It started as a trickle
The recent tussle between Duke Energy of the US and Spanish utility
Endesa to secure control of Chilean electric company Empresa
Nacional de Electricidad is clear indication that investors are
back in Latin America sniffing the ground for power deals. After
taking two hits ? one from the Russian crisis in 1998 and the other
from Brazilian currency devaluation ? investor confidence is
cautiously starting to return to Latin America. ?It's not a frenzy,
though? says Matty Vengerik, managing director of power, utilities
and project finance at Credit Suisse First Boston in New York.
?Developers looking for opportunities in Latin America are partly
there to take advantage of the fact that there are less
participants in the market than before ? in anticipation that the
economies will eventually return to normal.?
Crisis leads to higher costs
Since October 1997, partly because of the Asian crisis, commercial sources of financing for Latin American projects in all sectors started to deteriorate considerably. Speaking at a conference recently Francisco Illarramendi, an executive with Latin American capital markets at Credit Suisse First Boston said: ?But it was the Russian default crisis that really tore up confidence in Latin America.? Borrowing costs for Latin American power and other infrastructure projects, as a result, shot through the roof. ?Trading spreads for Latin American 30-year sovereign bonds climbed to record highs during August and September [of 1998],? says Illarramendi. Spreads for Brazilian sovereign bonds, for example, hit a peak at about 1,400 basis points.
However, as the Russian crisis subsided towards the end of October, financial markets began to differentiate, or decouple, between different issuers of Latin America debt. Borrowing costs in Brazil and Venezuela ? partly because of their economic structures and substantially because of the domestic political situation and its dependence on just one export commodity ? started to gradually rise once again. On the other hand, project financing costs in Argentina and Mexico were gradually lower. Then, came the Brazilian currency crisis in January, when spreads, once again, surged.
Higher spreads were not the only concern. Commercial lending to Latin American power projects had just stopped. Says Daniel Kastholm, group vice-president at Duff & Phelps Credit Rating (DCR) Agency in Chicago: ?During the second half of 1998 all deals came to a stop. A lot of these deals were parked in the expectation of ?let's wait for spreads to narrow'. By the time borrowers realized that spreads were not narrowing, the commercial lending market had dried up. Japanese banks were not lending and the syndication market had closed up.?
The drought in lending forced a number of power companies to default on payments. Argentine hydro-electric generating company Hidroelectrica Piedra del Aguila (HPDA) had announced a delay in a $5.3 million interest payment for April against a $100 million euro bond issuance due 2001. HPDA has also defaulted on a $19.8 million principal payment due in March to Banco Nacion. This default, however, was also partly attributed to poor hydrological conditions and tax reforms in Argentina that negatively influenced cash flows. As a result of these setbacks, HPDA is pursuing a strategy of lowering its risk by reducing sales to the spot market ? which accounts for 70% of its revenue ? while securing more term contract sales to large users.
Another victim includes Colombian multi-utility company EmCali. Recent poor economic conditions in Colombia has strained Emcali's operating performance, reducing the company's ability to meet monthly debt maturities and make timely payments to its suppliers of energy.
Since March, spreads throughout Latin America ? including Brazil ? are once again starting to settle downwards at a faster pace. Says Illarramendi: ?Latin American spreads have no-way gone back to where they were in October 1997, but they are back to a reasonable level where the market [for financing infrastructure projects] has started to pick up.?
Liquidity returns to the market
Brazil's proper conduct in the handling of its currency crisis has assured the markets that their assets are safe in Latin America. Says Kastholm: ?The Brazilian government's ability to adhere to the conditions of the International Monetary Fund package has created a perception of cautious optimism among bankers.? As a result, ?there is a reverse of the trend experienced in the second-half of last year. We're starting to see some of these ?carry over' deals from 1998 percolate? into the in the second-quarter of this year. But at higher cost, of course.
Chilean generator Endesa-Chile issued a 10-year, $400 million Yankee bond during April 1999 at a 330 basis points spread over comparable treasuries. To illustrate the difference between market conditions and the pre-crisis period, a little over two years ago, Endesa-Chile issued a 30-year, $230 million Yankee bond, and priced it at slightly over 100bp.
Although the crisis has widened spreads on borrowings for infrastructure projects across-the-board, what has been noticed is that there has been a differentiation between investment-grade and non-investment grade projects. Says Illarramendi: ?Clearly those that have investment-grade rating are enjoying lower spreads.? Many electricity companies, however, if not investment grade, may face a harder task of climbing into the ranks of investment grade. A company could have a non-investment grade rating either because of the way the deal has been structured or because the commodity it sells is denominated in local currency. ?The difference between oil and electricity is a clear example,? says Illarramendi. Almost all electricity sales are in local currency because it is sold into the domestic market. Having said this, ?we are nevertheless also beginning to see some improvement in spreads for non-investment grade projects as well.?.
Alternative sources of funding ? when commercial markets dry up ? include the US's Opic, the World Bank's International Finance Corporation, Corporacion Andina de Fomemento, export credit agencies and the Inter American Development Bank. Says Illarramendi ?The drawback of going to these financial institutions is that they take a longer time to look at projects and put in place the right kind of financing package.? This seems to be changing somewhat, though. ?These [alternative] sources of financing appear be getting a lot more responsive and faster.?.
Besides lending, these financial institutions are looking at other ways in which they can support projects as well. Says Illarramendi: ?Opic, for example, could provide risk insurance for US companies to mitigate some of the risk that could arise in the middle of, say, the project's construction or operation. Implementing some of these measures into potential capital market financings could also be a way of mitigating risk and lowering financing costs.?
Demand outlook
Despite the crisis, ?long-term growth prospects are intact,? says DCR's Kastholm. Brazil, which accounts for half of Latin America's population and where the process of power sector reform is way behind others in the neighbourhood, is obviously the hottest market prospect. ?Brazil requires at least $3 billion a year for the next 10-years just to avoid electricity shortages,? says Kastholm. ?Venezuela would need $5 billion for up to 2001; and even a small market such as Peru requires $250 million to $300 million a year up to 2002.?
Even in countries where power sector reform is advanced ? such as Argentina, Chile and Colombia ? there is still substantial requirement for new capacity. Colombia is forecast to require capacity additions of 500MW to 600MW a year up to 2010, while Chile is expected to add 300MW to 500MW a year up to 2005. Power surplus Argentina too has requirement for new capacity. ?Argentina has a totalled installed capacity of 19,000MW, but demand is only 10,000 MW,? says Kalsthom. ?Yet Argentina will be adding 5,400MW by the end of 2001.?
What's driving demand?
One of the key driving forces behind investment in new capacity is ?low-per capita consumption?, says Kalsthom. At this low base, demand growth for electricity is expected to outstrip economic growth. Chile, for example, which enjoyed economic growth of only 3% in 1998, experienced 7% increase in electricity demand in the same period. The economy suffered shortages even though activity was subdued. ?Although economic growth in Latin America has slowed down over the past few years, long-term prospects are bright on grounds of vigorous structural reforms being implemented throughout the continent,? says Kastholm. ?This will drive the growth of demand for electricity, which, we believe, will outpace economic growth.?
Trends in new generation projects
Generating plants that will come on stream are likely to be combined-cycle gas-fired thermal units, partly because they are relatively cheap, efficient, relatively low in technology and enjoy low operating risks. The rapid build-up of gas-supply infrastructure networks is also pushing for the installation of gas-fired plants.
Says Kastholm: ?Many such units are already operating in Argentina, Chile and Colombia where there is a substantial natural gas industry.? Consumption of natural gas in Latin America is forecast to surge. This partially explains the 119% premium that was recently paid by a British Gas and Royal Dutch/Shell consortium for the purchase of Brazilian gas utility, Comgas. The utility is expected to receive first supplies of Bolivian gas through a new 3,200km pipeline that has been scheduled to start operations in May.
According to a report issued in the Financial Times the surge in gas supplies is expected to release pent-up demand for gas, mainly for industrial use and power generation. New gas-fired co-generation power plants to be built in the state [of São Paulo] will be the new customers. An interesting observation of this transaction is that the premium paid for Comgas for the reasons just stated ? less then three months after the currency devaluation ? provides evidence of investor confidence in Latin America's power sector.
The demand for gas-fired units is also driven by the imperative in these countries to improve on the fuel mix in the continent. Says Kastholm: ?If you look at most of these countries, there's a very heavy skew towards hydro generation.? Brazil has exhausted nearly all of its hydroelectric generating capacity, which accounts for 90% of its power capacity. In Chile, over-reliance on hydro is also taking a toll on the economy. Electricity is being rationed in the midst of one of the worst droughts that has afflicted this country.
Financing and risk issues
Except Brazil, Latin American power markets are either deregulated or at an advanced stage of deregulation. Says Kastholm: ?The markets are highly competitive. This is creating a decreasing trend in pricing.? As the revenue inflow on these merchant plants is not guaranteed, there is a higher level of business risk in operating such a unit compared with one supported by a long-term power-purchase agreement. To facilitate future project financing deals, says Vengerik ?lenders are likely to require a higher proportion of equity to debt as compared with before.? The days of debt-to-equity ratios of 80:20 are unlikely to be seen anymore. Now, it is more likely to be 60:40 or 50:50. Also, mainly on grounds of enhanced caution as a result of the emerging markets crisis ?commercial lenders will now require more comfort on currency convertibility?, says Vengerik. This places a heavier responsibility on the shoulders of sponsors and multilateral agencies to support future project financing for power.
The currency crisis has delayed the progress of Latin America's largest power privatization programme in Brazil. Says Sandra Boente, Senior Utilities Analyst for Latin America at Smith Salomon Barney in New York: ?The offer for Electrobras, for example, has been moved back. But the programme is basically intact.?
Says Boente: ?We are waiting for new regulation to cover the implementation of the spot market. We are hoping to see its beginning some time next year, but it will take six-to-seven years for it to be fully in place.?
Unlike other Latin American countries that have deregulated, Brazil poses higher risk on grounds that it has not linked its electricity prices to the dollar. Says Boente: ?Brazil carries higher risk on exchange rate volatility. Brazil appears hesitant to provide this linkage on grounds that should the real slide again, tariff in local currency will shoot up.? Hiking prices is a politically sensitive issue, especially in a country where a large proportion of the population lives close to or below the poverty line. Perhaps the Brazilians have been quietly taking lessons from the Indonesians?
Crisis leads to higher costs
Since October 1997, partly because of the Asian crisis, commercial sources of financing for Latin American projects in all sectors started to deteriorate considerably. Speaking at a conference recently Francisco Illarramendi, an executive with Latin American capital markets at Credit Suisse First Boston said: ?But it was the Russian default crisis that really tore up confidence in Latin America.? Borrowing costs for Latin American power and other infrastructure projects, as a result, shot through the roof. ?Trading spreads for Latin American 30-year sovereign bonds climbed to record highs during August and September [of 1998],? says Illarramendi. Spreads for Brazilian sovereign bonds, for example, hit a peak at about 1,400 basis points.
However, as the Russian crisis subsided towards the end of October, financial markets began to differentiate, or decouple, between different issuers of Latin America debt. Borrowing costs in Brazil and Venezuela ? partly because of their economic structures and substantially because of the domestic political situation and its dependence on just one export commodity ? started to gradually rise once again. On the other hand, project financing costs in Argentina and Mexico were gradually lower. Then, came the Brazilian currency crisis in January, when spreads, once again, surged.
Higher spreads were not the only concern. Commercial lending to Latin American power projects had just stopped. Says Daniel Kastholm, group vice-president at Duff & Phelps Credit Rating (DCR) Agency in Chicago: ?During the second half of 1998 all deals came to a stop. A lot of these deals were parked in the expectation of ?let's wait for spreads to narrow'. By the time borrowers realized that spreads were not narrowing, the commercial lending market had dried up. Japanese banks were not lending and the syndication market had closed up.?
The drought in lending forced a number of power companies to default on payments. Argentine hydro-electric generating company Hidroelectrica Piedra del Aguila (HPDA) had announced a delay in a $5.3 million interest payment for April against a $100 million euro bond issuance due 2001. HPDA has also defaulted on a $19.8 million principal payment due in March to Banco Nacion. This default, however, was also partly attributed to poor hydrological conditions and tax reforms in Argentina that negatively influenced cash flows. As a result of these setbacks, HPDA is pursuing a strategy of lowering its risk by reducing sales to the spot market ? which accounts for 70% of its revenue ? while securing more term contract sales to large users.
Another victim includes Colombian multi-utility company EmCali. Recent poor economic conditions in Colombia has strained Emcali's operating performance, reducing the company's ability to meet monthly debt maturities and make timely payments to its suppliers of energy.
Since March, spreads throughout Latin America ? including Brazil ? are once again starting to settle downwards at a faster pace. Says Illarramendi: ?Latin American spreads have no-way gone back to where they were in October 1997, but they are back to a reasonable level where the market [for financing infrastructure projects] has started to pick up.?
Liquidity returns to the market
Brazil's proper conduct in the handling of its currency crisis has assured the markets that their assets are safe in Latin America. Says Kastholm: ?The Brazilian government's ability to adhere to the conditions of the International Monetary Fund package has created a perception of cautious optimism among bankers.? As a result, ?there is a reverse of the trend experienced in the second-half of last year. We're starting to see some of these ?carry over' deals from 1998 percolate? into the in the second-quarter of this year. But at higher cost, of course.
Chilean generator Endesa-Chile issued a 10-year, $400 million Yankee bond during April 1999 at a 330 basis points spread over comparable treasuries. To illustrate the difference between market conditions and the pre-crisis period, a little over two years ago, Endesa-Chile issued a 30-year, $230 million Yankee bond, and priced it at slightly over 100bp.
Although the crisis has widened spreads on borrowings for infrastructure projects across-the-board, what has been noticed is that there has been a differentiation between investment-grade and non-investment grade projects. Says Illarramendi: ?Clearly those that have investment-grade rating are enjoying lower spreads.? Many electricity companies, however, if not investment grade, may face a harder task of climbing into the ranks of investment grade. A company could have a non-investment grade rating either because of the way the deal has been structured or because the commodity it sells is denominated in local currency. ?The difference between oil and electricity is a clear example,? says Illarramendi. Almost all electricity sales are in local currency because it is sold into the domestic market. Having said this, ?we are nevertheless also beginning to see some improvement in spreads for non-investment grade projects as well.?.
Alternative sources of funding ? when commercial markets dry up ? include the US's Opic, the World Bank's International Finance Corporation, Corporacion Andina de Fomemento, export credit agencies and the Inter American Development Bank. Says Illarramendi ?The drawback of going to these financial institutions is that they take a longer time to look at projects and put in place the right kind of financing package.? This seems to be changing somewhat, though. ?These [alternative] sources of financing appear be getting a lot more responsive and faster.?.
Besides lending, these financial institutions are looking at other ways in which they can support projects as well. Says Illarramendi: ?Opic, for example, could provide risk insurance for US companies to mitigate some of the risk that could arise in the middle of, say, the project's construction or operation. Implementing some of these measures into potential capital market financings could also be a way of mitigating risk and lowering financing costs.?
Demand outlook
Despite the crisis, ?long-term growth prospects are intact,? says DCR's Kastholm. Brazil, which accounts for half of Latin America's population and where the process of power sector reform is way behind others in the neighbourhood, is obviously the hottest market prospect. ?Brazil requires at least $3 billion a year for the next 10-years just to avoid electricity shortages,? says Kastholm. ?Venezuela would need $5 billion for up to 2001; and even a small market such as Peru requires $250 million to $300 million a year up to 2002.?
Even in countries where power sector reform is advanced ? such as Argentina, Chile and Colombia ? there is still substantial requirement for new capacity. Colombia is forecast to require capacity additions of 500MW to 600MW a year up to 2010, while Chile is expected to add 300MW to 500MW a year up to 2005. Power surplus Argentina too has requirement for new capacity. ?Argentina has a totalled installed capacity of 19,000MW, but demand is only 10,000 MW,? says Kalsthom. ?Yet Argentina will be adding 5,400MW by the end of 2001.?
What's driving demand?
One of the key driving forces behind investment in new capacity is ?low-per capita consumption?, says Kalsthom. At this low base, demand growth for electricity is expected to outstrip economic growth. Chile, for example, which enjoyed economic growth of only 3% in 1998, experienced 7% increase in electricity demand in the same period. The economy suffered shortages even though activity was subdued. ?Although economic growth in Latin America has slowed down over the past few years, long-term prospects are bright on grounds of vigorous structural reforms being implemented throughout the continent,? says Kastholm. ?This will drive the growth of demand for electricity, which, we believe, will outpace economic growth.?
Trends in new generation projects
Generating plants that will come on stream are likely to be combined-cycle gas-fired thermal units, partly because they are relatively cheap, efficient, relatively low in technology and enjoy low operating risks. The rapid build-up of gas-supply infrastructure networks is also pushing for the installation of gas-fired plants.
Says Kastholm: ?Many such units are already operating in Argentina, Chile and Colombia where there is a substantial natural gas industry.? Consumption of natural gas in Latin America is forecast to surge. This partially explains the 119% premium that was recently paid by a British Gas and Royal Dutch/Shell consortium for the purchase of Brazilian gas utility, Comgas. The utility is expected to receive first supplies of Bolivian gas through a new 3,200km pipeline that has been scheduled to start operations in May.
According to a report issued in the Financial Times the surge in gas supplies is expected to release pent-up demand for gas, mainly for industrial use and power generation. New gas-fired co-generation power plants to be built in the state [of São Paulo] will be the new customers. An interesting observation of this transaction is that the premium paid for Comgas for the reasons just stated ? less then three months after the currency devaluation ? provides evidence of investor confidence in Latin America's power sector.
The demand for gas-fired units is also driven by the imperative in these countries to improve on the fuel mix in the continent. Says Kastholm: ?If you look at most of these countries, there's a very heavy skew towards hydro generation.? Brazil has exhausted nearly all of its hydroelectric generating capacity, which accounts for 90% of its power capacity. In Chile, over-reliance on hydro is also taking a toll on the economy. Electricity is being rationed in the midst of one of the worst droughts that has afflicted this country.
Financing and risk issues
Except Brazil, Latin American power markets are either deregulated or at an advanced stage of deregulation. Says Kastholm: ?The markets are highly competitive. This is creating a decreasing trend in pricing.? As the revenue inflow on these merchant plants is not guaranteed, there is a higher level of business risk in operating such a unit compared with one supported by a long-term power-purchase agreement. To facilitate future project financing deals, says Vengerik ?lenders are likely to require a higher proportion of equity to debt as compared with before.? The days of debt-to-equity ratios of 80:20 are unlikely to be seen anymore. Now, it is more likely to be 60:40 or 50:50. Also, mainly on grounds of enhanced caution as a result of the emerging markets crisis ?commercial lenders will now require more comfort on currency convertibility?, says Vengerik. This places a heavier responsibility on the shoulders of sponsors and multilateral agencies to support future project financing for power.
The currency crisis has delayed the progress of Latin America's largest power privatization programme in Brazil. Says Sandra Boente, Senior Utilities Analyst for Latin America at Smith Salomon Barney in New York: ?The offer for Electrobras, for example, has been moved back. But the programme is basically intact.?
Says Boente: ?We are waiting for new regulation to cover the implementation of the spot market. We are hoping to see its beginning some time next year, but it will take six-to-seven years for it to be fully in place.?
Unlike other Latin American countries that have deregulated, Brazil poses higher risk on grounds that it has not linked its electricity prices to the dollar. Says Boente: ?Brazil carries higher risk on exchange rate volatility. Brazil appears hesitant to provide this linkage on grounds that should the real slide again, tariff in local currency will shoot up.? Hiking prices is a politically sensitive issue, especially in a country where a large proportion of the population lives close to or below the poverty line. Perhaps the Brazilians have been quietly taking lessons from the Indonesians?
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