Project Financing for Hydropower

This is part of a condensed report on the Small Hydropower Promotion Projct (SHPP). For an overview on the whole report please refer to following page: SHPP Report.

Financing hydropower projects involves getting the money and investing it in the implementation of the project. Largely, this holds true if such a project is being implemented as a government project or grant-funded project. This aspect can be deemed to be project financed in a wider sense.
On the other hand if a hydropower project is to be constructed and operated with private funds and/or as a business proposition it needs to worry about a number of other issues (risks) inherent to these kinds of activities. Moreover, an entrepreneur should worry about recovery of the investment with a decent return therein as well as servicing of the debt if any debt financing is involved. This approach is much more challenging as well as interesting besides being timely in view of liberalisation, privatisation and globalisation. Therefore, let us examine various issues with respect to such financing by considering a number of financing scenarios.

Equity Finance

Pure equity financing of a hydropower project is a rarity, especially because this sector is capital-intensive with a long gestation period. But it is not unthinkable. Full equity financing of a hydropower project is basically applicable in the case of a private sector flush with funds, not needing to borrow from anywhere else. Literally, in this context, financing involves using or investing own funds to construct or erect a project. There is not much to worry about in such a scenario as far as mobilizing funds are concerned or if a grant is available for the purpose.
Such a mode of financing poses few risks for the investor. First of all, s/he will solely be exposed to the full risk of the project. The developer’s exposure will be limited if s/he is able to leverage non-recourse fund from lenders. Moreover, return on equity generally tends to be higher, depending upon the extent of leverage gained by higher ‘debt to equity’ ratio if the rate of return on total investment is higher than the rate of the interest on loan.

Debt Financing

At another extreme of the financing spectrum is borrowing full amount of the cost of the project. But such a scenario is also rare. Such borrowing is possible where the developer is able to provide full collateral, including an adequate margin against the loan, or enjoy high credit rating and is able to borrow against its balance sheet, or is able to provide a third party guarantee, including guarantee of the parent company. From the standpoint of exposure, in this scenario too, the developer or the surety of the developer’s parent company is exposed to the full risk of the project. A prudent businessperson will also stay away from this type of financing.
However, when we are discussing debt financing, let us touch on a few of the concepts related to ‘debt’. The term, debt, is generally used interchangeably with loan, but there are a number of instruments available for the purpose and there are a number of different types of debts or loans.

Unsecured Debt

Generally, a borrower that enjoys high credit rating is able to borrow without providing any security in the form of collateral or guarantee from its parent company or third party. Such borrowing is known as unsecured loan. Financial institutions rely on the credit rating of the borrower based on its balance sheet in providing unsecured loan. Large, financially strong corporate undertakings are able to borrow without putting up collateral or providing other forms of security.

Secured Debt

Where a lender provides loan to a borrower on the basis of security furnished by the borrower, the debt is secured. Security against a loan may be perfected in several ways. The oldest form of security for the purpose of borrowing is pledging real property (even precious metal) as collateral. One may mortgage landed property in one’s ownership in order to borrow. In such an instance, a lender will be willing to advance a loan up to the value of such property minus a margin. An illustration is borrowing up to, say, 60 per cent of the value of land to construct a building on that land. In this instance, one real property is being mortgaged to create another real property. Another version of secured loan is where the lender keeps the title to the property procured with the loan as collateral. This happens in ‘lease purchase’. Here also, the margin will come to play in the form of a down payment from the borrower. In both of these scenarios, the lender is able to resort to the lien property in case of default by the borrower.

Security for a loan can also be perfected without putting up real property as collateral. Financial institutions lend money against third party guarantee; a parent company can also stand guarantee for the loan taken by its subsidiary. In the event of default by the borrower, the loan and other amounts due in respect to such a loan will be recovered by the lender from such a guarantor.

Project Finance

‘Project Finance’ can be described as lending money for a project by accepting the ‘project’ itself as the collateral so 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, project finance is distinct from hire-purchase because the assets procured under the latter scheme are registered in the lender’s name and repossession of the said asset, as a part of foreclosure, is rather simple while not so in the former. The exposure of both the developer and the lender 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.