Intense negotiations were taking place in September over the troubled San Pedro de Macoris power project in the Dominican Republic, where offtakers have been failing to pay only months into the life of a 20-year power purchase agreement (PPA). Hanging upon resolution of this situation will be the prospects not only for sustained investment in the country, but also the raft of capital markets products by which multilateral, ECA and private insurers hope to finance new development in emerging markets.

Commercial operations at the greenfield power plant began in the final quarter of 2001, when the first two 100MW units were fired up. The third and final 100MW unit was switched on in March of this year.

But the plant, which is located in the southern coastal town of San Pedro de Macoris, about 80km east of the capital Santo Domingo, was not fully operational for long. After a series of late or partially unpaid invoices, plant manager Cogentrix temporarily shut it down for several days in mid-August, though all three units have subsequently been restarted, and as of late September a plant manager said that it was ?running fine.?

The power produced by the San Pedro de Macoris facility is being sold under a 20-year PPA to Corporacion Dominicana Electricidad (CDE), an entity which was privatised in the late 1990s. CDE in turn sells the power to the three Dominican distributors which were privatised back in 1999, Empresa Distribuidora de Electricidad del Norte (EDE Norte), EDE Este and EDE Sur. But CDE has been unable to collect sufficient amounts from the distributors, and Cogentrix has found itself caught in the crossfire of a dispute between these privatised electricity distributors and the Dominican government.

The problem is centred upon various cross-subsidies that the government has promised the distributors, but has been slow in paying.

The solution on the part of the distributors has been to reduce payments to the CDE in order to offset the amounts owed to them by the government within their respective service territories, and payments to San Pedro have become caught up in this.

It is a difficult situation for the government, which guaranteed offtake risk in order to get the San Pedro project successfully financed and built. The Dominican government faces the worry that the building of further electric generation capacity in the Dominican Republic will be endangered by the current dispute. In addition, governments tend to go out of their way to avoid alienating ECAs and multilateral lenders, and in the case of San Pedro the list of those involved is a long one.

The project is 65% owned by Charlotte, North Carolina-based Cogentrix, with the remaining 35% held by UK state-owned entity CDC Capital Partners. This involvement of a UK government-controlled entity is accompanied by an involvement on the debt side with the Export Credits Guarantee Department (ECGD).

ECGD came in alongside the German ECA Hermes, in what at the time was seen as a breakthrough in co-operation between the German and UK ECAs and Kreditanstalt fur Wiederaufbau. KfW provided $95 million to the project, out of which $70 million was covered by Hermes and $13 million by ECGD.

Even more deeply involved is the Inter-American Development Bank (IDB), which provided a Partial Risk Guarantee of up to $144 million, which essentially mitigates the offtake risk of the project. This was the first such guarantee extended by the IDB in the republic.

In September representatives of the IDB and KfW, along with Cogentrix representatives, were in Santo Domingo, holding talks trying to resolve the situation. And sources add that the British Embassy in Santo Domingo has also been involved, with one referring to the project as ?an intensive care case.?

They add that the Dominican government has been coming up with eleventh hour payments each month in order to keep the project limping along, and avoid it going into default. But as long as the situation persists there are likely to be problems with obtaining ECA cover on other projects in the Dominican Republic.

?The problems with this specific project, and with the energy sector overall, will undoubtedly have consequences with regard to bank lending policies,? says one banker involved with the San Pedro project.

?It is hardly imaginable that banks would lend to the energy sector in the Dominican Republic on an uncovered basis, which means that financing will depend on available coverage, and the European ECAs are quite reluctant,? he continues, though he adds that some loans in other sectors needing ECA cover could probably proceed in spite of the problems.

The big question now is whether the situation can be resolved by monthly top-up payments from the government, or whether the project will fall so far into arrears that the PPA is terminated. But either way the Dominican government will be obliged to compensate lenders, because of the sovereign guarantees that it provided.

There is also talk of a wider approach, with various contracts between the CDE, distributors and government being looked at, but Cogentrix is understood to be reluctant to get involved in any such negotiations, having won the concession to build the San Pedro plant via a competitive bid process, and already being a low-cost producer.

The San Pedro project bonds and commercial bank loans were originally rated BBB by Fitch Ratings, and thus far the agency has not made any move to downgrade them, though it is closely monitoring the situation.

The original $137.2 million worth of debt financing was placed by WestLB, in the form of $65 million worth of bank loans and $72.2 million worth of notes. Buyers of the notes, which were sold at a spread of 400bp over treasuries, included Met Life and Siemens Financial Services. Siemens was also involved in the project as the EPC contractor, which explains the significant involvement of KfW as loan provider.

?The IDB guarantee is for $144 million, so right now the entire principal and accrued interest of commercial bank lenders would be covered,? explains Jason Todd, a director in the Latin America group at Fitch Ratings in Chicago. However, the note guarantee is an important part of the IDB's efforts to expand its capital markets capabilities ? San Pedro has been the first of only two in the project finance market. The strength of its guarantee will be a crucial test of whether its efforts for expanding the funds available to Latin American projects will be successful.

The IDB is relying upon an Implementation Agreement (IA), providing for full and timely payment of the CDE obligations to the project, supported by an unconditional and irrevocable guarantee by the Dominican Republic.

?The partial risk guarantee backstops the Dominican government guarantee, and this guarantee is of the PPA between CDE, the government-owned electricity company, and the San Pedro project,? Todd explains. ?The IDB guarantee is what gives lenders comfort ? we would never have rated this deal so highly as triple B if it was just Dominican risk.?

Fitch's rating of the notes is predicated on the expectation that the lenders exercise their rights under the financing documentation in a timely manner, to accept coverage by the IDB guarantee, if necessary, to avoid a payment default by the project and ensure full recovery of principal and accrued interest. Failure to exercise these rights in a timely manner could trigger a downgrade.

Fitch is keeping a close watch on San Pedro to ensure that, if the PPA is cancelled, then lenders will be quickly repaid by the IDB. Thus it is unlikely that San Pedro would be downgraded by only a few notches. It will either remain at BBB, or go into default if the process of reimbursing lenders is too slow.

The Dominican government would likely wish to avoid seeing the notes downgraded to default status, and even if the PPA is cancelled will likely want to see the process take place in a timely manner, allowing the IDB to quickly reimburse lenders, and then the government itself reimburse the IDB. And in fact sources say that the government did come up with some cash to get the turbines switched back on over the summer. It has also made payments to top up subsequent partially unpaid invoices. But further payment crises loom each month, as monthly invoices are sent out by San Pedro to the distributors.

The controversy is bad news for the efforts of the Dominican Republic to attract foreign investment, an area where capital flows have greatly increased in recent years.

The country has been experiencing strong economic growth, and the government led by President Hipolito Mejia is viewed as being generally pro-business.

The energy sector has accounted for much of this investment volume, with thermoelectric plants and distributors being privatised in 1999. San Pedro was viewed as is a high profile success story for the sector, being not only the largest single power facility in the Dominican Republic, but also one of the region's lowest cost operators,

The privatised distributors have also relied upon IDB support for some of their financing needs. Last year a $188 million A and B loan was approved by the IDB for both EDE Sur and EDE Norte to improve their efficiency, including reducing technical and non technical losses and improve the quality of service that they provide.

Some bankers are pessimistic about the various issues in the electricity sector being resolved to everyone's satisfaction. Electricity prices are often viewed as a political football in the region, with politicians often looking to win support by offering subsidies to poorer consumers.

Indeed in late September President Mejia announced a new set of subsidies for 3.5 million Dominicans living in poorer neighbourhoods. This was accompanied, after meetings with executives from the distribution companies, by the elimination of subsidies to other consumers, who will now pay a new tariff linked to oil prices, inflation and interest rates.

But further disputes between the distributors, generators, CDE and government look likely in the future, and one bankers say that it may take some time before all these issues are resolved and the energy sector becomes bankable again.

The publicity surrounding San Pedro also comes at a bad time for the Dominican Republic, since it is currently working on a large international securitisation, this time involving airports.

Revenues from six airports are being used to back a $170 million deal which goes by the name of Wings, and is being led by Banca IMI of Italy. European institutional investors are the likely target for placing the paper. But IDB backing, in the form of political risk insurance, is also needed to get Wings off the ground. XL Capital Insurance is also involved in this deal.

Clearly there is pressure on the Dominican government to resolve the controversy at San Pedro de Macoris so that further financings involving important players such as the IDB and KfW are not endangered.