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Financing energy projects
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EnergyPoli~y.Vol. 23. No. II. pp. 967475. 1995 Copyright ~©1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4215/95 $10.00 + 0.00
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Financing energy projects Experience of the International Finance Corporation Gary Bond and Laurence Carter Corporate Planning Department, International Finance Corporation, Washington, DC, USA
This paper provides an overview of the recent trend towards private ownership and financing of power projects in the developing countries, focusing on the role played by both private and public agencies in meeting the large financing challenges. The paper draws upon the operational experience of the International Finance Corporation, which has been involved in the financing of more than 30 private power projects in the developing countries over the past three decades. Among the issues that affect implementation of private power projects is the balancing of risk and reward to equity investors and to commercial lenders. The paper discusses the principal sources of risk and the strategies used to manage them. A related issue is the competition for capital on the international markets, and the techniques that are being devised to bring more finance to the power sector. Finally, the paper considers the role of government in bringing private investors to the power sector, and the approaches being adopted to balance the needs of investors with the needs of the public. Ke),words: Energy projects; Private investors; Developing countries
The last few years have seen a rapid increase worldwide in private participation in infrastructure financing, particularly in the power sector. The International Finance Corporation (IFC), which is part of the World Bank Group, has been an active supporter of these developments, with an involvement in private developing country infrastructure that extends over almost three decades. This paper reviews the preliminary lessons emerging from IFC's experience with infrastructure financing in the developing world, with examples taken from power generation, transmission and distribution. Infrastructure has traditionally been the preserve of the public sector, particularly in developing countries, partly on account of its perceived strategic importance to the economy, and partly because the large investment costs and long gestation periods usually associated with such projects were thought to have constituted serious disincentives to private investors. Recent trends in privatization of major utilities in various countries have shown that this is no longer the case. Private financiers have
shown themselves able to mobilize the funds necessary to finance infrastructure projects, and private sponsors willing to accept both project and country risks, provided that the institutional environment has met certain minimum standards and the projects have been appropriately structured. Governments are assisting this process by creating new opportunities for private investors in an effort to bring more efficiency to project construction and operation, greater competition in the supply of infrastructure services, and greater access to international capital markets. The development of local capital markets has also been assisted by the move towards private participation in the power sector. IFC is a major source of project and corporate finance to private companies in developing countries (providing loans, equity, other financial instruments and advisory services) and as such has participated in many of the private power and related infrastructure transactions completed or in the process of being financed to date. Between its first transaction in 1966 and June 1994 Energy Policy 1995 Volume 23 Number 11 9 6 7
Financing energy projects: G Bond and L Carter
Table I Power projects approved by IFC to 30 June 1994 a FY
Company
1966 1981 1988 1989 1989 1989 1990 1990 1991
Meralco I Conenhua Meralco 11 Ahmedabad Electric Hopewell Navotas Tata Electric I Calcutta Electric I Kepez Elektrik Tata Electric II
1991 1991 1992 1993 1993 1993 1993 1993 1993 1993 1993
Aconcagua I Bombay Suburban Calcutta Electric 11 Aconcagua II Pangue Belize Electric Co Hopewell Pagbilao Northern Mindanao Puerto Quetzal Yacyclec Scudder Fund
1994 1994 1994 1994 1994 1994
Tucuman Edenor Hidrozarcas Tata Electric IV Asia Infrastructure Fund Pangue I1
1994
Global Power Fund
1994 1994 1994 1994
Edenor II Fabrigas GVK Power Northern Mindanao
1994 Manah Power 1994 Neyveli Power 1994 Khimti Khola Total (US$million)
Project size (US$ million)
Power Power: transmission Power: distribution Power: distribution Power: generation Power: generation Power: transmission Power: transmission Power: generation Power: transmission and generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: transmission Equity fund for private power projects in LAC Power: generation Power: distribution Power: generation Power (GDR issue) Power (regional fund) Power: generation (increase in loan) Mezzanine finance for power projects Power: distribution (increase) Power: generation Power: generation Power: generation (currency swap) Power: generation Power: generation Power: generation
IFC net (US$ million)
Country
94.0 18.0 313.2 83.3 41.0 79.7 92.2 67.6
12.0 4.5 32.0 20.0 1 I. 1 34.5 20.0 25.0
Philippines Peru Philippines India Philippines India India Turkey
273.7 82.0 653.3 547.7 na 465.0 59.4 888.0 103.0 92.0 134.7
60.0 19.5 50.0 30.0 2.1 74.9 15.0 70.0 19.5 20.0 20.0
India Chile India India Chile Chile Belize Philippines Philippines Guatemala Argentina
200.0 1.5 402.4 15.0 26.6 504.5
25.0 0.3 45.0 4.4 _b 33.7
Latin America Argentina Argentina Costa Rica India Asia
_b
Chile
1010.0 8.0 8.6 290.7
51.1 _b 3.5 48.3
World Argentina Guatemala India
23.4 204.5 450.0 125.7 7408.7
0.5 19.0 48.0 31.0 849.9
Philippines Oman India Nepal
50.0
alFC's financial year runs from 1 July to 30 June. bFunding arranged on the account of other participants. Source: International Finance Corporation.
IFC's board approved an IFC financing role in 88 infrastructure operations with a total project cost of nearly US$15 billion, in 26 countries. Within the power sector, IFC had approved 34 projects to June 1994, with a total project cost of US$7.4 billion (see Table 1).
R e a s o n s for the c h a n g e The main reason for the shift towards private infrastructure is growing disenchantment by government policy makers and users with public monopoly ownership and provision of infrastructure services. Underinvestment by many state utilities has resulted in a backlog of unmet demand for infrastructure services, and in many countries this is the principal constraint to 968
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growth. Power shortages have led to production shortfalls, higher costs (self-generation) and a decline in investment. Governments are responding to these inadequacies by providing increased opportunities for private participation. There is increasing evidence that the private sector generally is performing better in terms of construction costs and times, operation and customer service. Second, fiscal constraints on governments and external aid agencies have led to an increasing realization that private finance is necessary to address capacity shortages. Some governments have used infrastructure privatization to improve their public finances. The extra resources that private financiers and management bring are important.
Financing energy projects: G Bond and L Carter
Third, technological developments have reduced natural monopoly characteristics and allowed unbundling, private entry and competition into many infrastructure services. Independent power producers can construct and operate relatively small plants at unit costs comparable with larger generators. Better metering of power and water usage enables pricing for demand management, encouraging more efficient use. These technological changes are facilitating competition. Even small, low income countries are reaping the benefits: IFC has financed independent power plants in Guatemala and Nepal. Fourth, innovative financing techniques and the globalization of financial markets are offering more infrastructure financing options. The volume of transactions and the range of instruments used on the international capital markets has increased sharply in recent years. This has been driven partly by an increased supply of funds, as venture capitalists and institutional investors in developed countries have sought to diversify their portfolios and achieve higher returns, in addition the large size and long payback periods of infrastructure projects have demanded innovative financing techniques. Project financing has grown very rapidly: 1993 saw the first issues of bonds by greenfield private infrastructure projects in developing countries (Philippines and Malaysian power projects). Learning from other countries' experiences has been important. Many of the pathbreaking actions occurred in developed countries: the 1978 US Public Utilities Regulatory Policy Act started the independent power producer industry by requiring utilities to purchase power from competitive generators. The unbundling and privatization of the UK electricity industry in 1991 showed that it was feasible to introduce competition into distribution as well as generation. Particular countries have led the way: Chile and Argentina in Latin America; Malaysia and the Philippines in south-east Asia; Hungary in Eastern Europe; Sri Lanka, India and Pakistan in south Asia; and Ghana and Uganda in Africa. Private participation has spread across infrastructure subsectors, from telecoms and power generation, to ports, pipelines, roads, and more recently to water, railways and energy transmission and distribution.
ously when presented with appropriate opportunities. Clearly, many of the risks private investors confront are considered manageable. There are three stages to considering risk. First, the severity of each risk needs to be assessed. From the sponsor's perspective, what is the government's macroeconomic record? What has happened with similar projects? From the government's perspective, is the sponsor technically and financially strong? Is it politically feasible to allow the concessionaire to reduce employment in an enterprise? Lenders ask both sets of questions: given that they lend from a leveraged capital base but do not share higher than expected profits, they have the strongest incentive to assess risks thoroughly. Second, the party that is in the best position to manage each risk is identified. For example, the project sponsor is best able to manage commercial risks, whereas the government has control over regulatory risk. Finally, each risk is allocated, priced or mitigated between the parties, via contractual agreements. Risks do not disappear, but are borne by the parties best able to manage them.
Risk management
Fuel availability and costs are important operational risks in power generation projects. Fuel costs are often passed on to the purchaser, although the tariff regimes in operation allocate these risks differently. In the Philippines, contracts have been signed which pay independent power producers only for the cost associated with energy conversion; the project developer is relieved of any responsibility for purchasing the fuel and passing on the cost. The alternative method is for the project developer to arrange
Infrastructure projects differ from many other types of private sector investments in developing countries. Many have long lives, are large, immobile, generate only local currency revenues, buy from or sell to government agencies directly, are vulnerable to regulatory changes, and have politically sensitive tariffs. Private financiers are understandably cautious, yet they have responded vigor-
Construction risk
Management of construction risk is critical to completing projects within budget. Companies hedge construction risk by: (1) using fixed price, certain date turnkey construction contracts and building in provisions for liquidated damages if the contractor fails to perform (and bonuses for better than expected performance); (2) taking out business start up and other standard insurances; (3) building in a contingency to cover for variations; and (4) building in excess capacity, to allow for some technical failure to reach the required capacity. Lenders will not assume completion risk, so the burden is put on the project company, its sponsors, contractors, equipment suppliers and insurers. Typically the project company stipulates a completion date in the project agreement, complete with penalties and bonuses. It negotiates a similar, but tighter contract with a construction company, with liquidated damages provisions and bonuses. Lenders may also require project developers to guarantee to fund cost overruns and sometimes will require them to establish a standby credit facility for this purpose. Operational risk
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Financing energyprojects: G Bond and L Carter fuel purchase and then to pass on the fuel cost along with the cost of converting it to electricity; this has been used in Guatemala and in some Indian projects. Technical risks are borne by the project company, which undertakes to operate and maintain the plant to certain standards. These risks are typically hedged via (1) performance guarantees from supplier companies; (2) subcontracting a specialist company to undertake operation and maintenance, with bonus and penalty payments for performance; (3) business interruption insurance. In one project financed by IFC the concession requires the lead sponsor to maintain a minimum ownership share, in order to ensure that its technical skills are always available to the concessionaire. Market risk In most power generation projects, the market risk is taken by the purchaser. The power purchase agreement (PPA), which is the key contract in an independent power project (IPP), is usually structured in two parts: (1) a fixed capacity fee is paid if the plant meets designated availability requirements, and which usually covers debt service payments and an equity return; and (2) an energy fee, which is related to actual power deliveries. Inasmuch as the sponsors share in the market risk through the energy fee they are really sharing in the upside potential: higher energy purchases usually mean larger profits. However in more sophisticated and privatized regulatory environments IPPs take more market risk. In an IFC Chilean build--operate-own (BOO) power project the company is developing the project without having a single-purchaser PPA; instead it has signed several long-term contracts with different (private) purchasers. With a single purchaser, market risk becomes payment risk. Companies can hedge against this by asking for guarantees of the contractual performance of state owned enterprises (SOEs), as has been done in IFC projects in several countries, including India, Nepal and the Philippines. Although a government guarantee of contractual performance facilitates private entry, ultimately the government needs to address the underlying problems of non-viable state owned utilities, by allowing them to charge economic tariffs, improving efficiency standards and/or promoting privatization. Foreign exchange risk Foreign exchange risks are a major concern of foreign financiers investing in developing countries. Most infrastructure projects generate local currency revenues which raises two issues: (1) will the project have access to foreign exchange to cover debt service and equity payments; and (2) will the foreign exchange equivalent of the project's tariffs be adjusted for devaluation and 970
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thus enable foreign debts and equity to be serviced. Most of IFC's infrastructure projects have been undertaken in countries where private investors judged that convertibility was likely to be maintained, or where charges could be levied directly in hard currency. How can the foreign exchange equivalent value of a project's revenue stream be maintained - especially when infrastructure tariffs are subject to political influence? The methods used to deal with foreign exchange risk in IFC-financed infrastructure projects include: (1) building into the concession a commitment to link the project's tariff to the US dollar, but making payment in local currency. This leaves the project's lenders vulnerable to convertibility risk and has been used in countries where foreign financiers have been willing to bear that risk; (2) similarly, the government may permit a given return on an asset base that explicitly includes the cost of foreign debt service; (3) power purchase agreements may be partly denominated in US dollars, or the state utility may pay fees directly into an offshore dollar account, thereby assuming convertibility risk; (4) companies that earn foreign exchange directly, such as where power is exported to a neighbouring country, can charge customers in US dollars; (5) large companies (or smaller companies with strong sponsors) operating in major currencies may be able to hedge currency mismatches; and (6) where foreign investors felt sufficiently confident in the macroeconomic management of an economy, they were prepared to take currency risk. There is no single answer: the choice depends on the project, the country, the financial structure and the perceptions of the lenders. Regulatory risk Two kinds of regulatory risk frequently occur in infrastructure projects: (1) tariff adjustments not being permitted or made on time (in the face of inflation, or devaluation, for example). Companies can hedge against this risk by building in automatic adjustments to contracts, but ultimately complying with these obligations lies with the government, or its SOEs; and (2) regulatory changes. For instance, possible changes in environmental regulations concern many infrastructure companies and their lenders. Ultimately there is limited scope for companies (and, by extension, financiers) to avoid these risks, except to build in buy out mechanisms under certain extreme circumstances. In the Philippine BOT projects, the state
Financing energy projects. G Bond and L Carter Box I Addressing environmental concerns: Pangue hydroelectric project During the appraisal of the Pangue hydroelectric project in Chile concerns emerged over the project's impact on indigenous communities, the need for improved elcological knowledge in the region and the project's potential effects on river flows, fish habitats and other water users. After determining the volume of water that would need to be released to sustain fish habitats, the project was redesigned to meet the requirements of power generation, fish habitats and other water users. Addressing the impact of the project on indigenous communities and the local ecology required a more innovative approach. At IFC's initiative, the Pehuen Foundation was established to fund specific activities for the three communities of indigenous peoples in the project area. The Foundation is funded through a charge on the project's revenues. This approach was preferred to alternatives such as lump sum transfers because funds are available as long as the project operates and it targets the collective needs of the people most directly affected. Also at IFC's initiative, an ecological station has been established to rehabilitiate the construction site and study the ecology of the project area. Support lbr the research centre is coming from the project and other international research centres.
utility is obliged to buy the company's assets according to a prespecified formula, under certain circumstances. Investors are also offered some protection against regulatory risk through the costs borne by the host country in the event of adverse actions by government. If a government alters the regulatory framework in such a way that existing privately financed infrastructure projects become inviable, the economy may suffer costs larger than those borne by a single project's financiers. For example, potential future private investors may choose to locate in other countries. Environmental risk management
Private infrastructure provision is giving rise to new approaches to environmental management. Risks to the natural environment can result in risks to companies and their financiers. Private companies and financiers thus have financial incentives to assess environmental risk to distinguish acceptable from unacceptable outcomes, and to manage and mitigate those risks. Environmental risk mitigation can give companies and their financiers competitive advantage, and lowers the risks of damage to the natural environment. Infrastructure projects can affect the environment (see Box 1) through: (1) major hazards such as fire or explosion; (2) violation of environmental regulations such as emission standards; (3) site contamination; and (4) special concerns such as resettlement, affecting the indigenous population etc. These impacts may jeopardize the viability of a project, and therefore expose companies and their financiers to risks. For example, if a private power company installs
equipment that does not meet a country's emission standards, it faces the risk of(1) a civil suit; (2) incurring retrofitting downtime costs; (3) having its permit revoked, and not being awarded future permits. The company's financiers may have a bad loan, with collateral worth much less than originally estimated. These risks are systematic; they cannot be diversified away. Infrastructure financiers need to find a middle way between the two extremes of rejecting all projects with any environmental risk and ignoring environmental impacts altogether. Both companies and financiers therefore have strong incentives to minimize their exposure to these risks by assessing them, and then finding appropriate means to reduce them. Reduced environmental risks for companies and financiers mean correspondingly lower risks of damage to the natural environment. All projects in which IFC participates are subjected to environmental appraisal and clearance as a condition of approval. In some countries the experience of dealing with Bank Group environmental requirements has provided a model for upgrading local standards and developing institutional capabilities. Several beneficial environmental impacts have been observed from IFC's projects. Private entry is often associated with tariff reform, so prices of services more closely reflect economic costs, leading to large efficiency savings. The US$400 million 1992-95 investment programme of an Argentinean electricity distribution company, is expected to reduce energy losses from 30% to 15% over three years, which will reduce its purchases of bulk electricity by about 6%, equivalent to about 1.5 million barrels of fuel oil used in its production. By 1996 savings are expected to rise to 2 million barrels of fuel oil per annum. Another lesson is that private government contractual arrangements provide a mechanism for building in explicit environmental standards, and incentives for implementing and monitoring them. in the Philippines, energy conversion agreements signed between private power developers and the state utility incorporate a schedule detailing the information to be included in the environmental impact assessment study, warranties which bind the developer to construct, operate and maintain the facility 'in accordance with internationally accepted environmental standards adopted in the Philippines', and general conditions precedent which refer explicitly to an 'environmental compliance certificate for the power station'. The presence of explicit environmental warranties in the contract provides increased scope for ensuring compliance. A better understanding of what is at stake in environmental clearances is emerging as country and company experience increases. Many countries are upgrading their environmental standards, clearance procedures and Energo: Poli~T 1995 Volume 23 Number I l
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enforcement efforts. At the same time governments are recognizing that companies (and their financiers) need an indication of the liabilities that might be imposed via changing environmental standards before they will make large investments.
Finance Successful financing of private infrastructure involves matching the risk-return requirements of different sources of finance with project characteristics, and this is achieved through careful structuring. Many agencies participate in private infrastructure financing, often acting in concert in a single project. In addition to the finance provided directly by IFC, project funds are also supplied by international commercial banks, equipment suppliers' credits, private local lenders and investors, internal cash generation from the project company, and export credit agencies (EXIM banks) and multilateral banks. In IFC's projects, private foreign sources provided a quarter of the financing; adding in suppliers' credits raises this to 35%. Some suppliers' credits were financed by export credit agencies, whose role in infrastructure financing is becoming more prominent. A quarter of the financing in the IFC sample originated from private local sources. This is partly because many of IFC's established projects were in countries where domestic financial markets were already quite developed (such as India and the Philippines), or have since evolved rapidly (eg Chile, Argentina). Nearly a fifth of financing in the IFC sample was from internal cash generation, which is more often associated with an existing operation undergoing expansion than a greenfield project. External official agencies such as IFC, the World Bank and the Asian Development Bank, as well as domestic publicly owned institutions, provided finance. Where is the foreign equity coming from? US based multinational companies have provided over half. The single largest equity placement in an IFC project was for a Philippines power project, sourced from Hong Kong. In other projects, companies based in Spain, Malaysia and Singapore have also provided equity. These partners reflect both historical ties (eg Spanish links with Latin America), and the increasingly global approach to investment opportunities being taken by large companies, either as sponsors or minority participants. The financial structure of IFC power projects have been as follows:
(1) The average debt:equity ratio was 68:32, but this conceals a wide dispersion of debt:equity ratios between individual projects. 972
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(2) Power projects have had a higher proportion of debt than telecoms. The difference lies mainly in internal cash generation. Many power projects are greenfield (ie starting from scratch), without any internal cash generation available at the time of financing, whereas telecoms projects often use reinvested profits to help finance expansion. (3) Foreign financing exceeds local financing in all regions. Although there is sample bias (by definition all of IFC's projects have some foreign financing), most countries seem to need foreign financing during the early stages of a shift to private involvement in infrastructure. Mobilizing finance
During the last few years, for a variety of reasons, equity has become relatively more easily available for many projects in developing countries. Debt, which often accounts for over two-thirds of financing in a greenfield project, has become the key constraint- both in terms of volume and (particularly for infrastructure projects) maturity. There are several explanations. First, there are only 30 to 40 banks worldwide that have traditionally played a project financing role, although this is growing. Each bank has exposure limits to individual clients, sectors and countries and since a single bank can rarely meet all of the loan requirements of a large project, debt finance typically involves a syndication of l e n d e r s which can be time consuming and complex. Commercial banks are also constrained by the time profile of their deposits. They cannot prudently lend large volumes of long-term debt: the longest international commercial bank loans are typically 7-12 years. In contrast, many infrastructure projects require financing of over 10 years maturity if the tariffs to service the debt are not to be prohibitive. Institutional sources with long-term depositors, such as pension funds and life assurance companies, provide a better maturity match for infrastructure financing- but are highly risk averse. Lenders face many of the same risks as equity investors, but without the upside potential that attracts equity. They may compensate for these risks by adjusting their margins but there are limits to how far loan pricing can be pushed. More often, lenders seek to reduce a project's risks by negotiating the minimum conditions under which they will participate. Many of the agreements associated with project financings are risk control devices imposed by lenders. In most projects it is the lenders who have the strongest say in how the financing is to be structured, how support agreements from sponsors, government agencies and other contracting parties are specified, and how security provisions covering claims on assets are set out.
Financing energy projects: G Bond and L Carter New patterns of[inance
The limitations faced by banks in lending to projects in developing countries have stimulated the development of alternative financing arrangements to meet the large demand for infrastructure financing. Over the past two years several new investment funds have been created to mobilize funds from investors in the world's major financial centres for onlending and equity investment in developing country infrastructure projects. The Scudder Latin American Trust for Independent Power, formed in June 1993 with the assistance of IFC, was the first specialized fund designed to mobilize risk capital for investments in private power in developing countries. On a larger scale, the Asian Infrastructure Fund has been established as a US$500 million closed end fund (with IFC participation) that will invest primarily as an equity participant in private infrastructure projects in developing Asian countries. The Global Power Fund is another example of a fund set up to provide equity financing to power projects in IFC member developing countries. Larger private utilities are starting to access equity markets directly. Several companies have used American depositary receipts (ADRs) to tap the US equity market. ADRs enable foreign companies to issue equity on the US market without complex settlement and transfer mechanisms. Some large multinationals based in developed countries are expanding their financial intermediation role by issuing securities on US and European markets and investing the funds in selected funds and projects in developing countries. Securities issued by these companies are backed by the group's total operations, and hence their placement is made easier than if they were for developing country projects alone. Developing local capital markets
Although the volume of funds raised from local financial markets is still small (apart from in certain markets, such as India), it is growing. There are four channels through which local financing capabilities are being developed. First, companies already engaged in providing infrastructure services may issue equity on the local stock market. Second, institutional investors such as insurance companies and pension funds make private equity placements with individual project companies. A third linkage between infrastructure and local capital markets is through debt financing provided by local commercial and development banks. These institutions can be privately, publicly (government) or jointly owned. Most projects have local currency financing requirements and where possible local banks can contribute to the overall debt package. A fourth avenue for developing local capital markets is where infrastructure companies obtain debt finance through locally issued bonds. Bond issues
are more common from established companies with an earnings track record. However, examples of precompletion bond financing are starting to emerge in Chile and Malaysia. Each of these four types of capital market impact can be beneficial in terms of a country's broader funds mobilization capability, but the strongest impacts occur when project financing is taken to the local market, either in the form of an equity listing or a domestic bond issue. Permanent private ownership of facilities tends to be more conducive to a market offering than temporary arrangements like BOT. Hence the pattern of private entry that a country chooses for its infrastructure activities can to some extent determine the capital markets benefits that it receives.
Managing private entry The question for many governments now is not so much whether to involve the private sector in infrastructure provision, but how to manage the transition to private ownership so that it delivers as many benefits as possible. But deregulating and managing private entry can be politically and technically difficult. Government dilemmas include: (1) how to implement changes in the face of political opposition from important groups; (2) how to manage the transition from subsidized infrastructure service prices to cost related tariffs that enable a rapid expansion programme to be financed; (3) how to gain access to external technology and management, without engendering overriding opposition to 'foreign control' of politically sensitive assets and services. The political problem associated with infrastructure privatization is that, despite potentially large benefits for the population as a whole, there may be short-term losers, including: (1) existing consumers receiving subsidies, if private entry is accompanied by tariff reform; (2) employees of state owned enterprises who may be made redundant if they are privatized; and (3) existing private producers who may currently benefit from lack of competition in their sector. Furthermore, each of these groups is likely to be better organized and have more political influence than the broader community who ultimately stand to gain from more efficient service provision. There may also be technical difficulties. Most civil servants have little experience in dealing with risk taking entrepreneurs. Attempts to overregulate private entry can reduce the equity that sponsors are prepared to Energy Policy 1995 Volume23 Number 11 973
Financing energy projects: G Bond and L Carter
Political costs of adjustment/regulatory effort
LOW
HIGH
Publicly owned regulated monopoly
=-i "6
Unbundling and deregulation
Private entry allowed
No unbundling, vestiture only
Unbundling and )rivatiization
Divestiture
._o E
8 8
uJ Divestiture of SOE
Unbundling/ demonopoliization
Competitive/contestable private infrastructure provision HIGH
Figure I Transitional paths in infrastructure privatization
provide. Governments may not be ready to provide the politically independent (and sometimes highly technical) regulation that fully privatized infrastructure might require. IFC's experience provides examples of ways in which governments have addressed these difficult questions. There is no single blueprint for what works; the route depends on political commitment (critical), strength of opposition to change, institutional capabilities, investors' perceptions, and the domestic economic and legal environment. Furthermore, different infrastructure subsectors may be addressed in different ways in the same country. Figure 1 illustrates three ways in which private entry is occurring. The starting point in many countries is a state owned utility which operates as a monopolist and involves little regulatory complexity (top left corner). Private entry may occur through:
(1) Approach A: limited entry allows the private sector to enter parts of the market to provide infrastructure services. This often focuses on the construction of new assets, such as independent power plants, cellular networks or new ports. This approach may involve relatively low political costs, as many existing assets remain under state ownership. It is typically characterized by contractually based relationships 974
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(such as concessions), rather than wholesale regulatory reform. (2) Approach B, which requires considerable political will, is to divest (privatize) state utilities, but to postpone the unbundling in order to attract a strong response from private financiers. (3) Simultaneous unbundling, deregulation and divestiture (approach C) requires significant political commitment and institutional capability. It has been undertaken in several infrastructure subsectors in Argentina. Approach A (limited entry) may initially have advantages for certain countries. It has relatively low political and regulatory costs. Usually this requires steps to demonopolize the state utility's market, allow the participation of foreign capital, make a commitment to tariff reform, issue licences or concessions, and undertake a transparent tendering process to award them. The announcement of a credible set of sectoral reform policies can elicit a strong private sector response.
Conclusions The main conclusion to emerge from IFC's experience to date is that despite the risks, private financiers are
Financing energy projects: G Bond and L Carter
providing large amounts of at risk capital to invest in infrastructure services in developing countries. The volume of funds now being mobilized from the market is well above that anticipated only a few years ago and innovative new financing methods are being explored. Private firms are replacing state utilities and delivering better service to more people at reasonable cost. Both private companies and governments are assisting this process. Companies have supplied finance, and the ability to take risks and to implement projects efficiently. Governments have contributed a willingness to privatize, to experiment with new, more competitive regulatory environments and to encourage non-guaranteed financing. IFC's contribution has been as a facilitator, helping with business-government negotiations and bringing financing plans to completion, sometimes in a difficult country or regulatory environment. Many countries are improving their investment climate with the result that, in many parts of the world, perceived country risk is falling. Divestiture of state utilities has proved to be the most efficient way of enabling companies to mobilize the financing needed to carry out their infrastructure plans. Privatized companies have a much wider range of financing alternatives than projects financed on a limited entry basis. Privatization has given firms opportunities to access capital markets, and has
stimulated local funds' mobilization. Foreign loans are essential to most countries in overcoming their initial infrastructure problems but there are limits to the ability of countries to borrow offshore. Ultimately more funds for infrastructure investment will have to be mobilized domestically; governments that recognize this are taking steps to develop their local capital markets. These beneficial outcomes are not being experienced everywhere. Country risk is still a major obstacle to large-scale funds mobilization in many countries. Some governments remain committed to state ownership of infrastructure and in others vested interests are blocking competitive and transparent private entry. Institutional constraints are also a problem. The pace of reform will depend on how serious inadequacies in traditional infrastructure provision arrangements are perceived to be, and how the political process of transition is handled once private entry' is allowed.
Acknowledgement This article is derived from G Bond and L Carter (1994)
Financing Private Infrastructure Projects." Emerging Trendsfrom 1FC ~ Experience IFC Discussion Paper No 23, Washington, DC.
Energy Policy 1995 Volume 23 Number 11
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EnergyPoli~y.Vol. 23. No. II. pp. 967475. 1995 Copyright ~©1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4215/95 $10.00 + 0.00
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Financing energy projects Experience of the International Finance Corporation Gary Bond and Laurence Carter Corporate Planning Department, International Finance Corporation, Washington, DC, USA
This paper provides an overview of the recent trend towards private ownership and financing of power projects in the developing countries, focusing on the role played by both private and public agencies in meeting the large financing challenges. The paper draws upon the operational experience of the International Finance Corporation, which has been involved in the financing of more than 30 private power projects in the developing countries over the past three decades. Among the issues that affect implementation of private power projects is the balancing of risk and reward to equity investors and to commercial lenders. The paper discusses the principal sources of risk and the strategies used to manage them. A related issue is the competition for capital on the international markets, and the techniques that are being devised to bring more finance to the power sector. Finally, the paper considers the role of government in bringing private investors to the power sector, and the approaches being adopted to balance the needs of investors with the needs of the public. Ke),words: Energy projects; Private investors; Developing countries
The last few years have seen a rapid increase worldwide in private participation in infrastructure financing, particularly in the power sector. The International Finance Corporation (IFC), which is part of the World Bank Group, has been an active supporter of these developments, with an involvement in private developing country infrastructure that extends over almost three decades. This paper reviews the preliminary lessons emerging from IFC's experience with infrastructure financing in the developing world, with examples taken from power generation, transmission and distribution. Infrastructure has traditionally been the preserve of the public sector, particularly in developing countries, partly on account of its perceived strategic importance to the economy, and partly because the large investment costs and long gestation periods usually associated with such projects were thought to have constituted serious disincentives to private investors. Recent trends in privatization of major utilities in various countries have shown that this is no longer the case. Private financiers have
shown themselves able to mobilize the funds necessary to finance infrastructure projects, and private sponsors willing to accept both project and country risks, provided that the institutional environment has met certain minimum standards and the projects have been appropriately structured. Governments are assisting this process by creating new opportunities for private investors in an effort to bring more efficiency to project construction and operation, greater competition in the supply of infrastructure services, and greater access to international capital markets. The development of local capital markets has also been assisted by the move towards private participation in the power sector. IFC is a major source of project and corporate finance to private companies in developing countries (providing loans, equity, other financial instruments and advisory services) and as such has participated in many of the private power and related infrastructure transactions completed or in the process of being financed to date. Between its first transaction in 1966 and June 1994 Energy Policy 1995 Volume 23 Number 11 9 6 7
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Table I Power projects approved by IFC to 30 June 1994 a FY
Company
1966 1981 1988 1989 1989 1989 1990 1990 1991
Meralco I Conenhua Meralco 11 Ahmedabad Electric Hopewell Navotas Tata Electric I Calcutta Electric I Kepez Elektrik Tata Electric II
1991 1991 1992 1993 1993 1993 1993 1993 1993 1993 1993
Aconcagua I Bombay Suburban Calcutta Electric 11 Aconcagua II Pangue Belize Electric Co Hopewell Pagbilao Northern Mindanao Puerto Quetzal Yacyclec Scudder Fund
1994 1994 1994 1994 1994 1994
Tucuman Edenor Hidrozarcas Tata Electric IV Asia Infrastructure Fund Pangue I1
1994
Global Power Fund
1994 1994 1994 1994
Edenor II Fabrigas GVK Power Northern Mindanao
1994 Manah Power 1994 Neyveli Power 1994 Khimti Khola Total (US$million)
Project size (US$ million)
Power Power: transmission Power: distribution Power: distribution Power: generation Power: generation Power: transmission Power: transmission Power: generation Power: transmission and generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: generation Power: transmission Equity fund for private power projects in LAC Power: generation Power: distribution Power: generation Power (GDR issue) Power (regional fund) Power: generation (increase in loan) Mezzanine finance for power projects Power: distribution (increase) Power: generation Power: generation Power: generation (currency swap) Power: generation Power: generation Power: generation
IFC net (US$ million)
Country
94.0 18.0 313.2 83.3 41.0 79.7 92.2 67.6
12.0 4.5 32.0 20.0 1 I. 1 34.5 20.0 25.0
Philippines Peru Philippines India Philippines India India Turkey
273.7 82.0 653.3 547.7 na 465.0 59.4 888.0 103.0 92.0 134.7
60.0 19.5 50.0 30.0 2.1 74.9 15.0 70.0 19.5 20.0 20.0
India Chile India India Chile Chile Belize Philippines Philippines Guatemala Argentina
200.0 1.5 402.4 15.0 26.6 504.5
25.0 0.3 45.0 4.4 _b 33.7
Latin America Argentina Argentina Costa Rica India Asia
_b
Chile
1010.0 8.0 8.6 290.7
51.1 _b 3.5 48.3
World Argentina Guatemala India
23.4 204.5 450.0 125.7 7408.7
0.5 19.0 48.0 31.0 849.9
Philippines Oman India Nepal
50.0
alFC's financial year runs from 1 July to 30 June. bFunding arranged on the account of other participants. Source: International Finance Corporation.
IFC's board approved an IFC financing role in 88 infrastructure operations with a total project cost of nearly US$15 billion, in 26 countries. Within the power sector, IFC had approved 34 projects to June 1994, with a total project cost of US$7.4 billion (see Table 1).
R e a s o n s for the c h a n g e The main reason for the shift towards private infrastructure is growing disenchantment by government policy makers and users with public monopoly ownership and provision of infrastructure services. Underinvestment by many state utilities has resulted in a backlog of unmet demand for infrastructure services, and in many countries this is the principal constraint to 968
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growth. Power shortages have led to production shortfalls, higher costs (self-generation) and a decline in investment. Governments are responding to these inadequacies by providing increased opportunities for private participation. There is increasing evidence that the private sector generally is performing better in terms of construction costs and times, operation and customer service. Second, fiscal constraints on governments and external aid agencies have led to an increasing realization that private finance is necessary to address capacity shortages. Some governments have used infrastructure privatization to improve their public finances. The extra resources that private financiers and management bring are important.
Financing energy projects: G Bond and L Carter
Third, technological developments have reduced natural monopoly characteristics and allowed unbundling, private entry and competition into many infrastructure services. Independent power producers can construct and operate relatively small plants at unit costs comparable with larger generators. Better metering of power and water usage enables pricing for demand management, encouraging more efficient use. These technological changes are facilitating competition. Even small, low income countries are reaping the benefits: IFC has financed independent power plants in Guatemala and Nepal. Fourth, innovative financing techniques and the globalization of financial markets are offering more infrastructure financing options. The volume of transactions and the range of instruments used on the international capital markets has increased sharply in recent years. This has been driven partly by an increased supply of funds, as venture capitalists and institutional investors in developed countries have sought to diversify their portfolios and achieve higher returns, in addition the large size and long payback periods of infrastructure projects have demanded innovative financing techniques. Project financing has grown very rapidly: 1993 saw the first issues of bonds by greenfield private infrastructure projects in developing countries (Philippines and Malaysian power projects). Learning from other countries' experiences has been important. Many of the pathbreaking actions occurred in developed countries: the 1978 US Public Utilities Regulatory Policy Act started the independent power producer industry by requiring utilities to purchase power from competitive generators. The unbundling and privatization of the UK electricity industry in 1991 showed that it was feasible to introduce competition into distribution as well as generation. Particular countries have led the way: Chile and Argentina in Latin America; Malaysia and the Philippines in south-east Asia; Hungary in Eastern Europe; Sri Lanka, India and Pakistan in south Asia; and Ghana and Uganda in Africa. Private participation has spread across infrastructure subsectors, from telecoms and power generation, to ports, pipelines, roads, and more recently to water, railways and energy transmission and distribution.
ously when presented with appropriate opportunities. Clearly, many of the risks private investors confront are considered manageable. There are three stages to considering risk. First, the severity of each risk needs to be assessed. From the sponsor's perspective, what is the government's macroeconomic record? What has happened with similar projects? From the government's perspective, is the sponsor technically and financially strong? Is it politically feasible to allow the concessionaire to reduce employment in an enterprise? Lenders ask both sets of questions: given that they lend from a leveraged capital base but do not share higher than expected profits, they have the strongest incentive to assess risks thoroughly. Second, the party that is in the best position to manage each risk is identified. For example, the project sponsor is best able to manage commercial risks, whereas the government has control over regulatory risk. Finally, each risk is allocated, priced or mitigated between the parties, via contractual agreements. Risks do not disappear, but are borne by the parties best able to manage them.
Risk management
Fuel availability and costs are important operational risks in power generation projects. Fuel costs are often passed on to the purchaser, although the tariff regimes in operation allocate these risks differently. In the Philippines, contracts have been signed which pay independent power producers only for the cost associated with energy conversion; the project developer is relieved of any responsibility for purchasing the fuel and passing on the cost. The alternative method is for the project developer to arrange
Infrastructure projects differ from many other types of private sector investments in developing countries. Many have long lives, are large, immobile, generate only local currency revenues, buy from or sell to government agencies directly, are vulnerable to regulatory changes, and have politically sensitive tariffs. Private financiers are understandably cautious, yet they have responded vigor-
Construction risk
Management of construction risk is critical to completing projects within budget. Companies hedge construction risk by: (1) using fixed price, certain date turnkey construction contracts and building in provisions for liquidated damages if the contractor fails to perform (and bonuses for better than expected performance); (2) taking out business start up and other standard insurances; (3) building in a contingency to cover for variations; and (4) building in excess capacity, to allow for some technical failure to reach the required capacity. Lenders will not assume completion risk, so the burden is put on the project company, its sponsors, contractors, equipment suppliers and insurers. Typically the project company stipulates a completion date in the project agreement, complete with penalties and bonuses. It negotiates a similar, but tighter contract with a construction company, with liquidated damages provisions and bonuses. Lenders may also require project developers to guarantee to fund cost overruns and sometimes will require them to establish a standby credit facility for this purpose. Operational risk
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Financing energyprojects: G Bond and L Carter fuel purchase and then to pass on the fuel cost along with the cost of converting it to electricity; this has been used in Guatemala and in some Indian projects. Technical risks are borne by the project company, which undertakes to operate and maintain the plant to certain standards. These risks are typically hedged via (1) performance guarantees from supplier companies; (2) subcontracting a specialist company to undertake operation and maintenance, with bonus and penalty payments for performance; (3) business interruption insurance. In one project financed by IFC the concession requires the lead sponsor to maintain a minimum ownership share, in order to ensure that its technical skills are always available to the concessionaire. Market risk In most power generation projects, the market risk is taken by the purchaser. The power purchase agreement (PPA), which is the key contract in an independent power project (IPP), is usually structured in two parts: (1) a fixed capacity fee is paid if the plant meets designated availability requirements, and which usually covers debt service payments and an equity return; and (2) an energy fee, which is related to actual power deliveries. Inasmuch as the sponsors share in the market risk through the energy fee they are really sharing in the upside potential: higher energy purchases usually mean larger profits. However in more sophisticated and privatized regulatory environments IPPs take more market risk. In an IFC Chilean build--operate-own (BOO) power project the company is developing the project without having a single-purchaser PPA; instead it has signed several long-term contracts with different (private) purchasers. With a single purchaser, market risk becomes payment risk. Companies can hedge against this by asking for guarantees of the contractual performance of state owned enterprises (SOEs), as has been done in IFC projects in several countries, including India, Nepal and the Philippines. Although a government guarantee of contractual performance facilitates private entry, ultimately the government needs to address the underlying problems of non-viable state owned utilities, by allowing them to charge economic tariffs, improving efficiency standards and/or promoting privatization. Foreign exchange risk Foreign exchange risks are a major concern of foreign financiers investing in developing countries. Most infrastructure projects generate local currency revenues which raises two issues: (1) will the project have access to foreign exchange to cover debt service and equity payments; and (2) will the foreign exchange equivalent of the project's tariffs be adjusted for devaluation and 970
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thus enable foreign debts and equity to be serviced. Most of IFC's infrastructure projects have been undertaken in countries where private investors judged that convertibility was likely to be maintained, or where charges could be levied directly in hard currency. How can the foreign exchange equivalent value of a project's revenue stream be maintained - especially when infrastructure tariffs are subject to political influence? The methods used to deal with foreign exchange risk in IFC-financed infrastructure projects include: (1) building into the concession a commitment to link the project's tariff to the US dollar, but making payment in local currency. This leaves the project's lenders vulnerable to convertibility risk and has been used in countries where foreign financiers have been willing to bear that risk; (2) similarly, the government may permit a given return on an asset base that explicitly includes the cost of foreign debt service; (3) power purchase agreements may be partly denominated in US dollars, or the state utility may pay fees directly into an offshore dollar account, thereby assuming convertibility risk; (4) companies that earn foreign exchange directly, such as where power is exported to a neighbouring country, can charge customers in US dollars; (5) large companies (or smaller companies with strong sponsors) operating in major currencies may be able to hedge currency mismatches; and (6) where foreign investors felt sufficiently confident in the macroeconomic management of an economy, they were prepared to take currency risk. There is no single answer: the choice depends on the project, the country, the financial structure and the perceptions of the lenders. Regulatory risk Two kinds of regulatory risk frequently occur in infrastructure projects: (1) tariff adjustments not being permitted or made on time (in the face of inflation, or devaluation, for example). Companies can hedge against this risk by building in automatic adjustments to contracts, but ultimately complying with these obligations lies with the government, or its SOEs; and (2) regulatory changes. For instance, possible changes in environmental regulations concern many infrastructure companies and their lenders. Ultimately there is limited scope for companies (and, by extension, financiers) to avoid these risks, except to build in buy out mechanisms under certain extreme circumstances. In the Philippine BOT projects, the state
Financing energy projects. G Bond and L Carter Box I Addressing environmental concerns: Pangue hydroelectric project During the appraisal of the Pangue hydroelectric project in Chile concerns emerged over the project's impact on indigenous communities, the need for improved elcological knowledge in the region and the project's potential effects on river flows, fish habitats and other water users. After determining the volume of water that would need to be released to sustain fish habitats, the project was redesigned to meet the requirements of power generation, fish habitats and other water users. Addressing the impact of the project on indigenous communities and the local ecology required a more innovative approach. At IFC's initiative, the Pehuen Foundation was established to fund specific activities for the three communities of indigenous peoples in the project area. The Foundation is funded through a charge on the project's revenues. This approach was preferred to alternatives such as lump sum transfers because funds are available as long as the project operates and it targets the collective needs of the people most directly affected. Also at IFC's initiative, an ecological station has been established to rehabilitiate the construction site and study the ecology of the project area. Support lbr the research centre is coming from the project and other international research centres.
utility is obliged to buy the company's assets according to a prespecified formula, under certain circumstances. Investors are also offered some protection against regulatory risk through the costs borne by the host country in the event of adverse actions by government. If a government alters the regulatory framework in such a way that existing privately financed infrastructure projects become inviable, the economy may suffer costs larger than those borne by a single project's financiers. For example, potential future private investors may choose to locate in other countries. Environmental risk management
Private infrastructure provision is giving rise to new approaches to environmental management. Risks to the natural environment can result in risks to companies and their financiers. Private companies and financiers thus have financial incentives to assess environmental risk to distinguish acceptable from unacceptable outcomes, and to manage and mitigate those risks. Environmental risk mitigation can give companies and their financiers competitive advantage, and lowers the risks of damage to the natural environment. Infrastructure projects can affect the environment (see Box 1) through: (1) major hazards such as fire or explosion; (2) violation of environmental regulations such as emission standards; (3) site contamination; and (4) special concerns such as resettlement, affecting the indigenous population etc. These impacts may jeopardize the viability of a project, and therefore expose companies and their financiers to risks. For example, if a private power company installs
equipment that does not meet a country's emission standards, it faces the risk of(1) a civil suit; (2) incurring retrofitting downtime costs; (3) having its permit revoked, and not being awarded future permits. The company's financiers may have a bad loan, with collateral worth much less than originally estimated. These risks are systematic; they cannot be diversified away. Infrastructure financiers need to find a middle way between the two extremes of rejecting all projects with any environmental risk and ignoring environmental impacts altogether. Both companies and financiers therefore have strong incentives to minimize their exposure to these risks by assessing them, and then finding appropriate means to reduce them. Reduced environmental risks for companies and financiers mean correspondingly lower risks of damage to the natural environment. All projects in which IFC participates are subjected to environmental appraisal and clearance as a condition of approval. In some countries the experience of dealing with Bank Group environmental requirements has provided a model for upgrading local standards and developing institutional capabilities. Several beneficial environmental impacts have been observed from IFC's projects. Private entry is often associated with tariff reform, so prices of services more closely reflect economic costs, leading to large efficiency savings. The US$400 million 1992-95 investment programme of an Argentinean electricity distribution company, is expected to reduce energy losses from 30% to 15% over three years, which will reduce its purchases of bulk electricity by about 6%, equivalent to about 1.5 million barrels of fuel oil used in its production. By 1996 savings are expected to rise to 2 million barrels of fuel oil per annum. Another lesson is that private government contractual arrangements provide a mechanism for building in explicit environmental standards, and incentives for implementing and monitoring them. in the Philippines, energy conversion agreements signed between private power developers and the state utility incorporate a schedule detailing the information to be included in the environmental impact assessment study, warranties which bind the developer to construct, operate and maintain the facility 'in accordance with internationally accepted environmental standards adopted in the Philippines', and general conditions precedent which refer explicitly to an 'environmental compliance certificate for the power station'. The presence of explicit environmental warranties in the contract provides increased scope for ensuring compliance. A better understanding of what is at stake in environmental clearances is emerging as country and company experience increases. Many countries are upgrading their environmental standards, clearance procedures and Energo: Poli~T 1995 Volume 23 Number I l
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enforcement efforts. At the same time governments are recognizing that companies (and their financiers) need an indication of the liabilities that might be imposed via changing environmental standards before they will make large investments.
Finance Successful financing of private infrastructure involves matching the risk-return requirements of different sources of finance with project characteristics, and this is achieved through careful structuring. Many agencies participate in private infrastructure financing, often acting in concert in a single project. In addition to the finance provided directly by IFC, project funds are also supplied by international commercial banks, equipment suppliers' credits, private local lenders and investors, internal cash generation from the project company, and export credit agencies (EXIM banks) and multilateral banks. In IFC's projects, private foreign sources provided a quarter of the financing; adding in suppliers' credits raises this to 35%. Some suppliers' credits were financed by export credit agencies, whose role in infrastructure financing is becoming more prominent. A quarter of the financing in the IFC sample originated from private local sources. This is partly because many of IFC's established projects were in countries where domestic financial markets were already quite developed (such as India and the Philippines), or have since evolved rapidly (eg Chile, Argentina). Nearly a fifth of financing in the IFC sample was from internal cash generation, which is more often associated with an existing operation undergoing expansion than a greenfield project. External official agencies such as IFC, the World Bank and the Asian Development Bank, as well as domestic publicly owned institutions, provided finance. Where is the foreign equity coming from? US based multinational companies have provided over half. The single largest equity placement in an IFC project was for a Philippines power project, sourced from Hong Kong. In other projects, companies based in Spain, Malaysia and Singapore have also provided equity. These partners reflect both historical ties (eg Spanish links with Latin America), and the increasingly global approach to investment opportunities being taken by large companies, either as sponsors or minority participants. The financial structure of IFC power projects have been as follows:
(1) The average debt:equity ratio was 68:32, but this conceals a wide dispersion of debt:equity ratios between individual projects. 972
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(2) Power projects have had a higher proportion of debt than telecoms. The difference lies mainly in internal cash generation. Many power projects are greenfield (ie starting from scratch), without any internal cash generation available at the time of financing, whereas telecoms projects often use reinvested profits to help finance expansion. (3) Foreign financing exceeds local financing in all regions. Although there is sample bias (by definition all of IFC's projects have some foreign financing), most countries seem to need foreign financing during the early stages of a shift to private involvement in infrastructure. Mobilizing finance
During the last few years, for a variety of reasons, equity has become relatively more easily available for many projects in developing countries. Debt, which often accounts for over two-thirds of financing in a greenfield project, has become the key constraint- both in terms of volume and (particularly for infrastructure projects) maturity. There are several explanations. First, there are only 30 to 40 banks worldwide that have traditionally played a project financing role, although this is growing. Each bank has exposure limits to individual clients, sectors and countries and since a single bank can rarely meet all of the loan requirements of a large project, debt finance typically involves a syndication of l e n d e r s which can be time consuming and complex. Commercial banks are also constrained by the time profile of their deposits. They cannot prudently lend large volumes of long-term debt: the longest international commercial bank loans are typically 7-12 years. In contrast, many infrastructure projects require financing of over 10 years maturity if the tariffs to service the debt are not to be prohibitive. Institutional sources with long-term depositors, such as pension funds and life assurance companies, provide a better maturity match for infrastructure financing- but are highly risk averse. Lenders face many of the same risks as equity investors, but without the upside potential that attracts equity. They may compensate for these risks by adjusting their margins but there are limits to how far loan pricing can be pushed. More often, lenders seek to reduce a project's risks by negotiating the minimum conditions under which they will participate. Many of the agreements associated with project financings are risk control devices imposed by lenders. In most projects it is the lenders who have the strongest say in how the financing is to be structured, how support agreements from sponsors, government agencies and other contracting parties are specified, and how security provisions covering claims on assets are set out.
Financing energy projects: G Bond and L Carter New patterns of[inance
The limitations faced by banks in lending to projects in developing countries have stimulated the development of alternative financing arrangements to meet the large demand for infrastructure financing. Over the past two years several new investment funds have been created to mobilize funds from investors in the world's major financial centres for onlending and equity investment in developing country infrastructure projects. The Scudder Latin American Trust for Independent Power, formed in June 1993 with the assistance of IFC, was the first specialized fund designed to mobilize risk capital for investments in private power in developing countries. On a larger scale, the Asian Infrastructure Fund has been established as a US$500 million closed end fund (with IFC participation) that will invest primarily as an equity participant in private infrastructure projects in developing Asian countries. The Global Power Fund is another example of a fund set up to provide equity financing to power projects in IFC member developing countries. Larger private utilities are starting to access equity markets directly. Several companies have used American depositary receipts (ADRs) to tap the US equity market. ADRs enable foreign companies to issue equity on the US market without complex settlement and transfer mechanisms. Some large multinationals based in developed countries are expanding their financial intermediation role by issuing securities on US and European markets and investing the funds in selected funds and projects in developing countries. Securities issued by these companies are backed by the group's total operations, and hence their placement is made easier than if they were for developing country projects alone. Developing local capital markets
Although the volume of funds raised from local financial markets is still small (apart from in certain markets, such as India), it is growing. There are four channels through which local financing capabilities are being developed. First, companies already engaged in providing infrastructure services may issue equity on the local stock market. Second, institutional investors such as insurance companies and pension funds make private equity placements with individual project companies. A third linkage between infrastructure and local capital markets is through debt financing provided by local commercial and development banks. These institutions can be privately, publicly (government) or jointly owned. Most projects have local currency financing requirements and where possible local banks can contribute to the overall debt package. A fourth avenue for developing local capital markets is where infrastructure companies obtain debt finance through locally issued bonds. Bond issues
are more common from established companies with an earnings track record. However, examples of precompletion bond financing are starting to emerge in Chile and Malaysia. Each of these four types of capital market impact can be beneficial in terms of a country's broader funds mobilization capability, but the strongest impacts occur when project financing is taken to the local market, either in the form of an equity listing or a domestic bond issue. Permanent private ownership of facilities tends to be more conducive to a market offering than temporary arrangements like BOT. Hence the pattern of private entry that a country chooses for its infrastructure activities can to some extent determine the capital markets benefits that it receives.
Managing private entry The question for many governments now is not so much whether to involve the private sector in infrastructure provision, but how to manage the transition to private ownership so that it delivers as many benefits as possible. But deregulating and managing private entry can be politically and technically difficult. Government dilemmas include: (1) how to implement changes in the face of political opposition from important groups; (2) how to manage the transition from subsidized infrastructure service prices to cost related tariffs that enable a rapid expansion programme to be financed; (3) how to gain access to external technology and management, without engendering overriding opposition to 'foreign control' of politically sensitive assets and services. The political problem associated with infrastructure privatization is that, despite potentially large benefits for the population as a whole, there may be short-term losers, including: (1) existing consumers receiving subsidies, if private entry is accompanied by tariff reform; (2) employees of state owned enterprises who may be made redundant if they are privatized; and (3) existing private producers who may currently benefit from lack of competition in their sector. Furthermore, each of these groups is likely to be better organized and have more political influence than the broader community who ultimately stand to gain from more efficient service provision. There may also be technical difficulties. Most civil servants have little experience in dealing with risk taking entrepreneurs. Attempts to overregulate private entry can reduce the equity that sponsors are prepared to Energy Policy 1995 Volume23 Number 11 973
Financing energy projects: G Bond and L Carter
Political costs of adjustment/regulatory effort
LOW
HIGH
Publicly owned regulated monopoly
=-i "6
Unbundling and deregulation
Private entry allowed
No unbundling, vestiture only
Unbundling and )rivatiization
Divestiture
._o E
8 8
uJ Divestiture of SOE
Unbundling/ demonopoliization
Competitive/contestable private infrastructure provision HIGH
Figure I Transitional paths in infrastructure privatization
provide. Governments may not be ready to provide the politically independent (and sometimes highly technical) regulation that fully privatized infrastructure might require. IFC's experience provides examples of ways in which governments have addressed these difficult questions. There is no single blueprint for what works; the route depends on political commitment (critical), strength of opposition to change, institutional capabilities, investors' perceptions, and the domestic economic and legal environment. Furthermore, different infrastructure subsectors may be addressed in different ways in the same country. Figure 1 illustrates three ways in which private entry is occurring. The starting point in many countries is a state owned utility which operates as a monopolist and involves little regulatory complexity (top left corner). Private entry may occur through:
(1) Approach A: limited entry allows the private sector to enter parts of the market to provide infrastructure services. This often focuses on the construction of new assets, such as independent power plants, cellular networks or new ports. This approach may involve relatively low political costs, as many existing assets remain under state ownership. It is typically characterized by contractually based relationships 974
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(such as concessions), rather than wholesale regulatory reform. (2) Approach B, which requires considerable political will, is to divest (privatize) state utilities, but to postpone the unbundling in order to attract a strong response from private financiers. (3) Simultaneous unbundling, deregulation and divestiture (approach C) requires significant political commitment and institutional capability. It has been undertaken in several infrastructure subsectors in Argentina. Approach A (limited entry) may initially have advantages for certain countries. It has relatively low political and regulatory costs. Usually this requires steps to demonopolize the state utility's market, allow the participation of foreign capital, make a commitment to tariff reform, issue licences or concessions, and undertake a transparent tendering process to award them. The announcement of a credible set of sectoral reform policies can elicit a strong private sector response.
Conclusions The main conclusion to emerge from IFC's experience to date is that despite the risks, private financiers are
Financing energy projects: G Bond and L Carter
providing large amounts of at risk capital to invest in infrastructure services in developing countries. The volume of funds now being mobilized from the market is well above that anticipated only a few years ago and innovative new financing methods are being explored. Private firms are replacing state utilities and delivering better service to more people at reasonable cost. Both private companies and governments are assisting this process. Companies have supplied finance, and the ability to take risks and to implement projects efficiently. Governments have contributed a willingness to privatize, to experiment with new, more competitive regulatory environments and to encourage non-guaranteed financing. IFC's contribution has been as a facilitator, helping with business-government negotiations and bringing financing plans to completion, sometimes in a difficult country or regulatory environment. Many countries are improving their investment climate with the result that, in many parts of the world, perceived country risk is falling. Divestiture of state utilities has proved to be the most efficient way of enabling companies to mobilize the financing needed to carry out their infrastructure plans. Privatized companies have a much wider range of financing alternatives than projects financed on a limited entry basis. Privatization has given firms opportunities to access capital markets, and has
stimulated local funds' mobilization. Foreign loans are essential to most countries in overcoming their initial infrastructure problems but there are limits to the ability of countries to borrow offshore. Ultimately more funds for infrastructure investment will have to be mobilized domestically; governments that recognize this are taking steps to develop their local capital markets. These beneficial outcomes are not being experienced everywhere. Country risk is still a major obstacle to large-scale funds mobilization in many countries. Some governments remain committed to state ownership of infrastructure and in others vested interests are blocking competitive and transparent private entry. Institutional constraints are also a problem. The pace of reform will depend on how serious inadequacies in traditional infrastructure provision arrangements are perceived to be, and how the political process of transition is handled once private entry' is allowed.
Acknowledgement This article is derived from G Bond and L Carter (1994)
Financing Private Infrastructure Projects." Emerging Trendsfrom 1FC ~ Experience IFC Discussion Paper No 23, Washington, DC.
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