As the year 2003 saw hydro generation projects around the world finding themselves in financial difficulties, Richard Metcalf looks at project finance and considers whether this financing technique still offers a viable method of developing hydro power projects


IN 2003, the Bujagali project in Uganda and the Nam Theun II Power project in Laos experienced difficulties, which were widely reported. They were not alone. Other projects, less advanced, or perhaps involving less high-profile developers, experienced difficulties but did not attract the same headlines. Whilst it is difficult to generalise on the reasons for these difficulties, common themes emerge. The lead time required to develop hydro power projects can be seen to be considerably longer than equivalent thermal generation projects. This represents an unwelcome increase in development costs for sponsors at a time when the number of sponsors active in the market has fallen sharply, and when those remaining sponsors are suffering pressures on their profits in their home markets.

There has been an increase in the scrutiny of hydro power projects by environmental interest groups. Indeed, such projects seem to find themselves under contradictory scrutiny. On the one hand, environmentalists point to the damage caused by such large generation schemes. On the other, large hydro is seen as a way of generating emissions reductions as part of the drive launched by the Kyoto Protocol to reduce global emissions.

Project finance requirements

The essence of project financing is that the funding institutions involved look at the merits of the project itself, rather than the credit of its sponsors.

The sorts of questions they will ask are:

• Can the project be built on time, to specification and within budget?

• Is the management adequate and experienced?

• Is there a market demand sufficient to give confidence in future revenue expectations?

• Is the projected revenue sufficient to enable full repayment to be achieved within the term or concession period?

• Is there sufficient political will to help the project succeed and is the residual political risk acceptable?

In other words, the funding institutions want to be satisfied that the project can be built for a particular cost and within a specified time, so that a revenue stream can be generated in order to meet interest and principal repayment obligations.

The main characteristic of a project finance transaction is its reliance on the revenue generated from a project for the repayment of loans and investment. Since the money is raised on the basis of the project, and not on the basis of any major guarantees granted by the state or by a private company, this type of financing is known as non-recourse or limited recourse financing.

The loan is secured by the expected earnings of the project. A lender will therefore wish to examine closely the viability of the project. The lender will have recourse only to the assets the loan has paid for, and the cash flow those assets may generate. This differs from traditional financing techniques, which rely for their security on a sovereign guarantee or on a guarantee from a private company.

In practice, few projects are financed on a true non-recourse basis with total reliance on the cash flows. Lenders must feel comfortable that the loan will in fact be repaid on a worst case basis. Lenders therefore place great reliance on the identification and management of potential risks to those cash flows and on the likelihood of actual payments being made, and therefore require that a comprehensive risk management programme be in place to protect the debt service.

Appreciating risks

All projects are subject to some degree of risk since:

• The future cannot be assured

• Technical performance can never be 100% reliable

• External political, economic and human influences exist that are outside the control of some or all of the project parties.

The key to risk management is for the parties to agree mutually at the outset how the risk will be shared between them, and on the consequent extent of their liability, which will inevitably be financial. This financial liability may be a limited exposure, such as through specified limits to levels of liquidated damages or the cost of insurance premiums, or an unlimited exposure to variations in costs arising from some risk events.

In circumstances where financial caps are placed on liabilities, one party is effectively accepting the consequences of that risk over and above the value of the cap.

As a general principle, liability for specific risks is best allocated between the parties to reflect the degree to which each party has an element of control over or responsibility for that risk event occurring. In some instances, the responsibility may be indirect in that a party may be able to lay off the liability to a third party which itself has a clear responsibility.

For example, if the plant is commissioned late owing to a contractor shortcoming, and the owner is liable as a consequence to pay damages to the power purchaser, the owner will seek redress from that contractor to cover those liabilities.

Risk allocation is not prescriptive, with variations between types of project and country; and indeed between similar projects in the same country. Major business issues can be treated differently as national objectives change or investors become more confident of operating in that market. It is therefore necessary that the parties appreciate their respective legitimate concerns in order that mutually acceptable arrangements can be negotiated.

It is the failure to appreciate this point fully, which has in many instances led to delays in bringing projects successfully to close.

Practical risk management

A central feature of practical risk management is the availability within the host country, at an early stage in the project process, of a clearly defined institutional framework and set of policies covering the major areas of concern to sponsors.

Lenders are well versed with the issues involved in financing projects where those projects are located in developed regions such as North America and Europe. However, where schemes are located in an emerging market, as is often the case with hydro power projects, lenders have to take into account additional matters reflecting the diverse nature of that market, such as the economic and political stability of the country concerned.

The construction phase poses the greatest risk to lenders. The risks faced during this period are mainly delays in completion and cost overruns. Lenders will mitigate such risks by:

• Ensuring that the project company enters into fixed price supply and service contracts with creditworthy and reliable construction firms.

• Requiring performance bonds and guarantees from suppliers and contractors or their banks to ensure construction is completed by a designated date.

• Providing an adequate fall back in the financing plans of the project to cover cost escalations and overruns.

But even so, things can still go wrong: for example, the Eurotunnel project, despite an exceptional degree of logistical co-ordination, was considered technically straightforward from an engineering point of view. Nonetheless, project completion was delayed because of design, equipment delivery and testing problems, with the total cost of the project exceeding more than twice the original estimate (US$17B).

Some projects require a significant development of associated infrastructure or support services such as access to roads, railway links, water, utilities and wastewater disposal. In many developing countries, lenders may find that there is very little or no supporting infrastructure available and will need to be assured that the necessary infrastructure will be completed on time so that the development of the project itself is not delayed.

Political risk

One of the major challenges faced by lenders with respect to projects in emerging countries is political risk. Unexpected political events, such as expropriation, revocation of a concession or government interference with currency conversions and transfers, are some of the greatest risks faced by lenders and can have a dramatic effect on the project economics.

Political risk is particularly relevant in the context of project financing for several reasons:

• The project itself is often dependent upon governmental concessions, licences or permits being granted and maintained throughout the life of the project

• The project may be particularly vulnerable to expropriation or requisition by the host government, owing to its fundamental importance to national security or infrastructure

• Where domestic supplies of equipment required for the project are inferior, substantial tariffs may be imposed on the import of necessary plant and machinery

• Where the project has been particularly successful, the government may seek to levy additional taxes on the offtake.

Obtaining export credit agency cover is an effective way for lenders to the project to mitigate these political risks.

Environmental issues

Generation projects are subject to an ever-increasing level of environmental regulation, during the planning, construction and operational phases. This can have a material effect on decisions whether or not to proceed with projects.

Hydro power projects rely heavily on environmental and location factors. A hydro scheme must be developed at the location of the resource and little can be done for the relocation of water resources. If the location of the site is far removed from where the electricity is required, substantial further investment may be needed to construct a transmission framework. The project company may be required to make a heavy investment in transmission cables or rely on a third party to do so if it is contracted out separately.

The associated infrastructure will also need to be financed and maintained. The potential lenders to the project may take some comfort if the development of the infrastructure is to be financed by the relevant host government separately, say, through the World Bank or International Finance Corporation (IFC), as this is likely to increase the certainty that the necessary infrastructure will be completed on time.

Environmental policies are of high priority for most governments, where environmental rules and regulations are well-developed and generally enforced. In certain developing countries, a full environmental assessment may have to be conducted before the relevant consents for the project are given by the host government. For example, the World Bank will insist that its own environmental policies are complied with if it is to provide finance for the project.

Environmental concerns with hydro power plants may include:

• Inundation, resulting in loss of land (particularly acute where there is loss of forests and/or wildlife habitat)

• In upstream areas, the potential for flooding, effects of silting and destruction of wildlife habitat

• In downstream areas, the effect of the reduction of water supply

• Erosion of downstream water courses

• Change in climate

• Dislocation of communities and their resettlement.

Thus it can be that a project such as the Epupa scheme, on the Kunene river between Angola and Namibia, has suffered delay in part because of the need to study the socio-economic and environmental problems and constraints met by the Himba community living in the construction area.

The possibility of liability for environmental damage can cause particular concern among lenders. They are keen to ensure that the project does not contravene any existing or future environmental legislation and also that it will not impose any liability on them, especially when they are seeking to enforce security. Therefore lenders ensure that, before any loan facilities are drawn down, the project company has obtained all environmental consents necessary at that stage and also that the project company complies with all environmental rules and regulations by including representations, warranties, undertakings and events of default in the project credit agreements to that effect.

On 4 June 2003, ten major commercial banks (ABN AMRO, Barclays, Citigroup, Credit Lyonnais, Credit Suisse Group, HVB Group, Rabobank, Royal Bank of Scotland, WestLB and Westpac), along with the IFC, signed up to a new set of guidelines – the ‘Equator Principles’ – designed to promote responsible environmental and social practices in the project finance sector. Other banks have signed up subsequently. The Equator Principles are a set of voluntary guidelines which aim to provide a common framework for lenders to assess and manage the environmental and social issues that arise from the development of energy and infrastructure projects.

With the endorsement of such a significant group of lenders, the Equator Principles are set to become an important part of both the lender due diligence process and the borrower compliance regime for many project loans. The institutions that have adopted the guidelines will apply them to new projects for which they provide project financing and which have a total capital cost of US$50M or more. The guidelines cover projects in all industry sectors worldwide and will have an effect on the future financing of hydro power projects.

Features of the equator principles

Lenders will classify new projects according to the environmental and social risks that they pose. If a project is classified as posing a high or medium level of risk, the lenders will require the borrower to provide a satisfactory Environmental Assessment, assessing those risks by reference to local laws, and World Bank and IFC guidelines.

For a project that poses a high level of risk (or, in certain circumstances, a project that poses a medium level of risk), the lenders will require the borrower to prepare an Environmental Management Plan (EMP) setting out how the environmental and social risks identified in the Environmental Assessment will be mitigated, monitored and managed. The EMP must be formulated in the light of public consultation undertaken by the borrower in relation to the Environmental Assessment.

Loan documentation for projects that have an EMP will include undertakings by the borrower to comply with the plan throughout the life of the project and to provide regular compliance reports to the lenders. Non-compliance by the borrower with those undertakings will constitute an event of default.

Implications for lenders

The banks that have already adopted the guidelines account for a significant share of the global project finance market. More institutions may adopt the guidelines in the future. In that context, arranging banks will need to consider carefully how much appetite (if any) there will be in the syndication market for projects that do not comply with the Equator Principles. Underwriting and arranging banks in that position may consider it appropriate to apply the guidelines to individual loans in order to maximise the prospects of achieving a successful syndication. Where appropriate, lenders should from now on include specific references to the Equator Principles when negotiating financing term sheets.

Implications for borrowers

Borrowers are already required to prepare Environmental Assessments under local laws in many countries. In some circumstances, international financial institutions providing finance already require compliance with higher international standards. This means that in many instances the application of the Equator Principles will not significantly increase the compliance burden faced by project sponsors. However, the Equator Principles will impose additional burdens in some areas. The guidelines have particular implications for projects in emerging markets, for which the Environmental Assessment must now take into account international standards. Obligations such as public consultation may also go further than those required under local laws. The guidelines are also significant in that they impose requirements in relation to the social implications of projects, such as population resettlement and the impact of projects on indigenous peoples and cultural heritage. All these are issues which are likely to arise in relation to hydro power projects.


The financing of major hydro projects on a pure project finance basis has proved increasingly difficult. The risks involved in such projects are of such a scale that lenders have been reluctant to rely on the project alone as security for the large loans required. The situation has become even more difficult with the evolution of environmental and social principles as embodied in the Equator Principles. Banks are now formalising procedures for socially responsible lending, which will only add to the time and cost involved in developing hydro power projects. It must therefore be open to question whether the private sector can now be expected to carry forward such projects on its own. Perhaps the public/private partnership idea, which has been adopted in other areas of project finance, represents the future for hydro power.

Author Info:

Richard Metcalf

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