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It has been said time and again in popular discourse that Nepal has the theoretical capacity to produce 83,000 MWs of hydro-power, whereas from a practical engineering/economic perspective only around 35,000 MWs to 40,000 MWs are feasible (Jha, 2010). Politicians frequently talk about producing 10,000 MW in ten years. However, from a current day financing perspective these figures  are very unrealistic.

The reality is that the combined core capital of all Nepalese commercial banks stand at only USD 907 Million and they have only around US$ 10 Billion in deposits (NRB, 2012).  According to Nepal Rastra Bank (“NRB”) Unified Directive No. 3/069, banks are only allowed to have exposure of 50% of core capital in hydropower projects. Because of this, all Nepali banks combined can only lend around to lend US$ 450 Million in a given loan maturation period to hydropower projects. Assuming that the average construction cost per megawatt of hydroelectricity is US$ 1.8 Million (Pradhan, 2008), Nepali banks can only finance up to a maximum of 250 MWs of hydropower projects with a period of 8-10 years (usual loan maturation period). However, in practice many banks have lent far less than this to hydropower projects  because of their lack of expertise and risk diversification strategies. The actual local bank financed independent power producers (“IPPs”) hydropower projects, excluding Nepal Electricity Authority (“NEA”) and NEA affiliated projects, stands at a mere 154 MWs (IPPAN, 2012).

Meanwhile, generation licenses of more than 1,800 MWs and survey licenses of around 12,000 MWs has already been granted by Department of Electricity Development (“DoED”). NEA has signed power purchase agreements (“PPA”) with new projects totalling 860 MW which are yet to achieve financial closure and start construction. Only 63 MW have been already been built by local IPPs (excluding Bhotekoshi, Khimti, and Chilime projects) and only projects totalling 91 MWs (excluding Upper Tamakoshi) are in construction stage (IPPAN, 2012). There is clearly not enough capital in Nepal to successfully finance and build more than 250MWs of projects. Therefore, it is  prerequisite that IPPs, who are aiming to build the other remaining 11,750MWs, should start looking for international banks to finance their projects. However, not many international banks are currently interested in Nepal. Many potential lenders have already backed out after preliminary studies. They do not consider hydropower projects in Nepal as “bankable” from a project finance perspective. This article will discuss more about project finance and how projects in Nepal can be made bankable to ensure that IPP projects find the requisite financing in the future.

1. Why project finance?
Project finance is a structured financing of a specific economic entity – project company - for which the lender considers cash flows as being the primary source of loan reimbursement and where assets of the company represent the only collateral (Gatti, 2008). For example, if a hydropower project is being constructed with a loan, where there is no additional collateral (eg. lands, shareholders guarantees, parent company guarantees) provided to the banks; only the project itself and its project assets such as revenue producing contracts - the PPA, the engineering procurement and construction contract (EPC), the project licenses and other assets should constitute the collateral for the banks. The debt terms are not based on the sponsor/shareholder's credit support or on the value of the physical assets of the project. Rather, the project performance, both technical and economic, is the nucleus of project finance (Hoffman, 2001). Project finance is a very popular technique of financing projects all over the world – in fact, most public-private partnership projects (PPPs) and majority of power projects in the world are financed using this method (Gatti, 2008).

Aside from the advantages of project finance such as non-resource/limited recourse of debt, off balance sheet treatment, highly leveraged structure, risk diversification and shareholder collateral free lending, there are also disadvantages. Project finance deals are very complex with documents allocating risk running to thousands of pages, there is increased risk for lenders, interest rates are higher than direct collateral loans, the fees for documentation and project assessment are high as it requires highly skilled manpower, there is increased lender supervision and loan contract terms are very strict, there are more lender reporting requirements and insurance costs are high (Hoffman, 2011).

Irrespective of the disadvantages, this technique is used for various reasons - most importantly the lack of adequate traditional sources of collateral. For example, it can cost up to US$ 180 Million to construct a project of 100 MW capacity. This means, assuming a 70:30 debt-equity ratio the project will require around US$ 126 Million (estimated around NRs. 10 Arabs equivalent) as loans. Can it be expected that the shareholders of the project provide the bank with land worth that amount (US$ 126 Million/NRs. 10 Arabs) to finance the project? No group of shareholders or promoters  are likely to own that much collateral.  Therefore, the project in question should have assets worthy of being used as a collateral in its own right. In other words - the project itself should be “bankable”.

2. Key requirements for a bankable project
Essentially, for a project to be bankable - the project company and the bank should be legally “risk free”.  All the foreseeable project risks should be allocated to parties other than the project company and the lenders. For example, inter alia, the construction delay risk under the control of the contractor is to be taken by the construction contractor through a turnkey EPC contract, the risk of not being able to sell the produced electricity should be taken by the power purchaser (NEA) for the period of the PPA on a take or pay basis, the project should have a clean and irrevocable licence to produce electricity, the natural force majeure risks of landslide, flood, earthquake should be taken by a reputable insurance company through insurance policies such as Construction Erection All Risks and Advanced Loss of Profits Insurance, currency risk (for financing in any other currency than Nepali Rupees) should be taken by a hedging counter-party through a currency swap contract or other parties such as the power purchaser or the government, operating risk should be taken by the Operation and Maintenance Contractor and political force majeure risk such as change in law, nationalization and war should be taken by the government. Once all these risks are managed by allocating them contractually, the project becomes “bankable” or capable of being used as collateral in its own right (Dewar, 2011). As all such risks are allocated by contracts, the role of qualified project finance lawyers is very important in developing bankable projects.

To explain again in layman terms - if a reputable construction contractor agrees to construct the proposed project for a fixed price within a fixed period of time (through EPC contract ) and a reputable and creditworthy company contracts to take or pay the electricity produced (though the PPA) and all other risks are allocated through insurance and other contracts, the project then becomes “bankable” and banks will be willing to loan the required sum for the project after the sponsor/shareholders inject their committed equity up front without having needing other collateral except the project itself.

3. Do Nepali hydro-power project meet “bankability” requirements of international banks?
Most hydropower projects in Nepal currently in the development stage generally do not meet bankability requirements of international banks. Coupled with significant financing constrains of the local banks as already explained above - this is the reasons why IPPs have not been currently able to achieve financial closure and begin construction.

Projects in Nepal are not bankable for various reasons – the currency risk cannot be managed in a commercially acceptable manner, the PPA and Interconnection Agreements based on the standard NEA format has many loopholes, and thirdly, political force majeure risks are not adequately managed. We discuss them in detail below:

A. Currency Risk
Currency risk is one of the most important risks that has to be managed in a project. If the lender is lending in US Dollars and the earning through the PPA is in Nepali Rupees, exchange rate fluctuation will have to be managed through a currency swap contract, or both the loan and the PPA earnings should be in the same currency (Dewar, 2011). However, this is not the case currently for Nepal and is a major reason preventing projects from being financed by international banks.

After Khimti and Bhotekoshi projects – the NEA has been unwilling to enter into PPAs in US Dollars. It costs around 10-15% to hedge Nepali rupee currency risk in the international market, which will make most projects financially unviable. Therefore, the only alternative for Nepal is for the Nepal Electricity Authority to take the currency risk sufficient for the debt repayment period (10-12 years) through the Power Purchase Agreement. Unless there is progress in this regard, Nepal can never utilize its hydropower potential through IPPs and most project developers are never going to be able to construct hydro-power projects.

B. Power Purchase Risk
The PPA is often the foundation of a power project's bankability. The rate or tariff paid for the energy must be sufficient to cover both the fixed costs, including debt service and variable costs, including operation and maintenance expenses. With the revenue stream established, the lenders wish to ensure that the PPA remains effective for the entire debt repayment period and does not contain any loopholes or escape routes (Dewar, 2011). The power purchaser under the PPA must also be creditworthy.

However, there are two fundamental problems with the NEA's existing PPA format. First, it is not well drafted and contains many loopholes. It seems to have a “take or pay” system, however, that can be easily be avoided by using other excuses and loopholes available in the contract. This is not bankable by international standards. Same problem exists with the interconnection agreements. Secondly, NEA is itself in a loss, and  uncreditworthy. Accordingly, it cannot be expected that the PPA NEA signs will be considered bankable by most international banks. These problems can be solved by having a good PPA template and secondly, the Government of Nepal should guarantee that it will pay the PPA rate if the NEA defaults.

C. Political Force Majeure and Change in Law Risk
Various types of insurance are obtainable for natural force majeure circumstances such as earthquake and floods that may damage the project in both construction and post-construction phases (Dewar, 2011). However, insurance is not obtainable for political force majeure events such as nationalization, war and change in law that may impact the project.

Currently, nationalization is restricted by section 29 of the Electricity Act 1992 (2049 BS), and article 19 of the Interim Constitution of Nepal 2007 (2063 BS) states that private property will not be nationalized without paying compensation that will be determined by law. However, this is not enough to satisfy most international banks as laws passed by parliament can always be changed by it.

Therefore, an agreement such as the proposed Project Development Agreement (PDA, also called “concession agreements”) is required for the government to take such risks. However, in the current draft made public by the DoED does not go far enough to take such risks adequately and places too much additional and unnecessary burdens on the IPPs. Unless this changes we will not see significant international financing activity in hydropower projects.

D. Regulatory Risk
There are also various regulatory risks under the Electricity Act and Electricity Regulations that needs to be addressed. Firstly, the Electricity Tariff Fixation Commission can fix maximum tariff for electricity producers too. This is also a part of change-in-law risk for which the PDA is needed. Secondly, the current Electricity Acts are going to be replaced by a new regime, this adds another layer of risk and uncertainty for project financing banks.

5. Conclusion
The private sector in Nepal is severely constrained by the financing capacity of the local banks, Therefore, there is a need to develop projects that are bankable under international banking standards for any IPPs to succeed. The use of project finance technique and meeting the bankability criteria is the only alternative.

Although the government claims that it wishes the private sector to lead in electricity generation, NEA's policy of not undertaking the PPA in a bankable format and in US Dollars until the debt repayment period, the lack of creditworthiness of NEA, and the lack of a bankable Power Development Agreement are the main reasons why international banks have not been interested to provide loans to projects in Nepal. If these policy changes are not made, despite many licenses granted and the cheap talk of building 10,000 MW in ten years, that dream will never be realised. If these matters remain unaddressed, it can also be predicted that most IPPs holding survey and generation licences will not be able to generate any electricity. Therefore, it is about time that we discuss the technical financing aspects of hydropower and move beyond limiting ourselves to cheap talk of being one of the richest potential hydropower producing countries in the world.

Originally published in the Hydro Nepal Journal 2014 by Anjan Neupane (Partner).