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When complexity becomes feasible: A must-have risk solution for large power plant construction projects

Large power plant projects often risk being affected by political structures. This calls for insurance to protect them, writes Benjamin Mugisha, senior underwriter at the African Trade Insurance Agency (ATI).

In 2013, the United Nations Development Programme published a report on “De-risking Renewable Energy Investment”. A basis of this report was the categorisation of risks that can affect energy projects in two broad classes: policy risk resulting from the underlying barriers that are the root causes of risks and financial risks that are transferable to third parties. In sub-Saharan Africa, policy risks still exist including poor energy policies, lack of institutional capacity and resources, and poor grid connections. Investors in the energy sector must always be cognisant of how these risks manifest in the country of investment. On the other hand, financial risks can partially be mitigated through, for example, loan guarantees and political risk insurance (PRI).

Large power projects are exposed to a broad range of risks, which can be defined as mostly political risks. These are risks triggered by the action or inaction of a government, which may deprive a project of its assets, prevent or limit the performance of contracts and impact the repayment of loans. These risks are linked to changes in a country’s political structure, for example in the period leading up to or after an election, and most importantly, the related risks are usually outside the control of the project.

Playing to the masses

In sub-Saharan Africa, where up to 85% of the population lacks access to reliable energy, economic development and investment in energy-sector projects are inextricably linked. Large power projects have the ability to unleash real economic impact, uplifting millions out of poverty. So strategically, these projects tend to be economically and politically important but they are not easy to realise.

Host governments recognise that they may not be able to finance all the required infrastructure for economic development and may also be constrained in increasing sovereign debt, for example due to International Monitory Fund borrowing restrictions. For this reason, they are keen to seek private sector participation in financing infrastructure, which has led to the growing trend toward private-public partnerships in commissioning largescale power projects.

One inherent risk in private sector participation is the financial cost to the country of this investment. For example, the 250MW Bujagali hydropower dam in Uganda, commissioned in 2012, is a perfect example of a public-private partnership lauded as the trail blazer, lighting the path for other African countries to follow. However, four years later, there are indications that the government is assessing options to refinance the project in order to reduce the electricity tariff – a tariff resulting from the expensive cost of borrowing for private investors, estimated at an interest rate of 6-8% versus the concessionary rates available to most governments at 0.78% for 40 years with a 10-year grace period or at commercial terms of 3.5%.

On the surface, the finance costs are evidently lowered by refinancing the more expensive loans. However, over the period of the power purchase agreement (PPA), the government of Uganda is expected to earn $1.8 billion in revenue to its coffers from taxes and fees paid by the project. In contrast, the government would have to borrow $1.5 billion to buy back Bujagali from the current owners. Sparked by political agitation to lower the tariff, the argument has been controversial when detractors have noted what other pressing development priorities the government could achieve with this money (it could build 225,000 primary school classrooms or tarmac 2,000km of roads). This example underscores the important role of politics in many large projects.

Keep your eye on the cash flow

Long-term power projects are typically project finance-based. Financing is underpinned by a financial structure where the project debt and equity are paid back from the cash flow generated by the project. The tariff paid, 11 cents/kWh in the Bujagali example, generates the cash flow, which is the sole source of revenue. Payments may be back-stopped by a government guarantee, but there would be significant financial, economic and reputational consequences if the project was not able to meet the expectations of its investors and this guarantee was to be called.

In this scenario, all parties will necessarily focus on the risks that might adversely affect the future cash flow (and thus the debt service and equity return). Risk identification and mitigation is therefore at the heart of successful power projects, particularly large-scale projects where the financial impact will be that much greater.

The risks in power projects can be identified, and mitigations implemented, in three major stages of the project cycle: pre-construction stage (including pre-feasibility, feasibility and preparatory); construction stage; and operation stage. At each of these stages, the objective is to identify the risks, analyse them, mitigate them and allocate them.

Risk identification is the process of mapping all key risks, which might affect the success or the cash flow of the power project. It is important because sponsors, potential lenders and other interested parties will all aim to avoid bearing excessive risk and look for ways to mitigate or transfer risks. Identified risks are allocated to the highest extent possible to those parties that can best bear them (‘fair burden sharing’). This risk structuring or allocation is done through contractual arrangements.

Only those that ‘can’ should manage risks

The fundamental principle in managing risks, including those related to large power projects, is that the risks should not only be allocated to specific parties but, more importantly, to the parties that are best able to handle them. A possible mitigation is insurance. Specifically, for power projects, political risks can be mitigated with political risk insurance.

There is a wide array of potential risks in a large power project. Broadly, these include technological, commercial, financial, country specific, and, of course, force majeure. Every project is different and so too are the possible risks. For each identified risk, the options are:

i Retention: Retain the risk and manage it by establishing a project specific risk management system.

ii Allocation: Transfer the risk by allocating it to the counterparties who can, in principle, best manage or control it, including insurers and underwriters. However, in reality risk allocation on large power projects is influenced by the negotiation power of the different project parties as well as the legal and regulatory framework in which the project is being undertaken and implemented.

The importance of carrying political risk insurance

Political risk insurance is intended to protect the project against unfair government actions and inactions that can impair the project’s performance under the contractual agreements for the project.

As the off-taker is typically a public buyer, the main risk is the ability to pay its financial dues under the PPA. This involves both short term delays in payments (liquidity constraints) and protracted default that can trigger termination of all contracts. In this case, political risk insurance protects investors (debt and equity) against either non-payment or arbitral award default under the dispute resolution clauses of the PPA.

As an example, there are insurers that are able to work with commercial banks to provide guarantees or letters of credit that address short term delays in payment caused by liquidity constraints of an off-taker but can also cover the long term protracted default that results in the termination of PPAs. If these risks have been mitigated by a government through a guarantee, political risk insurers can offer cover in the event that this guarantee is not honoured.

As described above, the government will often provide some form of guarantees or support to the project in the event that other political risks (expropriation, war, etc.) lead to project termination. Political risk insurance can cover the nonhonouring of this project support and also cover any other political risks not covered in the contractual documents between the project and the government.

Political risk insurance will not protect against legitimate actions by the government to cancel any contracts where the other parties have not honoured their agreements. A holistic assessment of the contractual obligations of all parties, as well as the due consideration of the potential risks that need to be addressed by the investors themselves are key to the success of large power projects. ESI