Arnold Attoungbre on the challenging credit quality of the power sector in Africa

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Who are the key players in the project financing of Power projects in Africa ?

The project finance or limited recourse debt funding market in Africa has developed significantly over the past two decades, and
the financing of independent power projects has been a key outlet for utilisation of project finance. The nature of the funding participants in the power project finance sectors of the various countries on the continent is not uniform, and is typically a function of the scale and sophistication of the banking systems and capital markets in the respective countries.

Countries with well-developed capital markets, such as South Africa, Egypt and Morocco have an array of domestic project finance
commercial banks that are able to provide long term project finance debt in domestic currencies. Further to this, there are a few markets,
such as Nigeria and Kenya, with vibrant banking systems despite developing domestic capital markets, which have the capability to
provide long term finance to projects. Project finance commercial banks in these territories have been able to provide capital to
projects, although this has tended to be in hard currencies, such as US dollars and Euro. In other markets, the banking systems do not have the capacity to provide long term project financing, and this is where multilateral and bilateral development finance institutions tend to step into the breach. These DFIs provide long term project finance debt, and this can typically be provided in either hard currency or, in
some limited instances, in domestic currency.

Other key participants in the project financing of projects include: off-takers, who buy power from the projects and provide a revenue
source for projects; guarantors, such as local finance ministries, who guarantee the obligations of the off-takers, where required;
technical parties, who construct and operate the power projects, and guarantee their own performance; fuel suppliers, who provide
the required fuel, depending on the nature of the respective power projects.

What are the key pitfalls of project financing Power projects in Africa?

The major challenge to project financing power projects in Africa is the credit quality of the power sectors across vast swathes of the continent. There are few power utilities (the typical off-takers from independent power projects) on the continent who have permitted tariff levels that are reflective of their cost structures, including ongoing maintenance and expansion of the power system. The lack of cost reflectiveness in utility tariffs entails that these utilities are not sustainable on their own on a long term basis, and require significant subsidisation from their local ministries of finance. This entails that, in many instances, independent power producers will require government guarantees to provide the payment certainty required by project financiers.

The lack of capital market development is another project financing pitfall in that projects tend to be financed in hard currencies, rather than the local currency which is earned by the power end-users. This currency mismatch could have an impact on the long term sustainability of local power sectors.

Structuring power deals as project finance transactions facilitate the apportionment of various transaction risks, what are the major risks of power project financing in Africa?

  • The major risks of power project financing in Africa are:
    Creditworthiness of Off-Takers: The off-taker’s ability to perform as contractually obligated is the single most important risk facing private power projects. High transmission and distribution losses, tariffs below costrecovery levels, and poor billing and collection systems are key issues that can severely affect the financial standing of utilities. Average distribution losses in SubSaharan Africa are 23 percent compared with the norm of 10 percent or less in developed countries. Moreover, average collection rates are only 88.4 percent compared with the best practice level of 100 percent. Combining the costs of distribution losses and uncollected revenue and expressing them as a percentage of utility turnover provides a measure of a utility’s inefficiency. In Africa, this inefficiency is equivalent, on average, to 50 percent of turnover.
  • Regulatory and political risk, i.e. changes in law, or risks which relate to the effects of government action or political force majeure events such as war and civil disturbance.
  • Construction Risk: A key funding consideration for project financed power projects is whether the project can be completed on time, on budget and to the required specification. This question revolves around the risks inherent in the construction process such as: land acquisition and access; site conditions; permits and approvals; and the skill and experience of the construction contractor.
  • Environmental risks: The project’s impact on the surrounding environment, during both the construction and operation phases, needs to be considered. A large number of financiers are now loth to finance projects involving coal and other fossil fuels, as renewable energy is seen as being more environmentally sustainable.
  • Currency risk: The majority of African economies do not have financial systems that can sustain the long term financing of projects using local currencies. As a result, the mismatch between local currency revenues (from end-users) and hard currency financing costs remains a key risk in project financings.
  • Use precedent and do not attempt to reinvent the wheel on every transaction.
  • Reduce transaction costs by seeking entities that can partially operate on risk.
  • Ensure that the scale of projects makes sense relative to the nature of the financing being sought, a quicker solution could be corporate or blended financing solution.Involve participants earlier in the process to avoid reworking
    aspects of the transaction at a later point.

Project finance could be more affordable or more expensive than financing a project on the host country balance sheet, what are the factors that affect power project finance costs in Africa ?

Project finance is invariably more expensive to implement than a public procurement in absolute terms. The legal and commercial rigour involved in project financing, requires a significantly larger allocation of management time and expertise from both the public and private sector, than would otherwise be the case in the instance of a utility procuring a power unit. The factors negatively affecting power project finance costs in Africa relate to the management of the afore-mentioned pitfalls, such as the credit issues, political risk aspects and currency risks inherent in the project financings. The relatively small scale of the projects being financed relative to more developed markets also entail that the
project finance costs per unit of power produced are also higher.

Another key aspect affecting the cost of project financings is the dearth of local project finance skills and capital. This entails the importation of technical, legal and financial skills from outside the host countries, which adds to the overall cost envelope.

Project finance adds layers of complexity to a transaction relative to balance sheet financing which could cause delays, what are your five recommendations to shorten timelines?

We believe that the benefits of pursuing a project financing exceed the associated challenges, but only in instances where the project finance solution is fit-for-purpose and appropriate for the nature of the project being financed.

  • Limit the numbers of participants involved in a project to reduce coordination risk.