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Guarantee Instruments & Currency Risk Mitigation Instruments addressing Investment risks

Analysis
Typography

Risk mitigation is especially important in renewable energy projects because of their high upfront capital requirement. Financial de-risking instruments accompanied by sound policy can reduce the financing costs of renewable energy investment and help attract capital at scale (Waissbein et al., 2013).

Project risk can take multiple and often parallel forms (Table 2). This includes political and regulatory risk, counterparty, grid and transmission link risk, currency, liquidity and refinancing risk, as well as resource risk. Resource risk is a particular concern for geothermal energy projects.

By providing access to effective risk mitigation instruments, public finance institutions make a critical contribution to helping mobilise private capital for renewable energy investment. It is a particularly important strategy in the light of the limited public resources available for investment in renewable energy projects. These instruments will hence become increasingly important as the rate of private investment requirements in renewable energy project rises along with the growing need for new energy solutions across the world.

This chapter discusses several types of financial risk mitigation instruments targeting these investment risks. The first part of this chapter focuses on various types of guarantee instruments, the most prominent financial risk mitigation tool. It examines their use in renewable energy projects. The rest of the chapter considers currency, liquidity and resource risk mitigation instruments more closely. These are an increasingly significant feature of renewable energy investment. Box 4, Box 6 and Box 7 offer case studies that demonstrate how these measures can play a critical role in enabling investment. Table 3 displays a matrix of risk types and the instruments to address them.

1. Guarantee instruments

By addressing various risks, guarantee instruments can improve the structure and quality of renewable energy investment, making projects more attractive to private investors. A recent study finds that increased use of guarantees could result in an additional USD 100-165 billion in private sector investment in sustainable infrastructure over the next 15 years (Bielenberg et al., 2016).

Guarantees supporting energy investments are usually issued by public entities such as governments and international finance institutions to address political, policy, credit and currency risk, for instance. Such risks covered by guarantees in renewable energy investments are in general similar to those covered in fossil fuel projects. Guarantee instruments dedicated to mitigating a technology-specific risk (e.g. geothermal resource risk guarantees) are an exception to this. The use of guarantees for renewable energy investments differs from those used for fossil fuel in the limited track record thus far in applying, issuing and using the guarantees.

Guarantees offer an efficient way of leveraging private investment with limited public capital. However, moral hazard may arise because a guarantee may provide the buyer with a counterproductive incentive to engage in riskier behaviour, undermining its purpose to guard against risk. Such behaviour would magnify the costs for the entity providing the guarantee. To dispel moral hazard and reward projects that are financially viable, guarantees are issued usually only after comprehensive due diligence and screening. Limiting the guarantee to the partial coverage of potential losses can also reduce potential moral hazards.

This section examines various types of guarantee that can be used in renewable energy investments. The guarantee instruments discussed in this section are versatile. They can be used to mitigate investment risks, including political, policy, regulatory, currency, credit and technology risk. Other types of guarantee instruments dedicated to specific risk categories, especially currency, liquidity and resource risk, are discussed in the later sections.

While the use of guarantee instruments is well known in project finance, it has been less common in renewable energy investment. The end of this section presents the results of a survey showing the extent of guarantee use, revealing another barrier to attracting private capital.

Government guarantee

 By issuing guarantees, governments backstop project risks they are in a better position to take, thus helping enable financing. In the three case studies presented in this chapter, including the Yap Renewable Energy Project in the Federated States of Micronesia (Box 4), governments provided guarantees to mitigate currency, regulatory and power off-taker risk. Typically issued by the treasury or ministry of finance, government guarantees are often required by investors and lenders for projects in developing countries. Commercial lenders in particular may require a government guarantee when they are not confident about the project’s financial viability without government backing.

Sometimes governments are not able to provide a guarantee for one of the following reasons:

» Public sector financial constraints and associated International Monetary Fund obligations mean some governments can only provide a letter of comfort (or assurance of willingness to enter a contract) through the state utility to purchase electricity from the project;

» Some governments do not provide an additional guarantee letter on top of a government-backed PPA;

» Some countries are not able to provide a guarantee for relatively small loans as they have vehicles only for larger loans.

Private sector projects sometimes face difficulty in obtaining a government guarantee, and promising project proposals have fallen through the process as a result. Lenders and development funds supporting renewable energy projects could consider the following possible alternatives to government guarantees:

» A national bank guarantee, in which a central bank or a state-level bank (public finance institution) guarantees a project instead of the ministry of finance. Alternatively, a guarantee fund set up by reciprocal guarantee partnerships could play this role. These partnerships are usually set up by federal or provincial government banks and have a liquid fund used as collateral. Argentina, Spain and other countries have developed these types of funds.

» A corporate guarantee fund or trust with a credit-risk rating or other similar indicator, which ensures they comply with international solvency standards.

Sometimes, these alternative approaches may not be sufficient or strong enough to be acceptable, or the creditworthiness of the government entity may be in doubt. In these situations, risk guarantees issued by public finance institutions such as DFIs or export credit agencies may be necessary. The sections below discuss guarantees that leverage the creditworthiness of public finance institutions to mitigate various project risks as well as risks associated with government.

Political risk insurance 

Investors are highly sensitive to the potential impact of political risk, making the transfer of such risks essential, especially in countries with an unstable political system or inadequate rule of law. Political risk insurance issued by public finance institutions can provide a broad coverage of risks related to government action, building on their strong creditworthiness and government membership. 

A member of the World Bank Group, the Multilateral Investment Guarantee Agency (MIGA) is the largest public provider of political risk insurance in terms of volume. Five main categories of political risk typically covered by MIGA’s political risk insurance include: 

» War, terrorism and civil disturbance, which may include losses from revolution, insurrection, coups d’état, sabotage and terrorism. 

» Currency inconvertibility and transfer restriction, meaning losses arising from an investor’s inability to convert local currency into hard currency due to government action (or inaction). 

» Breach of contract, meaning losses arising from the utility’s breach or repudiation of a contract (e.g. breach of a PPA by a government entity). This coverage requires arbitration. 

» Expropriation, meaning losses arising from government action like nationalisation or confiscation which reduce investors’ ownership or control over an asset. In addition to outright nationalisation and confiscation, such behaviour may include ‘creeping’ expropriation—a series of acts that, over time, lead to expropriation. 

» Non-honouring of financial obligations, meaning losses resulting when a sovereign or state-owned enterprise defaults on financial payment obligations such as guarantees of loan repayment or equity injection.

In addition to political risk, political risk insurance can be used to address policy and power off-taker risks. OPIC, the US government’s DFI, extends the coverage of its political risk insurance to offer protection against such risks for renewable energy investments (OPIC, 2011). This application is relevant because many governments participate in the market as power off-takers through state-owned utilities and set policies that support revenue, such as feed-in tariffs and tax credits. It could, for example, be relevant in a case where the government-owned utility breaches the PPA by unexpectedly changing policies without negotiations. 

The use of political risk mitigation instruments thus can play a key role in attracting private capital. The MIGA political risk insurance mitigated such government-related risks affecting the 250 megawatt (MW) Bujagali hydropower project in Uganda through ‘breach of contract’ coverage (for 90% of the equity investment). This drew in a higher level of private investment than any other comparable hydropower project in the region (Frisari and Micale, 2015).

Partial risk guarantee 

Another guarantee instrument to cover political risks is the partial risk guarantee structure. This was first introduced by the World Bank to cover a wider range of political risks (and for a longer tenor) than those covered by the insurance market (Matsukawa and Habeck, 2007). Depending on the specific coverage on the contractual agreements, a partial risk guarantee can also be used to mitigate policy and regulatory risks. It can be provided to investors to ensure a government’s obligation to compensate for loss of regulated revenues resulting from defined regulatory risk. This could happen when the government or regulatory agency changes, repeals or fails to comply with the key provisions of the regulatory framework (AfDB, 2013a). It can also be used to backstop a government commitment in the early stages of power sector reform to ensure reliable and timely enforcement of the measures required for the reform (AfDB, 2013a). 

Uncertain grid access is one of the most significant factors in determining the commercial viability of a new power project (Clean Energy Pipeline, 2015). Partial risk guarantees can be particularly important for covering transmission line and grid interconnection risk because such infrastructure systems are often owned by government entities. 

In many cases, renewable energy independent power producers (IPPs) must assess whether they can operate at partial capacity or bear the full cost of grid expansion and interconnection. Developers in sub-Saharan Africa note that existing transmission infrastructure often prevents renewable energy power generators from interconnecting with the national grid (Roelf, 2015), delaying financial closure and deterring investors. Box 5 showcases how a partial risk guarantee could address transmission line delay risk in the development of the Lake Turkana Wind project in Kenya. 

Partial risk guarantees are an effective means of lowering moral hazard associated with insurance. However, since the coverage is less than the guarantees with full coverage, the risk mitigation may not be as effective. Establishing the right balance of coverage is thus essential.

Partial credit guarantee 

Partial credit guarantee can cover part of the debt service default by the borrower regardless of the cause of default for a specific period of the debt term for a public investment. Being relatively more flexible than political risk insurance or partial risk guarantees, partial credit guarantees can cover a wider range of risks. For renewable energy projects, partial credit guarantees can be employed to address currency transfer and convertibility risk caused by host government action. For example, the IFC’s partial credit guarantee can mitigate currency risk with the guarantee structured to cover only the debt service due during the estimated time of currency inconvertibility (IFC, n.d.). This can offer a cost-effective way to reduce transfer and convertibility risk because it guarantees only the debt portion of the financing during a specific time period.

Partial credit guarantees can address technology risks in small and mediumsized renewable energy companies to enhance their credit. Due to their size and the nature of nascent technologies, these companies often have difficulties in providing industry-standard completion and performance guarantees, which may prohibit them from participating in bidding processes. The US Department of Energy loan guarantee scheme is targeted to support new domestic technologies via partial credit guarantees to win their first reference cases. The ARECA (Accelerating Renewable Energy Investments in Central America and Panama) project partial credit guarantee scheme by the Central American Bank for Economic Integration (CABEI) also targets smallscale renewable energy projects under 10 MW. It covers 75% of the loans up to USD 500,000 (Aldana, Braly-Cartillier and Shuford, 2014). Such a high coverage provides a strong incentive to engage in small-scale projects and allows project developers to accept some of the other high transaction costs. 

In addition, partial credit guarantees can be used to reduce power off-taker risk in developing countries by enhancing public utility creditworthiness. A partial credit guarantee was used to spread the credit risk of the power off-taker and facilitate local debt financing in the Kalangala case discussed in Box 6.

Export credit guarantee 

If a project involves trade, it may be possible to get access to an export credit guarantee. Like most credit guarantees, export credit guarantees cover default on any debt service regardless of the cause, thereby offering a comprehensive risk coverage (both commercial and non-commercial) to private exporters or their lenders. This can be particularly useful for mitigating technology risk for renewable energy technology providers and equipment manufacturers without a proven track record and weak credit ratings. The presence of export credit guarantees and involvement of export credit agencies can also reduce the perceived risk of local lenders as well as financing costs. It increases the project developer’s chance of acquiring affordable project finance with long-term loan tenors. 

Many export credit agencies are increasingly interested in supporting renewables. Under the OECD Arrangement on Officially Supported Export Credits Sector Understanding for Renewable Energy, Climate Change Mitigation and Water Projects, participating export credit agencies can offer longer credit repayment periods. The maximum is 18 years instead of ten years. In addition, they can offer flexible repayment structures for renewable energy projects in the importing countries if the project fulfils certain requirements (OECD, 2014). An increase in the tenor can reduce the interest rate, leading to a decrease in the electricity tariff. The longer tenor enables more flexibility in cash flow, which can thus reduce the repayment risk to borrowers. 

Limited use of guarantees in renewable energy investments – IRENA survey results 

This section has shown how guarantees issued by public finance institutions not only manage and change the perception of risk but also improve lending terms and returns. They strengthen government participation and commitment, leading to improved project bankability and mobilisation of private investment. Despite these benefits, little data are available tracking guarantees and how they are being used in renewable energy projects. Understanding the use of risk mitigation instruments is key to releasing renewable energy investment. 

IRENA thus conducted a survey of international financial institutions between March and June 2014, reaching out to 35 separate institutions. Eleven organisations responded, supplying IRENA with data on the issuance of renewable energy risk mitigation instruments. Complementary data were collected through additional research on further five other organisations. A number of respondents also participated in targeted interviews, supplying insights on the opportunities, barriers and project developer needs. The survey focused on the guarantee instruments discussed in this section: political risk insurance, partial risk guarantees, partial credit guarantees and export credit insurance. 

Based on data from 16 institutions, IRENA analysed guarantee issuance and use in renewable energy investment. The key findings are summarised below.

» Use of guarantee instruments for renewables remains limited. Although international financial institutions are well positioned to mitigate investment risks, they have dedicated only about 4% of their total infrastructure risk mitigation issuance value to renewable energy. Among the institutions surveyed, this rate ranged from 0% to 13%. In particular, four organisations indicated that they have no experience of deploying risk mitigation instruments for renewable energy projects. 

» Guarantees have been used mainly to support larger-scale projects. Hydropower has received the most support followed by geothermal energy. As illustrated in Figure 10 below, hydropower projects received slightly over half (54%) of the value of risk mitigation instruments issued. Geothermal projects followed, receiving 29% of the value of risk mitigation instruments issued. Wind projects received 8% and solar received 7%. Biomass and other technologies made up the remaining 2%.

» Political risk insurance is the most common form of support. It made up 56% of the value of all issuances for renewable energy projects captured in the survey. This was followed by export credit insurance (24%), partial risk guarantees (10%) and partial credit guarantees (10%).

» Institutions placing priority on renewable energy issue more guarantees. Seven out of 16 institutions designated renewables as a priority sector, which entails setting up a dedicated team or relevant strategies. The aggregated value of risk mitigation instruments issued by the seven institutions that give the sector priority accounts for over 70% of total issuance value. While the sector’s priority status allows for institutional-level support, it also reflects increasing demand to issue guarantees for renewable energy projects. 

» The lack of demand for risk mitigation instruments from users, not just for renewables, is the main reason for underutilisation. As illustrated in Figure 12, this is mainly due to lack of product awareness, long processing times, high due diligence requirements and high transaction costs. These are compounded by potential users’ lack of financial or administrative capacity to manage the risk mitigation instrument application and reporting requirements (e.g. feasibility studies, financial modelling). Such a low inquiry rate can also result from competition between loans and guarantees within the issuing organisations. 

» The lack of institutional incentives or resources to increase the provision of risk mitigation instruments for renewable energy investments is a limiting factor on the supply side. Of the issuing institutions researched, none had developed formal quotas or goals to drive the use of risk mitigation instruments for renewable energy. Risk mitigation instruments were issued according to demand from host countries.

Based on the results of this analysis, Chapter 6 provides specific recommendations that could help increase the use of guarantees in renewable energy projects. The following sections focus on mechanisms targeted at specific risks – currency, liquidity and resource risk for geothermal energy. 

2. Currency risk mitigation instruments 

Currency risk arises in situations in which the project has revenue in one currency and loan payments in another. For renewable energy projects, a mismatch between the financing currency (hard) and the revenue currency (local) is often a problem for debt repayment. Due to these concerns, some transnational project developers would only sign a contract in hard currency to insulate themselves from currency risk. Although it can remove currency risk, it also opens up exposure to non-payment risk if the off-taker cannot pay the PPA price in hard currency (Chadbourne, 2014). Some governments take some of the currency risk by offering USD tariffs payable in local currency (see Cabeólica Wind Farm project in Cabo Verde, Box 7).

This approach can, in principle, be beneficial for project developers because the government will be taking over the majority of the currency exchange risk. However, there may be other problems such as convertibility risk (AbdelRazek, 2015) if local banks do not have the ability to convert debt payments denominated in the local currency into foreign currency. 

While currency hedging instruments are commonly used to mitigate currency risk, they are accompanied in some countries by high costs, which increases the cost of capital. As alternative ways to address currency risk, other options such as a currency risk guarantee fund or local currency lending instruments can be used in renewable energy projects. Focussing the discussion on renewable energy, this section considers how risk mitigation instruments can resolve currency mismatches. 

Currency hedging instruments 

Taking an offsetting position on a security (selling or buying) is known as hedging and can help protect the security against adverse price movements (Nickolas, 2015) and mitigate market and commercial risks. Hedging instruments such as forward contracts and swaps have been used to address currency mismatch in renewable energy projects. A currency forward contract can eliminate the risk of a loss in value arising from making the payment by using the instrument to lock in the differential in advance. This allows projects and investors to artificially remove currency fluctuations. An overlay currency swap allows projects in developing countries to borrow from the international financial markets with minimal to no foreign currency exchange risk. As illustrated in Figure 13 below, IFC currency swaps convert USD LIBOR loan payments into local currency obligations, (IFC, 2015). The tenor and swapping rates of the overlay currency swap can be adjusted to suit the needs of the investor and the developer.

In many countries, however, forward or swap markets are not sufficiently liquid to execute these trades in the requisite amount over a long period. This therefore limits the extent to which they can mitigate risks. More often, the cost of currency hedging can be so high that it offsets the lower cost advantage of foreign debt. In India, for instance, the cost of a currency hedging instrument is said to be around 6%-7% (Bridge to India, 2015). This elevates the cost of borrowing in foreign currency but it may still be advantageous given the high cost of local debt. 

Currency risk guarantee fund 

A currency risk guarantee fund can address high costs of hedging by covering the difference in exchange values between local and hard currencies over the long term. The Indian government, for instance, has been experimenting with the concept and has plans to launch such a fund to support solar development. Under this fund, distribution companies would quote their price for solar energy in hard currency (USD) while locking up solar power for 25-year contracts and charging customers in Indian Rupees (INR).

India’s Ministry of New and Renewable Energy may create a (real) hedging fund of approximately USD 1 billion by charging developers a hedging fee of INR 0.90/kWh (about USD 0.015/kWh). The fee would be put into an escrow account to cover against local currency depreciation (Dutta, 2015). Such a scheme would help developers access international capital and reduce high hedging costs. In addition, pooling the hedging costs and putting the government’s weight behind the programme will significantly reduce the cost of currency hedging in the market (Bridge to India, 2015). India’s government is in the process of planning such a fund. This includes consideration of the right amount of hedging fee to be charged. 

Local currency lending

Local currency financing is a more fundamental way to resolve currency mismatch. DFIs can address high hedging costs by investing capital in funds that provide local currency lending through portfolio diversification. For example, several DFIs and non-governmental organisations have since 2007 invested in the TCX Currency Fund, which offers local currency lending for developing markets. Investors can diversify risks through direct investment in the fund, which is exposed to over 40 developing market currencies (TCX Fund, 2013).

Another example is GuarantCo, which is sponsored by the governments of the UK, Sweden, Switzerland and the Netherlands through the PIDG and the Dutch development bank FMO (GuarantCo, 2016). GuarantCo provides flexible guarantees over local currency loans to support projects and companies in raising debt financing in emerging markets. GuarantCo provides partial credit and partial risk guarantees, first loss guarantees, tenor extension or liquidity guarantees, thus loosening constraints in local currency debt finance to infrastructure projects (GuarantCo, 2016).

Source: IRENA (© IRENA 2016)