RLSF: A new approach to mitigating offtaker risk in African power

African economic growth continues to outpace most other regions in the world. International Monetary Fund (IMF) projections estimate that seven of the ten fastest growing economies in the world in 2017 will be in Africa. This growth is expected to continue into the next decade, with increased foreign direct investment and improved regulatory and fiscal management. Future growth, however, is predicated on improvements in infrastructure. Improvements to public services such as power, transportation and water can increase trade, provide employment and promote access to better services such as healthcare - all of which compound to increase the attractiveness of the region to investors.

Within infrastructure, the energy deficit remains perhaps the most critical challenge in sub-Saharan Africa. Daily per capita electricity use in the region is estimated to be 124 kilowatt-hours, or the equivalent of using a 100-watt bulb for three hours. This represents one-tenth of per capita usage in other developing regions around the world. Limited access, rolling blackouts and increasing costs also act as a disincentive to investment by corporates which face an average of nearly 60 days of power outages each year. Added to this is an estimated $40 billion funding gap in terms of available capital vs demand. African countries realise the urgent need to invest in the energy sector, but they cannot finance the investments required solely through the public sector. They are also hampered by an inability to make energy sector projects appealing to private investors.

Most infrastructure investments in the region are currently financed by governments (the public sector), the private sector and other countries - such as China. External official development assistance (ODA) represents a fraction of the total financing – well under 10%. Multilateral and bilateral organisations, as well as development finance institutions (DFIs) such as the World Bank’s Multilateral Investment Guarantee Agency (MIGA), the African Trade Insurance Agency (ATI), the African Development Bank and other similar institutions, are also important partners in bridging the financing gap by reducing risk so as to encourage private sector investors.

DFIs typically bring to power projects significant experience, a commitment to encourage sustainable development, improved transparency, risk mitigation and improved returns on investments (or certainty of return). They provide options such as direct loans, credit enhancements and first-loss funds. Export credit agencies (ECAs) also provide similar products such as guarantees and insurance.

Challenges to using project financing in Africa’s energy sector

Traditional funding sources such as project finance from commercial banks are increasingly a challenge in the region due to Basel III requirements and the sub-investment grade ratings of most African countries. In addition, the turn-around time to execute a deal in Africa can take between 30 and 72 months compared to the average of 12 months in Asia and Latin America.

There are several important factors restricting the use of project financing more broadly for energy projects in Africa. Long tenures, the complexity of coordinating between multiple public and private sector partners, credit and sovereign risks, and a lack of sound regulatory frameworks in many countries are all inhibitors.

Power projects themselves are typically financed through a mix of equity investors and debt providers according to risk appetite. Projects financed in this manner normally include an equity investment from a private equity firm or investors, with an insurance wrap from a DFI and a pledged debt from a bank.

Successful project financing relies on the prediction of future cash flows. The greater this is, the easier a project is to finance. Cash flow in the energy sector depends on the amount of power generated by the independent power producer (IPP), and then sold to a state-owned utility – known as the offtaker. To determine projected cash flows, developers and sponsors create a power purchase agreement (PPA). Essentially, this provides the terms and conditions that guides the sale of the energy into the national grid or other power source.

Frequently, the biggest single obstacle to financing in this dynamic is the perceived (and often actual) poor financial state of the main sovereign offtakers. They are often caught between political realities (such as the need to keep down the cost of power for the general population) and the actual cost of the power being produced. The offtakers’ biggest arrears tend to be to other stateowned enterprises (SOEs), while they may also be obliged to sell at a tariff that is below their actual cost of production.

This situation leads to a deteriorating dynamic where higher quality, more reputable IPPs are reluctant to bid for tenders, leaving governments with higher cost power from less reliable IPPs. Without adequate risk mitigation instruments on the national offtaker, the cost of power will increase even further given the increased debt and equity hurdles that investors will demand in order to participate. The result is often reflected in a higher rate of defaults on such high cost or marginal PPAs over time, leading to international arbitrations and law suits. This is generally a vicious cycle that will further deter future investors.

With these well documented challenges, much needed innovations are being developed and, in some cases, successfully implemented as a means of addressing the energy sector financing gap.

Existing innovations from investors

The Milken Institute, an economic think tank, hosted investors in a forum designed to offer new financing options for Africa’s energy sector. Broadly, it was felt that Africa could address the funding gap while appealing to a wider variety of investors by tackling credit/sovereign risk, improving deal implementation and time to completion, and mitigating financial risk through an increased variety of product offerings.

Some of the solutions outlined included alternatives to current risk mitigation tools such as sovereign guarantees, which were perceived by investors as untrustworthy. A put/call option to the sovereign was listed as a viable alternative. These effectively function as a guaranteed sale of the power plant to the government at a specified price if the offtaker doesn’t pay as scheduled. They are structured as such to have no effect on the sovereign balance sheet. The “Sponsor” rating model was another option cited. It basically substitutes a better-rated “sponsor” for the sovereign to issue debt that would then be repaid through a loan to the government. The World Bank utilises this model by issuing bond offerings to fund infrastructure projects while the government repays the bank to cover the bond.

Other options outside the area of sovereign risk include developing more effective and uniform rating systems. They could assess projects across the entire energy spectrum and across countries and regions in Africa. Investors could then quickly assess projects and expedite their due diligence and decision making process. Participants also suggested the development of structured portfolio options that would allow investors to participate in different tranches of an investment portfolio, such as junior, mezzanine and senior debt as well as equity and first-loss junior positions. This model, implemented by the African Development Bank, ensures greater risk sharing, which helps attract more investors.

Fixed-income products such as infrastructure project bonds (with debt that is typically covered by government-issued or corporate offerings with an insurance wrap provided by multilaterals) and covered bonds (securities that are backed by a pool of loans, which stay on the credit issuer’s balance sheet) are also being used more frequently in Africa. They offer a double recourse to the issuer and the pool of loans – the diversification of the pool can help mitigate the impact of project default.

A new innovation by KfW and ATI

There are insurance products available to mitigate offtaker risks, principally arbitration award default insurance. This responds after the IPP has taken the defaulting sovereign to international arbitration and obtained a judgment that is subsequently not honoured. The downside to this option is that it is timely and expensive. Smaller IPPs may well also be insolvent by the time a judgment is reached. But obtaining a cleaner ‘protracted default’ insurance (that responds, for instance, after six months of default by the offtaker) is frequently a challenge given the poor financial health of many sovereign offtakers.

Because of the perceived high risk of offtaker default, we (the African Trade Insurance Agency - ATI) in partnership with Germany’s KfW, in June 2017 launched a new instrument, the Regional Liquidity Support Facility (RLSF). It is designed to tackle the offtaker liquidity risk for renewable energy IPPs. Usually, such IPPs – especially when project financed - rely on the predictable and regular cash flow of the PPA for debt service and repayment. Off-taker payment delays therefore constitute a real threat to the IPP and project lenders.

To mitigate, lenders to project-financed IPPs insist on letters of credit (L/Cs) being put in place in order to provide a buffer for a certain period of time – usually three to six months of the IPP’s revenues – for which respective collateral needs to be put in place. However, utilities struggle to – or are not willing to – provide such (cash) collateral. If the liquidity cannot be found, for example by the sovereign or by the IPP itself, this can create an un-bankable project. The project economics can also be severely impacted.

For that reason, the main objective of the RLSF is to provide a bridging mechanism in order to help lenders in markets that have a limited track record with IPPs, and little to no transparency on the payment record of the utility. The business practice as described above is currently rather inefficient and prevents many IPPs from reaching financial close.

The RLSF offers the required collateral for project lenders, rather than the utilities or host governments being required to do so (for example by drawing on existing financing structured instruments in the market as much as possible). It does not aim to be a substitute for the role of L/C bank(s), but rather to replace the existing cash collateral requirements made under such L/Cs.

The proposed liquidity support facility is considered a crucial piece of the overall enabling environment attracting private investments. Offering liquidity support mitigates challenges which cannot be addressed by the IPPs directly, but are imposed on them by lenders. The RLSF is complementarity to other risk mitigation instruments, therefore it will further assist IPPs in attracting suitable financing and ultimately create bankable projects.

We see this direction - utilising public and private partnerships to provide regional solutions - as a blueprint for innovation in the energy sector space within Africa. ATI expects to unveil another energy sector solution within the next year which also features another partnership with a well-respected international financier.

For Africa to move beyond the current deficit it seems clear that it must focus on options that boost the appeal to investors. At the same time, governments must continue to implement financial sector reforms. As a start, investors can be encouraged by some of the innovations already taking place in this sector. I also predict that, over time, as more and more equity investors and commercial banks establish solid track records in this sector, this in turn will pave the way for others to follow and costs to continue to fall.