For large scale energy infrastructure in many countries in sub-Saharan Africa and Southeast Asia, the most difficulties lie in the following buckets: risk and ticket size.
At a high level, risk can be broken down into three categories: political, financial and economic. All, of course, interconnected.
Too often in the target markets, there is no systematic way of starting, and running, an energy infrastructure project. This creates uncertainty about how long it would take to set up, and how reliably it could be run without political interference. In democratic countries elections tend to bring economies to a halt, and make it difficult to make sure payments are made on time. In addition, recourse to the law in these jurisdictions can sometimes not be relied upon to be an impartial arbiter.
The financial credibility of the ‘offtaker’, the organisation that buys the electricity produced by the project- is crucial. A lot of the time, the electricity in large scale energy projects is bought by a utility company (almost always state owned). Some companies on occasion delay payment of what they owe often because these companies are not financially secure. At times governments artificially suppress the price ordinary citizens pay for electricity, which means that there is often a severe imbalance between the utility company’s revenue and the price it pays for electricity.
Additionally, governments don’t usually have the money to plug the gap and instead have to issue some form of guarantee essentially backing up a utility company’s obligations. These are difficult to get, and depending on the government in question’s credit rating, more or less effective as reassurance for investors. What about private offtakers? These organisations tend to be a little more reliable with regard to payments, and being able to power factories, for instance, for more hours creates more jobs. However the size of desired projects tends be much smaller.
A third element of risk is the overall strength of the macroeconomy in the country where a project is located. This determines currency risk- investors require assurance that cash flows can be extracted reliably. Weaker economies with limited foreign exchange, rightly or wrongly, put capital controls on their economy. So a big problem, regardless of the type of investor, is extracting the money. Another problem is inflation, which tends to be high, raising local costs and preventing contracts priced in local currency being approved by investors. There are ways around this- you can price in dollars, or arrange for dollars paid in local currency at the spot exchange rate for the time of payment, but foreign exchange constrictions and volatility mean that some jurisdictions tend to be no-go areas for investors even when there are well structured projects available for investment.
Ticket: Size Matters
The combination of these risks leads us to the second main difficulty- ticket size. Because it has been difficult to expand energy infrastructure, the total installed generation capacity remains low in many of these countries. This means that even a mid-size project by international standards can be a very big deal. Things get difficult politically if you inform a country’s government you intend to increase their energy generation capacity by a fifth. It is easier to get approval for smaller projects as it is far less political, and easier for a less mature economy’s financial and energy infrastructure to accommodate. However, because there is a cap on project size it is very difficult in many jurisdictions in emerging markets to get a project large enough for investors in North America and Europe to take interest in.
In parallel, ticket size also impedes a more nimble approach to grid connected energy infrastructure expansion. The markets tend to lack the immediate demand for projects that are relatively speaking enormous. Energy infrastructure needs to grow with the demand created by previous infrastructure expansions. There is no point building a 200 MW solar plant in a country with only 300 MW installed; there won’t be enough other infrastructure, people, companies or governments with enough money or requirement to buy the power. Unfortunately, you need to build it out more gradually than that, but the requirements of international investors prevents this.
All these factors make investor’s money expensive. This means debt can be priced at unaffordable rates, and equity is given in exchange for an overwhelming majority of shares (in many cases, 90% or more) in the project. Debt investors know that whatever mitigations are put in place, cash flows can be interrupted, and so the rate of lending is high. This means that for the tenor of the debt, the project’s profits are grossly depressed. Equity investors are also aware that cash flow interruption is likely. In addition, with debt investors claiming cash first, equity investors know their return won’t be realised until the debt is paid off. They take such large stakes because they want to capture all the value after debt repayments, and all the value while the cash is actually flowing.
The high interest rates and large equity stakes investors require put off local would-be project originators- depressing the market. Investors thus do not have much to choose from, and tend not to have to compete with each other to invest in projects- leading to substantially higher charges than what fettl deems is entirely necessary to satisfy their risk and return calculations. And this is the crux of the matter- the difficulties described above not only depress the number of projects coming to financial close in emerging economies, in Africa and elsewhere, they also depress the total number of available projects.
Bundle Up: Fettl has the Solution
As Fettl, we’ve experienced the barriers of this huge, but broken market firsthand and have committed ourselves to addressing them. We are building an alternative renewable energy financing company specifically for emerging economies. We founded Fettl because, as outlined above, the current model for financing renewable energy infrastructure in countries that need it most is not working.
Conventional project structuring in developed markets involves risk mitigation based on cash flow interruption probabilities that are much lower than in the emerging economies that Fettl will be operating in. This is why even the best structured projects still find it difficult to reach financial close- the conventional mitigations aren’t designed to de-risk projects where the underlying risk is much higher due to the factors discussed.
Understanding inevitable cash flow interruptions from individual projects, our solution is to bundle these projects. Including small to medium sized projects spread out across multiple jurisdictions, the bundle’s investment size is large enough for investors to be interested with increasingly uncorrelated risks. Crucially this allows for liquidity when cash flows from individual projects are temporarily interrupted. We then aim to securitise the funding of these project bundles.
More on our model in further posts.