Financing of any project/work involves getting the money and investing it in the implementation of it. Largely, this holds true if such the project/work is being implemented as a government project or grant funded project. This aspect can be deemed to be project financing (that is: “financing a project”) in a wider sense.
Whereas the term “project finance” has a specific meaning in the limited sense. Project finance is a specific mode of financing used by financial institutions (FIs) under which the very project is accepted by FIs as collateral and no additional/external collateral is required for the purpose, thereby resulting in limited recourse to the institutions providing debt financing. In other words, the proponent that is able to find financing on “project finance” basis will not need to lodge other tangible/intangible asset as collateral. In the absence of “project finance” the proponent will need to put up tangible/intangible assets with a value higher than the debt amount to include a margin as collateral, corporate guarantee from third party or parent company, and so forth.
Under “Project Finance” the lenders accept the “project” itself as the collateral such that the lender is enabled to step into the shoes of the borrower to continue with the project, whether under construction or in operation, in the event of default of lenders’ terms, conditions and covenants by the borrower. This is basically a way of perfecting security of a debt without having to put up collateral or furnish third party guarantee. It can also be described as a mix of debt and equity financing or “an instrument to perfect security of debt.”
This kind of financing can be loosely compared with “hire purchase” as the collateral for such financing is the item being procured under the scheme. However, the project finance is distinct from hire purchase because the assets procured under latter scheme is registered in the lender’s name and repossession of the said asset, as a part of foreclosure, is rather simple while it is not
so simple in the former. The exposure of both the developer and the lender to the risk is in proportion to their investment, essentially as per the debt to equity ratio. Moreover, the margin is available to the lender based on the debt to equity ratio.
Chilime project, that has borrowed Rs 1.39 billion from FIs, can be used as an illustration to further explain the term “project finance.” Nepal Electricity Authority holds 51% shares in Chilime Project Company and has also provided the “corporate guarantee” against the loan taken to finance Chilime project (including bridge loan to cover the proceed from sale of shares to general public and NEA staff). In other words, FIs have provided loan for Chilime project against the parent company guarantee of NEA and not against the project itself. Therefore, financing of Chilime project by the FIs is not based on “project finance.” There are a number of examples of such financing in the recent development of hydropower projects.
There underlying principle behind “project finance” is that the risk is shared pro rata between the developer (equity investor/s) and the lenders as well as managed by each financial stakeholder. This does not happen in other kinds of financing except when lenders provide unsecured debt. Therefore, “project finance” is basically a function of management of various risks and it entirely depends on how the security is perfected. Therefore, in the first part below various risks and the mitigation thereof shall be discussed and in the latter part the mechanism of perfecting security will be dealt with.
A few important risks and ways to mitigate them are dealt with below:
Foreign Exchange Risk
A developer can borrow locally or from foreign FIs but the borrower’s exposure to certain risk will be different depending upon the source of debt financing. There are mainly two types of risks that a borrower needs to be aware of while borrowing from a foreign lender.
Foreign exchange risk is inherent in foreign loan due to the fact that foreign currency tends to be relatively strong compared to relatively weak Nepali currency. This risk materializes with devaluation if revenue is denominated in local currency while having to service the loan denominated in foreign currency. There are two ways of mitigating this risk. Either have the tariff denominated in foreign currency in the PPA or use the hedge fund instrument.
Similarly, this risk may also be manifest in the rising cost of imports. This risk can be mitigated by (a) either having the tariff rate denominated in foreign currency or (b) by arranging insurance coverage against cost escalation.
Another risk associated with foreign loan is “repatriation risk.” This becomes of greater concern to a foreign lender whether it will be able to repatriate the proceeds of debt servicing. Generally governments of developing countries, in their quest to attract foreign investment, have enacted legislation guaranteeing repatriation. If such a guarantee is not available, either the lender will not lend or charge exorbitant rates of interest. In Nepal, repatriation is guaranteed by Electricity Act, 2049 for hydropower projects specifically and additionally by Foreign Investment & Technology Transfer Act, 2049. A foreign equity investor is also subject to this risk but there is no problem as same repatriation provision is applicable to equity investors too.
Sovereign Risk (Country Risk)
A foreign entrepreneur investing in Nepal is exposed to risks such as those associated with the government’s creditworthiness, the possibility of confiscation, expropriation and nationalization, changes in the local political environment, and enforceability of contracts. These types of risk are known as sovereign and country risk. Multilateral Investment Guarantee Association (MIGA), a member of The World Bank Group does provide insure against such risk at a fee. However, the availability of such insurance is limited only to foreign investors.
Interest Rate Risk
It is now time we also touched upon the concept of interest rate risk. Lenders offer two kinds of interest rates: (a) floating rate and (b) fixed rate. Floating rate entails changes in it during the term of the loan, thereby introducing an element of uncertainty or risk for the borrower. Banks prefer floating rate as they need to be able to adapt to changes in financial market as well as to cover their own exposure to the vagaries of changing interest rates (including bank rate). For a developer floating rate regime is preferred when the rates, like now, have tendency to go down while fixed rate is the best way to mitigate this risk during the time when it has the tendency to head north. However, banks tend to add a margin to the then prevalent rate to cushion their own risk in developing a product based on fixed interest rate.
The real value of a unit of nominal currency tends to depreciate over time with inflation. Even hard currency is subject to this risk. Escalation in the rate of tariff is the only way to mitigate it, short of trying to hold down the inflation with one’s bare hands!
Legislative Change Risk
Here we are talking about the risk of changes in the country’s laws that (a) increases rates and taxes or other expenses and liabilities (b) reduces revenue of the project or (c) reduces the value of the assets. Such changes impact the viability of a project adversely. Generally an entrepreneur has to take such risk. However, it can also be mitigated by passing the impact through to the utility provided that the utility is amenable to it.
It is common knowledge amongst engineers that energy requires guaranteed market due to the constraint with regard to, primarily, storage and transmission of electric energy. A simple way to mitigate this risk is to sign a long term PPA with the utility.
A developer can have a long term PPA but such a PPA also may not ensure plant factor at a specific level if the utility accepts delivery of the energy at its pleasure, mainly in the case of a run-of-the-river type of project lacking pondage. This means there will not be a guaranteed stream of revenue to the project in order for it to meet its financial obligation with regard to (a) operation, maintenance and repairs, and (b) debt servicing. “Take or pay” provision in a PPA mitigates this risk.
However, with respect to both market risks and revenue risk, it needs to be noted that people have started to trade electric energy in the spot market in Western Europe.
This risk emanates from the lack of creditworthiness on the part of the utility, buyer of the energy. In many developing countries, state-owned utilities do not have established credit histories and also suffer from records of poor management, over-employment, high leakage (technical or otherwise), etc.
Developers are known to ask the government to issue counter guarantee to cover for the payment risk. This basically entails a government standing surety to the fact that the utility pays its dues to the developer in time and in the case of the utility’s failure to meet its obligations the government is required to promptly make payments to mitigate the delinquency of the utility. Now a days multilateral funding agencies like the World Bank take a dim view of a government issuing counter guarantee. Having a letter of credit put in place by the utility with the IPP as the beneficiary is another way of mitigating this risk for the short term.
Time and cost overrun risks is one group of construction risk of which time overrun risk results in loss of revenue as well, while it also increases total amount of interest during construction of the debt financing and may even attract penalty for late delivery of energy. Other construction risks are force majeure risk, geological risk, rated performance risk, design risk, etc. One can arrange insurance coverage against such risks by purchasing coverages like CAR, TAR, EAR, professional liability etc. including “advance loss of profit” insurance which can be complemented by signing a “fixed price” turnkey contract (or EPC contract) and incorporating a clause for imposition of liquidated damages on the contractor for delayed substantial completion or commissioning of the plant.
Hydropower projects are also susceptible to risks emanating for environmental reasons. But there is no insurance coverage that could be purchased to mitigate this risk. The best way to mitigate this risk is to have a reliable study conducted with a good plan to mitigate and minimize the adverse impact.
The “take-or-pay” nature of the PPA guarantees the fact that all energy generated, depending on the availability of water, irrespective of whether the season is dry or wet, shall be turned into cash. However, if there is no water to generate energy due to the change in the level of precipitation, climatic reason or change in the hydrology of the catchment area then these projects are on their own. This risk emanates from the fact that seasonal rainfall patterns affect the amount of water available to a hydropower plant and generation may fall below contract levels in any season, thus threatening the revenue stream of such projects. Obviously a dry year will be an unmitigated disaster for a hydropower plant. The most effective way to mitigate hydrology risk is to gather hydrological data for a reasonable number of years in the past and design the project accordingly after having selected a project with better hydrological potential as well as information.
Mechanism and Mechanics of Perfecting Security under Project Finance
Following factors must be considered in lending money on project finance basis for a hydropower project in order to perfect the security:
1. Revenue – watertight arrangement for commercial operation during debt service period:
· Assign the PPA to the lender(s) with the Nepal Electricity Authority’s consent.
· Ensure that the revenue stream received from NEA is directed to a bank account specified by the lender. NEA will have to be approached for their concurrence.
· Designate such a bank account as an “escrow account” in which the lender shall have first lien.
· Allow the developer to withdraw money from such account without any hindrance only to the extent necessary to operate the project plant and to maintain the plant in top condition pursuant to “prudent operating practices.”
· Money to be automatically transferred to the lenders for their debt service (both principal and interest thereon) on specified dates.
· Allow the developer to withdraw money from the account for the distribution of dividend to its shareholders, to the extent permissible based on fund balance in the escrow account after leaving an amount necessary to meet one (or the unit agreed between the borrower and lender) debt service obligation in the immediate future.
2. Expenditure – watertight arrangement during construction period
· Assign all contracts/agreements, inter alia, related to construction, supply, transportation, erection/installation, consultancies (design, engineering, supervision, etc.) etc. to the lenders so that the lender is able to continue to complete implementation and operation of the project, in the case of default by the borrower, by being able to step into the shoes of the borrower or have someone do so on the lender’s behalf. (Should even include employment contracts of key personnel that are indispensable for the implementation of the project!)
· Ensure that the borrower company’s equity-holders inject their equity, at least, on pari passu basis, if not more, during the implementation of the project.
· Ensure that both debt and equity for the project is injected into a dedicated bank account, on which the lender has first lien, and outflows from this account is closely monitored by the lender/s.
· Ensure that proper contractual arrangements are made such that (a) cost overrun and (b) time overrun is effectively avoided. (Time overrun tends to be more expensive due to additional interest during construction, loss of revenue and even penalty to NEA for delayed delivery of electricity.)
· Ensure that there are no gaps and cracks between various contracts/agreements which could become reason for increase in the total project cost.
· Ensure that the borrower company has or is able to access necessary contingency fund to complete the project even if the project cost goes up due to unforeseen reasons.
· Payments for construction closely supervised by lenders.
3. Safety-net – success or failure depends on robust and sturdy safety-net of insurance coverage.
· Risk assessment should be made to prepare a risk profile which will dictate the insurance program.
· Ensure that all necessary insurance policies are put in place in order to cover all exposures to all possible risks (e.g. CAR, EAR, TAR, ALOP, increase in cost due to devaluation, contractor’s equipment, third party liability, comprehensive workmen’s compensation, professional liability and so on so forth). The words of the proposed insurance policies to be finalized in consultation with the lender.
· Ensure that the lender is mentioned in such insurance policies as the co-insured, in order to provide for the eventualities emanating from default by the borrower.
· Ensure that the project’s cost estimate has adequately budgeted for the payment of insurance premium.
4. Documentation to perfect security
· Execute loan agreement between the lender and the borrower to sign off on the arrangements agreed and put in place as listed above.
· Have such agreement “registered” wherein all tangible and intangible (various contracts, agreements, licenses, permits, approvals etc) assets are mortgaged against the loan enabling the lender to foreclose without having to resort to court of law.
A distinct difference between project finance loan and other types of loan (except for unsecured loans) is that the lender shares in the risk with the developer/promoter in the case of former while that may not be the case in the case of latter. Therefore, besides everything, the lenders will very minutely scrutinize three Cs (commitment, credibility and competence) with regard to the developer/promoter. Levels of confidence as well as comfort become very important for a lender venturing into project finance investment.
Paper presented at the symposium organized by SHPP/GTZ on November 5, 2005