Managing Risks in Private Sector Hydro Development in Nepal

Changes in Nepal’s energy policy in the 1990s opened the way to foreign investment in some Nepali hydropower projects. The Nepali government and the Nepal Electricity Authority have adopted new risk-sharing policies to support these projects, limiting investors’ exposure to risks related to economic, social, and legislative conditions.

Nepal’s Hydropower Development Policy of 1992 was formed by the first popularly elected government of Nepal shortly after the restoration of democracy in that country in 1989. At the time, Nepal had formulated plans to develop the 402-MW Arun project and the 100-MW Kaligandaki project. Objectives of the 1992 policy were to meet interim power demands, provide electric power to the hilly and remote Himalayan region of the country not served by the national electricity system, and extend distribution networks to rural areas.

Under the policy and subsequent legislation, hydropower projects smaller than 100 MW would be open to private sector participation, but larger projects would remain within the public sector. Prior to the 1992 act, the Nepal Electricity Authority (NEA) had exclusive authority to construct and operate hydropower projects and to transmit and distribute electricity to the general public. The new policy opened the door for private-sector organizations to construct and operate hydropower projects. The electricity generated at the privately developed projects would be sold in bulk to the NEA.

The involvement of the private sector in Nepali hydropower development threw a spotlight on the risks manifest in such investment decisions. All of the players in the decision, including investors, lenders, contractors, the Nepali government, and the NEA, had a strong interest in the management of these risks.

This article provides specifics about the risk-sharing arrangements between the government of Nepal and the developers of two new privately owned hydroelectric projects in terms of:
· Country risks;
· Monetary risks;
· Market and revenue risks; and
· Project risks.

The details with regard to management of these four risks in these two particular situations can provide useful background when structuring risk-sharing approaches in other countries.

The development of a detailed plan for managing risk and for limiting the exposure of the investors to certain types of risk was essential in advancing the projects toward construction.

Easing the “country risk” for foreign investors
Nepal’s new hydropower development policy soon attracted Norwegian investment in the Khimti I hydropower development, a 60-MW run-of-river project. In June, 1996 the Norwegian firms ABB Kraft AS, Kvaerner Energy AS, and Statkraft SF, and the Butwal Power Company from Nepal, reached final agreement on the US$140 million Khimti project and commenced construction. In December 1996, Panda Energy and Harza Engineering from the U.S. and the Himal International Power Corporation from Nepal also reached agreement on the 36-MW Bhote Koshi project, at a projected cost of US$98 million. The Khimti project was commissioned in July, 2000, and commissioning of the Bhote Koshi project is scheduled for December 2000.

A foreign entrepreneur investing in Nepal is exposed to risks such as those associated with the government’s creditworthiness, the possibility of expropriation and nationalization, changes in the local political environment, and enforceability of contracts. These types of risk are known as sovereign and country risk. In the case of the Khimti and Bhote Koshi projects, the investors arranged to purchase insurance against these risks through the Multilateral Investment Guarantee Association, a member of The World Bank Group. The NEA, as purchaser of the project electricity, agreed to have the cost of the insurance incorporated in the rates paid for project power. The NEA and the project developers negotiated these rates, or tariffs, on the basis of cost plus a certain profit margin. For the Khimti project, the tariff needed to be renegotiated when the expected cost of the project rose and sponsors discovered that the tariff set originally would not cover their cost plus profit.

The lenders and investors for the two projects also perceived a payment risk associated with a lack of creditworthiness on the part of the NEA. This concern arose from investors’ experience in many developing countries, where state-owned utilities lack established credit histories and, in some cases, have poor records of management. Under the project agreements, NEA is required to substantiate its willingness and ability to pay by opening letters of credit to cover monthly demand charges.

The investors, however, also insisted upon a counter-guarantee from the Nepali government, ensuring that if the NEA fails to make timely payments the government will make prompt payments mitigating the delinquency. The government agreed to this condition in spite of the fact that neither the World Bank nor the International Monetary Fund generally approve of governments standing guarantee for such investments. In the case of the Nepali projects, the government is the sole owner of NEA and would almost certainly cover delinquent payments even in the absence of a guarantee. For the Khimti and Bhote Koshi projects this guarantee was exacted from the government on the insistence of the lenders, which included the International Finance Corporation, a member of the World Bank Group, and the Asian Development Bank.

Another risk is related to Nepali legislation affecting tax rates. Under the Finance Act passed each year in Nepal, the country’s parliament reviews tax laws each fiscal year and may impose new taxes or alter the tax structure. These changes in legislation pose a serious risk to developers, as unanticipated taxes could significantly dilute the project’s return. Consequently, under the financing agreements for the two projects the NEA was required to assume risks associated with changes in tax laws. In the agreements, tax risks were transferred to NEA by a provision for making adjustments to the negotiated tariff to ensure that the developers’ returns were not affected by tax changes.

Managing monetary risks
Considerable risk is associated with changes in monetary values such as interest rate, inflation rate, and the value of currency.

The greatest concern on the part of the Khimti and Bhote Koshi lenders and developers was for risks related to devaluation and repatriation of the Nepali rupee, which at the present time is weak in the international currency market and not fully convertible.

For both projects, NEA accepted the devaluation risk by agreeing to have the tariff defined in U.S. dollars. To insulate the investors against repatriation risks, the Nepali government also committed to making available sufficient foreign exchange to cover each month’s demand charge from the project. Guaranteed U.S. dollars in exchange for the amount paid to the project sponsors by NEA will allow the project sponsors to repatriate the revenue stream each month.

For relatively large projects with long payback periods such as the Khimti and Bhote Koshi hydro projects, lending institutions typically prefer a floating interest rate that follows market fluctuations to fixed rates. Developers, on the other hand, usually seek interest rates which are fixed for the duration of the loan or for a long period during the life of the loan. The developers of both the Khimti and Bhote Koshi projects chose relatively costly fixed rates of interest. The high financial cost of avoiding interest rate risk was passed on to NEA through the tariff agreement, which stipulated that the price NEA paid for power would incorporate all of the costs of construction, financing, and mitigating socioeconomic and environmental effects, as well as a contingency allowance and a specified rate of return.

The risk of inflation applies to all currencies. To shield the investors against losses due to inflation, NEA agreed to denominate the tariff in constant U.S. dollars for the duration of the power purchase agreement. The tariff will be escalated based on the New York consumer price index, ensuring that the developers will receive the revenue stream in real dollars based on the year of the power purchase agreement.

Limiting market, revenue risks
The continued availability of a market for the power generated poses a serious risk for capital-intensive investments such as hydroelectric projects. Market risk is a particular concern in view of the single-buyer situation in Nepal, where NEA maintains monopsony status in the electricity market. Long-term power purchase agreements (20 years for Khimti and 25 years for Bhote Koshi) effectively reassign this market risk to NEA.

Both projects are run-of-river projects, so their ability to generate optimum revenue depends upon how closely the seasonal demand for power coincides with the availability of water for generation. Nepal generally experiences eight wet months from mid-April to mid-December, and four dry months from mid-December to mid-April. The demand for energy tends to peak in the dry season and drop off in the wet season, in opposition to the natural cycle of water availability. The power purchase agreement transfers revenue risks associated with excess electricity production to NEA by a “take-or-pay” stipulation. NEA is required to purchase every joule of contract energy produced by the two hydroelectric plants, regardless of the existence of a market for that energy. The project developers, however, still bear the risk of losses caused by low flows related to fluctuations in precipitation, climate change, or hydrologic changes in the watersheds.

Allocating project risks
The construction of any hydroelectric projects entails various construction risks, including time and cost overrun risks, force majeure risk, socioeconomic and environmental risks, and geological risks. Also included in the general category of project risk are design risk and performance risk, which represent the possibility of the project’s not functioning or delivering energy as anticipated in the design phase.

The sponsors of the Khimti and Bhote Koshi projects both arranged for “loss-of-profit” insurance to cover time overrun risk and force majeure risk. Since the premium for this insurance is a part of the total cost of financing and constructing the projects, it is eventually assigned to NEA through the tariff agreement.

Similarly, the “fixed price” or engineering-procurement-construction agreements signed with the project contractors guarantee that the plants will generate at the rated capacity and at the agreed-upon date at a stated cost. This form of contract minimizes the exposure of the sponsors to losses caused by delays, performance problems, or design failures. Contractors, in turn, usually control their own risk by setting a relatively high price for fixed-price contracts, a cost which again is ultimately borne by NEA through the tariff agreement.

Assessing costs, benefits of assuming risk
The entrance of the private sector into hydroelectric generation in Nepal marks some important and positive changes. Before, the Khimti and Bhote Koshi projects, hydroelectricity in Nepal was the exclusive enterprise of the NEA with its appurtenant inefficiencies, ineffectiveness, and uneconomical approach.

Now, with the entrance of privately owned and operated power facilities, there is opportunity for consistent, reliable electricity delivery as well as in-country economic development. However, risk sharing does not come without challenges. For example, paying for the commodity of electricity using international pricing and a transparent, pre-negotiated tariff system at a time when the Nepali rupee has lipped about 30 against US dollars has resulted in higher electricity prices for the time being. The experience of Nepal in making this transition to private-sector instatement offers valuable lessons to other nations considering ways to support the development of new hydropower projects.

Ratna Sansar Shrestha, a management professional, Chartered Accountant, and attorney, has worked in the field of hydropower development for more than a decade. He is currently a program consultant in the renewable energy program of Winrock International, a private voluntary organization working throughout the world to increase agricultural productivity and rural employment while at the same time protecting the environment.
Published in HRW Journal of November 2000.