HYDROPOWER FINANCING - EFFECTIVE RISK MANAGEMENT
by CHRIS J. BALL, Vice President, Corpfinance International Limited
Most independent power financial proposals contain one or more elements of a non-recourse nature. Traditionally, this means prospective lenders will not have a substantial corporate credit or state guarantee standing behind a project loan, which forces attention to be focused on a single asset as the security and debt repayment source. While this major risk remains present, if properly understood, uncertainty can be mitigated and managed, including financial and development hazards inherent in hydropower projects.
The specific risk points that a project developer or sponsor must satisfy from the lender’s purposes are numerous. However, they can be grouped primarily into seven key risk areas: project profiles, site securing, power sales agreements, government agreements, in-service management, construction and insurance.
While a developer strives for a minimum internal rate of return of at least 20 percent, the lender’s expectations are much more modest. Often, developers need to place themselves in the proverbial shoes of the other entity, namely the independent lender, whose only attraction may be some interest, fee income and placement of capital in a safe investment, which provides a return in an orderly and uninterrupted manner. Only then is it possible to objectively view and effectively manage the risks mentioned earlier.
Site Profile, Security
Political and cultural risks are present in every project, both domestic and international, and a developer should be aware.
Government Agreements
As was the case with securing the site, lenders will not expend physical energy until the probability of obtaining a strong power purchase agreement (PPA) is demonstrated. In the lender’s eyes, the PPA is the primary ticket for loan repayment. Therefore, a buyer’s quality and terms are critical to receiving a reasonable and economically viable loan.
The buyer has to be worthy of a long-term risk and have a business standard that demonstrates an honourable and reliable payment history. Once this basic hurdle has been passed, the developer can address the more technical points within the agreement that a lender will examine. For example, the term of the contract must be for a period sufficient to reflect a reasonable payback to investors. A lender does not want to be placed on a reducing slope of returns wherein the developer receives back all risk capital and leaves the lender with diminishing debt cover ratios over an extended period. The contract should deal with inflationary factors, which normally appear as a slippery slope or cash flow squeeze that occurs in a project’s mid and later years.
Cancellation of a contract must be dealt with and should be restrictive and well defined in its terms. Force Majeure of a government or the buyer to interfere with power sales should be restrictive. Likewise, interconnection issues and wheeling agreements should be laid out and well defined within the contract. Pricing of these agreements should also be well defined and fixed, so the net sales proceeds are known from the outset. More often than not, monitoring agreements by local jurisdictions in certain incidences will materialize and should be minimized in order to secure cash flow expectations.
The lender will require a legal opinion on the enforceability of the contract and thus in negotiations with the power purchaser, it is prudent to remember a third party will review the contract with a jaundiced view. Remember, in the legal environment of power sales, the contract is a contract and when a problem arises, the lender’s hopes for repayment may rest only with rights and flexibility of the PPA and thereafter only.
In all projects, some government regulations or exemptions are required. It may be the case that with international projects, a form of implication agreement should be entered into to define the role of all parties. The tax effect on revenue will need to be analyzed and opined upon. Foreign exchange issues should be reviewed and net cash flow exposure investigated to ensure the loan is not affected. Expropriation must be reviewed and the scenario calculated so the lender receives its capital back on a make-whole basis.
A project with the typical 20-year PPA will most likely be subject to three or four changes of government during its lifetime. Therefore, it is probable some unpredictable exposure to various government policies must be considered. Properly drafted legal documentation and agreements are one insurance for protecting the lender and developer alike.
Management, Construction
In international projects and some domestic projects, the requirement for local involvement may need to be taken into account and contemplated in the project analysis. The operator’s reliability, strength and ability to meet the project’s requirements will be scrutinized. Effective ongoing programs of preventive maintenance must be established, documented and costed out. Lenders will independently have these issues reviewed and will challenge the level of cash set aside for hydrology, maintenance and debt service reserves. These reserves are seen as a form of safety net, and therefore, more is better from the lender’s standpoint. Through their loan agreement, management will be required to provide detailed statistical reports on a frequent basis. The manager’s ability to provide such reports can be costly in terms of labour. But from the lender’s view, problems that are identified and solved early can, for the most part, prevent later calamity.
For most developers, construction risk would be the first point to consider once it is determined whether or not a project is profitable. However, from the viewpoint of the lender, while this factor invites important deliberation, it does not top the list of overall concerns. The lender is aware that the market is full of very good, reputable and hungry construction contractors, with the same being said for equipment suppliers. The lender is most interested in the way the engineering, procurement and construction or fixed-price contractors will ensure costs be kept in line and construction schedules met as assigned.
Commissioning standards must be established so that the one or more contractors are responsible for plant’s output. The lender’s independent engineer (IE) will be called for a basic overview, undertaking regular inspections during construction and providing commission reports and annual inspections thereafter. The IE thus becomes the lender’s eyes and ears regarding construction issues. Also, the developer must ensure any egotistical differences do not develop between the contractor/design engineer and the lender’s IE. The cost and delays if such an exchange commences can become onerous; the developer must ensure both parties are suitable for one another.
Bonding, Insurance Issues
A strong bond company will be able to issue a sizable bond that can satisfy the many unknown variables a lender may develop. Bonds need to be sufficient to cover all defaults and issued by a firm that has substantial capital footing. The next consideration in the lender’s mind is the pricing received from all candidates and the specific tenders for construction services and equipment.
Concerns can arise if the returned bids fall far apart, and the developer, acting prudently, chases the most reasonably priced bid. If these variations are great, the lender will require that the bonds and other assurances are capable of supporting a change in contractors, even if the most competitive contractor is removed from the site and an agreement is struck with a replacement contractor. If required, this task must be completed without affecting the lender’s advances-to-completion ratio. The matter of holdbacks should be addressed and a portion of each draw held back to ensure the contractor is attentive to the fine details. In most jurisdictions, these are legislated, but wherever possible, a lender wishes enhancement.
Basically, any level of contingencies must be addressed in detail. While a developer may see this as a profit position, a lender’s view of contingencies is that they provide an extra level of comfort. Even with a fully priced turnkey contract, a lender will be looking for a further portion of contingencies just to cover any what-if situations. The basic problem with insurance coverage is that a little knowledge of the subject can be dangerous. For the most part, the lender and developer are inexperienced in this field and even their well-chosen respective legal counsels probably have a lower level of expertise than is imagined. It is advisable to enter an insurance program for all possible perils during and after construction. The various policies should provide necessary coverage to minimize and protect the lender’s advances and the developer’s equity.
The lender will be engaging an insurance consultant who should be truly independent The consultant’s function is to read the offered policies for content and protection levels. Usually, the insurance industry is flexible and policies can be negotiated to cover all reasonable risks. Permitting even subtle improvements to the coverage can be a saviour in a project that suffers a large loss. The lender leans on the contract as a crutch to protect its position and capital and hangs tough regarding quality and quantity of insurance coverage.
Lenders witness the unpleasant experience of projects being brought forward prematurely. Unfortunately, they also see participant hopes raised to the point that the developer believes a lender will participate prior to having all risk aspects covered and the necessary contracts or document drafts in hand. In general, lenders’ representatives are charged with the duty of placing their clients’ capital into private placement markets, and from this standpoint, they pursue deals and foster project interest. However, this initial enthusiasm should not be misinterpreted. Lenders will not close or underwrite the financing without proper documentation. Enthusiasm is best tempered by experience, legal advice and the lenders’ usual “belt-and-suspenders” cautious review.