It's all about the money

THERE are many difficulties faced in trying to finance a large hydro power project. Some of these difficulties are common to all hydro projects, such as environmental concerns, and others are specific to the project itself. However, developers, advisors and potential lenders have worked together in an attempt to overcome some of these difficulties by accessing new sources of funding for projects, or developing variations to existing options.

Capital markets

Much has been written recently about accessing the capital markets for project financing, but what does this entail? A project is typically funded by loans from commercial banks or, as more applicable in the developing world, from multilateral and bilateral institutions such as the World Bank and various development finance institutions (DFIs). These banks and DFIs have limits on the amount they can lend to a certain sector or to a particular country, however, the capital markets provide a larger source of funding and potentially at cheaper rates and for longer terms.

The capital markets are regulated markets where capital (debt and equity) are traded and include organised markets and exchanges such as the London Stock Exchange. The financial instruments which are traded in these capital markets are often carefully controlled and a lot of time, effort and cost is entailed before one of these financial instruments can be 'placed' into a market. This requires detailed disclosure of information, including all potential risks, in a prospectus and may also require a rating agency to provide a credit rating for the financial instrument. The level of disclosure required depends on whether the instrument is being privately placed with regulated and authorised financial institutions (who are assumed to have a certain commercial sophistication and so less disclosure is required) or publicly placed such as the stocks of a public company in the UK.

One of the most common financial instruments used to place project debt is a bond. Bonds typically obligate the issuer of the bond to pay a specific amount, at specific intervals, to the holder of the bond and to pay the principal on the bond's maturity. The use of project bonds is commonplace in the US, but has only relatively recently been utilised for projects in Europe.

Rating agencies play a crucial role in project bonds as they perform much of the due diligence of a project and the associated risks that a lending bank would perform. Generally, the higher the rating, the lower the return to the bondholder, as they are assuming less risk.

In order to obtain any rating for a project bond, let alone a high rating, a different financing structure may be required to that used in a typical project financed deal. Other forms of credit-enhancement may also be required such as specialised insurance to cover some of the potential risk (mainly political) to the bond holders and to 'wrap' the bond. However, it may be advantageous for the project to pass on some of the risk to the bondholders. Financial institutions invest in a wide port-folio of bonds and other financial instruments in order to spread their exposure and so can include riskier investments, along with their potential for higher returns.

So if the capital markets can provide cheaper financing and for longer tenors, why aren't bonds more commonly used for projects? One of the key factors that the rating agency will consider is the period of the project during which the bond will be outstanding. If this includes the construction period, then the rating agency will be particularly concerned due to the lack of cashflow to support the repayment to the bondholders during the construction period, and the number of additional risks related to the timely (and proper) completion of the construction of the project. Therefore, a rating agency's review will generally be more rigorous for bonds which are issued to cover the construction period and, potentially, more conservative in its outcome.

It is mainly for this reason that projects have had difficulty accessing the capital markets, but this is especially so for a hydro project with its extensive civil works, large capital outlay, and the potential for unknown or uncertain geological risk. Therefore, hydro power projects do not easily lend themselves to financing through the capital markets. However, this may change in the future as the capital markets increase their exposure to projects and become more knowledgeable and experienced in the potential risks.

One potential use of the capital markets has been shown by the Bujagali project in Uganda which is proposing a private placement through a local bond issue. This will be only the fourth placement in Uganda and certainly the first time that a bond has been utilised in this manner to raise equity for a project in the country. The bond is to be issued in Ugandan shillings and in two tranches, each for the equivalent of US$10M. Although the first issue will be a private placement (with local banks) it is hoped that the second tranche may be publicly listed. The bond holders are to be repaid from the operation and maintenance fees earned by the operating company but the principal amount has been back-stopped by the FMO (the Dutch DFI).

Export credit agencies

Another increasingly flexible source of financing can be obtained using Export Credit Agencies (ECA) supported loans. Many ECAs, especially those in countries with major civil and mechanical contractors in the hydro business, have developed from their traditional role to provide cover for project financing. By doing this, the ECA provides cover of certain commercial risks as well as its 'usual' political risks.

Some ECAs have also been increasingly flexible in the required percentage of the cost of services and/or equipment to be provided from their country compared to the amount of debt being covered by it. In addition, the ECAs are proving to be more co-operative in their dealings with each other, in order to provide a co-ordinated tranche of debt with payments being made to the project company rather than individual payments to the company, the activities of which the ECA is supporting.

Unfortunately, the political nature of an ECA can also prove to be a hindrance to a project as political pressure can be more persuasive than commercial influences in their decision-making process. This can be the case in respect of environmental concerns and lobbying from NGOs and similar groups.

Development finance institutions

The multilateral and bilateral funding agencies have always been a prime source of debt for projects in the developing world. The largest provider of such debt is the World Bank Group, but it has also been involved in developing other instruments to aid financing and as a response to changing requirements. For example, commercial lenders can be persuaded to provide debt to a project via loans covered by either a partial risk guarantee provided by the Partial Risk Guarantee Group or with the help of political risk insurance provided by the Multilateral Investment Guarantee Agency (MIGA).

In fact in the Bujagali project, following a partial withdrawal by one ECA to provide cover, a variation to the MIGA insurance has been developed with the aid and backing of the World Bank Group. This variation has been called a 'parallel guarantee' and provides cover for certain Ugandan political risks that the ECAs were not able to cover. This is effectively a MIGA wrap to the ECA covered tranche of debt and helps to significantly reduce the ECA margin and the overall financing cost for the project.

It is hoped that this new initiative from MIGA will be used in other projects which face similar problems or could provide an inducement to other ECAs that are less eager to enter project financing or are less flexible in their approach.

Other initiatives

So far, the discussion has centred on the lenders. However, the entity with, perhaps, the biggest opportunity to help the financing of hydro projects is the host government or utility. By the host government and/or utility carrying out some of the development activities or by accepting and dealing with certain project risks, this could not only speed up the development process but also greatly influence the viability of a particular project. A recent example is the Russian government's initiative, again alongside the World Bank, to provide its own political risk cover to projects with the aim of increasing outside investment into the country.

Another area that the host Government could take the initiative is in providing the hydro site free from encumbrances and persons. It would still be a requirement to adequately compensate the affected persons in accordance with applicable standards, such as those of the World Bank, but there are often many other rights and options available to a government which are unavailable to a private company. Also, during the development of a project, a developer can waste a significant amount of time dealing with bureaucracy and the various government bodies that need to be consulted. By the host government providing a one-stop shop for a developer or by undertaking to obtain, for example, the consents required for a project, this alone could take weeks or even months off the development time of a hydro project.

Another initiative is to change the way hydro power projects are structured. This would involve a redistribution of some of the risks and require certain parties to accept more or very different risks then they are commonly used to (mainly to the host government or utility).

Obviously this will not be favoured by the government or utility but if this change in structure is what is required to allow any clearance for a project to be developed, then these attitudes might change.

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