Improving Project Bankability

The aggregate payments for hydropower projects remitted by a state-owned utility (“SOU”) under a long-term power purchase agreement (“PPA”) can involve substantial amounts (e.g., from roughly USD 1.5 billion to USD 6.5 billion for a 100 MW and 700 MW facility, respectively, over 25 years). For this reason, a weak balance sheet of a domestic SOU can prevent projects designated for domestic production from ever proceeding beyond the stage of a feasibility assessment. From the standpoint of project lenders and investors, the PPA provides a contractually guaranteed revenue stream that the company established by such investors can use to repay project debt and recover a return on investment. If, however, a domestic SOU’s credit cannot support the significant PPA payments, then project investors will find the risk/reward ratio too small and/or lenders will decline to provide debt financing.

By reconfiguring the project's offtake strategy to export surplus energy into an international market with one or more creditworthy offtakers, the government of the host country can greatly enhance the creditworthiness of the project. In other words, an export strategy can effectively replace the weak balance sheet of a host country SOU with the stronger balance sheet of an international offtaker, transforming an unbankable project into a bankable one.

Some examples of the successful implementation of an export strategy by host governments in emerging market countries include the Shuakhevi Project in Georgia, which, upon completion, will export power into the Turkish wholesale spot market. Other examples include Nam Theun 2 as well as the many other hydropower projects moving forward today in Laos, which currently export (or will export upon completion) power to EGAT, the Thai SOU. Likewise, the government of the Democratic Republic of Congo (“DRC”) has expressly adopted an export strategy to develop its hydropower potential on the Congo River. Currently under a competitive tender process, the 4,800 MW Inga III project, will, if completed as described in the current documentation tendered by the DRC government, export half of its production from the DRC to South Africa's SOU Eskom.

Avoiding Hidden Costs of “Free Carry” and Royalties

Governments in emerging market countries such as Nepal, Myanmar, Laos and Papua New Guinea increasingly desire to participate in the equity ownership of hydropower projects developed by the private sector, and often require the private sector to provide them “free carry,” i.e., to fund the government’s equity portion. This form of public-private partnership (“PPP”) gives the public sector access to project dividends without contributing to development costs, effectively driving up the cost of the project, which investors defray by increasing the power tariff.

For domestic projects, the government of the host country will in turn fund this through subsidisation of the domestic SOU purchasing the power, since the domestic ratepayers often cannot afford to pay for the full cost of power generation. Depending on the size of the free carry, power prices can increase by up to 30%, which represents a hidden cost of domestic PPP arrangements. A host country government effectively self-funds the dividends paid to itself (i.e., the public sector shareholder) by a project set up exclusively for domestic production, notwithstanding the label of “free carry” given to this type of PPP.

For export projects, by contrast, the government of the export country and/or its electricity ratepayers fund these incrementally higher power prices, not the host country. This means that the host government receives an actual “free carry” on its equity interest in the project. Thus, while PPPs established for domestic projects involve hidden costs paid by the host government, PPPs established for export projects avoid such costs and make commercial sense for the host government.

Similar to the free carry issue, emerging markets often require water royalties and other taxes from hydropower projects, which essentially get passed to local ratepayers in the form of higher power prices for domestic electricity consumption. For export projects, foreign ratepayers instead bear some or all of these royalty costs, lessening or removing the burden on domestic ratepayers.

Providing Additional Foreign Exchange

An SOU will typically pay the local currency equivalent of an invoice amount, denominated (or indexed) in an internationally convertible currency such as US dollars, under a PPA for the purchase of power from a domestic hydropower project. The project company then needs to convert a large portion of these local currency payments into US dollars inside the host country to fund debt service, dividend distributions to foreign shareholders and other offshore expenses. The central banks of many emerging market countries maintain insufficient foreign reserves on their accounts to meet these conversion requests, which becomes another major impediment to the bankability of a hydropower project designed for domestic supply.

By configuring a project for export, the company can set its power prices in US dollars, or a mix of internationally convertible currencies, and collect payments in the same currencies, denominated in foreign exchange. At a minimum, this alleviates the need for the host country to use its limited foreign reserves for the project and often can even increase the foreign reserve surplus of the host country because the project company needs to convert foreign exchange into local currency to fund its local expenses and remit dividends to local shareholders.

Improving the Sovereign’s Balance Sheet

Most domestic projects funded by the private sector in emerging market countries require host government support. This often takes the form of a guarantee, issued in favour of the project company and backed by the sovereign balance sheet of the host government, covering monthly payments by the domestic SOU under the PPA over the entire 20-25 year supply period, and very large payments for early termination. These guarantee commitments represent contingent liabilities on the sovereign balance sheet, which in many cases can diminish the sovereign credit rating/capacity of the host country for decades, and also limit access to international capital markets and other sources of sovereign-level debt required for funding ongoing expenses of the host country’s public sector. While export projects will also involve host government support, often in the form of a project development or concession agreement, the host government typically does not guarantee payments under the project's PPA, which greatly reduces the contingent liabilities on the host country's balance sheet.

Improving Overall Energy Security and Reliability

Export projects, and the resultant cross-border grid interconnections, create a number of energy security and reliability gains shared by interconnected countries. These can collectively produce cost savings for domestic utilities that can be passed on to local ratepayers or reinvested into further development of clean energy. Examples include:

• By sharing ancillary services, such as spinning reserve and emergency generation capacity, interconnected parties can better stabilise system frequency, absorb sudden variations, reduce load shedding and improve system reliability.
• Hydropower export and grid interconnection allows interconnected parties to optimise their collective generation mix. They may, for instance, balance the intermittency of solar and wind with the energy storage function of pumped storage and/or reservoir hydropower.
• Interconnected parties can take advantage of seasonal differences in demand (e.g., winter versus summer demand peaks) or supply (such as excess hydropower in wet seasons) through diversity contracts to ensure reliable year-round electricity supply.

Conclusion

Exporting a portion of the electricity produced by a large-scale hydropower project can help some emerging market governments overcome initial stumbling blocks of such project’s development, including bankability concerns and the large liabilities on the host country’s balance sheet.

Another King & Spalding article will also explore some of the unique drawbacks of these export projects. The authors published a version of these articles as an IHA Briefing in December 2016