| 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 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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.