PROJECT FINANCING IN
By
SARA MAHBOOB[1]
I. Background: The Need for
Project Financing in
Countries
in
The financing in such projects generally takes place in two forms: equity and debt capital.[3] The sponsors or developers of the project are usually a group of large investors, both domestic and foreign, that make equity contributions to the project in the range of 20% to 25%.[4] The lenders are generally large international commercial banks and multilateral lending agencies.[5]
Because of the large amount of funding required for infrastructure projects, debt is usually obtained in the form of syndicated loans with the participation of more than one bank.[6]
Unlike other methods of financing projects, project finance is a seamless web that affects all aspects of a project‟s development and contractual arrangements, and thus the finance cannot be dealt with in isolation. The various parties involved in the project (e.g., project developers, governments and other public authorities, engineers, contractors, equipment suppliers, product off takers, and other parties to the project contracts) need to have understanding of how project finance works, and how their part of the project is linked to and affected by the project finance structure.[7]
Despite
the risks and challenges present,
According
to the World Bank, the need for infrastructure investment in
II. A
Tale of Two Power Projects: The Hub Power Project and Dabhol
Power Project
Not all South Asian countries suffer from the same problems, but as a generalisation the region still has the legacy of state owned vertically integrated electricity supply industries, often with the characteristic politicization of tariff setting, high level of non-technical losses, high levels of debt or arrears, high level of manning, and poor commercial performance. As a result, it is difficult for the public sector to finance its investment needs on commercial terms.[10]
Therefore, the government is incapable of publicly funding projects of the required scale and requires private participation in energy development ventures.
This paper analyses two mega power projects in the emerging market economies in South Asia; the Hub Power Project in Pakistan and the Dabhol Power Project in India. The paper will discuss these projects from a legal, business economic and public policy perspective with a special focus on the role of investors, lenders, owners and governmental participants. The main area of focus of this paper is the structuring patterns and the financing patterns of these projects when they were negotiated.[11] Also, a discussion of some of the risks (which were or weren‟t allocated) is also undertaken.
While
there are positive aspects of both these projects,[12]
this paper presents a discussion focusing more on the gaps and challenges faced
to help foreign investors understand the nature of risks and challenges
involved when investing in power infrastructure in
a. The Hub Power Project in
The Hub
power project is located on the
Hub is
important to
The
process of setting up the project began when Pakistan Government first declared
a policy of privatization of its power plant development in 1985. In response
to Government of Pakistan‟s (GOP) request in 1987
for Private Sector proposals to design, finance, construct, own and operate power
plants to supply the national grid, 20 proposals were submitted, ranging in
capacity between 2MW and 600 MW. Of these, Xenel
Industries of Saudi Arabia and Hawker Siddeley Power
Engineering of the
Several
sites were examined in terms of efficiency of fuel supply, ease of
interconnection with the national transmission network, and environmental
considerations. The site at the mouth of the Hub River in Baluchistan on the
Arabian Sea was selected as fuel could easily be delivered to the power plant
by barges or a pipeline, and linkage with WAPDA transmission network was
possible by cutting eastwards across Baluchistan‟s
virtually uninhabited desert and connecting with WAPDA‟s network near Jamshoro in Sindh Province.[18]
At
this point, Xenel and Hawker Siddeley
saw the merits of combining forces as sponsors and investors (SI) to: capture
the economies in sharing infrastructural facilities such as fuel and water
supply systems and achieve better coordination in negotiating with the GOP. In
order to ensure that the site for the Complex would meet environmental
standards, an environmental screening study was undertaken by KBN Engineering
and Applied Sciences Inc. of the
i) Structuring
of the Project
In
accordance with the minimum functional specifications for the Complex, agreed
by SI and WAPDA, a consortium led by Mitsui Co. of Japan was selected by SI for
the implementation of the Complex from among four major international companies
who quoted for the construction of the Complex. Mitsui & Co. was selected
on account of various reasons including its competitive price and its good
performance in constructing a 600 MW coal-fired power station in
Mitsui
& Co. put together a consortium of equipment suppliers and contractors, to
participate in the construction of the power station within the parameters
agreed by SI and GOP. The construction consortium entered into a lump sum fixed
price for the design and construction of the Complex which would provide for
the commissioning of the plant in accordance with a timetable and penalties for
delay or failure of performance. All members of the construction consortium
took several and joint liabilities, contributing towards project development
and provided equity. SI selected British Electricity International (BEI) of the
U.K, and Canadian Utilities Power (CUP) of
Under limited recourse project financing, lenders usually require the earmarking of a fund to meet contingencies not anticipated at the time the fixed price turnkey contract[26] is signed. The fund is intended to ensure that delays, if any, due to unforeseen events are expeditiously addressed to minimize the adverse impact on the forecast project revenues. In the present case, a reserve contingency fund of US $150 million had been included in the overall estimate of the cost to cover increases in costs during construction.
ii) Financing of the Project
The financing of the project was largely achieved due to the comprehensive set of contractual agreements containing the necessary security that would ensure the viability of the project in the coming years. The major shareholders of HUBCO were Xenel Industries Ltd., National Power Energy, Commonwealth Development Corporation, IHI,[27] Mitsui and K&M Engineering. The debt was financed in two forms with major provisions from a World Bank organized fund (PSEDF) and other debt provided from Japanese, Italian, French export credit agencies and the Commonwealth Development Corporation (CDC).[28]
In addition to the support from the World Bank and other governmental and multilateral sources, including the governments of France, Italy, Japan, the United Kingdom and the United States under the Pakistan Energy Development Fund, the World Bank and the Import/Export Bank of Japan jointly developed an Expanded Co-financing Operations Program to assist the international commercial debt funding by provisions of a partial guarantee.
A
significant portion of the offshore debt was also guaranteed by certain export
credit agencies. Rupee debt was provided by a group of local banks led by the
National Development Finance Corporation of
A total financing of US$ 1.8 billion included US$ 1.7 billion equivalent in foreign exchange and about US$ 100 million equivalent in local costs. The capital structure was 20% equity and 80% debt[31] – the debt was mobilized on a project finance basis. Included in the financing plan were costs associated with the turnkey construction contract, development costs, interest during construction and other finance related costs, as well as a reserve contingency fund.
The Power Purchase Agreement (PPA) secures the project‟s revenue streams and is the most important commercial agreement in such projects. This 30-year agreement in current case also defined the interface between HUBCO and WAPDA. Fuel Supply was secured through this 30 year agreement between the Government owned fuel supplier, Pakistan State Oil Company, and HUBCO. An Operation and Maintenance Agreement (OMA) between HUBCO and National Power International (a subsidiary of National Power, UK) had an initial term of 12 years and provides for operation and maintenance of the plant according to agreed terms and technical criteria.
Several
other agreements/provisions were integral components of the contractual
arrangements of the project. These included: i)
escrow agreements[32]
for local and offshore escrow accounts; ii) foreign exchange risk insurance
provided by the State Bank of Pakistan for a fee included in the project cost;
and iii) a shareholders‟ agreement and related
corporate documentation.[33]
iii) Corruption Allegations and Renegotiations
In
Initially, the Bank had advised the Government to separate the commercial and criminal issues in an attempt to bring the perception of an orderly framework to resolving the Independent Power Projects (IPPs) disputes. WAPDA was facing severe cash flow problems and was not in a position to honor its payment obligations under the PPAs. In addition, the country's foreign exchange reserves were dangerously low which jeopardized the Government's obligation under the Implementation Agreements to convert rupees into foreign exchange. Some IPPs indicated a willingness to renegotiate in recognition of the country's difficulties. However, separating the commercial and corruption issues proved difficult to do in practice in the case of HUBCO, where the Government/WAPDA was of the view that the original commercial terms were fraudulently obtained. Ultimately, both HUBCO and the Government/WAPDA requested the Bank to act as a facilitator in resolving the dispute since attempts by the parties to renegotiate the commercial terms were continuously bogged down in corruption allegations and refutations. In light of this, the lesson learnt for such projects is that governments and governmental agencies should be encouraged to pursue corruption strictly according to law and internationally recognized due process, and in the meantime contractual obligations should be honored.[36]
Renegotiating concession agreements is not unusual in the private sector, particularly when prevailing conditions substantially change (e.g. external macro shocks). However, negotiations will more likely result in mutually acceptable solutions when they occur in a commercial atmosphere, free of coercion. Particularly, in the context of future IPP solicitations, it may be useful to set out the principles of how the benefits or burdens of future debt refinancing or restructuring should be shared among the parties involved. Including such principles in future PPAs could: (a) facilitate the restructuring of debts in jeopardy situations, and/or (b) encourage IPPs to refinance debt in the event interest rates fall substantially and refinancing could lead to significantly lower cost of debt to the benefit of the both the IPPs and the host country. Not having had at the outset such “rules of the game” could be one of the reasons for the few incidents of debt refinancing or restructuring among the Pakistan IPPs.[37]
b. The Dabhol Power
Project in
In 1991, as part of India‟s liberalization efforts, the power sector was identified as one of the key infrastructure sectors to be developed to spur economic growth in the country. While the Government of India‟s (GoI) intent was to liberalize the entire sector, the generation sector was opened up first, since it was felt that this sector was more amenable to private sector participation. In 1992, pursuing this intent of economic liberalization, the Congress led GoI under then Prime Minister P V Narasimha Rao, announced it would open up the power electricity sector to foreign investment.
In turning to private investment for power plant development, the GoI gave the first few private sector projects the status of pioneer projects, or “fast track” projects.[38] For these fast track projects, eight of which were eventually signed, the standard public tendering process was not followed because the Indian Government was sensitive to its weak negotiating position.[39]
Instead,
the Central Government negotiated with the IPPs for individual projects in
order to entice them to invest in
Enron
had begun to investigate opportunities in the Indian power sector in 1992, when
i) Structuring
of the Project
From the project‟s inception, Enron strongly promoted Dabhol as a key element of its international strategy. The Dabhol project was easily Enron‟s most significant overseas endeavor in its size, cost, and political visibility. According to Enron, the 2, 184 megawatt Dabhol plant is the largest gas-fired power plant in the world.[42]
Interestingly,
when the World Bank evaluated the Dabhol project it concluded
that the project was “not economically viable, and this could not be financed
by the Bank.”[43]
The World Bank found that the proposed plant would produce too much power at
too high a price for the state. Specifically, the World Bank found that the
project was too large for base load operation in
According
to media accounts, “India‟s Planning Commission
originally opposed the project on grounds that the plant‟s
annual requirement of 3 million tons of gas would drain at least $250 million
from India‟s foreign exchange reserves.”[45]
While the size of the project was scaled down from the originally proposed
2,550 megawatts to a still massive 2,184 megawatts, it is not clear whether this
reduction fully resolved the concern about the project‟s
effect on foreign exchange reserves.[46]
The Dabhol project was envisaged as an integrated energy complex comprising a power station, constructed in 2 phases, and an LNG re-gasification plant. The operating entity was the Dabhol Power Company (DPC),[47] which was a joint venture. During most of the project development period, Enron owned 80% of the project, while General Electric and Bechtel each owned 10%. In late 1998, MSEB purchased part of Enron‟s equity stake, which dropped Enron shares to 65%.[48]
While
the project company (DPC) had numerous contracts with various counterparties
for construction, financing and operation of the project, the key contract was
the power purchase agreement (PPA). Under the PPA, dated
MSEB was the sole customer for DPC, with which it had a 20 yr. (extendable) power purchase agreement (PPA). The tariff structure for DPC was very different to the tariff structure of most other Indian IPPs. While most IPPs had a “cost plus” structure, which provided compensation for operating costs, fuel costs and debt servicing plus a fixed return on equity, DPC had proposed a levelized tariff structure over the life of the PPA in dollar terms. Further, the contract provided for significant penalties on DPC, if it failed to achieve the target availability levels.
ii) Financing of the Project
The parties negotiated the project terms over an 18-month period, which culminated in the Dabhol Power Company and MSEB signing a power purchase agreement in December 1993. Over the next year, Enron developed the project financing, obtaining US$635 million in financing, insurance, and loan agreements from Bank of America, ABN Amro, a group of Indian banks, the U.S. Export-Import Bank, and the Overseas Private Investment Corporation (OPIC).[52] The main lender group for the project were the domestic lenders (IDBI, ICICI, SBI, IFCI & Canara Bank), export credit agencies (J-Exim/MITI, OND of Belgium, US Exim), OPIC and a consortium of foreign commercial lenders (led by ABN AMRO, Citibank, ANZ Grindlays, Bank of America).
The sponsors were looking to develop the project with non-recourse funding, limiting their liability towards the project to their equity investments and other guarantees that they provided. The fact that the project had only one customer with a weak credit quality, implied that the financing of the project was critically dependent on the credit support mechanism for the project.
In view of this, a multi-layered credit support mechanism was established for both monthly bill payments and termination related payments of the project comprising a letter of credit, a guarantee from GoM, a counter-guarantee from GoI and an escrow account consisting of MSEB‟s cash collections from selected regions. Of these, the GoI counter-guarantee was available as credit support only for obligations related to Phase I, while the cash flows from the escrow account were only available for Phase II related obligations. In setting up the Dabhol power project financing, the lenders were relying heavily on the guarantees furnished by the GoM and the counter-guarantee given by GoI.
iii) Negative Reaction, Munde
Committee and the Revised Agreement
Enron‟s Dabhol project in
Fueled by
growing negative reaction to the Dabhol project, the
opposition party won in
Based on
this evaluation, in August 1995, the state decided to halt construction and
cancel the project. In response to the state‟s
action, Enron sought US$300 million in compensation, while attempting to convince
the Indian government to reverse its decision. The state government countered by
filing suit to void the agreement, alleging fraud and misrepresentation.[56]
However, negotiations took place between both the parties and while the state
dropped its law suit a revised agreement was drawn. The revised agreement
expanded Phase I of the project from 695 megawatts to 740 megawatts and
committed the state to both Phase I and the 1,320 megawatt phase II portion of
the project (under the initial agreement, the state was bound only to the Phase
I portion). As the MSEB was still committed to buying 90% of the plant‟s output and covering the risk of currency
fluctuations, the expansion increased the financial risk to the state under the
revised agreement.[57]
As it
turned out, the price of the power from Dabhol was
far beyond what consumers in the area will pay or the state could afford. Phase
I of the project ran on naptha, but oil prices were
apparently higher than projected, and demand had been substantially lower.[58]
In addition, the deal was structured to peg the costs of power to the dollar,
so the state bore the risk of currency fluctuations. The state was contracted
to buy the full output of the plant, but was purchasing only 10%-20% of the plant‟s output from Phase I. The state was
obligated nonetheless to pay the plant‟s
full fixed costs, which further increased the rates. In 2001, power from Dabhol was four times more expensive than that from
domestic power producers.
III. Lessons Learnt and Looking Ahead
An
analysis of both these mega power projects makes it easy to discern some common
issues facing such projects in
Most of
the problems faced by both these projects are typical of projects attempted in
a politically unstable and, for foreign investment, unsophisticated environment
without proper on ground analysis.
In
Due
to political instability, a weak legal and economic environment, and infighting
amongst project participants due to vested interests, it took nine years of
negotiations before financing was arranged and construction was underway in
Matching sponsors of the project of this nature to the scale of the project is essential. Keeping the number of project participants – contract counterparties, contractors and co- financers – to a minimum may help in overcoming administrative hurdles and make the whole process more time efficient. An important lesson learnt from Hub Project is that the power purchase agreement tariff should be determined in the same currency as the project funding. Additionally, the project participants should continue to strive for continuity in the advisers who provide specialized expertise to contract counterparties. An important suggestion in such a project with fragmented financing plans is to create a formal co-financiers steering committee, chaired by the Bank, during project development.[63]
In
The difficulties with projects like Hub Power Project can largely be attributed to its size. To begin with, the Government should have concentrated its efforts on modest-sized, and as a consequence, more easily financeable projects. In addition, rather than proceeding through competitive bidding for private power, Pakistan instead set a tariff ceiling for investors in an effort to accelerate the private power program and reduce transaction costs in order to quickly address the blackout situation facing the country. This was a very successful tactic in attracting foreign investors, but too many projects were approved due to this and the selection process was not considered transparent.
The Dabhol Power
Project was mainly financed by the government financial institutions.
Similarly, when the project came into controversy, the
As far as the problem of corruption allegations
in both projects is concerned, there must be greater enforcement of
anti-corruption laws in future, which can include the establishment of an
independent agency on combating corruption. Moreover, an integral component of
combating corruption in
To sum it up, critics generally accused the two mega projects as being poor on detail, agreement with one-sided negotiations, inadequate acknowledgment of political challenges and not achieving the ultimate goals of producing energy efficiently and in a cost effective manner. An investment which ensures that the above criticisms are not raised can ensure that the investment will be secure despite the challenges in this region.
[1]. LL.M. (
[2]. There is no single agreed upon definition
of project finance. For various approaches to explain project finance please
see: http://www.people.hbs.edu/besty/projfinportal/definition.htm.
[3]. See Nagla Nassar, Project Finance, Public Utilities, and Public
Concerns: A Practitioner’s Perspective, 23 Fordham INT’L L.J.60,60(2000).
[4].
[5].
[6].
[7]. Principles of Project Finance, E.R. Yescombe, Academic Press, 2002 at pg. 1 - 2.
[8]. Annual Report 2009, The
International Bank for Reconstruction and Development/The World Bank, at pg.
38.
[9]. Benjamin C. Esty,
The Economic Motivations for Using Project Finance,
[10]. See David Newberry, Power Sector Reform,
Private Investment and Regional Cooperation, June 2006, at pg. 6.
[11]. It should be noted that there may be certain
revisions in the agreements and certain figures (like estimated costs of the
projects) down the road. The facts and figures provided in this paper are true
for when the agreements were negotiated.
[12]. For example, the Hub Power Project utilized
“co-financing” as a successful mechanism of financing in dealing with financial
institutes working under Islamic finance. Also, most aspects of the contractual
framework have served as a model for the future projects in this region.
Considerable investments were made to meet environmental standards and the Hub
Project’s model should be followed in this respect. The Project is also
assisting with the sustainable community development of 25 local communities in
that area.
[13]. A country where a company
that is based in another country has business activities.
[14].
[15]. For more information please visit:
http://www.hubpower.com.
[16]. WAPDA, the Pakistan Water and Power
Development Authority, was created in 1958 as a Semi-Autonomous Body for the
purpose of coordinating and giving a unified direction to the development of
schemes in Water and Power Sectors, which were previously being dealt with, by
the respective Electricity and Irrigation Department of the Provinces.
[17]. See The World Bank,
[18].
[19].
[20]. Due to budgetary constraints, boosting power
generation capacity sufficiently would not be possible if Pakistani government
relied solely on the public sector. As an alternative, it instituted, with
support from the World Bank, "The Private Sector Energy Development
Fund"(PSEDF) in June, 1988. The objective of this fund is to foster
investments in the energy sector by providing long-term financing under
favorable terms to private energy development projects.
[21]. Supra note 15, at pg. 11.
[22].
[23]. Toshiba, Kumagai
and CUP, could not renew the validity of their prices beyond
[24]. The World Bank, Pakistan – Expanded
Co-financing Operation to the Hub Company , Staff Appraisal Report, Pakistan,
Report No. 9004-Pak, October 1991, at pg.11 – 12.
[25].
[26]. A turnkey contract is a contract for design
and construction of a complete project.
[27]. IHI Corporation.
[28]. The World Bank, Project Finance and
Guarantees, Co financing and Financial Advisory Services Vice Presidency,
Project Finance Group, “World Bank Guarantee Sparks Private Power Investment in
Pakistan,” June 1995, at pg. 1 and 2.
[29]. Hubco Company
website: http://www.hubpower.com/history.php.
[30]. The World Bank, Project Finance and
Guarantees, Co financing and Financial Advisory Services Vice Presidency,
Project Finance Group, “World Bank Guarantee Sparks Private Power Investment in
Pakistan,” June 1995, at pg. 2.
[31]. Some sources quote “the project was financed
on a 25:75 equity debt ratio.”
[32]. Defined as: a) Document that lays down the
conditions (or describes the event) upon fulfillment of (or occurrence) of
which the escrow agent delivers the asset or document held in trust by him or
her to the named second party or beneficiary; b) Document issued by a bank to
certify that the securities or other assets listed in it are on deposit with
the bank.
[33]. Supra note 30, at pg. 2.
[34]. See: Lessons from the Independent Private
Power Experience in
[35].
[36]. Lessons from the Independent Private Power
Experience in Pakistan, Julia M Fraser, Energy and Mining Sector Board
Discussion Paper, May 2005 at pg. 15.
[37].
[38]. See: Andrew Ink pen, Enron and the Dabhol Power Company 2 (Am. Graduate Sch. Of Int’l Mgmt.,2002).
[39].
[40].
[41]. Human Rights Watch, The
Enron Corporation: Corporate Complicity in Human Rights Violations, 10 (January
1999).
[42]. High Stakes Showdown; Enron’s Fight Over Power Plant Reverberates Beyond India, New York Times (
[43]. Letter from Heinz Vergin, Director of the
[44]. Anu Bhasin Et Al., Enron Development Corporation: The Dabhol Power Project in
[45].
[46]. Committee on Government
Reform U.S House of Representatives, Background on Enron’s Dabhol
Power Project (
[47]. Some sources refer to this entity as the Dabhol Power Corporation.
[48]. Case Study, supra note 44.
[49]. Expropriation Claim of Bank of America, OPIC
Memorandum of Determinations 3 (2003), available at
http://www.opic.gov/insurance/claims/report/documents/Bank
ofAmerica-September30-2003.pdf (hereinafter referred to as “OPIC Memorandum of
Determinations.”).
[50].
[51].
[52]. Financing for Indian Plant Secured,
[53]. Tony Allison, Enron's eight-year power
struggle in
[54]. High Stakes Showdown; Enron’s
Fight Over Power Plant Reverberates Beyond India, New
York Times (
[55]. The Munde
Committee, Report of the Cabinet Sub-Committee to Review the Dabhol Power Project (1995).
[56]. Committee on Government
Reform U.S House of Representatives, Background on Enron’s Dabhol
Power Project (
[57]. Id and for a detailed discussion on this
please see Harvard Business School, Enron Development Corporation: The Dabhol Power Project in Maharashtra, India (C)2 1996.
[58]. Bidding Set for Enron’s
India Project, Reuters (
[59]. For a detailed discussion on this see Paul
Handley, BOT Privatization in
[60]. In 1993, the Pakistan People’s
Party won elections. In 1994, Prime Minister Benazir Bhutto unveiled Power
Policy 1994.
[61]. Lessons from the Independent Private Power
Experience in Pakistan, Julia M Fraser, Energy and Mining Sector Board
Discussion Paper, May 2005 at pg. 7.
[62].
[63]. For a detailed discussion on this please see
Gerrard, Michael. 1997. "Review of the Hub Power
Project." Resource Mobilization and Co-financing
Discussion Paper 118. World Bank, Project Finance and
[64]. Build-Operate-Transfer (“BOT”) projects: In
this type of project, the Project Company never owns the assets used to provide
the project services. However, the Project Company constructs the project and
has the right to earn revenues from its operation of the project.
[65]. See: Paul Handley, BOT Privatization in
[66]. Through
[67]. While the Supreme Court in
[68]. Preeti Kundra, Looking Beyond the Dabhol
Debacle: Examining its Causes and Understanding its Lessons, Vanderbilt Journal
of Transnational Law, Vol 41:907 at pg. 934.