Foreign exchange (FX) challenges pose significant risks to the viability and financial stability of the projects we work on across frontier markets. In this article, we explore the various FX challenges faced in those projects and discuss both contractual and non-contractual protections available to mitigate these risks.
Power and infrastructure projects often involve multiple offshore stakeholders, funding sources, and currencies, making them susceptible to FX challenges. These challenges include exchange rate fluctuations, capital controls, repatriation restrictions, and liquidity risks. Currency volatility can affect project costs, revenues, debt servicing, and profitability, potentially jeopardising the financial viability of the venture. These issues are particularly prevalent in a number of African jurisdictions in which we work, including Nigeria, Ethiopia, Kenya and Mozambique.
Contractual protections and other safeguards and mitigants are essential in managing FX risks. Below we have set out some key protections to consider to help parties allocate and mitigate risks appropriately and some thoughts on their practicability:
- Currency Hedging: Parties can employ various hedging techniques, such as forward contracts, options, and swaps, to minimise exposure to exchange rate fluctuations. Hedging instruments can provide stability by fixing the FX rate at a pre-determined level or within a range, protecting project revenues, costs, and debt service obligations. The downside is the overall cost to the project of paying for additional hedging products particularly on a long-term basis. This is one area that is ripe for support from the World Bank and other multilaterals and we expect to see further initiatives in this space.
- Currency Escalation Clauses or “True-Ups”: Including currency escalation clauses in contracts allows for adjustments in contract prices or tariff rates based on changes in the exchange rate. Alternatively, where the tariff is denominated in ‘hard currency’ but payable in local currency there may be a reconciliation or “true-up” payment to reflect changes in the exchange rate between the date of invoicing and the date of exchange. These mechanisms help mitigate the impact of currency depreciation on project economics. However, these provisions often result in more local currency being paid to the project company which does not address the underlying unavailability of the required hard currency. We are also increasingly seeing governments and offtakers reject such provisions or seek to challenge or limit their exact application on existing transactions due to the volatility of FX rates.
- Indexation Mechanisms: Inflation-indexed tariffs or contracts linked to a stable foreign currency, such as the US dollar or Euro, can provide a hedge against local currency volatility. Indexation mechanisms help maintain the purchasing power and revenue streams of projects, particularly in high inflationary environments.
- Force Majeure and Change in Law: Contractual provisions addressing force majeure events can provide relief in extreme currency fluctuations or unforeseen economic crises. It is very unlikely that a force majeure provision will excuse non-payment but we have seen specific “force majeure” categories negotiated in relation to a power producer’s ability to continue operations when its access to relevant foreign currencies is hindered. We have seen instances in which a government implements restrictions or changes in regulations – typically through the country’s central bank – that have an impact on the availability and pricing of hard currency in the country. Depending on how those restrictions or changes are put in place, it may be that a change in law or economic stabilisation provision may provide some protection. However, as with true-up provisions above, if the result is that the project company receives more local currency – as opposed to hard currency – this is an imperfect resolution.
- Government Contractual Support: In many power and infrastructure projects, the host government provides contractual protection in relation to the occurrence of certain risks, particularly political risks, through a contract of some sort, which might include a guarantee, implementation agreement, concession agreement, put and call option agreement, development agreement or support letter. That protection may extend to risks associated with the availability of hard currency in the relevant jurisdiction, the ability to convert local currency into hard currency, the ability to transfer hard currency offshore and to hold hard currency reserves offshore. The nature and robustness of the contractual protection in relation to these matters tends to vary between jurisdictions, from a relatively soft obligation to assist in sourcing hard currency to guaranteeing that hard currency will be paid or made available at a certain rate, including an obligation to pay that hard currency directly offshore to shareholders and/or lenders. The ultimate contractual protection, though it is one that sponsors and lenders will not want to contemplate lightly, is the payment of compensation should there be a termination event. That compensation is typically, though not always, denominated in hard currency.
- Political Risk Insurance: Acquiring political risk insurance from reputable providers can help mitigate the risk of capital transfer restrictions, currency inconvertibility, and expropriation. This coverage provides financial protection for macro events of political or economic instability affecting the project. If there is an underlying obligation, particularly in the relevant government support contract (as described in 5 above), the political risk insurance can also cover breach of contract which would pay out should the government (or relevant state-owned enterprise) default on the relevant obligation. It should be noted, however, that political risk insurers are unlikely to be willing to offer cover in relation to FX risks in jurisdictions in which there is an existing shortage of FX, or where the law does not permit payments in, conversion into, or transfer offshore of, hard currency.
- Multilateral Guarantees and Development Finance: Partnering with multilateral institutions and development finance organisations can provide additional protection against FX risks. This may be directly, through the provision of debt, credit enhancements, guarantees, political risk insurance or currency swap facilities offered by those institutions or, indirectly, through the “halo effect” of using their unique positions to lobby governments and central banks to resolve FX issues facing the projects they are funding.
- Local Currency Financing: Exploring opportunities for local currency financing can reduce exposure to FX risks. Raising funds in local currency can align revenues and costs, minimising the impact of exchange rate fluctuations. However local currency lending can be prohibitively expensive and is unlikely to be available for sufficiently long tenors. To date we have seen limited impact on large scale projects. “Synthetic currency” loans are another tool deployed to try to relieve FX pressure from borrowers but they ultimately rely on a hedging product to be in place to equalise the lender whose lending is still based on hard currency – their true potential can therefore only be unlocked once the first point above is resolved.
- Diversification of Revenue Streams: Projects can also explore revenue diversification strategies, such as selling power to multiple offtakers or exploring export opportunities. By diversifying revenue streams across different currencies, the project’s overall FX risk can be mitigated. For example, as the energy sector on the African continent matures we are seeing power producers diversifying away from selling to a single offtaker and seeking cross-border customers including selling to regional power pools that permit payment in hard currency.
By utilising a combination of contractual protections and non-contractual safeguards, project stakeholders can navigate challenges more effectively. It is therefore important that mitigation of FX challenges is considered in the round when structuring a project.