In the last year solar photovoltaic (PV) power projects have increased in size and number, with several reaching financial close in Sub-Saharan Africa – a high number in South Africa under the Renewable Energy Independent Power Producer Procurement Programme (including projects in excess of 70MW), and also some in new markets such as Rwanda. Tariff prices for solar PV continue to fall across the continent as concession bids get increasingly competitive and crowded. With pricing falling below that often seen with thermal plants, growth in solar PV is expected to achieve rapid adoption. There are many projects currently seeking finance in countries across the continent including Egypt, Nigeria, Ghana, Senegal, Kenya, Namibia, Uganda, Tanzania, Zambia and Ethiopia.
Project finance lenders are becoming increasingly comfortable with solar PV as an asset class, which is consistent with the financing of solar PV in the more established renewable energy markets of Europe, the United States and Asia. At the same time, other lenders have not financed solar PV previously, or at least not in Sub-Saharan Africa, and are understandably taking a cautious approach.
In this briefing we have set out some insights based on our experience advising sponsors and lenders on the financing of solar PV projects across Africa. We have also drawn upon our global experience advising on solar PV projects to provide a benchmark for what is happening in other markets.
We hope you find these insights useful.
One of the critical issues for the financing of solar PV projects in Africa is the tenor available from potential lenders.
In many jurisdictions, the term of the power purchase agreement (PPA) will be between 20 to 25 years, with a tariff structured to match this period. A trend towards longer tenors for PPAs is being driven by a combination of host governments seeking a lower tariff (outside South Africa) and looking to match the tenor with the anticipated useful life of the solar PV plant.
Traditionally it has been difficult to achieve financing tenors to match a PPA term of 20 to 25 years on African power projects, and many times a debt tenor of even 15 years has been a stretch. Development finance institutions (DFIs) generally have more capacity to provide long term debt, particularly compared to commercial banks, though debt tenors offered by DFIs are still unlikely to cover the full term of the PPA.
We have seen some encouraging signs over the past six months, with several lenders accepting tenors of 17 to 18 years plus the construction period – however, this is still the exception.
As an intermittent energy source depending on irradiation levels, the financial model base case for solar PV depends on the electricity that is forecast to be generated by the power plant over the term of the loan. Forecast generation is calculated using ‘Probability’ or ‘P’ values – with a P90 forecast being a more conservative forecast (representing a 90 per cent probability that the electricity generated will exceed this value) and P50 being the average (a 50/50 chance that the electricity generated in the period will exceed or fall below this value).
There is no long term track record for the performance of solar PV power plants in Africa. However, the expectation is that the solar PV projects will perform well in most African environments, especially as the currently installed global solar PV fleet is generally performing in line with P50 forecasts (out-performing the more conservative forecasts).
In the first round of the South African REIPPP programme lenders tended to insist on P90 forecasts for the base case in the financial model. This contrasts with some of the more developed markets, such as Europe and the United States, where P50 is usually adopted. We are now starting to see a move in South Africa towards P50 forecasts being used for the base case.
Our expectation is that most of the DFIs and multi-lateral finance institutions (IFIs) will look to use P90 levels until it is proven that solar PV projects in Africa have performed in line with P50 or P75 expectations for several years.
In African solar PV project financings, the debt service cover ratios accepted by lenders have generally been in the range of between 1.25 and 1.35. The energy forecasts underpinning such DSCRs have usually been on a P90 basis (as described above).
In mature markets such as Italy, the norm is more like a DSCR of 1.3 using a P50 forecast.
In reverse auction processes such as the REIPPP programme in South Africa, we are starting to see more pressure on the base case ratios as sponsors and lenders seek to optimise the tariff.
Unlike thermal power projects, most solar PV projects will have a fixed tariff for the term of the PPA and predictable operating characteristics and costs. Our view is that lenders should be able to rely on historic ratio tests only. Forecast DSCRs and loan life cover ratios (LLCRs) are most useful when the project’s revenues and/or load factors are variable, or where costs are expected to fluctuate significantly over time or year to year.
However, market practice is that lenders tend to require compliance with forecast ratios for distributions and, in some cases, to avoid triggering a default.
We would expect that once lenders are comfortable that solar PV projects around Africa are performing solidly and in line with forecast expectations, they may start to relax such requirements.
In many jurisdictions in Sub-Saharan Africa, the ratio between debt to equity on a power project has been traditionally close to 70:30. We have not seen a debt to equity ratio in excess of 80:20. The issue faced by developers in this respect is to strike a balance between the low tariffs required by host governments, and an economically attractive investment rate of return (IRR) for equity investors. This is particularly so given the perceived risk for equity investors of investing in Africa power projects.
Faced with host governments encountering pressure from regulatory authorities and consumers to keep PPA tariffs as low as possible, and with debt tenors unlikely to match the tenor of the PPA, sponsors are seeking to increase the gearing ratio of project companies beyond the traditional levels.
Some lenders are requiring sponsors to inject equity upfront, however this usually reflects the credit quality of the sponsors and we do not believe it relates to any African or solar PV specific risk issues.
We have seen some DFIs and IFIs insist on an on-going debt to equity ratio test which must be met during the life of the project. This is not an unusual project finance requirement as project finance traditionally looks at revenue expected to be generated by the project, and not the balance sheet of the project company. The impact of this on-going test is that sponsors cannot prepay shareholder loans any faster than is envisaged in the base case, otherwise they will breach the debt to equity ratio. This can be even more problematic when the base case is determined using P90 levels, as where the power plant generates at P50 levels this can result in cash being trapped in the project company.
Outside South Africa most solar PV projects are being financed in US dollars (or, less commonly, in euros). This reflects the tariffs which are generally either denominated in US dollars, or denominated in local currency but either linked to or paid in US dollars.
Local currency financing is available in some markets but tenors are generally short and pricing is much higher than dollar or euro denominated debt.
Margins are varying significantly from project to project based on the usual dynamics of country risk, competitive tension between lenders, sponsor relationships and prevailing market conditions.
Our general view is that there is downwards pressure on margins in many African jurisdictions. This reflects in part the improved macro-economic conditions, but also the increasing number of attractive solar PV projects which has resulted in funders ‘crowding in’ on bankable projects.
To put African solar PV in context, during the course of 2015 the margins for European project finance fell significantly, reflecting reduced country risk and improving liquidity. Accordingly, it is not uncommon for sponsors to achieve margins below 200 basis points for European PV projects. We are seeing pricing pressure in strong economies in other markets such as South East Asia and Latin America. African pricing has not always followed other markets but we expect the increase in deal flow across the continent will help reduce margins in coming years.
To date, most power projects in Africa have required some form of government guarantee (often with political risk insurance backing up with obligation) in order to attract project financing. These are primarily designed to protect against risks such as offtaker credit, hard currency availability and other forms of political force majeure. As with emerging markets in many other parts of the world, we expect that such backing will be required in most African countries for some period of time, as they seek to establish a track record of contractual compliance and system stability. However, the rapid pace at which solar PV projects are being deployed across the continent is likely to challenge the continued calls for such guarantees and political risk products much sooner than we have seen in the development of other emerging markets.
It is usual to expect sponsors to have a debt service reserve account (DSRA) funded by no later than completion of the project with an amount equal to six months of debt service payments.
Occasionally, lenders may also require sponsors to set up a maintenance reserve account (MRA), which will cover anticipated major maintenance expenses. Whether an MRA is needed depends on the contractual structure of the operations and maintenance arrangements for the project and the underlying warranties on the modules, inverters and other key components of a solar PV power plant, such as the frames or trackers.
A notable example of this is inverter replacement, which often occurs approximately seven to ten years after the commercial operations date. In some cases we have seen lenders insist on an inverter reserve account, which requires the project company to slowly set-aside and build-up a reserve to meet the anticipated costs of replacing inverters.
We firmly believe that lenders financing a well-structured solar PV project should not require significant completion support from the sponsors.
It is usual (and reasonable) for the lenders to expect that there is a sensible level of contingency set aside by sponsors - taking into account the location and design of the project and the counterparties – but this is a question of project risk in general, rather than any specific risk relating to PV. In Africa the level of contingency required by the lenders may be higher than other regions due to concerns on issues such as change in law risk, offtake/ transmission risk and the limited number of projects developed to date.
However, the concept of a full or partial completion guarantee from sponsors, in addition to a robust construction contract, should be resisted, unless there are other factors that affect the bankability of the project.
Regardless of where a solar PV project is situated in the Africa region, location should not make a difference in respect of whether completion support is required. It is not usual for lenders to require completion support from sponsors on thermal projects in Africa over and above the contingencies (which may be provided by way of standby equity), and solar PV should be no different.
The story may be different if the project is utilising new technology. For example, solar PV cannot be compared to concentrating solar power (CSP) which is a less-established technology which commonly requires a certain level of completion support.
In project finance a ‘cash sweep’ is often used as means of prepaying debt if the performance of the project (and therefore available cash) has exceeded a given level or, alternatively, if the project has under-performed and lenders are keen to reduce debt as quickly as possible.
In our view, cash sweeps are not a pre-requisite to financing solar PV projects. That said, cash sweeps remain part of the tool kit for many lenders, and we commonly find cash sweeps in project finance transactions where the lender is keen to shorten the nameplate debt tenor.
On some solar PV projects in Africa lenders have looked for a downside cash sweep – where failure to meet lock-up levels results in an immediate or potential cash sweep. This is often a request of DFIs.
Distribution conditions represent an area of much contention between sponsors and lenders. If there are credit concerns with a project, we often see lenders and advisers seeking to extend the list of conditions that must be met prior to equity distributions being made to sponsors. The aim of this is to lock in the project’s cash as an additional buffer in case of hard times in the future.
We have set out below our views on various lock-up conditions which may be applicable to solar PV, categorising them as (1) a certain requirement of lenders, (2) a reasonable requirement of lenders, depending on the circumstances, or (3) generally to be resisted by sponsors:
As more proven and creditworthy top-tier sponsors enter the African power market we are starting to see the use of equity bridge facilities. These are often used to reduce the tariff bid in an auction process, as they improve the equity IRR for the sponsor.
In a solar PV context the attractiveness of equity bridge facilities is often reduced. This is due to the short construction period for solar PV projects compared to other power projects (months compared to years), which means that sponsors are only receiving the benefit of delaying their equity contribution for a short time. As a result of this, the costs of arranging and documenting an equity bridge facility may outweigh the benefit to sponsors.