How can Independent Power Producer (IPP) investments be accelerated on the African continent?

What keeps the risk-return profile of investments unattractive and projects commercially unviable?
June 17, 2016

Reprinted with permission from the 2016 Africa Energy Yearbook

To quote Alice from Alice in Wonderland “(is) there no use trying … one can’t believe impossible things;” in respect of which the Queen responded, “When I was younger, I always did it for half an hour a day. Why, sometimes I have believed as many as six impossible things before breakfast”. Victims of the slow development of a number of IPP projects on the African continent probably believe that acceleration is impossible – however, like Francis of Assisi said, “we should start by doing what is necessary, then do what is possible and suddenly we will be doing the impossible”.

To continue with the theme of Alice in Wonderland – and thinking about the magic referred to by the Mad Hatter when he said “(you) know what the issue is with this world? Everyone wants a magical solution to their problem, and everyone refuses to believe in magic” – I’d like to ask the question, “what magic is required”. Are we all hoping for something that will never happen? 

This article considers my personal view on how IPP investments can be accelerated. The term IPP in this article refers to a privately developed power plant, which sells electricity to a public electricity grid, in terms of a power purchase agreement (PPA) concluded with a state utility.

What keeps the risk-return profile of investments unattractive and projects commercially unviable?

For many countries on the African continent mobilising capital may be beyond the capacity of the governments and they will require private investment. The accumulation of investment risks sometimes makes financing difficult. Perceived risk that may be associated with renewable energy technologies is exacerbated by investment risks typical for developing countries: political risk, currency risk and commercial risk (caused by poor creditworthiness of state utilities which are required to pay for the energy). These factors sometimes worsen the investment profile and the return expectations of developers and their backers exceed risk thresholds acceptable to lenders. In determining whether to invest, investors will check out institutional weakness, corruption, poor governance and low labour productivity and differentiate among economies by the quality of governance.

Africa’s energy sector requires private sector funding for growth. A project’s risk-return profile often determines the outcome in raising finance. Competitively priced energy and reasonable returns on investments for IPPs is required in Africa. Regulatory frameworks are required to facilitate funding on an appropriate scale and incentive structures assist.

Strategies must be designed to reduce or eliminate inefficiencies and remove bottlenecks to private enterprise. This helps resources go further and creates an attractive investment climate for private finance. Governments must drive the process. An important factor that led to the successful Renewable Energy Independent Power Producer Programme (REIPPPP) in South Africa was the formation of an empowered IPP office responsible for ensuring proper implementation. It is desirable to have a least-cost plan to produce energy, with clarity on the requisite bidding and procurement processes for new projects.

An appropriate institutional framework is vital to encourage private investment and consequently accelerate IPP investment. The design of the institutional framework should take the risks into account and seek to mitigate them. Reducing risk will protect against failure of the project, lower the cost of development and encourage private investment.

What was done in successful programmes and what can be learned?

Five years ago green energy developments in South Africa were limited. Today there are more than 2,000MW installed across the country with more to come.

The REIPPPP strength is that it was developed methodically and systematically. The programme was structured around effective co-ordination. The REIPPPP is a success story but there are still lessons to be learned. The grid is under pressure. Some projects have been affected by delays caused by required grid upgrading. Connecting projects where grid infrastructure is insufficient and not in place when the plant is ready to produce energy is a key challenge. There should therefore be an intense focus on the ability to connect to the grid when implementing IPP programmes.

Virtually all projects selected as preferred bidders under the REIPPPP have reached financial close. This achievement is the result of lessons learned from previous initiatives. Key features are effective and efficient institutional co-ordination, coherence and certainty, flexibility if the market changes or unintended consequences arise, certainty on return on investment, coordination between interest groups, development goals for rural populations and regulatory principles of transparency, clarity and predictability 

What are the barriers to acceleration?

Unstable macroeconomic conditions, non-transparent governments who focus on politics rather than delivery of conditions conducive for private investment, and unclear power sector strategies will remain persistent challenges. IPP investment must be designed to overcome those challenges. Countries with good governance attract investors, and deals seem to be done quickly. The quality of governance is not the only factor but it is an important one.

Power projects require huge capital investment. Investor returns are dependent on government controlled entities honouring the deal. Financing hinges on a bankable PPA. Projects financed on a limited-recourse basis are sensitive to uncertainty because lenders rely on project revenue as security for loans. The financing structure means that banks are particularly concerned in seeking stringent and specific loan agreements. Project lawyers try to close all loop-holes by means of PPAs that protect IPPs in the long-term.

Usual risks IPPs face and mitigation

The usual risks are country and political risks, market risks, economic risks, construction risks, operating risks and fuel risks. Country and political risk encompasses risk of expropriation, breach of contract, war and civil disturbance. The robustness of the contractual structure as well as the neutrality of the legal system is important. Programmes that mitigate risks assist in the acceleration of projects.

Efforts to manage project risk must start with the PPA. Where the off-taker is a state owned utility a sovereign guarantee is ideally required if a utility’s credit rating is poor. Project documents usually try to shift legal and regulatory risk to the government by including change-in-law terms in the contract that indemnify investors for losses stemming from adverse legal or regulatory changes.

What is required is a bankable PPA in the form of a long-term offtake agreement with a creditworthy off-taker and having a sufficient tenor to enable repayment of debt by providing an adequate and predictable revenue stream. The PPA must cover inter alia dispatch risk and foreign exchange risk. In order to avoid currency risk the PPA should preferably be either denominated in or linked to an exchange rate of the currency of the power producer’s debt and there should be no limitation or additional approvals required to transfer funds to offshore accounts as required. The PPA should allow collateral assignment of the agreement to the power producer’s lenders with the right to receive notice of any default and to cure such default. Permitting step-in rights between the lenders and the off-taker will assist. A change in law provision in the agreement may also be important and the PPA should state which party takes the risk of the law and tax regime changing so as to diminish the economic returns of the transaction.

The terms of the PPA should also include international arbitration. Where there is a risk of home town decisions it’s best to provide for international commercial arbitration to resolve disputes. Arbitration is an ultimate deterrent to unacceptable adjustments in contracts. The involvement of export credit agencies or multi-lateral lending institutions may also serve as a deterrent to political interference. Market risks can also be mitigated by a long-term PPA specifying the price and quantity of energy that will be purchased.

Although governments should focus on risks they should not lose sight of the necessity to reform the electricity sector and ought to introduce regulatory and market reforms to reduce the dominance of state-owned enterprises.

What should be focussed on to accelerate IPP investments?

The determinative factor is project design. Bidding results in low prices for power and increased transparency. Contracts must allocate risks and rewards and rights and responsibilities in a way that keeps incentives aligned between the different parties.  

Aligning rights and interests to prevent pressure and danger to projects is crucial. A welldesigned transparent bidding process helps to allay concerns and results in projects that are competitive. Effective reform in the electricity sector is required and in the economy generally that will reduce risk and increase the availability of local capital. The main issue is whether current market conditions encourage private investment.

Project level factors must be addressed such as: (i) the nature and experience of project developers and whether multilaterals are involved; (ii) the characteristics of the IPP programme, including goals, relationship to sector reform, project selection, government counterparties and support etc.; (iii) the sale of energy and the terms and cost of obtaining financing for the projects; (iv) fuel and technology choice; (v) operations and management; and (vi) capacity to manage the political, regulatory and social risks involved in developing country power investment. The risk of counterparty non-performance is a central concern for investors particularly those selling to a single off-taker. Designers of IPP programmes ought to ensure (i) that the series of contracts known as “project documents” accurately record the intention of the parties; (ii) payment security arrangements ensure a regular flow of income to finance investment; (iii) the involvement of multilateral partners, lenders and insurers, whose presence may deter contract breach by governments involved; (iv) off-shore arbitration to give comfort in not having to resolve disputes in local courts and improve the enforceability of contract terms; and (v) risk-pricing systems and contracts intended to bind the government and to allocate risks precisely. Structural variables such as adverse macroeconomic conditions, the failure of power sector reform and corruption affect the dangers to IPPs and their contracts but project level factors are more determinative of the outcome.

Legislative and regulatory frameworks rank amongst the most important factors. Perceived regulatory or legal risk can increase the cost of capital. There must be legal authorisation for foreign investment and for private investment, allowing utilities to procure energy from IPPs. If the basic enabling legislation exists, private projects can be structured and obligations can be identified and established in contracts between the IPP, the purchaser of energy and the government. Sources of danger to projects do not occur in isolation and the extent to which they affect a project’s bottom line or the impression that a particular country is a risky place to do business is dependent on complex factors.

Investing in a country may be evaluated by considering indices including commercial sovereign debt rating, commercial country risk evaluation or rankings developed by multilateral or non-governmental entities. Of importance is the stability of contracts, the record of payments, subjective evaluations by IPPs, experts and officials, as well as whether private investors will invest in projects in the future. Gathering and evaluating financial data on infrastructure investment across countries, including differing accounting and reporting standards and the confidentiality of critical data, can be difficult. Countries wishing to develop IPP programmes should consider loading relevant information onto an updated portal that IPPs can refer to. It is useful to have the information IPPs require to make decisions contained on one portal.

Another factor involves the management of risk. This involves governments and IPPs anticipating issues of vulnerability to reduce the likelihood that particular risks will materialise and to align incentives in a way that allows projects to withstand stress. A key issue for policy-makers seeking to promote conditions for investment is public policy. Ideally projects should be “investment grade”. Project finance must be the crux of policy-making. Targets, fiscal incentives or availability of public finance alone is insufficient if there are high risks associated with other factors, as risk-adjusted returns must be commercially attractive.

Key features for investment grade energy policy are: (i) clear, unambiguous policy objectives with clear enforcement provisions; (ii) streamlined policy and regulation from planning approval to delivery; (iii) incentive or support mechanisms to achieve targets; (iv) policy stability; (v) reduced complexity and variables that add risk; and (vi) attention to infrastructure – planning, integration and regulatory requirements – to ensure optimisation of the programme.

Governments must formulate interim and long-term targets. IPPs may then be prepared to establish businesses within a country to “drive” development. When designing programmes renewable energy development zones should be identified for large scale wind and solar PV projects. These zones can be identified through integrated spatial analyses and stakeholder consultation. Factors to be taken into consideration must include energy resource potential, infrastructure availability, stakeholder and local authority support, environmental suitability and socio-economic needs.

Where there is limited transmission grid capacity investment is essential to support procurement. Lead-times for transmission upgrades and the associated grid projects need to be identified and initiated in advance of procurement. Network capacities, time-lines and upgrade costs known prior to implementing a programme avoid costly delays. The location of the generation plants is important and directly impacts on grid connection scope, cost and timeline. In South Africa grid constraints are becoming more prevalent as the REIPPPP progresses and the spare capacity in areas with good resources is depleted. A lack of grid capacity delayed financial close of projects. A phased expenditure plan must be developed with the programme.

For acceleration IPPs require an understanding of grid availability and costs. Utilities must assist in providing information concerning (i) transmission upgrades to evacuate power along the major routes to the load centres; and (ii) the sub-transmission network expansion and upgrades to connect the individual IPPs to the main transmission sub-stations. A prioritised transmission plan needs to be developed for the procurement of grid upgrades in a phased manner that aligns with the program time frames, design and capacity 

Where there are grid constraints developers must be offered the option of developing grid connections themselves by having a “do it yourself option”. This will assist the time line and grid connection costs. A grid access unit should be set up as the point of contact for IPPs for generators to connect to the grid and deal with the needs of IPPs. This unit must be set up with sufficient autonomy to facilitate non-discriminatory grid access for IPPs and generators. The aim must be to ensure transparency on pricing policy, network contracts and operating agreements. Utilities must plan the future transmission grid to ensure that it is able to connect increasingly widespread sources of power generation. An access risk assessment of connection to the grid needs to be done. The risk allocation will inform IPPs of possible infrastructure constraints that should be taken into consideration in the preparation of their bids. The objective of the risk allocation will be to inform IPP developers of the relative risk of infrastructure constraints and of being unable to connect within the programme target date.

An issue to be considered is tariff finalisation timing because bidding may be an extended process. A two-stage process with bids evaluated on feasibility and a second stage on price and economic development criteria could overcome tariff concerns arising from delays in announcing successful bidders. PPAs that accord with the plant life may improve the economics of projects and increase acceleration.

Regulatory governance that is transparent, fair and accountable, credible and predictable results in a positive outcome. An effort must be made to achieve effective regulatory oversight, which will lead to a reduction in capital costs as well as improved efficiencies. Governments must provide easy market access and grid access to the private sector developers on a competitive basis. Feed-in tariffs may help. Targets and a formulated government vision will provide certainty. Fiscal incentives and quotas will help. IPPs sometimes complain about not having a level playing field but it is the regulatory set-up that causes delays. Electricity systems dominated by a state-owned national power utility with a monopoly and vertically integrated supply chain or similar set up usually lack the incentives and flexibility to provide easy grid access and market access, on fair terms, to third-party and private sector independent power producers.

In every investment decision there is a wide set of variables and parameters that influence the decision. Whatever these variables may be and in order to understand their influence on the decision, it is helpful to recognise their impact on the project through their ramifications in its risk-return profile. The risk-return profile of a project is the key determinant of whether to finance or not.

Unfamiliarity or uncertainty concerning the performance of technology, particularly in countries with an insufficient track record, will often result in projects requiring additional time for permitting and financing. Transaction costs of renewable energy projects, including resource assessment, siting, permitting, planning, development project proposals, assembling financing packages and negotiating power-purchase contracts with utilities, may be larger on a per MW basis and programmes should be designed to try and drive down these costs. Lower permitting and inter-connection fees and the presence of incentives can drive down the levelized cost of electricity. PPAs and implementation agreements made available to potential IPPs with a standardised set of financial data that bidders are required to provide for evaluation is important. The sealed bid system utilised in South Africa under the REIPPP has worked well but there are other systems that have also worked well such as the reverse auction system utilised in Brazil.

IPPs rely on various arrangements to secure payments including sovereign or corporate guarantees, escrow arrangements and letters of credit – all designed to bolster confidence around a predictable stream of payments from off-takers whose financial position may be concerning. Long-term sovereign guarantees for a project is desirable, which have the effect of allocating the risk of non-payment to the person that in principle has the greatest capacity to intervene and fix most problems that befall a project. Investors can perhaps rely on escrow arrangements and letters of credit. Political risk insurance can also be taken out to protect investments, projects, goods and contracts against unfair political action or inaction by a government that would cause damage, financial loss or business interruption. It can also cover loss due to war and civil disturbance.

Involving prominent investors in projects may help. Governments may feel constrained from making adverse decisions if prominent investors are involved. This strategy may be implemented by (i) co-investment (i.e. equity) by a multilateral lending institution; (ii) lending by international development banks, either directly or as guarantees for commercial loans; (iii) risk guarantees or political risk insurance; and (iv) reliance on the presence of commercial banks that are critical repeat-players in financing governments.

Another possibility that should be explored is mitigating risk against non-creditworthy local utilities is a cross-border PPA where some of the energy from the project is sold cross-border to a more creditworthy utility.

Conclusion

Progress is impossible to be made without change and what is required is a change in mind set otherwise nothing will change. It’s important to have active participation by all relevant stakeholders in an IPP programme to ensure its effective design and implementation. Political will and leadership from the department of energy and national treasury must drive the programme. A programme that caters for the risks identified in this article ought to result in acceleration. The design of the institutional framework should take risks into account and seek to mitigate them. Reducing project risk should protect against overall failure, lower the cost and accelerate development.