Small Hydro Power Project Nepal - Supporting Financial Institutions

Supporting Financial institutions - SHPP Nepal

A large aspect of SHPP’s sector development focussed on SHP financing. Improving the stability of political, regulatory and financial environments builds the basis for the provision of SHP investment opportunities and capital inflows. Even though this is a big task to be carried by the renewable energies or SHP sectors alone, there have been many activities in the past years to mitigate factors that are deterring private equity and debt providers from involvement in SHP in Nepal. We will highlight a few experiences from banks, insurers and investors. What they have in common is that they seek financing opportunities that deliver a good balance of security (predictability of the environment, risk, insurance), liquidity (exit options) and yield (returns), based on their own motivations and profiles.

 

Banks Counselling

Given investment volumes in the range of a few million USD, an important part of technical support to the sector included upgrading the capacity of the financial institutions to understand small hydropower generation and to understand whether a project was going to be feasible or profitable. The sector needed a party to carry out appraisals on received proposals. In former times the Nepal Industrial Development Corporation (NIDC) used to provide a similar service for tourism and agriculture/forestry projects, but this service was terminated in 1990 after a failed attempt to merge NIDC with the Ministry of Industry. Now financial institutions needed to rely on external experts or develop in-house expertise like the Clean Energy Bank (see box). SHPP conducted many events to bring this expertise to financial institutions, using training sessions with Swiss and local technical and financial experts.

 

“No risk – No Gain”

The idea that no worthwhile profit will be gained without a substantial amount of input is a well known concept when it comes to investment. Still, smart investors are aware of the risks they are taking and should know which opportunities exist to mitigate such risks. The table below groups the main risks that investments in renewable energies are exposed to.

TABLE

Risk Management (Ratna Sansar Shrestha, FCA)

Financing a hydropower project is very heavily dependent on prudent management of risk. This 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. 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 the same. However, the borrower’s exposure to certain risk will be different. There are two main types of risks that a borrower needs to be aware of when 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 Nepalese currency. 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 the 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. In the case of increase in the cost of imports, an insurance coverage against cost escalation would mitigate this risk. 

Repatriation Risk

Another risk associated with foreign loan is ‘repatriation risk’. This becomes of greater concern to a lender if he is not 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, 2049 and Electricity Act, 2049 for hydropower projects. A foreign investor is also subject to this risk.

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 risks are known as sovereign and country risks. Multilateral Investment Guarantee Association (MIGA), a member of The World Bank Group, provides insurance against such risks for a fee. However, the availability of such insurance is limited only to foreign investors.

Interest Rates

It is now time, we also touch 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 rates 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, the 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.

Inflation Risk

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 answer, 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 risks. 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 engineers 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 PPA with the utility.

Revenue Risk

A developer can have a long-term PPA, but such a PPA may also 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 poundage. 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’ type of PPA mitigates this risk.
However, with respect to both market risks and revenue risk, it needs to be noted that electric energy is being traded in spot markets in Western Europe. 

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-guarantees to cover 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. Nowadays, 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 Risk

Time and cost overrun risks are a group of construction risks of which time overrun risks result in loss of revenue as well as raising total amount of interest during construction of debt financing and may even attract a penalty for late delivery of energy. Other construction risks are force majeure risk, socioeconomic or environmental risk, geological risk, performance risk, design risk, etc. One can arrange insurance coverage against such risks 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.

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 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.

Public and private investors and equity financing

The main advantage of working with these financiers is that they can bring in a lot of ‘non-financial resources’ like modern and efficient project management skills. This often leads to significant efficiency and productivity increases. Additionally, this kind of capital and the corresponding ‘non-financial resources’ have a leveraging effect of attracting debt financing at more interesting terms.
In the case of Nepal, these financiers have certainly had a good influence on single SHP projects and the growing volume of private SHP plants in operation. There is, however, a strong indication that organising this kind of capital through equity investment companies could result in better accessibility to capital for SHP financing.

 

Project Financing (Ratna Sansar Shrestha, FCA)

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. 

Mechanisms and Mechanics of Perfecting Security under Project Finance:

The following factors must be considered in the loaning of money on project finance basis for a hydropower project in order to perfect security.

Revenue: watertight arrangement for commercial operation during debt service period:

• PPA:
• Assign it to the lender(s) with the Nepal Electricity Authority’s (NEA) 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 the first lien.
• Allow the developer to withdraw money from such an 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 immediate future.

Expenditure: watertight arrangement during construction period

• Assign all contracts or agreements, inter alia, related to construction, supply, transportation, erection or installation, consultancies (design, engineering, supervision, etc.) to the lenders so that they are able to continue to complete implementation and operation of the project in the case of borrower default 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 are injected into a dedicated bank account on which the lender has the first lien and outflows from this account are closely monitored by the lender.
• Ensure that proper contractual arrangements are made such that (a) cost and (b) time constraints are not exceeded. (Time overrun tends to be more expensive than cost overrun 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 or agreements, which could increase the total project cost.
• Ensure that the borrower company has or is able to access the 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.

Safety-net: success or failure dependent on robust and sturdy safety-net of insurance

• 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, contractors’ equipment, third party liability, comprehensive workmen’s compensation, professional liability and so on and so forth). The words of the proposed insurance policies are 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.
• 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, license, etc.) assets are mortgaged against the loan, enabling the lender to foreclose without having to resort to court of law.