Between 2009 and 2011 in Pakistan, thirteen independent power projects (IPPs) with aggregate costs of around $3 billion, and a total installed capacity of 2,632MW, were commissioned. This new wave of capacity additions is designed to counter the country’s wide demand-supply gap in power.

These IPPs are typically 200-230MW dual-fuel thermal power plants that run on fuel oil or gas (see Table 1 below). The sponsors of these projects, usually large domestic business conglomerates, develop the plants through project companies to segregate them from the parent company’s balance sheet. Syndicates of mostly local banks structured, arranged and provided up to 75-80% of total costs as project debt financing.

Projects repay these loans using assured revenues under power purchase agreements (PPAs) with the sole government off-taker, the National Transmission & Dispatch Company (NTDC). This article highlights the key risks and uncertainties that banks factored into their due diligence processes, and how lenders and sponsors were able to mitigate these risks.

Risks and mitigants

Completion risk: The terms of the standard PPA require the project to be constructed, commissioned and commercially operational using an agreed timeline and at a specified cost. Any deviations from the two may lead to the project company paying liquidated damages (LDs) to the offtaker NTDC and a reduction in the sponsors’ return on equity, because sponsors often provide a liquidated damages undertaking directly to the offtaker, leaving debt unaffected, but draining a sponsor of funds. The success of a project is, therefore, dependent on a project’s engineering, procurement, and construction (EPC) contractor’s ability to mee the specifications agreed in its contract. The date-certain fixed- price EPC contracts ensure that all risks associated with design, implementation, construction, commissioning and testing will be borne by the EPC contractor. Performance guarantees and liquidated damages undertakings from the contractor give further assurance to lenders. It is also helpful if the EPC contractor is a contractor of international repute and is financially strong. Wartsila, for instance, was the EPC contractor on several of the IPPs in the recent wave.

Political risk: This covers risks such as non-contract related force majeure events, changes in law and nationalisation. Under the projects’ implementation agreements, the government of Pakistan guarantees the performance obligations of NTDC under the PPA. There are provisions that compensate generators for increased costs resulting from a political event or a change of law, in the form of supplemental tariff payments and the government guarantees that it will enforce these. Furthermore, keeping in mind the current precarious power demand supply balance in Pakistan, it is likely that the government will strive to ensure a stable environment, to encourage further private sector investment and minimise any potential political and economic deterrents. The liberalisation and deregulation of the power sector and improved structure of the power sector’s regulatory bodies further mitigate this risk.

Operational risk: A plant’s capacity payments are linked to the amount of its capacity upon which the offtaker can depend. Making sure that the offtaker can rely on this capacity is crucial to the stability of a plant’s revenues, as NTDC would reserve the right to reduce capacity payments if the project company’s available capacity drops substantially below the agreed dependable capacity. Furthermore, a decline in a plant’s efficiency would reduce energy payments since, under the standard PPA, the project company cannot pass through any increase in fuel expenses to NTDC due to plant inefficiency, so any decline would constrain the project company’s cashflows. Projects’ operations and maintenance contracts typically include guaranteed minimum performance standards, bolstered with appropriate commercial insurance cover. These contracts also specify liquidated damages for operations- related losses. The performance risk of the plant is also mitigated if the EPC contractor is also its O&M contractor, as is the case in most of the recent wave of IPPs in Pakistan.

Offtaker performance risk: NTDC is the sole offtaker for IPPs in Pakistan, which exposes the project company to concentration risk. If NTDC fails to meet its obligations under the PPA, it might result in the project company receiving insufficient cashflow to meet its debt repayment obligations. However, under the PPA, NTDC pays the project company for capacity made available up to a load factor of 70%, even if it does not use it. NTDC is the transmission and distribution arm of the public utility Pakistan Electric Power Company (PEPCO), and the government of Pakistan provides budgetary support to PEPCO to help it meet its financial obligations, which mitigates credit risk somewhat. In addition, if a project company is supplying power at a competitive tariff this should ensure that a plant is dispatched at its maximum levels and therefore achieves the highest levels of efficiency possible. The implementation agreement covering the government guarantee of NTDC’s obligations further mitigates offtaker performance risk.

Fuel supply and price volatility risk: Insufficient availability of fuel could stall the operations of the plant, and therefore affect its cashflows. In addition, fuel oil prices in Pakistan are linked to international prices and so subject to volatility. But for projects that run primarily on fuel oil, fuel supply agreements between the project company and suppliers such as Pakistan State Oil or Shell guarantee the supply of fuel oil according to the buyer’s requirements. If the supplier fails to meet the terms of the contract, it would be subject to liquidated damages. Additionally, there is a surplus of fuel oil capacity in the country, and no shortage is currently forecast. In the event of a shortage, additional fuel oil could be easily imported from nearby markets in the region. Moreover, on-site storage capacity at projects provides them with a buffer against any interruptions in supply. Projects that run on natural gas have access to an assured supply at regulated prices from the Sui Northern Gas Pipeline Company for only a few months of the year, as current demand for gas (5.2 billion cubic feet per day (cfpd)) in Pakistan outstrips supply (4 billion cfpd). Therefore, these projects have to run on more expensive alternate fuels such as diesel and fuel oil for the rest of the year. However, as per the tariff structure approved by the National Electric Power Regulatory Authority, fuel costs can be passed through to a power purchaser. So a project company and its lender are not exposed to fuel oil or gas price volatility risk.

Sponsor default risk: This is the risk that the lead sponsor failed to inject its required equity contribution during construction. Senior lenders make sure that the project funds agreement outlines exactly the nature and extent of equity injection by the sponsors. They also make sure that sponsors obtain financial instruments to back up these funding obligations. Lining up these commitments forms a key part of the conditions precedent for the loan facility.

Foreign exchange and interest rate variation risk: Foreign exchange fluctuations are pass-through items to NTDC, and will not have a material impact on the project company’s operations. Also, as per the tariff determination, any fluctuations in KIBOR are passed through to the power purchaser and so would not adversely affect the project company’s financials.

Lender requirements and accounts

In addition to the measures outlined above that dealt with specific risks, the banks generally sought the following security package for their loan: exclusive assignment over any receivables from NTDC, a hypothecation charge over the project company’s movable assets, a mortgage over immovable property, assignment of all rights and benefits under concession agreements and other project documents and insurance, and lien over project accounts.

Additionally the sponsors and the senior lenders executed project funding agreements that laid out the mechanism for injection of funds into the project. It includes the maintenance of a debt:equity ratio of 80:20 (or 75:25 for some of the projects) for the life of the loan, that contingencies are to be funded by senior lenders and sponsors in an 80:20 ratio, and that the principal sponsor has to maintain 51% or more shareholding for the tenor of the loan.

The project company will also maintain the following key accounts: a collection account assigned to lenders for all payments from NTDC, a debt payment account, and disbursement account. A sponsor may also maintain a debt service standby letter of credit to cover the upcoming period’s interest and principal repayments.

Other covenants and requirements upon which lenders may insist include a current ratio that is in accordance with the prudential regulations of the State Bank of Pakistan, a dividend distribution test that requires the project to maintain a debt service coverage ratio of around 1.2x for dividends, satisfactory reports from a technical adviser, an environmental impact analysis, a robust financial model, and direct agreements for the key project elements.

Sectoral problems

It is not all smooth sailing, however, in Pakistan’s power sector. The IPPs and the government owned generating companies, or gencos, sell power to the single-buyer NTDC, which then sells it on at cost to eight local distribution companies, or discos, which then supply power to end consumers. The sharp recent increase in fuel oil prices, and a scarcity of cheaper domestic gas, have caused the IPPs to charge a higher energy tariff. Wary of the political repercussions of passing these rises on, the government had been absorbing this rise by giving budgetary subsidies to the discos, which have yet to be fully privatised, so that they charge a subsidised tariff to consumers.

Lately, however, the government has failed to make subsidy payments on time, due to the country’s ongoing economic crisis. Pakistan still suffers from high transmission and distribution losses of between 30% and 40%, due to the failure of public entities to pay their bills, and inefficient transmission infrastructure. This has meant the discos have been unable to generate sufficient revenue to service their payables to NTDC, which in turn cannot pay for power from IPPs just as this power is becoming more expensive. The IPPs as a result have not been able to pay their fuel suppliers, which in turn have started cutting back supplies.

This precarious circular debt crisis, involving liabilities that now stand at about $4.5 billion, has meant that the IPPs have been producing well below their design capacities, thus exacerbating the country’s severe load-shedding problems. The IPPs have now threatened to invoke the government’s sovereign guarantees if their payments are not cleared.

Conclusion

The healthy bank appetite for financing the new IPPs was largely due to the comfort the lenders derived from the contractual and commercial structure of the IPPs and Pakistan’s investor-friendly power policies. Local banks provided more than $2 billion in financing for this wave of IPPs.

However, recent developments have showed that no amount of financial due diligence can completely cope with systemic inefficiencies. The government’s policies remain the biggest factor affecting investor returns.

The true benefits of private investment can only be derived from a robust process of reform. The deregulation, liberalisation, and unbundling of the Pakistani electricity sector should gather momentum, and allow all players to compete on an equal footing. A market-oriented system would encourage not just ex-public players but also private players like the IPPs to maximise efficiencies in order to retain their consumers. If all market players can compete fairly, the end objective of the cheapest prices for the end user should be achievable, and subsidies can be eliminated.

Usama Siddiqui is an energy-sector executive, who has worked in strategic planning roles at Repsol and Shell, and is a former head of project finance at Allied Bank. The views expressed in the article are solely the author’s own.