The rocky road to independents

Africa is in dire need of electricity to achieve predicted growth targets. Privately-financed independent power projects (‘IPPs’) are essential to meeting this need. Despite this, IPPs are faced with major challenges.

Africa is in desperate need of power. It has little: the same amount as Spain despite having over 20 times the population. IPPs are key to resolving this problem, though the development of IPPs on African soil presents acute challenges. What can be learned from those African IPPs that have been successful?

A well-defined and robust legal and regulatory framework is essential to provide a transparent environment for IPP development. A liberalised energy market, a truly independent regulator and separate transmission, distribution and generation functions should provide a level playing field for public and private investors alike. This requires a long-term view, all too often hindered by short-term political objectives.

Governmental support is also key. Support must take several forms for a successful IPP, including soft support from relevant ministries, credit support and fiscal and investment support. An effective foreign investment authority (‘FIA’) to facilitate foreign direct investment is crucial. An FIA can commit to the availability of forex, remove certain import duties, allow access to international arbitration, permit remittances of dividends and other payments abroad and allow repatriation of capital. This provides joined-up thinking at government level, effectively a one-stop shop for the IPP. This should provide consistency of approach and reduce red tape, time and costs.

Banks and other debt providers to IPPs demand a particular risk allocation between the relevant stakeholders before they will lend to a project, typically referred to as "bankability". Ensuring an IPP’s structure is bankable from the start avoids wholesale changes (and delays) when the lenders enter the transaction. Surprisingly, few developers get this initial stage right.

Key to bankability is the creditworthiness of the utility that purchases the IPP’s electricity. Sub-Saharan Africa utilities typically lack creditworthiness so credit enhancement, often a sovereign guarantee, is required. Credit support is a sensitive subject for any utility so the negotiation of that support – particularly if it involves central government – will inevitably reduce the (already slow) negotiation of the transaction. Raising the issue early in negotiations is therefore paramount.

The pervasive mantra of bankability is that each risk should be borne by the party best able to bear it. Market practice has defined bankability in IPPs, with banks traditionally being the most risk-averse. Although market practice is well understood by expert developers, bankers and advisers, the devil is, of course, in the detail. In contracts that run to hundreds of pages each, the process of negotiation is slow and difficult. High-level issues that typically prove to be challenging include the price of power, the offtaker’s creditworthiness, the compensation payable by the public sector in the case of termination, the risk of change in law (and its impact on costs) and the risk of events outside the parties’ control (force majeure).

In jurisdictions or sectors where the private sector is taking its first steps, these concepts will be new to the public sector. If the public sector does not understand bankability, the development of an IPP will be, at best, even more time-consuming, frustrating and expensive and, at worst, not economically viable.

Public sector capacity constraints have to be handled delicately, preferably with government being advised by external experts with experience of international best practice. Unfortunately, experience suggests that such advisers are rarely instructed. The negotiation process is therefore slower and fraught with mutual suspicion.

Lessons are being learned, however, and a good example of this is Kenya. It has created a legal and regulatory framework and a liberalised market to attract private sector investment. Its national utility understands bankability requirements well. Having delivered the Rabai and Olkaria IPPs in 2008, several new IPPs are in tender and the 300MW Turkana wind project is currently being negotiated (amongst others). Kenya will hopefully continue to see the benefit of privately-financed IPPs.

With countless factors playing a part in the development of any IPP, the issues highlighted here are not exhaustive. Other factors include the comparative shortage of power developers in Africa, public sector bureaucracy, the poor state of transmission infrastructure and the lack of well-defined land rights. Another challenge is the artificially low tariff set in many jurisdictions resulting from the political sensitivity of passing on the true cost of power to the consumer.

More African countries are tendering IPPs and others are learning lessons from previous transactions. With great potential for investor returns, Africa’s massive infrastructure needs (estimated by World Bank in 2008 to be US$75 billion every year) present a huge opportunity for sponsors and their lenders to develop IPPs. Africa’s growth depends on them.