a cockroach on the carpet or a dead rat in a kitchen cupboard, just waiting to be discovered by some pesky analyst.

Hence, Chalkie reckons, the company's sort-out of its overseas ventures announced on Friday.

These ambitions in the United States, Chile and Germany were once so important they influenced 70 per cent of chief executive Doug Heffernan's long-term incentive pay, although his current scheme, which began last July, doesn't mention them.

There is also a sense of changing direction in the announcement, which revealed the termination of a 10-year contract halfway through its term at a cost of US$25 million ($29 million).

These things happen, you might say. Sometimes you have to suck it up and move on.

However, a less forgiving view was offered to Chalkie by one professional investor, who described the announcement as "a frigging disgrace".

"You're the only investor in a fund, and to get control of your own money you've got to write out a cheque for US$25m. For these guys on the other side it's bloody Christmas.

"Things like this really highlight to me why you need a lot more visibility on the activities of these [state-owned] businesses."

There were other rude words too, but you get the drift.

To get a handle on what could provoke such an outburst we need to look more closely at Mighty River's foreign foray.

It began in 2008 when Mighty River decided to commit US$250m to develop geothermal prospects, initially in the US. The investment was to be made via an overseas limited partnership fund structure called GeoGlobal Partners, with entities in the US, Ireland, Britain, Chile and Germany, in which Mighty River's stake was 99.8 per cent.

GG Partners' investments were to be managed by a separate US company called GeoGlobal Energy LLC, in which Mighty River held 29 per cent.

Although Mighty River had two directors on the board of GGE, the company was run by US executives and presented itself as a US investor, with Mighty River's involvement described only as a provider of "significant backing".

The fund's first investment was in May 2010, when it paid US$90m to become the largest equity investor in a US$400m, 50-megawatt geothermal project beside a lake called the Salton Sea in southern California.

The money bought a 20 per cent holding in US company Energy Source, the project developer. Most of the rest of the money came from a consortium of eight bank lenders, encouraged by government subsidies and a 30-year deal to sell the plant's power to consumers in Phoenix, Arizona.

The plant was completed last March and the project debt was refinanced in October with the issue of US$313m of 30-year bonds, sold to life insurance companies.

At the same time there was a US$99m "tax equity" investment by an arm of oil giant Chevron.

As far as Chalkie can make out, tax equity is a form of investment that takes advantage of US tax breaks on renewable energy. Apparently an investor puts in money and receives returns in the form of tax credits rather than cash.

It is also apparently very complicated, which is perhaps why Mighty River has said almost nothing about how much it has made, or expects to make, from the Salton Sea project.

In October, after the refinancing, Mighty River said it had received a "cash return" from the GG Partners fund, which had received a return of capital from the project.

Chalkie reckons this was probably connected to the Chevron arrangement, although how is not clear.

Heffernan said the payment "is consistent with our business case" and "provides the first demonstration of the financial success of Mighty River Power's international geothermal strategy".

Maybe, although Chalkie has been unable to find any dollar figures relating to the payment. Perhaps they will be in tomorrow's interim results, but given the absence of crowing so far from Mighty River your correspondent isn't expecting anything flash.

Word around the market is that the project made a positive return, but not as much as it should have.

Since that first project, GG Partners has continued to invest money and by last June had forked out US$225m.

Some of the money has gone on developing a geothermal project in Tolhuaca, Chile, a volcanic area about 650km south of Santiago. So far two wells have been drilled, one of which hit a resource capable of generating 12MW - "the most productive geothermal well ever drilled in South America", said Mighty River.

Chalkie hopes Chile becomes more productive than that, because last October in Reno, Nevada, GGE executive Greg Raasch told an industry meeting that geothermal energy was struggling to show adequate returns.

"Today, almost all projects are project-financed," he said. "The project finance world is made up of a relatively small group of lenders and they all talk to each other. Project debt in default or a tax equity that's ‘gone south' hurts the whole industry. Geothermal in general does not have a very good reputation today in the financial world."

The cost per kilowatt to develop geothermal power had risen, rather than fallen, he said, and drilling for new resources could be risky.

Heffernan told Chalkie that Raasch's remarks reflected the small size of many geothermal projects in the US, often less than 20MW.

The most successful project in the US had been the one Mighty River invested in at Salton Sea, he said. "If you're working under 50MW size it's really hard to get a good engineered solution with good risk mitigations and make money."

So maybe the Chile project, which would be the first to operate commercially in South America, has some way to go to be financially viable.

Certainly, part of its development involves investing a whole lot more money, and Mighty River got cold feet about continuing to channel cash through GG Partners.

Hence the announcement on Friday terminating the deal with GGE.

Heffernan said the arrangement was like investing in a fund with an external management contract, so "we had an investment in which we had obligations to pay fees going forward and in which returns were diluted by the holding of the fund manager".

Or to put it another way, Chalkie reckons Mighty River was putting up all the money but the US management company was deciding what to do with it.

Signing up to 10 years of that was probably not so smart, particularly when it then costs you US$25m to get out of the contract half-way through.

As well as US$25m, the other owners of GGE get Mighty River's 29 per cent stake and the fund's development projects in Germany and sundry assets in the United States not connected to EnergySource.

For its part, Mighty River gets direct ownership of the 20 per cent EnergySource stake and the Chilean operation.

This type of rejig is sometimes called restructuring, but Chalkie reckons it amounts to recognition the GGE deal was a bad one and it was best to get rid of it rather than reveal its ugly details in a public share offer prospectus.

It also seems not a good look to pay the CEO a long-term incentive and then unwind the deals you incentivised your CEO to do.

Still, it's probably better than leaving the dead rat in the cupboard.

- Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.