Presented during the Hydropower & Dams conference in Portoroz, Slovenia on the 15th to 17th of September 1997
The role of the consulting engineer in the process of private power project financing
Author: RM Gaillard, Stucky Consulting Engineers Ltd.
Introduction
This paper examines the position that the consulting engineer holds in the implementation structure of private power projects and his possible contribution, within the group of developers, to the process of securing the necessary financing. In the context of this paper, project financing is understood as the scheme where loans or credits will be paid back only from project revenues, without recourse to the developer's assets. The source of project finance includes equity, bank debt, capital markets, export credit agencies' programs and multilateral lending institutions.
The first part reviews some of the changes which led power projects to gradually pass from the responsibility of governments and public entities to the initiative of private developers. It then reports on the reasons observed for the poor performance of this trend during the last decade. The risks which make financiers reluctant to allocate funds under the BOO, BOOT, IPP schemes are presented. The ways in which the consulting engineer can contribute to the mitigation of certain of the technical risks within these schemes as well as his resulting contribution in the process of financing is described in the main part of the paper.
Privatisation of the power industry
We are in the middle of a decade where the investment requirements needed to expand the power sectors of newly industrialised and developing countries was predicted to be of the magnitude of a trillion dollars. This impressive figure translates into an amount of 100 billion dollars a year to satisfy the growing energy demand fostered by the legitimate aspiration of all human beings for a better quality of life and a sustainable development of their socio-economic environment. The failure of governments to adequately face the need to develop power infrastructures was obviously caused by their insistence to finance them through the taxpayer or by transfer of public funds, which are mostly exhausted or in abyssal deficits. Guaranteeing the necessary injection of capital into the energy infrastructure will then require innovation and a considerable effort from all interested parties to prepare a global legal and institutional environment to make investments in this sector attractive. It is worth bearing in mind that, historically, most of the public infrastructure of so called developed countries was financed through private savings, not through tax payers' funds. During a given period that could be called the golden age, such capital intensive infrastructures were supported by international aid, the development banks and other multilateral institutions. Due to the failure of beneficiary countries to implement the recommended measures of the lending institutions as prerequisites for the continuation of their financial assistance, this sources of funds decreased rapidly. However, access to electricity remains critical to achieving economic and social development. Governments and utilities unable to secure finance for their power system expansion had, therefore, to encourage private participation in this sector. This was the period of promotion of private power projects in various forms and through numerous trials of which very few came to materialisation.
Reasons for failure of Private power projects
Despite a number of successes, the implementation of many private power projects are facing serious problems. The players involved are recognising that bringing them to fruition is longer and more costly than first imagined. In the light of experience, the various reasons for the poor performance in their implementation are the following :
- Absence of a well defined and comprehensive regulatory framework
- Absence of transparent and fair procedures for awarding concessions
- Award of concessions to " preferred " developers without required experience and capabilities
- Errant concession holders opening negotiations with numerous partners instead of constructing a strong trustworthy group
- Competition of other power projects in the same region
- Long delays for negotiations and decisions by inexperienced government officials
- Poor understanding of technicians in financial matters (Poor understanding of financiers in technical matters has also been observed)
- Poor quality of the feasibility study and proposed project design.
Last but not least, provided the above issues have been adequately solved or mitigated, numerous private power projects are still in a frozen state, because their developers were unable to complete their financing mechanism and, more specifically, the structuring of the debt portion.
Private power projects are complex. They need the involvement of various players, with different professions, sometimes divergent interests and often of diversified cultures. The process of their development is iterative and requires optimisation of the technical as well as the financial aspects.
Role of the consulting engineer
Fig. 1 illustrates the typical ownership and contractual structure of private power projects. The structural links existing between the concerned parties are dominated by financial relations and the allocation of various liabilities. The consulting engineer is positioned at the various interfaces. His usual duty is to provide the project developers with services allowing them to complete the project on time, within budget and with the required quality.
The scenario where the main issues concerning the regulatory framework, the terms of the concession and even the outline of the power purchase agreement are settled has a good chance to occur more and more frequently in the future. In such a case, the group of developers is nearly complete as far as the major technical partners are concerned. Among them are the suppliers of equipment and contractors who have good perspectives for placing their products or constructing the works for a price which is usually attractive for them. At this point arises the question of securing the partnership of the financiers. The word financier encompasses investors, lenders and bankers. Representatives of this corporation have usually a limited understanding of technical matters. They have, in addition a conservative attitude and a basic principle to accept risks in the neighbourhood of zero. Consequently, it is rather difficult to obtain their enthusiastic and unconditional support to provide the required flow of money into the project. Their legendary cautious attitude, which certainly contributed to build their present healthy status, needs to be changed into a constructive and positive appraisal of the risks related to private power projects. Fig.2 illustrates the major families of risks which make financiers reluctant to enter into private power projects. The parties assembled to develop a private power project have potential gains but may suffer the consequences of these risks at various stages of the development and implementation of the project. As project developers are sometimes unable and very often unwilling to provide corporate guarantees for the portion of the investment financed by debt, financiers, therefore, have to look for guarantees based on the robustness of the project itself. As skilled professionals, the financiers can explore and activate the numerous tools which have developed during these recent years to overcome non-technical critical constraints on financing. The instruments available with multilateral institutions (like IFC, MIGA, World Bank Guarantee Program), or derived from insurance companies, export credit agencies and national aid agencies are well known nowadays and mitigate reasonably the financial risks. However, for the remaining technical risks, the consulting engineer can be a valuable support in providing the financiers with objective views for the execution of their due diligence. The following part of this paper describes the fields where the consulting engineer can intervene at the early stage of the project preparation. His possibilities to improve the quality of the project definition reside in the following subjects :
- Improvement of the feasibility study completeness
- Determination of the project cost
- Addressing of environmental and ecological issues
- Assessment of geographical and natural patterns of the project site.
Completeness of the feasibility study
In the past, the public infrastructure feasibility studies and project preparation studies were performed under the responsility of the owner either from its own resources or through the concessionnal financing from various institutions. Interested contractors then bidded to be awarded the various contracts for supplies, services and works. They did not have to care too much about design, engineering or optimisation works and their related cost which was part of the hidden cost of the project. Since multilateral lenders have drastically decreased their support to public infrastructure projects, the quality of preliminary and project preparation studies has drastically dropped. There are even examples where tender documents inviting bids for private power projects were launched without the proper state of preparation, sometimes including project memorandum or feasibility documents deliberately optimistic. They were obviously formulated with the aim of inflating the attractiveness of the project and the possible lucrative return. A deeper analysis of these documents by an experienced consulting engineer quickly shows that the reality is less brilliant than superficially depicted in the documents. The need for professional technical preparation of hydropower projects is now widely accepted by project developers and by construction companies and equipment suppliers. Under-informed or poorly organised project preparation is the cause of cost and quality problems in the construction phase. Some of the technical aspects which make the lenders hesitate in financing private power projects, can be analysed, clarified and explained by the consulting engineer. The level of development of his analysis will directly influence the level of the lender's financing fees. Reducing the number of uncertainties in questionable issues will ultimately allow the lenders to reduce the cost necessary to cover their exposure to these risks. In projects where all partners are struggling to save a portion of a percent in equipment efficiency or to shorten the construction time in order to commission the plant at an earlier date, the competitiveness of the lenders proposal is highly appreciated by the developers.
Project cost determination
A very frequent situation occuring in many power projects offered to private developers is that in which the cost is only broadly estimated by the entity calling for bids. Encouraging lenders to commit themselves into projects where cost accuracy is in the order of plus/minus 20 to 30 % is very difficult. This is even more impossible for hydropower projects where physical factors and natural patterns of the site greatly influence technical choices, construction methods and duration. The pricing of so many technically different components of a power project is not credible if such components are not down on paper in sufficient detail. This is critical in project financed undertakings where the total cost has to be established before detailed engineering can take place. In these circumstances, most of the contractors and suppliers who are required to provide the developer with prices apply very conservative "uncertainty factors" resulting into figures which simply kill the project. Successive and time consuming adjustment and calibration rounds are necessary to arrive at an amount which more realistically reflects the market conditions. These necessary negotiations could result in the development of unfriendly and unpleasant relationships between parties which have note the same commercial or vested interests in the project. Lenders are extremely sensitive to the risk of project cost overrun. In this case, at a crucial stage of the construction of the project, the lenders have little choice but to re-inject additional funds. Deferring the allocation of these funds will directly endanger the capacity of the project to repay their loans at the expected terms. The consulting engineer can remove an important part of the project cost uncertainty or inaccuracy. Usually involved in several projects at the same time in different places and countries, with various suppliers and contractors, the consulting engineer disposes of valuable data banks of unit prices and their structure as well as estimation ratios and formulas that his experience has consolidated over the years. For calibrating prices of key elements of the project, he can launch enquiries in the international industrial or contractors' community. This independent approach will allow the developers to focus on the realistic cost of the project that they need to know for performing financial computations and engaging in preliminary dialogue with lenders.
Environmental and ecological issues
Aggressive pressure and lobbying groups are developping world-wide to monitor and observe the construction of large infrastructure projects. Aside from the various cases where the environment is actually affected, many hydropower projects are often the object of undue discrimination. The mediatisation and amalgamation of different subjects such as resettlement issues, water borne disease, endangered species, land deprivation, cross-boundary water rights a.s.o. can result in the unwillingness of lenders to enter into a private power project. It is worth underlining here that export credit guarantee agencies are very sensitive to the aspect of the environment, having an obligation to report to their government authorities and to international surveillance or regulating organisations which ultimately have to say a word in the final decision to release their insurance coverage. The consulting engineer is certainly the right professional to treat the aspect of environment related to power projects. At the time when developers are initiating discussions with lenders, the consulting engineer can formulate pertinent advice on the validity of the available impact assessment reports. With his experience of many projects in various countries, his staff of diversified experts and his knowledge of international recognised standards in this field, he can quickly point out the issues which have not been addressed properly. If adjustment, remedial measures or compensations have to be envisaged, he can estimate the additional costs to be borne by the developers. Sorting out the environmental issues by weighing their cost wise influence on the project, is a valuable tool offered to the lenders for their go or no-go decision.
Hydrological variability and project site physical patterns
The risk relating to fuel supply and price is supposed to be non existent in hydropower projects. Nonetheless, there are risks from the variability of the hydrology. The consulting engineer is in the position to qualify and quantify this risk and provide lenders and developers with good advice for implementing reasonable provisions in their loan agreements. Exploring the possibilities to defer debt repayment or adapt the power purchase agreement by modulating the capacity charge, the energy charge and a possible availability charge in the structure of the energy price is of interest in the process of project financing optimisation. The average availability of power over long periods is derived from the thorough analysis of hydrological data. The quality of this data is of prominent importance for performing projections for the future. The consulting engineer can review available hydrological records and through cross checking, statistical computations and appropriate comparisons and simulations ascertain or question their validity. They are nowadays sophisticated and reliable methods for processing this kind of data and for calculating accurate parameters needed by designers for dimensioning key components of the project. Reducing one part of the uncertainty risk in this sector will directly result in a better precision of the project cost. The electromechanical equipment suppliers usually size their machines and the best suitable technology on a relatively limited number of parameters. Such data is supplied by others from fields of investigation where suppliers are not too conversant. Water discharge and a few corresponding water levels at given locations are usually sufficient for selecting the most adapted equipment. Further optimisation of the power production machinery and their operation will then depend on the accuracy and reliability of the design criteria retained by the consulting engineer at the completion of his hydrological records analysis. In addition to this, the dimensions and, therefore, the cost of flood evacuation structures also directly depends on the results of the hydrological data computation. The spillway system of hydropower projects, as well as the concept of the temporary diversion scheme, are key elements for protecting the works during its lifetime operation and construction phases respectively. Their share in the total cost of a project is not negligible. The validation of the selected system at an early stage of the project preparation is, therefore, of importance to the developers who most define their financing requirements and, in parallel, reassure the lenders that the project and its surroundings are physically adequately protected against natural threats. The same precautions apply in the fields relating to the physical patters of the project site such as geology and seismology. It is the function of the consulting engineer to review these aspects and warn the developer when the data and records is not sufficiently complete when the data and records is not sufficiently complete for confirming the design of the key components of the project. Geographical patterns of hydropower projects are imposed by nature and are difficult to change. They must be carefully assessed and sound, economic solutions must be developed by experienced professionals.
Conclusion
The construction of a private hydropower project requires the collection of numerous, sometimes conflicting, often complex and almost always interrelated professions. There are substantial risks associated with these types of projects. The appraisal of the technical risks can vary drastically from one partner to the other depending on his field of core business. If the consulting engineer can reassure the lenders with appropriate explanations concerning the risks which according to their judgement can jeopardise repayment of their loans, an appreciable step ahead will be achieved. As finance is the main fuel for private power project development, it is crucial that the financiers and lenders are fully informed of the risks and the ways in which they can be monitored and controlled. The consulting engineer can be a driving force in this process. With the adequate language, he can translate untangible aspects into figures, understandable to the financiers. The likelihood of a private power project attracting sufficient financing depends on the premise of a competent project definition allowing them to properly optimise the balance between risks and rewards. The consulting engineer has a decisive role to play in this process. This important asset will be more and more recognised by the other partners of private power projects. As a results, traditional barriers and misunderstandings between the world of technicians and the world of financiers will disappear and leave room for a constructive and innovative approach to achieve a common objective : to capture the technical innnovation, the management skills, and the funding capacity of private partners in order to reach the goals that the public sector has failed to achieve.