Project Financing in Emerging Markets: Four Pertinent Issues That Can Affect the Success of a Project

Introduction

Emerging markets faced with increasing population, urbanization and environmental concerns offer significant investment opportunities. According to the IMF, emerging markets constitute around 60% of global GDP and makeup 80% of the current global population – it is anticipated that the global population will increase by approximately 2.1 billion people by 2050, with 58% of the population growth coming from Africa and a further 33% from Asia. Opportunities abound for developmental projects focused specifically on heavy transport and social infrastructure, agricultural production and innovative power generation solutions. It is estimated by the African Development Bank that Africa alone has a development financing gap of nearly USD 108 billion and an estimated need for infrastructure investment of between USD 130 billion and USD 170 billion a year. Such opportunities, however, are hampered by major challenges significantly reducing the attractiveness of desperately needed projects. To successfully implement infrastructure, development sponsors, lenders, and their advisors, need to recognize and understand these challenges and how to price for or overcome, them.

This article focuses on four topical issues that can affect the success of projects and project financings in the emerging markets:

• project procurement, structuring and tender processes (including the challenges of unsolicited bids). The establishment and implementation of objective procurement processes which are acceptable to international sponsors and lenders is key to achieving financial close and the long-term success of a project;
• increasing emphasis on environmental, social and governance (ESG) considerations – ensuring that when projects are developed, they are consistent with internationally reorganized ESG standards whilst demonstrating that responsible investing preserves and adds value to projects, and generates returns for stakeholders;
• delivery of a sufficient, stable and secure revenue stream for a project – for successful project financings, cash is king. Offtake arrangements, whatever the form, can either unlock or deter investment; and
• trends in the evolution of investment treaties and how these tools can mitigate risks for investors and lenders alike.

Project Procurement

Generally, the award of projects by public authorities requires compliance with a system of competitive tendering as set out in national law but, in certain instances, this will extend to awards by public corporations. Additionally, it will always be a condition of finance by development finance institutions (DFIs) that the award of project contracts by a public authority is subject to a system of competitive tendering. For example, the World Bank Group emphasizes the importance of fair, open and well-functioning public procurement systems and the benefit which they bring to all stakeholders.

While it has never been easy to put together a project where the public sector is planning a construction project which is input-based (i.e. traditional procurement), PPP challenges are significantly greater when the procurement is of a long-term output-based project covering both construction and operating phases. Where sponsors propose to project finance the project, additional complications arise.

These are some of the challenges:

• Putting together an attractive PPP project that is suitable to be project financed takes considerable time, skill and attention to detail. As PPPs represent a significant shift from construction procurer to procurer of services based on greenfield or transformed brownfield infrastructure, the skills required of the procurement team are quite different. For example, there needs to be greater emphasis on taking account of the results of market soundings. Stages can often be rushed with political pressure to go from planning to operation within a single presidential election cycle and often market soundings may be ignored on the grounds that it is asserted that the private sector is always self-serving. Consequently, a project that is offered for tendering based on flawed assumptions of what can be accepted (to serve political-ends, or with an insufficiently compelling project pipeline), will not attract the best quality of potential bidders to bid. Alternatively, there can be too large a project pipeline that cannot be managed by the procurement unit.
• Competitive pressure between bidders often results in uncommercial low-balling, based on the often justified belief that the lowest-priced bid will always win and on over-optimistic risk assessments. Light bidder questioning of proposed project concession terms before the preferred bidder stage occurs for fear of being marked out as a potentially difficult partner compared to other bidders. This culture and that “your” bidder is only one of a number of bidders, makes project finance lenders reluctant to commit early on, meaning any financing proposals will be “subject to due diligence and internal approvals”. This leaves the lenders having significant leverage to fully negotiate the project terms with the public authority at the later stages of the procurement process for their and their customer’s benefit. This is of course what the particular bidder always intended but it extends the procurement phase further, significantly reducing the competitive pressure that public procurement is supposed to achieve, and is not always successful.
• A bid that is through a special purpose vehicle to be project financed will be inherently weaker than one that is supported by a stronger balance sheet. There will be limited committed equity, the conditions precedent prior to funding being disbursed will be lengthy, the covenants to the lenders to which the project vehicle is subject will be inflexible with waivers being subject to lenders’ consent being given, and many events of default that, if triggered, would entitle lenders to require their loans to be immediately repaid. On top, lenders’ due diligence and risk mitigation exercises will extend the difficulty and time to achieve financial close, particularly in emerging markets where, typically, offtake, currency, political and legal risks will be higher.

These factors encourage governments to be more accepting of unsolicited proposals (USPs) or otherwise avoid public procurement by designating the project within an exception in the local law. These exceptions are typically around there being a national emergency or urgent need, the project having national defence/security aspects or there only being one capable supplier. The Sierra Leone PPP law, for example, contemplates this by reference to trade secrets, intellectual property or exclusive rights. In some instances, efforts are made to have other tenderers compete against a USP. This is unusual and it is difficult to achieve a level playing field with fair compensation for the original bidder if their proposal loses out. A review of experiences of USPs in 2017 by the World Bank was critical, including finding “strong indications” that some public officials use USPs to avoid competition and potentially engage in corrupt practices.

Development in the structures for public procurement of PPP projects has been the introduction of funding competitions for project finance. The idea is to optimize the competition between prospective lenders and the financing terms for the selected project vehicle. This is instead of each bidder having their own selected lead arranger for their financing if they were to be awarded the project. This is of limited use in many emerging markets where, particularly since the 2008 financial crisis, commercial banks have substantially stepped back from “funding” projects in emerging markets in the absence of export credit support, leaving the field for national, regional or global DFIs who are more likely to agree how the financing is to be shared between them, rather than bid against each other.

At different stages of the procurement process there remains the risk that no bids are compliant with the requirements of the tender, bidders withdrawing (although this is reduced through bid bond requirements), or not being able to financially close the project financing through over-challenging or restrictive lending terms. This likely leaves the procuring unit with about 18 months, or maybe even longer, wasted effort.

The lengthy tendering period is not the only aspect that may put off bidders from bidding. The investment time it takes to assess the opportunity, put together a compliant proposal and the required information, and to engage with the process, together with the costs involved, are material and largely wasted if the bid is unsuccessful. So while a bidder is unlikely to bid if they consider their proposal will not have a strong chance of success, with the additional risk factors in play were they to be successful, it does not take much to deter a prospective bidder from bidding.

While public procurements are strongly supported, the difficulty of preparing and managing the process to attract acceptable bids to achieve optimum value for money from reliable bidders financed by project finance should not be underestimated.

Environment, Social and Governance Considerations

With intensifying challenges across the globe and as environmental tensions grow, the relationship between ESG considerations and infrastructure investment will only strengthen and should not be ignored. Whilst also of concern across developed markets, with rapid population growth and urbanization, and often with a significant dependence on the exploitation of natural resources as a source of income, emerging markets are acutely exposed to these key risks. With limited funds available and with traditionally weaker national and regional institutions, managing environmental and social concerns of projects and enforcement of regulations has been a significant challenge in emerging markets. As such, the importance of ESG factors for sponsors and international lenders is of particular concern when considering investment processes and decision-making.

Key ESG risks in emerging markets can be categorized as:

• climate change and environmental impacts (including water management);
• rights of local communities impacted by projects;
• gender imbalance and availability of skilled local workforce;
• management of supply chains;
• corporate and national governance; and
• health and safety policies.

For sponsors, a failure to manage ESG risks across the life of a project may have significant implications such as:

• negative impacts on the environment, local communities and the reputation of the project and its sponsors, investors and lenders;
• a negative impact on the risk profile of a project potentially leading to increased capital and operational expenditure and cost of funds, ultimately impacting on economic returns; and
• the blocking of funds, particularly where lending terms are based on internationally recognized terms and conditions.

In order for a project to succeed, there needs to be a healthy relationship between key stakeholders, the environment, local communities, regulators and host governments. In the past decade, there has been an evolving understanding of the significance of ESG implications on infrastructure development finance, and stakeholders across the globe have become increasingly alert to ESG factors.

For example, established in 2006, the UN’s Principles for Responsible Investment scheme is now a thriving global initiative with over 1,600 members representing over USD 70 trillion of assets under management. Echoing this, in emerging markets particularly, project financings are embedding ESG factors within financing arrangements. For lenders, and sponsors, this means ensuring that:

• environmental and social assessments (ESIA) have been carried out by sponsors that meet the requirements of international lenders and DFIs, not simply local law requirements. This may mean upgrading an existing ESIA which, without appropriate expertise or resources allocated to this, could delay financial close;
• appropriate implementation plans have been developed (where required). This will require long-term engagement with ESG consultants to enable lenders to carry out appropriate due diligence and monitoring of the project on a long-term basis;
• there is effective stakeholder engagement with sufficient internal and external communication throughout the life of the project, and
• the covenant package within loan documentation captures ESG-related matters. For example, lenders frequently require continued monitoring of the impact of a project on the local environment and local communities under their reporting requirements. Also, where finance is provided by multilateral lenders, it is common for project vehicles to be required to comply with specific provisions relating to (i) environmental and social health, (ii) transfer of skills, (iii) fraud and corruption, (iv) codes of conduct, and (v) sanctions.

Aligning development needs with environmental and social standards requires expert planning, structuring, assessment and monitoring and considerable effort and financial investment from sponsors and lenders. Challenges are further intensified by disparities between international requirements and varied and complex social norms, priorities and practices in host markets. The challenge is then how sponsors can demonstrate that responsible investing in accordance with standards such as the UN Principles for Responsible Investment, IFC Performance Standards or the Equator Principles which preserve and add value to a project. Arguably, although there is the challenge for infrastructure projects to meet ESG objectives whilst ensuring a project remains profitable, in doing so effectively, this can bring visible transformational change to emerging markets as the lives of the local population increase the value of a project and on-sale revenue and, of course, prove a useful marketing tool for sponsors, investors and lenders alike.

An example of how ESG continues to evolve is the recently updated Equator Principles. Published by the Equator Principles Association, the risk management framework voluntarily has been adopted by over 100 financial institutions (EPFIs) and aims to provide a common baseline for EPFIs to identify, assess and manage environmental and social risks when financing projects. The revised Equator Principles (EP4) will come into effect on 1 July 2020. There are four main areas of change:

• EP4 has a wider scope, now applying to project-related corporate loans over USD 50 million (previously USD 100 million). Project re-financings and acquisition financings are now also covered if: (a) the underlying project was financed using the EPs; (b) its scale and scope have not materially changed, and (c) project completion has not occurred.
• Principle 3 (Applicable Environmental and Social Standards) retains different standards – for projects located in non-designated countries, IFC performance standards and World Bank EHS guidelines and, in designated countries, relevant host country laws apply. However, for category A and B projects (projects carrying adverse environmental and social risks), EPFIs must now confirm how each principle is met. In designated countries, EPFIs must also evaluate the specific risks to determine whether any IFC performance standards can also be used as guidance on how to address them.
• In line with the times, EP4 goes beyond EP3’s 2013 recognition of climate change as “important”, introducing a requirement for climate change assessment. For category A and B projects, these assessments must consider relevant physical risks. For all projects, when emissions are expected to be over 100,000 tonnes of CO2 equivalent, assessments must consider relevant transition risks and complete an alternative analysis to evaluate less greenhouse gas emission-intensive alternatives.
• EP4 has, however, potentially made one aspect easier. EP3’s Principle 5 (Stakeholder Engagement) included an absolute requirement to obtain free, prior and informed consent from potentially-affected indigenous peoples. EP4 provides a narrow mechanism allowing diversion from this IFC standard, where the consultation requirements have been followed and documented.

Offtake and Change in Law Risk

An important consideration for any project financier assessing bankability is whether a project will generate the expected revenues from the sale of the product to pay the project debt, meet ongoing operating expenses, and generate a return on equity for sponsors. Offtake risk is the risk of not being paid for the products or services produced by the project vehicle.

To address this concern, prospective lenders (and their credit committees) will be influenced by the robustness of the offtake arrangements. A contractual arrangement with a committed obligation to purchase from a financially strong offtaker is preferable to one where there is no committed purchaser, where the project takes “merchant risk” and is exposed to the vagaries of the market. The power market is a classic example of where a captive offtaker, typically in emerging markets, a national electricity utility (whether through a capacity payment or take-or-pay arrangement), is preferable to a plant where merchant risk is assumed.

Factors determining robustness include:

• The creditworthiness of the offtaker – for example in Argentina, the creditworthiness of the national utility company and administrator of the national wholesale electricity market, CAMMESA, has been, in respect of Argentina’s RenovAR renewables programme, supported by a national trust fund for renewable energy with offtake payments being ultimately supported through World Bank guarantees.
• Volumes to be supplied and the commitment by the offtaker – for example, are the contracted volumes sufficient to meet the project’s liabilities and when in the project cycle does the commitment commence? Are there any penalties, or indeed incentives, which affect the revenue received?
• Collection or recovery risk – will the offtaker pay promptly or is recovery dependent on third parties or customers paying? For example, in sub-Saharan Africa, this is perceived to be a significant risk with late or non-payment by customers or theft of power from the grid as a common issue.
• How robust is the pricing/tariff structure per unit? For example, how much influence does the market have on the tariff and are pricing adjustments free of any political influence prior to an election?
• The duration of the offtake arrangements which impacts on affordability – for example, longer-term power purchase arrangements (PPAs) are more bankable than those of a short-term nature as has been evidenced in the sub-Saharan power sector where a 20 to 25-year term PPA is not uncommon.
• To what extent is there currency risk and, by implication, exposure to currency devaluation?
• To what extent is the timing and continuing of the transmission system a project, government or off-taker risk?

Recent developments in the electricity markets across, for example, Latin America and sub-Saharan Africa, demonstrate that these factors continue to influence new projects with the issues identified above being addressed. The requirement for affordable electricity to satisfy demand and boost economic development is common to all emerging markets. In particular, sub-Saharan Africa is no exception, but progress historically has a mixed record with tariffs being often too high to allow a step-change in economic development. That, in turn, has led to difficulties in forecasting demand. However, as has been seen across Latin America as well, developments in support for State-supported offtake arrangements demonstrate encouraging signs for closing the power “gap” in future years, allowing economic growth to accelerate.

Historically, there has been a focus on one-off negotiated concessions between governments (or their State-owned utilities) and independent power producers underpinned by expensive capacity payments or fixed tariffs. However, with the development of the renewables industry, driven in part by falling technology costs and with the support of international donors, the trend has moved towards competitive renewable procurement programmes rather than the reliance on the “on-off” investment model.

For example, on the heels of the success of the renewables programme in South Africa (REIPPP), Uganda, Zambia and now Ethiopia have or are pursuing a pragmatic approach to transparent, standardized and competitive programmes which address many of the offtake issues for renewable power projects, thereby reducing risk for sponsors (and lenders) and cost for governments. Certainly, a competitive environment has resulted in a virtuous circle with evidence of tariffs falling substantially – for example in Zambia the most recent solar tariffs have demonstrated substantial reductions.

However, whatever the economic and market environment, uncertainties about tariff and offtaker creditworthiness remain in, for example, sub-Saharan Africa, where offtaker risk is high. The level of the tariff has historically been problematic as only a handful of countries have moved to cost-reflective tariffs and, with evidence of utilities facing challenges in bill collection, sponsors and lenders have often looked to host governments to guarantee PPA payments. This was not sustainable. These challenges have opened an opportunity through the procurement programmes for development finance institutions to support long-term PPA arrangements, examples being Uganda’s GetFit programme and Ethiopia and Zambia’s partnership with the IFC scaling solar programme. In the case of Uganda, the German international development agency KfW, and four other European donors, provided support for “top-up” payments to be added to the feed-in tariff, whilst in Ethiopia and Zambia, International Development Agency payments and loan guarantees are available.

Finally, currency devaluation will remain a potential risk in offtake arrangements and consequently in any project financing denominated in comparatively hard currency. Since 2000, many sub-Saharan economies have experienced currency depreciation against USD, in some cases up to 40%. Historically, to circumvent the risk of currency mismatch substantially, all of the projects with long-term PPAs have been priced in USD – with the utilities exposed to local currency receipts but with payment obligations in USD. There will always be an ever-present incentive for PPA payments to be priced in local currency but international lenders (and indeed sponsors) will strongly resist any such developments.

Turning to change in law risk, refers to the risk of changes that may affect the project outcome, impacting capital expenditure or operating costs. Allocation of, and clarity on, the financial risks associated with the change in law, including the tax regime, is fundamental to managing the underlying economics of long-term contractual arrangements, as they may have a potential financial impact on construction, future capital expenditure requirements and operating costs. Conventional businesses pass on the impact of changes of law through increased prices to their customers to the extent commercially possible. For project vehicles, this may not be possible where, for example, the public sector is the offtaker and there is a fixed-price payable for the services or products being provided.

Value for money considerations should always be considered in deciding how to allocate risk: there is a strong argument to be made that the risk should remain entirely with the public sector, being that it is the driver for changes in the law. Where the public sector is in a comparatively weak position, it is not unusual for it to agree to place the project vehicle (and sponsors) in a no better no worse position, as the debate becomes focused on the scope of what the change in law entails (for example, should it extend to all changes or those which only affect businesses within the sector/country and what regulations should it extend to) and a confident public sector could push for a mechanism to ensure the public sector benefits from the upside where a change results in lower costs (and therefore improved returns for the project vehicle). Allocating any risk to the public sector is not without its critics, however; for example, should the State be paying the price of its efforts to raise environmental standards throughout the lengthy period of a project, thereby protecting sponsors but leaving the government with less money to support healthcare or education in the country?

With a more traditional allocation of risk model (in particular where laws/regulations are not of a specific nature), the project vehicle often assumes a general change in law risk (where the effect is likely to be additional capital expenditure) during the construction phase (with the risk being passed down to the construction contractor) whilst any cost implications of a change in law during the operating phase are generally shared between public and private sectors (although it is less likely for an operator sub-contractor to assume the risk through a pass down arrangement). Risks associated with a specific or discriminatory change in law always remain with the public sector. This is a model that has generally been accepted and what discussions there are will be generally around the margins of the scope and materiality of the change of law’s impact.

Parties will always attempt to mitigate and minimize this risk and, depending on what is finally agreed, options to manage the risk include:

• agreeing on a detailed scope identifying the allocation of risk with compensation provisions to ensure the project vehicle is placed in a no better no worse position where the risk arises;
• preserving the economic robustness of the project vehicle bypassing the risk (in whole or part) to either an offtaker or a sub-contractor;
• where the public sector adopts an aggressive position, introduce a change in law facility within the financing so that extra committed financing is available to fund the increased costs, but whether this represents value for money is debatable; and
• where there are foreign sponsors, introduce a stabilization clause into the concession arrangements – but this can be controversial. The most common types of stabilization clauses are “freezing clauses” (which fix or freeze, for the term of the project, applicable domestic legislation or regulations) or “economic equilibrium” clauses (which provide for changes in the law following execution but require the host government to indemnify the project vehicle for costs associated with implementing such changes). A hybrid model combining both freezing and economic equilibrium clauses is also an option.

Investment Agreements and the Impact on Investors

Investors making inward investments in foreign States are subject to numerous forms of risk, including political risk. It is essential that those investors consider what protections they have against this risk at the time of investing. As opportunities arise more often (and therefore the opportunity for disputes in the future), we expect investors to increasingly focus on what protections are available for sponsors.

Investment agreements (whether multilateral or bilateral) are agreements entered into between States in which a State agrees to protect the investments of nationals of another State. Bilateral investment treaties (BITs) are treaties entered into between just two States. However, there are also many multilateral investment treaties between multiple States, the most well-known of which is the Energy Charter Treaty for investments in the energy sector. Such investment agreements give rights and protections to those nationals (whether individuals or companies). There are around 2,600 investment agreements in force currently. Investment agreements typically contain a number of core protections, including protection against expropriation of investments without adequate compensation, obligations to provide fair and equitable treatment (FET), full protection and security (FPS), and treatment of sponsors that is no less favourable than that afforded to nationals of the host State.

In order to benefit from these protections, the claimant entity needs to be an “investor” with an “investment”. An “investment” is usually widely defined to include every kind of asset and may include, for example, shares, loans, bonds, project financing, hedging agreements, purchases of assets, branches and promissory notes. An “investor” may include both the entity making the investment directly and entities with an indirect investment, such as shareholders or sponsors with a degree of control over the investment vehicle.

If the host State where the investment is made breaches the investment agreement, then an investor may be able to initiate a claim directly against that State. The forum for any such claim will depend on the wording of the investment agreement, but most investment agreements provide access to international arbitration. Many will permit an investor to bring a claim under the auspices of the International Centre for Settlement of Investment Disputes (ICSID), a World Bank institution. ICSID arbitration awards are directly enforceable in the 163 States that have signed the ICSID Convention. ICSID arbitration is increasingly attractive to financial institutions; in 2019, 15% of new ICSID cases registered were in the finance sector, representing a 3% increase from 2018.

In the past, sponsor-State cases in the financial sector have involved measures taken by States arising out of nationalization, economic or political crises, austerity policies, sovereign debt restructuring, regulatory intervention and bank bailouts. In the majority of these cases, the main allegation against the State has been expropriation without adequate compensation, although many cases will also involve breaches of the FET and FPS provisions in the relevant investment agreement.

Recent examples of claims in the project finance sector include cases where:

• A bank succeeded in a dispute concerning rights under a power purchase agreement between the operator of a power plant (from whom the bank had acquired rights) and a State-owned electricity distributor. In this case, the State was found to have breached various articles (including articles on expropriation and FPS) in an implementation agreement entered into by the power plant operator and the State.
• An award was rendered in favour of a State in November 2019. This case concerned a road infrastructure project in Mozambique that was funded by the European Development Fund and arose out of the State’s offer to compensate the investor for delays to the works. The Tribunal determined that the investor had not properly accepted the State’s offer to compensate and that the State had therefore not breached the BIT obligation to ensure fair and equitable treatment.
• An investor which had invested in a natural gas transportation project successfully argued that the State had breached its obligation to ensure fair and equitable treatment under a BIT after the State’s “emergency measures”, taken to recover from a financial crisis, resulted in the sponsor being unable to repay its project debts.

Recently there has been a rise in the number of ICSID cases in the financial services sector against the South-Eastern European States. Many cases in the financial sector have arisen as a result of abrupt changes in legal frameworks, such as Croatia’s conversion of over USD 3 billion worth of bank loans which has resulted in four ICSID arbitrations against Croatia.

Over the past decade, tribunals have shown a willingness to expand the definition of “investor” to banks which have financed the acquisition of an investment and which have obtained substantial control of the investment. This presents a growing opportunity for sponsors to have their interests in project finance projects recognized and protected by investment agreements.

The prospect of off-balance-sheet borrowing remains appealing to single asset sponsors, consortia and multi-billion conglomerates alike, and there remain liquidity and appetite among lenders to fund appropriately procured, environmentally and socially responsible projects, with stable offtake arrangements. However, the general challenges of project finance as a lending product remain: it is an expensive, time-intensive process to achieve financial close with the significant effort required from sponsors, investors, and lenders, as well as the costs associated with financial, legal, technical and environment advisor participation. Restrictive covenant packages, consultation and consent rights in favour of lenders may, for some sponsors, result in too great a transfer of power and say over a project to its lenders. But closing the infrastructure and power gap in emerging markets is necessary to propel economic growth across emerging markets. Project finance, despite its many challenges, remains a viable economic model in the 2020s and a vital tool to close this gap and support transformational change. We have focused on four topical issues that will continue to be prominent as emerging markets develop – none, however, are insurmountable and, if analyzed and addressed properly, will assist in the successful implementation of viable projects.