Much has changed since the D-word (Dhabol) first appeared on the lending scene. Most recently the Mundra and Sasan ultra mega power projects (UMPPs) have reached financial close, along with a number of smaller power projects. Domestic debt pricing is falling back in India's encouragingly liquid bank markets. And government-led initiatives are boosting the availability of much-needed equity in the power sector.

But projects continue to be dogged by concerns over the offtake risk posed by regional distribution companies – the nemesis of the Dhabol project – and land security issues. This has meant that despite the huge number of projects in India, foreign banks have seldom lent to the larger deals.

Mundra pulled in foreign debt and Reliance Power hopes to weave foreign lending into its Sasan project, but with global debt markets still struggling to provide long-term tenors, and long-term hedging instruments both hard to find and expensive, Indian power projects will, for the meantime, continue to source debt locally.

Disco risk

With international commercial banks more cautious than ever in assessing project risk, concerns over the offtake risk posed by India's distribution companies (discos) are at the forefront of banker's minds. India's distribution sector is only partially privatised, and many distribution companies remain controlled by the government. Power subsidies to poorer rural areas can complicate the balance sheets of the local discoms, and when considering payment default risk, domestic banks tend to be more knowledgeable than foreign lenders on the creditworthiness of these offtakers.

However, the regulatory framework has improved substantially since 2003, when the government boosted the powers of the regulator, and there is now a more transparent history of payment performance at the discos – although they still rely heavily on state government subsidies to make good the revenue shortfalls.

Mitigation techniques have also improved. "One way projects mitigate against offtaker risk is to have a bank supply a 12-month revolving letter of credit, backing up the PPA payments," says Srinivasan Nandakumar, senior director, infrastructure and project finance, at Fitch Ratings in India. "A second layer of security could be the escrow of incremental receivables of the utility," he says. Under this arrangement, the funds received by the offtaker utility, from its customers, are escrowed into a separate account, to which the project has access. "The utility does not have access to this cash until it manages to pay off the amounts due," Nandakumar adds.

The large size of the UMPPs also means that often several distribution companies have separate power purchase agreements (PPAs) with a single plant, and this smoothes some of this risk. A further risk mitigant is the ability to divert power into India's wholesale market if the disco defaults. In many states, wholesale prices are much higher than the tariff prices given to rural areas, and this makes selling into wholesale markets on a merchant basis attractive to some projects. For example, Tamil Nadu has a severe power deficit and has been purchasing power at between R7 and R8 per kWh at the margin, whereas the PPA power tariff can be less than half that.

Nevertheless, many participants in the sector believe foreign commercial banks are only likely to invest in some of the larger power projects in India if they come in with multilateral support, or associated export credit agency (ECA) financing, as BNP Paribas did on the Mundra project.

Land security

The bureaucracy and delays surrounding the acquisition of land is another major hurdle for power projects in India with squabbles over original ownership rights to privately-held land, leading to litigation.

Historically, under central government statute, state governments can require private landholders to sell whole areas of land to project companies, providing appropriate compensation is provided. Because of recent public opposition to land acquisition by companies, there is a change to this statute pending, which would require the project companies to acquire around three-quarters of the disputed land, before they can go to the government for help with the remaining portion. This is likely to cause difficulties for some projects, says Sumanto Basu, partner at J. Sagar Associates (borrower's counsel for the Mundra project).

These are problems India could do without, given it aims to build 100,000MW of new capacity between 2007 and 2012. The central government has sanctioned the construction of around 10 UMPPs and set up special purpose vehicles for each plant, which are then awarded to developers through a competitive tariff bid process.

Four of these plants have been awarded to developers: Tata Power, through its subsidiary Coastal Gujarat Power, is building Mundra in the Western state of Gujarat. Reliance Power has been awarded three other UMPP projects, the Sasan, Krishnapatnam, and Tilaiya plants. Sasan and Tilaiya are to have access to captive coal mines, whilst the Krishnapatnam plant is to source coal from the market, as is the case for Mundra.

Krishnapatnam

Following the financial close of Sasan, Reliance Power is now charged with sourcing debt for another mega-deal, the Krishnapatnam UMPP, which will have Asian Development Bank (ADB) support.

The ADB, which lent to the Mundra project, was asked whether it wanted to get on board the Sasan and Krishnapatnam projects, but decided to devote its resources to Krishnapatnam. "Our decision to look at Krishnapatnam was based on many factors, including our own exposure limits for the sponsor, sector and the country," explains Don Purka, an investment officer in the private sector operations department at the ADB. "We signed a mandate letter with Reliance Power [for Krishnapatnam] and we are conducting due diligence. We haven't yet committed to finance the project," Purka adds.

Under the rules set by the government, Reliance Power had 12 months from award to financial close. The project was initially intended to close by December 2008, but delays in the government's handing over of some of the land to the project has given Reliance extra time. The land delays are expected to be resolved within weeks rather than months.

Negotiations on coal procurement are also underway. While the Reliance ADA Group is looking to develop greenfield mines in Sumatra to source coal for Krishnapatnam and other Reliance power generation projects in India, the softened coal market opens up new options for cheaper coal supply contracts.

IDBI is lead rupee debt arranger on the project, and is likely to go to the domestic syndication market in the next few months. "Krishnapatnam must be structured to account for the market conditions which have deteriorated since Mundra was signed," says a banker close to the deal. "You might see shorter tenors on this project, with a refinancing balloon payment at the end, to get the banks more comfortable with taking long-term risk".

Purka says the ADB is looking at whether it can use of some of its guarantee facilities to keep foreign commercial banks in the structure. "A partial credit guarantee may be one option," he says. A plant's engineering procurement and construction contract could attract ECA cover, under which foreign banks could lend. An ECA tranche is in place in Tata Power's Mundra project, and Reliance Power is also looking at bringing such an arrangement into the financing of Sasan.

Local lender advantage

Whilst many foreign banks have pulled back from project lending, liquidity has remained relatively strong within the Indian bank market. Domestic bank lending to power projects has become cheaper since the start of 2009, after the central bank cut its interest rates and put pressure on banks to follow. After a lull between October and December 2008, the project market has picked up.

The government's moves to facilitate refinancing for banks should prompt further softening in margins, as banks become more comfortable with market conditions, adds Aditya Aggarwal, principal at IDFC Project Equity. "The banking community is still providing limited project finance at interest rate levels of around 12%, which hopefully will come down over the next couple of quarters," he says.

Avinash Anurag, assistant vice-president in State Bank of India's project advisory & structured finance division, estimates that domestic lending is currently around 200bp higher than hedged foreign lending. "9.5% is the ECB pricing with full hedging I'm getting right now for a typical project. If I go to an Indian bank for the same project, it will offer me something like Prime Lending Rate (PLR) minus 100bp. Using a PLR figure of around 12.5% puts the effective domestic lending rate at 11.5%," he says. "The main problem is I cannot arrange ECB financing for each and every project – I'm not getting enough money from foreign markets," he adds.

Purka says the price advantage of foreign lending has fallen sharply since the crunch: "You used to be able to do offshore corporate debt at spreads of less than 100bp for say a five- or seven-year deal for top tier borrowers. Now those spreads are gone-you're looking at 300-500bp spreads. That is what we hear foreign banks are looking at for corporate as well as some limited recourse debt, in the Indian market."

Although five-year debt pricing from foreign banks is cheaper than domestic banks, there is a huge risk to borrowers from exchange rates on longer-term financing, says Aggarwal. "If you look at just last twelve months, the dollar-rupee rate has moved from 40 to 50. We really don't have instruments in the Indian financial system to hedge 10-year or 15-year money at reasonable pricing and liquidity. To that extent unhedged dollar denominated debt is not a preferred option for infrastructure projects, which have rupee denominated revenues, as long as money is available in domestic markets," he says.

With high project risks already brought about by low power tariffs, which can be as low as R1 per kWh, foreign lenders are faced with little room to build forex risk into a deal. The absence of a vibrant bond market restrains tenors on project loans to around 10 years and means some projects are open to interest-rate risk, says Nandakumar at Fitch Ratings.

Projects often have clauses through which banks can adjust interest rates on a regular basis, to account for swings in their disparate base rates. Those projects subject to the regulated tariff regime escape this risk, as the interest-rate change is passed through to tariff prices. It can however be a risk for projects won through competitive bidding on a fixed tariff basis and an upswing in interest rates last year prompted adjustments.

The equity hole

Whilst the number of power projects submitted to the State Bank of India for financing has not dropped compared with last year, volatile equity and commodity prices have meant many projects are taking a longer time to close, says SBI's Anurag.
But equity is more problematic. As IDFC's Aggarwal says, "If there is a sponsor wanting to put up a 500MW standalone project, not too many private equity players are interested, given the exit-related issues with taking such a company with limited operations public over a short-term horizon."

However, that equity gap is being bridged by a growing number of India-focused infrastructure funds that offer a long-term commitment. IDFC spawned IDFC Project Equity Company in 2007. And most recently, State Bank of India, IFC, and Macquarie also announced the launch of Macquarie-SBI Infrastructure Fund in April.

IDFC PE has just signed its first power deal, by investing Rs3.5 billion in project developer Essar Power. Rather than acquiring a straightforward percentage equity stake in Essar, IDFC's deal is a structured equity transaction. "There are lots of options built into the structure. The stake will depend on two broad parameters: how much of the business plan comes to fruition going forward and what will be the valuation of the company when it goes in for a public offering five or six years down the line," says Aggarwal.

The equity held by Essar in its other four planned projects ranges between 74% and 100%, depending on the project – to conform with law some of the equity of certain projects must be held by the captive offtakers. Essar Power closed one of these projects in January and one in February, and the pricing on that that debt was around 12 to 12.5% for both projects. All the lending on the two deals came from domestic banks, although talks are underway with international banks regarding the two open projects.

IDFC PE is looking at investing in several other power projects. "We have entered into non-binding term sheets with three entities," says Aggarwal. These investments could range from $50-$70 million each, and all would be power plants fired by locally sourced coal. "We have almost settled on the broad project structures, some of them are having due diligence, and for another couple of deals, we are still negotiating on the terms," says Aggarwal.