Understanding Power Project Financing
Understanding Power Project Financing
Understanding
Power Project
Financing
Funded By
Developed By
Understanding Power Project Financing – Version 1.0
FOREWORD
1. INTRODUCTION
2. CONTEXT
2.1. Introduction 11
2.2. Evolving Market Structures 12
2.3. Creating an Enabling Environment 15
3. FINANCING STRUCTURES
3.1. Introduction 20
3.2. Project Finance Essentials 31
3.3. Sources of Financing 37
3.4. Particular Aspects of Project Finance 45
3.5. Stakeholders 52
3.6. Summary of Key Points 54
6. SOVEREIGN SUPPORT
6.1. Introduction 95
6.2. Sovereign Guarantees 97
6.3. Letters of Comfort and Letters of Support 100
6.4. Put and Call Option Agreements 102
6.5. Liquidity Letters of Credit 105
6.6. Liquidity Escrow Accounts 109
6.7. Debt Sustainability 111
6.8. Host Government Considerations 118
6.9. Summary of Key Points 125
7. THIRD PARTY CREDIT SUPPORT AND RISK
MITIGATION
7.1. Introduction 128
7.2. DFI Guarantees 129
7.3. DFI-Guaranteed LC Structures 137
7.4. Political Risk Insurance 144
7.5. A/B Loan Syndication 148
7.6. Summary of Key Points 150
APPENDIX
Glossary 152
Online Resources 166
Acronyms 171
Foreword
Foreword
Contributing Authors
1
FOREWORD
Foreword
The critical role of access to power in economic growth is perhaps one of
the few core elements of economic development that all economists can
agree upon. There are few resources that can benefit the public as broadly
and as effectively as access to power. From schools to hospitals and homes
to offices, the existence of plentiful, affordable and reliable power is the
cornerstone of growth in the modern era.
With this reality in mind, it should come as no surprise to you, the reader,
that there is an intense effort by governments, international organisations,
and the private sector to drive investment into power projects in both un-
der-served power markets in developing countries and remote markets in
developed countries. The intensity of the drive to electrify the world has
taken on an even greater dimension in recent years with the realisation
that access to power can also serve the equally important goal of a reduc-
tion in carbon emissions if much of the new investment is directed away
from conventional fuel sources towards cleaner sources of power. The re-
sult is a world where power sector growth has the potential to improve the
condition of both our lives and our planet.
2
FOREWORD
As with our previous handbook, the intent here is to share with you an
overview of the challenges, strategies, and nuances of private financing of a
power project. As explained in the chapter on power markets, many coun-
tries, including some developed countries, are still facing challenges in
transitioning towards a more predictable and competitive power market.
In addition to the market challenges, the chapter on finance structures ex-
plains how the ever growing burden on the national budgets in many de-
veloping countries has reduced the ability of the state to develop projects
directly and has instead necessitated a shift towards privately developed
and financed power projects. The issue of risk in power projects is again al-
located its own chapter, with more attention given this time to the pricing
and allocation of risk. The PPA continues to play an important role, with
the chapter on financial obligations under the PPA setting the scope of fi-
nancial commitments that are necessary for a power project. Perhaps the
most critical insight provided by this handbook is contained in the final
two chapters, which lay out the options for governments as they seek to
support investors in power projects by reducing the credit risks that are
often the single greatest barrier to financing.
3
FOREWORD
We would like to thank our Book Sprint facilitator Laia Ros Gasch for her
persistent guidance and endless patience. We would also like to thank illus-
trator Henrik van Leeuwen for his unfailing ability to translate our scrib-
bles into works of informational art. We are also deeply appreciative of
Book Sprints' offsite team, including Raewyn Whyte (proofreader) and
Juan Carlos Gutiérrez Barquero and Julien Taquet (Technical Support).
We are especially thankful for the strategic planners that helped conceive
this project: Mohamed Badissy, Nnamdi Ezera, Sheryl Weisflog and Mo-
hammed Loraoui (Commercial Law Development Program); Amir Shaikh
and Toyin Ojo (African Legal Support Facility); and Adam Hyde, Katerina
Michailidi and Mark Brokering (Book Sprints). The authors would also
like to thank the generous funding and logistics support from Power
Africa, the United States Agency for International Development and the
African Legal Support Facility, without which neither the consultations
nor the Book Sprint would have been possible.
4
FOREWORD
Bridging the gap between the promises of a more electrified world and the
delivery on those promises is the core mission of every single person in our
group of authors. Much as we brought together governments, private com-
panies, private banks, development banks, and leading legal experts to
share their best strategies for securing the financing necessary to go from
dream to reality, we hope that others will leverage this handbook in their
own drive to bring electricity to all who want it. We are honoured to con-
tribute to this noble mission and thank you for taking the time to consider
our contribution.
Sincerely,
5
FOREWORD
Contributing Authors
Mohamed Badissy Rhoda Limbani Mshana
Attorney Advisor (International) Principal Results Specialist
U.S. Department of Commerce African Development Bank
United States Côte D'Ivoire
6
1. Introduction
7
INTRODUCTION
1.1. Introduction
Bankable transactions are central to the development of the power sector
in many emerging economies.
For example, when the issue of a “sovereign guarantee” arises it can cause
debate, leading to a potential impasse.
The handbook starts out with an overview of the different financing alter-
natives for power transactions and the advantages and disadvantages of
each. The text then proceeds into a deeper analysis of the mechanics of
project finance and its relevance to implementing power projects.
8
INTRODUCTION
9
2. Context
2.1. Introduction
2.2. Evolving Market Structures
2.3. Creating an Enabling Environment
10
CONTEXT
2.1. Introduction
The power sector is a fundamental building block for economic advance-
ment in any country. Power is a critical input for the successful growth and
functioning of a country’s economy, across all its sectors, and thus for job
creation. Electricity demand is closely correlated with GDP growth and
other socio-political advancements. As such, power investments demon-
strate a clear and quantifiable economic return upon completion and com-
missioning of the financed power projects, with a resultant multiplier ef-
fect on the broader economy. Successfully financed power transactions will
thus have broad-reaching development impact.
In this context, even as governments begin to open the sector for private
participation, they are relied upon for legislative support, regulation, li-
censing, oversight, and ancillary market functions such as fuel supply
and/or transmission. They are relied upon to create an enabling environ-
ment that fosters the evolution of their power sectors. While a great deal
of time and effort is involved in such endeavours, by creating an enabling
environment, a government can increase the likelihood of reaping the ben-
efits of independent power projects, with the main advantage being that
the up-front cost of the project is provided through private sector-led fi-
nancing and not from the sovereign's balance sheet.
11
CONTEXT
Power markets typically start out as fully government financed, owned and
controlled. As noted in Section 3.1 (Overview of Power Financing Alterna-
tives), this model requires less coordination by the government with vari-
ous third party funders, but it also requires the government to add more fi-
nancing obligat ions to its balance sheet. This can limit the available cash
reserves or external financing that a government can channel to other capi-
tal-intensive sectors that it may need to support. Consequently, many gov-
ernments have deemed it beneficial to privatise certain revenue-generating
power assets (primarily generat ion assets), as opposed to social sectors such
as educ ation and health. In this way, the government is able to benefit from
financing structures encouraging private capital that help to free up its bal-
ance sheet for other priorities.
12
EVOLVING MARKET STRUCTURES
13
CONTEXT
14
CONTEXT
Summarised below are some critical factors that private investors will re-
view to understand a country's legal and regulatory framework. A review
of the general enabling environment, as well as the project structure, will
often be the starting point for investor negotiations that may result in the
investor sometimes requesting additional comfort in the form of credit en-
hancements from the host government and/or the offtaker.
15
CREATING AN ENABLING ENVIRONMENT
16
CONTEXT
The private sector also plays a key role in ensuring a commercially viable
power sector. Sponsors who build and operate efficient plants that attain
the end goal of providing electricity in a sustainable and cost-effective
manner are required in this long-term partnership.
Competitive Tenders
17
CREATING AN ENABLING ENVIRONMENT
Competitive Tenders
Procuring power through a public and competitive tender process is often
seen as the best way to ensure that value for money is achieved regarding
power generation pricing. This process, however, will generally take more
time to complete than procurement of power through unsolicited bids (in-
cluding emergency power) and may not be appropriate in circumstances
where the government needs to procure power on an expedited basis.
However, this additional time allows prospective providers to formulate
the best possible bid according to well-specified guidelines, and gives the
government time to assess and compare bids against pre-specified criteria.
18
3. Financing
Structures
3.1. Introduction
3.2. Project Finance Essentials
3.3. Sources of Financing
3.4. Particular Aspects of Project Financing
3.5. Stakeholders
3.6. Summary of Key Points
19
FINANCING STRUCTURES
3.1. Introduction
Principal Financing Models
Four financing structures are primarily used to finance power projects.
They are distinguished by which party or parties bear responsibility for
funding the upfront costs of a project. Each alternative presents its own ad-
vantages and disadvantages related to timing, cost and complexity of struc-
turing and implementation. The four primary structures are host govern-
ment financing, developer financing, resource-based infrastructure
financing, and project financing. There are many variations of these
four structures on transactions, but the core concepts remain similar.
The cost of funding varies based on the source of the funding and the
credit-worthiness of the sovereign. Development Finance Institutions may
provide lower income countries with financing at significantly lower costs,
and possibly at longer tenors, than financing provided by the private mar-
ket. This financing is typically referred to as concessional financing.
20
INTRODUCTION
dinate with multiple funding parties and all of the complicated structures
that such coordination can entail. Procurement is usually governed by na-
tional procurement rules so the parties selected to construct the project will
usually be selected by the offtaker through a transparent and competitive
process.
The diagram that appears below graphically depicts a host government fi-
nancing structure.
21
FINANCING STRUCTURES
Strengths:
• Lower financing costs, particularly if concessional financing is available
or if the host country is able to raise funds by issuing bonds on interna-
tional capital markets
• Fewer coordination challenges
22
INTRODUCTION
Weaknesses:
• Opportunity cost of capital
• Significant cash required from government
Developer Financing
Some large multinational corporations – such as international oil compa-
nies and mining companies – can use the strength of their balance sheets to
fund a project by contributing in the form of equity all of the funds that are
required by the project company to develop the project. These funds may
be derived from retained earnings or may be borrowed by the developer
from banks or raised through the issuance of corporate bonds. Developer
financing could be one component of a public private partnership (PPP)
depending on the project structure.
23
FINANCING STRUCTURES
Strengths:
• Fewer coordination challenges
• No cash required from government
Weaknesses:
• Limited number of developers with appetite for this structure
24
INTRODUCTION
As with developer financing, this model limits the number of funding par-
ties with which a host country has to deal, and avoids the complexity that is
often associated with multi-party financing. This model reduces the com-
plexity of dealing with third-party owners and operators during the life of
the project, presumably speeding up the timeline of the development. It
also presents the added benefit of not tapping into a sovereign’s available
cash reserves or its access to third-party lending, giving the appearance of
avoiding the opportunity cost faced by many governments when contem-
plating sovereign financing.
The primary challenge with this model is how to accurately value the rights
to natural resources that are exchanged for the infrastructure. Volatility of
commodity prices, timing of planned extraction, and financial capacity of
the governments to benefit from the natural resources, make it almost im-
possible to properly assess their value. The rights to natural resources
(often non-renewable) are used to pay the foreign country. Host countries
may not be able to calculate the true costs of the transaction for several
years.
This structure also presents opportunity costs that may not be as readily
apparent as those present in sovereign financing, but that are very real
nonetheless. While not directly impacting the balance sheet of the host
country, this financing structure does require a sovereign to give up poten-
tial future revenues from natural resources that could be used to pay for
other products, services or initiatives for future generations.
25
FINANCING STRUCTURES
Strengths:
• Fewer coordination challenges
• Shorter time frame from concept to operations
• No cash required from government
26
INTRODUCTION
Weaknesses:
• Actual costs to host country not known for several years
• Mortgages natural resources of future generations
• Difficult to monitor and enforce performance and warranty obligations
of contractor
Project Financing
In project finance structures, the sovereign (or a government offtaker)
grants certain concession rights related to the building, ownership, and op-
eration of a project to a special purpose company whose sole business is the
building, ownership, and operation of the project. The project company
will often contract third parties to perform certain of these obligations
(such as construction and operation). The project company is obligated to
finance the project using:
• funds injected by its owners as equity investments or shareholder loans
(funds borrowed from the shareholders that are subordinated to the se-
nior lenders);
• loans provided by lenders such as commercial banks, export credit agen-
cies, development finance institutions, multilateral development banks,
export-import banks; and
• in some cases, funds made available by the sovereign or by donor parties
either as concessionary loans or grants.
Lenders typically lend the majority of the funding required by the project
company on a limited-recourse basis. This means that loans are secured by
all of the assets of the project company (including their contractual rights
under the project agreements) and by a pledge over the shares in the pro-
ject company. In the event that the project company is not able to repay the
loans, the lenders have no recourse against the investors.
27
FINANCING STRUCTURES
28
INTRODUCTION
that the funding sources available to the government may have shorter or
longer tenors (which would impact the timing of the burden on govern-
ment). If there is no alternative source of funding available, project finance
will allow the project to move forward and the government to benefit from
the wider economic benefits of having a power project.
Project finance transactions may incur more up-front costs due to the mul-
tiple parties, financing documents, and legal documents involved as well as
extensive due diligence required. There are costs associated with the multi-
ple arrangers who structure the deal, legal fees associated with the various
project agreements and financing documents, agent fees for the coordina-
tion of payments and the holding of the security, and other related costs.
29
FINANCING STRUCTURES
Strengths:
• No cash required from Government
• Project risk efficiently and equitably allocated to parties willing and able
to bear the risks
• Thorough due diligence and performance guarantees required by pro-
ject company
Weaknesses:
• Complex coordination challenges
• Projects take more time to reach operations
• Higher up-front costs
30
FINANCING STRUCTURES
31
PROJECT FINANCE ESSENTIALS
32
FINANCING STRUCTURES
In a transaction with multiple lenders, the role of the facility agent is to co-
ordinate activities on behalf of the lenders, including requests for disburse-
ment, repayments, monitoring of covenants and general communication
between lenders and borrower.
Finance Documents
Common Terms Agreement
The common terms agreement contains all the financing terms common to
all the different loan facilities, (for example, conditions to funding, finan-
cial covenants, events of default, representations and other undertakings).
The common terms agreement is likely to be a lengthy document with sev-
eral schedules and annexures. It is the key finance document between the
project company and the lenders.
33
PROJECT FINANCE ESSENTIALS
Facility Agreements
The specific terms and conditions applicable to each loan facility (tenor, re-
payment profile, pricing) are set out in loan agreements between the pro-
ject company and the lenders.
Security Documents
Lenders will require security over the project company and all of its assets
as a condition to lending. Security packages depend on the jurisdiction, but
would usually include security over the shares in the company, over both
moveable and immovable assets and overall project agreements and rights.
Common types of security documents include mortgages, pledges, assign-
ments, charges and liens. Depending on the jurisdiction, third parties (such
as government entities and contractors) may need to be notified of, and in
some cases either acknowledge or consent to, the granting of security by
the project company.
Accounts Agreement
Lenders will seek to control the project company's cash flow by stipulating
the order in which payments from project revenue can be made. This is
commonly termed the "payment waterfall". Lenders also require that cer-
tain bank accounts be opened and that funds are moved between accounts
in accordance with this waterfall. This movement of funds is regulated in
the Accounts Agreement.
Intercreditor Agreement
34
FINANCING STRUCTURES
Intercreditor Agreement
Different financial institutions have differing objectives. DFIs may be more
concerned with environmental, social and other policy guidelines. ECAs
may be concerned about matters that affect the spending on equipment or
other costs from their respective country. Commercial lenders may take a
more conservative view on project company defaults. Mezzanine or subor-
dinated lenders may have limited decision-making and/or security rights.
Hedging banks will wish to ensure that in the event of an early termination
of the project, they receive amounts due to them from the project company
out of any sums available to creditors.
Hedging Documents
Lenders often require the project company to hedge risks relating to for-
eign exchange, interest rates and/or commodity price movements.
Direct Agreements
As the lenders are not a party to the key project agreements that the project
company enters into, they do not have contractual relationships with the
counterparties to such agreements. In order to acknowledge the lenders'
rights in terms of the project, lenders require direct agreements between
themselves and the parties to certain project agreements.
35
PROJECT FINANCE ESSENTIALS
36
FINANCING STRUCTURES
Types of Financing
There are various types of financing available to a project company. These
relate to the different tiers of funding structured within a project, which
have differing repayment profiles and rates of return. Different lenders also
have different objectives from a project and this governs both the level of
and pricing of their participation in the financing.
The seniority of the debt (i.e. the priority when it gets repaid as against
other sources of funding) is governed by the cash flow payment waterfall
for the project.
37
SOURCES OF FINANCING
38
FINANCING STRUCTURES
ern Africa (DBSA) in Africa, and the China Development Bank, the Devel-
opment Bank of Japan and the Korea Development Bank in Asia.
Multilaterals
Multilaterals are international institutions with governmental membership
such as the World Bank, International Finance Corporation (IFC), Multi-
lateral Investment Guarantee Agency (MIGA), Inter-American Develop-
ment Bank (IDA), European Bank for Reconstruction and Development
(EBRD), Asian Development Bank (ADB), African Development Bank
(AfDB) and Inter-American Development Bank (IaDB), all of which con-
duct a significant part of their activities in favour of development.
Among multilaterals, the World Bank Group, through MIGA, the Interna-
IFC and AfDB, among others, can provide a variety of credit enhancement
products, including partial credit guarantees for private sector projects and
companies to mobilise private sector financing. In addition, under their B-
Loan programmes, other lenders can benefit from their respective pre-
ferred creditor status as loans syndicated by them receive pro rata and pari
passu treatment through cross-default arrangements.
39
SOURCES OF FINANCING
Commercial banks
Commercial banks are privately owned banks that participate and provide
funding to projects. Typically these institutions are regulated by central
banks and other international banking regulations which impact the level
of liquidity, risk thresholds and pricing.
Where ECAs are involved, exporters are likely to offer more competitive
business terms. ECAs can provide appropriate cover when commercial
lenders are more reluctant to assume political risks.
Syndication
Syndication refers to a situation whereby there is a primary or initial group
of lenders that provides funding for a project and thereafter sells portions
of it to secondary lenders that were not involved in the initial lending
process. Syndications are more prevalent in larger transactions. There
could be various motivations for the sale including increasing headroom
capacity for the initial lender and facilitating investments in the secondary
market.
40
FINANCING STRUCTURES
Sponsor / Developer
The sponsor/developer typically takes a significant stake of equity in the
project and would be required to subscribe for shares in the project com-
pany and meet any required ongoing equity obligations for successful com-
pletion of the project. Sponsors can provide enhancements through two
methods: stand-by equity and corporate/parent guarantees. Stand-by eq-
uity serves as an enhancement to cover cost overruns on a project during
construction. Corporate/parent guarantees are enhancements that allow
the sponsor to utilise the balance sheet of its corporate or parent company
to protect against cost overruns during the construction period. Some-
times, such guarantees may extend beyond the construction completion to
backstop certain operational risks until certain pre-determined financial
criteria are achieved. In addition, lenders may require claw-backs of divi-
dends distributed to sponsors for a certain period during operation.
41
SOURCES OF FINANCING
capital are not as common for larger investments and less relevant for on-
grid power generation deals.
Impact Investors
These are private investors who will accept a lower market return in ex-
change for a social return, such as increased rural electrification rates or
improvements in performance of the SME sector. In certain emerging
markets, impact investors in the power sector may also be referred to as
"angel investors". Examples of impact investors include family or corporate
foundations. The benefit of impact investors is that they invest in projects
where commercial lenders are hesitant to invest and facilitate proof of con-
cept in newer untested structures.
Capital Markets
Domestic and international capital markets are a fourth source of financing
for power project finance transactions. The term "capital markets" broadly
refers to markets in which one can buy and sell securitized debt and equity
instruments. In the context of power financing in Africa, capital markets
include both international and local capital markets. The depth and in-
vestor interest in both markets will vary significantly. While the capital
markets in emerging and frontier markets are still developing, there are
several structured finance and equity products that have been relevant in
financing power in other parts of the world. Those may become more
prevalent on the African continent in the years to come, including project
bonds, public offerings and yield companies. These are discussed further
below.
Project Bonds
A project bond is a debt security that pays investors on a fixed schedule
from the proceeds of the project, being the future cash flows of the project
company. This financing tool has not been widely used in many emerging
markets, but the potential exists for it to be a viable means of financing as
energy markets mature and become more attractive to capital market in-
vestors. Many of them are often institutional investors with a lower risk
42
FINANCING STRUCTURES
appetite. The reasons project bonds are not so prevalent include the rela-
tive inflexibility (in terms of repayment).
Refinancing
As a project matures and becomes less risky, a project company may refi-
nance its debt. Typically, refinancing implies replacing an earlier loan with
a new loan that has more favourable terms, including, for example, an ex-
tension of debt maturity, or tenor extension. The more favourable terms
reflect the reduced level of risk.
43
SOURCES OF FINANCING
companies that have reached COD and are earning revenues. They are not
yet commonly seen in emerging markets, but this can change as markets
mature.
Public Offerings
Finally, an initial public offering (IPO), is the first sale of equity interest, or
stock, by a private company to the public. An IPO offers investors in a pro-
ject company the chance to raise capital for the company from the public.
Market conditions and cycles, as well as a company’s particular financials
and performance, play a large role in the perceived attractiveness and suc-
cess of IPOs.
44
FINANCING STRUCTURES
Refinancing Post-Completion
Financing risks on a project are broadly categorised into pre-completion
and post-completion risks. The pre-completion phase refers to the period
during which the project is being constructed whilst the post-completion
period commences at the point that the plant is fully operational and pro-
ducing cash flow.
Lenders are aware of this and may build in early pre-payment penalties
into their loan agreements to discourage refinancing. On the other hand,
some lenders may be satisfied that they have received adequately priced re-
turns during the riskiest phase of a project and be pleased that capital is
45
PARTICULAR ASPECTS OF PROJECT FINANCE
freed up for investment in other projects. This is particularly true for com-
mercial banks who have a particular focus on re-allocating capital.
Loan agreements may contain built-in incentives for refinancing where in-
terest rates ratchet up after the first few years of operations to entice the
project company to refinance the project and pay lenders out. Equally, the
project company may negotiate downward ratchets of margins at a pre-de-
termined date certain during the operations period, meaning the interest
rates will lower as the project continues to operate. Lenders will want to
ensure that, if they agree to this, their total recovery over the life of the
loan remains at a level commensurate with the risk profile for the given pe-
riod (which may mean higher pricing during the early years of operation).
Tenor Extensions
Certain lenders, particularly commercial banks, may have limits on the
length of time for which they are able to lend. Projects can be structured so
that other finance parties (like Multilaterals or other DFIs) "buy" or guar-
antee the repayment of the existing debt at a point in time (e.g. after the
second year of operations) at a pre-determined price. This effectively
shortens the contractual lending period for the commercial bank, whilst re-
taining some flexibility on further extensions of tenor at the point of refi-
nancing. This refinancing can often be at the project company's request (so
that it can test the market at the time to see if other options are available).
46
FINANCING STRUCTURES
47
PARTICULAR ASPECTS OF PROJECT FINANCE
loans are almost always lower than for local currency loans in emerging
and frontier markets.
At the same time, an offtaker, like a utility, almost always charges an elec-
tricity tariff to local end-users, and thereby earns revenue in local currency.
This results in a currency mismatch, whereby power finance and PPAs in
emerging markets are denominated in a different currency than the rev-
enue stream of the offtaker. This mismatch is significant and strains the
overall risk profile of a power investment in the following ways:
• First, particularly in times of local currency depreciation and volatility,
it reduces an offtaker’s ability to meet its payment obligations to a
power producer (in this instance, the project company) under a reserve
currency-denominated PPA.
• Secondly, if a currency depreciation strains an offtaker’s ability to pay
the project company, it can result in the project company lacking funds
to repay its reserve currency-denominated debt.
48
FINANCING STRUCTURES
Hedging Instruments
Hedging is used by the project company to protect it against movements in
currency exchange rates and interest rates and often, commodity price fluc-
tuations. Whilst hedging instruments can be highly complex, in a project
finance context they are usually kept relatively simple in form. Typically,
the financial institutions providing the hedging instruments are themselves
senior lenders to the project company.
49
PARTICULAR ASPECTS OF PROJECT FINANCE
50
FINANCING STRUCTURES
51
FINANCING STRUCTURES
3.5. Stakeholders
A typical limited recourse project finance structure in an energy project in-
cludes the involvement of several stakeholders as illustrated in the table
below:
52
STAKEHOLDERS
53
FINANCING STRUCTURES
The project company is a new, legally distinct, and ring-fenced entity, es-
tablished specifically for the purpose of owning, constructing, and operat-
ing a project.
54
SUMMARY OF KEY POINTS
Sources of Financing
Projects are typically financed through a combination of debt and equity.
The split between the debt and equity in a project is referred to as the level
of gearing or leverage. If a sovereign is providing a project with credit
support, then it needs to understand the gearing ratio to determine the re-
sulting liability implications.
55
FINANCING STRUCTURES
Capital Markets
Capital markets broadly refers to markets in which one can buy and sell
debt and equity instruments. These markets include both international and
local capital markets. The capital markets for the purchase and sale of debt
and equity interests in power project finance transactions in emerging
markets are still developing and may become more prevalent in the years to
come.
56
SUMMARY OF KEY POINTS
Hedging Instruments
To avoid or mitigate some of the payment risks associated with currency
mismatch, some projects are financed in part in local currency and in part in
reserve currency. In addition, a project company can employ certain hedg-
ing instruments to hedge – or protect – against commodity price, and inter-
est rate fluctuation. Hedging may involve complex financial instruments,
but at its core, provides a way of insuring against certain price movements
that can affect the payment (and re-payment) structure of a deal.
57
4. Risk Assessment,
Pricing and
Allocation
4.1. Introduction
4.2. Risk Assessment and Tools
4.3. Risk Pricing and Allocation
4.4. Managing Political and Payment Risks
4.5. Summary of Key Points
58
RISK ASSESSMENT, PRICING AND ALLOCATION
4.1. Introduction
To evaluate the economics of a power project and in turn, secure financing
for a project, all stakeholders must conduct a detailed upfront assessment of
the project risks. This includes identifying all possible risks, understanding
how those risks are allocated amongst stakeholders, and pricing those risks.
Each stakeholder group will conduct its own assessment of risk, based on
their respective assumptions, objectives and tolerance for risk and reach its
own conclusions relating to the allocation and pricing of that risk.
The decision on whether or not to assume a particular risk may depend on:
• how a party perceives that risk;
• the likelihood of its occurrence;
• the severity of its impact;
• the level of control they have over that particular risk;
• the availability of mitigating instruments for the risk;
• the risk tolerance of each party for a particular risk; and
• the cost of those instruments.
In the case of most IPP power projects, there are two principal risk takers
who must agree on the allocation and pricing of risk: (i) the offtaker, typi-
cally a government owned power utility, and (ii) the sponsors, representing
the project investors. Lenders and other financing providers (such as letter-
of-credit issuing banks and hedge providers) also actively participate in the
risk allocation process, as they effectively become exposed to all of the allo-
cated risks through their financing. Other risks may also be shifted, to
some extent, to insurers and other project participants, though at a cost to
the project.
59
RISK ASSESSMENT, PRICING AND ALLOCATION
These different links in the value chain exist regardless of whether a utility
is bundled or unbundled, the only difference being whether all the func-
tional areas are housed within the same entity or have been split off into
independently-managed corporate entities.
60
RISK ASSESSMENT
61
RISK ASSESSMENT, PRICING AND ALLOCATION
62
RISK ASSESSMENT
63
RISK ASSESSMENT, PRICING AND ALLOCATION
64
RISK ASSESSMENT
The end result of risk assessment and pricing is translated into a cost of de-
livered power to the offtaker, referred to as the tariff on the one hand, and
the ultimate return to the shareholders of the IPP on the other hand, re-
ferred to as the shareholder return or shareholder IRR.
65
RISK ASSESSMENT, PRICING AND ALLOCATION
Even when strictly following this principle, risk allocation must still be
done in an equitable manner. To arrive at an equitable allocation, three ele-
ments must be fulfilled: (i) each party fully understands the risks under-
taken; (ii) the eventual taker of risk is best positioned, willing and/or able
to take on that specific risk; and (iii) each party is confident that it is receiv-
ing economic value proportionate to the risk allocated to it.
Compromising on Risk
There are scenarios where a party that may not necessarily control a risk, is
nonetheless willing to take it for the right economic benefit or simply to
get the deal financed. For example, a government seeking to attract greater
private sector investment may agree to a lower tariff in exchange for as-
suming certain risks outside of its control. For instance, even if the offtaker
has no direct control over the government fuel supply entity, it may agree
to take the risk of fuel supply with a view to attracting investment.
If a sponsor agrees to take such a risk outside of its control, it may seek a
tariff which in turn results into a higher IRR in return. There is, however,
a limit to the extent to which parties can shift risk. Ultimately, the alloca-
tion of risk must still result in a bankable and viable project. The diagram
below highlights some of the more pertinent risks and illustrates the sphere
of risk tolerance for a government on the one hand and a developer on the
other hand. It also illustrates the portion of risk which falls outside of ei-
ther government or developers.
66
The Universe of Risk Tolerance
67
RISK PRICING AND ALLOCATION
RISK ASSESSMENT, PRICING AND ALLOCATION
Force majeure, for example, can be political or natural. Political force ma-
jeure can occur within a country (local political risk events) or emanate
from outside. Political force majeure includes events such as expropriation,
war, widespread riots, terrorist attacks, change in law or the regulatory or
tax regime in a country, foreign exchange restrictions, and arbitrary revo-
cation of permits and approvals. Certain political force majeure events are
largely unforeseeable, such as riots and terrorist attacks, while local politi-
cal risk events may include events within the government's control, such as
expropriation and changes in law/tax. Natural force majeure covers a broad
range of natural events, including weather conditions that could imperil a
project, such as hurricanes, earthquakes, and flooding.
68
RISK PRICING AND ALLOCATION
The developer and equity investors will reflect their evaluation of the cost
of the risk in their projected target profit or internal rate of return (IRR).
The government will form its view of what constitutes an affordable and
acceptable tariff based on its assessment of underlying socio-economic con-
ditions and all other risk factors. Similarly, lenders will calculate the rate at
which they are willing to participate in the lending to take into account
their overall risk assessment, including any risk mitigants that may be im-
plemented, and ensure that they meet their investment return require-
ments. This adjustment of negotiated economic returns by the parties to
69
RISK ASSESSMENT, PRICING AND ALLOCATION
account for the perceived risk of a project is commonly known as the “pric-
ing” of risk. The pricing of risks by stakeholders and lenders is not an inde-
pendent exercise, and parties can often influence each other. For example, a
developer/equity investor may seek a higher tariff to account for the risk-
adjusted interest rate set by the lender.
70
RISK ASSESSMENT, PRICING AND ALLOCATION
Political risks are typically those which the host government is considered
better placed to manage. This management will often embody a wide range
of risks, including:
• Restrictions on the convertibility of local currency into foreign ex-
change and its transfer outside of the host government;
• Expropriation of ownership, control, or rights to an investment;
• Breach of contract by the host government of a contractual obligation
(such as construction of a transmission line);
• Terrorism and acts of violence;
• War, civil disturbances and insurrection;
• Changes in law, including taxation and other adverse legal or regulatory
changes;
• Refusal of government agencies to grant permits and approvals after the
developer has fulfilled all necessary requirements; and
• Action or inaction by the host government or government authorities.
Such risks will often be captured in a PPA through the concept of Political
71
MANAGING POLITICAL AND PAYMENT RISKS
Such risks will often be captured in a PPA through the concept of Political
Force Majeure or Political Risk Events. For additional detail on political
force majeure, please see Section 5.3 (Other Extraordinary Payments
Obligations).
Payment Risk
Although the components of the revenue stream (capacity and energy) are
contractually agreed under the PPA, there still exists the risk that the off-
taker does not meet its ongoing payments to the project company when re-
quired. This is known as payment risk. Non-payment by the offtaker will
impact the ability of the project company to meet its scheduled payment
obligations which include capital costs, fixed operating costs and debt ser-
vice. This risk is magnified when the offtaker is seen as uncreditworthy
and/or financially insolvent.
72
RISK ASSESSMENT, PRICING AND ALLOCATION
73
SUMMARY OF KEY POINTS
74
5. Financial
Obligations
Supported by Credit
Support
5.1. Introduction
5.2. Recurring Payment Obligations under
the PPA
5.3. Other Extraordinary Payment
Obligations
5.4. Termination and Transfer
5.5. Summary of Key Points
75
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
5.1. Introduction
This section examines the principal financial obligations of an offtaker in a
power purchase transaction and the role of credit enhancement in reducing
the risk of non-fulfilment of these obligations. The obligations of an off-
taker in a power purchase agreement with an IPP are, broadly speaking, as
follows:
• recurring payment obligations payable in the ordinary course of busi-
ness;
• extraordinary payment obligations that may arise over the lifecycle of a
project, but which do not arise in the ordinary course of business; and
• payment obligations that may arise upon the termination of a PPA,
prior to the expiration of its term or upon the expropriation of either
the shares in a project company or the plant itself.
In some cases, and as discussed in more detail in this section and in Chapter
6 on Sovereign Support, the host government may become directly respon-
sible for certain of these financial obligations. This may occur through the
execution of an Implementation Agreement, which is a contract between
an IPP and the host government. In contrast, a PPA is an agreement be-
tween the IPP and the offtaker, which may be a government-owned or
controlled entity, but is generally not the host government itself.
76
INTRODUCTION
Where the transaction risks, including the offtaker's payment risk, are as-
sessed at a level where an investor or lender can price a bankable deal with-
out supplemental credit support, then such credit support or guarantee
may not be required.
77
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
Components of a Tariff
The components of tariffs payable for a power generation facility will vary
depending on a number of factors.
78
RECURRING PAYMENT OBLIGATIONS UNDER THE PPA
run-of-river hydro, and wind, because they are reliant on natural condi-
tions and accordingly, may be intermittent. Tariffs for projects using dis-
patchable technologies usually have capacity payments and energy charges;
projects with non-dispatchable technologies usually only provide for the
payment of energy charges.
Capacity Payments
A capacity payment is a monthly charge for capacity made available to the
offtaker (or deemed to have been made available), regardless of whether
the offtaker actually dispatches the plant.
in all cases regardless of whether and to what extent the offtaker actually
dispatches the plant.
79
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
Energy Payments
Energy payments are monthly charges for the energy dispatched by and ac-
tually delivered to the offtaker. It is calculated with reference to the net
electrical output of the plant that is delivered to an agreed delivery point. It
is usually measured in units of MWh or kWh.
For dispatchable plants, energy payments are structured to allow the pro-
ject company to recover the cost of inputs (such as fuel) used to generate
the net output delivered and to recover operations and maintenance costs
that vary depending on the quantity of net output generated.
80
RECURRING PAYMENT OBLIGATIONS UNDER THE PPA
Pass-through Payments
IPPs which have a separate fuel supply contract will themselves often have
a take-or-pay obligation to the fuel supplier. Under a take-or-pay provi-
sion, the purchaser commits to purchase an agreed quantity of fuel over a
given period of time and will be liable to pay for this quantity regardless of
whether or not it actually accepts delivery of the fuel. By the same token,
the supplier may have a put-or-pay obligation to compensate the IPP for
non-delivery of fuel. Similar provisions apply to other feedstock supply
contracts, such as geothermal.
The PPAs for such IPPs will typically include a provision whereby this lia-
bility is passed through to the offtaker/host government where non-delivery
is caused by a risk which is assumed by the offtaker/host government. In
other words, if an offtaker fails to dispatch a plant at a level that will enable
the project company to consume the specified take-or-pay quantity of fuel,
the offtaker (or host government, depending on the risk) will be required
to make a payment to allow the project company to cover the take-or-pay
payment (in part or whole, depending on the PPA provisions) to the fuel
supplier.
81
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
82
OTHER EXTRAORDINARY PAYMENT OBLIGATIONS
The host country is therefore in the best position to mitigate these risks, ei-
ther directly by entering into an agreement with the project company, or
indirectly by allocating them to the offtaker and permitting the offtaker to
pass such risks onto consumers by increasing its rates or including a sur-
charge on electricity builds.
83
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
Changes in Law
Changes in law include the repeal, modification, or reinterpretation of any
law, regulation, decision, code, or consent that is in effect when the PPA is
executed, or the adoption of a new law, regulation, decision, code or con-
sent thereafter, that:
• establishes any requirement for the development, design, construction,
financing, ownership, operation, or maintenance of a plant;
• increases the costs incurred by the project company or its contractors in
connection with the project, or decreases the revenues they may earn in
connection with the project (particularly if the change in law is discrim-
inatory);
• otherwise has a materially adverse effect on the project company or its
contractors or its/their ability to perform their obligations or exercise
its/their rights under the PPA; or
• otherwise affects the interests of the investors, including the returns
they may expect to earn on their investment in the project, in a signifi-
cant or material manner.
Changes in law can influence the economics of a project by, among other
84
OTHER EXTRAORDINARY PAYMENT OBLIGATIONS
Changes in law can influence the economics of a project by, among other
things:
• requiring that the project company incurs a capital expense to modify a
power plant;
• requiring that the project company incurs increased operating expenses;
or
• reducing the revenues the project company may earn.
Changes in Tax
A change in tax is the adoption, repeal, amendment, reinterpretation, or
other change in the laws of the host country that increases the taxes
payable by the project company or by the investors in respect of their in-
vestment in the project.
85
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
Costs associated with political force majeure events are usually allocated to
the offtaker or host government. These risks are allocated to the offtaker
through provisions that:
• provide for the continued payment of capacity or deemed energy pay-
ments during the continuation of a political force majeure event or their
effects; and
• provide for adjustments to the tariff in the event that a political force
majeure event requires the company to incur capital expenses to restore
a plant that has been damaged by a political force majeure event.
In scenarios where the lenders and investors are not comfortable with the
ability of the offtaker to make these payments, they may seek to have the
costs covered by host country credit enhancement.
86
OTHER EXTRAORDINARY PAYMENT OBLIGATIONS
87
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
In the event a project company fails to perform its obligations under a PPA,
and the offtaker exercises its right to early termination of that PPA, the off-
taker/the host country may seek the option to purchase the power plant
and run and operate it itself, or to place the plant with a private third party
whom it believes is well suited to do so.
There are therefore two broad types of rights with respect to the power
plant that are either in favour of the offtaker or project company, depend-
ing on the trigger or cause of the early termination of the PPA:
a. the right of the offtaker (or host country) to purchase the plant or its
shares (sometimes called a "call option" or simply "call"); and
b. the right of the project company to require the offtaker or host country
to purchase the power plant or its shares (sometimes called a "put op-
tion" or "put").
These put or call option rights may be part of the PPA, as post-termination
88
TERMINATION AND TRANSFER
These put or call option rights may be part of the PPA, as post-termination
obligations of the parties to the PPA (the offtaker and the project com-
pany), or they may be set forth in a separate agreement (such as a "put/call
option agreement"). A put/call option agreement may have additional par-
ties to it that are not parties to a PPA, including, for example, the host
country and project investors.
The diagram below depicts some causes or "triggers" that may result in
early termination of a PPA and the potential sale or purchase rights with
respect to the power plant that may follow. While the diagram illustrates
certain of the key project company and offtaker events of default, it should
be noted that not all events of default result in an early termination of a
PPA. Whether there is an early termination of a PPA will depend, in part,
on the relevant provisions of the PPA and/or other agreements between
the parties. The key point remains, however, that the early termination of
a PPA is a risk that can be assessed by the parties and allocated through ne-
gotiated terms such as power plant sale/purchase provisions.
Termination Triggers
89
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
With respect to triggers, an offtaker event of default could be, for example,
a failure to meet recurring payment obligations under the PPA – i.e. the
offtaker fails to pay the project company for power/capacity provided/de-
livered per the agreement. A project company default pre-COD could be
the failure to commence construction by a specified time; a project com-
pany default post-COD could be breaking certain laws, for example, com-
mitting corrupt practices. Certain of the other risks, such as political and
natural force majeure, are described in more detail in Section 5.3 of this
handbook.
The purchase/sale price of the power plant will vary, depending on the
trigger event, including its cause. A wide variety of methods can be used to
calculate purchase prices, but some fundamental building blocks are com-
monly used, such as the amount of outstanding debt, termination costs, and
outstanding shareholder contributions, among others. These building
blocks – and the definitions used below under the column "Typically
agreed Purchase Price" – are described in more detail in the "Default and
Termination" section of the Understanding Power Purchase Agreements
handbook. It should be stressed that the section simply provides examples
of how purchase prices can be calculated. Other methods could be used to
calculate purchase prices. The table below depicts whether a particular trig-
ger may result in put or call option rights on the part of the project com-
pany or offtaker, respectively. The use of the word "maybe" below reflects
the fact that these matters are often subject to discussion and negotiation
between the parties.
The trigger events, the resulting rights, and the consequent purchase price
reflected in the table below are indicative only. The categories of trigger
events listed are not intended to be exhaustive, and the exact rights and
price calculations will always be subject to what is negotiated and agreed
upon by the parties.
90
TERMINATION AND TRANSFER
The diagram below illustrates some of the building blocks commonly used
in calculating a termination payment. Items in the "Additions" column in-
dicate amounts usually added to the termination payment calculation and
items in the "Subtractions" column indicate amounts typically deducted
from the calculation.
91
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
92
FINANCIAL OBLIGATIONS SUPPORTED BY CREDIT SUPPORT
Recurring payment obligations are typically set forth in the tariff structure
and formalised in a PPA. The tariff can include payments for actual and/or
deemed energy capacity, payments for actual and/or energy delivered,
and/or payments that account for certain take-or-pay obligations. The par-
ticular tariff structure adopted will reflect the parties' assessment of risks
associated with the project.
Power project investors may require provisions that allow for payment in
the event of extraordinary events during the lifecycle of a project. The na-
ture and type of such extraordinary payment obligations will depend on the
parties' assessment of risks associated with the corresponding events.
93
6. Sovereign Support
6.1. Introduction
6.2. Sovereign Guarantees
6.3. Letters of Comfort and Letters of
Support
6.4. Put and Call Option Agreements
6.5. Liquidity Letters of Credit
6.6. Liquidity Escrow Accounts
6.7. Debt Sustainability
6.8. Host Government Considerations
6.9. Summary of Key Points
94
SOVEREIGN SUPPORT
6.1. Introduction
Even as host countries create power markets and begin to move toward
private participation (removing elements of the power market from their
balance sheet), their governments are often still relied upon to extend their
support. This support takes many forms, including legislative support, reg-
ulation, licensing, oversight, and ancillary market functions such as trans-
mission and/or fuel supply.
the private investors' perception of the host country risks may not yet
make the project attractive enough at the agreed price.
95
INTRODUCTION
There are a number of reasons that a host country might agree to provide
an IPP with credit enhancement, and a number of instruments through
which a host country might provide this support. This chapter seeks to
identify and describe these reasons and instruments, as well as how a host
country might account for credit enhancement it has provided, and the
challenges a host country might face in providing such support.
96
SOVEREIGN SUPPORT
97
SOVEREIGN GUARANTEES
For the project lenders and the project company requesting a guarantee,
the value of the guarantee must be pragmatically assessed. The value of the
guarantee may be influenced by the credit quality of the host government.
The value may also be constrained by a sovereign debt ceiling. Prudent
project lenders and project companies should, in all circumstances, evaluate
the requirement and practical consideration of obtaining guarantees, espe-
cially in light of alternative risk mitigation products available in the market
which are discussed later in this handbook.
98
SOVEREIGN SUPPORT
99
SOVEREIGN SUPPORT
This support may include facilitating approvals required for project imple-
mentation, general support of its offtaker as well as fiscal incentives. As
compared to a sovereign guarantee, letters of comfort, particularly if
drafted in a manner that they are not legally binding, do not provide the
same level of credit enhancement from an investor or lender perspective.
This is primarily due to the reality that if the host government does not ho-
nour its commitments as specified in a letter of comfort it may, in the
worst case, result in reputational damage to the host country but without
any further legal or financial recourse by the investors against it.
The primary criticism of letters of comfort is that they put the government
in a position where it is expected to backstop the obligations of an offtaker
without enjoying the full reduction in credit risk of the offtaker, and by ex-
tension without granting the full cost savings of a lower cost of capital or
improved probability of project implementation that would otherwise be
afforded by a sovereign guarantee.
In many cases, the reason that letters of comfort or letters of support are
given is that guarantees require (i) parliamentary or constitutional ap-
proval; and (ii) as noted in Section 6.7 below, the granting of guarantees
may impact on debt sustainability levels of the sovereign, which could im-
pact further borrowing from external institutions.
101
SOVEREIGN SUPPORT
The PCOA also defines under which conditions the options can be exer-
cised and defines the formula for how payments under the PCOA are to be
calculated.
The put option held by the project shareholders is subject to certain condi-
tions defined under the PCOA, which would typically include either the
termination of the PPA following certain defined trigger events, or the ex-
propriation of some or all of the project’s assets.
Trigger Events
As noted above, the put and call options under a PCOA are subject to
strictly defined conditions, or “triggers”, that must be satisfied prior to ex-
ercise of the option. This constrained nature of the PCOA is important
since this type of sovereign credit support is, in essence, a “last-resort” op-
tion rather than a guarantee of actions or payments that are in the regular
course of business for a power project. For example, in the case of default
due to non-payment by the offtaker, the project shareholders may be re-
quired to first draw, under a standing letter of credit (which may or may
not be part of a partial risk guarantee arrangement) or from an escrow ac-
count, prior to exercising its put option under the PCOA. Similarly, in the
case of default due to the seller’s failure to maintain the power plant, the
government may be required to allow time for the project shareholders to
correct the operational issue or for a lender to step in and appoint a new
project operator, prior to the government exercising the call option under
the PCOA. Even when it comes to eventually exercising the put or call op-
tion under the PCOA, due to the gravity of the situation (i.e. a permanent
end to the power generation business by the IPP), the agreement may yet
provide for a final consultation period for the parties, with time to remedy
the situation and increase the probability of recovering value for all parties
(i.e. through mutually agreed restructuring of the financing), before either
of these options can be exercised.
103
SOVEREIGN SUPPORT
For additional detail on default triggers and their operation under a PCOA,
please review the chapter titled "Default and Termination" in Understand-
ing Power Purchase Agreements.
104
SOVEREIGN SUPPORT
PCOAs are not designed to address the risk that an offtaker may suffer
from short-term liquidity problems. In this way, PCOAs are different from
sovereign guarantees because a sovereign guarantee is (usually) a guarantee
both of an offtaker’s obligation to pay ongoing payments, such as capacity
payments and energy payments, and also to pay the purchase price for a
plant following the termination of a PPA. As a result, PCOAs are often
combined with credit enhancement tools that are specifically designed to
address short-term liquidity problems. A liquidity letter of credit is one
such mechanism.
If the offtaker fails to make a payment when required under the PPA, then
the project company can directly make a demand on this letter of credit.
This provides a liquidity buffer enabling the project company to remain
solvent with continued operations whilst being able to meet overheads and
service its debt, even if the offtaker fails to pay. The offtaker is usually
obliged to replenish such a letter of credit by paying the issuing bank under
a document called the reimbursement and credit agreement, fairly quickly
after a drawing is made.
105
LIQUIDITY LETTERS OF CREDIT
In exchange for posting and maintaining a liquidity letter of credit, the ini-
tial failure by the offtaker to pay a capacity payment, energy payment, or
similar payment that is secured by a liquidity letter of credit, will typically
not constitute an offtaker event of default. Rather, an offtaker event of de-
fault will occur if the offtaker subsequently fails to replenish the letter of
credit within a certain period of time, or if the offtaker fails to make a re-
quired payment under the PPA after the letter of credit is exhausted.
A liquidity letter of credit may be less expensive (or have less opportunity
cost) versus using a cash escrow account to cover short-term payment risk.
In some cases, by not having the reimbursement obligation covered by a
partial risk guarantee, a payment guarantee or a similar DFI product, as
discussed below in Section 7.2 (DFI Guarantees), the liquidity letter of
credit will be less expensive, less complex, and less document-intensive
than those options.
106
SOVEREIGN SUPPORT
In such cases, the host government may agree to take on the obligation to
replenish the letter of credit, as shown in the diagram above. In other cir-
cumstances, letter of credit issuing banks may only be willing to take the
credit risk of the host government, and the host government may be un-
willing to directly take on the reimbursement obligation, in which case the
parties will likely need to pursue one of the options discussed in Chapter 8
below (Third-party Credit Support and Risk Mitigation).
A final point to note is that sometimes, the offtaker and the project com-
pany may engage in negotiations about the credit rating of the issuing bank
for the letter of credit. To minimise the risk of the issuing bank not hon-
ouring the payment request under a letter of credit, the project company
may seek a bank with a high credit rating, or a lower-rated bank whose let-
107
LIQUIDITY LETTERS OF CREDIT
ter of credit has been confirmed by a higher-rated bank. The parties will
need to agree on what works for each transaction.
108
SOVEREIGN SUPPORT
If the offtaker fails to make a payment when required under the PPA, then
the project company can draw on this escrow account. This provides a
buffer so that the project company can continue to operate and to pay its
debt service, even if the offtaker fails to pay. After any draw on the escrow
account, the offtaker must immediately (or after a specified number of
days) replenish the account.
Cash escrow accounts have the advantage of being clear, simple, and
straightforward. The only third party that needs to be involved is a deposit
bank, so the documentation normally requires minimal transaction costs,
compared to other credit enhancement options.
However, there are a number of reasons why parties may prefer not to use
escrow accounts. Cash escrow accounts are typically only a short-term so-
lution to liquidity/payment risk. Cash is an expensive credit enhancement
option since the cash must be placed in a deposit account that will typically
earn little to no interest; and in any case, the amount escrowed will earn
less interest than the cost of obtaining the capital. Therefore, there is nega-
tive carry on the amounts on deposit. Whether this cost is directly paid by
the project company or the offtaker, it would typically be part of the overall
costs that are passed on to the customer through the tariff.
109
LIQUIDITY ESCROW ACCOUNTS
110
SOVEREIGN SUPPORT
111
DEBT SUSTAINABILITY
The issue with reporting on a cash basis is that this gives the illusion of
positive financial results in the short-term – possibly at the expense of
longer-term financial health and fiscal stability. Accrual accounting allows
governments to demonstrate an increased desire for both transparency and
accountability. It allows better information for decision-making across all
sectors of government. A move to accrual accounting may be part of a
wider financial sector reform programme that looks to improve govern-
ment operations across the board as well as contributing to the long-term
sustainability of public finances, given the ability for governments to antic-
ipate and react more readily to wider risks or threats to the financial health
of a country.
That said, accruals accounting is not the only method to increased trans-
parency. In respect of guarantees and credit support, transparency can also
be strengthened by disclosing supplementary information in budget docu-
ments, fiscal reports and financial statements.
112
SOVEREIGN SUPPORT
113
DEBT SUSTAINABILITY
It is certainly the case that contingent liabilities which are likely to be called
should be provided for in annual budgets as appropriations.
It has been suggested that governments should take into account the
volatility of public financing and the potential impact of large projects on
their overall risk exposure. In some cases, it may be better for a govern-
ment to provide direct budgetary support than a guarantee because of the
value of being able to predict public financing requirements.
A reserve fund may also partly reduce the fiscal risks that can result when
contingent liabilities fall due.
In collaboration with the WBG, the IMF determines the baseline used to
assess debt sustainability and also determine the risk classifications for each
country. The assessment includes various aspects such as:
• calculating current and future debt burden indicators;
• identifying the country-specific factors to be included in the DSA;
• comparing external debt burden indicators with appropriate indicative
debt thresholds; and
• important for the power sector, analysing how domestic debt or contin-
gent liabilities affect a country’s capacity to service future debt.
The main point to note here is that IMF/WBG guidelines, policies and
analysis vary from country to country and over time.
115
DEBT SUSTAINABILITY
The classification of risk distress forms the basis for determining future
grant, loan and guarantee allocation by IDA and by other multilateral cred-
itors such as the African Development Fund. The classification affects both
the amount and the pricing of such loans.
Key to the IMF's analysis will always be to look at the entity to which gov-
ernment owes the obligations (i.e. who is able to call the guarantee). In
most cases, the guarantee will be in favour of an external (foreign) investor
or lender. In some cases, however, monies under a support agreement or
guarantee may technically be owed to a locally-incorporated project com-
pany. A government may therefore quite fairly consider this not as "exter-
nal" debt but rather as debt owed within the country.
116
SOVEREIGN SUPPORT
As part of undertaking a holistic DSA, the relevant teams assess how other
factors such as contingent liabilities can affect a country’s capacity for ser-
vicing future debt service payments. This is viewed at the most general
level as a “fiscal risk”, which may be defined as any potential differences be-
tween actual and expected fiscal outcomes (for example, fiscal balances and
public sector debt).
Until then, while these contingent liabilities may not appear on a balance
sheet or directly restrict government borrowing limits by external lenders,
this should not obscure the fact that a financial undertaking by the govern-
ment remains a valid and enforceable legal obligation with potentially sig-
nificant financial consequences in the future. It is, therefore, prudent for
government departments to continuously monitor and review a govern-
ment's total borrowings.
117
SOVEREIGN SUPPORT
Often the main reason cited for why host government credit enhancement
is required is simply "if you don't give the support, the project will not be
bankable because lenders will not lend." While there may be some truth to
this statement, it does not do justice to the various considerations a host
government must decide upon.
In addition, depending on the risks that the investors to the IPP are seeking
to cover, it may be possible to negotiate for credit enhancement that closely
tracks the concerns of the investors and does not represent a guarantee of
the entire cost of the IPP. However, this will largely depend on the con-
cerns of the investors and in some situations, they may not be satisfied with
anything less than a full guarantee from the host government.
Government Control
The risks that credit enhancement is intended to cover often relate to per-
ceived risks that the sovereign is best able to mitigate, such as certain polit-
ical force majeure events. As such the host government is best positioned
to control and potentially diminish these perceived risks. The payment risk
of the government offtaker will likely diminish as the power market ma-
tures and the offtaker builds up a solid payment track record.
A PPA is usually signed by the offtaker and the project company. The other
government stakeholders are often not directly involved in the decision-
making process but they may significantly influence the process. Ministries
of Energy set the policy and will often advocate for private investment in
the sector in order to assist them in meeting their goals of providing af-
fordable electricity to the citizens of the host country. Investment promo-
tion agencies are established to encourage private investment and facilitate
interactions between investors and government bodies. The regulatory
agency primarily seeks to balance the competing interests of the citizens
(affordable power) and the project company (reasonable return on invest-
ment).
Debt Sustainability
When offering credit enhancements, host governments should consider
the impact this will have on the overall debt sustainability framework. This
is discussed in more detail above in Section 6.7. The impact of these frame-
works is that governments have limited headroom to absorb additional lia-
bilities (contingent or otherwise). The opportunity cost of accepting an ad-
ditional liability should be considered by all stakeholders.
Furthermore, many legal frameworks require that any contract that creates
a liability or contingent liability for the host country will require parlia-
mentary approval. This approval process can be complex and time-con-
suming as most parliaments have a complicated committee system and
meet sparingly. Parliaments must balance the value of any one credit en-
hancement against the competing needs of the citizenry.
124
SOVEREIGN SUPPORT
125
SUMMARY OF KEY POINTS
126
7. Third Party Credit
Support and Risk
Mitigation
7.1. Introduction
7.2. DFI Guarantees
7.3. DFI-Guaranteed LC Structures
7.4. Political Risk Insurance
7.5. A/B Loan Syndication
7.6. Summary of Key Points
127
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
7.1. Introduction
This section focuses on the different credit enhancement and political risk
mitigation products that third parties offer in the context of IPPs. These
products can be used for two separate purposes.
Sponsors and commercial lenders will also often welcome MDB or DFI
participation in a project because of the general "halo effect" that the par-
ticipation in a project by MDBs or other DFIs can have on the bankability
of a project, as a political risk mitigant.
128
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
129
DFI GUARANTEES
serves as a risk mitigant that further enhances the overall credit of a power
project. This enhancement is sometimes referred to as a "halo effect".
Types of Guarantees
The products offered by DFIs to mitigate financial risk and enhance the
credit of a power project are typically grouped into two broad categories,
since they benefit two different stakeholders in the project structure. While
this section describes some of the most common DFI guarantee structures,
it should be understood that DFIs have a wide variety of guarantee prod-
ucts, structures and loan instruments, not all of which are covered in this
handbook.
Loan Guarantee
The first broad type of DFI guarantee is the loan guarantee, which mitigates
the risk of non-payment by the project company to the project's lenders,
commonly referred to as a debt service default, as the result of action or in-
action by the government or the state-owned offtaker. The latter condition
is a critical feature of the loan guarantee, since this ensures that the product
does not act as general coverage of the debt payment obligation of the pro-
ject company to the project lenders. The beneficiary of the loan guarantee
in the IPP context is the project's lenders rather than the project company.
It is important to note that if there is a dispute about the government's
obligations, payment to the beneficiary under the DFI guarantee is made
only after the dispute has been resolved amicably or through the dispute
resolution procedures set out in the project contracts.
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THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
tain DFIs may have a bilateral or treaty-level agreement with the host gov-
ernment, which may also impact the cost of coverage.
Loan Guarantee
Payment Guarantee
The second broad type of DFI guarantee is the payment guarantee. Unlike
the loan guarantee, the payment guarantee is meant to benefit the project
company directly and may cover a number of different payment obliga-
tions. These payment obligations may include, among other things:
• Recurring payments by the offtaker to the project company under a
PPA;
131
DFI GUARANTEES
Payment Guarantee
133
DFI GUARANTEES
All of the finance and project documents are required to be in a form ac-
ceptable to the DFI providing the guarantee.
DFI guarantees are intended to be flexible and can be used for any com-
mercial debt instrument (loans, bonds) provided by any private institution,
including debt provided by sponsors in the form of shareholder loans.
They can also support other payment obligations to private-sector entities,
such as payments to private-sector sellers or suppliers under a PPA. The
duration of the guarantee is also flexible and will normally correspond to
the term of the underlying guaranteed debt investment or obligation.
Allocation Issues
In determining whether to use a DFI guarantee that requires a host gov-
ernment counter-indemnity, the host government must consider how the
guarantee will impact their balance sheet, their overall country strategy,
and their country allocations for financing from the applicable DFI.
Government balance sheet issues are discussed in Section 6.7 (Debt Sus-
tainability).
In the case of MDBs, country allocations are set on a periodic basis, keep-
ing in mind that these institutions must allocate their limited resources
across their eligible countries. While a guarantee typically has a different
impact on a MDB's country allocation than a direct loan, the guarantee still
uses up some of the available country allocation. Whatever the precise im-
pact on the country allocation, this will mean that less resources will be
available for the host government’s other development priorities.
134
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
DFIs generally or often prefer partial (rather than full) coverage for a num-
ber of reasons, including:
• when a DFI provides full guarantee coverage, the commercial lenders
and other parties may not conduct as extensive a due diligence on the
underlying risk;
• partial financing is consistent with a development policy goal of assist-
ing governments or public-sector entities in creating a track record of
creditworthiness as borrowers or payers by retaining some unguaran-
teed payment obligations; and
• partial financing allows the DFI to catalyse more third-party financing
with less of its own funds.
135
DFI GUARANTEES
136
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
A typical structure for a guaranteed SBLC is set out in the diagram below.
137
DFI-GUARANTEED LC STRUCTURES
Guaranteed LC Structure
As illustrated in the diagram above, there are three primary financial com-
mitments under the guaranteed LC structure:
First, if the offtaker fails to make a payment to the project company under
the PPA, the project company may draw from the LC issuing bank under
the guaranteed LC to satisfy the non-payment by the offtaker.
Secondly, if the project company then makes a draw under the guaranteed
LC, the drawing will automatically convert into a loan from the issuing
bank to the offtaker pursuant to a reimbursement and credit agreement
(RCA) between the offtaker and the issuing bank. The general rule is that
138
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
the offtaker then has an extended period (typically 6-12 months) in which
to repay the issuing bank for any such loan, with interest accruing at the
agreed rate during that period.
Third, if the offtaker fails to reimburse the issuing bank under the RCA
when repayment is due, the issuing bank may make a demand for payment
from the DFI under the guarantee. If this occurs, the DFI will make a pay-
ment directly to the issuing bank to satisfy the outstanding payment due
from the offtaker.
All of the finance and project documents are required to be in a form ac-
ceptable to the DFI providing the guarantee.
Tenor of SBLC
The SBLC will generally be required to remain in force for an extended pe-
riod, generally equivalent to the term of the PPA / senior debt. Normally,
the LC structure is such that there is a fixed maximum amount (e.g.
$100m) available under the LC for the full term of its availability (e.g. 15
yrs.), however, SBLCs may sometimes set out lower and/or fluctuating an-
nual sub-limits. This can allow a cost saving for the applicant (where there
was no need for the full $100m in, say, years 1 – 3 of the PPA, or where
sub-limits were appropriate throughout the life of the PPA). However, as a
result of Basel III, the issuing bank will now essentially be required to lock
up capital equivalent to the maximum amount for the entire term of the
LC, irrespective of whether the full maximum amount is capable of being
called in one given year, or not.
One alternative, to save costs for the applicant, would be to have a se-
quence of short-term LCs in line with the relevant exposure under the
PPA, i.e. adjusting the maximum amount each year resulting in a one-year
tenor. This, however, gives rise to a need for annual replacement, and,
therefore, replacement risk on the part of the power producer. Note in par-
ticular, that the guarantee structure does not allow for a drawdown of the
SBLC if the offtaker is making timely payments but there is a replacing gap.
Sponsors have in many cases taken the view that the long-term certainty of
availability outweighed the cost savings and replacement risk, although this
may not be the case in every transaction.
141
DFI-GUARANTEED LC STRUCTURES
erage is also possible on other matters (e.g., loss to the producer arising
from local events of political force majeure, where that is covered by the
government/offtaker in question, e.g. under a separate state guarantee).
The DFI may seek to suspend or terminate its obligations under the guar-
antee. This may be for breach of the project agreement on the part of the
company or offtaker (e.g. sanctionable practices or corruption on the part
of the company, unauthorised change of control, insolvency, unapproved
privatisation, etc.), or the relevant host nation ceasing to be a member in
good standing by the relevant DFI.
The general rule, however, is that the guarantee will continue to apply to
142
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
The general rule, however, is that the guarantee will continue to apply to
advances made prior to the suspension/termination.
143
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
Providers
PRI can be provided by both public and private insurers.
Public insurers include both ECAs and DFIs. These insurers typically have
mandates to support the policy goals of their sponsoring government(s) or
institution(s), such as fostering development or facilitating exports in cer-
tain emerging markets. These mandates may also place restrictions on the
types of investments that are eligible for coverage. Such restrictions may
address environmental issues, the nationality of the investors, eligibility of
the investment, or other issues derived from the insurers' policy objectives.
Private insurers have greater flexibility in the types of projects and breadth
of coverage they can underwrite, but have lower tolerance for risk to pro-
vide coverage in high-risk markets or to underwrite risks which cannot be
reinsured. They also typically have shorter tenors.
What is Covered?
144
POLITICAL RISK INSURANCE
What is Covered?
Traditional PRI policies are insurance contracts that provide protection
against commercial losses that result from asset-backed and trade-related
risks. Asset-backed risk includes confiscation, expropriation, nationalisa-
tion, deprivation, forced divestiture, forced abandonment, arbitral award
default, license/permit cancellation, embargo, war and political violence.
Trade-related risk includes currency inconvertibility, currency transfer re-
strictions, contract frustration and wrongful/unjust withdrawal of a guar-
antee.
PRI coverage can cover project stakeholders (sponsor or lender) against the
project company's failure or loss due to a breach of contractual obligations
if the failure or loss is caused by one of the defined political risk events
under the PRI. PRI can also cover non-honouring and breach of contract of
financial obligations by a host government or state-owned offtaker and as
such can serve as additional credit enhancement for the project.
145
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
PRI providers typically subrogate to the rights of the investors and lenders
covered, and require an assignment of the underlying rights. Depending on
146
POLITICAL RISK INSURANCE
the political risk insurance provider, and the type of coverage being sought,
a counter indemnity with the host government may also be required.
Considerations
Aside from determining the length of time involved and the cost of seeking
PRI cover, there are many other practical considerations when an investor
or lender seeks insurance cover. These include:
• Eligibility: Does the political risk coverage being sought meet the in-
surer’s underwriting guidelines, for example, the geographic location of
project, country risk limits, environmental and social requirements, per-
ception of political and economic instability?
• Ability to recover: An ability to receive payment under a claim can depend
on contract language ambiguities, exclusions and deductions to cover-
age, gaps in coverage, and/or subjective determination of cause and ef-
fect.
• Timeline/process for payment of claims: Payment of claims can be subject
to waiting periods, require an exhaustion of remedies, or resorting to
international arbitration rulings or another dispute resolution proce-
dures specified under the agreements.
• Salvage and subrogation: The clauses require the policyholder to cede
ownership of imperiled assets to the insurer in the event of a total loss
as well as underlying rights to the project agreements. This feature al-
lows insurers to recoup losses to the extent of their ability to salvage
value in the assets or salvage from the host government directly. The
ability to transfer these rights may be complicated by existing security
that has been granted to the other financing parties in the transaction.
The parties may address these issues under a document known as a
Claims Cooperation Agreement.
• Pricing and Syndication: Unlike DFI policies, PRI coverage is market-
priced and may allow for syndication, enabling greater leverage of the
policy.
147
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
148
A/B LOAN SYNDICATION
The fact that the MDB is lender of record will also bring a wider "halo ef-
fect" and help mitigate commercial lenders' concerns with respect to more
general country and political risks. The MDB is not giving a guarantee to
the commercial loan participation, but they will nonetheless take comfort
from the wider developmental relationship that the MDB has with the host
government and the influence that that can bring.
Considerations
There are typically restrictions on eligibility for B-loan participants:
• Financial institutions cannot be incorporated, nor can they have their
head office, in the country where the borrower is incorporated. The B-
loan participant cannot have an office or branch that is resident in the
host country.
• Financial institutions cannot be an official agency such as an ECA or
other governmental, quasi-governmental or multilateral development
bank.
149
THIRD PARTY CREDIT SUPPORT AND RISK MITIGATION
Sponsors and commercial lenders often value the general "halo effect" that
some DFIs bring to a project in addition to any direct credit enhancement.
Governments will need to consider the accounting impact and country al-
location implications of different forms of guarantee product, depending
on the provider and conditions of the product.
150
Appendix
Glossary
Online Resources
Acronyms
151
APPENDIX
Glossary
A/B Loan product – see Section 7.4
Accounts Agreement – agreement setting forth the terms for the flow of
funds through a project company’s accounts. See also Section 3.2.
Assignment – a legal term describing the act of transferring the rights, but
not obligations, of a party under an agreement to another party. The right
of a party to assign its rights under an agreement will be subjected to re-
strictions and limitations set out in the relevant agreement and may require
the prior consent of other parties to the agreement.
152
GLOSSARY
Call Option – the right of the offtaker (or host country) to purchase the
power plant or its shares.
Concession - the right granted by the host government to build and oper-
ate the power plant and sell electricity in the host country for a number of
153
APPENDIX
Contingent Liability - a liability that has not yet materialised but which
may materialise in the future.
Cure Period - the time period during which a defaulting party has a
chance to correct a breach which would otherwise lead to an event of de-
fault.
Deemed Capacity – the capacity that a power plant would have been able
to make available, but for the occurrence of an event or circumstance for
which the offtaker bears the risk.
154
GLOSSARY
155
APPENDIX
Equity – money invested by the sponsors in the project that is not bor-
rowed by the project company. The term "Equity" may sometimes be used
to include shareholder subordinated debt (which is finance made available
to the project company by the sponsors or shareholders of the project com-
pany, which is subordinated to debt made available by the lenders).
156
GLOSSARY
Export Credit Agencies – public agencies and entities that provide gov-
ernment-backed loans, guarantees and insurance to corporations from their
home country that seek to do business overseas in developing markets.
Facility Agent – agent on behalf of any debt facility. See also Section 3.2.
Financial Closing (Financial close) – either (i) the execution of the Fi-
nancing Documents, or (ii) the execution of the Financing Documents and
the satisfaction of all of the conditions for disbursement of the project
loans.
Force Majeure Event – an event beyond the control of the affected party
that prevents it from performing one or more of its obligations under the
relevant contract. Events constituting force majeure are generally further
classified into Political Force Majeure Events and Non-Political Force Ma-
jeure Events, with different financial and contractual consequences to the
contracting parties. Natural Force Majeure falls within the latter category.
157
APPENDIX
158
GLOSSARY
Insolvency - the inability of an entity to pay its debts when or as they be-
come due.
Letter of Comfort – letter from a host government whereby the host gov-
ernment promises to facilitate a project by offering certain assurances to
the project developer. See also Section 6.3.
159
APPENDIX
producer/borrower to repay the loan with interest and to comply with var-
ious covenants set forth in the loan agreement.
160
GLOSSARY
161
APPENDIX
Project Loan – a loan from one or more lenders to the project company,
made for the purpose of financing a power project.
Put Option – the right of the project company to require the offtaker (or
host country) to purchase the power plant or its shares.
162
GLOSSARY
Security Agent – agent on behalf of any debt facility with respect to secu-
rity and collateral matters. See also Section 3.2.
Seller – the entity which is selling power under the PPA. Also referred to
as the Project Company, Power Producer or Generator.
Site (project) – the land upon which the power plant is located.
163
APPENDIX
Step-in Rights – the rights granted to the lenders under a Direct Agree-
ment to step-in and cure a default by the project company, under a project
agreement, before the counterparty to the project company may take any
action to enforce the contract against the counterparty or terminate the
contract.
Term – the period of time during which a contract will remain in force,
unless terminated earlier by either party in accordance with the terms and
conditions of the contract. The term of a PPA is usually expressed to run
until a date falling a fixed number of years after COD.
164
GLOSSARY
165
APPENDIX
Online Resources
The following is a non-exhaustive list of additional online resources:
Debt Sustainability
• Government Finance Statistics Manual 2014 (IMF):
http://goo.gl/iuxirn
• IMF Debt Sustainability Analysis: http://goo.gl/3eCSGz
• Public Sector Debt Statistics Guide (TFFS): http://goo.gl/eDm693
• Quarterly External Debt Statistics (World Bank): http://goo.gl/RhYYp0
• World Bank-IMF Debt Sustainability Framework: http://goo.gl/nsLcEa
166
ONLINE RESOURCES
167
APPENDIX
Guarantees
• African Development Bank: Partial Risk Guarantees:
http://goo.gl/kRVCFl
• World Bank: Guarantees: http://goo.gl/RXm2Tn
Negotiation Support
• African Legal Support Facility: http://goo.gl/hux9Va
• Host Government Negotiation Support Portal:
http://www.negotiationsupport.org
168
ONLINE RESOURCES
Procurement
• African Development Bank Procurement Guidelines:
http://goo.gl/ZegcL9
• EIB Procurement Guidelines: http://goo.gl/GXd0U3
• South Africa's Renewable Energy IPP Procurement Program: Success
Factors and Lessons: http://goo.gl/1YnSGy
• World Bank Procurement Guidelines: http://goo.gl/cT3X47
Project Finance
• Harvard Business School Project Finance Portal: http://goo.gl/HQufjo
• Project Finance Key Concepts (PPPIRC): http://goo.gl/xlTpFN
169
APPENDIX
Syndicated Loans
• B Loan Structure and Benefits (IFC): http://goo.gl/ep4BzO
• Universal Recognition of B Loan Structure (IFC):
http://goo.gl/tFN80U
170
APPENDIX
Acronyms
ADB – African Development Bank
171
ACRONYMS
LC – Letter of Credit
172
APPENDIX
173
Funded By
Developed By