PROJECT FINANCE: Seeking a model for Latin America

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Latin America is likely to require between $5 and $7 billion of capital investment per year over the next few years in order to build the power generation capacity needed to keep up with economic growth. Another $2-4 billion will be required annually for pipelines, transmission lines, distribution systems and other support infrastructure. About three-quarters of this investment will be required by Brazil and Mexico alone. In order to meet these demands, active participation by foreign investors and lenders in the future development of Latin America’s power sector will be necessary.

Although many Latin American countries have made notable progress over the past few years in attracting foreign investment to the power sector, formidable challenges remain. These include the need for changes to regulatory frameworks, diminishing investment capacity of foreign equity investors and lenders, concerns about the creditworthiness of public-sector offtakers, uncertainty regarding possible future government interference and competing needs for investment in the USA and other developed countries.

Most foreign financing of power sector projects in Latin America is still highly dependent upon support from multilateral credit agencies (such as the IDB, the IFC and the EIB), export credit agencies (such as US ExIm Bank, Coface, JBIC, EDC and ECGD) and political risk insurers (such as OPIC, MIGA and a few large private insurance companies). Participation by these institutions typically involves protracted approval processes and complex contractual arrangements that can add to project cost.

Few projects in Latin America today, however, are able to attract financing without the risk mitigation that these institutions provide and even fewer deals can obtain the risk ratings needed to directly access international capital markets. The capacity of the multi-lateral and export credit agencies to participate in Latin American power sector projects nonetheless is limited and other solutions to attract financing are required if future needs for power are to be met.

Sound basics

Most sponsors of power projects will seek to minimize their equity exposure and, to the extent possible, finance required capital investment on a non-recourse and long-term basis. In order to attract such financing, projects must fundamentally be economically and technically sound, backed by committed and capable sponsors and operate within a rational, transparent and stable environment. Project risks will need to be allocated among participants (including builders, suppliers, offtakers, owners, operators and lenders) on the basis of their capacity to effectively manage and assume such risks.

As passive participants, lenders naturally will have a lower threshold for risk than equity investors and thus be more demanding in seeking risk mitigation and coverage.

Non- or limited-recourse lenders ideally would like to see deals in which project completion is covered by a fixed-price, date-certain turnkey contract with financially strong and experienced contractors. Equipment employed would be proven and covered by manufacturer warranties. Owners would guarantee debt servicing during the construction period and provide contingent equity or subordinated funding commitments to ensure completion as proven by independently monitored technical tests. Fuel supply, in the case of oil- or gas-fired plants, would be covered by contracts with reliable suppliers for a period covering loan maturities. Debt service coverage would be ensured (with a safety margin) by minimum cash flows resulting from PPAs with financially strong offtakers who commit to pay for capacity and output over the life of the loans.

Pricing established in the PPAs would include fuel cost pass-through features as well as linkage to foreign currency values (through denomination or indexing) such that the foreign exchange needed for debt servicing is ensured. Plant operation and maintenance would be covered by a long-term contract including defined costs and recourse to contractors, owners or insurers in cases of failures. Finally, a debt-reserve account funded by owners or trapped cash would be maintained during the life of the loans to ensure debt servicing for a period of at least six months.

Strong project fundamentals will provide the most effective basis for sponsors to negotiate demands sought by lenders and obtain extended repayment terms. Unfortunately, sponsors do not control all the elements necessary to attract financing for their projects. Host governments must also create the conditions needed to make lenders comfortable with making long-term commitments without resorting to sponsor guarantees.

Several Latin American countries, most notably Chile, Argentina and Mexico, have been able to establish operating environments that will attract long-term financing to well-structured power projects on a non- or limited-recourse basis. Others on the other hand have yet to establish such conditions. Market controls by government, lack of adequate regulations, foreign exchange limitations and weak offtakers present risks that cannot be satisfactorily mitigated without recourse from the perspective of project lenders.

As a result, the development of power projects in these countries often lags demand requirements. In some cases the need for additional power capacity may become so great as to create return opportunities that are sufficiently high to attract financing on an all-equity or sponsor-recourse basis. Such seems to be the case of Brazil, where few projects to date have attracted foreign financing on a non-recourse basis.

Mexico: a success story

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Mexico has been highly successful in attracting foreign capital to the development of its power sector. Several international project developers and lenders have participated in numerous projects since 1998, when the first IPP project (Samalayuca II) was completed, under tenders solicited by the state-owned Comisiàƒ³n Federal de Electricidad (CFE). The tender programme’s success has been due in large measure to the financial strength of CFE, which commits to purchase project capacity and output, and its ability to denominate its PPAs in US dollars.

Project structures in Mexico have evolved from the original BLT (build-lease-transfer) model, under which all power was sold under a long-term PPA to CFE, to BOO (build-own-operate) contracts that now include ‘excess-capacity’ schemes, under which additional capacity is built onto CFE tenders to market directly to private consumers, as well as 100 per cent inside-the-fence arrangements.

Direct sales to private consumers enable project developers to enhance returns that are otherwise available from pure CFE deals. The Bajio project provides an innovative example of an excess-capacity financing transaction. It involved the placement of notes under a guarantee provided by US ExIm Bank. Lenders to the project nonetheless relied on the PPA with CFE for their credit decision thus requiring contingent sponsor commitments to support the entire financing, which included the excess capacity component.

Following the Bajio example, Iberdrola is developing a 1000 MW gas-fired cogeneration plant (Monterrey III) with only 489 MW committed to CFE and the remaining capacity to be sold to private industrial offtakers. Financing, including $455 million from the IDB, reportedly has had to proceed on the basis of balance sheet support by the sponsor until PPAs with the private offtakers are negotiated.

Breaking away

The Termoeléctrico del Golfo and Termoeléctrico Peàƒ±oles projects (sponsored by Sithe Energies, Alstom and Cemex) made significant progress in breaking away from dependence upon CFE offtake. These twin inside-the-fence projects obtained financing on the basis of offtake agreements with large well-known industrial consumers (who generate foreign exchange). Key to the success of inside-the-fence projects is technology that enables power production at competitive costs.

The Peàƒ±oles and del Golfo projects were noteworthy in that they obtained financing without the need for participation by the IDB or the IFC.

In December 2000, Transalta of Canada closed financing for $134 million in bank loans for its Campeche project, a 250 MW gas-fired plant reported to cost $188 million. The project is supported by a 25-year PPA with CFE for 100 per cent of its capacity. The financing did not require involvement by the IDB or the IFC although bank lenders received political risk insurance from EDC of Canada. Transalta also provided pre-completion guarantees to lenders. The transaction was noteworthy for the tenor of the loans, which extended to 16 years.

The Monterrey II project financing, closed in 1998, however, represents a model that can be used to help meet the challenges of financing Latin America’s future power needs. Financing of this project did not rely on multi-lateral agency support or bank lending but rather was raised through a 144A placement of ten-year senior secured notes issued by the project entity for $235 million. The project, sponsored by ABB Energy Ventures and Nissho Iwai, consists of a 484 MW gas fired plant supported by a PPA with CFE.

Mexican projects, most recently the Pemex Madero refinery project, generally have shied away from capital markets bond issues because of high spreads. As economic and political conditions in Mexico continue to improve, spreads may come down sufficiently to allow this financing alternative to become attractive.

Brazil: limited opportunity

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Brazil has been less successful than Mexico in attracting foreign financing for power projects in spite of a great need for additional capacity and a high priority given by the national government to the development of gas-fired plants. Reasons for limited participation by foreign developers and lenders include the inability in Brazil to denominate or index electricity prices to foreign currency, limitations on establishing traditional collateral arrangements and uncertainties regarding the application of new regulations, the operation of a new wholesale market and future privatization plans for distribution companies. Local institutions, including Petrobras and BNDES, have had to take up the slack but their capacity to meet the country’s large needs is limited.

Considering the opportunities that are likely to arise in Brazil from tight supply conditions, several gas-fired projects sponsored by foreign investors nonetheless have been undertaken and financed, apparently, on a corporate balance sheet basis. Enron is building a 480 MW facility in Mato Grosso (Cuiabàƒ¡) and has begun construction of a 350 MW merchant plant outside Ràƒ­o de Janeiro (RioGen). ABB, in partnership with Petrobras, has undertaken an inside-the-fence project in Bahia (Mataripe). El Paso Energy has announced several power projects (among them, Macaé, Corumbàƒ¡, Manaàƒºs and Araucaria). Intergen is planning a 945 MW facility in Sao Paulo (Carioba II).

Most of these projects are supported by offtake PPAs with Petrobras, industrial offtakers and/or local distribution companies. None however has yet been able to arrange foreign financing on a non- or limited-recourse basis.

Project financing, however, was obtained recently for two Brazilian hydroelectric projects – Cana Brava and Dona Francisca. Each received strong support from IDB and BNDES. The sponsors of the Dona Francisca plant are all Brazilian (including Inepar, Elesc, Copel and Gerdau) and the project is based on a long-term PPA with Electrobras. The Cana Brava project is sponsored by Tractebel (Belgium) while Gerasul, its large Brazilian generation and distribution subsidiary, has committed to purchase the plant’s output.

Unlike gas-fired projects, most of the inputs (fuel and capital) for hydro projects are priced in local currency thus reducing inherent foreign exchange exposure. Owners in each of these projects nonetheless will absorb the exchange risks arising from foreign currency borrowings as offtake prices are denominated in local currency. These models thus will be difficult for most foreign investors to follow.

In view of the power shortages expected to occur in Brazil over the next few years, major industrial corporations are sponsoring inside-the-fence projects to ensure supply. While BNDES is expected to support many of these, foreign-sponsored projects will likely require corporate balance sheet support until the issues concerning foreign lenders are resolved.

Useful models

Chile and Argentina serve as useful examples of countries that have created operating environments that have attracted foreign investors and lenders. Privatization and deregulation of the power industry combined with the implementation of sound economic policies and the creation of adequate foreign investor protections have enabled full development of the power sectors in these countries, to the point (in the opinion of some) of overcapacity. Several operators from Chile and Argentina are now looking to develop energy projects in other Latin American countries in the areas of gas and power supply.

A recent transaction in Argentina that serves as a useful model is the AES Paranàƒ¡ project. The project is noteworthy because it is a large gas-fired plant that was financed without the support of PPAs, demonstrating that merchant plants can be financed on a non- or limited-recourse basis. The key to the transaction’s success lies in the use of state-of-the-art turbine technology that enables the plant to operate as a highly efficient and flexible producer. A high proportion of equity financing also provided needed comfort to lenders in accepting market offtake risk.

The AES Paranàƒ¡ project, like most others in Latin America, nonetheless relied on participation and support by multi-lateral and credit agencies. But the capacity of these institutions to continue enabling the development of needed power capacity in Latin America is diminishing. Other solutions, such as private placements of 144A bonds, eventually will need to be found.

Capital success

One well-known example of a successful capital markets transaction is the financing of the TermoEmcali project in Colombia, closed in 1997. Notes issued under 144A rules were rated BBB- by Duff and Phelps, carried a 17.5-year tenor and are reported to have been attractively priced from the standpoint of the issuer. The placement’s success was based on a full offtake commitment by Emcali, a financially strong local utility at the time, strong debt support arrangements and well-established market acceptance at the time of Colombian debt obligations.

Since the issue was placed, Emcali’s financial condition has weakened along with the deteriorating political and economic situation of the country, causing it to fall behind on scheduled debt service payments and leading to a downgrade of the project bonds to a CCC rating. Unfortunately for the rest of Latin America, TermoEmcali’s problems may have momentarily delayed further access by future power projects to international capital markets and postponed needed independence from multi-lateral agency support.

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