Hydropower - Types of Financing
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Equity Finance
Equity finance means investing own funds to construct a SSHP. Pure equity finance is rare in hydropower development – particularly in the larger size range – since hydropower is capital intensive and has long gestation periods which would expose an equity investor solely to the full risk of the hydropower project.
Therefore, risk exposure is typically limited by blending equity with debt (i.e. taking a loan). As long as the interest rate of a loan is lower than the rate of return on the total investment, the profitability of the investment increases with a higher debt-to-equity-ratio (so called ‘leverage effect’).
Sweat Equity/ Non financial equity
Equity can not only consist of finance but also of assets that are provided to the investment in-kind (e.g. land which has been owned by the investor).
A particular type of in-kind contribution is physical labour during the construction phase of a hydropower project. If the respective workers do not get paid for their (unskilled) labour but instead become (partial) owners of the hydropower scheme, their in-kind contribution is often called ‘sweat equity’.
In publicly supported SSHP-construction for rural communities where an equity contribution from the later owners (i.e. the villagers) is expected, providing sweat equity is often the only possibility for the poor households to contribute their share.
Debt Finance
Debt finance means taking a loan. Pure debt finance (i.e. borrowing the full amount of the investment cost) is rare since it requires to provide either full collateral or paying a high risk margin (as part of the interest rate) to compensate the borrowers risk or provide a third-party guarantee which usually is also not available for free. Therefore, debt is typically combined with equity.
‘Unsecured debt’ or an ‘unsecured loan’ (i.e. without collateral or third party guarantee) is provided to borrowers with high credit rating (which inter alia is derived from the borrower’s balance sheet).
‘Secured debt’ is provided against a third party guarantee or collateral. In industrialized countries, real property regularly serves as collateral. In developing countries, borrowers (and in case of default the lender as well) often struggle with unclear land title issues.
Project Finance
In project finance, the project itself serves as collateral which is possible when the lender can easily step into the borrower’s shoes and continue the project in case of the borrower’s default.
In order to create such a set-up, a number of watertight arrangements need to be in place for the construction period as well as for the operation during the debt service period. All required licenses and permits, insurance policies and other important contracts must be forged in a way that interruptions or cost overruns do not occur in case that the lender needs to take over. With financiers (i.e. lenders) in many developing countries often not being familiar and thus extremely cautious with doing business in small-scale renewable energies for remote rural areas, project finance for SSHP is difficult to obtain.
Soft Loan
Soft loans are provided as a promotional instrument. The term ‘soft loan’ refers to the conditions of a loan which are typically more favourable than alternative commercial loans in question for a specified investment purpose. They typically have lower interest rates, longer grace periods (i.e. initial time during which no repayment has to be made) and longer duration so that the debt-service can be done with smaller amounts.
Grant
Another promotional instrument is the grant, which provides money that does not need to be repaid. Whilst receiving a grant relieves the financial burden from the investor, it also distorts the development of commercial markets. Therefore, the purposes and consequences of providing grants should be carefully assessed.
For many rural electrification projects where the electricity customers are not able to cover the high upfront investment costs or an outside-investor would need too long to earn back his initial investment, it is widely accepted to provide a grant. Here, the ‘golden rule’ is that the initial investment cost can be paid from whatever source as long as the current costs during the operational phase are covered by current revenues.
In other words, the subsidy is used to start a development process which is then perpetuated by itself, i.e. by its beneficiaries in the village who regularly pay a tariff that beyond routine operation and small repairs ideally also would allow for a major re-investment.
In order to create a sense of ownership and caretaking for the SSHP assets, it proved to be a successful approach to combine grant money with beneficiaries’ (sweat) equity. Otherwise nobody would look “the gift horse in the mouth” and it would lose its proverbial teeth too soon - if it was provided with ivories at all.
