paper on financing power projects in developing countries what are the needed ingredients required...

7/30/2019 Paper on Financing Power Projects in Developing Countries What Are the Needed Ingredients Required to Make It

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FINANCING POWER PROJECTS IN

DEVELOPING COUNTRIES: WHAT ARETHE NEEDED INGREDIENTS REQUIRED

TO MAKE IT BANKABLE?

2010

Femi AdekoyaLL.B (Lagos), LL.M (CEPMLP, Dundee), ACI.ArbBarrister and Solicitor of the Supreme Court of Nigeria


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TABLE OF CONTENTS

Page

List of Figures.............. i

Abbreviations.............. ii

Dedication.......... iv

Abstract................................ v

Introduction.......... 1

1. POWER SECTOR REFORMS IN DEVELOPING COUNTRIES ............ 41.1 Pre-existing Conditions............ 4

1.2 Power Sector Reforms.................. 6

1.3. Liberalisation........... 9

2. FINANCING POWER PROJECTS IN DEVELOPING COUNTRIES ............ 132.1 Types of Financing Methods.......... 13

2.2 What is Project Finance......... 17

2.3 Parties and their Roles.......... 22

2.4 The Project Finance Structure......... 28

2.5 Sources of Finance......... 30

2.6 Build, Operate and Transfer (BOTs) and Long Term

Contracts................. 33

2.7 Hubco Power Project in Pakistan. ............ 36

3. BANKABILITY ISSUES (PART 1).............. 383.1 Risk Identification, Allocation and Mitigation............. 38


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3.2 The Power Purchase Agreement.............. 44

3.3 Purchasers Credit-worthiness and Government Support

And Guarantees.............. 48

4. BANKABILITY ISSUES (PART 2 )......... 504.1 Project Documentation............. 50

4.1.2 Concession Agreement.............. 50

4.1.3 Consents and Approvals........... 52

4.1.4 Sponsor Contribution and Shareholder Agreements ............ 53

4.1.5 Construction Agreement.............. 54

4.1.6 Operation and Maintenance Agreement........ ............ 55

4.1.7 Fuel Supply Agreement................ 55

4.2 Lenders Security Concern and the Role of Security................ 56

CONCLUSION................... 59

List of Charts

Bibliography


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i

LIST OF FIGURES

Chart 1..20

Chart 2..29


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ii

ABBREVIATIONS

AfDB African Development Bank

BOO Build-Operate-Own

BOT Build-Operate-Transfer

BP British Petroleum

BTO Build-Transfer-Own

CFE Comision Federal de Electricidad (Mexico)

DPC Dahbol Power Company

EBRD European Bank for Reconstruction and Development

EPC Engineering, Procurement and Construction

FM Force Majeure

GE General Electric

HFO Heavy Fuel Oil

Hubco Hub Power Company

IEA International Energy Agency

IMF International Monetary Fund

IBRD International Bank for Reconstruction and Development

IFC International Finance Corporation

IPP Independent Power Project

IsDB Islamic Development Bank

LDC Less Developed Country

MFS Minimum Functional Specification

MW Megawatt

NEPA National Electric Power Authority


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NERC Nigerian Electricity Regulatory Commission

PHCN Power Holding Company of Nigeria

PLN Perusahann Listrik Negara

PPA Power Purchase Agreement

SEB State Electricity Board

SEC State Electricity Company

SPV Special Purpose Vehicle

WAPDA Water and Power Development Authority


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iv

DEDICATION

This is to my family the ADEKOYAS for their unfailing love and faith in me

that has enabled me to reach this far.


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v

ABSTRACT

The importance of the power sector on the overall economic growth of a country cannot be

over-stated, as it serves as a catalyst for the improvement of the various segments of the

economy. This view served as the motivation for developing countries to take on the role of

financer and manager of the entire power sector with little success. The result of which has

been bad management, poor network coverage, irregular power supply, power shortages

and a host of other vices. These attendant problems caused a financial drain on the

developing countries who simply cannot afford to continue financing and managing the

sector. With this in mind, developing countries have had to devise innovative ways of

financing the power sector without draining government funds. Hence, the essence of this

paper which is the financing of power projects in developing countries and the needed

ingredients required to make it bankable.

This paper commences with an insight into the prevailing circumstances of the power

sector of developing countries with particular reference to Nigeria, which will be followed

by looking at the relevant power sector reforms and the role of liberalisation in

encouraging foreign investment. In addition to this, the paper will proceed to examining

the methods of financing power projects in developing countries with a bias for project

finance as the preferred choice. The paper then continues with a thorough assessment of

the issues required to make a power project bankable by looking at various issues such as

risk identification, allocation and mitigation, the power purchase agreement and the

necessary project documentation such as the concession agreement, the fuel supply

agreement, the construction agreement and a host of others. The paper ends with theconclusion that though power projects are country specific, the general issues studied are

peculiar to all developing countries and as such they should be followed to ensure the

bankability and success of the project.


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INTRODUCTION

The power sector is an important aspect of any countrys economic growth and

development. This is particularly evident in the case of developing countries (LDCs) who

need such development to not only catch up with the developed countries like the UK, but

to also develop adequate and modern infrastructure to better the lives of their citizens. It is

a well established fact that the power sector of most LDCs are in a dire state. This has

resulted in economic stagnation and increased poverty across board. The impact of

electricity on a nations overall growth finds expression in these two phrases; a nation

without electricity will be perpetually under-developed; a city without electricity is like a

ghost-city, while a home without electricity looks like a deserted house or a grave and the

electricity system is the blood stream of an industrial society.1

Most LDCs in the past were of the view that the power sector is of national importance and

as such, it should be left in the hands of the government to manage and finance the sector.

This has proved to be not only challenging for the government which is burdened with

other governance issues, but has also led to a complete neglect of the power sector,

resulting in poor management, irregular power supply, power shortages and most

importantly a financial drain on the government purse. To overcome this hurdle, LDCs will

have to invest in building new power plants to increase generating capacity, refurbish the

existing ones and expand the network. This may not seem so easy because the investment

required runs into hundreds of millions of US dollars and in some cases billions. A host of

LDCs are cash strapped and simply cannot afford such investment, which makes it

increasingly difficult for them to adequately manage and finance the sector. With this inmind, most LDCs have introduced some form of reform to attract the needed funds in order

to develop the sector either through foreign or local investment.

1 A.A. Tejuoso, How Can Nigerias Reformed Power Sector be Developed through Project Finance?(UnpublishedLLM Dissertation submitted to the CEPMLP, University of Dundee, 2007).


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As earlier stated, financing power projects is very expensive and as a result, the proper

financing mechanism should be employed to allow the project be funded in the most cost

effective manner, which will be acceptable to all stakeholders involved. This paper seeks to

review the manner in which power projects are financed in LDCs with particular emphasis

being placed on project finance as the preferred choice for financing. This paper also

reviews some of the requirements needed to make such a project bankable.

The paper commences with a review of the power sector of LDCs with particular reference

to Nigeria. In so doing, the paper looks at the pre-existing conditions and the needs of the

sector; the power sector reforms that will promote foreign investment and liberalisation of

the sector (the level and extent). Since liberalisation is essential to promoting foreign

investment for the purpose of financing power projects, the paper looks briefly at features

of a liberalised market such as an adequate power sector reform law, unbundling of the

state utility, provision of third party access, regulatory institutions and the market

structure (most LDCs do not have a mature power market so the paper will be biased

towards the single buyer model).

Chapter 2 looks at the manner of financing power projects in LDCs. It begins with types of

financing methods such as balance sheet finance, asset based finance and finally project

finance, with particular emphasis on project finance. Following this, the paper considers

the parties and their roles, the project finance structure, sources of finance, BOTs and long

term contracts as well as the Hubco power project in Pakistan as a case study.

Chapter 3 analyses the main ingredients necessary for the projects bankability, by looking

at the process of risk identification, allocation and mitigation between all the relevant

stakeholders. This will be done through an examination of the elements of the power


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purchase agreement (PPA), the purchasers credit worthiness and a combination of

government support and guarantees.

Chapter 4 continues the process with an analysis of the relevant project documents such as

the concession agreement, the consents and approvals, the shareholders agreement and

contributions, the construction contract, the fuel supply contract as well as the operation

and maintenance contract. The last part of this chapter will consider the lenders security

concerns and the role of security.

The paper will then conclude as to whether the requirements discussed will indeed

guarantee the bankability of power projects in developing countries.


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1. POWER SECTOR IN DEVELOPING COUNTRIES

1.1 Pre-existing Conditions

The power sector of LDCs is one which is dominated by the state electricity company (SEC),

whereby the state managed the power sector. The SEC is usually vertically integrated,

which means aspects such as generation, transmission, distribution and supply (metering

inclusive) were all under its exclusive control and management. This made the SEC a

monopolist in all rights, as it could act as it saw fit without any form of competition to make

it perform at its best. In some cases, the SEC was also charged with the responsibility of

regulating the sector, which not only made it the alpha and omega of the sector but also

guaranteed its stranglehold on it. Under this kind of circumstances, electricity consumers

had no choice but to employ the services of the SEC whether or not they got the best value

for their money.

The lack of competition and the total control of the power sector by the SEC not only

affected its performance and services but also led to the mismanagement and neglect of the

sector. Since SECs are not always the best managers, one can only say that they have lived

up to that expectation by their abysmal performance. This has led to a series of crises for

the power sector such as irregular power supply, infrastructure decay, power shortage, low

quality service, bad management, high network losses and poor service coverage.2 In most

cases, it has led to serious financial strain on the government, which has no choice but to

keep financing the SEC or risk the entire nation experiencing a black out. As a result of this

power shortage, consumers have had to resort to self-help to avoid living in darkness or

closing up shop (in the case of businesses).

Most consumers have resorted to using generating sets to carry on with their daily lives,

while some have gone as far as using illegal power connections to access electricity. This

has increased the cost of doing business in LDCs as well as the cost of living because

consumers have had to pay the extra cost for diesel, kerosene and other alternate fuels to

2 O.O. Adekoya, Power Sector Reforms: What are the Needed Requirements for Developing Countries?(Unpublished Research Paper submitted to the CEPMLP, University of Dundee, 2009).


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power their various generating sets. This has not only depressed economic growth, it has

also affected the influx of foreign investment into the country. An example of this kind of

scenario was that of the National Electric Power Authority (NEPA) of Nigeria. NEPA

controlled and managed the entire power sector of Nigeria without any form of

competition until recently when the government enacted a power sector reform law. NEPA

was the alpha and omega in the power sector and was responsible for providing power as

well as regulating the sector. NEPAs hapless performance bloomed and blossomed, its

consumers (those without self generating sets) could go days without electricity. As a

result of this, most Nigerians invested in generating sets. This accounted for a staggering

2400MW, thereby making Nigeria one of the highest generator importing countries in the

world, with an estimated cost of $152 million of the $432.2 million spent by all African

countries in 2005 alone.3

The situation is even more pathetic for people living in rural communities. Most of them

are not even connected to the national grid, with the far less prospect of having regular

power supply. This has led to a situation in which most rural communities are using the

more traditional means of power supply in the form of biomass. For instance, in Uganda

biomass constitutes over 90% of total energy consumption in the country. It provides

almost all the energy used to meet basic needs of cooking and water heating in rural and

most urban households, institutions and commercial buildings. Biomass is the main source

of energy for rural industries.4

Conditions and circumstances like those mentioned above only expose the inefficiencies

and mismanagement of the power sector by the SEC. This has helped propel a wave of

power sector reforms across most LDCs, which will help in improving not only the terrible

conditions of the power sector but also better control and management of the SEC through

privatisation and liberalisation. With this in mind, this paper proceeds to highlight some of

the elements of such reforms.

3See Tejuoso, supra note 1.4 The Energy Policy of Uganda, Ministry of Energy and Mineral Development, athttp://www.rea.or.ug/userfiles/EnergyPolicy%5B1%5D.pdf (last visited, January 16, 2010).


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1.2. Power Sector Reforms

In most countries, infrastructure activities such as those in the power sector have been

viewed as strategic activities with natural monopoly characteristics. These monopoly

characteristics result from the existence of economies of scale and scope. Hence, the view

has been that supply is best provided by vertically integrated monopolies owned by the

government.5 Regrettably, the governments of LDCs have not found it easy to do and have

failed in efficiently managing their respective power sectors, which has proved disastrous

for the country. As a result of this, some LDCs have embarked on varying types of power

sector reforms all geared towards improving performance of the sector and most

importantly removing the financial strain from the government.

Electricity sector reforms are multi-dimensional activities with interacting factors and a

variety of impacts. The process generally involves a set of concrete steps or measures

based on a specific model of reform. At one level, these measures involve structural and

organisational changes to the industry, and at another level there is a requirement for

appropriate institutional arrangements such as legislation and new agencies.6 Before

proceeding with power sector reforms, LDCs must consider the dimensions (such as social,

legal, economic and political), the circumstances on ground (such as historical

development, size, technological advancement and the resource mix of the power sector)

and the processes (such as privatization, liberalization and regulation).7 The above

considerations will help in tailoring the reforms to their individual needs and

specifications.

5 Y. Zhang, C. Kirkpatrick, and D. Parker, Electricity Sector Reforms in Developing Countries: An EconometricAssessment of the Effects of Privatisation, Competition and Regulation, at http://www.competition-regulation.org.uk/publications/working_papers/wp31.pdf(Last visited, January 17th, 2010).6 T. Jamasb, R. Mota et al, Electricity Sector Reforms in Developing Countries: A Survey of Empirical Evidence onDeterminants and Performance, at http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2005/03/30/000012009_20050330110431/Rendered/PDF/wps3549.pdf(Last visited, November 17th, 2010).

7See Adekoya, supra note 2.


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There are a host of differing reasons for embarking on power sector reforms but most LDCs

have similar reasons. Some of these are:

Financial Strain: Activities in the power sector cost huge sums of money to embarkon, from refurbishing existing plants to building new ones, cash that LDCs just dont

have. This has caused a serious financial burden on them, which has resulted in the

deterioration of the sector. For example, in India, the combined dues of all the

Indian state electricity power utilities to central power suppliers and fuel suppliers

amounted to about US$5.5 billion equivalent in 2001. To put this magnitude into

perspective, this amount was about half of what all the state governments in India

combined were spending on all levels of education every year. It was double what

they were all spending on health, and three times what they were spending on

water supply. If power sector financial losses were reduced by only one-third, the

savings from a single year would have been sufficient to fill every teacher vacancy in

the country and provide every school with running water and toilet facilities.8

Foreign Investment: Capital investment for new generation capacity is one of thefundamental needs of the power sector of LDCs. According to the IEA, LDCs areprojected to invest nearly $60 billion a year in new generation capacity: $40 billion

in Asia alone, $7 billion in Latin America and more than $5 billion in Africa and the

Middle East. With the exception of a few countries in East Asia, LDCs lack sufficient

domestic capital to support this level of investment on their own.9

Subsidies: As a result of the low standard of living prevalent in most LDCs, theirgovernments have been saddled with the responsibility of subsidising electricity

prices which have added to the financial constraints they face.

Privatisation: This is also an important reason why LDCs carry out power sectorreforms. This involves selling state assets to raise cash which can be channelled to

8 J.E. Beasant-Jones, Reforming Power Markets in Developing Countries: What Have We Learnt?, athttp://siteresources.worldbank.org/INTENERGY/Resources/Energy19.pdf(Last visited, January 17th, 2010).

9 S. Babbar and J. Schuster, Power Project Finance: Experience in Developing Countries, athttp://siteresources.worldbank.org/INTGUARANTEES/Resources/Power_Project_Finance.pdf (Last visited,February 28th, 2010).


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other capital projects in the country. It can involve privatisation of the SEC and

other aspects of the power sector as part of the reforms.

Efficiency: The operating efficiency of the power sectors of LDCs is below standard,suffering from a series of poor coverage, irregular power supply, network losses and

a host of other vices.

Competition: With competition comes effective and efficient management, whichwill be occasioned as a result of the new market players who will give consumers a

choice as to their service provider and in turn improve the overall performance of

the sector.

Effects: The attendant results and demonstration effects of the pioneering reformsof the power sectors in Chile, Norway, England and Wales in the 1980s.10

Pressure: Pressure for reform from international financial organisations and donoragencies such as the IMF and World Bank, through their lending for institutional

reform programmes.11 For example, World Bank the traditional financier of the

power sector in Ghana had made clear its inability and unwillingness to fund power

sector investments (especially in LDCs), unless recipient countries demonstrate

some commitment towards reforming the sector.12

The above reasons ignite the spark in LDCs to carry out the necessary reforms, but in doing

that, they must ensure the proper implementation of the following elements:

Commercialisation and corporatisation of the SEC. Enacting a well rounded electricity reform law. Unbundling the SEC into generation, transmission, distribution, supply and

metering.

Provision of third party access

10See Y. Zhang, C. Kirkpatrick, and D. Parker, supra note 3.

11 See id.12 I. Edjekumhene, M.B. Amadu et al, Power Sector Reform in Ghana: The Untold Story, athttp://pdf.wri.org/ghana.pdf(Last visited, January 18th, 2010).


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Establishing rules for consumer and investor protection. Privatization: Selling parts of the system amenable to competition to multiple

private firms.

Create Regulatory Institutions: Implement regulatory reforms and establish anindependent regulator to oversee market conduct in the competitive industry and

to regulate the monopoly prone parts of the system.13

Create Markets: Allow markets to function for parts of the system amenable tocompetition.14

An example of an LDC which embarked on a reform programme similar to that outlined

above is Chile. The Chilean reform programme which commenced as a result of the 1982

Electricity Act has been hailed as a highly successful example of electricity reform in a LDC

and a model for other privatisations in Latin America and around the world.15 Where all the

above elements have been implemented by the LDCs, an avenue for competition (through

new market participants) to thrive will be created, thus opening up the sector and

increasing the chances for foreign investment.

1.3 Liberalisation

Liberalisation as opposed to being a single event is the process of introducing competition

in the industry. Liberalisation can be done on varying levels and scales between the

different parts of the power sector; but the usual segments which are subject to

competition are the generation and the supply aspects of the sector. This is because of the

monopoly characteristics of the transmission and distribution parts. There are two

categories of countries in a liberalisation programme, which are, those with sufficient

capacity to meet demand and those who have insufficient capacity to meet demand,

13See Adekoya, supra note 1.14 D.G. Victor and T.C. Heller (eds.), The Political Economy of Power Sector Reform: The Experiences of Fivemajor Developing Countries 6 (2007).

15 M. Pollitt, Electricity Reform in Chile: Lessons for Developing Countries, at

http://tisiphone.mit.edu/RePEc/mee/wpaper/2004-016.pdf(Last visited, January 17th, 2010).


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thereby resulting in either full scale or partial black-outs.16 Recognising that they are in the

second category, LDCs have a number of options. They can do nothing and the population

can live with blackouts, which will tend to make the government unpopular and also lead to

various forms of expensive self generation. Second, the LDCs can demand that the SEC

provide additional capacity, which requires investment. If the government has no funds

available for investment, the option that is left is to liberalise the sector in an effort to

attract private capital.17

There are basically three (3) models which LDCs can employ in their liberalisation process;

the first is the single buyer model whereby there is only one purchaser for the power

generated. The second is wholesale competition which allows distribution companies to

purchase electricity directly from generators they choose, transmit this electricity under

open access arrangements over the transmission system to their service area, and deliver it

over their local grids to their customers, which brings competition into the wholesale

supply market but not the retail power market. The third is retail competition which allows

all customers to choose their electricity supplier. This implies full retail competition under

open access for suppliers to the transmission and distribution systems.18

The single buyer model with little or no restructuring has been widely used to attract

private investment into power generation, since it removes most market risk for the

investors.19 Also, an LDC which seeks investment under limited competition in the power

market can unbundle its supply structure and allow limited cross-ownership between

generators and suppliers to help investors manage their risks.20. Most LDCs do not have

16 S. Dow, Downstream Energy Law and Policy Primer, athttps://my.dundee.ac.uk/webapps/portal/frameset.jsp?tab_tab_group_id=_2_1&url=%2Fwebapps%2Fblackboard%2Fexecute%2Flauncher%3Ftype%3DCourse%26id%3D_25518_1%26url%3D (Last visited, January17th, 2010).17 See id.18 R.W. Bacon., and J. Beasant-Jones, Global Electric Power Reform, Privatisation and Liberalisation of theElectric Power Industry in Developing Countries, athttp://rru.worldbank.org/Documents/PapersLinks/567.pdf(Last visited, January 18th, 2010).19See J.E. Beasant-Jones, supra note 6.

20See id.


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advanced power markets due to the dominance of the SEC on the sector; with this in mind,

this paper will focus on the single buyer model as opposed to power pools used in

developed countries such as the UK or US.

This model is frequently used as the precursor to full blown liberalisation. In the single

buyer model, there is usually one buyer (typically the SEC) which handles both the

transmission and distribution of power to the final consumer. Competition in this model

may come about at the bidding process for the construction of the generation plant. The

government will usually set its requirements for a power plant and the potential investors

will make their bids. The government then looks at the company or companies which can

fulfil its requirements at the most affordable costs and awards the building of the power

plants to such companies.21 To guarantee the sale of the power, the SEC enters into a PPA

which may be between 5-20 yrs with the power generator, whereby they agree on the

terms of the sale, which will include price review clauses, technical specifications of the

generated power, take or pay obligations, hours of availability and a host of other issues.

The PPA acts as both the power sales agreement as well as a medium for allocating risks.

Liberalisation can also take place in the supply side of the sector, whereby new entrants

will be allowed to trade power to the final consumers with the provision and guarantee of a

third party access regime that will not only be transparent but avoid the incidence of

market abuse by the network operator. The network operator who is in charge of the

monopoly parts of the system (transmission and distribution) will be paid an access or

transit fee to allow the traded power to flow through its wires to reach the final consumer.

The success of this will be largely dependent on there being an independent regulator who

will endeavour to promote competition, transparency and prevent market abuse by all the

stakeholders. For instance, the independent regulator of Nigerias power sector the

Nigerian Electricity Regulatory Commission (NERC) has as part of its goals and objectives

the following:

21See Adekoya, supra note 1.


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To promote uninterrupted, adequate, safe, reliable and affordable services ingeneration, transmission, distribution and trading of electricity through

appropriate regulations.

To promote private sector participation, an investor friendly market andcompetition.

To monitor industry operators and prevent abuse of market power. To ensure consumer protection. To establish and ensure an effective dispute resolution mechanism to guarantee

consumer protection while also encouraging private sector participation.

To ensure even-handedness, firmness and fairness in the enforcement of rules andregulations.22

For the liberalisation of the supply side to work properly, the power market needs to have

a degree of advancement or maturity, which most LDCs lack and as a result of this; LDCs

start their liberalisation process using the single buyer model and with time introduce

competition in the supply side, either in wholesale or retail competition. With the

introduction of liberalisation to the power sector, fresh capital and foreign investment tend

to find their way to the party, thereby creating new avenues to improve the sector by

bringing in fresh capital to building new power plants, purchase and refurbish the old ones

as well as relieve the LDCs the burden of funding the sector. With this in mind, this paper

continues highlighting the financing of power projects in developing countries,

commencing with the types of financing methods available to investors wishing to embark

on power projects in LDCs.

22 Goals and Objectives, Nigerian Electricity Regulatory Commission, athttp://www.nercng.org/index.php?option=com_content&task=view&id=51&Itemid=46 (Last visited, January19th, 2010).


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2. FINANCING POWER PROJECTS IN DEVELOPING COUNTRIES

2.1. Types of Financing Methods

Financing power projects is a very tedious and expensive process. This requires the use of

appropriate financing methods that are cost effective to all stakeholders. Not all financing

methods can be used for power projects, as some methods will prove to not only be too

expensive but also unable to meet the needs of the relevant stakeholders. There are three

possible methods of financing power projects. These are balance sheet finance, asset based

finance and project finance. This paper attempts to provide a brief explanation of each

method but in so doing greater emphasis is placed on project finance as the preferred

choice.

BALANCE SHEET FINANCE

With this method, a company uses retained earnings or short term debt to finance the

development and construction of the facility. Upon completion, when the project requires

permanent financing, long term debt, equity sales or other corporate finance techniques

are used to obtain the needed funds.23 For the project to be financed, the entire balance

sheet of the company will be studied. That is, the cash flow (profit and loss, revenue and

expenditure) as well as the assets of the company (which may be either tangible or

intangible assets) will be considered by the financial institution for the purpose of lending

it the required funds for building, maintaining and managing the project. The lender then

looks at the company as whole, for the purpose of granting the loan and the consequences

such a project will have on the balance sheet and the financial standing of the company.

The relevant criteria a project must satisfy to qualify for balance sheet financing includewhether the corporation has access to the needed capital at a reasonable cost, whether the

corporation has other capital projects that it has committed itself to both financially and

technically, whether the projects feasibility study projects a return on investment

acceptable to the project sponsors internal investment criteria, whether the project risks

23 S.L. Hoffman, The Law and Business of International Project Finance 7 (3 rd ed. 2008).


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are satisfactory and whether other types of financing methods provide lesser advantages to

the project sponsor.24 Where this criterion is fulfilled, embarking on this type of financing

method for power projects will still depend largely on the investment and corporate

strategy of the company.

It is quite possible that balance sheet financing could be used as a method of financing

power projects since energy companies of today are getting bigger in size and financial

capacity and may be able to embark on some types of power projects depending on the size

and magnitude. Companies such as Exxon Mobil, BP or GE Corporation have both the

technical expertise and financial muscle to take on such projects using its own internally

generated funds. For example, a 100 MW power plant using heavy fuel oil (HFO) can be

financed using this method.

Even though this may be the case, a lot of energy companies will be reluctant to toe this

path, as it will not only drain the company of its needed funds but may also hinder its

financial commitment towards other projects. It may also mean that the company will have

to assume some of the risks, particularly the financial risks associated with such projects,which may be avoided if another financing method is employed. It is also worth mentioning

that most power projects are time consuming, with some of them ranging from 2-5 years

before starting up. Where this is the case, a company may be deterred from using this

financing option, as it will not want to tie needed funds down for so long without it

generating any income during that period. In other words, the company must properly

consider the time value of the money it intends on using for the project and the attendant

consequences it will have on its balance sheet and financial standing. An example of a

power plant which was balance sheet financed is Ave Fenix a merchant power project;

which was constructed as a gas fired power plant in Argentina.25

24See id.25See Babbar and Schuster, supra note 9.


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ASSET BASED FINANCE

With this method of finance, a company raises funds intended for the project using its

assets or assets of the project as security. This could either be a fixed or floating security. A

fixed security is a property interest created by agreement or by operation of law over

assets to secure the performance of an obligation, usually the payment of a debt. It gives the

beneficiary of the security interest certain preferential rights in the disposition of secured

assets. Such rights vary according to the type of security interest, but in most cases, a

holder of the security interest is entitled to seize, and usually sell, the property to discharge

the debt that the security interest secures.26 While a floating security is a form of security

for a debt. Instead of naming a specific property, which can be taken by the creditor if the

debtor defaults (as in a fixed charge like a mortgage), a class of goods or assets is named,

such as the debtor's stock. This allows the debtor to trade in the assets freely, but if the

debtor fails to make repayments then the floating charge becomes a fixed charge (known as

crystallisation) over all the stock at that time. The creditors can then take and sell it to

recover the debt.27

In using asset based finance for power projects, the company must pledge its assets orassets of the power project as security for the repayment of both the loan and the interest

on it. This may be a thorny issue to deal with since assets of a power project are usually less

valuable to both the lender and the company because the cost of developing, constructing

and operating the power project far outweigh its value. Hence, the assets of the power

project may not serve as an adequate means of security for the loan. Since this is the case,

the company will have to advance additional means of security to the lender in form of

other assets in its business, either tangible or intangible. Therefore, using asset based

lending to finance power projects will place the company in a precarious position of

servicing both the loan and the interest on it without an immediate stream of revenue

coming from the project.

26 Security Interest, athttp://en.wikipedia.org/wiki/Fixed_charge (Last visited, January 19th, 2010).27 Financial Contracts Terms and Definitions Glossary, Floating Charge, athttp://www.businessballs.com/businesscontractstermsdefinitionsglossary.htm (Last visited January 19th,2010).


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PROJECT FINANCE

This is the arrangement of financing for long term capital projects, large in scale, long in life

and generally high in risk.28 This means debt supported by the project as opposed to debt

supported by the projects sponsoring companies.29 This type of finance is more like the

beautiful bride to a company wishing to embark on a power project because it caters for

the needs of the project and the company. This is because the company does not have to dip

its hands into its purse; hence, it will not suffer any major financial strain as a result of such

finance. This means it will have enough funds to embark on other projects it chooses.

Under this type of finance, the company will not have to assume all the risks associated

with the project as opposed to asset based and balance sheet finance earlier discussed.

Since this type of finance looks at the project for its repayment, the assets of the project

may not be the cardinal reason for the lender advancing funds to the company. Indeed, in a

project financing, the hard assets probably would not produce sufficient cash in a

foreclosure sale (in the event that there is a default as to the repayment of the loan or the

interest) to justify the value of an asset based loan.30

In project finance, the company may need to advance some part of the total funds requiredwhich will be termed or seen as its equity contribution to the project before the lender can

advance the balance of the funds. The debt ratio is usually very high for most project

financings. This is the case because the debt is supported not just by the projects assets but

also by a variety of contracts and guarantees provided by customers, suppliers and local

governments as well as by the projects owners.31 In some cases, the debt to equity ratio

may be as high as 70:30 respectively. Equity is a small component of project financing for

two reasons:

Firstly, the time scale of the investment often precludes a single investor or even acollection of private investors from being able to fund it;

28 D.K. Eiteman, A.I. Stonehill, et al, Multinational Business Finance 365 (10 th ed. 2004).29 F. Allen, S.C. Myers, et al, Principles of Corporate Finance 685 (9 th ed. 2008).30See S.L. Hoffman, supra note 22.31See F.Allen, S.C. Myers, et al, supra note 27.


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Secondly, many of these projects involve subjects that are usually funded bygovernments such as electric power generation, energy production and

development.32

This means that some of the risks associated with financing the project will be passed onto

the lender to bear; hence, the need for risk mitigation mechanisms. Having given a brief

insight into project finance, the paper will now proceed to provide an in-depth analysis of

what project finance is.

2.2. What is Project Finance?

Project financing is not a new financing technique. Venture-by-venture financing of finite

life projects has a long history; it was infact, the rule in commerce until the 17th century.33

An example of a type of project financing mechanism was that used for funding the Suez

Canal. It was not until some 60 years ago that project finance was used to fund

development of oil fields in the US. Some Texan and Oklahoman explorers lacked the

capital and the credit rating to get the needed funds to finance their oil fields. The lenders

developed a form of production payment scheme, in which they relied on the specific

reserves and the direct proceeds of oil sales earmarked for the loans repayment as opposed

to the companys balance sheet for security.34 Project finance in its proper sense did not

start until the exploration and development of the North Sea oil fields in the 70s and 80s

which ushered in the establishment of Special Purpose Vehicles (SPV) to handle the

individual aspects of the main project, ranging from its funding to the management of the

project.

Project finance is usually used to finance big infrastructural projects, notorious of which

are power projects, oil and gas field development, road projects and a host of others. This

method of finance has been used as an avenue for countries particularly LDCs to fund the

32See D.K.Eiteman, A.I. Stonehill et al, supra note 26.33 J.D. Finnerty, Project Financing: Asset Based Financial Engineering 4 (1996).34 A. Buckley, Multinational Finance 587 (5th ed. 2004).


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development of new power plants in order to ease the financial burden the government

will have to face.

Project finance can be described as follows:

A non-recourse or limited recourse financing structure in which debt, equity and credit

enhancement are combined for the construction and operation, or the refinancing of a

particular facility in a capital intensive industry, in which lenders base credit appraisals on

the projected revenues from the operation of the facility, rather than general assets or the

credit sponsor of the facility and rely on the assets of the facility, including any revenue

producing contracts and other cash flow generated by the facility, as collateral for the

debt.35

The US Financial Standard FAS 47 defines project finance as follows:

The financing of major capital projects in which the lender looks principally to the cash

flows and earnings of the project as the source of funds for repayment and to the assets ofthe project as collateral for the loan. The general credit of the project is usually not

significant factor, either the entity is a corporation without other assets or because the

financing is without direct recourse to the owners of the entity.36

Another definition worth mentioning is that of Peter Nevitt and Frank Fabozzi in their book

Project Financing which defines it as:

35See S.L. Hoffman, supra note 22.

36 Swiss RE, Project Finance: The Added Value of Insurance, at http://borja.amor.googlepages.com/4-ProjectFinance.pdf(Last visited, January 19th, 2010).


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A financing of a particular economic unit in which a lender is satisfied to look initially to

the cash flows and earnings of that economic unit as the source of funds from which a loan

will be repaid and to the assets of the economic unit as collateral for the loan.37

In other words project finance is a form of finance which concentrates on the cash flow of

the project and has no recourse or in some cases limited recourse to the sponsor of the

project. This means the financing of the project is off the balance sheet of the sponsor. The

assets of the project are usually not up to the value of the loan. Hence, the reason why

project finance is an expensive means of finance and is considered as a high risk/high

reward method of finance, even though the risk may be reduced by careful restructuring. 38

Project finance involves several parties and as a result of this, there is a complex web of

contracts between the different parties all having different stakes and interest in the

success of the project.

The two main elements of project finance are the project or economic unit and the revenue

or cash flow; other issues such as sponsor guarantees and risk mitigation though important

are ancillary matters. This is because both the economic unit and the cash flow form thebasis on which the entire concept of project finance was developed. There are some key

features which distinguishes project finance from other financing methods. Some of the

features are:

The establishment of a separate vehicle for the project. The revenue or the cash flow of the project forms the basis of advancing the funds

by the lender.

The lions share of the funds is provided for by the lenders. This may typically beanywhere from 60-80% of the total funds required for the project, while the

sponsors provide an equity of about 20-40%.

37 P.K. Nevitt and F.J. Fabozzi, Project Financing 1 (7th ed. 2000).38See Buckley, supra note 32, at 588.


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Since the project vehicle is separate from its owners and is a distinct vehicle, thefunds advanced to it by the lenders are usually separate from its owners. Hence, the

reason why it is referred to as limited recourse or non-recourse finance.

Even though project finance is referred to as non-recourse finance, the owners ofthe project vehicle still offer the lenders some form of guarantees for the project as a

result of the credit standing of the project vehicle.

The project involves a lot of contracts between several parties. Project finance is usually for large and time consuming projects.

Source: Swiss RE. Project Finance: The Added Value of Insurance, at http://borja.amor.googlepages.com/4-

ProjectFinance.pdf(Last visited, January, 20th, 2010).


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Project finance has some advantages which are peculiar to it alone and it is for this reason

that project finance seems attractive for large projects. Some of the advantages are:

Increase in the availability of finance or funds for large projects. A reduction in the overall risk for major participants, bringing it down to an

acceptable level.39

Increase in private investment for LDCs. Off-balance sheet treatment of the debt financing.40 Non-recourse or limited recourse to the sponsors of the project.

For lenders to consider financing or advancing funds to a project using project finance, they

will require the following from the project:

Economic viability of the project: Since the basis for advancing funds to the projectis the expected cash flow and revenue, the lenders will ensure that the project is

capable of being managed and operated profitably. The economic viability must

show that on the basis of cash flow projections, sufficient cash will be generated by

the project to pay for all operating expenses, debt service, taxes, royalties and other

costs; while leaving a surplus for the SPV to meet its target for return on equity.41

Therefore, there must be a clear, long term need for the projects output and the

project must be able to deliver its products or services to the market place

profitably.42

Technical viability of the project: Before advancing the funds to the project thelenders will ensure or carry out a technical feasibility study to verify that theproject can infact meet up to its technical specification and performance. Lenders

can do this by employing the services of independent experts who are

knowledgeable in the field of the project. For instance, lenders to a power plant

39 IFC, Project Finance in Developing Countries 7 (1999).40See Hoffman, supra note 22 at 8.41 C. Chance, Project Finance, 5 (1991).42See Finnerty, supra note 31 at 7.


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project will ensure that the plant will perform up to the standard as set in the

construction agreement.

Proper operation, maintenance and adequate raw materials: This is another keyissue for lenders because they will need to satisfy themselves that there is not only

sufficient raw material to keep the project going but there is also a capable

operation and maintenance team in place to sustain the project and ensure its

continued performance and success.

An example of project financing for a power project is Jorf Lasfar Power in Morocco, worth

$1.3 billion. This was the countrys first privately financed power project and North Africas

biggest IPP with limited recourse financing to date.43 Having made a critical assessment of

project finance, this paper will proceed to examine the relevant parties and the roles they

play in the project.

2.3. Parties and their RolesIt has been established that project finance is a complicated financing method which is

usually used for large infrastructure projects. As a result of this, it will involve several

actors or parties who play different roles to bring about the success of the project. These

roles are usually dependent on the varying interests each of the parties have in the project.

All the parties usually need to work together to implement the project successfully. The

parties involved in project finance range from the project sponsors to the lenders. As

earlier stated, there are several parties to the project but the following have been identified

as the main parties:

The project company which is usually an SPV The sponsors The lenders The host government

43See IFC, supra note 37 at 17.


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The contractor The offtaker in this case this will be the power purchaser. In the single buyer model

earlier discussed the offtaker will be the SEC.

The fuel supplier The operator

Having identified the key players in project finance, an analysis of the roles each party

plays will now be considered.

THE SPV

This is a very important party to the project. The SPV is charged with the responsibility of

implementing the mandate of the project. The SPV is created by the project sponsor for the

sole purpose of executing the project. The SPV is usually a separate and distinct entity from

the sponsors. With this in mind, the sponsors are able to finance the project off their

balance sheet with non-recourse or limited recourse to them by the lenders to the project.

As a result of the SPV being separate from the sponsors, it usually signs the relevant

agreements with different parties to the project on behalf of the project. Since it is the party

used to secure the financing of the project, it is also the same party the lenders look to for

the repayment of the not only the loan but also the interests accruable. For instance, the

Hub Power Company (Hubco) was created as the SPV for developing a large oil-fired power

plant in Pakistan. It entered into agreements with the major stakeholders including the

lenders.44

The SPV can be created in different forms, some of which are identified as follows:

Unincorporated joint venture; General partnership; Limited partnership and the most widely used

44 R. Brealey, S. Myers and F. Allen, Corporate Finance 688 (8 th ed. 2006).


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Incorporated company45

Before embarking on creating an SPV, the sponsors should consider the following:

Legal status of the SPV: The legal status of the SPV is important and should be wellconsidered by the sponsors. This is because it is the legal status of the SPV that will

determine the degree of coverage the sponsors have from the risks associated with

the project as well as whether the loan will be off balance sheet financing for the

sponsors. The legal status will also determine whether the loan will be non-recourse

or limited recourse to the sponsors. All of the above are as a result of the concept of

limited liability.

Tax considerations Repatriation of funds Operation and management of the SPV Procedure for creating and terminating the SPV Laws of the jurisdiction in which the SPV is to operate.

As a result of the above considerations, most project sponsors use an incorporated

company as the favoured choice for their SPV.

THE SPONSOR

This is the main party behind the project. They are the investors of the project who are

responsible for setting up the SPV. They usually put up part of the funds for the project in

the form of equity. They are the shareholders of the company and can be made up of one

company or a consortium of interested parties, such as contractors, suppliers, purchasers

or users of the projects products or facilities.46 The sponsor usually gives support to the

SPV in the form of completion guarantees and other sponsor commitments as requested by

the lenders. As with most business organizations, the main goal of the sponsor is to make

45 G.D. Vinter, Project Finance, (2nd ed. 1998).46See Chance, supra note 39 at 9.


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profit from the project which he does by using the SPV. In the case of the Mangalore power

project in India, Cogentrix a US company was the sponsor behind the Mangalore Power

Company.47

In some cases, profits even though important may not be the sole motivating factor for the

sponsor to embark on the project. Some other reasons for the sponsor embarking on the

project are:

Risk allocation and mitigation between itself and other parties to the project Obtaining large financing for the project which will be off their balance sheet with

little or no recourse to them.

The project may be part of the sponsors corporate strategy. For example, breakinginto the power market of LDCs.

THE LENDER

This is the party that makes available the bulk of the funds needed to carry out the project.

The lender can be an individual financial institution or a consortium of varying financialinstitutions with different capacities and financial strength. In financing large

infrastructure projects such as power plants, there will usually be a consortium of financial

institutions of international repute coming from different countries which may include

those from the host country. The essence of doing this is to promote diversity and prevent

the host government from nationalising the project or any of its assets. This is also done to

finance a project in a country which has restrictions of foreign companies taking security.

Where there is a group of lenders; it will be called a syndicate, while the lead bank that

arranges this type of cooperation is called the Arranging Bank.48 An example of an

international financial institution which may be a lender is the International Finance

47 D. Bath, India Power Projects: Regulation, Policy and Finance 413 (Vol 1. 1998). 48See Hoffman, supra note 22 at 72.


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Corporation which supported the first IPP in Africa; the Ciprel Power Project in Cote

dIvorie. The IFC provided a $14m loan for its own account and invested $1m in equity.49

THE HOST GOVERNMENT

The host government is the party that kick starts the whole process for the entire project.

This is as a result of granting the concession license or awarding the contract to the SPV.

Since the host government has multiple agencies, it may award the license or contract

through any of its agencies or directly by itself. The host government is also responsible for

ensuring the necessary permits and approvals will be granted to the SPV and to generally

create an investor friendly atmosphere for the SPV to thrive. The host government can also

put in place policies that will favour the SPV such as tax reliefs or subsidies. In most cases,

the host government will have to act as a support mechanism for the offtaker in the event

of its inability to pay. This will be done by giving the necessary guarantees and assurances

that it will come to the offtakers rescue and honour other risks it has agreed to help

mitigate such as foreign exchange risk or change in law risk. In the event that the project is

financed using a BOT scheme, the ownership of such a project will be transferred to the

host government at the expiration of the concession. An example of a host government isKarnataka government in Southern India for the Mangalore power project in India.50

THE CONTRACTOR

This is the party responsible for building the project. The contractor makes sure the project

is working at optimum performance by building it according to specification and technical

requirements. For example, if a company contracts Rolls Royce Engineering to build a 200

MW power plant, Rolls Royce as the contractor will make sure the plant meets the required

specification. In most cases, the contractor will build the plant under an Engineering,

Procurement and Construction (EPC) contract also known as a turnkey contract. The

contractor may also be retained to act as the manager/operator of the plant; this will be

advantageous to the project since it was built by the contractor. The majority of the

49See IFC, supra note 37 at 16.50See Bath, supra note 47 at 412.


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activities of the contractor are governed by the construction agreement. An example of a

contractor(s) is Bechtel Power Corporation and General Electric which constructed the

facilities and supplied equipment respectively for the Dahbol power project in India.51

THE OFFTAKER

This is the party who undertakes to buy the product or services of the project. In the case of

a power project (using the single buyer model), the entity will usually be the SEC. This will

be done by entering into a PPA with the SPV spelling out the obligations of the SEC. The

offtaker is a vital party to the project as its credit worthiness and ability to buy the product

or services of the project will greatly affect the financing or bankability of the project. For

example, in the Tangshan power project in China, the projects offtaker is North China

Power Grid (NCPG).52

THE FUEL SUPPLIER

This is the party responsible for supplying the material that will be used to power the

project. In this case, it will be the party responsible for supplying the fuel to the power

plant. Since power plants run on different types of fuels such as coal, gas or HFO the fuelsupplier will be mandated to supply the correct fuel to the plant while also ensuring that

the fuel supplied is the specified one with regards to quantity, quality and price. The price

of the fuel is also very important as it makes up part of the cost of running a power plant

which will be considered by the lenders. In other words, the fuel supplier must be able to

supply fuel to the plant. The quantity, quality and price specification of the fuel will be

found in the fuel supply contract. For instance, in the Jegurupadu power project in India

where there were three turbines (two running on gas and the third on naphta). The fuel

supplier for the turbine running on naphta was Bharat Petroleum Corporation Ltd

(BPCL).53

51See id.52See Babbar and Schuster, supra note 9.53Seeid.


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THE OPERATOR

This is the party responsible for the running, operation and maintenance of the project. The

operator can be any of the parties to the project ranging from the SPV itself, the sponsors,

the contractor or even an independent third party not associated with the project. The

main rights and obligations of the operator are spelt out in the operation and maintenance

contract. In the Samalayuca power project, the Mexican utility CFE is the plant operator and

is obliged to make lease payments regardless of plant performance.54

Now that the parties to the project and their roles have been studied, this paper will move

on to consider the intricacies surrounding the project finance structure.

2.4. The Project Finance StructureFinancing power projects is a herculean task which involves several parties with varying

interests, roles, rights and obligations. As a result of this, there is a myriad of complex

contracts and transactions which inter-connect and link all the relevant parties together to

bring about the proper implementation of the project. There needs to be a proper

harmonisation of these relationships between the parties in order to achieve success for

not only the financing but for the entire project. Each contract spells out the rights and

obligations each party has in the entire project and its financing. Some of such contracts are

the operation and maintenance contract, the construction contract, the concession or

awarding contract, the PPA, the shareholders agreements, the fuel supply contract and a

host of other ancillary contracts.

Project financing starts with the awarding contract or the concession which is granted tothe SPV by the host government. It is the awarding contract that sets the ball in motion

bringing about the other contracts. The structure for the project financing of a power plant

will look something like the diagram below:

54Seeid.


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Chart 2: Typical structure for an Independent Power Project

Source: V. Smith, Project Finance Review, at

https://my.dundee.ac.uk/@@/92D51D8D596F02F11DA6E5A97BA137A1/courses/1/CP52007_CAS_D65_20

0809/content/_1794218_1/PF%20review%20notes%20CEPMLP%2025.1.07.pdf (Last visited January 22nd

,2010).

The above diagram shows the links and connections between the parties. These links are

all in place with the aid of the relevant contracts. For example, the link between the

sponsor and the SPV in the above diagram is the shareholders agreement and the equity

subscription. This not only shows the relationship between the sponsor and the SPV but

also shows its role in the series of contracts and the project as a whole. Where all the

contracts are properly executed, the chances of the project succeeding will be high.


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2.5. Sources of FinanceThere is a wide range of funding sources available to a project. An SPV may be capable of

obtaining funding opportunities outside of its domestic financial market or the financial

market of the host country.55If the domestic financial market is mature enough to handle

big ticket transactions it may not need to go hunting for funds in the international market.

Where the opposite is the case, it will have no choice but to look outside. The sources of

finance will largely depend on the roles, interests, rights, obligations and objectives of the

different parties involved in the project. For example, the sponsors though interested in the

success of the project will be reluctant and unable to put up the entire amount needed for

the project. The two main sources of finance for the project are equity and debt. These

sources of finance can be provided for by a host of entities some of which are:

The sponsors of the project who will be the shareholders of the SPV; Commercial banks and institutional lenders; Equity markets; Bond markets; Investment funds; World Bank Group financing sources (IMF, IFC and IBRD); Regional development banks (AfDB, ADB, EBRD and IsDB); Bilateral agencies; Subordinated debt;56 Host government and a host of others.

The Sponsor: This is the entity that commences the project and provides the initial sum

needed to start the project. They are the ones who usually provide the equity and can be

made up of different parties some of which could even include the contractor or the host

government.

55See Nevitt and Fabozzi, supra note 35 at 67.56 S.L. Hoffman, The Law and Business of International Project Finance 430-468 (2 nd ed. 2001).


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Commercial banks and institutional lenders: After the equity contribution by the sponsors,

the commercial banks and institutional lenders are usually the first point of call by the

sponsors. The commercial lenders could be made up of domestic and international banks.

The funds provided could be in form of an individual loan or a group of loans otherwise

known as a syndicated loan (this is where there are multiple banks or lenders to the

project).

Equity markets: This is the avenue of accessing funds through the stock market whether

the domestic stock market (the host country) or international/foreign stock markets. This

can be either through public sales of shares (if the SPV is a public company) or through

private placements.

Bond markets: A bond is a debt obligation or security, where the holder or buyer expects

the holder to repay the principal and interest at maturity (a date in the future). The bond

market is a financial market where these bonds are bought and sold.57

Investment funds: Investment funds are funds which have access to large sums of money.An example of an investment fund will be a pension fund. They invest in projects on behalf

of their members for the sole purpose of making profits. They can act as both a lender and

an equity investor.

World Bank Group: Most major infrastructure projects whether in developed countries or

LDCs have one or more organisations of the World Bank Group involved in the transaction.

They provide not only funds for the project but also bring their reputation to bear on the

project.

Regional development banks: The roles of regional development banks such as the AfDB

are quite similar to that of the World Bank, as they are charged with supporting economic

57 What is a Bond Market, athttp://www.streetdirectory.com/travel_guide/36220/investment/what_is_bond_market.html (Last visited,January 23rd, 2010).


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growth and infrastructural development of its members. For instance, AfDB will

concentrate on infrastructural projects in Africa.

Bilateral agencies: These consist of two types namely; export-import financing agencies

and developmental agencies. Export financing maybe government supported and will

usually consist of long term financing and they make up much of the energy infrastructure

financing in LDCs; while developmental agencies provide grants or concessional financing

to promote economic goals of the organising government in LDCs.58

Subordinated debt: This is an avenue of raising money for the project in which funds are

advanced to the SPV but the lender has junior rights in comparison to other lenders as it

relates to both repayment and security. As a result of taking this risk, the lender will

normally have a higher interest rate.

Host government: The host government may also participate in the financing either as an

equity holder or as a lender.

There are several other sources of finance for the project but the above mentioned are the

key ones used. Financing of the project could be done by using one source or a combination

of sources but in most cases, it will be done by a combination of sources. The sources of

finance are important to the project because it is a key part of the project financing that

lenders consider before advancing funds to the project. With this in mind, the paper will

now proceed to study the methods in which the project can be implemented, either

through BOTs or long term contracts.

58See Hoffman, supra note 45, at 458-459.


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2.6. Build Operate and Transfer (BOTs) and Long Term ContractsProjects that need to be financed using the project financing method can be executed in

different ways but the main ways to implement such (for power projects in LDCs) will be to

use either the BOT scheme or enter into long term contracts with the relevant party.

Whichever method is used, it will need careful structuring in order to fit the purpose it was

intended for. The paper will now proceed to briefly study the meaning of a BOT scheme and

what is meant by a long term contract.

BOT

BOT comes into existence as a result of a concession which is either a license or a lease

granted by the host government or one of its agencies. BOT is not a new form, though

codifying it as such is relatively recent and can be attributed to Turgut Ozal of Turkey in the

1980s. Concessionised infrastructural development was employed for projects such as a

1782 water system in Paris and the Suez Canal which opened in 1869.59 Governments have

utilised concessions in the context of BOT projects as a means of developing the host

countrys infrastructure without having to invest public money, whilst ensuring the

relevant assets ultimately remain in the public sector.60

BOT which stands for Build-Operate-Transfer is a concept in which private investors, the

sponsors receive a concession to finance, build, and operate a facility over a set period of

time, in exchange for the right to charge the users of the facility at a rate which makes the

investment commercially viable. At the end of the concession period the facility is turned

over to the state.61 A BOT project will therefore have a definite life and part of the skill

when the project are put out to tender is to put together a financing package which willensure the lenders get repaid and the shareholders get a sufficient return on their

investment before the concession terminates.62 The concession usually lasts for a long time

59 P. Handley, A Critical View of the Build-Operate-Transfer Privatisation Process in Asia, 212 AJPA 19 No 2(1997).60 P.R. Wood, Project Finance, Subordinated Debt and State Loans 11 (1995). 61See Handley, supra note 49, at 204.62See Vinter, supra note 42, at 37.


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ranging from 20-30years. The duration of the concession is essential to help the investor

recoup not only his investment but to also enable him make some profits. The duration is

also considered by the lenders to ensure that there is sufficient time to recover the loans

and interest accruable. As is customary for a BOT scheme, there is a transfer period

whereby the facility is handed over to the government; this transfer period will depend on

terms as agreed to by the parties to the concession. The transfer period could either be at

the end or expiration of the concession or upon the concession holder reaching a certain

amount of money.

With BOT schemes, comes the expertise and financing of the project through the private

sector, without the host government having to dig into its purse to finance the deal. In a

BOT scheme, the concession holder is responsible for raising the needed funds to execute

the project. This is usually done through project finance. In other words, the entire

structure and considerations needed to finance a project using project finance will have to

be made. BOT schemes are mainly used to finance big infrastructural and developmental

projects and as such, it is a beautiful bride to LDCs, which have increasingly used it to not

only finance big projects but to also bring in the expertise and efficiency associated withthe private sector. As a result of the requirement of transferring the facility to the host

government at the expiration of the concession, BOT schemes facilitate and promote the

transfer of technology to the host government. With the success attained by the BOT

scheme, multiple schemes with similar ideas have been developed although with slightly

varying effects and degrees. Some of such schemes are BOO (Build-Operate-Own) and BTO

(Build-Transfer-Operate).

As with most infrastructure projects, BOT projects can be awarded either through

competitive bidding or by negotiation. Also, all the relevant technical and economic studies

needed for the success of the project will have to be carried out. An example of a power

project using a BOT scheme is the Al Manah Power Station in Oman estimated at $155


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million. It is the first BOT in the Gulf region in which the IFC invested $14 million for its

own account, $4 million equity and a further $57 million in B-loans.63

LONG TERM CONTRACTS

Entering into long term contracts is very essential for the project. This is because it helps

guarantee a steady and secure cash flow for the project, whereby such cash flow will be

used in packaging the loan deal with the potential lender. The lender will need to be

satisfied that there is sufficient time for the SPV to generate enough cash to service the debt

or repay both the loan and the interest accruable. Long term contracts also help the

investor determine its rate of return on its investment for accounting purposes and profit,

whilst also bringing about stability to the business environment of the power sector. An

example of a long term contract will be a PPA of 20-25 years. Long term contracts are

usually used to lock in and guarantee the sales of the product or the service of the facility

and it can be used for multiple buyers where the output and performance of the facility

permits. So a power plant with a capacity of 1000MW can enter into two PPAs with two

power purchasers selling anything between 400-500MW of output to both of them

respectively.

Long term contracts are quite similar to BOT schemes (except for the fact that in BOT

schemes ownership of the facility transfers to the host government at the end of the

concession, while in long term contracts ownership of the facility remains with the SPV)

and both of them can be used as a model or the basis for implementing a project which will

use project financing as a method of its funding. An example of a power project using a long

term contract is that of Merida III the first IPP in Mexico, lead sponsored by AES

Corporation. It is financed with $173 million led by Jexim ($69 million) and IFC (up to $104

million, including $74 million in B-loans). Merida III will sell electricity to the state owned

electric utility CFE under a 25 year PPA.64

63See IFC, supra note 37 at 16.64See id.


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2.7. The Hubco Power Project in Pakistan

The project commenced with the creation of the Hub Power Company (Hubco i.e the SPV)

for the purpose of owning the power plant. Hubco then employed a consortium of

contractors, headed by the Japanese company Mitsui & Co (the contractor) to build the

power station, while International Power a British company (the operator) became

responsible for managing and operating the plant. Hubco entered into a contract to buy fuel

from the Pakistan State Oil Company (PSOC i.e fuel supplier) and to sell the power

generated to Water and Power Development Authority (WAPDA i.e the offtaker) another

government agency under a PPA.

As a result of the nature of the transaction, Hubcos lawyers and consultants drew up a

series of complex contracts to ensure that all the relevant stakeholders were informed of

their respective rights and obligations. For instance, the contractors agreed to deliver the

plant on time and to ensure that it will operate to specifications. International Power, the

plant manager, agreed to maintain and operate it efficiently. Pakistan State Oil Company

entered into a long term contract to supply oil to Hubco and WAPDA agreed to buy Hubcos

output for the next 30 years. A major source of concern for Hubco was the fact that WAPDA

was to make payment of the power generated in rupees (this was motivated by a

possibility of the devaluation of the rupee). As a result of this the state Bank of Pakistan

arranged to provide Hubco with foreign exchange at guaranteed exchange rates. A

guarantee was made by the government of Pakistan that WAPDA, PSOC and the Bank of

Pakistan will fulfill their obligations.

The plant was heavily financed by debt with equity accounting for less than 75 percent ofthe $1.8 billion used in funding the project. A group of banks both local and international

(syndicate) came together to provide the needed funds though in different currencies. The

banks were encouraged to invest because of the knowledge that the World Bank and

several governments were in the frontline and would take a hit if the project were to fail.

But the banks still had reservations that the government of Pakistan will create obstacles

by preventing Hubco from paying out foreign currency or it might impose a special tax or


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prevent the company from bringing in the specialists it needed. In order to protect Hubco

from these political risks, the government promised to pay compensation if it interfered in

such ways with the operation of the project. In the event that the government interfered,

Hubco had the option of calling on a $360 million guarantee by the World Bank and the

Japan Bank for International Cooperation which was supposed to keep the Pakistan

government honest when the plant was built.

As with other power projects, Hubco was fraught with costly, complex and time-consuming

activities which stalled its take off. Legal issues such as a Pakistani court ruling which

declared that the interest accruable to the loans breached Islamic laws further delayed its

launch. Ten years after the start of discussions the final agreement on financing the project

was signed and within a short time Hubco was producing a fifth of all Pakistans electricity.

This was not the end of the Hubco story. There was a take or pay obligation in the PPA

which obligated WAPDA to keep making payments to Hubco whether or not it received any

power. This resulted in the near collapse of WAPDA. A new tariff system which introduced

a 30 percent cut in power tariffs was ushered in following the fall of the Benazir Bhutto led

government. After a painful dispute and renegotiation process, Hubco accepted the newtariff structure and by 2006 it had repaid its senior debts.65

Source: R. Brealey, S. Myers and F. Allen, Principles of Corporate Finance 686-687 (9th ed. 2008).

Having discussed the issues within the power sector of LDCs and the financing of power

projects, this paper will now proceed to study the considerations that the lenders will have

to make before advancing funds to the project. In other words, this paper will now study

the ingredients required to make a power project bankable.

65See Brealey, Myers and Allen, supra note 42 at 688-689.


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3. BANKABILITY ISSUES (PART 1)Even though there are several issues to consider before a project can be considered as

bankable, this section of the paper will focus primarily on the key issues that lenders will

consider before advancing funds to the project.

3.1. Risk Identification, Allocation and MitigationAs earlier stated, project finance is used for large infrastructural projects that require huge

sums of money to execute, has several parties with differing interests and a series of

complex contracts involved. With this in mind, it is safe to say that there are bound to be

multiple risks of varying nature associated with the project, which will not only need to be

identified but properly allocated (to the right parties in the project) and reduced to the

barest minimum or better said mitigated. Before proceeding to identify the myriad risks,

this paper proffers a definition for risk.

A risk concerns the expected value of one or more results from one or more future events.

Technically, the value of those results may be positive or negative. However, general usage

tends to focus only on potential harm that may arise from a future event, which may accrue

either from incurring a cost (downside risk) or by failing to attain some benefit (upside

risk).66

The next issue to consider is how parties (particularly the lender) to project finance views

risk. To such parties risk is any factor which will change the expected or projected project

cash flow.67 The lender views the risks associated with a project with close scrutiny to

ensure that the risks are allocated to the right people who can bear it and to ensure