Ratna Sansar Shrestha, FCA
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.
Before the promulgation of Hydropower Development Policy, 1992 hydropower projects were implemented as public sector project. Main sources of funding for the purpose were grant and soft loan. Grant funding from donor community tended to be expensive as donors attached various strings to the grant. Similarly, the impact of soft loan was always hard due to foreign exchange risk inherent in the depreciation of local currency.
Whereas, private sector would fund implementation of hydropower project with owners’ own equity supplemented by debt from financial intermediaries (FIs). The public private partnership modality has also been used for the implementation of hydropower projects. Various types of public private partnership range from assets creation by the private sector under a concession granted by the government to management of public assets.
Especially with a hydropower project, financing it is a matter of financial engineering, supplementing civil, electric and mechanical engineering, which comprise an integral part. Financing it is a little more than “have money and will spend” and the core issue is accountability; with regards to generating return on investment and with regard to debt servicing. Financing involves sourcing fund, investing it prudently with assurance of recovery. Successful financing depends on risk management and on how the security is perfected.
Theoretically it is also possible to implement a hydropower project with full equity financing which depends on availability of own money or grant for using as equity. Hydropower being capital intensive, coupled with a long gestation period, full equity financing of it is rather rare. Because the equity holder will be exposed to the full risk of the project. However, this modality of financing is not preferable for ability to leverage with high “debt to equity” ratio results in higher rate of return on equity compare to rate of return on the project. Equity can also be raised from general public as ordinary equity or preferred equity. These instruments enable a developer in extending the ability to leverage bigger loan.
Equally rare is full debt financing which is possible where the borrower is able to provide full collateral covering the loan amount or third party guarantee (surety) is available. It is possible to secure full debt financing if the borrower enjoys high credit rating. Primarily the lender or the surety is exposed to the full risk of such financing. It is rare for a financial intermediary to provide debt without any security (unsecured debt). Fund can also be mobilized for hydropower financing by issuing bond and/or debenture.
The middle path is a mix of equity and debt; the proponent putting in some equity and borrowing the rest. The proponent will be required to provide repayment guarantee for debt in the form of collateral and/or third party guarantee. However, as hydropower is capital intensive, it may not be possible and/or desirable to provide collateral/guarantee. The way out is to go for “project finance.”
Definition of “Project Finance”
In the wider sense, financing a project is project finance. Whereas the term “project finance” has a specific meaning in the limited sense. Project finance is a specific mode of financing used by financial intermediaries (banking and financial institutions regulated by Nepal Rashtra Bank and other financial institutions – FIs) under which the very project is accepted as collateral and no additional/external collateral is required for the purpose, thereby availing in limited recourse to FIs providing debt finances. 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, except for the project itself. 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 in such manner 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.
The underlying principle behind “project finance” is that the risk is shared on pro rata basis 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, various risks and the mitigation thereof shall be discussed in the latter part of this paper.
“Project Finance” can be described as lending money for a project by accepting 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.
Mechanism and Mechanics of Perfecting Security
Success of project finance depends on arrangements during construction period, post commissioning (debt servicing period). The arrangement is also necessary to provide robust and sturdy safety net and proper documentation. Therefore, following factors must be considered in loaning money on project finance basis for a hydropower project:
1. Expenditure – watertight arrangement during construction period:
Following steps, inter alia, should be followed for the purpose:
- 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(s) is/are able to continue to complete implementation and operation of the project, in the case of default by the borrower, by being able to step in 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.
- 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.
- Payments for the implementation should to be closely supervised by FIs.
- 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.
Following steps, inter alia, should be followed for the purpose:
- Assign 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 to for their concurrence.
- Designate such a bank account as an “escrow account” in which the lender shall have first lien. The borrower is to be allowed to open accounts in banks only with concurrence of the lenders.
- 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.
The success or failure of project finance depends on robust and sturdy safety net which can be ensured by following, inter alia, procedure:
- 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, contractors’ 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.
Following documentation, inter alia, needs to be in place 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.
- Include following in the loan documentation as collateral, inter alia
- project’s all intangible assets; inclusive of all licenses, contracts, agreements necessary for the
implementation and operation of the project.
- Have such agreement “registered” wherein all tangible and intangible (various contracts, agreements, license, 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.
People are exposed to risk of all sorts in every walk of 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
There are mainly two ways a developer could be exposed to 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. 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. This risk can be mitigated by (a) either having the loan denominated in local currency or (b) rate of revenue denominated in foreign currency.
Similarly, this risk may also be manifest in rising cost of imports. Now-a-days insurance coverage could be arranged against cost escalation due to declining value of the local 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.
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.
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.
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.
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.
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.
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.
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.
Based on the presentation made on May 20, 2010 in Bankers' traning program in Pokhara