Wednesday, February 4, 2009

Risk Management for Private Sector Hydropower Investors


Investment in hydropower entails certain uncertainties which amount to risks for an investor. An investor is required to identify such risks and assess the impact of such risks on his financial health. In order to ensure better financial health, an investor is required to mitigate the impact of risk which depends on management of the risks. The main risks range from monetary risks, country risks, market and revenue risks, and risks related to implementation of the project.

People come across risk in every walk in life. Risks emanate from uncertainty which is inherent in most of the investment decisions. It is said that “nothing ventured, nothing gained.” Financing a hydropower project is very heavily dependent on prudent management of risk. Actually financing power system is the function of risk management. Besides the investor, the project proponent, energy off-taker, project implementer, government and even financier need to mange their own risks.

Management of risk involves identification of various risks associated with a project and assessment thereof. However, the most important step lies in arranging measures to mitigate such risks including an effective insurance program. Simply put, risk management entails shifting and/or sharing risks. Let us take a look at certain important risks from the perspective mentioned here.

Foreign Exchange Risk
A developer can borrow locally or from foreign institutions and the conditions with regard to security will be same. However, the borrower’s exposure to certain risk will be different. 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 Nepali currency (it has been a little different for last few years due to weakening dollar). This risk materializes with devaluation if revenue is denominated in local currency while having to service the loan denominated in foreign currency. Similarly, this risk may also be manifest in rising cost of imports. This risk can be mitigated by (a) either having the loan denominated in local currency or (b) rate of revenue denominated in foreign currency.

A foreign investor is also exposed to this risk if the currency of the host country is weak and is subject to devaluation vis-à-vis his own currency. Foreign investors have insisted on denominating the revenue stream in hard currency in order to avoid being exposed to this risk.

The foreign exchange risk is also manifest in the increasing cost of imports. Now-a-days insurance coverage could be arranged against cost escalation due to declining value of the local currency.

Repatriation Risk
Another risk associated with foreign loan is “repatriation risk.” This becomes of greater concern to a 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 make a loan or will make it subject to exorbitant rates of interest. In Nepal repatriation is guaranteed by Foreign Investment & Technology Transfer Act, 1992 and Electricity Act, 1992 for hydropower projects.

A foreign investor is also exposed to this risk. However, countries aspiring to attract foreign investment do ensure repatriation of return on equity as well as proceed from the sale of such ownership stake.

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 expropriation and nationalization, changes in the local political environment, and enforceability of contracts. These types of risk are known as sovereign or 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 the interest rate 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 fixed rate is the best way to mitigate this risk. However, banks tend to add a margin to the then prevalent rate to cushion their own risk if they are asked to offer fixed interest rate.

Inflation Risk
The real value of a unit of nominal currency tends to depreciate over time with inflation. This phenomenon is universal – irrespective of strong or weak economy of the host country. Even hard currency is subject to this risk. Escalation in the rate of tariff is the only answer, as it is not possible hold down the inflation at any cost.

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 such pass through.

Market Risk
It is common knowledge amongst engineering community that energy requires guaranteed market due to the constraint with regard to, primarily, storage and transmission. A simple way to mitigate this risk is to sign a long term Power Purchase Agreement (PPA) with the utility.

Revenue Risk
A developer can have a long term PPA but such a PPA also may not ensure plant load 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. This means there may not be a guaranteed stream of revenue to the project in order for it to meet its financial obligations with regard to (a) operation, maintenance and repairs, (b) debt servicing (c) and also assuring a reasonable return on investment to the investors. “Take or pay” type of PPA mitigates this risk which entails the energy off-taker accepting dispatch of all contract energy and, if unable to accept as such then paying for all contract energy even if it is not able to dispatch full quantum of the such energy.

However, with respect to both market risks and revenue risk, it needs to be noted that people are not only setting up merchant plants but the electric energy is also being traded in the spot market in Western countries.

Payment Risk
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 ensure 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 short term.

Construction Risks
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 raises 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, socioeconomic/environmental risk, geological risk, performance risk, design risk, etc. One can arrange insurance coverage against such risk like contractor’s all risk (CAR), transportation all risk (TAR), erection all risk (EAR), professional liability etc. including “advance loss of profit insurance” which can be complemented by signing a “fixed price” turnkey contract and incorporating a clause for imposition of liquidated damages on the contractor for delayed substantial completion or commissioning of the plant.

An investor also does face risk due to gaps and cracks between various contracts if there is more than one contract for the implementation of a project. This can be mitigated by signing engineering, procurement and construction (EPC) contract.

Hydrological Risk
The “take-or-pay” nature of the PPA guarantees the fact that all energy produced by a plant, 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 hydrologic 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.

There is no need to be frightened by the list of risks dealt with above as most of the risks can be mitigated some way or other. There is an old saying that no risk, no gain. The entrepreneurship lies in taking risk and also being able to manage it. If an investor is able to do so then there is ample opportunity to invest in the hydropower sector of the world.

Presented in the “International Conference about Hydel Power Development in Pakistan” on 17-19 March 2008 at University of Engineering & Technology, Taxila, Pakistan.

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