Dfccfinalr Report 1 1

Renewable Energy for Rural Economic Development Project
Evaluation of Capital Market Constraints to Financing Renewable Power Projects in Sri Lanka
Final Report
Mangala Boyagoda
31 Frances Road Wellawatte, Colombo 6, Sri Lanka Tel: 4517302; 0722 452452 E-mail: mboyagoda@yahoo.com
Colombo, 15th May 2007
Prepared for the DFCC Bank on behalf of the Ministry of Finance, Government of Sri Lanka in terms of Contract dated 27th November 2006
Table of Contents
Page No Executive Summary 1.0 2.0 3.0 4.0 5.0 6.0 Introduction Objectives and Scope of Consultancy . Methodology.. Data Sources . Limitations.. The Renewable Power Sector and Projects 6.1 Overview of the ESD and RERED Projects 6.2 Project performance in Facilitating Finance 6.3 Status of the Electricity Sector. 6.4 Funding Needs.. The Domestic Financial Sector 7.1 The Banking System 7.1.1 Evolution of the Banking Industry.. 7.1.2 Present Status . 7.1.3 Constraints in Project Lending. 7.1.4 Viewpoint of PCIs . 7.1.5 Absorptive Capacity of PCIs 7.1.6 State Banks as PCIs. 7.2 Capital Markets. 7.2.1 Evolution . 7.2.2 Present Status .. 7.2.3 Constraints in Debt Markets... 03 04 06 07 07 07 08 08 10 11 12 13 13 13 14 17 22 24 25 26 26 27 30 32 33 33 34 35 35 36 36 38 38 39 39
7.0
8.0 9.0
Addressing Capital Market Constraints. The Proposed Renewable Energy Bond 9.1 Salient Features of RESB 9.2 Observations on RESB Recommendations.. 10.1 Establishment of REDA. 10.1.1 Objectives. 10.2 Alternate Issuance Process [1]. 10.2.1 The Participants. 10.2.2 Advantages 10.2.3 Role of SPV 10.2.4 Role of PCIs..
10.0
Evaluation of Capital Market Constraints to Financing Renewable Power Projects in Sri Lanka .
10.3
Alternate Issuance Process [2] 10.3.1 The Process.. 10.3.2 Advantages.. Timing of the Bond Issue
39 40 41 41
10.4 10.5
Value Addition to Attract Investors. 42 10.5.1 Eligibility for SRR Classification 42 10.5.2 Eligibility for Liquid Assets 42 Proposed Benchmark.. Tax Exemptions Support Required. 10.8.1 GOSL. 10.8.2 Central Bank. Interim Support... 42 43 43 43 43 43
10.6 10.7 10.8
10.9. 11.0
Annexures .. Annexure 1.1 - Cash flows of On-grid Projects Annexure 1.2 - Cash flows of solar home projects.. Acknowledgements
44 45 46
12.0
Executive Summary
The power sector in Sri Lanka has made notable progress over the past several decades, predominantly attributed to hydro electric power generation. In spite of this fact, power sector strategies are yet to ensure that supply keep pace with the growing demand. Among the several initiatives to foster energy efficiency and promote renewable power development, is the World Bank initiative that ensured stable funding to facilitate sector growth. The DFCC Bank, on behalf of the Government of Sri Lanka has now commissioned this study to identify medium term funding needs of the renewable power sector as well as the constraints to financing sector projects and to recommend appropriate financing mechanisms, to continue fostering the sector in the absence of external support funds. The salient issues that surfaced during the study include the several constraints experienced by the domestic banking sector that deter long term fixed interest rate project lending; such constraints include the dearth of long term financial resources, volatile financial market conditions, significant asset and liability mismatches, high intermediation costs and statutory impositions that affect the industrys cost of funds. The study also considered the viewpoint of selected Participating Credit Institutions, to ascertain both project related financing concerns and the possibility of extending power project funding out of own resources. In addition to the constraints common to the banking industry set out above, these institutions operated within single borrower and sector exposure limits that could restrict the development of the power sector. Recent measures to enhance minimum capital requirements of the banks would however serve to ease this pressure given that most participating credit institutions belong to the banking sector. The financial sectors high cost of funds is also a deterrent in suitably funding the renewable power sector. Primary attractions of the World Bank initiated credit schemes from the perspective of these instituitions, were the low rate of interest and the ability to make use of the float of funds. The answer to the dilemma is likely to manifest in several ways. Firstly, harnessing strengthens of the state banks that have the greatest resources in the banking sector, in the disbursement of any proposed credit line. Secondly, a dis-intermediation process through capital market instruments, although the capital market itself is not without its own limitations. The crowding out effect associated with the fact that the government is the largest borrower in the debt market, the anomaly in the risk reward structure and the pricing of long term debt for example are factors that warrant attention if the renewable power sector is to be suitably positioned in the corporate debt market. The proposal made by the Government of Sri Lanka to raise Rs 2,000 million by way of a Renewable Energy Support Bond, by tapping the debt market is a further viable option. The other alternative is to gain access to the capital market via a Special Purpose Vehicle fully backed by the government to mobilise long term financing assistance with private sector participation, through local capital markets. Given the long term payback period of small scale power projects and the limitations encountered by the banking industry and in equity markets, the proposed bond issuance, and the establishment of the Special Purpose Vehicle could be the ideal facilitator in accessing long term finance of a sustainable nature to help foster the power industry.
1.0
Introduction
Comprised of a total terrain of 65,610 square kilometers, Sri Lanka is home to a rapidly growing population that expanded from 16 million in 1990 to 19 million in 2005. Population density expressed in square meters, increased from 259 to 314 in that period. Approximately 76% of the population lives in the rural areas where the main occupation is agriculture. In contrast, energy sector strategies have failed to keep pace with the emergent population and increased industrialization, triggering a persistent crisis in the sphere of electricity generation, transmission and distribution. Sri Lankas energy sources consist primarily of biomass, hydro-electricity and petroleum that contribute to 47%, 8% and 45% of total energy respectively. In the power sector, the installed capacity for electricity generation from hydro, thermal and wind power presently stands at 2,407 MW, compared to 1,409 MW in 1999, which is nonetheless insufficient to meet the present demand from households as well as commercial and industrial sectors. Less than 75% of households as yet have access to electricity, while the demand for electrical power on the other hand is estimated to rise at an annual pace of 8% - 10%. Per capita consumption of electricity meanwhile reflected 348 kWh/ person in 2005. A combination of factors has contributed to the emphasis in recent times for generating electricity through less conventional renewable sources. Electrification of rural areas, for instance poses many challenges, foremost amongst which are the high capital investment, operational costs and the difficulties associated with extending grid connected electricity lines to remote areas. In this context renewable sources of energy including solar power, small scale hydro power, wind power, biomass and dendro power, have emerged as an economical and sustainable alternative source to promote medium term electricity generation to the rural populace, albeit in small measure. In terms of the National Energy Policy and Strategies for Sri Lanka, which was introduced in 2006, as much as 80% of the total household electricity requirement is estimated to be generated through the extension of the national grid while off grid sources are being promoted to meet 10% of the requirement by the year 2015. Together with economic benefits, renewable resources provide the advantage of achieving such ecological efficiencies as minimizing pollution and mitigating adverse climatic factors through the provision of clean environment friendly energy. The potential from renewable energy technologies in Sri Lanka have been estimated as set out in Figure 1.1 Figure 1.1 Energy Source Solar Energy Wind Energy Mini Hydro Energy Biomass Energy
Source: DFCC Bank
Estimated Potential by year 2015 11 MW 50 MW 300MW 90 MW
In the light of the above facts, it is of the essence that Sri Lanka optimizes the considerable potential for energy generation from commercially viable off-grid renewable sources so as to reduce dependence on imported petroleum and minimize the resultant trade imbalances, in alleviating the prolonged energy problem. The endeavour to implement renewable energy technologies have thus far been facilitated through dedicated credit support extended by external lending agencies. The World Bank and the Global Environment Facility [GEF] assisted Energy Services Delivery [ESD] Project introduced in 1997, at a time when more than half of the population did not have access to electricity, provided an initial invaluable boost to the sector. Following the success of this project the Renewable Energy for Rural Economic Development [RERED] Project was launched in 2002 to provide electricity access to rural households and small and medium enterprises through the deployment of offgrid renewable energy technologies as well as to promote private sector power generation from renewable energy sources. The credit support made available under both projects played a pivotal role in nurturing the sector. The challenges faced by Sri Lankas energy sector are evidenced in the composition of the total energy supply. The share of petroleum in the total energy supply has expanded significantly in recent times, from 32% in 1996 to almost 45% in 2005. The trend reflects the growing dependence on petroleum, in spite of power sector support strategies. It also highlights the difficulties presently encountered in power generation and the resultant slow growth of the sector. In the quest to minimize petroleum dependence and accelerate the growth momentum of the sector it is indisputable that renewable energy technologies needs to be scaled up beyond the existing stage to one that facilitates the generation of greater commercial capacity. For this to happen the sector needs continued and steadfast access to adequate funding at reasonable cost. Both the ESD Project and the RERED Project were concerned with addressing the issue of providing long term financing support for renewable energy investments. Such measures have served the purpose excellently, with capacity installed often surpassing targets. However, given the magnitude of the task still ahead, the need to formulate a viable long term financing mechanism to augment electricity generation, transmission and distribution throughout the country, remains a critical need.
2.0
Objectives and Scope of Consultancy
The International Development Association [IDA], of the World Bank together with the Global Environment Facility [GEF] has extended a line of credit and a grant for technical assistance respectively, to the Government of Sri Lanka [GOSL] to set up the RERED project. The objectives of the RERED project include expanding commercial use of energy generated from renewable sources and fostering rural economic development and thereby improve quality of rural life by providing access to electricity. Under the project, the Ministry of Finance through a dedicated unit set up within the DFCC Bank has on lent proceeds of the credit line to eligible Participating Credit Institutions [PCIs] by refinancing up to 80% of qualifying loans extended by PCIs to eligible sub borrowers. With the RERED Project credit line now almost fully committed, the need to seek additional sources of long term funds to foster the continued growth of the sector has been identified. GOSL, with a view to addressing the issue, has requested the World Bank for supplementary financing for the RERED Project through IDA credit in a sum of US$ 40 million. Meanwhile, DFCC Bank, on behalf of GOSL seeks to ascertain avenues to achieve the objective of raising long term financial resources on a sustainable basis to facilitate sector growth, through domestic capital market sources. The primary objective of the Consultancy assignment is to identify obstacles to raising long term debt capital within the domestic capital markets to finance renewable power projects. Supplementary objectives include evaluating options to facilitate mobilizing long term capital, current exposure and absorptive capacity of present PCIs, assess the appetite of the two state banks in financing the sector and assess the sector growth and related funding requirements. The scope of the present Consultancy is to, inter alia, review the development and the current status of the domestic banking sector and capital markets, evaluate performance of the ESD and RERED Projects as regards the provision of long term financing to the renewable energy sector, assess the medium term funding requirements of the sector and thereafter identify the constraints, risks and options associated with long term financing of the renewable energy sector by means of both the banking sector and capital market. The final scope of the assignment is to comment on DFCC Banks alternate financing proposal and to recommend a suitable strategy for implementation of a viable long term financing mechanism to sustain the growth of the renewable energy sector, particularly considering an absence of continued World Bank assistance.
3.0
Methodology
The methodology adopted is primarily focused on the areas set out below. 3.1 An assessment of the two renewable energy projects implemented from 1997, in relation to its financing mechanism; An assessment of the sector growth and funding needs based on information received; The evolution of financial systems, both banking and capital markets, constraints and issues of the various members in the system including the Participating Credit Institutions and state banks; Gap assessment between sector needs and financial system capabilities Financing options to sustain sector growth An assessment of the alternative proposal submitted by DFCC Bank Recommendations
3.2 3.3
3.4 3.5 3.6 3.7
4.0
Data Sources
Information in this report has been compiled from publicly available documents; print and electronic sources; in particular data published by the Central Bank of Sri Lanka, research material and other project data provided by the Administrative Unit of the DFCC Bank as well as from interviews with selected PCI and other relevant stakeholders.
5.0
Limitations
The contents of this report are subject to the following limitations; 5.1 The Consultant has in essence relied on the information supplied with regard to technical and specialized aspects of the ESD and RERED projects and has not performed an independent review of these areas. Information has been compiled from the most recent available data. Statistics pertaining to few segments of the capital market is not readily available from public sources and have not been captured in the report.
5.2 5.3
6.0
The Renewable Power Sector and Sector Projects
The renewable power sector captured in the study comprises primarily of small scale hydro, solar, wind and biomass sub-sectors. The two sector projects referred hereinafter are the ESD and RERED Projects.
6.1
Overview of the ESD and RERED Projects
The ESD and RERED projects, implemented with the assistance of the World Bank, facilitated the generation of both on-grid and off-grid renewable resource based electrification projects, as a means of addressing the severe constraints in power grid expansion. Six Participating Credit Institutions [PCIs] namely DFCC Bank, National Development Bank [NDB], Sampath Bank, Hatton National Bank [HNB], Commercial Bank and Sarvodaya Economic Enterprises Development Services [SEEDS] were appointed to assist in implementing the ESD project. Following the successful implementation of the project, several other financial institutions, including commercial banks, leasing companies and micro finance institutions displayed a keen interest in participating in the implementation of the follow-on RERED project. In addition to the 06 PCIs involved in the successful ESD project 04 new PCIs were selected under the RERED project, namely Seylan Bank, Ceylinco Leasing Corporation, Lanka Orix Leasing Company and Sanasa Development Bank. More recently, Alliance Finance Co had been admitted as a PCI in the program. Proceeds of both credit lines were disbursed to PCIs at the Average Weighted Deposit Rate [AWDR]. PCIs assume the credit risk in extending sub loans to final borrowers operating in different sub sectors and obtain refinance up to 80% of qualifying sub loans. PCIs also have the flexibility of determining both tenor, subject to a maximum of 10 years, and the rate of interest to eligible sub-borrowers. A total of US$ 30.1 million was committed to Sri Lanka under the ESD project, while US$ 83 million has been pledged in terms of the RERED project. The ESD project facilitated cumulative capacity installation of 350 kW by means of off-grid village hydro schemes, whist an aggregate capacity of 31 MW was generated by way of mini hydro schemes. Besides these, 20,953 solar home systems generating a capacity of 984.6 kW were moreover installed under the project. A pilot wind farm supplying an annual capacity of 4.5 Gwh implemented under the ESD project, had furthermore been successfully linked to the national grid.
Figure 6.1 Projects implemented under ESD credit arrangements

Mini hydro capacity 40 30 MW 20 10 0 Target Installed capacity
Source: Energy Sector Unit World Bank
Solar home systems 25,000 20,000 15,000 No 10,000 5,000 0 Target Installed Nos
Village hydro schemes 400 300 kw 200 100 0 Target Installed Capacity
The on-going RERED project status data as at 30th September 2006 reveal that thus far additional capacities of 109 MW and 1 MW are being generated by way of grid connected hydro and biomass schemes, while 927 kW and 35 kW are being installed through off grid community village hydro and biomass investments respectively. Moreover, non PCIs have added 328 kW in hydro power through community investments. A total of 73,604 solar systems have been installed as at the above mentioned date of review. Figure 6.2
Status of RERED Funds of US$ 75 mn
11% 17% Disbursed Committed Unutilized 72%
Source: DFCC Bank Evaluation of Capital Market Constraints to Financing Renewable Power Projects in Sri Lanka .
The two renewable energy development projects have enabled the electrification of almost 100,000 rural households. The project initiatives have furthermore provided a firm foundation for entrepreneur and technical capabilities as well as financing capabilities. 6.2 Project Performance in Facilitating Finance
Achievement of project disbursement targets The long term financing arrangements extended under both ESD and RERED credit programs, has been identified as a key attribute that enabled PCIs to meet project funding targets. The credit facility provided the end user access to liquidity for both capital investment and working capital on affordable terms. While some project developers required long term financing to meet high infrastructure costs coupled with relatively long term cash flow generation, other developers, such as solar system developers needed access to affordable finance. Some developers sought readily accessible working capital. The financing structure of the two projects successfully addressed the needs of the various end users. The availability of long term financing to PCIs was a pre-requisite to match the long pay back periods, in particular of village and mini hydro projects. Payback period and financing costs The ESD and RERED credit programs had been structured to effectively support the sector in terms of pay back as well as the rate of interest. Loans to sub borrowers incorporated maturity periods up to 10 years, while the rate of interest under RERED was pegged to the least volatile and least costly benchmark in the country, the AWDR. PCIs that receive refinance at AWDR extended sub loans at variable margins over AWDR, re-priced semi annually. The terms associated with grid connected mini hydro projects were typically AWDR plus 4% to 5% for maturities of 6 to 8 years, while the terms for off-grid projects were AWDR plus 4% to 6% for similar maturities. Solar home systems were however typically linked to AWDR plus a minimum margin of 10% for maturities of 2 to 4 years, primarily due to high administrative costs involved. The long term nature of the repayment program together with the reasonable interest rate structure, matched the long term requirements of mini hydro developers. The floating rate benchmark, AWDR, being the least volatile moreover served to mitigate the fluctuations in interest costs. The suitability of the above financing schemes is reflected in the satisfactory collection ratios reported by PCIs that have been in excess of 95%. It is however pertinent to note that some PCIs that extended sub loans for solar projects up to 5 year tenors had experienced difficulties in recoveries in the latter years. The delays in collection were attributed to additional maintenance expenses incurred by the end user, such as replacement of batteries used in solar home systems. Some PCIs thereafter disbursed sub loans to end users for periods of 3 to 4 years, which strategy had reportedly resulted in a marked improvement in their collection ratios.
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6.3
Status of the Electricity Sector
6.3.1 Demand growth Net electricity consumption in the country has more than doubled between 1992 and 2005. The total number of electricity consumer accounts of the Ceylon Electricity Board [CEB] increased by 5.9% to 3.3 billion accounts in 2005, while energy procured by CEB from independent power producers increased by 51% in that year. Latest statistics reveal that total electricity consumption had increased by 8% in 2006, while the growth in installed capacity reflected a mere 1%. In contrast the demand for electricity is expected to grow at 8% to 10%, annually. As per Central Banks Annual Report estimates, this additional demand would necessitate new power plants of 200 MW annually. 6.3.2 Inadequate supply Electricity demand continues to outstrip supply. The rapid rise in the demand for power had been largely addressed through hydro-power generation. However, with optimum mini-hydro locations already in use, the remainder is likely to require greater capital outlay for development. The following illustrates the electrification of households between the periods 1953 to 2003/04. Figure 6.3
Electricification of households 80 70 60 50 % 40 30 20 10 0 1953 1963 1973 1978/79 1981/82 1986/87 1996/97 2003/04
Source: Central Bank of Sri Lanka
The National Energy Policy of Sri Lanka is focused on the promotion of renewable sources of energy as a means of addressing the above concern and sets out several initiatives and concessions to developers. The government has set itself a minimum target of 10% of national grid electricity to comprise of renewable energy sources by the year 2015. Based on the foregoing the DFCC Bank has estimated resource capacities from renewable power sources as follows. Increase in mini- hydro capacity from 99 MW in 2006 up to 300 MW by 2015. Biomass and wind capacities, which are almost non-existent at present to increase up to 90 MW and 50 MW by 2015, respectively. Meanwhile an increase is estimated in solar power generation from 4MW at present to 11.2 MW by 2015.
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Figure 6.4
Growth in Mini-Hydro Capacity
350 300 250 200 150 100 50 0 2006 2008 2010 2012 2014
Growth in Wind Capacity

60 50 40
MW
MW
30 20 10 0 2006 2008 2010 2012 2014
Source: DFCC Bank
Source: DFCC Bank
Growth in Biomass Capacity

100 80
MW
Growth in Solar Capacity

12 10 8 6 4 2 0 2006 2008 2010 2012 2014
60 40 20 0
20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15
Source: DFCC Bank
Source: DFCC Bank
6.4
Funding needs
Funding needs of the sector has been assessed given the estimate considered in the National Energy Policy and Strategies for Sri Lanka, that of 10% of electricity generation to comprise from renewable energy. While sources attributed to the Central Bank estimates that new power plants of 200 MW would be required annually to meet the growth in demand, it is anticipated that nearly 350 MW of the above requirement would comprise of new generating capacity to be installed through renewable resources by the year 2015. The additional funding requirement to facilitate the above increase in renewable energy capacity is estimated to be approximately US$ 242 million. The refinance component of 80% would amount to US$ 193 million.
MW
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7.0
The Domestic Financial Sector
The ensuing discussion focuses on the financial systems and financing mechanisms relative to funding the power sector. The domestic financial sector is comprised of the banking system spearheaded by the Central Bank, financial institutions and capital markets. The sector contributes almost 10% to the nations GDP. The analysis relates to the development of the sector, the present status, market practices and impediments in mobilizing long term finance and makes special reference to the PCIs in the RERED project and the two state owned banks.
7.1
7.1.1
The Banking System

Evolution
At the time the country gained independence in 1948, the banking industry was dominated by 9 foreign banks that held over 60% of the banking sector assets. Two key policies changed the status quo of the industry. Firstly the nationalization of the Bank of Ceylon and the setting up of the state owned Peoples Bank in 1961, whereupon the two banks then emerged to dominate the banking sector. The core objective of the state banks at the time was to promote the rural economy, in particular providing finance to the priority sectors of agriculture and industry. Secondly the economic reforms of 1977 encouraged the presence of foreign banks once again in the country and paved the way for financial innovation in terms of products, services and technical capabilities. The entry of private commercial banks marked yet another milestone in banking. The first private commercial bank, the Commercial Bank of Ceylon was incorporated in 1969, followed by Hatton National Bank a year later. The two development banks, DFCC Bank and the National Development Bank of Sri Lanka [NDB] were established in 1956 and 1999 as government owned development banks to provide financial support for small and medium enterprises. The National Savings Bank was formed in 1972 to promote small scale savings. By 1998 there were 26 commercial banks operating in the country comprising 18 foreign banks and 8 local banks. The total assets of all financial institutions amounted to Rs 67,725 million in 1980. At present the domestic banking sector is comprised of 22 licensed commercial banks [11 domestic and 11 foreign banks], 14 licensed specialized banks, including 2 development banks, 3 savings banks, 3 housing finance institutions and 6 regional development banks. The total assets of financial institutions had expanded to Rs 3,144 billion by 2005.
Changing focus: While the two Development Finance Institutions [DFIs] were established with the objective of supporting long term capital formation in the country, with the subsequent curtailment of the privilege of concessionary multilateral funding lines, one of these DFIs has now become a commercial bank, with a view to accessing public deposits and short term lending rather than extending long-term project finance. It is pertinent to note that the development banking sector has moved towards a universal
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banking concept rather than focus on the original objective of project lending. At the same time commercial banks have set up development banking units to provide term loans to projects in selected sectors. The business scope of the banks have broadened to include consumer banking, investment banking, fee based activities, venture capital, fund management, stock broking and bank assurance products.
7.1.2
Present Status
State Bank dominance: The banking sector, together with Central Bank, accounts for almost 70% of the total assets in the countrys financial system. Non-bank financial institutions that include registered finance companies, co-operative rural banks, thrift societies, primary dealers, leasing companies, merchant banks, unit trusts and venture capital companies, together accounted for only 8% of total assets in the financial sector.
Figure 7.1
Total Assets in Financial System 14% 22% 4% 4% 10%
Central Bank Licensed Specialized banks Specialized Financial Institutions
46%
Licensed Comm. Banks Non bank deposit taking Financial Institutions Contratual Savings Institutions
The dominance of the state owned banks is reflected in the fact that the assets of these two banks, Bank of Ceylon and Peoples Bank, aggregate Rs 595 billion and comprise 19% of the total financial sector assets. Expanding Outreach: The outreach of the banking sector grew by 57% from 2003 to 2005 by way of expanded branch networks and outlets. Banking density per hundred thousand persons, improved from 6.9 in 2003 to 7.2 in 2005, enabling the banks to expand island wide activities. The two state banks have spanned all nine provinces of the country and are better represented in the rural areas.
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Figure 7.2
Bank Outreach
6% 35% 43% Domestic Commercial Banks Foreign Banks Licensed Specialized Banks State Banks National Savings Bank 14% 2%
Focus on short term lending: The primary focus of the main banks remains on traditional banking services, namely deposit mobilization, lending and investment activities. Overdrafts and trade finance lending that are of short term nature aggregate Rs 161.2 billion and represent 13% of the total assets of Rs 1,242.2 billion of commercial banks. Loan advances of Rs 486.7 billion of both short term and medium term maturities comprised 39% of total assets. Rs 436 billion relating to 27% of total assets are maintained in the form of liquid assets. The concentration towards short term lending is represented in the fact that 56% [Rs 368 billion] of all advances of commercial banks [Rs 655 billion] are in the form of short term facilities, while medium and long term lending comprise 24% and 20% of total lending respectively. The major long term lending has been towards financing the housing sector and represents 14% of all lending. The reasons for reluctance for long term lending are discussed elsewhere in this report. Figure 7.3
Maturity Profile of Commercial Banks Advances
20% Short term Medium term 24% 56% Long term
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Figure 7.4
Sector Composition of Lending
7% 17%
8% 33%
Trading Financial Agriculture Industrial Tourism Housing Consumption 4% 5% Services Others
14%
2%
10%
The following table illustrates the profile of long term assets with maturities greater than 5 years, relating to the major PCIs and the two state owned banks. Figure 7.5 Interest Earning Assets Maturity Total % more than 5 years Rs mn Rs mn 2,800 41,145 6.8% 1,836 34,676 5.3% 16,408 143,464 11.4% 9,481 160,018 5.9% 10,823 96,903 11.2% 4,170 72,348 5.8% 23,867 281,362 8.5% 20,724 258,672 8.0% Total Assets Maturity Total more than 5 years Rs mn Rs mn 9,500 50,039 5,251 50,955 22,205 166,012 14,857 180,077 14,688 113,608 6,544 84,811 29,106 319,504 24,383 275,262
DFCC Bank NDB Bank HNB Comm. Bank Seylan Bank Sampath Bank Bank of Ceylon Peoples Bank
18.9% 10.3% 13.4% 8.3% 12.9% 7.7% 9.1% 8.9%
Source: Annual Reports 2005 and 2005/06
Note: Peoples Bank data is prior to deduction of provisions
Deposit base key funding source: The primary source of funding of the commercial banks is the deposit base of Rs 945.5 billion that account for 76% of total assets of Rs 1242.2 billion. LCBs mobilized a greater proportion of resources in 2005 through rupee deposits, 63% and foreign currency deposits, 22%. The Average Weighted Deposit Rate [AWDR] associated with borrowings declined from 12.9% in 1990 to 7.6% in 2006. Interest rates on savings deposits, including long term minor savings, ranged from 3% to 10.25% in 2005 while the average interest rate
16
was approximately 5%. The interest rates on 2 year fixed deposits ranged from 8.5% to 11.5% p.a. The greater proportion of the countrys deposit base, 41% is captive to the state owned banks. Figure 7.6
Distribution of Deposit Base
1% 4% 33% 2% State Banks 41% NSB Commercial Banks Other LSB Finance Companies Others 19%
Source: Central Bank and Annual Reports 2005
7.1.3
Constraints in Project Lending
Lack of long term deposit base: The deposit base of commercial banks is primarily comprised of short term maturities of up to one year. The savings base of Rs 511 billion account for almost half of the total deposits in the system which is used as the core for medium term lending. The liability structure of the banking sector is thus a barrier to support long term lending. In the absence of dedicated long term credit lines the banking sector is consequently reluctant to finance such long term projects as infrastructure, housing and other development activities essential for economic growth. Figure 7.7
Composition of Interest Bearing Deposits
19% 17%
Savings - State Banks Savings - Commercial Banks Savings - Others FDs - State Banks FDs - Commercial Banks FDs - Others
24% 9% 7%
24%
Figure 7.7 illustrates that almost 50% of the total deposit base comprises of savings deposits which are less than one year. More than 80% of total fixed deposits also mature in less than one year.
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The following table illustrates the maturity profile of long term liabilities, greater than 5 years including shareholder funds relating to the major PCIs and the two state owned banks.
Figure 7.8 Deposits More than 5 years Rs mn 0 0 3,056 4,362 5,549 2,919 18 2,556 Total Rs mn 4,017 13,785 128,284 127,601 85,874 65,418 232,836 225,600 % Total Liabilities & Shareholder funds More than 5 Total % years Rs mn Rs mn 19,145 50,039 38.3% 13,782 50,955 27.0% 14,958 166,012 9.0% 18,715 180,077 10.4% 11,152 113,608 9.8% 11,138 84,811 13.1% 16,618 319,504 5.2% 9,140 275,262 3.3%
0.0% 0.0% 2.4% 3.4% 6.5% 4.5% 0.0% 1.1%
The above table highlights the dearth of long term resources within the PCIs and state bank sector to support long term project lending.
Inadequate capital base: The capital base of commercial banks, comprise of tier 1 and tier 2 capital, reserves and undistributed profits. The total capital base as at end 2005 was Rs 103.09 billion which represents a mere 8% of the total assets of Rs 1,242.2 billion in the banking sector. The capital account of registered finance companies of Rs 12.7 billion, on the other hand represents 14% of total assets of Rs 87.4 billion. In April 2005, the Monetary Board increased the minimum capital requirement of LCBs from Rs 500 million to Rs 2500 million and of LSBs from Rs 200 million to Rs 1,500 million. Existing licensed banks were given time until December 2006 to meet 50% of the shortfall in minimum capital and the balance 50% by December 2007. A further extension was granted in 2006 to enable Licensed Banks to infuse 50% of the shortfall in capital by 2008 and the balance 50% by 2009. The capital structure of the selected PCIs and the two state banks reflect that lending, including project lending is being mostly funded by debt.
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Figure 7.9 Shareholders Funds Rs mn 11,516 7,840 11,239 15,768 4,626 5,632 16,182 4,181 Total Assets Rs mn 50,039 50,955 166,012 180,077 113,608 84,811 319,504 275,262 % 23.0% 15.3% 6.8% 8.8% 4.1% 6.6% 5.1% 1.5%
Mismatch in assets and liabilities: Asset and liability mismatches of a significant nature are inherent within most banking and non-banking financial institutions. Figure 7.5 and figure 7.8 depict the mismatch that exists in the longer term tenor maturities. The study revealed that most long term lending had been backed by short term borrowings that expose the PCIs to liquidity risks. The risk is managed by retaining a higher interest spread that adversely affects long term lending rates. Interest rate risk however is mitigated through floating rate lending. Fixed rate lending that is essential for small scale power projects is rare.
Pricing benchmarked to floating rates: Project and term lending is mostly pegged to a floating rate benchmark, with a smaller fraction of lending extended on fixed rates. Banks have moreover begun to deviate from pegging the lending rate to Treasury Bills [TB} and instead adopt the Average Weighted Prime Lending Rate [AWPLR] as the benchmark lending rate, in the absence of an active inter-bank market. A risk premium ranging from 0.5% to 4% is usually incorporated in the pricing. The benchmark rate is re-priced periodically, mostly quarterly. Project and term fixed lending rates presently range from 13.5% to 17% p.a. The AWPLR on the other hand declined from 18.5% in 1990 to 15.4% in 2006. The average weighted lending rate applicable on the entire loan portfolio of commercial banks stood at 15.4% by end 2005. The primary impact on small scale power project proponents arising from the above is as follows. 1. The base rate in computing the AWPLR is the TB. The AWPLR is several percentages higher than the TB, presently 2.5% over 3 month TB which results in higher cost of financing. 2. Periodic re-pricing results in greater exposure to interest rate fluctuations from the borrowers perspective. Financing renewable power projects in the above context from a proponent perspective becomes s a costly and risky affair.
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Debt financing is costly The recent successful offer made by a leading PCI, Commercial Bank, for the issue of unsecured, subordinated debentures redeemable in 5 to 10 years and carrying fixed and floating rates of interest exemplifies the banking sector cost of funds. The issue entailed the following terms as depicted in Figure 7.10. Figure 7.10 Type of Interest Fixed Interest Rate Fixed Interest Rate Fixed Interest Rate Floating Interest Rate Floating Interest Rate Floating Interest Rate
Rate of Interest 14%p.a. payable annually 13.75% p.a. payable annually 13.5% p.a. payable annually 1 year gross Treasury Bill rate +1% p.a. payable annually 1 year gross Treasury Bill rate +1% p.a. payable annually 1 year gross Treasury Bill rate +1% p.a. payable annually
Tenor 10 years 7 years 5 years 10 years 7 years 5 years
The cost of debt finance in the present context is extremely high and has a direct impact on lending activities. High reserve requirement: The Statutory Reserve Requirement [SRR] placed on the domestic banking sector is identified as one of the highest in the region. The obligatory need to maintain a high reserve requirement of 10% of deposits in non-interest bearing cash reserves together with a mandatory 20% in liquid assets increases the cost of long term borrowing especially due to the upward yield curve. This necessitates a higher interest spread, thus inflating the pricing that affect prospective rural grid and off-grid developers. High Bank Intermediation Cost: The intermediation cost of LCBs is still the highest in the region. The interest spread retained by regional banks is below 3% compared to Sri Lankas 4.2% in 2004. Although LCBs AWDR declined by 6.7% from 12.9% in 1990 to 6.2% in 2005, the AWPLR declined only by 6.3% during the period, from 18.5% in 1990 to 12.2 % in 2005. The high intermediation cost has been brought about consequent to assets and liability mismatches, high reserve requirement, extent of non-performing advances, the lack of effective risk management frameworks, high dependence on fund based activities and operational inefficiencies. This further impedes the bank ability to provide low priced long term funds to the renewable power sector. Figure 7.11
Commercial Banks Interest Spread
20 15
10 5 0 1990 2001 2002 2003 2004 2005 2006
AWPLR AWDR
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Sector exposure limitations of the banks: The twin exposure limits of the banks could restrict lending to a given borrower or industry sector. The Central Bank prescribed Single Borrower Limit [SBL] that presently stand at 30% of capital could limit lending to power project developers. The sector exposure limit maintained as a measure of prudence on the other hand would restrict advances to any given sector. Measures taken by Central Bank to augment the capital base of the banks by increasing the minimum capital requirement as stated in Section 7.1.3 page 18, may serve to ease the present limitation. In spite of this fact, state banks may continue to have an edge over other commercial banks in terms of exposure limits. It is also pertinent to note that the SBL could be broadened in the event banks engaged in syndicated lending to approved prioritized sectors. Collateral based approach to lending: Banks usually extend credit against tangible collateral, with credit terms often dependant on the nature of collateral. Many entrepreneurs in the power sector may be excluded from the banks lending portfolio merely because of a lack of adequate collateral. From the banks perspective, the comfort of having collateral that could be readily acquired in the event of a default, provides a buffer against non performing advances and necessitates lower provisions for bad and doubtful debts. At present unsecured lending comprise only 13.4% of total advances made by the banking sector.
Figure 7.12
Bank Advances by Type of Security 13% 0% 3% 2% 6% 9%
24% 1% 32% 10% Documentary Bills & Trust Receipts Stocks inTrade Property, vehicles, plant & machinery HP Agreements Unsecured
Govt. Securities Shares, Co.Stocks, Bonds Deposits Personal Guarantees, Pro notes Other securities
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7.1.4
Viewpoint of PCIs
The Consultant conducted interviews with selected PCIs and other stakeholders in order to make an objective assessment of their commitment to promote renewable energy projects as well as to ascertain specific concerns in funding the sector. The following salient observations reflect the broad consensus among the stakeholders. 1. Project lending under both ESD and RERED schemes to promote rural electrification had been mostly committed for mini hydro projects. Two PCIs had however focused on financing solar home systems. 70%of disbursements under the ESD project were for mini hydro projects, followed by solar projects that received 28% of the funds. Meanwhile 67% of the RERED credit line had been deployed to fund mini hydro projects and 32% for solar projects. 2. Most PCIs had engaged in a syndication process to synergize technical skills and minimize risk exposure. Technical expertise was available in house with some PCIs, while some others had obtained outside assistance. 3. The average loan tenor ranged from 6 to 8 years, besides a grace period of 1 to 2 years. The rate of interest on an average amounted to AWPLR + 5% for mini hydro projects, while solar projects received lending at a flat rate ranging from 10%p.a. to 12%p.a. 4. One PCI reported exposure to this sector of 5% of their total asset book while some PCIs are considering the imposition of a sector exposure limit. 5. The lack of power generation at optimal capacity was a concern reported by PCIs. Power generated reflected only 35% to 40% of expected capacity, the reasons for which are presently being investigated. 6. Since most of the optimum sites for mini-hydro projects are already in use, the cost of developing less favourable sites could be considerably higher resulting in the escalation of project cost estimates. 7. A time lag of 2 to 3 years is reported in the legal process relating to the acquisition of land, while project cost estimates could escalate in the interim. 8. The possibility of a revision in the Power Purchase Agreement for mini hydro projects with the Ceylon Electricity Board [CEB] and concerns of introducing a tiered structure in the tariff setting for grid connected projects. PCIs also expressed concern on the likelihood of the requirement of a guarantee from the PCI to CEB. The CEB has meanwhile indicated the possibility of transferring grid connection costs to developers, in view of the high cost incurred in absorbing power from remotely located projects into the grid. An agreement has not been reached in this regard, as yet. 9. Lack of proper planning on the part of the CEB in supplying electricity access to under privileged areas. The possibility of connection to the national grid has at times prompted borrowers to defer solar system implementation plans. This is primarily due to end user preference to obtain grid connectivity rather than a solar powered energy option.
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10. Recovery issues were experienced in some instances. One PCI that focused on solar home systems had disbursed almost 60% of that portfolio to the North and East provinces, the recovery of which is doubtful under present conditions. Some PCIs had incurred losses associated with the tsunami. While the overall recovery rate is very satisfactory, approximately 95%, such incidences have prompted PCIs to consider requesting equity contributions up to 40% for future lending. 11. Financing of renewable power projects would be costlier, due to depreciation of the rupee on the one hand and increasing cost of raw material such as solar cells, in the international market, on the other hand. 12. A lack of enthusiasm was witnessed in assisting wind power projects which remain in an experimental stage, as well as biomass projects due to possible constraints in raw material supply. 13. While PCIs remain committed to promoting the sector, doubts were expressed in deploying their own financial resources to fund renewable power projects, in the absence of RERED type assistance due to the inherent high asset liability mismatches that could be compounded by engaging in long term fixed rate lending. Given PCIs cost profiles any lending out of own resources would be pegged to the AWPLR plus a probable margin of 5%. This would expose the producer to a severe interest rate risk. Figure 7.13
AWPLR 20 15
10 5 0 1990 2001 2002 2003 2004 2005 2006
The study further revealed that PCIs who receive long term refinancing benefit from the positive cash flows associated with the overall project repayment structure. PCIs receive refinance repayable in 20 semi annual installments from the date of first disbursement after a grace period of 5 years. Borrowers on average receive 6 to 8 year funding excluding a grace period of 1 to 2 years. The agreement with PCIs stipulates that the interim cash surplus should either be made available for financing sector projects or repaid to the government after 6 months. However, such interim surplus funds are often re-lent to regular customers on market terms and not necessarily to the same sector. It was observed that a primary attraction of the credit scheme has been PCIs ability to take advantage of the interim float.
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7.1.5
Absorptive Capacity of PCIs
Discussions with present PCIs revealed that they remain committed to promoting the renewable energy sector. The collection performance in respect of sub loans extended under the scheme has been very satisfactory, reportedly over 95%. Two thirds of sub loans extended under the ESD project has already been repaid to PCIs by sub borrowers. Thus PCIs present exposure is mainly in relation to disbursements pertaining to the RERED credit line. As discussed in Section 7.1.4, one PCIs exposure to the sector is presently 5% of the total assets, while some PCIs are at present considering placing limits for financing the sector. In spite of the above, PCIs display a willingness to continue their role in promoting the sector. Their capacity for future projects would be essentially dependant on the merits of individual power projects, specifying a possible enhancement in promoters equity investment and their internal lending criteria. Possibility also exists to broaden the range of PCIs, as witnessed in the inclusion of a new PCI, Alliance Finance Company in 2007 and by implementing measures as discussed in Section 7.16 below which would facilitate greater penetration, especially in the rural areas.
Based on available data it is estimated that PCI would have the capacity to absorb the following. Rs bn 2008 2009 2010 2011 2012 2013 2014 2015 2.45 3.05 3.45 3.35 3.40 3.23 3.03 2.19
Refinance up to 80% of the above would be available for PCIs.
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7.1.6
State Banks as PCIs
The two state owned banks have considerable capacity to engage in RERED type project lending, given that they possess the greatest resources in the local financial system.
1. The total asset base as well as the deposit base of the two banks are significant; almost double that of other banks and financial institutions. 2. The sector exposure and single borrower exposure limits of the state banks are comparatively higher than their peers. 3. Both banks possess a comparatively higher number of branch locations as well as a wider spread branch network spanning both urban and rural provinces. The two banks together account for 35% of all bank branches in the island. 4. Both banks are considerably experienced in small scale project lending.
The reasons stated above spotlight the state banks as an attractive vehicle to speedily reach the rural populace and could be considered as potential PCIs in the disbursement of any future credit line for renewable sector projects. Both banks however lack the technical expertise in dealing with specialized projects of this nature. Hiring outside talent is one option that could address this problem. Entering into a syndication process with more experienced PCIs is another alternative available to the state banks. However, given limitations associated with the eligibility criteria for PCIs, Bank of Ceylon could be initially evaluated for admittance as a PCI for the program. The Bank is rated AA (lka) by Fitch Ratings Lanka Limited, with recent results reflecting strengthened fundamentals. On the strength of a major re-structuring drive, Peoples Bank too, has displayed a marked improvement in performance, in terms of profitability, growth in deposits, growth in capital funds, and by achieving a significant reduction in non-performing advances. With consistent profit growth over the past 6 years and improved financial ratios, Peoples Bank presently displays the potential to sufficiently recover and qualify as a prospective PCI at a subsequent stage.
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7.2 Capital Markets Besides the banking sector, local capital markets have evolved to some extent to facilitate the formation of capital investments. 7.2.1 Evolution
Sri Lankas capital market consists of the equities and debt markets. The debt market comprises government securities and listed and unlisted corporate debt markets. While the equity and government securities markets have evolved to some extent, the corporate debt market is yet in an emergent state in comparison to such regional players as India, Korea, Malaysia and Japan. At the time of gaining independence Sri Lankas capital markets were relatively underdeveloped, with a limited number of market participants and few financial instruments. Money market activities primarily consisted of trading in bills of exchange. Treasury bills [TBills] were introduced in 1950s and were of moderate values. The TBill yield at the beginning of 1960 was 2% p.a. compared to a Bank rate of 3%. Trading in TBills in the secondary market commenced in 1981, while repurchase and reverse repurchase windows were introduced in the mid nineties with the objective of developing a secondary market for government securities. Until 1997 the government made use of two instruments, TBills and Rupee Loans, to raise funds; the latter represented the administrative borrowings of the government out of captive sources. The introduction of a Treasury bonds [TBonds] market for government securities in 1997 however permitted market forces to determine the yield. The TBond market initially for maturities of 2 to 3 years has since matured to some extent to accommodate the issue of a 20 year bond. Meanwhile the Accredited Primary Dealer system was also replaced with a System of Primary Dealers in the mid nineties. A short term corporate securities market emerged with the introduction of commercial paper [CP] in 1993. The outstanding value of CPs in the late nineties was approximately Rs 2,000 to Rs 3,000 million and incorporated yields of 4% to 6% over TB yields compared to present rates of 2% to 4% over net TB yields. Listed corporate bonds [debentures] reflected Rs 151 million in 1997 and stands at Rs 11.9 billion in 2005. A unit trust industry meanwhile emerged in 1991. The industry of 6 unit trusts operating in 1997 had mobilized Rs 2,700 million from 25,000 unit holders. The industry remains passive comprising 5 unit trusts that had mobilized Rs 5.4 billion from 23,500 unit holders by 2005. The Colombo Stock Exchange [CSE] was meanwhile set up in 1984 and reflected marginal trades. The fully automated Central Depository System for share transactions and the Securities and Exchange Commission {SEC} were established 7 years later.
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7.2.2
Present Status
Robust equity market but few listings: As at end 2005, there were just 239 entities listed on the Colombo Stock Exchange [CSE] with a market capitalization of Rs 584 billion. This reflects 21% of the national GDP. The value of shares traded in 2005 was Rs 114.5 billion, compared to 13.9 billion in 2001. The key index the ASPI appreciated from 621 to 1,922 between the years 2001 to 2005. The share price index relating to the power and energy sector however reflects only 125 as at 2005 [base 1985 100]. Figure 7.14
Growth of Share Market
140000 120000 100000 2500 2000 1500 1000 500 0 1990 2001 2002 2003 2004 2005 Value of Shares traded ASPI [1985 100]
Rs mn
80000 60000 40000 20000 0
Government securities dominate debt market: Sri Lanka has an active government securities market consisting of Treasury Bills, Treasury Bonds, Development Bonds, loans and more recently, Index Linked Bonds. Bills and Bonds are traded in the secondary market. Treasury Bills [TB] outstanding as at end 2005 amounted to Rs 234 billion while the rates on 364 days TBs fluctuated from 13.74% in 2001 to 10.37% in 2005. Of the total domestic debt of Rs 1,265 billion outstanding as at end 2005, Rs 234 billion [19%] represented TBs, while Rs 751 billion [59%] and Rs 140 billion [11%] represented Treasury Bonds and Rupee Loans respectively. Figure 7.15
Composition of Government Domestic Debt 11%
19% 11%
Ownership of Government Domestic Debt

8% 21% 24%
13%
59%
Banking Sector
34%
Savings Institutions Private Sector Provident & Pension Funds Others
Treasury Bills Rupee Loans
Treasury Bonds Others
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Ownership of Treasury Bills

11% 8% 33%
Ownership of Treasury Bonds

6% 7% 14%
31% 17% Banks Private Sector Others Savings Insurance & Finance Cos
46% 27%
Banks
Savings
Private Sector
EPF
Others
The above graphs illustrate the paradigm shift in the ownership of TBills, from banks and Central Bank towards the private sector. Rupee Loans are held by institutions such as the Employees Provident Fund [EPF] which is managed by the Central Bank, the Employees Trust Fund [ETF] and insurance companies. Transactions in TBills in secondary market increased from Rs 390 billion in 2004 to Rs 443 billion in 2005 due to attractive yields. Moreover, the yields associated with government securities are net of the withholding tax element of 10% presently imposed on interest income, resulting in a higher gross yield to the investor.
Under developed listed corporate debt market: The total market capitalization of listed corporate debt of Rs. 11,914 million as at December 2005 is considerably insignificant when compared to the Rs. 584 billion of equity listed on the CSE. Figure 7.16
Type of Entity Listed commercial banks Listed non-bank finance institutions Listed corporate entities Unlisted commercial banks Unlisted non-bank finance institution Unlisted corporate entities Total No of Issuers 4 3 2 0 1 2 12 No of Listings 19 13 6 0 2 6 46 Market Capitalisation SL Rs. Million 9,655 249 607 0 250 1,153 11,914
Source: Colombo Stock Exchange
A total of 12 entities, comprising primarily of commercial banks and listed non-bank finance institutions, had been responsible for the issue of the above mentioned listed corporate debt. Such debt has been primarily in the form of debentures and has incorporated varying maturity tenors at the time of issue, comprising both fixed
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coupon interest issuances and floating coupon interest issuances. Most corporate debentures were issued for 5-year tenors that indicate the nature of investor appetite. The following table depicts the infrequent nature of secondary market trading in listed corporate debt.
Figure 7.17
Listed Corporate Debt Value traded (SL Rs. million) Volume traded (million) Trades (No.) 199 2 1,362 59,052 2,752 645,083 Equity
Source: Colombo Stock Exchange
Informal unlisted corporate debt market: Market instruments include commercial paper [CP], debentures and medium term promissory notes. Statistics pertaining to unlisted corporate debt is not readily available, other than CPs and debentures issued with the assistance of the banking sector. A total of Rs 2.8 billion in bank backed CP was outstanding as at 2005 consisting mainly of less than 3 month tenor maturities. CPs to the tune of Rs 10.9 billion at an interest rate range of 8.9% to 14.25% had been issued in 2005 compared with Rs 14.5 billion issued in 2004 at interest rates ranging from 7.75% to 14%. Pricing of unlisted debt is linked to the yield on government securities.
An emerging asset backed securities market: At present an Asset Backed Securities [ABS] market has emerged with issuers comprising mainly of leasing companies, engaging in the private placement of issuances. Investors in ABS are mainly banks, institutional investors and high networth individuals. The role of the Trustee in the ABS market is presently centered on two custodians. The SEC has at present initiated the enactment of a Securitisation Act to facilitate the development of this market. While statistics pertaining to the ABS market outstanding were not readily available at this juncture, market sources estimates the figure to be Rs 15 billion. Pricing of ABS is also linked to government securities. The power and energy sector has not engaged in securitization.
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7.2.3
Constraints in the Debt Market
The scope of the study has excluded the option of equity financing as a viable means of financing power projects, at this juncture. This is due to the many hindrances in listing power project entities, such as the modest size of the company and the lack of a proven financial track record. As such the study henceforth focuses on the debt market for financing sector projects.
Anomaly in the risk reward structure: Listed debt is generally priced in relation to the yield on gilt-edged instruments. The risk premium attached may vary from 1% to 3% thus increasing the pricing of listed debt. Interest on fixed rate debt issues range between 14% and 17% depending on the investor risk appetite. A fundamental issue that arises is that the yield to an investor in gilt-edged instruments is considerably higher than that offered by the banking sector, which is the AWDR. This affects the cost of accessing the capital market. This is illustrated in the following table. Figure 7.18
25%
20%
15%
10%
5%
0% Jan00 Jul00 Jan01 Jul01 Jan02 AWDR Jul02 Jan03 3M T Bill Jul03 Jan04 Jul04 Jan05 Jul05 Jan06 Jul06
Prime Lending Rate
Fiscal policy direction: A greater part of the composition of government debt is domestic debt that consists 56% of total government debt. The fiscal policy of tapping the domestic debt market as a means of funding the high government budget deficit restricts capital market activities. Considering that the government is the largest borrower in the capital market, this leads to a crowding out effect with the corporate sector competing for limited funds.
Monetary policy: Sustaining a consistent interest rate policy is often challenged by the constant pressure on inflation and exchange rates. The lack of a clear direction in interest rates hampers capital market activities, especially the pricing of debt. A case in point is the recent withdrawal of the reverse repurchase window that had earlier been introduced with a view to stabilizing the short term money market. The withdrawal has resulted in uncertainty among the market participants.
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Lack of instruments: The lack of diversity in capital market instruments as well as limited investment opportunities has also restricted primary and secondary capital market activities. Investors could be reluctant to participate in capital market activities due to the lack of an exit mechanism and prefer adopting a buy and hold strategy.
Absence of a credible long-term yield curve At present an active secondary market yield curve for government securities has not been observed beyond 3 years. Hence, the establishment of a credible long-term yield curve is difficult. In the absence of such a realistic long-term benchmark yield curve the pricing of long term debt for power projects becomes a challenge.
Captive sources: Large provident funds and pension funds such as the EPF and ETF are primarily captive to the government. Although the funds portfolio sizes are significant, their participation in capital markets is inadequate. Lack of awareness and reach Most savers and investors lack the knowledge and opportunity to derive benefits from capital market investments. Even though savers receive a negative return on bank saving programs, savings still remains the most popular vehicle for investment primarily due to the lack of knowledge and the lack of reach. This demonstrates that despite the shift witnessed in the ownership of government securities, savings still comprise the major part of banks funding base. Meanwhile, primary dealers who are expected to broad base investment in government securities are mainly confined to Colombo.
The issues stated above are some of the constraints that PCIs and other financiers of renewable power projects would encounter when looking to finance long term activities via the debt market.
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8.0
Addressing Capital Market Constraints
The report thus far focused on a discussion of the macro economic environment with specific relevance to the corporate debt market and provided an overview of the domestic debt market. It also focused on factors that currently inhibit the development of Sri Lankas corporate securities market. The salient issues that constantly surface during the course of the study include the lack of breadth, the lack of depth, the lack of investment knowledge, the lack of market knowledge, the risk-reward anomaly, the absence of an active secondary market and the absence of a credible long-term yield curve. To achieve the objective of developing the listed corporate debt market in Sri Lanka, the issues discussed in the report warrant immediate attention. Some of the key measures include fiscal discipline, pension reforms and the rectification of the risk reward anomaly, creation of retail market awareness with regard to corporate debt, the design and implementation of a comprehensive training program to cover all stakeholders and the design and implementation of a strategy to revive the unit trust industry. Whilst the scope of this study does not entail recommending strategy to deal with capital market constraints, the fore-going paragraphs would provide a general insight into possible remedies to alleviate market impediments, given the consideration of depending on capital markets to mobilize funds for future needs of the renewable energy sector.
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9.0
The Proposed Renewable Energy Support Bond
As a means of sustaining the growth of both on-grid and off-grid renewable resource based power projects in the context of the imminent completion of RERED, the government has requested the World Bank to consider a supplementary financing package of US$ 40 million and is at present evaluating the possibility of issuing a Rs 2,000 million Renewable Energy Support Bond [RESB]. Electricity is a priority sector that has thus far been subsidized by the government and backed by donor support. The government has not only extended concessionary finance to the sector, but has also assumed the credit risk of PCIs as well as the exchange risk associated with foreign financial assistance for the purpose of developing the sector. Financing of long term projects through the local debt market would only happen at a price, given the fairly under developed state of the market. Thus the success of small scale power projects would be dependant on the financial support that is made available. The proposed RESB has taken into account this need for a further financial subsidy for the sector.
9.1
Salient features of the RESB proposal: 1. The issuer would be the Treasury. 2. The bond would be of long tenor, 10 to 15 years and would incorporate a variable coupon linked to TBill, TBond, AWDR or AWPLR together with a premium thereon. 3. In the alternative, the bond may also be issued at a discount to face value, based on market expectations. 4. The bond may be offered on a tender as for TBills, as a debt listed on the Colombo Stock Exchange or take the form of a private placement. 5. The proceeds from the bond issuance would be made available for partial refinance of project loans extended by PCIs. The rate of interest considered for refinance to PCIs is the AWDR. 6. PCIs would obtain refinance directly from CBSL and service obligations to CBSL on due dates. 7. CBSL would create a sinking fund from the debt service payments from PCIs to settle coupon payments and to redeem the bond at maturity. 8. The fund would be invested by CBSL in an interest earning instrument until its liquidation. The interest would be credited to the fund. 9. Any shortfall arising between the liquidated sinking fund and the redemption dues, would be funded for instance through a Treasury subsidy.
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9.2
Observations on the proposed RESB: 1. The RESB structure would provide a sound platform for financing the power sector in the medium term and has been structured to meet most expectations of all participants. 2. The RESB should ideally be structured so as to attract the larger investor base comprising commercial banks, insurances companies, provident funds and high net worth individuals. 3. From an investor perspective a higher premium may be demanded in respect of a deep discounted bond, in the absence of a credible long term yield curve and the lack of periodic cash flows over the term of the investment. Hence the bond should ideally be issued as an interest bearing bond with fixed rate coupons or floating rate coupons. 4. CBSLs resource capacity and expertise to manage an active sinking fund needs to be ascertained, on the premise that active fund management does not form a part of CBSLs core objectives. 5. While the RESB would provide a conduit to financing the sector, it could also be used as an ideal mechanism to mitigating some of the constraints encountered by the banking system in mobilizing funds from the domestic capital market. This aspect of the issue would be discussed in the ensuing recommendations.
6. There is a need to establish an agency that would undertake on a dedicated

basis the structuring and administration of the RESB process. Some of the underlying factors are the resource constraints presently experienced in the state system. This will be addressed in the recommendation given hereunder.
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10.0
Recommendations
The route to mobilizing long term sustainable financing for renewable power projects is essentially through a process of market dis-intermediation. Capital market instruments such as Energy Support Bonds and other long term securities would therefore facilitate the accomplishment of this objective. However, the success of this strategy would be greatly dependant on the value as perceived by prospective investors in such bonds. In other words the features of the proposed bond should be attractive from a long term investor perspective. Given the need to foster the development of the renewable power sector, concessionary lending terms to PCIs, such as AWDR presently offered would need to be sustained. Placements in the capital markets on the other hand would need to be linked to market rates so as to attract investors. The cost of mobilizing funds should therefore be minimized so as to minimize the gap in lending and borrowing rates. Against this backdrop an alternative sustainable benchmark for lending to PCIs could be introduced, the details of which is discussed in Section 10.4. The ensuing suggestions are centered on strategies to mobilize investors including a favorable pricing strategy as well as other alternate mechanisms to achieve long term sustainability in financing the power sector growth. The measures recommended also seek to provide transparency and accountability and consist of the following.
10.1
Establishment of a Renewable Energy Development Agency
As a sustainable alternative mechanism for financing power sector projects, a Renewable Energy Development Agency [REDA] could be set up jointly owned by the government and donor agency. The Agency could be managed by the apex institution DFCC Bank. The primary objective of REDA would be to mobilize long term financing for renewable energy projects from the domestic capital market. REDA would initially confine its activities to on-grid and off-grid power sector projects. As a second stage its scope would however be broadened to include the entire renewable energy sector. The agency would structure and issue capital market instruments based on sector requirements. All instruments issued by REDA would initially be guaranteed by the government or donor agency. The need for the guarantee could be gradually phased off as the market matures. Capital market instruments would initially include long term bonds, debentures and asset backed securities. Funds mobilized by REDA would be available to project developers throughout the country through eligible PCIs.
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10.1.1 Objectives of REDA a) Evaluate, identify and address funding needs of the power sector. b) Mobilize long term financing for renewable energy projects through capital markets. c) Structure, market and issue listed and unlisted capital market instruments based on sector requirements. Capital market instruments would initially include long term bonds, debentures and asset backed securities d) Evaluate and recommend prospective PCIs for entrance into the program. e) Facilitate refinance of loans granted by PCIs for renewable energy sector projects. f) Monitor and ensure servicing of loans granted to PCIs. g) Monitor and manage pool of funds received from PCIs. h) Monitor interest rate risk and structure hedging instruments [Forward Rate Agreements and Interest Rate SWAPS]
10.2
Alternative Issuance Process (1) - Capital Guaranteed Renewable Energy Bond [REB]
a) REDA would on an on-going basis identify funding requirements of the renewable energy sector, structure appropriate financial instruments and market these instruments among prospective investors. b) In line with above sector needs and on request from REDA, GOSL would, from time to time, issue a deep discount bond to the SPV. As a first step a Bond could be issued for instance, with a maturity period of 15 years for a face value of Rs 2,300 million. The face value of the Bond could be discounted at the market rate [for example 15%]. The present value of the Bond would therefore amount to Rs 282.6 million.
Present Value Rs 282.6 mn Face Value Rs 2.3 bn Deep Discount Bond
GOSL
SPV
c)
The SPV would create a Trust 1 account at the designated bank for the sole purpose of facilitating the above transaction. SPV would thereafter issue interest bearing, capital guaranteed, renewable energy bonds /securities [REB] to the market for a similar term [15 years] and value [Rs 2,300 million]. The REB could be listed on the Colombo Stock Exchange.
d) The coupon rate attached to REB would be equivalent to market rate. With a view to attracting investors, the interest component on the REB could be guaranteed by GOSL. The capital component is backed by the GOSL Bond. e) The proceeds of Rs 2,300 million raised through the REB will be received to the credit of the designated bank account [Trust 1] maintained by the SPV. Of these proceeds the discounted value of Rs 282.6 million associated with the GOSL bond will be paid back to GOSL immediately.
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f)
The remainder, Rs 2,000 million will be made available by the SPV for PCIs to refinance power sector projects on the terms as proposed by the donor agency.
GOSL
Deep Discount Bond Face Value Rs 2.3 bn
SPV/Trustee
REB Rs 2.3 bn
Investors
`
Rs 282.6 mn
Designated Bank {Trust 1]

Refinance Rs 2 bn
Cash Rs 2.3 bn
PCIs
End Users
g) PCIs would collect principal and interest from end users which would be transferred to the designated bank account in terms of the agreement with GOSL. h) REDA, managed by the apex institution, DFCC Bank would also manage proceeds of Rs 2,000 million until fully utilized by the PCIs. REDA will also actively manage payments received from PCIs. The benefits accruing would be utilized to service investors. i) Interest payments on the REB would be serviced by SPV on specific due dates, out of the proceeds collected from PCIs, through the designated bank account. Since both the GOSL and REB would have an identical maturity date, the REB would be settled out of the maturity proceeds of the GOSL Bond. Any deficit on interest would be subsidized by GOSL as contemplated in the RESB structure.
j)
37
The settlement flow is as follows.
GOSL
SPV/ Trustee
Investors
Bond Settlement Rs 2.3 bn
Frequent Interest
Designated Bank [Trust 1]
Capital at Maturity Rs 2.3 bn
Repayments
PCIs
Repayments
End Users
REDA would continue with the above mechanism for raising future finance for the renewable energy sector as and when appropriate, by creating a Trust 2 account and so forth at the designated bank account of the SPV. 10.2.1 The Participants Government of Sri Lanka [GOSL] REDA Special Purpose Vehicle [SPV]/Trustee and designated Bank Investors PCIs Project proponents
10.2.2 Advantages Promote active private sector participation in the development of the renewable energy sector. Introduction of a new capital market product that would help foster the development of domestic capital markets. The issuer of the capital market instrument is not GOSL, but a dedicated agency fully backed by GOSL. No effect on the GOSLs cash flow. No impact on the country foreign currency reserve position. The guarantee to be issued by GOSL is limited to the interest component.
38
A focused approach to managing funding needs of the renewable energy sector. REDA would be managed by professionals with proven expertise in capital markets, active fund management and in the RERED project. Could be listed on the Colombo Stock Exchange and traded on the DEX system so as to provide liquidity to bond holders.
10.2.3 Role of the SPV / Trustee a) b) c) d) e) f) g) h) 10.2.4 a) b) c) d) e) f) Retains custody of the GOSL Bond until redemption. Creates trust accounts to facilitate mobilizing funds from time to time. Issues securities to investors and transfers funds thereon to GOSL and PCI. Maintains Register of Investors. Collects payments from PCIs to the credit of the Trust account. Advising REDA on non receipt of PCI funds on due dates. Effects periodic interest payments and redemption of securities on maturity. Oversee the interests of the investors. Role of PCIs Popularize the scheme to end users. Evaluates end users as for RERED project. Provide finance to end users. Receives refinance from SPV Monitor and collect repayments from end users on due dates. Transferring funds to Trustee account
10.3
Alternative Issuance Process (2) - Securitization
At present GOSLs sub loans extended to PCIs under the RERED Project are repayable in 20 equal semi-annual installments, commencing 66 months after the date of first withdrawal. Under the proposed scheme, the funds payable to GOSL would be used for the purpose of securitization. Asset backed securities could be issued by REDAs SPV for renewable power projects. The process would enable GOSL to convert book debts into marketable securities.
39
10.3.1 The process: PCIs would extend sub loans on the proposed terms to project developers who meet the usual eligibility criteria. PCI would agree on a repayment schedule on the loans disbursed with GOSL. REDA would select a pool of estimated future receivables due to GOSL from PCIs. The pool of future receivables would be transferred to a Special Purpose Vehicle [SPV]. The SPV would issue debt instruments to investors based on the strength of the future cash flows. The instrument tenor could range from 2 years to 15 years or take the form of a long term deep discounted bond. The securities issued by the SPV to be unconditionally guaranteed by GOSL. The rate of interest on the securities would be based on market expectations. The SPV would on lend the proceeds from securitization linked to AWDR to refinance PCIs future sub loans. The interest differential, if any, arising between the lending and borrowing rates would be subsidized by the government. PCI will transfer repayment proceeds to the SPV in terms of the repayment schedule agreement, which would be used to service coupon payments and redeem securities held by the investors at maturity. Issuance of Securitized Paper
PCI
Pool of Receivables
SPV /Trustee
Securities
Investors
Cash
Designated Bank [Trust xx]
40
Settlement of Securitized Paper
PCI
SPV /Trustee
Investors
Repayments
Settlement of Securities
Designated Bank [Trust xx]
10.3.2 Advantages: a) Enables GOSL to raise finance linked to future receivables. b) Provides GOSL with a continuous source of funds to support the sector.
10.4
Timing of the Bond Issue
In determining the timing of the bond issue, a detailed analysis of the overall cash flows associated with the ESD and RERED on-grid and solar home projects as well as the cash flows from the supplementary credit line were evaluated, the workings of which are given at Annexure 1. Primary assumptions relating to the forecast of cash flows are stated therein. Assumptions also include that PCIs would re-cycle funds from the ESD project within the renewable energy sector and that two thirds of the total re-finance provided to PCIs have been repaid by sub borrowers by end December 2006. The analysis reveals that funds relating to solar home sector projects could be recycled twice. The evaluation reveals that proceeds of US$ 40 million of the supplementary credit line, together with interim ESD and RERED cash flows, would sustain the sector funding requirements in the near term. Accordingly the REDA Bond would need to be introduced once the proceeds of the additional line have been fully disbursed and in the following manner in order to ensure adequate funding for project development.
Sector On-grid projects Solar home projects
Timing of the Bond Issue Third quarter of 2009 Commencement of 2012
Quantum of Issue Rs 1,500 million Rs 500 million
41
10.5
Value Addition to Attract Investors
Potential investors in REDA Bonds would include the banking sector, financial institutions, provident funds, insurance companies and high net worth individuals. Since commercial banks comprise the greater part of the prospective investor base, it would be advantageous to incorporate specific value added features in the Bond designed to attract this sector towards investing in the bond. Value added features that could be considered are as follows. 10.5.1 Eligibility of Securities for SRR classification: Securities could be offered to both local and foreign commercial banks, as an eligible asset in the composition of the bank statutory reserves. As stated in previous chapters, a high statutory reserve requirement [SRR] is enforced on commercial banks in Sri Lanka. As much as 10% of total deposits are required to be maintained in non-interest earning reserves that increase a commercial banks cost of funds. Given that the proposed issuer of RESB is GOSL, the bond could be classified as a part of statutory reserves maintained by a bank. A maximum limit in this regard could be prescribed. The coupon rate attached to the bond could be equivalent to AWDR or even a rate lower than AWDR. The primary advantage to GOSL is that it minimizes the cost of borrowing as the rate of interest could be lesser than AWDR. The primary advantages to the bank are as follows. (a) Provides an opportunity to convert non-interest earning reserves to interest earning reserves. (b) Facilitates the gradual release of the high SRR. (c) Reduces the banks cost of funds
10.5.2 Eligibility of Securities for Liquid Assets Permit capital market instruments issued to be eligible for classification as part of liquid assets of the banking sector.
10.6
Proposed Benchmark
Under the present credit terms the rate of interest to PCIs is the AWDR. As a more viable and sustainable option it is proposed that a benchmark computed as an average of AWDR and the 12 Treasury bill rate be considered for project lending to PCIs. Based on present market conditions the benchmark would represent the following.
42
12 month TB (net) AWDR Benchmark
16.15% 8.34% 12.25%
The above benchmark would serve to lessen the impact of the interest rate differential between the market rate and rate to PCIs.
10.7
Tax Exemptions
Exempting capital market instruments from the withholding tax element of 10% and also from corporate taxation would reduce interest costs on the securities and further help popularize the concept amongst investors.
10.8
Support Required 10.8.1 Government of Sri Lanka [GOSL]
a) Issuance of long term bonds to SPV and redemption on maturity. b) Bears the credit risk of PCIs c) Provides a subsidy only in the event of a shortfall in interest payments relating to REB. d) Provision of exemptions on withholding tax and corporate tax on securities issued by REDAs SPV. 10.8.2 Central Bank
Permit the classification of the REB as part of statutory reserves, subject to an upper limit and to categorize REB for liquid asset requirements.
10.9
Interim Support
The foregoing chapters reveal that the renewable power sector requires financing to the tune of approximately US$ 30 million per annum over the next 8 years, totaling US$ 242 million. Whilst capital markets could provide an ultimate viable platform for generating such financing needs, the present immature state of the markets limits access to the quantum of sums contemplated for the sector. The proposal specific to the power sector set out above would help overcome the barriers to accessing finance from capital markets needed for sector growth. Such measurers however require the participation of many stakeholders and would take time to come to fruition. Given this scenario donor support would therefore be a vital need in the interim.
43
12.0
Acknowledgements
I wish to place on record my appreciation of the support received from officials in many institutions who supported me with valuable information during interviews and provided me with research material and other relevant data. Firstly my thanks are due to DFCC Bank for useful insight, related facts and their invaluable support. Secondly, I extend my thanks to many market participants including Bank of Ceylon, Hatton National Bank, NDB Bank, Seylan Bank, Sampath Bank, Commercial Bank and Sarvodya Economic Enterprises Development Services [SEEDs], all of whom shared important information and provided valuable input to the study.
44

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Renewable Energy for Rural Economic Development Project

Colombo, 15th May 2007

10.6 10.7 10.8

Estimated Potential by year 2015 11 MW 50 MW 300MW 90 MW

Objectives and Scope of Consultancy

3.4 3.5 3.6 3.7

The Renewable Power Sector and Sector Projects

Overview of the ESD and RERED Projects

Figure 6.1 Projects implemented under ESD credit arrangements

Source: Energy Sector Unit World Bank

Source: Energy Sector Unit World Bank

Source: Energy Sector Unit World Bank

Status of the Electricity Sector

Source: Central Bank of Sri Lanka

Growth in Wind Capacity

30 20 10 0 2006 2008 2010 2012 2014

Source: DFCC Bank

Source: DFCC Bank

Growth in Biomass Capacity

Growth in Solar Capacity

Source: DFCC Bank

Source: DFCC Bank

The Domestic Financial Sector

The Banking System

Source: Central Bank of Sri Lanka

Source: Central Bank of Sri Lanka

Source: Central Bank of Sri Lanka

Trading Financial Agriculture Industrial Tourism Housing Consumption 4% 5% Services Others

Source: Central Bank of Sri Lanka

18.9% 10.3% 13.4% 8.3% 12.9% 7.7% 9.1% 8.9%

Source: Annual Reports 2005 and 2005/06

Note: Peoples Bank data is prior to deduction of provisions

Source: Central Bank and Annual Reports 2005

Constraints in Project Lending

Source: Central Bank of Sri Lanka

0.0% 0.0% 2.4% 3.4% 6.5% 4.5% 0.0% 1.1%

Source: Annual Reports 2005 and 2005/06

Source: Annual Reports 2005 and 2005/06

Tenor 10 years 7 years 5 years 10 years 7 years 5 years

10 5 0 1990 2001 2002 2003 2004 2005 2006

Source: Central Bank of Sri Lanka

Bank Advances by Type of Security 13% 0% 3% 2% 6% 9%

Source: Central Bank of Sri Lanka

10 5 0 1990 2001 2002 2003 2004 2005 2006

Source: Central Bank of Sri Lanka

Absorptive Capacity of PCIs

Refinance up to 80% of the above would be available for PCIs.

State Banks as PCIs

80000 60000 40000 20000 0

Source: Central Bank of Sri Lanka

Ownership of Government Domestic Debt

Treasury Bills Rupee Loans

Treasury Bonds Others

Source: Central Bank of Sri Lanka

Source: Central Bank of Sri Lanka

Ownership of Treasury Bills

Ownership of Treasury Bonds

Source: Central Bank of Sri Lanka

Source: Central Bank of Sri Lanka

Source: Colombo Stock Exchange

Source: Colombo Stock Exchange

Constraints in the Debt Market

Prime Lending Rate