Sunday, 17 February 2019

The lawyers' view

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The rough and ready first few years of infrastructure financing in Asia have seen their fair share of successes and failures. As any experienced project finance lawyer knows, there are myriad moving parts in any infrastructure project and any one of them could scuttle an otherwise well drawn-out plan. Prakash Krishnan traces the course of best practice adopted from days past to see if anything has really changed.

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The general consensus is that best practice in infrastructure project financing, from a legal perspective, has indeed improved over the years. And with US$20trn–$30trn needed for infrastructure financing over the next 10 years, governments are going to have to change their way of looking at risks and financing. And in turn, this will change the way governments will look at running these bidding processes.

As economies, especially those in emerging markets, scale up the pent-up demand for additional infrastructure always appears to be high. While that looks promising on the outside, “the explosion of demand for power, telecom and other infrastructure has put an enormous strain on small procurement teams”, said Stephen McWilliams of Latham & Watkins. He added that countries that have had less experience in soliciting bids for such projects also display a huge expertise gap, and that in turn affects the hiring budgets that are required to hire technical and legal advisers.

Local government procurement offices are inundated by demand for toll roads, power projects, water treatment plants. The Asian Development Bank (ADB) has recognised this as an issue and is currently in talks about schemes to fund procurement teams in terms of quality, given the huge expertise gap that the market alludes to.

Given the current market conditions it is going to be quite the task to finance infrastructure projects. Moreover, observers said that the commercial bank mindset had changed and that was it no longer easy to get finance in tapping different pools of money.

There are number of reasons for this, some of them being the innate tension between lenders and sponsors and deals coming under immense scrutiny. “It is not always about profit margins, especially for multilateral agencies,” said McWilliams.

Latham & Watkins, for example, has described how the government of Vietnam has engaged the International Finance Corporation (IFC) and its legal firm to put together a scheme for a new IPP programme.

“The initial seed funding [for structuring two recent new IPP initiatives in Vietnam and Bangladesh] was provided by IFC, which provided the solution to the classic ‘chicken and egg’ problem – how do you attract quality infrastructure participants before you have a clear model for developing infrastructure,” said Joe Bevash, managing partner for Japan.

More often than not, multilateral agencies are key to kick-starting any infrastructure project, particularly in emerging markets. It has been suggested that another potential model might be to attract a law firm on a speculative basis to review government requests for proposals (RFPs). However, this could result in complications as there is the possibility that law firms with no real relevant experience or track-record would jump in purely on the basis to build a reputation and/or future business. In such a case, it is likely that they will not devote their full attention to the project and that will inevitably lead to unsatisfactory results.

One of the key takeaways is that any government wishing to embark on infrastructure development would have to have a sufficient budget to attract high-quality participants and to ensure that all the effort made in drafting conditions for an RFP does not go to waste by having unrealistic deadlines.

“There is a tension between reality and fantasy when a host government is trying to attract infrastructure investment. If unrealistic expectations are not addressed early on, you can end up with unrealistic RFPs. Then bidders must practice ‘game theory’ [ie, accept the risk of problematic terms in order to win a concession, then attempt to negotiate modifications/corrections at a later stage],” said Bevash.

What one ends up with if a fully compliant but unrealistic bid gets accepted is a problematic execution, leading to rushing out an RFP at the last minute and bidders picking holes, ultimately leading to embarrassment to all parties. It is clear that there is a great need to engage quality parties and lawyers at the get-go, to ensure proper allocation of risk among participants and the tender terms being well-structured. If one is not able to invest early in the proceedings, the process will be flawed from the start and the project will limp on, making completion highly questionable.

The other risk is that of a badly structured tender hitting a political or economic cycle (or both). If a particular political party backing a project gets removed at some stage, the group of sponsors stand the chance of having to force a starting over. One could argue that political risk insurance should cover such a possible outcome but a badly structured tender will ultimately result in the entire process being restarted.

Over time, there is a natural increase in appreciation for what works and what does not. Observers said that if multilaterals were increasingly playing the role of facilitator, there was every chance that this would help keep markets clear and transparent and eventually for funding to succeed. “It is a happy evolution where everyone basically wants the same thing: quality participants to build quality infrastructure at a reasonable price,” said Bevash.

Some emerging market countries, such as Indonesia and Thailand, have much greater experience in terms of what works and what doesn’t, given the relative success of their independent power projects (IPPs) during the 1990s. Even so, any country runs the risk of a government playing to the lowest common denominator.

Lawyers said that in developing a well-structured process to attract bidders from the US, UK, or Japan, not having had the benefit of doing a technical analysis of the bid could spell trouble further down the road. “There is so much more to it than price,” said McWilliams. He added that in a power project one had to look at quality, reliability and the ability to be able to execute on time. “If you only have the one bidder, there’s no technical analysis or point of reference at all,” he said.

Or if there is even a hint of corruption in the process, one then runs the risk of terms being renegotiated. Again, this varies from one jurisdiction to another in Asia, and ultimately requires political risk insurance of a sort or fashion.

An example of how processes started off tentatively but ultimately evolved to a sophisticated level is Indonesia. The country has had a long history in attracting international players to its successful IPP programme, as they have had in paying sponsors on time. As confidence in the market and processes grew, banks became much more willing to lend to such projects. These schemes are well-run, with electricity tariffs that are price-competitive. And once a project can be done easier, adding to the track record gets easier as well.

Another example of how processes have changed, albeit a recent one, is the way Japan’s domestic power industry has seen a marked shift towards LNG, following the aftermath of the Fukishima earthquake. This, in turn, has led to Japanese utilities eyeing shale gas opportunities in order to secure feedstock.

But even the Japanese government realised that its power industry was in need of a radical reform and has since introduced legislation in 2013 to enable the first stage of power market reform, including how the bidding process is carried out in a bid to replace its old thermal power plants.

As noted by Anne Hung from Baker & McKenzie in a previous report, the government expectation is that the domestic electricity market is to be fully liberalised by 2020, by securing a stable supply of electricity, lowering high electricity rates, and increasing competition between power suppliers/operators

Some of the moves expected would include the monitoring of power generation capacity, with utilities to provide supply, demand and grid plans to ensure there is adequate supply of power, especially in the case of a power crisis. Hung said that the government also saw a need to co-ordinate network access, which is vital for renewable power project developers, and then evaluate which region has a higher demand for electricity and accordingly enable the developer to supply power to said region.

Developers and producers are also to be encouraged to trade on the Japan Electric Power Exchange (JEPX), thus liberalising the retail market. At the heart of adequate power supply to all regions in Japan, the government is to monitor how market competition proceeds in a balanced manner. And an important aspect of that is that transmission grids are stable and able to deliver power as and when required.

Observers said that the bidding process had also changed in Japan after the Fukushima disaster. Pre-disaster environmental impact assessments (EIAs) for new thermal power plants made it virtually impossible for new thermal power plants to be constructed. These days, however, all thermal power plants in the country, old and new, had been in full operation to ensure a stable supply of electricity, Hung observed.

With the revised EIA policy, new thermal power plants will have the chance to be built. In addition, the mandatory public bids provide a more level playing field for smaller power providers to participate, thus opening up various sub-regions for the implementation of these projects.

Naturally, it is also hoped that with the emergence of smaller, more nimble power producers and distributors, market competition will be accelerated and that regional monopolies will be a thing of the past. As Japan geared up to attract international power producers to its potentially huge power markets, lawyers said that it was going to be pivotal to find appropriate structures that had built-in tax and other incentives to make these project bankable.

Other interesting possibilities in Asia include countries such as Thailand, Mongolia, Sri Lanka and Bangladesh. Mongolia, for example, allows would-be power producers to set up using one of two approaches. The government, however, will determine which approach a power producer is to adopt, according to Kate Axup and Debra Counsell of Allens.

The first involves implementation under a concession governed by the Concession Law (where the property is state-owned and the electricity is solely for public use). The second is not dissimilar to a public-private partnership arrangement, where the special purpose vehicle (SPV) develops the project.

According to Allens, however, there are a number of legal issues an SPV may face in terms of land use, for example, in Mongolia, which is restricted to the government. Then there are issues around securing water rights, coal supplies and environmental clearances. These are likely to cause some headaches around the bankability of such projects, along with the World Bank limiting financing of coal-fired power projects in Mongolia.

There is also some complexity around the definitions of transmission and distribution under the licence granted by the government. This essentially disallows the SPV from holding both the supply licence and transmission licence.

An interesting case study could be India. Some years ago, the ADB had identified certain best practices that would benefit the country’s power industry. According to the ADB, the following guidelines are what all parties and the government bodies need to adhere to: get the investment framework right; decide on the goals of restructuring and the ideal industry structure; prepare the players to participate in a competitive market; privatise existing and new assets; and ensure that the competitive market is implemented properly

In implementing these guidelines, the ADB believes that actions that do not achieve or are inconsistent with the primary goal of benefiting the customers should be rejected. The ADB also suggests that the power sector should be completely unbundled into separate entities such as generation, transmission, and distribution to achieve the maximum cost benefit for customers.

Privatisation should include the sale of power distribution utilities, as well as generation, and should include existing assets, as well as new projects, using a transparent process. There should also be open access to transmission and distribution wires, and the ability to trade power between buyers and sellers in an open market, in order for the framework to be truly competitive.

The ADB has suggested partnering with developing member countries to help them achieve the maximum benefit for customers through increased private sector participation. Before determining how to best restructure and encourage private sector participation in the power sector, it is vital that the government analyse the objectives it hopes to achieve.

Among them would be lowering costs of wholesale and retail power prices for customers, increasing the efficiency of the power sector through better management and providing customers with greater choice. A key component of this would have to be improving the foreign investment climate and thereby stimulating the economy. Capital markets would need to be developed further as new techniques and technology were introduced.

This would have to include a rock-solid government commitment to restructure the power sector, along with an aggressive timetable, notwithstanding any changes to government parties. In turn, all relevant government bodies at federal and state level, would need to comply with these guidelines set out by the government and make sure all contractual terms were enforceable within a proper legal framework.

A key component for success would be to allow full foreign ownership of assets in the power industry and not restrict private or foreign ownership to a minority share. Along with that, promoting the growth of local capital markets and futures instruments would allow buyers and sellers to manage their price risks more effectively.

Apart from legislating on the power sector, the government would need to provide for a strict timetable on the privatisation effort as well as setting down the roles, duties and obligations for the regulator. According to the ADB’s findings, Asia requires much more attention on privatising distribution, as this is expected to create a more financially viable entity to which IPPs can sell power, and improve the performance for customers. Establishing a regulatory commission that is separate and independent of the ministry, responsible for tariffs, franchises and performance standards is clearly going to stabilise the framework.

Interestingly enough, it was suggested that India consider utilising a single buyer (either a single utility or the transmission system) with longer-term contracts for initial projects. Once a more viable investment climate and industry structure emerges, the country would be able to implement a power exchange and independent system operator.

As the privatisation process is rolled out, investors should be allowed to optimise the staff required to best meet the competitive challenge and to serve customers. However, principles for employment in the transition to private ownership must be established early on. Restricting the flexibility of a consortium bidding by imposing onerous conditions, such as requiring the use of government suppliers or local firms or the payment of large fees, is going to hamstring the process from the beginning.

The ADB also pointed out that there should not be a pre-determined type or level of financing that the winning bidder should use and that in setting a purchase price of the power generated, the buyer should focus on the credibility of the provider and the competitiveness of the price, and not on the generators’ potential rate of return.

A systematic schedule of the sale of existing power plants would determine which plants will be sold, when they should be sold and what timeframe they are to be sold in. Ideally, government-owned sites with existing power plants should be made available as well.

The ADB clearly sees its role as promoting private sector investment and competition in developing member countries. It seeks to provide models and encourage legislation demonstrating government commitment to restructuring and privatisation.

Moreover, a multilateral agency such as the ADB can provide influence and regional experience to assist in developing a legal framework by inviting international legal experts to advise on drafting laws to address issues central to investment in the power sector.

Any country that has not been able to establish a significant track record in attracting proposals for and/or financing of infrastructure projects is going to find it increasingly difficult to crack this nut. Apart from the development needed for a secure legislative and legal framework, power producers and emerging market governments face an uphill task in moving forward. While political risks are fairly straightforward, the ability to bring ECAs/MLAs together with bankers is a little bit harder.

Ultimately, a lot will depend on the degree of success present projects are implemented. As one lawyer put it: “It’s really a chicken and egg situation to ensure a successful result – from the co-ordination on multiple sides to attracting quality participants.”

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