New ways of frontier financing
The complexities of project financing power and infrastructure assets in frontier markets remains highly challenging. Aside from the legal and regulatory framework, which often may need to be created in order to allow foreign investment in infrastructure, three major hurdles exist preventing deals from closing. By Kaushik Ray, partner, Trinity International LLP.
These are: (i) the level of DFI support required to back host country financial obligations; (ii) the ability of a project company to convert and transfer foreign currency; and (iii) liquidity issues with government offtakers. Typical project finance structures increasingly require additional solutions to address these key needs.
This article outlines examples of how multilateral agencies and various public and private sector agencies from OECD countries are applying aid and development monies to addressing these issues, often with new products and solutions.
We primarily focus in this article on grid-connected, large-scale independent power projects (IPPs) developed by the private sector in frontier markets, though the products can be applied across a range of projects. What is key to note is that bilateral or multilateral development finance institutions (DFIs) do not just provide project finance loans – but a host of other products deriving from the need to address certain key areas of risk.
Although payment obligations, ongoing and termination, originally reside with an offtaker, investors in an IPP may require some form of guarantee or credit support to reduce or mitigate the risk of non-fulfilment of these obligations by the offtaker, particularly in order to secure international financing for a deal.
There are a number of types of sovereign support available, including sovereign guarantees, letters of support, implementation agreements and put and call option agreements. In order for a DFI to provide investors with protection in respect of certain key political risks, there must be an enforceable obligation on the part of government to make payments under certain conditions. It is this enforceable obligation that the third-party (bilateral or multilateral) credit support provider is guaranteeing or insuring.
* DFI loan guarantees– The first broad type of DFI guarantee is the loan guarantee, which mitigates the risk of non-payment by an IPP to its lenders, as the result of action or inaction by the government or the offtaker.
An example of a DFI loan guarantee is the European Investment Bank (EIB) political risk carve-out guarantee developed on European projects and used on the Lake Turkana wind farm in Kenya. The EIB political risk carve-out product reduces the cost of commercial bank lending, as political risk is not being taken, crowds in private sector lending and ultimately assists in creating a bankable deal.
*DFI partial risk guarantees(PRGs)– Unlike the loan guarantee, the payment guarantee may benefit the project company directly and may cover a number of different payment obligations. They may also be given directly to project lenders. The payment obligations covered may include payments by the offtaker to the IPP under a power purchase agreement (PPA) as well as early termination payments payable by the government.
The contractual structure of a DFI guarantee is extremely complicated, given the numerous legal obligations that must be established among the host government, the offtaker, the relevant DFI, the covered lenders and the IPP itself.
An example of the PRG is the World Bank PRG for debt mobilisation, usually provided by IDA or IBRD depending on the country. The debt mobilisation PRG is to be distinguished here from the “liquidity” PRG, dealt with below.
The debt mobilisation PRG was successfully used on the Azura IPP in Nigeria. The Azura debt mobilisation PRG backstops certain payment obligations of the Federal Government of Nigeria (FGN) in a termination scenario under the PCOA. The guarantee is issued to ensure that certain, mainly commercial, lenders are repaid in the event of, or in order to mitigate some of the, political risks expressly taken by FGN.
* Political risk insurance (PRI)– PRI is available from many bilateral and multilateral agencies. It offers coverage for political risks that are not covered under PPAs or government support agreements, or otherwise backstops those political risks that are. This type of risk includes war, expropriation or actions to restrict the movement of monies outside of a country. Examples of DFI PRI providers include MIGA, part of the World Bank Group, and African Trade & Insurance Agency (ATI).
An innovative example of a PRI product was used on the 190MW Amandi IPP in Ghana. OPIC implemented a political risk reinsurance policy under which private sector insurers, such as AIG and Talbot, provided commercial PRI to lenders and sponsors, with OPIC reinsuring that cover, up to a certain percentage. This lowers the cost of the PRI and gives the “halo effect” of US government involvement in the project. The product was used for the first time in many years on the Amandi transaction but should be able to be replicated on other transactions going forward.
There exists a gap in the market for multilateral or bilateral agencies to scale up political risk products where DFIs provide lending that is guaranteed by commercial banks – so that the DFIs retain political risk. This achieves development goals by crowding in the private sector as well as ensuring that political risks are placed with the relevant government, over whom the relevant DFI already may have a certain amount of oversight and leverage.
There remain certain key currency issues in IPP financings in frontier markets. IPPs remain typically financed in hard currency, typically euros or US dollars, due to liquidity, stability and long-term availability of those currencies. Many of the underlying materials required for an IPP are usually imported, eg turbines, and are priced in hard currency. The resulting mismatch between revenues – as an offtaker will inevitably charge its customers in local currency – and payment obligations leads to several issues. For example, if the local currency depreciates, it can result in the IPP failing to have funds to repay its hard currency debt.
A host government can undertake in a government support agreement certain guarantees that the project company will be able to exchange its local currency payments into hard currency; have access to some kind of priority of availability of hard currency, albeit this will always be subject to a macro view on a country’s hard currency earnings; and together with its shareholders and lenders, have the right to hold hard currency in offshore accounts and to transfer funds offshore.
If government gives one or more of the above undertakings or guarantees, DFIs are able to provide a host of products such as guarantees and insurance to cover the risk that government fails in meeting or performing these obligations. These include PRG and PRI products, similar to those noted above.
Other DFI providers of products to mitigate currency issues include:
MIGA, which provides standalone (in)convertibility cover for lenders and sponsors alike, guaranteeing the ability of the beneficiary to legally convert local currency into euros, dollars or yen. MIGA also provides a guarantee in respect of the ability of a sponsor or lender to transfer hard currency outside of the host country where the inability to transfer arises as a result of a government action or failure to act.
Private Infrastructure Development Group company GuarantCo, which seeks to bridge the gap between the financial requirements of a particular project or corporate and the financial terms available from the market by providing tenor extensions or local currency guarantees to support direct lending from other financial institutions.
The Currency Exchange Fund (TCX) is a special purpose fund that provides over-the-counter derivative products to hedge the currency and interest rate mismatch that is created in cross-border investments between international investors and local borrowers in frontier and less liquid emerging markets in order to promote local currency financing.
Tenor extensions – eg where a DFI steps in and “buys” the remainder of a locally financed loan at the end of its short tenor – can really assist in improving the attractiveness of local bank financing in a market. A number of DFIs, including AFD, are looking into products that address this solution.
The fundamental issue facing the financing of IPPs in Africa remains the ultimate creditworthiness of the often state-owned offtaker. The issue is complex and depends on a large number of factors, both macro and micro.
There are several ways to address liquidity risk. Short-term liquidity risk may be addressed by simply depositing cash into an account, variously referred to as a liquidity account or an escrow account. Cash escrow accounts have the advantage of being straightforward. However, cash is an expensive credit enhancement option.
Lenders may be concerned with the offtaker’s ability to replenish escrow accounts. This concern could be addressed by backstopping the offtaker’s obligation, either by the host government, eg as part of its sovereign guarantee, or alternatively DFIs can provide a DFI payment guarantee supporting an escrow account arrangement.
Upon a draw on the escrow account by the project company, the offtaker or host government, as applicable, will have an obligation to replenish it. If the escrow account is not replenished, the DFI provider of the payment guarantee backstops the offtaker’s or host government’s obligation and replenishes it. If the DFI provider is a multilateral agency, then the host government typically provides an indemnity in favour of the multilateral agency as the guarantee provider.
* PRG LC– While a DFI guarantee may seem a good solution, there are limitations on the DFI’s ability to make payments under the guarantee instrument without a full resolution of disputes and the passing of a specified period of time, which could take years. Therefore, inserting a standby letter of credit (LC) into the structure is a common way to create liquidity support where the financial position of the offtaker may be limited.
This guaranteed LC structure – sometimes referred to as a PRG LC – allows the beneficiary to draw from the letter of credit as payment defaults occur, rather than seek payment from the DFI for each instance of payment default. The guaranteed LC structure entails the provision of an LC or equivalent instrument by a commercial issuing bank in favour of the project company. The LC is typically put in place by the offtaker to cover the offtaker’s payment obligations under the PPA. This product – in particular that of the World Bank Group’s IDA – is being used on several IPPs in frontier markets, particularly in Africa, and was also used on the Azura IPP in Nigeria.
* Regional Liquidity Support Facility– Trinity, together with KfW and ATI, has designed and is in the process of launching an LC support facility to address the short-term liquidity issues outlined above. The RLSF functions in a similar way to the PRG LC described above in that a pre-selected LC bank will issue a letter of credit to an IPP in respect of a certain number of months of payment obligations of an (approved) offtaker and this LC is backed by cash monies from KfW and a guarantee from ATI.
The difference is that there is no formal counter-indemnity from government or the offtaker. The LC bank takes ATI and KfW risk and the IPP (and its lenders) can rely on 3–6 months’ worth of revenues being available in the form of an LC. RLSF is available for renewable projects of up to 50MW in countries where the offtaker and host government have accepted that ATI can provide coverage. In its first phase, RLSF is made up of just over €15m from KfW with an equivalent amount guaranteed by ATI.
RLSF is launching in an initial phase of just over €30m. To the extent that Phase 1 is successful and eligible projects are found, the product is eminently scalable as an agency-led solution to the liquidity issue.
Other DFI and financing initiatives
There are a large number of other initiatives sponsored by OECD member governments or multilateral entities, eg DANIDA, DfID, NORFUND, EIB, KfW etc. We set out below a couple of examples of recent products provided or supported by bilateral/multilateral agencies, particularly in the renewables sector.
Climate One Fund Managers is launching and managing a series of funds to address difficulties in closing renewable energy transactions. It is jointly owned by FMO and the South African infrastructure investment business, Phoenix InfraWorks.
Its first fund, Climate Investor One (CIO), seeks to simplify the manner in which capital is deployed and reduces the typical project finance complexity by providing a single financing source for each of the development, construction and operational phases of a project’s lifecycle. CIO provides development stage advisory services and financing, equity financing for the construction period and long-term debt once the project is operational.
The WBG is promoting sectoral reform in several countries, including the promotion of collection accounts across the IPP sector to minimise the risk of non-payment to a single IPP.
The African Energy Guarantee Facility (AEGF) is an initiative of the European Investment Bank. It is part of the support that the EIB pledged to the United Nation’s Sustainable Energy for All (SE4All). The EIB works with ATI on the initiative, which provides ATI with access to a large pool of insurance capacity.
The EIB issues guarantees to Munich Re, one of the world’s largest and best-rated reinsurers. Munich Re then reinsures ATI for its SE4All eligible business, ie renewable energy projects. We understand that African Development Bank is working on a similar guarantee product.
Rand Merchant Bank (RMB) together with KfW recently closed the Facility for Investment in Renewable Small Transactions (FIRST), a fund originally structured to enable the funding of small renewable energy projects in South Africa. The programme encourages smaller players and new businesses into the renewable energy market by reducing development costs.
There are several DFI products available outside of simple loans that can be used to promote power and infrastructure development in frontier markets. DFIs and government agencies continue to be at the forefront of this innovation – very often driven by existing and immediate challenges in getting a particular transaction to financial close. With continued innovation, there is great hope for the future of development.