2010

FINANCING

POWER

PROJECTS

IN

DEVELOPING COUNTRIES: WHAT ARE THE NEEDED INGREDIENTS REQUIRED TO MAKE IT BANKABLE?

Femi Adekoya
LL.B (Lagos), LL.M (CEPMLP, Dundee), ACI.Arb Barrister and Solicitor of the Supreme Court of Nigeria

TABLE OF CONTENTS
Page List of Figures.............. i Abbreviations..............ii Dedication.......... iv Abstract................................v

Introduction.......... 1 1. POWER SECTOR REFORMS IN DEVELOPING COUNTRIES ............ 4 1.1 1.2 1.3. Pre-existing Conditions............ 4 Power Sector Reforms.................. 6 Liberalisation........... 9

2. FINANCING POWER PROJECTS IN DEVELOPING COUNTRIES ............ 13 2.1 2.2 2.3 2.4 2.5 2.6 Types of Financing Methods.......... 13 What is Project Finance......... 17 Parties and their Roles.......... 22 The Project Finance Structure......... 28 Sources of Finance......... 30 Build, Operate and Transfer (BOTs) and Long Term Contracts.................33 2.7 Hubco Power Project in Pakistan. ............ 36

3. BANKABILITY ISSUES (PART 1).............. 38 3.1 Risk Identification, Allocation and Mitigation............. 38

3.2 3.3

The Power Purchase Agreement.............. 44 Purchasers Credit-worthiness and Government Support And Guarantees.............. 48

4. BANKABILITY ISSUES (PART 2 )......... 50 4.1 Project Documentation............. 50 4.1.2 Concession Agreement.............. 50 4.1.3 Consents and Approvals........... 52 4.1.4 Sponsor Contribution and Shareholder Agreements ............ 53 4.1.5 Construction Agreement.............. 54 4.1.6 Operation and Maintenance Agreement........ ............ 55 4.1.7 Fuel Supply Agreement................ 55 4.2 Lenders Security Concern and the Role of Security................ 56

CONCLUSION................... 59 List of Charts Bibliography

LIST OF FIGURES

Chart 1..20 Chart 2..29

ABBREVIATIONS
AfDB BOO BOT BP BTO CFE DPC EBRD EPC FM GE HFO Hubco IEA IMF IBRD IFC IPP IsDB LDC MFS MW NEPA African Development Bank Build-Operate-Own Build-Operate-Transfer British Petroleum Build-Transfer-Own Comision Federal de Electricidad (Mexico) Dahbol Power Company European Bank for Reconstruction and Development Engineering, Procurement and Construction Force Majeure General Electric Heavy Fuel Oil Hub Power Company International Energy Agency International Monetary Fund International Bank for Reconstruction and Development International Finance Corporation Independent Power Project Islamic Development Bank Less Developed Country Minimum Functional Specification Megawatt National Electric Power Authority
ii

NERC PHCN PLN PPA SEB SEC SPV WAPDA

Nigerian Electricity Regulatory Commission Power Holding Company of Nigeria Perusahann Listrik Negara Power Purchase Agreement State Electricity Board State Electricity Company Special Purpose Vehicle Water and Power Development Authority

iii

DEDICATION

This is to my family the ADEKOYAS for their unfailing love and faith in me that has enabled me to reach this far.

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ABSTRACT
The importance of the power sector on the overall economic growth of a country cannot be over-stated, as it serves as a catalyst for the improvement of the various segments of the economy. This view served as the motivation for developing countries to take on the role of financer and manager of the entire power sector with little success. The result of which has been bad management, poor network coverage, irregular power supply, power shortages and a host of other vices. These attendant problems caused a financial drain on the developing countries who simply cannot afford to continue financing and managing the sector. With this in mind, developing countries have had to devise innovative ways of financing the power sector without draining government funds. Hence, the essence of this paper which is the financing of power projects in developing countries and the needed ingredients required to make it bankable.

This paper commences with an insight into the prevailing circumstances of the power sector of developing countries with particular reference to Nigeria, which will be followed by looking at the relevant power sector reforms and the role of liberalisation in encouraging foreign investment. In addition to this, the paper will proceed to examining the methods of financing power projects in developing countries with a bias for project finance as the preferred choice. The paper then continues with a thorough assessment of the issues required to make a power project bankable by looking at various issues such as risk identification, allocation and mitigation, the power purchase agreement and the necessary project documentation such as the concession agreement, the fuel supply agreement, the construction agreement and a host of others. The paper ends with the conclusion that though power projects are country specific, the general issues studied are peculiar to all developing countries and as such they should be followed to ensure the bankability and success of the project.

INTRODUCTION
The power sector is an important aspect of any countrys economic growth and development. This is particularly evident in the case of developing countries (LDCs) who need such development to not only catch up with the developed countries like the UK, but to also develop adequate and modern infrastructure to better the lives of their citizens. It is a well established fact that the power sector of most LDCs are in a dire state. This has resulted in economic stagnation and increased poverty across board. The impact of electricity on a nations overall growth finds expression in these two phrases; a nation without electricity will be perpetually under-developed; a city without electricity is like a ghost-city, while a home without electricity looks like a deserted house or a grave and the electricity system is the blood stream of an industrial society.1

Most LDCs in the past were of the view that the power sector is of national importance and as such, it should be left in the hands of the government to manage and finance the sector. This has proved to be not only challenging for the government which is burdened with other governance issues, but has also led to a complete neglect of the power sector, resulting in poor management, irregular power supply, power shortages and most importantly a financial drain on the government purse. To overcome this hurdle, LDCs will have to invest in building new power plants to increase generating capacity, refurbish the existing ones and expand the network. This may not seem so easy because the investment required runs into hundreds of millions of US dollars and in some cases billions. A host of LDCs are cash strapped and simply cannot afford such investment, which makes it increasingly difficult for them to adequately manage and finance the sector. With this in mind, most LDCs have introduced some form of reform to attract the needed funds in order to develop the sector either through foreign or local investment.

1 A.A. Tejuoso, How Can Nigerias Reformed Power Sector be Developed through Project Finance? (Unpublished LLM Dissertation submitted to the CEPMLP, University of Dundee, 2007).

As earlier stated, financing power projects is very expensive and as a result, the proper financing mechanism should be employed to allow the project be funded in the most cost effective manner, which will be acceptable to all stakeholders involved. This paper seeks to review the manner in which power projects are financed in LDCs with particular emphasis being placed on project finance as the preferred choice for financing. This paper also reviews some of the requirements needed to make such a project bankable.

The paper commences with a review of the power sector of LDCs with particular reference to Nigeria. In so doing, the paper looks at the pre-existing conditions and the needs of the sector; the power sector reforms that will promote foreign investment and liberalisation of the sector (the level and extent). Since liberalisation is essential to promoting foreign investment for the purpose of financing power projects, the paper looks briefly at features of a liberalised market such as an adequate power sector reform law, unbundling of the state utility, provision of third party access, regulatory institutions and the market structure (most LDCs do not have a mature power market so the paper will be biased towards the single buyer model).

Chapter 2 looks at the manner of financing power projects in LDCs. It begins with types of financing methods such as balance sheet finance, asset based finance and finally project finance, with particular emphasis on project finance. Following this, the paper considers the parties and their roles, the project finance structure, sources of finance, BOTs and long term contracts as well as the Hubco power project in Pakistan as a case study.

Chapter 3 analyses the main ingredients necessary for the projects bankability, by looking at the process of risk identification, allocation and mitigation between all the relevant stakeholders. This will be done through an examination of the elements of the power

purchase agreement (PPA), the purchasers credit worthiness and a combination of government support and guarantees.

Chapter 4 continues the process with an analysis of the relevant project documents such as the concession agreement, the consents and approvals, the shareholders agreement and contributions, the construction contract, the fuel supply contract as well as the operation and maintenance contract. The last part of this chapter will consider the lenders security concerns and the role of security.

The paper will then conclude as to whether the requirements discussed will indeed guarantee the bankability of power projects in developing countries.

1. 1.1

POWER SECTOR IN DEVELOPING COUNTRIES Pre-existing Conditions

The power sector of LDCs is one which is dominated by the state electricity company (SEC), whereby the state managed the power sector. The SEC is usually vertically integrated, which means aspects such as generation, transmission, distribution and supply (metering inclusive) were all under its exclusive control and management. This made the SEC a monopolist in all rights, as it could act as it saw fit without any form of competition to make it perform at its best. In some cases, the SEC was also charged with the responsibility of regulating the sector, which not only made it the alpha and omega of the sector but also guaranteed its stranglehold on it. Under this kind of circumstances, electricity consumers had no choice but to employ the services of the SEC whether or not they got the best value for their money. The lack of competition and the total control of the power sector by the SEC not only affected its performance and services but also led to the mismanagement and neglect of the sector. Since SECs are not always the best managers, one can only say that they have lived up to that expectation by their abysmal performance. This has led to a series of crises for the power sector such as irregular power supply, infrastructure decay, power shortage, low quality service, bad management, high network losses and poor service coverage.2 In most cases, it has led to serious financial strain on the government, which has no choice but to keep financing the SEC or risk the entire nation experiencing a black out. As a result of this power shortage, consumers have had to resort to self-help to avoid living in darkness or closing up shop (in the case of businesses). Most consumers have resorted to using generating sets to carry on with their daily lives, while some have gone as far as using illegal power connections to access electricity. This has increased the cost of doing business in LDCs as well as the cost of living because consumers have had to pay the extra cost for diesel, kerosene and other alternate fuels to
2 O.O. Adekoya, Power Sector Reforms: What are the Needed Requirements for Developing Countries? (Unpublished Research Paper submitted to the CEPMLP, University of Dundee, 2009).

power their various generating sets. This has not only depressed economic growth, it has also affected the influx of foreign investment into the country. An example of this kind of scenario was that of the National Electric Power Authority (NEPA) of Nigeria. NEPA controlled and managed the entire power sector of Nigeria without any form of competition until recently when the government enacted a power sector reform law. NEPA was the alpha and omega in the power sector and was responsible for providing power as well as regulating the sector. NEPAs hapless performance bloomed and blossomed, its consumers (those without self generating sets) could go days without electricity. As a result of this, most Nigerians invested in generating sets. This accounted for a staggering 2400MW, thereby making Nigeria one of the highest generator importing countries in the world, with an estimated cost of $152 million of the $432.2 million spent by all African countries in 2005 alone.3 The situation is even more pathetic for people living in rural communities. Most of them are not even connected to the national grid, with the far less prospect of having regular power supply. This has led to a situation in which most rural communities are using the more traditional means of power supply in the form of biomass. For instance, in Uganda biomass constitutes over 90% of total energy consumption in the country. It provides almost all the energy used to meet basic needs of cooking and water heating in rural and most urban households, institutions and commercial buildings. Biomass is the main source of energy for rural industries.4

Conditions and circumstances like those mentioned above only expose the inefficiencies and mismanagement of the power sector by the SEC. This has helped propel a wave of power sector reforms across most LDCs, which will help in improving not only the terrible conditions of the power sector but also better control and management of the SEC through privatisation and liberalisation. With this in mind, this paper proceeds to highlight some of the elements of such reforms.
See Tejuoso, supra note 1. The Energy Policy of Uganda, Ministry of Energy and Mineral Development, http://www.rea.or.ug/userfiles/EnergyPolicy%5B1%5D.pdf (last visited, January 16, 2010).
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1.2. Power Sector Reforms

In most countries, infrastructure activities such as those in the power sector have been viewed as strategic activities with natural monopoly characteristics. These monopoly characteristics result from the existence of economies of scale and scope. Hence, the view has been that supply is best provided by vertically integrated monopolies owned by the government.5 Regrettably, the governments of LDCs have not found it easy to do and have failed in efficiently managing their respective power sectors, which has proved disastrous for the country. As a result of this, some LDCs have embarked on varying types of power sector reforms all geared towards improving performance of the sector and most importantly removing the financial strain from the government.

Electricity sector reforms are multi-dimensional activities with interacting factors and a variety of impacts. The process generally involves a set of concrete steps or measures based on a specific model of reform. At one level, these measures involve structural and organisational changes to the industry, and at another level there is a requirement for appropriate institutional arrangements such as legislation and new agencies.6 Before proceeding with power sector reforms, LDCs must consider the dimensions (such as social, legal, economic and political), the circumstances on ground (such as historical development, size, technological advancement and the resource mix of the power sector) and the processes (such as privatization, liberalization and regulation).7 The above considerations will help in tailoring the reforms to their individual needs and specifications.

5 Y. Zhang, C. Kirkpatrick, and D. Parker, Electricity Sector Reforms in Developing Countries: An Econometric Assessment of the Effects of Privatisation, Competition and Regulation, at http://www.competitionregulation.org.uk/publications/working_papers/wp31.pdf (Last visited, January 17th, 2010). 6 T. Jamasb, R. Mota et al, Electricity Sector Reforms in Developing Countries: A Survey of Empirical Evidence on Determinants and Performance, at http://wwwwds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2005/03/30/000012009_20050330110431/Ren dered/PDF/wps3549.pdf (Last visited, November 17th, 2010). 7

See Adekoya, supra note 2.

There are a host of differing reasons for embarking on power sector reforms but most LDCs have similar reasons. Some of these are:

Financial Strain: Activities in the power sector cost huge sums of money to embark on, from refurbishing existing plants to building new ones, cash that LDCs just dont have. This has caused a serious financial burden on them, which has resulted in the deterioration of the sector. For example, in India, the combined dues of all the Indian state electricity power utilities to central power suppliers and fuel suppliers amounted to about US$5.5 billion equivalent in 2001. To put this magnitude into perspective, this amount was about half of what all the state governments in India combined were spending on all levels of education every year. It was double what they were all spending on health, and three times what they were spending on water supply. If power sector financial losses were reduced by only one-third, the savings from a single year would have been sufficient to fill every teacher vacancy in the country and provide every school with running water and toilet facilities.8

Foreign Investment: Capital investment for new generation capacity is one of the fundamental needs of the power sector of LDCs. According to the IEA, LDCs are projected to invest nearly $60 billion a year in new generation capacity: $40 billion in Asia alone, $7 billion in Latin America and more than $5 billion in Africa and the Middle East. With the exception of a few countries in East Asia, LDCs lack sufficient domestic capital to support this level of investment on their own.9

Subsidies: As a result of the low standard of living prevalent in most LDCs, their governments have been saddled with the responsibility of subsidising electricity prices which have added to the financial constraints they face.

Privatisation: This is also an important reason why LDCs carry out power sector reforms. This involves selling state assets to raise cash which can be channelled to

J.E. Beasant-Jones, Reforming Power Markets in Developing Countries: What Have We Learnt?, at http://siteresources.worldbank.org/INTENERGY/Resources/Energy19.pdf (Last visited, January 17th, 2010).
8

S. Babbar and J. Schuster, Power Project Finance: Experience in Developing Countries, at http://siteresources.worldbank.org/INTGUARANTEES/Resources/Power_Project_Finance.pdf (Last visited, February 28th, 2010).
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other capital projects in the country. It can involve privatisation of the SEC and other aspects of the power sector as part of the reforms. Efficiency: The operating efficiency of the power sectors of LDCs is below standard, suffering from a series of poor coverage, irregular power supply, network losses and a host of other vices. Competition: With competition comes effective and efficient management, which will be occasioned as a result of the new market players who will give consumers a choice as to their service provider and in turn improve the overall performance of the sector. Effects: The attendant results and demonstration effects of the pioneering reforms of the power sectors in Chile, Norway, England and Wales in the 1980s.10 Pressure: Pressure for reform from international financial organisations and donor agencies such as the IMF and World Bank, through their lending for institutional reform programmes.11 For example, World Bank the traditional financier of the power sector in Ghana had made clear its inability and unwillingness to fund power sector investments (especially in LDCs), unless recipient countries demonstrate some commitment towards reforming the sector.12

The above reasons ignite the spark in LDCs to carry out the necessary reforms, but in doing that, they must ensure the proper implementation of the following elements:

Commercialisation and corporatisation of the SEC. Enacting a well rounded electricity reform law. Unbundling the SEC into generation, transmission, distribution, supply and metering. Provision of third party access

10

See Y. Zhang, C. Kirkpatrick, and D. Parker, supra note 3. See id. 12 I. Edjekumhene, M.B. Amadu et al, Power Sector Reform in Ghana: The Untold Story, at http://pdf.wri.org/ghana.pdf (Last visited, January 18th, 2010).
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 Establishing rules for consumer and investor protection. Privatization: Selling parts of the system amenable to competition to multiple private firms. Create Regulatory Institutions: Implement regulatory reforms and establish an independent regulator to oversee market conduct in the competitive industry and to regulate the monopoly prone parts of the system.13 Create Markets: Allow markets to function for parts of the system amenable to competition.14

An example of an LDC which embarked on a reform programme similar to that outlined above is Chile. The Chilean reform programme which commenced as a result of the 1982 Electricity Act has been hailed as a highly successful example of electricity reform in a LDC and a model for other privatisations in Latin America and around the world.15 Where all the above elements have been implemented by the LDCs, an avenue for competition (through new market participants) to thrive will be created, thus opening up the sector and increasing the chances for foreign investment.

1.3

Liberalisation

Liberalisation as opposed to being a single event is the process of introducing competition in the industry. Liberalisation can be done on varying levels and scales between the different parts of the power sector; but the usual segments which are subject to competition are the generation and the supply aspects of the sector. This is because of the monopoly characteristics of the transmission and distribution parts. There are two categories of countries in a liberalisation programme, which are, those with sufficient capacity to meet demand and those who have insufficient capacity to meet demand,

See Adekoya, supra note 1. D.G. Victor and T.C. Heller (eds.), The Political Economy of Power Sector Reform: The Experiences of Five major Developing Countries 6 (2007).
13 14 15

M. Pollitt, Electricity Reform in Chile: Lessons for Developing Countries, http://tisiphone.mit.edu/RePEc/mee/wpaper/2004-016.pdf (Last visited, January 17th, 2010).

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thereby resulting in either full scale or partial black-outs.16 Recognising that they are in the second category, LDCs have a number of options. They can do nothing and the population can live with blackouts, which will tend to make the government unpopular and also lead to various forms of expensive self generation. Second, the LDCs can demand that the SEC provide additional capacity, which requires investment. If the government has no funds available for investment, the option that is left is to liberalise the sector in an effort to attract private capital.17

There are basically three (3) models which LDCs can employ in their liberalisation process; the first is the single buyer model whereby there is only one purchaser for the power generated. The second is wholesale competition which allows distribution companies to purchase electricity directly from generators they choose, transmit this electricity under open access arrangements over the transmission system to their service area, and deliver it over their local grids to their customers, which brings competition into the wholesale supply market but not the retail power market. The third is retail competition which allows all customers to choose their electricity supplier. This implies full retail competition under open access for suppliers to the transmission and distribution systems.18

The single buyer model with little or no restructuring has been widely used to attract private investment into power generation, since it removes most market risk for the investors.19 Also, an LDC which seeks investment under limited competition in the power market can unbundle its supply structure and allow limited cross-ownership between generators and suppliers to help investors manage their risks.20. Most LDCs do not have
S. Dow, Downstream Energy Law and Policy Primer, at https://my.dundee.ac.uk/webapps/portal/frameset.jsp?tab_tab_group_id=_2_1&url=%2Fwebapps%2Fblack board%2Fexecute%2Flauncher%3Ftype%3DCourse%26id%3D_25518_1%26url%3D (Last visited, January 17th, 2010). 17 See id. 18 R.W. Bacon., and J. Beasant-Jones, Global Electric Power Reform, Privatisation and Liberalisation of the Electric Power Industry in Developing Countries, at http://rru.worldbank.org/Documents/PapersLinks/567.pdf (Last visited, January 18th, 2010). 19 See J.E. Beasant-Jones, supra note 6.
16 20

See id.

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advanced power markets due to the dominance of the SEC on the sector; with this in mind, this paper will focus on the single buyer model as opposed to power pools used in developed countries such as the UK or US.

This model is frequently used as the precursor to full blown liberalisation. In the single buyer model, there is usually one buyer (typically the SEC) which handles both the transmission and distribution of power to the final consumer. Competition in this model may come about at the bidding process for the construction of the generation plant. The government will usually set its requirements for a power plant and the potential investors will make their bids. The government then looks at the company or companies which can fulfil its requirements at the most affordable costs and awards the building of the power plants to such companies.21 To guarantee the sale of the power, the SEC enters into a PPA which may be between 5-20 yrs with the power generator, whereby they agree on the terms of the sale, which will include price review clauses, technical specifications of the generated power, take or pay obligations, hours of availability and a host of other issues. The PPA acts as both the power sales agreement as well as a medium for allocating risks.

Liberalisation can also take place in the supply side of the sector, whereby new entrants will be allowed to trade power to the final consumers with the provision and guarantee of a third party access regime that will not only be transparent but avoid the incidence of market abuse by the network operator. The network operator who is in charge of the monopoly parts of the system (transmission and distribution) will be paid an access or transit fee to allow the traded power to flow through its wires to reach the final consumer. The success of this will be largely dependent on there being an independent regulator who will endeavour to promote competition, transparency and prevent market abuse by all the stakeholders. For instance, the independent regulator of Nigerias power sector the Nigerian Electricity Regulatory Commission (NERC) has as part of its goals and objectives the following:

21

See Adekoya, supra note 1.

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To promote uninterrupted, adequate, safe, reliable and affordable services in generation, transmission, distribution and trading of electricity through appropriate regulations.

To promote private sector participation, an investor friendly market and competition.

To monitor industry operators and prevent abuse of market power. To ensure consumer protection. To establish and ensure an effective dispute resolution mechanism to guarantee consumer protection while also encouraging private sector participation.

To ensure even-handedness, firmness and fairness in the enforcement of rules and regulations.22

For the liberalisation of the supply side to work properly, the power market needs to have a degree of advancement or maturity, which most LDCs lack and as a result of this; LDCs start their liberalisation process using the single buyer model and with time introduce competition in the supply side, either in wholesale or retail competition. With the introduction of liberalisation to the power sector, fresh capital and foreign investment tend to find their way to the party, thereby creating new avenues to improve the sector by bringing in fresh capital to building new power plants, purchase and refurbish the old ones as well as relieve the LDCs the burden of funding the sector. With this in mind, this paper continues highlighting the financing of power projects in developing countries, commencing with the types of financing methods available to investors wishing to embark on power projects in LDCs.

Goals and Objectives, Nigerian Electricity Regulatory Commission, at http://www.nercng.org/index.php?option=com_content&task=view&id=51&Itemid=46 (Last visited, January 19th, 2010).
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2.

FINANCING POWER PROJECTS IN DEVELOPING COUNTRIES

2.1. Types of Financing Methods

Financing power projects is a very tedious and expensive process. This requires the use of appropriate financing methods that are cost effective to all stakeholders. Not all financing methods can be used for power projects, as some methods will prove to not only be too expensive but also unable to meet the needs of the relevant stakeholders. There are three possible methods of financing power projects. These are balance sheet finance, asset based finance and project finance. This paper attempts to provide a brief explanation of each method but in so doing greater emphasis is placed on project finance as the preferred choice.

BALANCE SHEET FINANCE With this method, a company uses retained earnings or short term debt to finance the development and construction of the facility. Upon completion, when the project requires permanent financing, long term debt, equity sales or other corporate finance techniques are used to obtain the needed funds.23 For the project to be financed, the entire balance sheet of the company will be studied. That is, the cash flow (profit and loss, revenue and expenditure) as well as the assets of the company (which may be either tangible or intangible assets) will be considered by the financial institution for the purpose of lending it the required funds for building, maintaining and managing the project. The lender then looks at the company as whole, for the purpose of granting the loan and the consequences such a project will have on the balance sheet and the financial standing of the company.

The relevant criteria a project must satisfy to qualify for balance sheet financing include whether the corporation has access to the needed capital at a reasonable cost, whether the corporation has other capital projects that it has committed itself to both financially and technically, whether the projects feasibility study projects a return on investment acceptable to the project sponsors internal investment criteria, whether the project risks

23

S.L. Hoffman, The Law and Business of International Project Finance 7 (3rd ed. 2008).

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are satisfactory and whether other types of financing methods provide lesser advantages to the project sponsor.24 Where this criterion is fulfilled, embarking on this type of financing method for power projects will still depend largely on the investment and corporate strategy of the company.

It is quite possible that balance sheet financing could be used as a method of financing power projects since energy companies of today are getting bigger in size and financial capacity and may be able to embark on some types of power projects depending on the size and magnitude. Companies such as Exxon Mobil, BP or GE Corporation have both the technical expertise and financial muscle to take on such projects using its own internally generated funds. For example, a 100 MW power plant using heavy fuel oil (HFO) can be financed using this method.

Even though this may be the case, a lot of energy companies will be reluctant to toe this path, as it will not only drain the company of its needed funds but may also hinder its financial commitment towards other projects. It may also mean that the company will have to assume some of the risks, particularly the financial risks associated with such projects, which may be avoided if another financing method is employed. It is also worth mentioning that most power projects are time consuming, with some of them ranging from 2-5 years before starting up. Where this is the case, a company may be deterred from using this financing option, as it will not want to tie needed funds down for so long without it generating any income during that period. In other words, the company must properly consider the time value of the money it intends on using for the project and the attendant consequences it will have on its balance sheet and financial standing. An example of a power plant which was balance sheet financed is Ave Fenix a merchant power project; which was constructed as a gas fired power plant in Argentina.25

24 25

See id. See Babbar and Schuster, supra note 9.

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ASSET BASED FINANCE With this method of finance, a company raises funds intended for the project using its assets or assets of the project as security. This could either be a fixed or floating security. A fixed security is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets. Such rights vary according to the type of security interest, but in most cases, a holder of the security interest is entitled to seize, and usually sell, the property to discharge the debt that the security interest secures.26 While a floating security is a form of security for a debt. Instead of naming a specific property, which can be taken by the creditor if the debtor defaults (as in a fixed charge like a mortgage), a class of goods or assets is named, such as the debtor's stock. This allows the debtor to trade in the assets freely, but if the debtor fails to make repayments then the floating charge becomes a fixed charge (known as crystallisation) over all the stock at that time. The creditors can then take and sell it to recover the debt.27

In using asset based finance for power projects, the company must pledge its assets or assets of the power project as security for the repayment of both the loan and the interest on it. This may be a thorny issue to deal with since assets of a power project are usually less valuable to both the lender and the company because the cost of developing, constructing and operating the power project far outweigh its value. Hence, the assets of the power project may not serve as an adequate means of security for the loan. Since this is the case, the company will have to advance additional means of security to the lender in form of other assets in its business, either tangible or intangible. Therefore, using asset based lending to finance power projects will place the company in a precarious position of servicing both the loan and the interest on it without an immediate stream of revenue coming from the project.
Security Interest, at http://en.wikipedia.org/wiki/Fixed_charge (Last visited, January 19th, 2010). Financial Contracts Terms and Definitions Glossary, Floating Charge, at http://www.businessballs.com/businesscontractstermsdefinitionsglossary.htm (Last visited January 19th, 2010).
26 27

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PROJECT FINANCE This is the arrangement of financing for long term capital projects, large in scale, long in life and generally high in risk.28 This means debt supported by the project as opposed to debt supported by the projects sponsoring companies.29 This type of finance is more like the beautiful bride to a company wishing to embark on a power project because it caters for the needs of the project and the company. This is because the company does not have to dip its hands into its purse; hence, it will not suffer any major financial strain as a result of such finance. This means it will have enough funds to embark on other projects it chooses. Under this type of finance, the company will not have to assume all the risks associated with the project as opposed to asset based and balance sheet finance earlier discussed. Since this type of finance looks at the project for its repayment, the assets of the project may not be the cardinal reason for the lender advancing funds to the company. Indeed, in a project financing, the hard assets probably would not produce sufficient cash in a foreclosure sale (in the event that there is a default as to the repayment of the loan or the interest) to justify the value of an asset based loan.30

In project finance, the company may need to advance some part of the total funds required which will be termed or seen as its equity contribution to the project before the lender can advance the balance of the funds. The debt ratio is usually very high for most project financings. This is the case because the debt is supported not just by the projects assets but also by a variety of contracts and guarantees provided by customers, suppliers and local governments as well as by the projects owners.31 In some cases, the debt to equity ratio may be as high as 70:30 respectively. Equity is a small component of project financing for two reasons: Firstly, the time scale of the investment often precludes a single investor or even a collection of private investors from being able to fund it;

D.K. Eiteman, A.I. Stonehill, et al, Multinational Business Finance 365 (10th ed. 2004). F. Allen, S.C. Myers, et al, Principles of Corporate Finance 685 (9th ed. 2008). 30 See S.L. Hoffman, supra note 22. 31 See F.Allen, S.C. Myers, et al, supra note 27.
28 29

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Secondly, many of these projects involve subjects that are usually funded by governments such as electric power generation, energy production and development.32

This means that some of the risks associated with financing the project will be passed onto the lender to bear; hence, the need for risk mitigation mechanisms. Having given a brief insight into project finance, the paper will now proceed to provide an in-depth analysis of what project finance is.

2.2. What is Project Finance?

Project financing is not a new financing technique. Venture-by-venture financing of finite life projects has a long history; it was infact, the rule in commerce until the 17th century.33 An example of a type of project financing mechanism was that used for funding the Suez Canal. It was not until some 60 years ago that project finance was used to fund development of oil fields in the US. Some Texan and Oklahoman explorers lacked the capital and the credit rating to get the needed funds to finance their oil fields. The lenders developed a form of production payment scheme, in which they relied on the specific reserves and the direct proceeds of oil sales earmarked for the loans repayment as opposed to the companys balance sheet for security.34 Project finance in its proper sense did not start until the exploration and development of the North Sea oil fields in the 70s and 80s which ushered in the establishment of Special Purpose Vehicles (SPV) to handle the individual aspects of the main project, ranging from its funding to the management of the project.

Project finance is usually used to finance big infrastructural projects, notorious of which are power projects, oil and gas field development, road projects and a host of others. This method of finance has been used as an avenue for countries particularly LDCs to fund the

See D.K.Eiteman, A.I. Stonehill et al, supra note 26. J.D. Finnerty, Project Financing: Asset Based Financial Engineering 4 (1996). 34 A. Buckley, Multinational Finance 587 (5th ed. 2004).
32 33

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development of new power plants in order to ease the financial burden the government will have to face.

Project finance can be described as follows:

A non-recourse or limited recourse financing structure in which debt, equity and credit enhancement are combined for the construction and operation, or the refinancing of a particular facility in a capital intensive industry, in which lenders base credit appraisals on the projected revenues from the operation of the facility, rather than general assets or the credit sponsor of the facility and rely on the assets of the facility, including any revenue producing contracts and other cash flow generated by the facility, as collateral for the debt.35

The US Financial Standard FAS 47 defines project finance as follows:

The financing of major capital projects in which the lender looks principally to the cash flows and earnings of the project as the source of funds for repayment and to the assets of the project as collateral for the loan. The general credit of the project is usually not significant factor, either the entity is a corporation without other assets or because the financing is without direct recourse to the owners of the entity.36

Another definition worth mentioning is that of Peter Nevitt and Frank Fabozzi in their book Project Financing which defines it as:

35

See S.L. Hoffman, supra note 22.

Swiss RE, Project Finance: The Added Value of Insurance, at http://borja.amor.googlepages.com/4ProjectFinance.pdf (Last visited, January 19th, 2010).
36

18

A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.37

In other words project finance is a form of finance which concentrates on the cash flow of the project and has no recourse or in some cases limited recourse to the sponsor of the project. This means the financing of the project is off the balance sheet of the sponsor. The assets of the project are usually not up to the value of the loan. Hence, the reason why project finance is an expensive means of finance and is considered as a high risk/high reward method of finance, even though the risk may be reduced by careful restructuring.38 Project finance involves several parties and as a result of this, there is a complex web of contracts between the different parties all having different stakes and interest in the success of the project.

The two main elements of project finance are the project or economic unit and the revenue or cash flow; other issues such as sponsor guarantees and risk mitigation though important are ancillary matters. This is because both the economic unit and the cash flow form the basis on which the entire concept of project finance was developed. There are some key features which distinguishes project finance from other financing methods. Some of the features are:

The establishment of a separate vehicle for the project. The revenue or the cash flow of the project forms the basis of advancing the funds by the lender.

The lions share of the funds is provided for by the lenders. This may typically be anywhere from 60-80% of the total funds required for the project, while the sponsors provide an equity of about 20-40%.

37 38

P.K. Nevitt and F.J. Fabozzi, Project Financing 1 (7th ed. 2000). See Buckley, supra note 32, at 588.

19

Since the project vehicle is separate from its owners and is a distinct vehicle, the funds advanced to it by the lenders are usually separate from its owners. Hence, the reason why it is referred to as limited recourse or non-recourse finance.

Even though project finance is referred to as non-recourse finance, the owners of the project vehicle still offer the lenders some form of guarantees for the project as a result of the credit standing of the project vehicle.

The project involves a lot of contracts between several parties. Project finance is usually for large and time consuming projects.

Source: Swiss RE. Project Finance: The Added Value of Insurance, at http://borja.amor.googlepages.com/4ProjectFinance.pdf (Last visited, January, 20th, 2010).

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Project finance has some advantages which are peculiar to it alone and it is for this reason that project finance seems attractive for large projects. Some of the advantages are:

Increase in the availability of finance or funds for large projects. A reduction in the overall risk for major participants, bringing it down to an acceptable level.39

Increase in private investment for LDCs. Off-balance sheet treatment of the debt financing.40 Non-recourse or limited recourse to the sponsors of the project.

For lenders to consider financing or advancing funds to a project using project finance, they will require the following from the project:

Economic viability of the project: Since the basis for advancing funds to the project is the expected cash flow and revenue, the lenders will ensure that the project is capable of being managed and operated profitably. The economic viability must show that on the basis of cash flow projections, sufficient cash will be generated by the project to pay for all operating expenses, debt service, taxes, royalties and other costs; while leaving a surplus for the SPV to meet its target for return on equity.41 Therefore, there must be a clear, long term need for the projects output and the project must be able to deliver its products or services to the market place profitably.42

Technical viability of the project: Before advancing the funds to the project the lenders will ensure or carry out a technical feasibility study to verify that the project can infact meet up to its technical specification and performance. Lenders can do this by employing the services of independent experts who are knowledgeable in the field of the project. For instance, lenders to a power plant

IFC, Project Finance in Developing Countries 7 (1999). See Hoffman, supra note 22 at 8. 41 C. Chance, Project Finance, 5 (1991). 42 See Finnerty, supra note 31 at 7.
39 40

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project will ensure that the plant will perform up to the standard as set in the construction agreement. Proper operation, maintenance and adequate raw materials: This is another key issue for lenders because they will need to satisfy themselves that there is not only sufficient raw material to keep the project going but there is also a capable operation and maintenance team in place to sustain the project and ensure its continued performance and success.

An example of project financing for a power project is Jorf Lasfar Power in Morocco, worth $1.3 billion. This was the countrys first privately financed power project and North Africas biggest IPP with limited recourse financing to date.43 Having made a critical assessment of project finance, this paper will proceed to examine the relevant parties and the roles they play in the project.

2.3. Parties and their Roles

It has been established that project finance is a complicated financing method which is usually used for large infrastructure projects. As a result of this, it will involve several actors or parties who play different roles to bring about the success of the project. These roles are usually dependent on the varying interests each of the parties have in the project. All the parties usually need to work together to implement the project successfully. The parties involved in project finance range from the project sponsors to the lenders. As earlier stated, there are several parties to the project but the following have been identified as the main parties:

The project company which is usually an SPV The sponsors The lenders The host government
43

See IFC, supra note 37 at 17.

22

 The contractor The offtaker in this case this will be the power purchaser. In the single buyer model
earlier discussed the offtaker will be the SEC.

The fuel supplier The operator

Having identified the key players in project finance, an analysis of the roles each party plays will now be considered.

THE SPV This is a very important party to the project. The SPV is charged with the responsibility of implementing the mandate of the project. The SPV is created by the project sponsor for the sole purpose of executing the project. The SPV is usually a separate and distinct entity from the sponsors. With this in mind, the sponsors are able to finance the project off their balance sheet with non-recourse or limited recourse to them by the lenders to the project. As a result of the SPV being separate from the sponsors, it usually signs the relevant agreements with different parties to the project on behalf of the project. Since it is the party used to secure the financing of the project, it is also the same party the lenders look to for the repayment of the not only the loan but also the interests accruable. For instance, the Hub Power Company (Hubco) was created as the SPV for developing a large oil-fired power plant in Pakistan. It entered into agreements with the major stakeholders including the lenders.44

The SPV can be created in different forms, some of which are identified as follows:

Unincorporated joint venture; General partnership; Limited partnership and the most widely used

44

R. Brealey, S. Myers and F. Allen, Corporate Finance 688 (8th ed. 2006).

23

Incorporated company45

Before embarking on creating an SPV, the sponsors should consider the following:

Legal status of the SPV: The legal status of the SPV is important and should be well considered by the sponsors. This is because it is the legal status of the SPV that will determine the degree of coverage the sponsors have from the risks associated with the project as well as whether the loan will be off balance sheet financing for the sponsors. The legal status will also determine whether the loan will be non-recourse or limited recourse to the sponsors. All of the above are as a result of the concept of limited liability.

Tax considerations Repatriation of funds Operation and management of the SPV Procedure for creating and terminating the SPV Laws of the jurisdiction in which the SPV is to operate.

As a result of the above considerations, most project sponsors use an incorporated company as the favoured choice for their SPV.

THE SPONSOR This is the main party behind the project. They are the investors of the project who are responsible for setting up the SPV. They usually put up part of the funds for the project in the form of equity. They are the shareholders of the company and can be made up of one company or a consortium of interested parties, such as contractors, suppliers, purchasers or users of the projects products or facilities.46 The sponsor usually gives support to the SPV in the form of completion guarantees and other sponsor commitments as requested by the lenders. As with most business organizations, the main goal of the sponsor is to make
45 46

G.D. Vinter, Project Finance, (2nd ed. 1998). See Chance, supra note 39 at 9.

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profit from the project which he does by using the SPV. In the case of the Mangalore power project in India, Cogentrix a US company was the sponsor behind the Mangalore Power Company.47

In some cases, profits even though important may not be the sole motivating factor for the sponsor to embark on the project. Some other reasons for the sponsor embarking on the project are:

Risk allocation and mitigation between itself and other parties to the project Obtaining large financing for the project which will be off their balance sheet with little or no recourse to them.

The project may be part of the sponsors corporate strategy. For example, breaking into the power market of LDCs.

THE LENDER This is the party that makes available the bulk of the funds needed to carry out the project. The lender can be an individual financial institution or a consortium of varying financial institutions with different capacities and financial strength. In financing large infrastructure projects such as power plants, there will usually be a consortium of financial institutions of international repute coming from different countries which may include those from the host country. The essence of doing this is to promote diversity and prevent the host government from nationalising the project or any of its assets. This is also done to finance a project in a country which has restrictions of foreign companies taking security. Where there is a group of lenders; it will be called a syndicate, while the lead bank that arranges this type of cooperation is called the Arranging Bank.48 An example of an international financial institution which may be a lender is the International Finance

47 48

D. Bath, India Power Projects: Regulation, Policy and Finance 413 (Vol 1. 1998). See Hoffman, supra note 22 at 72.

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Corporation which supported the first IPP in Africa; the Ciprel Power Project in Cote dIvorie. The IFC provided a $14m loan for its own account and invested $1m in equity.49

THE HOST GOVERNMENT The host government is the party that kick starts the whole process for the entire project. This is as a result of granting the concession license or awarding the contract to the SPV. Since the host government has multiple agencies, it may award the license or contract through any of its agencies or directly by itself. The host government is also responsible for ensuring the necessary permits and approvals will be granted to the SPV and to generally create an investor friendly atmosphere for the SPV to thrive. The host government can also put in place policies that will favour the SPV such as tax reliefs or subsidies. In most cases, the host government will have to act as a support mechanism for the offtaker in the event of its inability to pay. This will be done by giving the necessary guarantees and assurances that it will come to the offtakers rescue and honour other risks it has agreed to help mitigate such as foreign exchange risk or change in law risk. In the event that the project is financed using a BOT scheme, the ownership of such a project will be transferred to the host government at the expiration of the concession. An example of a host government is Karnataka government in Southern India for the Mangalore power project in India.50

THE CONTRACTOR This is the party responsible for building the project. The contractor makes sure the project is working at optimum performance by building it according to specification and technical requirements. For example, if a company contracts Rolls Royce Engineering to build a 200 MW power plant, Rolls Royce as the contractor will make sure the plant meets the required specification. In most cases, the contractor will build the plant under an Engineering, Procurement and Construction (EPC) contract also known as a turnkey contract. The contractor may also be retained to act as the manager/operator of the plant; this will be advantageous to the project since it was built by the contractor. The majority of the
49 50

See IFC, supra note 37 at 16. See Bath, supra note 47 at 412.

26

activities of the contractor are governed by the construction agreement. An example of a contractor(s) is Bechtel Power Corporation and General Electric which constructed the facilities and supplied equipment respectively for the Dahbol power project in India.51

THE OFFTAKER This is the party who undertakes to buy the product or services of the project. In the case of a power project (using the single buyer model), the entity will usually be the SEC. This will be done by entering into a PPA with the SPV spelling out the obligations of the SEC. The offtaker is a vital party to the project as its credit worthiness and ability to buy the product or services of the project will greatly affect the financing or bankability of the project. For example, in the Tangshan power project in China, the projects offtaker is North China Power Grid (NCPG).52

THE FUEL SUPPLIER This is the party responsible for supplying the material that will be used to power the project. In this case, it will be the party responsible for supplying the fuel to the power plant. Since power plants run on different types of fuels such as coal, gas or HFO the fuel supplier will be mandated to supply the correct fuel to the plant while also ensuring that the fuel supplied is the specified one with regards to quantity, quality and price. The price of the fuel is also very important as it makes up part of the cost of running a power plant which will be considered by the lenders. In other words, the fuel supplier must be able to supply fuel to the plant. The quantity, quality and price specification of the fuel will be found in the fuel supply contract. For instance, in the Jegurupadu power project in India where there were three turbines (two running on gas and the third on naphta). The fuel supplier for the turbine running on naphta was Bharat Petroleum Corporation Ltd (BPCL).53

See id. See Babbar and Schuster, supra note 9. 53 See id.
51 52

27

THE OPERATOR This is the party responsible for the running, operation and maintenance of the project. The operator can be any of the parties to the project ranging from the SPV itself, the sponsors, the contractor or even an independent third party not associated with the project. The main rights and obligations of the operator are spelt out in the operation and maintenance contract. In the Samalayuca power project, the Mexican utility CFE is the plant operator and is obliged to make lease payments regardless of plant performance.54

Now that the parties to the project and their roles have been studied, this paper will move on to consider the intricacies surrounding the project finance structure.

2.4. The Project Finance Structure

Financing power projects is a herculean task which involves several parties with varying interests, roles, rights and obligations. As a result of this, there is a myriad of complex contracts and transactions which inter-connect and link all the relevant parties together to bring about the proper implementation of the project. There needs to be a proper harmonisation of these relationships between the parties in order to achieve success for not only the financing but for the entire project. Each contract spells out the rights and obligations each party has in the entire project and its financing. Some of such contracts are the operation and maintenance contract, the construction contract, the concession or awarding contract, the PPA, the shareholders agreements, the fuel supply contract and a host of other ancillary contracts.

Project financing starts with the awarding contract or the concession which is granted to the SPV by the host government. It is the awarding contract that sets the ball in motion bringing about the other contracts. The structure for the project financing of a power plant will look something like the diagram below:

54

See id.

28

Chart 2: Typical structure for an Independent Power Project

Source:

V.

Smith,

Project

Finance

Review,

at

https://my.dundee.ac.uk/@@/92D51D8D596F02F11DA6E5A97BA137A1/courses/1/CP52007_CAS_D65_20 0809/content/_1794218_1/PF%20review%20notes%20CEPMLP%2025.1.07.pdf (Last visited January 22nd, 2010).

The above diagram shows the links and connections between the parties. These links are all in place with the aid of the relevant contracts. For example, the link between the sponsor and the SPV in the above diagram is the shareholders agreement and the equity subscription. This not only shows the relationship between the sponsor and the SPV but also shows its role in the series of contracts and the project as a whole. Where all the contracts are properly executed, the chances of the project succeeding will be high.

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2.5. Sources of Finance

There is a wide range of funding sources available to a project. An SPV may be capable of obtaining funding opportunities outside of its domestic financial market or the financial market of the host country.55 If the domestic financial market is mature enough to handle big ticket transactions it may not need to go hunting for funds in the international market. Where the opposite is the case, it will have no choice but to look outside. The sources of finance will largely depend on the roles, interests, rights, obligations and objectives of the different parties involved in the project. For example, the sponsors though interested in the success of the project will be reluctant and unable to put up the entire amount needed for the project. The two main sources of finance for the project are equity and debt. These sources of finance can be provided for by a host of entities some of which are:

The sponsors of the project who will be the shareholders of the SPV; Commercial banks and institutional lenders; Equity markets; Bond markets; Investment funds; World Bank Group financing sources (IMF, IFC and IBRD); Regional development banks (AfDB, ADB, EBRD and IsDB); Bilateral agencies; Subordinated debt;56 Host government and a host of others.

The Sponsor: This is the entity that commences the project and provides the initial sum needed to start the project. They are the ones who usually provide the equity and can be made up of different parties some of which could even include the contractor or the host government.

55 56

See Nevitt and Fabozzi, supra note 35 at 67. S.L. Hoffman, The Law and Business of International Project Finance 430-468 (2nd ed. 2001).

30

Commercial banks and institutional lenders: After the equity contribution by the sponsors, the commercial banks and institutional lenders are usually the first point of call by the sponsors. The commercial lenders could be made up of domestic and international banks. The funds provided could be in form of an individual loan or a group of loans otherwise known as a syndicated loan (this is where there are multiple banks or lenders to the project).

Equity markets: This is the avenue of accessing funds through the stock market whether the domestic stock market (the host country) or international/foreign stock markets. This can be either through public sales of shares (if the SPV is a public company) or through private placements.

Bond markets: A bond is a debt obligation or security, where the holder or buyer expects the holder to repay the principal and interest at maturity (a date in the future). The bond market is a financial market where these bonds are bought and sold.57

Investment funds: Investment funds are funds which have access to large sums of money. An example of an investment fund will be a pension fund. They invest in projects on behalf of their members for the sole purpose of making profits. They can act as both a lender and an equity investor.

World Bank Group: Most major infrastructure projects whether in developed countries or LDCs have one or more organisations of the World Bank Group involved in the transaction. They provide not only funds for the project but also bring their reputation to bear on the project.

Regional development banks: The roles of regional development banks such as the AfDB are quite similar to that of the World Bank, as they are charged with supporting economic
What is a Bond Market, at http://www.streetdirectory.com/travel_guide/36220/investment/what_is_bond_market.html (Last visited, January 23rd, 2010).
57

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growth and infrastructural development of its members. For instance, AfDB will concentrate on infrastructural projects in Africa.

Bilateral agencies: These consist of two types namely; export-import financing agencies and developmental agencies. Export financing maybe government supported and will usually consist of long term financing and they make up much of the energy infrastructure financing in LDCs; while developmental agencies provide grants or concessional financing to promote economic goals of the organising government in LDCs.58

Subordinated debt: This is an avenue of raising money for the project in which funds are advanced to the SPV but the lender has junior rights in comparison to other lenders as it relates to both repayment and security. As a result of taking this risk, the lender will normally have a higher interest rate.

Host government: The host government may also participate in the financing either as an equity holder or as a lender.

There are several other sources of finance for the project but the above mentioned are the key ones used. Financing of the project could be done by using one source or a combination of sources but in most cases, it will be done by a combination of sources. The sources of finance are important to the project because it is a key part of the project financing that lenders consider before advancing funds to the project. With this in mind, the paper will now proceed to study the methods in which the project can be implemented, either through BOTs or long term contracts.

58

See Hoffman, supra note 45, at 458-459.

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2.6. Build Operate and Transfer (BOTs) and Long Term Contracts
Projects that need to be financed using the project financing method can be executed in different ways but the main ways to implement such (for power projects in LDCs) will be to use either the BOT scheme or enter into long term contracts with the relevant party. Whichever method is used, it will need careful structuring in order to fit the purpose it was intended for. The paper will now proceed to briefly study the meaning of a BOT scheme and what is meant by a long term contract.

BOT BOT comes into existence as a result of a concession which is either a license or a lease granted by the host government or one of its agencies. BOT is not a new form, though codifying it as such is relatively recent and can be attributed to Turgut Ozal of Turkey in the 1980s. Concessionised infrastructural development was employed for projects such as a 1782 water system in Paris and the Suez Canal which opened in 1869.59 Governments have utilised concessions in the context of BOT projects as a means of developing the host countrys infrastructure without having to invest public money, whilst ensuring the relevant assets ultimately remain in the public sector.60

BOT which stands for Build-Operate-Transfer is a concept in which private investors, the sponsors receive a concession to finance, build, and operate a facility over a set period of time, in exchange for the right to charge the users of the facility at a rate which makes the investment commercially viable. At the end of the concession period the facility is turned over to the state.61 A BOT project will therefore have a definite life and part of the skill when the project are put out to tender is to put together a financing package which will ensure the lenders get repaid and the shareholders get a sufficient return on their investment before the concession terminates.62 The concession usually lasts for a long time

P. Handley, A Critical View of the Build-Operate-Transfer Privatisation Process in Asia, 212 AJPA 19 No 2 (1997). 60 P.R. Wood, Project Finance, Subordinated Debt and State Loans 11 (1995). 61 See Handley, supra note 49, at 204. 62 See Vinter, supra note 42, at 37.
59

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ranging from 20-30years. The duration of the concession is essential to help the investor recoup not only his investment but to also enable him make some profits. The duration is also considered by the lenders to ensure that there is sufficient time to recover the loans and interest accruable. As is customary for a BOT scheme, there is a transfer period whereby the facility is handed over to the government; this transfer period will depend on terms as agreed to by the parties to the concession. The transfer period could either be at the end or expiration of the concession or upon the concession holder reaching a certain amount of money.

With BOT schemes, comes the expertise and financing of the project through the private sector, without the host government having to dig into its purse to finance the deal. In a BOT scheme, the concession holder is responsible for raising the needed funds to execute the project. This is usually done through project finance. In other words, the entire structure and considerations needed to finance a project using project finance will have to be made. BOT schemes are mainly used to finance big infrastructural and developmental projects and as such, it is a beautiful bride to LDCs, which have increasingly used it to not only finance big projects but to also bring in the expertise and efficiency associated with the private sector. As a result of the requirement of transferring the facility to the host government at the expiration of the concession, BOT schemes facilitate and promote the transfer of technology to the host government. With the success attained by the BOT scheme, multiple schemes with similar ideas have been developed although with slightly varying effects and degrees. Some of such schemes are BOO (Build-Operate-Own) and BTO (Build-Transfer-Operate).

As with most infrastructure projects, BOT projects can be awarded either through competitive bidding or by negotiation. Also, all the relevant technical and economic studies needed for the success of the project will have to be carried out. An example of a power project using a BOT scheme is the Al Manah Power Station in Oman estimated at $155

34

million. It is the first BOT in the Gulf region in which the IFC invested $14 million for its own account, $4 million equity and a further $57 million in B-loans.63

LONG TERM CONTRACTS Entering into long term contracts is very essential for the project. This is because it helps guarantee a steady and secure cash flow for the project, whereby such cash flow will be used in packaging the loan deal with the potential lender. The lender will need to be satisfied that there is sufficient time for the SPV to generate enough cash to service the debt or repay both the loan and the interest accruable. Long term contracts also help the investor determine its rate of return on its investment for accounting purposes and profit, whilst also bringing about stability to the business environment of the power sector. An example of a long term contract will be a PPA of 20-25 years. Long term contracts are usually used to lock in and guarantee the sales of the product or the service of the facility and it can be used for multiple buyers where the output and performance of the facility permits. So a power plant with a capacity of 1000MW can enter into two PPAs with two power purchasers selling anything between 400-500MW of output to both of them respectively.

Long term contracts are quite similar to BOT schemes (except for the fact that in BOT schemes ownership of the facility transfers to the host government at the end of the concession, while in long term contracts ownership of the facility remains with the SPV) and both of them can be used as a model or the basis for implementing a project which will use project financing as a method of its funding. An example of a power project using a long term contract is that of Merida III the first IPP in Mexico, lead sponsored by AES Corporation. It is financed with $173 million led by Jexim ($69 million) and IFC (up to $104 million, including $74 million in B-loans). Merida III will sell electricity to the state owned electric utility CFE under a 25 year PPA.64

63 64

See IFC, supra note 37 at 16. See id.

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2.7. The Hubco Power Project in Pakistan

The project commenced with the creation of the Hub Power Company (Hubco i.e the SPV) for the purpose of owning the power plant. Hubco then employed a consortium of contractors, headed by the Japanese company Mitsui & Co (the contractor) to build the power station, while International Power a British company (the operator) became responsible for managing and operating the plant. Hubco entered into a contract to buy fuel from the Pakistan State Oil Company (PSOC i.e fuel supplier) and to sell the power generated to Water and Power Development Authority (WAPDA i.e the offtaker) another government agency under a PPA.

As a result of the nature of the transaction, Hubcos lawyers and consultants drew up a series of complex contracts to ensure that all the relevant stakeholders were informed of their respective rights and obligations. For instance, the contractors agreed to deliver the plant on time and to ensure that it will operate to specifications. International Power, the plant manager, agreed to maintain and operate it efficiently. Pakistan State Oil Company entered into a long term contract to supply oil to Hubco and WAPDA agreed to buy Hubcos output for the next 30 years. A major source of concern for Hubco was the fact that WAPDA was to make payment of the power generated in rupees (this was motivated by a possibility of the devaluation of the rupee). As a result of this the state Bank of Pakistan arranged to provide Hubco with foreign exchange at guaranteed exchange rates. A guarantee was made by the government of Pakistan that WAPDA, PSOC and the Bank of Pakistan will fulfill their obligations.

The plant was heavily financed by debt with equity accounting for less than 75 percent of the $1.8 billion used in funding the project. A group of banks both local and international (syndicate) came together to provide the needed funds though in different currencies. The banks were encouraged to invest because of the knowledge that the World Bank and several governments were in the frontline and would take a hit if the project were to fail. But the banks still had reservations that the government of Pakistan will create obstacles by preventing Hubco from paying out foreign currency or it might impose a special tax or
36

prevent the company from bringing in the specialists it needed. In order to protect Hubco from these political risks, the government promised to pay compensation if it interfered in such ways with the operation of the project. In the event that the government interfered, Hubco had the option of calling on a $360 million guarantee by the World Bank and the Japan Bank for International Cooperation which was supposed to keep the Pakistan government honest when the plant was built.

As with other power projects, Hubco was fraught with costly, complex and time-consuming activities which stalled its take off. Legal issues such as a Pakistani court ruling which declared that the interest accruable to the loans breached Islamic laws further delayed its launch. Ten years after the start of discussions the final agreement on financing the project was signed and within a short time Hubco was producing a fifth of all Pakistans electricity. This was not the end of the Hubco story. There was a take or pay obligation in the PPA which obligated WAPDA to keep making payments to Hubco whether or not it received any power. This resulted in the near collapse of WAPDA. A new tariff system which introduced a 30 percent cut in power tariffs was ushered in following the fall of the Benazir Bhutto led government. After a painful dispute and renegotiation process, Hubco accepted the new tariff structure and by 2006 it had repaid its senior debts.65
Source: R. Brealey, S. Myers and F. Allen, Principles of Corporate Finance 686-687 (9th ed. 2008).

Having discussed the issues within the power sector of LDCs and the financing of power projects, this paper will now proceed to study the considerations that the lenders will have to make before advancing funds to the project. In other words, this paper will now study the ingredients required to make a power project bankable.

65

See Brealey, Myers and Allen, supra note 42 at 688-689.

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3. BANKABILITY ISSUES (PART 1)

Even though there are several issues to consider before a project can be considered as bankable, this section of the paper will focus primarily on the key issues that lenders will consider before advancing funds to the project.

3.1. Risk Identification, Allocation and Mitigation

As earlier stated, project finance is used for large infrastructural projects that require huge sums of money to execute, has several parties with differing interests and a series of complex contracts involved. With this in mind, it is safe to say that there are bound to be multiple risks of varying nature associated with the project, which will not only need to be identified but properly allocated (to the right parties in the project) and reduced to the barest minimum or better said mitigated. Before proceeding to identify the myriad risks, this paper proffers a definition for risk.

A risk concerns the expected value of one or more results from one or more future events. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost (downside risk) or by failing to attain some benefit (upside risk).66

The next issue to consider is how parties (particularly the lender) to project finance views risk. To such parties risk is any factor which will change the expected or projected project cash flow.67 The lender views the risks associated with a project with close scrutiny to ensure that the risks are allocated to the right people who can bear it and to ensure none is left at its doorsteps. Hence, the countless requests on the borrower who may ask the lender:

66 67

Risk, at http://en.wikipedia.org/wiki/Risk (Last visited, January 25th, 2010). R. Tinsley, Advanced Project Financing: Structuring Risk 67 (1st ed. 2000).

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Dont you people ever take any risk in a transaction?... No we dont take any risk because our leverage requires that we not enter into a loan in which there is any hint that we will not be repaid.68

By itself, risk identification is only a starting point or the first stage. The processes of risk analysis and management are important next steps in structuring a successful project;69 hence, the need to properly allocate the risks. The idea that risk is best borne by the party best able to bear it is a great nonsense as risk is best negotiated as far away from oneself as possible.70 As a result of this, the lender will avoid as much as possible, taking any risk. Before allocation and mitigation of risks can commence, one must first identify the risks associated with the project. Since there are several risks associated with the project, this paper will focus on the key risks that will affect the bankability of the project. These are as follows:

Construction/completion risks; Market risks; Credit risks; Operating risks; Force majeure risk; Political risks; Environmental risks; Legal risks; Supply risks; and Financial risks

See Nevitt and Fabozzi, supra note 35, at 43. See Hoffman, supra note 22, at 27-28. 70 See Tinsley, supra note 54, at 67.
68 69

39

Having identified the key risks which may affect the bankability of a project, this paper will briefly study the components of each risk, who best to allocate such risk to and the most effective way of mitigating against such risk.

Construction/completion risks: This is the probability that the power plant will not be built up to or according to specification and technical requirement. This is usually referred to as the Minimum Functional Specification (MFS). It will also involve the risk that the power plant will not be completed as at when due or in accordance with the EPC. The lenders may require a completion test to prove or guarantee that the power plant will work up to its stated capacity and level of efficiency with regards operation and cost. For instance, the completion test for a gas powered power plant generating 250 MW with a capacity to generate a minimum of 230 MW and able to operate uninterrupted for a minimum of one month may be running such a plant for at least one month uninterrupted generating the minimum stated. If the power plant cannot fulfil this, then it is assumed that the plant has not been completed and as such failed its completion test. The lender will also consider whether there will be any cost overruns at the construction phase on the part of the contractor. The construction risk is usually allocated to the contractor as a result of the EPC and can be mitigated by using the following:

Ensuring that the sponsor gives a completion guarantee and the contractor gives a performance bond.

The SPV should make sure the prices stipulated in the EPC are fixed to avoid cost overruns and also state operating targets.

The SPV should carry out proper insurance. For instance, in the TermoEmcali power project in Colombia the SPV took out a delay-in-completion insurance and set aside an owners contigency of $10 million in its construction budget to cover cost overruns.71

71 72

The SPV should establish its own supply sources and connecting infrastructure.72

H. Davis, Project Finance: Practical Case Studies 54 (2nd ed. 2003). See Chance, supra note 39, at 42.

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Market risks: This refers to risk of a financial loss as a result of adverse market movements.73 This can arise from a competing product or service, market size or customer behaviour. The lender will consider the market environment in which the power plant will be built and whether there is a likely competitor to the plant. It will also consider the price to be fixed for the power generated which will be specified in the PPA. In this case, the market risk will usually be mitigated by allocating such to the SEC. This can be done by including in the PPA, a take or pay obligation for the power generated which will state the price and quantity, as well as including a pass through clause which will help transfer both energy and capital costs to the SEC.

Credit risks: This is the probability of a default by a borrower or an associated party to a loan transaction in accordance with stipulated provisions. The lender will consider the credit standing of all the parties to the project particularly the SEC, to ensure that none of them default or fail to meet their obligations. To mitigate credit risk the lender may require the relevant parties provide insurance, some kind of guarantee or even performance bonds. For example, the lender may require a government guarantee for the SEC in the event that it fails to make its payments.

Operating risk: This is the probability that the power plant may not run at its stated operating capacity. The lenders will consider whether the operator is capable of managing the power plant to guarantee its efficient performance. This will be done by looking at its technical expertise as it relates to the power plant. The lenders will also consider the operating costs and how such can be properly managed. The operating risk will usually be allocated to the operator (which may be the SPV, contractor or an independent third party) using the operation and maintenance contract. This risk can be mitigated by the operator carrying out insurance to ensure that his default will not affect the cash flow of the plant, by the operator forfeiting his remuneration or offering some form of performance guarantee.

Glossary, Effectiveness of the New Zealand Debt Management http://www.oag.govt.nz/2007/nzdmo/glossary.htm (Last visited, January 25th, 2010).
73

Office,

at

41

Force majeure risk: Force majeure (FM) risk is the probability that an event which is beyond the control of the parties and is not reasonably foreseeable by them, occurs which suspends their obligations thereby disrupting the operation of the plant and its projected cash flow. It is usual for the parties to spell out a series of events which they consider as FM events. Acts such as earthquakes and other natural disasters will be considered as FM events. The lender will consider all the possible events and will require adequate insurance to mitigate the effect of such events on the project. This risk is usually allocated to either (or in some case both) the host government and the SEC using the PPA or the concession.

Political risks: This is a risk which is country specific and deals with the probability of a change in the existing political order affecting the project. Political risks include but are not limited to a change in law or regulation, threat to security (for example, the militants operating in the Niger Delta), change in government (whether abruptly through a coup detat or constitutionally), bribery and corruption and most importantly nationalisation or expropriation of the project. The party who usually bears this risk is the sponsor and in some cases the lenders who may not have any choice particularly where the political risk is expropriation without compensation. This risk may be mitigated by taking out political risk insurance, obtaining government guarantees against expropriation and a change in law; where that occurs, payment of adequate compensation to reflect the anticipated cash flow of the project, provision of adequate security in trouble prone areas and obtaining government guarantee for the smooth passage of the necessary consents and approvals for the project. The US sponsors of the Himpurna power project in Indonesia had obtained political risk insurance from US Overseas Private Investment Corporation and a Lloyds syndicate of private insurers which enabled Himpurna successfully claim over $200 million under the policy in December 1999 as a result of a breakdown in contractual relations which spurned from a series of political events ranging from corruption to regime change (of the Surhato government) and an outright suspension of various IPPs Himpurna inclusive.74

74

M. Kantor, Limits of Arbitration, at www.gasandoil/ogel/ Vol 1 Issue 3 (2003).

42

Environmental risk: This is the probability that the power plant will not satisfy the relevant environmental standards and as such may either be sanctioned or not granted the necessary consent to proceed as planned. Where this is the case it will affect the project and its cash flow. This risk may be borne by the sponsors, the contractor (where the plant fails to meet its stated emission standards) and in some cases the lender. This is because the lender may not be immune from litigation involving the violation of environmental law.75 This risk can be mitigated by getting professional advice from environmental experts and lawyers familiar with the host country laws, to ensure that the plant meets emission standards and where possible obtain adequate insurance.

Legal risk: This is the probability that the existing legal order will not support the project by offering it the needed protection from issues such as dispute resolution, intellectual property rights and the general laws against the likes of competition regulation. This risk is particularly important to lenders because most LDCs lack a mature legal order unlike countries like the UK. Where this is the case, the lender may require a thorough assessment of the legal order of the host country from its ministry of justice and other relevant legal agencies. The lender will also require the incorporation of a dispute resolution clause choosing a legal system which it is comfortable and familiar with.

Fuel supply risk: This is the probability that the required fuel for the plant will not be supplied and if supplied may not meet the requirements with regards quantity, quality or price as a result of interruption or unavailability. Fuel supply depends largely on the type of plant in operation and as a result of this the lenders will consider the type of plant to be built, the ability of the fuel supplier to deliver according to specification, availability of the fuel, transportation of the fuel to the plant and ability of the SPV to pass the fuel costs to the SEC. This risk is usually borne by either the SPV, fuel supplier or the SEC and can be mitigated by obtaining a form of supply guarantee from the fuel supplier, getting a standby alternate supplier, where possible having adequate storage facilities for the fuel and if available get substitute fuels.
75

See Nevitt and Fabozzi, supra note 35, at 47.

43

Financial risk: This is the probability that a change in the financial system of the host country will affect the project. This can result from interest rates, inflation, foreign exchange, currency devaluation and a host of others. The lenders will consider all these issues to make sure that none of them affect the projected cash flow of the plant. This risk can be borne by either the sponsor, the SEC, the host government and in some cases the lender (where the total loan package or its repayment is in different currencies) depending on the specific financial risk. This risk can be mitigated by putting in place adequate hedging instruments such as forwards sales or futures, getting government guarantees on the availability of foreign exchange and ensuring payment of the SPV in the stated currency. In the case of the Paiton power project in Indonesia, the PPA provided for payment to be made in rupiah but such payment will be equivalent to the same amount in US dollars at the current exchange rate and where the SPV failed to obtain it, PLN was obligated to acquire the foreign currency on behalf of the SPV. A support letter by Indonesias Ministry of Finance covered all PLNs obligations.76

The above risks are the key ones considered by the lenders before financing a project and as such, they carefully analyse who best can bear certain risks to help minimise its overall effect on the project. This paper will now consider how the PPA affects the bankability of a power project.

3.2. The Power Purchase Agreement

With every transaction, there is usually an underlying agreement which makes up the very essence of the relationship between the parties; the power sector is no exception. The PPA serves as the underlying agreement for the power project. The PPA is the agreement between the SPV and the SEC for the sale and supply of the power generated by the SPV. The PPA serves three main functions. These are:

76

See Kantor, supra note 73.

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To provide a framework for the dispatch of the plant and the supply of power in accordance with the utilitys requirement.77

To act as a medium to lock in sales of the power generated and guarantee a revenue and cash flow for the SPV

To act as the medium in which risks will be allocated.

As a result of the magnitude of the transaction, the PPA handles several key issues which the lenders consider as essential elements needed for the bankability of the project. The issues range from pricing structure to plant availability. These key issues will now be considered.

Pricing structure and payment: This is an important part of the PPA, as it will be necessary for the parties to be able to state with certainty, the price to be charged for the power generated and how such price can be adjusted as a result of economic changes. This will also include how to determine the capacity (this covers all the fixed and capital costs of the plant like debt servicing and tax payment) and energy (this covers variable costs such as fuel, maintenance and minor operating costs) charge. This will also provide for any take or pay or pass through obligations on the part of the SEC. The lender will also consider how payment will be made to the SPV. That is, the currency in which the payment will be made and the method of payment. In most cases, the lender would push for payment to be made in a stated currency and will want payment made to an escrow account with a trustee to administer it. The payment made into the escrow account will be used to service both the debt and interest. For example, in the renegotiated deal of the Dahbol power project, a levelised tariff of Rs1.86 per unit for 20 years to cover both phases of the project was reached with the tariff payment to be made in US dollars. This is as a result of the attendant risk of rupee devaluation and hence increased costs.78

77 78

Baker & McKenzie, Project Finance: The Guide to Financing Power Projects 28 (1996). See Bath, supra note 47 at 399.

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Plant availability: In order to raise project finance, the amounts payable under the PPA must be predictable. It will not therefore be acceptable (especially to the lender) if the SPV is only paid for what it actually generates.79 In other words, if the plant is capable of operating it should be paid. This allows the plant to continually generate revenue as long as it is available even if it does not actually generate power. The question then is; is the plant capable of operating? If the answer is yes then the plant will be paid for that availability.

Relevant connections: The lenders will need to be satisfied that the PPA will make provisions for the plant to be connected to the grid and other necessary networks as agreed to by the parties. For example, if the plant is a gas fired one it will need the necessary connection to the gas pipeline network.

Technical specification: As earlier mentioned, the plant should be built to specification. This is important to both the SEC and the lender. This is to ensure that the plant generates the right quality of power and also satisfy the stipulated emission standards. Both parties will also ensure that the plant is properly operated and maintained so as to promote the efficient use and long life of the plant.

Force majeure: This is another issue the PPA will make provisions for. The effect of the FM event will depend on which party it affects and the magnitude of the event. If the FM event affects activities on the side of the SEC, payments will still be made to the SPV because the plant will be deemed to be available. Where the FM event affects the plant, then it will suspend the plants obligation to generate. Where this is the case, the plant will not be available and as such payment may be suspended. But the lenders will require an extension of the concession period as a result of the FM event

Insurance: The lender will require the PPA to make provisions for insurance against any damage that may occur during the lifetime of the plant. The insurance may cover certain

79

See Vinter, supra note 42, at 75.

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FM events so as to be able to re-instate the plant to its former state. For example, fire insurance can be taken out to cover any incidence of fire.

Term, termination and compensation: The lender will require that there are stringent rules and conditions in place to prevent any of the parties from terminating the contract arbitrarily. Where such termination occurs, adequate compensation which takes into account the projected revenue of the plant should be made. This will enable the SPV service its debt and interests. The lender will also want the PPA to provide for a certain term in which the plant will be in operation. This will enable the lender make its necessary analysis as to the length of time required for the SPV to repay the loan and interest.

Lenders rights: The lender will require the PPA to make provisions for it to have step-in rights in the event that the SPV can no longer perform its obligations. In some cases, the lenders may go as far as asking for the PPA to be assignable in order to allow for the continued operation of the plant.

Restructuring: The lenders will try to prevent any further restructuring of both the SEC and the industry and where such takes place; it will ensure that it does not affect the operations of the plant. In doing this, the lender will require some form of guarantee or comfort letter from the host government saying no restructuring that will affect the plant will be implemented.

Dispute settlement: The lender will ensure that the PPA makes provisions for adequate dispute settlement mechanisms. Where arbitration is the preferred choice, the lender will make sure that the rules, venue, arbitral institution and a host of other matters will be agreed upon.

The PPA will be carefully considered by the lender who will employ the services of both legal and energy experts to make sure that its interest is well protected, as this will greatly influence the bankability of the project. Since the PPA forms the back bone of the revenue
47

of the plant and the SEC plays a key role in guaranteeing such revenue; this paper will proceed to study the credit-worthiness of the SEC as well as the government guarantees and support mechanisms available.

3.3. Purchasers Credit-worthiness and Government Support and Guarantees

As has been established, most LDCs use the single buyer model to attract foreign investment and build new generating capacity. With this in mind, there will be only one purchaser for the generated capacity and that purchaser is the SEC. Since this is the case, the ability of the purchaser to pay for the power is very crucial to financing the project. In other words, the credit-worthiness of the SEC is important. It is the payments of the SEC for the power generated that will be the revenue of the SPV which will be needed to service the debt and interest. That is, the SEC must have sufficient cash to pay its bills, as proven by past, present and expected future financial performance. To the extent that this is not present, credit enhancement such as a guarantee by a credit worthy central government or multilateral support, is needed.80 For example, the government of Maharashtra approved a state guarantee and the central government of India gave a counter guarantee to Dahbol Power Company (DPC) for payments to be made by the Maharashtra SEB.81

The lender will assess the credit-worthiness of the SEC, to ensure that the SEC can indeed make good on its promise to make not only the regular and stated payments as required by the PPA but also the method and the currency stated. The lender will need to carry out its own analysis. This will usually be done by employing consultants that will consider the SECs track record, industry rating, professional experience and consumer views. Where in the opinion of the lender, the SEC is found not to be credit worthy, it will push for a government guarantee that in the event of a failure by the SEC to live up to expectation and fulfil its obligations, the host government like a knight in shining armour will come to the rescue of the SEC. In most cases, the host government will try as much as possible to avoid
80 81

See Hoffman, supra note 22, at 63. D. Bath, India Power Projects: Regulation, Policy and Finance 394 (Vol 1. 1998).

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fully guaranteeing the financial commitment of the SEC but may agree to a partial guarantee or provide a comfort letter which will serve as evidence of such. An example of such can be found in the letter of support (comfort letter) from the government of Indonesia in the P.T Jawa project. It represents a strong commitment by the government that the Perusahann Listrik Negara (PLN) will honour its financial and contractual obligations.82

The lender will also push for some form of support from the host government to facilitate the success of the project. Support such as directing the central bank to make the necessary provisions for the availability of foreign currency and the easy repatriation of the funds generated by the plant for the purpose of servicing the debt, interest and profits. The lender will also push for the host government to guarantee a speedy passage of all the necessary permits, consent and approvals which will help facilitate the commencement of the project; also the co-operation of all the government agencies (whether at the state or local level) that the SPV will have to liaise with. Where the government or any of its agencies is the fuel supplier, the lender may also push for a guarantee that there will be constant availability and uninterrupted supply of fuel for the plant.

Since there is a potential risk of nationalisation or expropriation of the SPV by the host government, the lender will require that the host government give a guarantee that it will not nationalise the SPV and in the event that it does, adequate compensation which will take into account the projected revenue of the SPV will be made. The lender will also push for adequate security in the form of police or military protection for the SPV, its personnel and equipment, particularly if the SPV is situated in a trouble prone part of the country. This is to avoid any disruption to the operation of the plant. The lender may also require a guarantee from the host government that the SPV will not be a target for discriminatory policies or laws or changes in law that will have a negative impact on the SPV. For example,

82

See Babbar and Schuster, supra note 9.

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Peru provides non-discrimination protection to investors in the form of a stability agreement.83

Another crucial government support which the lender will push for is that of tax considerations for the SPV. This can take the form of accelerated or increased investment allowances, tax holidays, complete tax exemption, zone allowances or reduced tax rates. The lender may even be bold enough to secure a waiver from withholding taxes on payments of dividends, interest and royalties.84 The lender will also push for a waiver of import duties on equipment that will be needed for the plant.

This paper will now proceed to the second segment of requirements for the bankability of a project.

83 84

See id., 149. See Baker & McKenzie, supra note 61, at 73.

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4. BANKABILITY ISSUES (Part 2) 4.1. Project Documentation

The documents to be used in the project finance are a vital part of the entire structure and bankability of the project. The lenders will seek to satisfy themselves that each contract has the necessary requirements that will protect their interest as far as possible and will ensure that the relevant parties fulfil their obligations under such contracts to the letter. This part of the paper will study the relevant documentation and their contents and what these should entail from the standpoint of the lender, in order to make the project bankable.

4.1.2. The Concession Agreement

Since the concession agreement is the enabling licence for the projects commencement, the lender will seek to ensure that the concession reflects and protects its interest. The lender will require that the concession has a certain term which will be fixed and last for the duration of the plant. Such term should be long enough to allow the plant to raise sufficient revenue to service the debt and interest. Nationalisation of the SPV is another issue in which the lender will seek to address in the concession agreement. The lender will also ensure that there are stringent conditions attached to the termination of the concession by any of the parties or the nationalisation of the SPV. Where termination or nationalisation occurs, adequate compensation which will reflect the projected revenue of the plant sufficient to cover the repayment of the debt should be made.

In the event that an FM incident occurs affecting the operation of the plant, the lender will seek for a provision in the concession agreement, which allows for the extension of the concession period to cover the time in which the operations of the plant is disrupted. The lender will require the concession agreement be assignable in the event of a default on the part of the SPV, as this will serve as a form of security measure to ensure the continued operation of the plant for the purpose of repaying the debt. Stringent or discriminatory provisions against the SPV will be resisted by the lender, such as penalties or sanctions for
51

non-completion of the plant at the stated time by the SPV. The lender will also require that the concession agreement addresses the issue of a change in law or regulation as it relates to the concession and the effect it may have on the SPV. The lender would prefer and advocate for such risk to be borne by the host government.

4.1.3. Consents and Approvals

Since building power plants is considered a huge infrastructural project not standing alone, there is a requirement for different consents and approvals from different government agencies. This will help it connect to other relevant services, so as to enable its smooth operation. With this in mind, the lender will require that all the necessary consents and approvals are given not only promptly, but to also cover all areas of the plants operation. The lender will want all the necessary permits and approvals given to the plant to cover the entire term of the concession and such permits should not be withdrawn abruptly or discriminatorily as a form of sanction or penalty against the SPV. The co-operation of all the related government agencies will also be required by the lender, as this will ensure a harmonious flow of all interconnected activities of the plant ranging from the importation of the important equipments to repatriation of revenue.

The lender will want the consents and approvals be easily assignable and such consents should be attached to the plant as opposed to the SPV, in the event of a default on the part of the SPV or where the lender sells the plant or exercises its step in rights to take over its operations and management for the purpose of repaying the debt. In other words, the lender will not want a situation where a permit(s) will be withdrawn in the event of it exercising its security or step in rights or where the SPV defaults in its obligations under the concession. The lender will require a high level of certainty for the permits and such permits should not be adjusted, altered or amended at the whims and caprices of the regulator, agency(ies) or host government. With this in mind, the lender in order to reassure itself, may ask the host government for a guarantee or comfort letter requiring the host government to allow the speedy approval and other associated matters of all required
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permits.85 The Laibin B power project in China received strong support from the central government as the relevant consents and approvals for the project was made by Chinas relevant authorities such as the State Council, State Planning Commission, Ministry of Power, State Administration of Exchange Control, the Tax Bureau, the Guangxi provincial government and a host of other agencies all issuing separate letters of support for the project.86

4.1.4. Sponsor Contribution and Shareholders Agreement

One of the sources of financing a power project is through equity, which is the sponsor contribution. The sponsor needs to make its own contribution to the financing of the project. As part of the consideration the lender makes before financing a power plant project, it will require the sponsor make all or most of its equity contribution in advance and where the sponsor cannot cough up the full equity contribution, there should be a mechanism in which the lender can employ to make a call on such contribution in the event of a default by the sponsor. This may be based upon the happening of a specific event, which will trigger making the call by the lender. Such event will be agreed upon by the parties.

The lender will require the sponsor to make available, sufficient funds to cater for any possible cost overruns in the development of the plant. Since cost overruns are likely to occur in the development stage, the lender will want the funds made available which will be separate from the equity contribution so as not to affect the development of the plant. Another issue the lenders will require from the sponsor is making extra funds available for any gaps in insurance coverage for the project.87 In other words, the lender may devise a strategy to make the sponsor act as an insurer of some sorts. The lender will also require

DentonWildeSpate, A Guide to Project Finance, at https://my.dundee.ac.uk/webapps/portal/frameset.jsp?tab_tab_group_id=_2_1&url=/webapps/blackboard/ execute/launcher%3Ftype%3DCourse%26id%3D_20211_1%26url%3D (Last visited, February 28th , 2010).
85 86 87

H. Davis, Project Finance: Practical Case Studies 34 (2nd ed. 2003). See Vinter, supra note 42, at 95.

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that the sponsor receive its profit only after the payment of the debt and interest using an agreed formula.

4.1.5. Construction Agreement

The construction contract is an important aspect in the bankability of a power plant project. This is because the lender will require that the building of the plant meets the right criteria as to the operating, technical and emissions specifications. This is to ensure that the SPV is not penalised for any breach as to its obligations under the concession agreement and the PPA. The lender will also require that the construction of the plant is done under an EPC and the contractor will be responsible for the actions of all the sub-contractors to the plant (for instance, using quality materials). That is, if there is a breach by any of the subcontractors, the contractor will be held liable. The lender will need assurances that the plant will be completed at the stated date and where such is not achieved; the contractor should be liable to pay damages sufficient to cater for the repayment of the loan and the interest for the period in which the plant was not completed for. The lender will require an extensive coverage in the form of a performance bond from the contractor in the event of a default on his part, as well as adequate guarantees against any defect on the plant. Such guarantees should cover a long period such as 5 years and should commence only when the plant fulfils the completion test. In the TermoEmcali power project in Colombia, Betchel Power Corporation guaranteed the performance obligations and liabilities of two its affiliates for construction contracts totalling $124.1 million.88 The lender will also require a completion guarantee or sponsor support from the sponsor of the project.89

The lender will want to ascertain the costs of building the plant and resist the incidence of cost overruns as much as possible. In other words, the price once negotiated should be fixed and not have to be re-negotiated and payment of such should be done in whole upon completion or on an agreed method of payment (for instance, at different construction stages). The lender will also want that any FM events which may affect the construction of
88 89

See Davis, supra note 85 at 51. See DentonWildeSpate, supra note 80.

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the plant be limited so as not to affect the projected time frame for the completion of the plant.

4.1.6. Operation and Maintenance Agreement

This deals with the operation of the plant and determines who will be the operator. The lender will need to be satisfied that the operator has the technical expertise to run and maintain the plant. The lender may require adequate evidence of such. The lender will want a system of incentives and sanctions put in place to reward the operator for effective and efficient management of the plant, as well as sanction the operator for poor management of the plant especially if the plant does not achieve the set goals as enshrined in the agreement. For instance, in the TermoEmcali power project of Colombia, the operation and maintenance agreement provided for incentives for Stewart & Stevenson (the operator) to operate the plant as efficiently and cost-effectively as possible.90

The lender may also require the operator give certain guarantees that the plant will be run efficiently and such efficiency could be based on certain standards or criteria as established by the lenders based on the recommendation of an independent consultant.91 The lender will want to have the power to remove or effect the removal of the operator in the event of bad management of the plant and where this occurs to have the power or be consulted before the appointment of a new operator.

4.1.7. Fuel Supply Agreement

This is important to the running of the plant; as it will determine the specifications for the fuel with regards to quantity, quality and cost. The lender will require the supplier have the ability to supply the right fuel at a reasonable cost to the plant. This will entail the mode of delivery, quantity, quality and cost of the fuel. The lender will also want regular deliveries to be made with little or no interruption to supply. The lender may also require the supplier to guarantee the supply of the fuel and if possible be liable for a failure to deliver,
90 91

See Davis, supra note 85 at 53. See DentonWildeSpate, supra note 80.

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where such delivery was the fault of the supplier. Where there is a take or pay obligation on the SPV in the fuel supply agreement, the lender will want such obligation be relaxed so as not to sanction the SPV for a failure to take in the event of a constraint out of its control.

4.2. Lenders Security Concern and the Role of Security

Security is an important issue in any type of financing and project finance is no exception. The common view of security is that the lender takes security over an asset in order to sell it if their loan is in default and to apply the proceeds against the amounts outstanding under the loan.92 This is the typical method in which security in a loan is used and for this to occur the security must be something of value and in most cases, more valuable than the sum borrowed. It is also worth mentioning that the security in question is one which should be fairly easy to dispose off or sell, so as not to prolong the non-payment of the loan. In relating this to project finance, the assets of the power plant even though are valuable, are not usually more valuable than the funds advanced to it. There is also the issue of the relative ease in which a power plant in an LDC can be disposed off. Hence, the need for the lender to have step in rights in order to take over the running of the plant or have the plant assigned or transferred to an independent third party who will be able to run the power plant efficiently and profitably in order to repay the loan.

Notwithstanding, the lender will still feel a bit secured if the assets of the plant are used as collateral for the loan. This will make the lender rank ahead of an unsecured creditor in the event of the bankruptcy of the plant. But all this will depend on the bankruptcy or insolvency laws of the host country. This is because while some countries allow foreign companies to take over the assets of domestic companies, others are not so accommodating and frown at or out-rightly reject the idea. The lender will need to seek legal advice in relation to the security issues before proceeding with financing the plant.

92

See Vinter, supra note 42, at 149.

56

The lender must also consider the relative costs involved with the realisation of the security, such as appointing a receiver/manager, legal costs, valuation of the assets, any possible tax issues and other attendant matters. The lender will require that all the associated contracts, consents and approvals are all in place in a permanent or physical form in the event of a realisation of the security. This is to ensure a smooth and hitch free process.93

The lender will also make use of direct agreements between all the parties ranging from the host government to the fuel supplier of the project, allowing the lender to step in and run the plant or appoint a third party to do so. This will involve all the relevant parties having individual agreements with the lender stating that they will allow such and continue with the relationship as if it were still the SPV. This will allow the lender have the rights and obligations the SPV had with regards the different contracts and continue as such. Where the SPV has incurred a huge liability, the lender may seek to have a provision in the agreement to reduce it by negotiation. The lender can use the direct agreements as a double edged sword. That is, it can serve both protective and offensive purposes for the lender. As a protective form, it prevents the termination of associated agreements by the parties and as an offensive form the lender takes over the rights and benefits accruable to the SPV under those contracts.94

The lender may also require collateral warranties from the parties to the project. Such warranties will relate to issues such as implementation of services to the SPV up to specification, acknowledgement of a duty of care, using appropriate raw materials, passing relevant data to the lender for record and security purposes and a host of others. Collateral warranties allow the lender to be notified on the progress of the services rendered by third parties to the plant. The lender will also want some form of sponsor support in relation to the debt, particularly where the plant can only generate sufficient funds for the repayment
93

See Vinter, supra note 42, at 103. See Vinter, supra note 42, at 149.

94

57

of only the loan and not the interest. Where this is the case, the lender will require an undertaking or a form of guarantee from the sponsor requiring them to make additional payments to the lender in order to service the payment of the interest. In the event of the lender realising the security, it will require the sponsor give an undertaking for the payment of the balance of money (if any) not covered by the security.95

95

See DentonWildeSpate, supra note 80.

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CONCLUSION
LDCs have been plagued by a series of bad management which has wrecked havoc on their power sectors and caused a huge financial burden on the government. The incessant power shortages and failures have led to excessive spending on cash strapped governments. As a result of this, LDCs have realised the need for foreign investment to help in financing their ailing sectors. But for this to be done, an enabling environment which is investor friendly is needed. Also, a critical analysis of the myriad issues that confront power projects particularly in LDCs is required.

This paper has been able to study the issues surrounding the financing of a power project in a LDC and the ingredients required to make it bankable. The paper looked at the prevailing circumstances LDCs have found themselves in, studied the possible methods of financing power projects with a bias for project finance and finally examining the issues lenders consider before financing a power project. With this in mind, this paper acknowledges that each power project to be embarked upon is country specific having used Hubco as an example. Such issues should be studied on a country by country basis but the issues studied in the earlier chapters are peculiar to all LDCs. Therefore, when financing power projects particularly in LDCs, such issues should be followed religiously to ensure that the entire project package is worthwhile for all the parties involved, particularly the lender; since its the lender who will determine whether a project is worth financing. That is, whether the project is bankable.

This paper concludes with the assurance that the above studied requirements will not only ensure the bankability of a project but will also guarantee a substantial return on investments made by all the stakeholders particularly the lender. This can be likened to obtaining the needed ingredients to ensure that a pot of soup is not only well cooked but refreshingly tasty.

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