Financing the energy sector in developing countries

Energy"Policy. Vol. 23, No. I I, pp. 929439. 1995

I"~UTTERWORTH I~IE I N E M A N N

Copyright ~ 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0301-4215/95 $10.00 + 0.00

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Financing the energy sector in developing countries Context and overview

Joy Dunkerley 3921 Cleveland Avenue NW, Washington, DC 20008, USA

Traditional 'business as usual' financing methods will no longer be adequate to meet the unprecedented demands for capital to finance energy sector expansion in the developing countries. in recognition, many countries are opening up their power sectors to private investment, initially through the establishment of independent power projects, but in some cases through sector privatization. Project financing has many advantages, but further seetoral reorganization, including tariff reform, will be needed to attract resources on the scale required, especially from domestic investors. In oil and gas, in contrast to power, private capital from the international oil companies has always played a major role in the developing countries. However, sharply increasing investment requirements require a growing role for external finance. There should, in principle, be no shortage of investible funds to finance energy sector expansion in developing countries so long as host countries establish conditions which are attractive to private investors. The augmented role of private finance requires a continuing, if different, role for the public sector in both host countries and official aid agencies. Kevwords: Financing; Electricity; Oil and gas

This overview examines the changes taking place in energy sector I financing in the developing and emerging countries, in particular the growing role of private capital in the power sector which for the past 40 years or so has been dominated by the public sector. This is an important issue. The provision of adequate, reliable and high quality energy supplies is an essential condition for economic growth and social and environmental improvement. The lack of such supplies can impose immense economic and social burdens on a country. In the words of lndira Ghandhi, 'There is no power more expensive than no power'. 2 It is estimated, for example, that electricity shortages and disruptions in China during the 1980s were responsible for idling at least 20% of industrial capacity (Smil, 1990). Lost industrial output IWe deal here only with oil, gas, and power in the energy supply industry. We do not cover coal, whose level of investment though substantial is much lower than in the other sectors, perhaps about 6% of the total. Finally, coal is a major source of energy in only a few (though important) countries. 2Quoted in Financial Times survey of Maharashtra, 19 June 1995.

caused by shortage of electricity in India and Pakistan is estimated to have reduced total GDP by about 1.5 to 2% in the mid- 1980s (Sangvi, 1991). Shortages of transport fuels, especially in rural areas, hinder agricultural development and marketing. This is a good moment to examine trends in energy sector financing. A sufficient number of privatizations and privately financed projects are under way to provide some basis for evaluation, and to consider whether this movement is merely an extended flash in the pan or the beginning of a fundamental, beneficial and sustainable change in the way the energy sector is financed and organized. As stated in a recent article on developments in infrastructure finance in general, 'Should the recent wave be viewed as the beginnings of a new trend, or "simply" as another cycle of the great privatization/nationalization wheel? '3

3For further discussion of this trend see Klein and Roger (1994).

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Financing the energy sector in developing countries: d Dunkerley

Table 1 Estimated investment in commercial energy supplies in developing countries, early 1980s (billions of 1982 US$) Source of funds Electricity O11 and gas Coal Total Foreign exchange external borrowing other Local Total

11 1I 0 19 30

20.5 4.2 16.3 h 10.5 31

1 0.5 0.5 3 4

32.5 15.7 a 16.8 32.5 65

a o f which export related US$5.1 billion, multilateral US$3.9 billion, bilateral US$1.5 billion, financial institutions US$5.2 billion. bAssumed private investment and expenditure of countries own foreign reserves.

Source: Based on data in World Bank (1983), pp 68, 69.

requiring, private investment from domestic sources. Though these projects are characterized as 'private', many have an important public sector component, in the form of guarantees from host governments, and support from bilateral and multilateral agencies. The developing interest in private finance was due to a combination of reinforcing causes (see Bond and Carter, this issue) that together gave a powerful impetus to overcome the considerable barriers that had previously discouraged or prohibited these developments. Underlying these circumstances was a growing realization of the magnitude of the financing task ahead, and the inability of governments to raise or underwrite the required funding.

Power Context

To appreciate the nature of the new developments, it is helpful to put them in historical context. Early power systems in developing countries were usually small systems by today's standards, privately financed and confined to selected markets largely in urban areas. Developments in technology favouring larger units and integrated transmission systems to capture economies of scale, and the realization of the strategic role of electricity in modernization and economic development, led to the nationalization of the sector in most countries upon independence - following the pattern established in many European countries in the post World War 2 years. The local cost component of power sector investment (which accounts for about two-thirds of the total (see Table 1) was met entirely by the public sector. Public sector agencies also orchestrated the foreign exchange component, derived largely from official assistance agencies, and in the 1980s at least, from loans from financial institutions. This was the situation until a few years ago, when several countries began to permit private capital to invest directly in the power sector. This was done in a number of ways. In a few countries, with Chile the outstanding example among developing countries, the power sector was completely privatized, and the vertically integrated structure 'unbundled' to separate generation from transmission and distribution. Other developing countries undertaking power privatization include the Philippines, Mexico, South Korea, Malaysia, Turkey and Argentina.4 However, most countries took the more limited route of encouraging privately financed independent power projects (IPPs) - usually relying heavily on foreign investment and enterprise, but sometimes including, even 4privatizations of power generation and distribution in these countries between 1988 and 1992 totalled over US$5 billion: Bond and Carter (1994), p 45.

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Power sector investment needs. Investment in the power

sector alone (accounting for about half of total energy sector investment in the developing countries in the early 1980s) is put at (current) US$1 trillion (US$740 billion if expressed in constant 1990 dollars) for the decade of the 1990s, or US$100 billion a year (World Bank, 1990). This estimate, though carefully qualified by the authors ('It is a compilation of LDC programmes and not a World Bank forecast') has been widely used to underline the need to look for alternative forms of finance. Large though these numbers are, they could well underestimate energy sector financing requirements. The estimates are based on an assumed annual rate of growth in electricity consumption in the developing countries of 6.6%, considerably lower than the 8.1% experienced between 1971 and 1992 (IEA/OECD, 1995, Table A13), despite a much higher rate of economic growth. Ownership of electric appliances is increasing rapidly in the households of the developing world. Even low income households, such as in India and China, have rising levels of TV, radios, fan and refrigerator ownership. The industries of the developing world, seeking to expand their export markets and remain competitive at home, will require rapid increases in electricity services. It could be quite reasonable, and not out of line with historical experience, for electricity use to increase much faster than current projections. In Ghana, for example, electricity consumption over the past eight years has been growing at more than twice the rate of increase in gross domestic product (GDP) (The Economist, 1994, p 45). If demand grew more rapidly than forecast, so would the estimates of capital investment that underpin them. Another factor leading to possibly higher power sector capital investment stems from the changing nature of the product. Electricity must now meet high standards of availability, reliability and cleanliness. When electricity using equipment is robust or inexpensive (as in the case of light bulbs and simple electric motors) poor quality electricity supplies can be accommodated,

Financing the ener~, sector in developing countries: J Dunkerl~

though at some cost. As the use of electricity spreads to complex motors, computers and sophisticated household appliances, the quality of electricity becomes critical. Moreover, environmental considerations are likely to play a greater role in future. At present the power sector is a major source of air pollution. A massive addition to generating capacity, likely under any scenario, without aggressive efforts to address pollution issues, could lead to intolerable environmental damage. Improving electricity quality and minimizing environmental impact are likely to add to capital investment. It is argued, of course, that these extra up front expenditures pay for themselves by reducing costs of after the fact damage, but the initial impact will be higher initial capital costs. On the other hand, the assumptions of declining rates of growth in electricity consumption could possibly be fulfilled and even exceeded. Many studies testify to the large potential for improving the efficiency with which energy is used in the developing countries. An Office of Technology Assessment (OTA) report (1992), for example, concludes that for a wide range of electricity using services - cooking, water heating, lighting, refrigeration, electronic information services, industrial motor drive - overall electricity savings of nearly 50%, with lifecycle savings of 25%, are possible with current available energy efficient technologies. Improving efficiency along these lines could lower installed capital costs when all system-wide financial costs are accounted for. In addition, the power sector in many developing countries operates at very low levels of technical efficiency. Substantial savings in capital investment could be achieved through the rehabilitation and performance improvement of existing capacity. These different considerations suggest that actual capital investment in the developing country electricity sector could be higher or lower than the widely accepted US$1 trillion. Even allowing for some range, these still appear to be awesome figures. However, to put them into context, they are probably not much out of line with the customary share of electricity in total investment or economic output and, on paper at least, need not place undue demands on domestic and international financial resources (Churchill, 1993, p 455). In practice, however, such sums could not be raised within the traditional financial framework that has developed post World War 2. Meeting these increased capital needs virtually dictates the need for changes in the structure and organization of the power sector in developing countries.

The.lkdtering traditional financing system. The immediate reasons for looking to new forms of power sector finance was the growing inadequacy of the traditional forms of capital- revenues of utilities, government sub-

sidies, and public and private foreign loans, in principle, revenues from the sale of electricity should provide the utility with financing sufficient to cover operating costs and meet the costs of future expansion. However, throughout the 1980s tariff increases failed, by a wide margin, to keep pace with rising costs. Electricity tariffs in developing countries towards the end of the 1980s at US¢(1988)4.5 were just over one-half of tariffs in the Organization for Economic Cooperation and Development (OECD) countries (US¢8.1) and probably represented no more than one-third of costs (Schramm, 1993, p 739). Indeed some estimates (Anderson, 1994) suggest that the revenue shortfall amounted to over US$100 billion a year (about the same as the estimates for new investment). The financing gap caused by these low tariffs was largely met by advances from governments, who were themselves encountering mounting budget difficulties. Difficulties were also encountered with external financing, provided in the 1980s largely by multilateral and bilateral aid, and private financial institutions. However, as external debt and debt service ratios rose (World Bank, 1994, Table 23, p 206) many developing countries were unable to borrow from abroad as freely as before, and nor were the commercial banks, who had burned their fingers in developing country lending during the 1970s, eager to accommodate them. Multilateral and bilateral aid levels were also constrained by budgetary difficulties in donor countries and were thought unlikely to rise substantially in future, or even to decline.

The need./or improved ef[iciency. These financial problems gave rise to a 'demand' for private financing from several developing countries. The interest in encouraging private finance is also closely associated with the need to improve the overall performance of the power sector. A large number of careful studies attest to the low level of performance and operational efficiency in the utilities of the developing countries (Schramm, 1993). Average thermal efficiencies are some 30% lower in many developing countries compared with utilities in industrial countries, and distribution and transmission losses are similarly higher. It was felt that an increased private presence would not only provide financial resources but also the financial and managerial discipline lacking in the public power sector. Quality considerations in particular weigh heavily with industrial users whose tolerance for poor quality electricity is low. Indeed, many install expensive back up facilities (costing as much as US¢60/kWh) to compensate for erratic public sector supplies. For these customers, the higher tariffs charged by an unsubsidized IPP could well represent a significant decline in their total electricity costs (Schramm, 1993, pp 741-742). Energy Policy 1995 Volume 23 Number l I

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Financing the energy sector in developing countries: J Dunkerley Table 2 Growth of developing country and global electricity production Electricity output (TWh) Region Scenario A: energy savings World Developing countries Developing countries as share o f world (%) Scenario B: capacity constraint World Developing countries Developing countries as share of world (%)

Increase in output (TWh)

1971

! 992

2010

1971-1992

1992-2010

5308 549

12 220 2 796

17 947 6 618

6912 2247

5727 3822

10

23

37

33

67

5308 549

12 220 2 796

20 308 7 014

6912 2247

8088 4218

10

23

35

33

52

Source: International Energy Agency (1995).

The availability of private finance. Coinciding with the rising 'demand' for financial innovation were several developments on the 'supply' side. Suppliers of electrical equipment in the industrial countries, experiencing surplus capacity because of slower growth in their traditional OECD markets, came to realize that the expanding markets of the future lay in the developing world. From 1971 to 1992 (see Table 2) the developing countries accounted for less than one-third of the global (excluding the former Eastern Bloc (FEB)) increase in electricity consumption. Over the next 30 years, the International Energy Agency (lEA, 1994, p 59) projects that developing countries will account for about 60% of global capacity increases (again excluding the FEB), which probably represents a higher share of global capacity increases likely to be accessible to foreign investment. Capacity in both Asia and Latin America is projected to increase by 50% over the next 5 to 10 years, of which one-quarter could represent private sector potential. 5 The developing countries are seen as the growth markets of the future. Supplier companies looking to the developing world for business are inevitably drawn into looking for ways for financing projects. At the same time, new sources of funds were becoming available. The deregulation and growth of the global capital market in recent years meant that large sums of money were newly available for investment, especially in the countries of the developing world where economies were growing faster and returns were perceived to be higher. Along with the increase in funds available, new institutions and instruments were also being developed, including infrastructure funds (see Bond and Carter, this issue). Although much attention has been addressed to foreign investment in the power sector, the financing requirements are of such a scale and maturity that the bulk of investment must necessarily come from indigenous markets.

Technology. Recent changes in technology played an important role in encouraging project finance, at least in its early stages. Previously technology had appeared to encourage large central generating stations, vertically integrated, with captive transmission and often distribution systems, in order to capture the full benefits of economies of scale. New developments are offering a broader range of options. The combined cycle gas turbine (CCGT), which has permitted the construction of relatively small plants at unit costs similar to larger generators, is particularly important. This technology could have profound impacts on the structure of the power sector. Being small and modular, it permits decentralization of generating capacity, and makes it easier to develop capacity incrementally with load growth. It also makes it easier for newcomers to enter the industry. Continual technical improvement is improving efficiency; current designs are already 20% more efficient than the state of the art technology of five years ago. CCGT technology provides a market for natural gas whose deposits in many developing countries were not developed due to lack of market. This technology also offers strong advantages to private investors, especially from abroad. The smaller scale of the project means that less capital is tied up in a single project, and the speed of construction 6 starts the revenue stream much sooner. Furthermore, the capital costs per

5Data compiled by M Hoskote of the World Bank and quoted in Anderson (1994).

6A CCGT can start operating in its single phase in nine months, with the combined cycle being added while the plant is operating.

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Here, too, deregulation and innovation is helping to unlock these countries substantial financial resources. Chile, for example, has its privatized pension funds, which are well situated to provide the long maturity loans required in utility financing. However, progress in capital market development is as yet modest. Further reform and deregulation will be required if adequate supplies of local capital are to be forthcoming (see Jechoutek and Lamech, this issue).

Financing the energy sector in developing countries: J Dunkerlo:

kilowatt for gas turbine plants are between 40 and 60% of those of conventional thermal or hydro plants. Technical developments in renewable energy also offer new opportunities for decentralized power.

role in granting permission for the project to be undertaken and in the first wave of projects at least, providing guarantees without which the projects would not have gone ahead.

The spirit of the age. The interest in introducing private capital into the power sector can be seen as part of a strong movement towards privatization and deregulation in recent years, 7 the counterpart of the strong wave of nationalization that took place in the 1950s. The beginning of the deregulatory movement in the power sector can be marked by the passage of the US Public Utilities Regulatory Policy Act in 1978, which required utilities to purchase power from independent producers able to supply it at a lower cost, though it took some ten years before independent power projects got under way in the USA. The privatization and unbundling of the UK electricity industry in 1991 was o f particular interest to many of the developing countries because the nationalized structure of the UK sector more closely resembled their own than did the US investor owned system. These developments meant that new options were introduced into the ongoing debate about what to do about the power sector. Furthermore, countries wishing to try something new received strong encouragement, particularly from the highly influential MDBs.

The pros oflPPs. Once negotiated (a process which can take many years, however) these projects can be built and put into operation quite quickly. In some cases they can offer a dramatic improvement in supplies, alleviating serious shortages. For example: the Philippines mounted a crash programme under the 1993 Power Crisis Act (International Private Power 1st quarter 1995, pp 179-190) in which 27 IPPs were negotiated and put into operation in less than two years. Most projects are reported to operate at a high level of efficiency and availability. Second, they can provide additions to capacity without further burden to the public finances. If a host government does not have the resources to expand its power sector either because of fiscal or external indebtedness constraints, then private capital, from both home and abroad, could finance capacity that otherwise would not have been built. However, things are rarely as clear cut as that. Most projects call for government participation in one form or another (see Carstairs, this issue). For example, governments may be asked to provide a guaranteed market for the electricity produced. If, as in many countries, the guaranteed price is higher than domestic tariffs, and the difference has to be met out of public funds, there may be no lightening of the fiscal burden. Furthermore, government guarantees are considered by the International Monetary Fund (IMF) and therefore capital markets, as contingent liabilities. A government which is considered profligate in its extension of guarantees risks damaging its credit rating, thereby incurring higher interest costs on its foreign debt. These guarantee related problems are being addressed by the development of techniques, such as escrow accounts, and direct billing of customers, which reduce the need for government guarantees while still providing foreign investors with sovereign risk protection. Third, IPPs can represent an important force for tariff reform. It is difficult to see how power supplies can be increased without substantial upward revision in tariffs, irrespective of sector organization or ownership. So far, political pressure has been overwhelmingly on the side of subsidized power. Private investors, both foreign and domestic, can provide an important counterweight in the inevitable debate that will be taking place on the future of the power sector in developing countries. The new private investment environment might serve to bring home to policy makers the true costs of subsidized electricity, and encourage them to allow the state owned utility to begin raising tariffs.

Assessment A substantial amount of project finance has been undertaken in recent years, especially in the power sector. The essence of project finance is that it sets up a project which is entirely freestanding - that is not backed by the full assets of the sponsoring companies. This procedure has the advantage of not putting the balance sheets of the parent companies at risk. But it also means that payments to equity and bond holders must come out of the revenues and profits of the project itself. This is often called non-recourse financing to signify that those who invest in the project have no 'recourse' to assets other than those of the project itself. (Limited recourse projects are a variation under which investors have some but not total recourse.) The equity is typically provided by the project sponsors and covers the development and construction phase. The share of equity in the project is usually higher - 25 to 30% - than in established utility markets. The rest of the capital is borrowed from a variety of sources - foreign investors include commercial banks, infrastructure funds, equipment suppliers, multilateral development banks (MDBs) and export credit agencies (ECAs). Domestic investors include the business community, pension funds, local commercial banks and pension funds. The host government plays a major 7For an excellent account see Klein and Roger (1994).

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Financing the enelgy sector in developing couno'ies: J Dunkerl~

Fourth, these projects are initially attractive to host governments as they permit them to address power problems at the margin, without disturbing the existing structure of the sector. IPPs can improve power supplies in some regions without the difficult political issues raised by privatization or otherwise fundamental sector restructuring. In this sense, IPPS entail relatively low political costs for host governments. The power sector inevitably attracts a good deal of political interest. 'It is illusory to believe that politics can be removed from the utilities. They are central to the performance of the economy as a whole, there is a strong monopoly element and they have a large impact on living standards. '8 Any innovation that can finesse these political problems, or even postpone them, is attractive to host governments. Fifth, these projects can give a country access to new technologies, and perhaps more important, access to the high level of management and commercial discipline needed if these new projects are to be successful. One of the major reasons attributed for the wholesale failure of the power sector in developing countries in recent years is reported to be poor management. An allied advantage is that the presence of new efficient generators can provide a competitive jolt to moribund state systems. Indeed there is an argument to be made 9 that the important thing about foreign capital may not be its sheer volume but rather its role as a catalyst for the reform and improved performance of the energy industries of developing countries. Sixth, the new projects are almost certainly environmentally beneficial as generating operations. Those that receive support or guarantees from MDBs or ECAs are obliged to undergo an environmental assessment. The concept of environmental risk is widely accepted in the contract negotiations, and most projects exceed regulatory requirements by a considerable margin to protect themselves from any future tightening of standards. The new generating facilities are more efficiently operated than those of the public sector, thus reducing the amount of pollution for a given output of electricity. Many use new technologies (especially gas) which minimize environmental pollution. Finally, the new private projects leverage available public sector resources. The World Bank has been a major source of finance to the electricity sector of the developing countries (loans totalled about US$2.5 to US$3 billion annually, representing some 7% of total external sector financing). The vast majority of World Bank lending is to public power projects, and all of its financing requires a government guarantee. By provid8K Dieter Helm, Oxford Economic Research Associates, quoted in the Financial Times. 9Edward Cart, The Economist newspaper, personal communication.

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ing resources and guarantees in non-recourse projects (like the Hub Valley project in Pakistan), however, the World Bank and the other MDBs are able to increase the impact of their lending activities. The IFC has leveraged US$7.4 billion of power projects from its net investment of US$850 million. Bilateral agencies, such as the Overseas Private Investment Corporation (OPIC) are also leveraging their lending and guarantee activities through the development of project finance programmes (see Himberg, this issue). The limitations oflPPs. As IPPs combine so many interests, and actors, and need to allocate a variety of different risks they are complex and time consuming to negotiate. The apparent unravelling of the Enron power project in the state of Maharashtra, India, after years of negotiation and a firm contract, underlines the risks of such venture, and suggests that small projects are easier to negotiate than larger ones. These projects are, on paper at least, more expensive than government financed operations based on (lower) public financing rates. In part this is due to the explicit recognition and pricing of risk that had previously been borne implicitly by the public sector. Though it is always useful to recognize the size of implicit subsidies, the public sector may in fact be the most logical party to bear certain risks (analogous to self-insurance). Part of the higher cost may be due in some countries to the high returns guaranteed to investors (25% in real terms in the case of Indonesia). However, publicly financed projects often turn out to be more expensive than initially planned because of cost and time overruns. Though environmentally sound as far as they go, independent projects are designed to produce and sell electricity. In many cases their contracts are structured to provide strong incentives to increase sales over a specified level. 10 This means that they have little incentive to include end use efficiency programmes, which on a systemwide or national basis, may be a more cost effective way of meeting the demand for energy services than increasing supplies. However, pressure to increase tariffs which will come from greater private participation in the power sector will encourage end use efficiency, Independent power and the broader power sector. A longer-term question is how independent power projects fit into the financing of the broader power sector. The power sector in the developing countries - with some notable exceptions - is typified by poor operational, fin-

101n current Indian projects, for example, a rate of return of 16% is allowed for independent power producers. However, the private generator can earn more than if the plant load factor exceeds the agreed norms. See Ranganathan (1993).

Financing the e n e l ~ sector in developing countries: J Dunkerlcy

ancial, management and regulatory performance. Poor maintenance results in unreliable service and frequent and costly system breakdowns. IPPs contribute to the solution of these problems by providing (relatively small) amounts of high quality power, and an example of efficient and disciplined operation. But they can play only a limited role in addressing the wider problems of the power sector (see Jechoutek and Lamech, this issue) both because of their relatively modest scale in the total and the structure of their finance which depends heavily on foreign investment. Though foreign investment can play an important role in power sector development, the bulk of power sector finance must eventually come from local sources and, in the absence of major increases in public sector funding, largely from domestic capital markets. However, domestic investors are unlikely to be attracted to the power sector in its present economic and financial condition. Major sector restructuring, as well as reform of local capital markets, will be required before sufficient domestic resources can be mobilized. The restructuring debate has centred on two models: corporatization (which provides for management autonomy while retaining public ownership) and privatization (which transfers ownership to the private sector). Proponents of the corporatization model argue that the basic problem of the energy sector in developing countries is poor performance rather than ownership as such. They contend that so long as the industry operates in a competitive market, staff incentives are focused on efficiency and reliability, and management is given autonomy to follow market signals, it makes little difference whether the industry is privately or publicly held. In support of their argument, they point to several power systems in OECD countries which are publicly owned but operate at high levels of efficiency. Another example more recently quoted is South Africa's ESKOM, a government owned entity, which is one of the largest utilities in the world, with low costs but relatively high rates of profit. Supporters of privatization cite empirical s t u d i e s comparing rates of return in public and private enterprises, and observing the experience of the same enterprise before and after privatization - that support the view that privatization delivers better results. They argue that even if a government establishes correct policies under a corporatization model, in practice it may be difficult to make these policies stick (see Nellis, 1994). Privatization gives greater assurance of long-term sector autonomy, especially in the highly political area of tariff setting. Supporters of privatization point out that even countries (such as Thailand, South Korea, Malaysia) where publicly owned power companies have performed well, are privatizing, implying that these

countries consider private ownership important for power sector development. There is unlikely to be one solution to fit all cases. Despite the common features of the power sector throughout the world, its organization, including the role of government, varies widely between countries, suggesting that history, and local institutions have a considerable influence on industry organization (Gilbert et al, 1995). Whatever the choice, government will continue to play an important role in the power sector. Privatization is not a 'one off' affair, which removes government from the sector once and for all. An active and continually adjusting government facilitative and regulatory role is also necessary (see Lock, this issue).

Oil and gas The financing of the oil and gas industry in developing countries differs markedly from power sector financing (see Table 1). Though there have been many changes in recent years, private foreign investment continues to play a major, even predominant, role in industry finance (Razavi, forthcoming). Large oil projects in the past have usually been for export, giving the project 'automatic' access to international prices and foreign exchange without requiring major reforms in the local economy, as is the case with power projects. Oil projects are therefore perceived as less risky than power projects. (With growing local demand, however, more oil projects will cater for local rather than export markets.) Domestic gas projects are, however, similar in many respects to power projects, and even gas export schemes, while providing access to foreign currency are more complex in that they require dedicated customers and longer pay backs, Before the 1970s virtually all oil and gas development in developing countries was financed by a handful of large international oil companies (IOCs), either from their internal resources or borrowing from commercial banks. The major change in this system took place in the 1970s when a number of developing countries nationalized oil operations and established large national oil companies (NOCs). I1 In this way, the public sector came to play a larger role in providing or channelling funds to oil and gas projects. The IOCs remained highly active in those developing countries with nationalized industries, however, through various types of joint ventures and/or service contracts with the NOCs. At the same time, there was a rapid increase in the number of

Iqn some countries, such as Mexico and Argentina, nationalization had taken place much earlier.

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Financing the eneJ~gysector in developing countries: J Dunkerley Table 3 Growth of developing country and global (primary) oil consumption Oil consumption (Mtoe) Region 197 ! ! 992 Scenario A: energy savings World Developing countries Developing countries as share of world (%) Scenario 13: capacity constraint World Developing countries Developing countries as share of world (%)

2010

Increase in consumption (Mtoe) 1971-1992 1992-2010

2327 313

3109 862

4210 1624

782 549

1101 762

13

28

39

70

69

2327 313

3109 862

4394 1717

782 549

1285 855

13

28

39

70

69

Source: International Energy Agency (1995).

smaller oil companies engaged in international exploration activities. J2 The 1990s are witnessing further change. As with the power sector, governments are reducing their role in oil and gas development. Several countries, for example, Argentina, have privatized their oil industry, and others have become more open to foreign investment through liberalizing access to acreage and improving the terms governing joint ventures and service contracts. The IOCs, however, are operating under much more stringent conditions, leading to higher demands for external capital. There is also a shitt from corporate to project financing, partly because of the sheer size of some of the planned oil or gas projects, but primarily for risk spreading. The oil and gas industry share a common challenge with the power sector- how to finance the capital expenditure needed to satisfy the rapidly rising demand for petroleum products and gas. Oil consumption in the developing countries (see Table 3) is projected to rise by an annual average of 3.6% - twice the world average - increasing the share of the developing countries in global consumption to almost 40% in 2010, compared with 28% now. Under this scenario, the developing countries would account for almost 70% of total increases in world oil consumption. No doubt part of this increase in consumption will be met by imports, but much will necessarily be produced or processed at home. The rising demand for transport fuels in the developing countries implies the restructuring of the refinery sector, including high cost refinery reconfigurations. There are similar trends in gas (see Table 4). Sharp increases in consumption would double the share of the developing countries in world gas consumption from 15% to 30% in 2010. These countries would account for between 50 and 80% of the global increase in gas consumption between now and 2010. The strong demand t2According to a World Bank study 'more than 300 oil companies explore in two or more countries, and exploration by private companies takes place in more than 150 countries': Khelil (1995).

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for gas in the developing world (particularly in India, Pakistan, Thailand, and Brazil) underpins some of the massive LNG and pipeline projects currently under discussion (Hamso et al, 1994). Finding the capital resources to meet these growing demands for petroleum products represents a major challenge. During the 1980s capital investments by the global oil and gas industry amounted to about US$1 trillion dollars, most committed in the early 1980s. Capital requirements for the 1990s are assumed to rise sharply from this level. Extra investment is needed to compensate for the low levels of investment in the late 1980s. In addition, the privatization of state oil and gas companies, and the reduction in the level of state ownership is creating unprecedented investment opportunities, amounting to many billions of dollars. The total will be swelled by the development of major gas projects such as the proposed Qatar-India LNG project (US$5 billion), and the development of the Natura fields in Indonesia (US$1619 billion) (Razavi, forthcoming). Finally, the rehabilitation and development of the oil and gas industry of the former USSR (FSU) will require huge amounts of capital investment. It is estimated that from US$50 to US$100 billion capital expenditures would be needed to restore FSU oil production to its peak level of 12.5 mbd and ensure a continued rise in gas production (Petroleum Finance Company, 1993, pp 3, 4). Estimates of total capital requirements for the global oil and gas industry in the 1990s range from US$100 to US$200 billion annually (see Humphries, this issue) with the expectation that they will considerably exceed the lower level of the range. This would amount to between substantially over US$1 trillion for the decade, and possibly as much as US$2 trillion. Though these are large numbers, they do not seem unattainable. A recent industry survey of capital expenditures of 38 US companies, for example, showed capital spending of about US$55 billion by those companies alone in 1993.13 A 13Clive Armstrong, Washington DC, personal communication.

Financing the energy sector in developing countries." J Dunkerley

Table 4 Growth of developing country and global (primary) gas consumption Gas consumption (Mtoe) Region 1971 ! 992 Scenario A: energy savings World Developing countries Developing countries as share of world (%) Scenario B: capacity constraint World Developing countries Developing countries as share of world (%)

Increase in consumption (Mtoe) 2010

! 97 I-1992

1992-2010

896 41

1745 258

2263 672

849 217

518 414

5

15

30

26

80

896 41

1745 258

2708 741

849 217

963 483

3

15

27

26

50

Source: International Energy Agency (1995).

substantial part of this capital expenditure will be committed in the developing countries. One estimate assigns about US$500 billion to these countries (not including OPEC and countries of the FSU) (Petroleum Finance Company, 1993, Appendix 1).14 These large demands for capital investment are coming at a time when the industry's cash flow - traditionally a major source of investment funds - is depressed, due to low oil prices. This means that both the IOCs and the NOCs will have to raise increasing amounts of external capital. In some respects the situation is favourable. The deregulation of international money markets has resulted in large increases in the availability of investible funds. But the scale of the needs does mean that, like the power sector, there will have to be some departure from 'business as usual' procedures. The oil and gas industry may be better situated than the power sector in this respect. Change in financing has been forced rather abruptly on the power sector, whereas the oil and gas industry has had considerable experience in financial innovation, especially in the development of the Alaskan field, and the North Sea in the 1970s. These new areas presented both the oil industry and financial community with the challenge of financing projects using new technology in high risk, hostile environments. The challenge is similar today both in terms of the scale of funding and the need to allocate risks between both borrowers and lenders. There are a number of potential suppliers of funds (see Humphries, this issue). The equity market will remain an important if necessarily limited, source of capital. Syndicated debt is of increasing importance in energy related projects as it can be structured to meet the particular relaNote that Table 1 shows capital expenditure in oil and gas in the developing countries in the early 1980s comparable in magnitude to investments in the power sector. If the same relationships were to hold in the 1990s, this would imply oil and gas industry capital expenditures in the developing world alone of US$1 trillion. However, the early 1980s were a time of exceptionally high capital expenditures in the oil and gas industry that were not sustained throughout the decade.

quirements of the individual project and can be rapidly arranged. The bond market is also attractive because of its lower rates. The oil industry raised about US$52 billion in new public debt in 1992. A new and important development is the increased use of derivatives to hedge against crude oil and oil product price movements as part of long-term risk management strategies. The MDBs and ECAs can play a catalytic/demonstration role in capital mobilization. In addition to funding oil and gas projects in developing countries, the World Bank (see Razavi, this issue) develops legal and regulatory frameworks in host countries, and helps restructure and privatize the industry. The World Bank also helps mitigate political risk, a major consideration in large projects as in the international gas trade where output is delivered to a captive market. The Multilateral Investment Guarantee Agency (MIGA), part of the World Bank group, provides insurance (at a price) against specific political risks - currency transfer, expropriation, and war and civil disturbance. The International Finance Corporation (IFC), the private sector branch of the World Bank Group is also active in helping finance oil and gas projects in the developing world. IFC investment approvals total nearly US$2 billion in projects whose total investment amounted to nearly US$15 billion, mainly in production. Unlike most other sources of multilateral financing, the IFC accepts commercial risk on the projects that it supports and is also an active equity investor. In the final analysis, however, the attitude of host governments is critical to the mobilization of adequate capital. If developing countries wish to receive an adequate share of global oil and gas investment, they must offer terms and rates of return which compare reasonably with those offered in other areas. In some respects the position is improving. In recent years, many developing countries have been liberalizing access to their oil and gas sectors. Argentina has privatized its industry (YPF) and Brazil and Peru plan to privatize shortly. Even Mexico is opening up certain portions of its industry to Energy Policy 1995 Volume 23 Number 11

937

Financing the energy sector in developing countries." J Dunkerley

private sector activities. Changing views of economic development in India, China, and Vietnam are resulting in greater incentives for foreign investment. Despite these moves, the incentives offered by developing countries frequently do not compare favourably with other areas. The World Bank (Khelil, 1995) calculated the government 'take' - that is the percentage share of the government in the total cash flow of the project - of a large number of countries, including importing countries with 'modest' geological prospects (such as the Republic of Korea, Nepal, Bangladesh, India, Tanzania, Ghana) and found that these countries offered terms that were not internationally competitive, even if they appeared competitive on a regional basis. In company with many other countries, the developing countries have fiscal systems which discourage the development of small fields. This fiscal characteristic, which may not be critical for those countries with large resources, can be damaging to the prospects of countries that may only have small fields.

for the public sector in both host countries and official aid agencies. In oil and gas, global capital needs are rising sharply at a time when the industry's cash flow - traditionally a major source of investment - is depressed due to low prices. Both IOCs and NOCs will therefore be obliged to raise increased amounts of external capital. This process should be less disruptive than in the power sector. Private investment has always played a major role in the oil and gas industry. The industry has also had considerable experience in financial innovation especially as a consequence of the development of Alaska and the North Sea. New financial instruments, derivatives, are at hand to mitigate risk. The challenge for the developing countries will be to offer terms and rates of return which compare reasonably with those offered in other competing areas. As in the power sector, this will require new public sector roles both in host countries and official aid agencies.

Conclusions

The author wishes to thank Denis Anderson of the World Bank; Clive Armstrong and Lawrence Carter of the International Finance Corporation; Scott Custer of Shaw, Pittman, Potts and Trowbridge, Washington, DC; Michael Humphries of the Petroleum Finance Company, Washington, DC; Gunter Schramm, Independent Consultant, Washington, DC; Gabriel Roth, Independent Consultant, Washington, DC; Edward Carr, The Economist newspaper, for helpful and detailed reviews. She has also benefited from discussions with David Jhirad, the coeditor of this special issue. The author is of course responsible for any remaining errors or misconceptions.

Both the power and oil and gas sectors in developing countries face problems in raising unprecedented amounts of financial resources to finance their future expansion. In the power sector there is growing evidence that traditional, public sector dominated financing methods will not be adequate to meet future demands for high quality electricity services. In recognition, many developing countries have opened up their energy sectors to private investment, through privatization in a small number of cases, but more typically through the establishment of independent power projects. A number of these projects are in operation, under way, or in advanced planning. Although their share of total generating capacity or additions to capacity is still quite small in most countries, they offer important advantages. They provide a vehicle for private investment, particularly foreign investment; they introduce new technologies and financing and management techniques; and could act, through their demonstration effect, as a catalyst for the reform of the whole energy sector, including the critical area of tariff reform. But the role of IPPs is necessarily limited, and sustained mobilization of resources on the scale envisaged will require more radical change in sector organization and tariff structure to offer attractive incentives to investors. Foreign investment will always have a useful role to play, but the bulk of finance (especially long-term finance) must come from domestic sources. This implies additional efforts to develop domestic capital markets. The augmented role of private finance, whether domestic or foreign, requires a continuing, but different, role 938

Energy PolioT 1995 Volume 23 Number I 1

Acknowledgements

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Financing the energy sector in developing countries: J Dunkerley

International Energy Agency/Organization lbr Economic Cooperation and Development (1994) World Energy Outlook IEA/OECD, Paris International Energy Agency/Organization for Economic Cooperation and Development (1095) World Energy Outlook IEA/OECD, Paris International Energy Agency (1995) World Energy Outlook lEA/ OECD, Paris Khelil, Chakib (1995) Fiscal SystemsJbr Oil Industry and Energy Department Note No 46, World Bank, Washington, DC Klein, M and Roger, N (1994) 'Back to the future: the potential in infiastructure privatisation" American Express Bank reprint from Finance and the hTternational Economy 8 Nellis, John (1994) 'Is privatization necessary?' in Public Poliqv[or the Priwue Sector The World Bank, Finance and Private Sector Development, Washington, DC Petroleum Finance Company (1993) CompetitionJor Capital in the International Oil and Gas lndustcv Washington, DC

Ranganathan, V (1993) 'Electricity in privatization: the case of India' Energy Poli~T 21 (8) Razavi, Hossein (forthcoming) Financing Oil, Gas and Power Projects: A Guide to Accessing Multilateral. Bilateral and Commercial Funds" PennWell Books Sangvi, Arun P ( 1991 ) "Impacts of power supply inadequacy in developing countries' Energy Poli¢y 19 (5) 425440 Schramm, Gunter (1993) 'Issues and problems in the power sector of developing countries' Energy Policy 21 (7) 739 Smil, Vaclav (1990) 'China's energy: a case study' contractor report prepared for the US Congress Office of Technology Assessment World Bank (1983) Energy Transition in Developing Countries Washington, DC World Bank (1993) Capital Expenditures,/or Electric Power m the Developing Countries in the 1990s Industry and Energy Department Working Paper, Energy Series Paper No 21. Washington, DC World Bank World Development Report (1994) lnlrastructure/or Development Washington, DC

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