In a public-private partnership approach to financing hydro development — often referred to as a PPP arrangement — the objective is to achieve an acceptable balance of risks and rewards between private companies and publicly owned entities.
By Jean-Michel Devernay
Opportunities abound throughout the world for development of new hydroelectric projects. However, in order to take advantage of these opportunities, it is often vital for the public sector to work in partnership with the private sector. In such a public-private partnership, known as a PPP, both sectors have specific roles in the funding, construction, and operation of a hydro project.
For example, the public sector can:
- Be responsible for the works that use natural elements, such as the dam, to create storage and generation potential;
- Take the natural risks, such as hydrological and geological, involved in project development; and
- Establish tools and mechanisms toward decreasing high front-end costs often associated with hydro project development.
The private sector can:
- Invest in the power plant;
- Take responsibility for the risk involved in power plant performance; and
- Once debt has been repaid, increase royalties to the public entity, with this money being used to establish an energy fund to aid financing of other projects.
The combination of public and private funds and adequate sharing of risks creates a win-win situation. The private sector owns the project and gets access to a share of its revenues for a specified period of time (i.e., the concession period) with an acceptable level of risk. The public sector achieves debt reduction, which puts it in a better position to control issues of national interest — such as safety, water rights, and resettlement. The public sector also gets full ownership of a relatively new hydro facility at the end of the concession period.
A PPP can take several different forms, depending on the degree of involvement of both sectors. For example, the public sector could use tax revenues to provide capital for the investment or, alternatively, provide contributions “in kind,” such as the transfer of an existing asset (i.e., a dam). However the PPP is structured, its main purpose is to provide a mechanism for balancing risks and rewards among various parties so that clean, renewable, low-cost power can be added to a country’s generating portfolio.
Easing the financial burden
Reducing the need for capital and/or increasing project revenues are key steps toward making a PPP work. Avenues for easing the financial burden include cost reduction, local involvement in construction, identification and valuation of all benefits, and longer repayment terms.
Develovpment costs can be reduced if standard documentation and a step-by-step approach are adopted. Excellent project preparation, including proper site investigations, is an important factor in reducing construction costs and uncertainties.
In most cases, ensuring fair and transparent competition among contractors and equipment suppliers, as well as top-of-the-line project management, can help minimize final construction costs. For example, Electricité de France (EDF) is the head contractor for construction of the 1,070-MW Nam Theun 2 project in Laos. Construction of the project is being carried out by five subcontractors. Four of the five subcontracts were competitively bid; the fifth was benchmarked against the others. To satisfy transparency arrangements, the subcontracts awarded by EDF were made available to Nam Theun 2 Project Company (NTPC) — the limited company incorporated under government law to build, own, and operate Nam Theun 2 — under an open-book policy.
Local involvement in construction
Construction funds should be borrowed in the same currency as the future revenue stream, to minimize devaluation concerns. This provides a clear advantage in using local or regional resources for project construction. In particular, local or regional contractors can be mobilized at an attractive price for construction of the civil works, possibly as partners or subcontractors of larger international firms. The concession agreement may stipulate an obligation for “local preference,” but such a clause must remain realistic and consistent with the availability of proper local resources.
An example of local involvement in hydro development is Malana Power Company Ltd., which will develop, own, and operate the 192-MW Allain-Duhangan project in India. Malana Power Company is a joint venture between an industrial group in India with diversified interests in a number of industries and international hydropower investor Statkraft Norfund Power. This local company already has developed the 86-MW Malana project in Himachal Pradesh, India.
Identification and valuation of all benefits
Efforts should be made to provide financial reward for the many benefits hydro projects bring in addition to electricity generation. This includes other services rendered to the power system and social and environmental benefits, such as improvement of roads and bridges, recreational activities, local or regional job opportunities, flood protection, water supply, irrigation, fishery, and navigation. Not all of those benefits are easily marketable, but all efforts should be made to include them in the economic analysis when setting up investment priorities.
An example of environmental benefits is the reduction of greenhouse gas emissions. Most of the hydro projects have had access to carbon finance under the Kyoto Protocol mechanisms (clean development mechanism and joint implementation) are small, run-of-river projects. The deals have been concluded on a basis of about US$5 per ton of CO2 equivalent, resulting in an increase in revenues of 5 to 10 percent.
The somewhat theoretical restriction that projects have to be “additional” to what would have happened anyway is hindering implementation of the Kyoto Protocol mechanisms for hydro projects, along with the issue of methane emissions by large reservoirs in tropical areas. The International Hydropower Association (IHA) is working with partners to solve these various issues. Should these efforts be successful, the environmental value of the investment (carbon credits) could become a more systematic complement to the traditional electricity scale.
Longer repayment terms
Hydro projects require relatively high upfront investment costs but deliver an attractive cash flow in the long term. Therefore, long repayment periods can be decisive for the financial viability of a hydro project.
In May 2005, the Organisation for Economic Co-operation and Development (OECD) extended the allowed loan tenors (the initial term length of a loan) to 15 from 12 years for renewable energy projects. This change is intended to promote the use of renewable energy resources by enhancing their economic and financial viability. In late 2005, OECD determined that these extended repayment terms could be implemented for hydropower projects (which previously were excluded from the definition of renewable energy resources).
Solving the risk issue
For private investors and lenders to be willing to fund development of a hydro project, it is essential that all risks be properly identified and quantified, efforts be made to reduce or mitigate these risks, and residual risks be properly allocated and managed. The risks associated with hydro projects may arise at several points:
- During development, if financial closure is not reached and thus the funds expended to advance this development are "lost;"
- During construction, if the project is not completed on schedule, within budget, and with the required performance;
- During operation, if the project cannot generate revenues in accordance with the assumptions made in the financial model or must bear higher-than-expected operating costs; and
- At any time, under the effect of events beyond the control of any party to the various agreements, including force majeure events.
The development costs incurred before financial closure of a hydro project are high, typically ranging from $30 million to $100 million if creation of a large reservoir is involved. This high cost is due to the fact that each project is site-specific and requires extensive technical, social, and environmental studies.
Few private investors will be ready for that kind of expense — even if they have entered the project on a negotiated basis — while they remain exposed to a significant risk of the project not being developed. For those reasons:
- A hydro project should be undertaken only after the host government has performed a full assessment of the options and verified the hydro project is the best choice to meet the demand;
- Non-governmental organizations (NGOs), affected people, and representatives of the main beneficiaries of the project should be engaged in a transparent consultation process as early as possible to address potential social or environmental difficulties, thus reducing the risk of stopping the project after large development costs have been spent; and
- The host government should be involved in funding studies and site investigations during the project preparation phase, either directly or with the help of international financing institutions. These costs may eventually be recovered from the private investor selected to implement the project.
In addition, defining the main characteristics of the project (general layout, installed capacity, reservoir size, etc.) and evaluating its environmental and social effects should not be left exclusively to a private party. These formative activities involve the long-term use of a country’s natural resources, which must be examined on the basis of social, environmental, and economic (not financial) optimization.
Over the past decade, the trend has been toward turnkey or engineering, procurement, and construction (EPC) contracts. Under EPC contracts, most of the risks associated with design and construction are the responsibility of the contractor. Such an arrangement often is used for small privately developed projects because lenders require it in an attempt to reach maximum clarity in the allocation of responsibilities. But some public owners have considered EPC contracts, especially after experiencing delays and cost overruns on previous projects.
It can be tempting for an owner to push all the construction risks and responsibilities onto the contractor. But several facts affect this decision:
- A reputable contractor will only agree to bear those risks that can be managed or insured against. This may not be the case for all construction risks, such as unforeseen ground conditions;
- The contractor will include a provision for risk in the price, which the owner will have to pay even if the project is constructed without significant risk materializing;
- Only financially strong contractors can take such risks. Local contractors, which would be in the best position to construct the project with payments in local currency, may not be able to take such risks. Large international equipment suppliers often are reluctant to take joint and several liabilities with such local civil contractors; and
- The EPC contract gives the contractor a lot of control over project design because major civil works cannot be precisely defined and specified in advance. If the contractor gets into difficulties, it is a natural commercial decision to try to design a solution in the least expensive way possible, which may not be in the long-term interest of the project.
As a result, the turnkey approach should be carefully qualified when applied to hydro projects. While the overall pattern may work, the developer (either private or public) generally will find it to his or her own interest to retain some construction risks. These risks include all or part of the geological risks, specific adverse events such as reservoir outside the work area, unavailability of transmission lines at the time of commissioning, political or social turmoil during construction, and floods beyond a certain discharge.
Generally speaking, it makes sense that the public sector bear those risks with a low probability of occurrence but high effect. The private sector would absorb the risks for which the effect remains under a certain threshold, even if the probability for those risks is rather high. Figure 1 shows an example of this risk-sharing principle, applied to construction cost overruns.
When the owner has proven capacity in construction management and the necessary financial strength, substantial savings can be obtained by accepting the risk of overall completion by coordinating several construction packages. In such cases, the EPC approach often is not the most cost-effective solution.
During operation, the main risk is the water supply. Hydrological conditions must be extensively studied at the feasibility stage and be based on long-term rainfall and discharge records. This will provide a robust estimate of the average annual flow, its distribution over the year, and variations between years. The only realistic way to handle the risk of hydrological variations is to pool it within a larger portfolio of projects to dilute its effect. A single project company, which is a frequent case for an independent power producer, is not able to do that.
Therefore, in the case of a private project or a PPP engaging in a power purchase agreement with a utility, the payment mechanism in the agreement must attempt to reduce the effect of variations of project revenues from year to year.
It may be of mutual interest to the owner and the company receiving the electricity to elaborate a remuneration mechanism mostly based on capacity charge, or even a “lease” payment. Under this arrangement, revenues would be guaranteed to the owner as long as the plant is kept available, while the purchaser of the electricity would gain the freedom to use the plant and dispatch generation to best meet real-time needs.
The host government also can play a role by developing a special “energy fund.” This could be accomplished with assistance from an international financing institution. Hydro plant owners can be required to contribute to the fund when they receive extra revenues in wet years and be compensated for dry years through that same fund. This fund can be used to aid financing of other hydro projects.
In all cases, revenue stability is a key component of a hydro project’s bankability. This revenue stability also is ensured by:
- Obtaining guarantees from the host government regarding the consequences of eventual construction of any other dam or irrigation project that could artificially affect the flow regime;
- Entrusting operation and maintenance responsibility to an experienced operator. Choosing an operator who also is a member of the ownership company provides motivation to secure the plant performance level over the whole concession period. If not, some incentive mechanism has to be included in the operation and maintenance contract; and
- Strictly complying with all social and environmental commitments made during project development and construction. This is a prerequisite for building a long-term partnership with the local population and NGOs, which is the basis for a sustainable positive climate around the project.
Catalysts for making PPPs happen
There are other risks that are less specific to hydro projects and would have to be addressed for most large infrastructure projects. They include commercial; regulatory; macro-economic, such as inflation; political, such as expropriation; and force majeure risks. These risks cannot be assumed by a private investor or commercial lender. Therefore, those risks must be taken on by other key stakeholders, including:
- Host government, which is responsible for creating a legal and institutional environment in which developers will feel reasonably protected;
- ; International financing institutions, which can help by lending to the project while taking political risk, providing partial risk guarantee products, or providing political risk insurance coverage; and
- Export credit agencies, which can cover part of the commercial risk.
International financing institutions have an essential role to play in providing risk mitigation and, therefore, in stimulating the involvement of private capital in countries or sectors with perceived high risks. Indeed, many developing countries do not have the resources required from the public sector to either develop a project on their own or make a successful PPP happen. The international financing institutions have a crucial role in filling this gap by providing technical and financial assistance to their developing member countries. This assistance is needed on three levels:
- Assist governments in creating an attractive environment for the private sector. In particular, they should mobilize grant assistance for capacity building; support baseline studies; encourage development of local capital markets; promote transboundary and regional opportunities; and collaborate with professional organizations in progressing hydropower sustainability;
- Help prepare and develop projects by assisting in setting up a realistic option assessment process, funding bankable feasibility studies, and contributing toward simplifying and standardizing documentation to make projects easier to close; and
- Contribute directly to solve the financial challenge, by means of providing loans that are attuned with the creation of long-term infrastructure assets; lending more at a decentralized level; providing insurance and guarantees for risks that neither the private sector nor the government can handle; providing refinancing facilities to allow commercial banks to extend loan tenors; assisting government authorities in raising their share of equity; and mobilizing international co-financing.
In 2005, the World Bank officially decided to support construction of Nam Theun 2. This is the largest public-private hydro project built and one of the largest internationally financed projects in Asia since the 1997 financial crisis. EDF is the lead developer of this project, in partnership with public company Lao Holding State Enterprise, private company Italian-Thai Development Public Company Ltd. of Thailand), and independent power producer Electricity Generating Public Company Ltd. of Thailand (which has both public and private shareholders). Construction of Nam Theun 2 is well-advanced, and full commissioning is expected before the end of 2009. This is just one example of the success that can be achieved in hydro project development through the use of the PPP approach.
Hydro Finance Handbook, HCI Publications, Kansas City, Mo., 2008. Prepared as a companion document for "Hydro Finance Tutorial," Session 1C of the New Development Track of the HydroVision 2008 Conference.
Jean-Michel Devernay is deputy managing director of Electricité de France's (EDF) Hydro Engineering Centre and vice president of the International Hydropower Association. He is the chair of the EDF steering committee for construction of the 1,070-MW Nam Theun 2 project in Laos, being developed and implemented under a public-private partnership.