development and project financing of private power projects in

Pergamon International Journal of Project Management Vol. 16, No. 2, pp. 99-105, 1998 © 1998 Elsevier Science Ltd and IPMA. All rights reserved

Printed in Great Britain 0263-7863/98 $19.00 + 0.00

PII: S0263-7863(97)00030-6

Development and project financing of private power projects in developing countries: a case study of India

Jyoti P Gupta* and Anil K Sravat School of Management, Asian Institute of Technology, GPO BOX 2754, Bangkok 10501, Thailand

The power sector development is crucial to sustain the faster economic growth of the Asian region. This article analyses the critical issues involved in the development and project financing of the Independent Power Projects in India. The issues examined are related to policy, power purchase, risk factors, financing, fuel supply and transportation and key success factors. This study presents a brief profile of the power sector in India and a case study of the Dabhol power project, the first IPP being developed by foreign investor, Enron Development Corporation (EDC). The conclusions have been drawn in the end of this article. © 1998 Elsevier Science Ltd and IPMA. All rights reserved

Keywords: power projects, privatisation, development, financing, risk factors, Dabhol power project

Economic growth depends on the state of infrastructure, The Asian economies are growing at a higher rate and therefore the demand for infrastructure is out- stripping the supply. The role of the power sector becomes vital in the economic development of the country. As per estimate of the world bank 290000 MW of new generating capacity would be required in Asia by 2004. To build this generating capacity in a decade, utilities and private power developers will need to bring on line an average of 2000 MW to 2400 MW of new capacity each month. Each year $ 35 billion will need to be invested in power plants and transmission and distribution facilities in Asia.

India is on the eve of a large industrialization program, this trend is reflected in the country's insatiable demand for power. The current generating capacity is about 81000 MW. India's power demand would be about 145000 MW by 2006-2007. This would mean adding about 68 000 MW to the current capacity. The total investment over the period 1995-2005 is estimated to be US $ 78 billion. 4 The country is unable to meet this requirement due to the paucity of funds and resource constraints. The privatization of the power sector is encouraged firstly to mobilize the needed financial and managerial resources, secondly, to improve the efficiency of services to the users . 6'7

This article has been structured into four parts. Part-I deals with the brief profile of the power sector

*Author for correspondence.

in India, Part-II deals with development and project financing of IPPs in India and the critical issues involved have been analyzed. Part-III contains a case study of the Dabhol power project. The various conclusions drawn have been mentioned in Part-IV.

Power sector prof i le - - India

Although the expansion has been impressive in the last 15 years, yet the availability of power continues to fall short of demand. The Indian power industry has been dominated by the public sector. The private sector accounts for just 4% of the total power generating capacity.

Industry structure and regulation

The Indian energy Supply Act was enacted in 1948 to set stage for a restructuring of the power industry. Under the act, the Central Electricity Authority (CEA) was created to develop a national power policy and to coordinate power development at the national level which involves giving techno-economic clearance. The state electricity boards were set up as autonomous bodies to promote the development of the power sector in the respective states. The Industrial Policy of 1956 explicitly reserved the generation, transmission and distribution of power to the domain of the public sector. The companies in the central sector are allowed only the generation and

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Private power projects in developing countries. J P Gupta and A K Sravat

transmission of power, the distribution lies with the respective State Electricity Boards (SEBs). 3

Supply and demand

The power generation was 351.02 billion energy units in 1994-95. The eight plan expects power generation to reach 418.2 billion energy units by 1996-97. India has been facing power shortages in the last decades. By and large, power shortage has declined from 10 to 12% during the first half of eighties to 7 to 8% in the second half of eighties and first half of nineties. During 1994-95 the energy shortage was 7.1% and peak shortage was 16.5%. 7

Financial status

According to the economic survey of 1994 95 all the SEBs put together showed a negative rate of return of 12.2% in 1993-94. According to CMIE* survey, 342 projects currently under implementation or proposal stage involve an investment of Rs 3474.47 billion?.

These projects plan to install 102220 MW of capacity. Out of this 28 038 MW of capacity is under implementation. The public sector accounts for 42% of the total investment. The central government accounts for 16% and state sector accounts for remaining 25% of investment in the power sector.

Earlier in India the power projects were developed mostly by government utility firms and financing was arranged through government budget, multilateral agency credit, bilateral credits, supplier credits and commercial loans from banks. Due to the resource constraints and paucity of funds the privatization of power projects is taking place at a faster pace. The independent power projects are being financed through non recourse project financing. 9

Development and financing of private power projects Privatization o f power sector

The Indian power sector is facing a severe resource crunch and inadequacy of funds with the central/state public sector: The uncovered gap of about 37 000 MW and 47000 MW in 1997-2002 and 2002-2007 has to be bridged by the private sector. The investment required to add this 37 000 MW is about Rs 1500 billion (US$ 47 billion). Therefore due to paucity of resources, and in order to meet the growing demand, in 1991, Government of India opened the power sector to both Indian and foreign private investors by enact- ing the Electricity Laws (Amendment) Act, 1991. The private sector participation not only provides the needed resources but should encourage competition and improve efficiency in the electricity sector in India. The power industry is highly capital intensive and to arrange large funds for power projects in the conventional way is extremely difficult for promoters and therefore limited or non-recourse project financing is

*CMIE = Centre for Monitoring of Indian Economy. "l'Rs 31.9 - 1US$ (End 1995)

adopted for financing private power projects by almost all promoters. 2 The salient features of the private power policy are given in the Appendix.

Private sector response

Proposals have been received for 245 projects for a total capacity of 93 661 MW involving an investment of about Rs 3397.08 billion. Out of these, foreign investor have made 52 proposals for a capacity of 37503 MW including an investment of Rs 1466 billion. 6 The Foreign investment promotion board (FIPB) has already cleared 25 proposals and 16 of these have been cleared by the Cabinet committee of foreign investment. The government has cleared initial eight projects on a fast track basis and extended them counter guarantee to support the obligation of the state electricity board. 8

Counter guarantee

Due to the poor credit rating t° of the State Electricity Boards, promoters have insisted on state guarantees and Government of India (GOI) guarantees for the payment obligations of the SEBs. The Govt. of India decided to extend counter guarantees to the initial eight projects (fast track projects) to convince the lenders. This scheme was envisaged as a transitory measure to boost private sector investment. Since this was a temporary measure GOI is exploring several alternatives to counter guarantee which are as follows:

• Direct supply of power by IPPs to HT consumers • Opening of an Escrow Account in which identified

payment by consumers are credited and payment liability to the IPP is the charge on this account

• Linking power generation with distribution • Escrow arrangement with central devolution at the

request of state government • World Bank guarantee

Competi t ive bidding and M O Us

At the beginning of the privatization program the projects were awarded to private developers through memorandum of understanding route. This policy was criticized by different sections and the Govt. of India has made it mandatory that private power projects are awarded through competitive bidding effective from 18th February 1995. However, competitive bidding in its current form is not quite effective, at best it is indicative only. Some projects are being revised even though these are won through competitive bidding.

7"ar/ff At present, GOI has adopted a two part tariff which effectively guarantees the return of generating companies. The first part of the tariff covers recovery of fixed costs, including the return based on normative par-

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ameters. The second part of tariff covers variable costs as well as premium on efficiency. A post tax rate of return of 16% is assured regardless of their operational efficiency.

Risks factors

The development of power projects in India is in a nascent stage and the developers have to face many risks involved ~2 in the development of these projects. The major risks described by various participants such as developers, investors and contractors are as follows:

• Country/political risk ~ • development and construction risk • Operation and maintenance risk • Fuel supply and transportation risk • Foreign exchange risk • Risk of non-payment by SEBs (sole power purcha-

ser) • Regulatory environment risk

These risks are generally present in the projects but in the case of India it needs special consideration as credibility to meet the contractual obligations by state owned monopolies (power purchaser, fuel supplier and transporter) is very poor. The country/political risk rates very high in the mind of the investors.

Financing

The financing of the private power projects on project financing basis ~ is in the nascent stage. The issues involved are discussed in the following section. 9

Conventional/existing financing methods. Structured financing: 2 As power projects involve large investments, the risk profile along with the cash flow profile of the projects decides the financial structure and package of the project. In India, government sponsored projects have had staggered or incremental financing patterns, which were mainly determined by the availability of resources rather than specific relationship with the requirements of the projects. However there are no private sector projects which have such financing patterns. The institutional financing in India is mainly done through a consortium. A development financial institution acts as lead banker in the consortium. The other existing form of financing in India has been the equity route.

Use of special purpose vehicle: The most widespread financing option at present is limited recourse financing. In this method of financing a Special Purpose Vehicle (SPV) 14 is created, which acts as the nodal agency for bringing together private investors and con- cerned Government agencies for the project. The SPV can be any Company/Trus t /Mutual Fund with necessary financial strength to act as an intermediary. The SPV and the lender sign a 'Financing and Security Agreement ' which specifies the conditions for financing and other aspects. Private sponsors also pledge ad- ditional cash-inflow streams for meeting debt-service obligations.

Sources of funds: ~2 The current guidelines of the government permits a debt-equity ratio of 80:20. The 60% of the debt should come from sources other than

domestic financial institutions. The govt. has also put the limit on foreign debt to twice of equity Therefore the promoters has to raise substantial capital from domestic sources. The various sources of capitaP 3 are:

• Foreign equity; • Foreign debt; • Commercial finance; • Domestic capital market; • Indian Financial Institutions (IFIs); • Commercial banks; • Infrastructure funds; • Private Power Development Facility of the World

bank.

Credit enhancement: The need for credit enhancement emerges from the perceived inability of the power purchaser (SEBs) to meet its payment obligations. ~° The credit enhancement essentially guarantees either power purchase or debt repayment. Some of the alternatives require major structural/sectoral reforms. While these changes would be needed, the various alternatives being considered for use include the following:

• Government of India or sovereign guarantee • Letter of credit and Escrow account backed by SEB

customer receivable • LC and Escrow account with guarantee from Indian

Financial Institutions (IFT). • LC and Escrow account with State Government

Guarantees (and central devolution) • Blended GOI guarantee • Power purchase agreement with central agencies

such as Powergrid • Direct distribution by IPPs to large industrial consu-

mers • World bank guarantee • Corporate balance sheet of developers

Credit support capability of Indian institution: The main reason that promoters are not able to do the financial closing is the difficulty in obtaining project financing, especially debt financing. The lenders ask for different guarantees due to the poor financial condition of the state electricity boards which are the sole purchasers of electricity from the IPPs. The GOI has been reluctant to give the sovereign guarantee as it affects the national balance sheet by increasing contin- gent liability of the government. The SEBs are expected to provide the largest amount of credit support despite their poor financial condition. Only half of the power sector needs can be fulfilled if the desired reforms are not put in place.

Critical issues in private power projects development

The private sector participation is of crucial import- ance for the development of power sector in India. The private power developers are facing daunting chal- lenges in developing the projects. Some of the critical issues are discussed below:

• Government allowed a maximum debt to equity ratio of 2 : 1 in the project for foreign investors. However it is very difficult to achieve this ratio along with an Indian partner as guidelines limit the

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Private power projects in developing countries." J P Gupta and A K Sravat

foreign debt twice to foreign equity. The method of selection of promoters and their appraisal needs consideration; the MOU route has been severely criticized as it lacks transparency and in many cases the MOUs were not based on well developed project concepts.

• The government guidelines assumes these plants as base load stations and tariff structure has been designed accordingly. However some investments made for peaking load factor is of more economic benefit and hence tariff guidelines should be made more flexible to include this operational mode.

• The financing through Export Credit Agencies is most viable route but specific agency's overall country limit, competing demand from power projects in public sector and projects in other sectors would limit the amount available for private power. Additionally, the commercial banks balance sheet capacity would be considerably stretched if these were required to furnish guarantees to the ECAs as well as fund the bulk of the requirement of domestic financing. Under the current market condition it is difficult to tap the international market for medium term finance both for the amount and maturity required by power projects without some form of credit enhancement from multilateral institutions.

• In view of the constraints on the availability of external finance, the developers would need to raise a significant part of their capital requirements from the domestic capital and credit markets. Investors have a preference in India due to speculative gains and it does not appear difficult to raise the domestic equity for a private power projects however the raising of long term debt is quite diffficult due to immature secondary debt market in the country. There is absence of liquidity in the secondary market.

• Indian financial institutions limit their exposure (including term loans guarantees and underwriting commitments) to not more than 25% of their net- worth to a single project Maximum 15% to a sector. The sector exposure of these institutions would reach their limits and after few projects the financing would be possible only to the extent of annual growth and repayments by the already financed projects. Commercial banks seems to have enough capacity to meet the working capital requirement of the private power projects but their underwriting capacity is not expected to be significant, therefore the IFIs have to support the bulk of the underwriting needs of the projects.

• The ability of the SEBs to pay their obligations in terms of power purchase agreement (PPA) is a source of serious concern for private power project development The option that these payment may be secure by making the 'escrow' arrangement by certain designated industrial consumers is seen causing problems for the domestic creditors in pro- viding finance for other SEBs activity, such as working capital requirements, and moreover it dis- turbs their consumers mix, eroding their receivables further.

• The SEBs risk would best be mitigated by an improved and profitable performance of the SEBs.

and this would need to be given a continuous pri- ority.

• The assurance of steady fuel supply of the agreed quality (and adequate compensation in case of fail- ure) is another issue of concern for the investors and lenders. The present suppliers of the fuel in India are government monopolies and there is no commercial commitment between them and the power projects.

Case study--Dabhol power project Introduction

In May 1992, the Government of India and Ministry of power had invited EDC an internationally recog- nized independent developer of power to consider set- ting up a power plant in India with imported liquefied natural gas (LNG). This is the first large scale private sector project developed through foreign direct investment

The project entails the design, engineering, construction, commissioning and commercial operation of a 2015 MW natural gas fired combine cycle power station in two phases. The first phase will have generating capacity of 695 MW. It will include the development of harbour and fuel oil facilities. The second phase will have generating capacity of 1320 and will consist of building the necessary infrastructure for off loading, storage and regasification facilities.

The Dabhol Power Company (DPC)

The Dabhol power project is owned by an Indian company, the Dabhol Power Company. The DPC was set up to undertake the responsibility of developing and operating all aspects of the power station and fuel facility. The equity would be provided by the consortium of foreign companies (in which Enron development corporation is the lead member with Bechtel Enterprise Inc. and General Electric Company as the members) and other Indian equity participants. The debt would be provided by export credit agencies and multilateral agencies. Up to 30% of the equity will be offered to the Indian investors through private and public offerings. The project would be connected to the Maharastra State Electricity Board (MSEB) grid through a 400KV transmission system. The latest technology will ensure environmental considerations.

Financing

Dabhol power project is the first project to achieve the financial closing after the privatization of the power sector in India. The project has been financed on non-recourse basis with a sovereign counter guarantee from the Government of India. The entire equity came from the consortium of US companies led by Enron Development Corp. The Power purchase agreement for this project was signed in end of 1993 The time for the financing of a project in the developing country like India was not favorable, due

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Table 1 Financing details of Dabhol power project

Amount (US $ in Source million) Interest [%]

Debt/loan 643 US Exim Bank 298 OPIC 100 BOA and ABN- 150 AMRO Bank Syndicate of Indian 95 Bank led by IDBI Equity 277 Enron Dev. 221.6 Corp.[80%] General Electric [10%] 27.7 Bechtel USA [10%] 27.7 Total 920

8 10

Libor + 3

17.5

to the Mexican peso crises and the Indian investment rating.

From the issuance of the Basic Information Memorandum (BIM), it took about one year to achieve the financial closing in March 1995. The agreement calls for the banks to provide US$ 643 million in commercial finance. The lenders comprises of the US Exim bank, Overseas Private Investment Corp.(OPIC), Bank of America and A B N - A M R O bank of Netherlands and a syndicate of Indian banks led by Industrial Development Bank Of India. The loan has been fully underwritten by the main lenders.

The original plan of the company was to retain the 50% equity and thereby spread the risk among various parties. The financial details are given in Table 1. The project was financed on limited recourse project financing basis. The mortgage trustee for all the lenders is the Industrial Development Bank of India. The onshore trusties is the Bank of America, Bombay and the offshore collateral agent is the Bank of America, New York.

Power purchase agreement, performance guarantee and penalty

The power purchase agreement between MSEB and DPC is signed for a period of 20 years, extendable for a further period of five or ten years by mutual consent. DPC has guaranteed an average availability of 90% for 20 years and also heat rate for twenty years. There are severe penalties for nonperformance in the PPA. ~5 The DPC has to commission the project within 33 months (1005) days from the date of financial closure failing which they would pay the penalty. DPP was the first project to be executed under the power sector privatization program of India and Government of Maharas t ra (GOM) has given guarantee for the payment obligation of MSEB, supported by the counter guarantee from GOI.

Risk o f Dabhol Power Company

Some of the critics of the Dabhol power project maintain that the DPC is getting this business without assuming any risk. Even the Accountant General has remarked in the report on the project that " D P C will conduct the business of selling power without the company taking any risk". However company has

taken the risk which it is in a best position to bear. Some of the risk which DPC has taken are as follows:

• Construction risk: DPC has quoted a power price based on an estimated capital cost. The company takes the risk to build the project within this cost, any extra cost has to be born by the company

• Completion risk: The plant has to be completed within 33 months from financial close, otherwise heavy penalty is to be paid by the company to MSEB for the delay.

• Operational risk: DPC has guaranteed certain performance of the plant and if it can not operate the plant upto the guaranteed performance, the company is liable to pay the penalty to MSEB accordingly.

• Fuel supply risk: The company has to ensure that the power plant has sufficient fuel supply to generate the required electricity. The company has to pay the penalty for the non- availability of the fuel, reducing the return of the company.

• Financial risk: The company has to bear the risk of any change of the rate, terms and conditions of the financing as the cost quoted is fixed.

In addition to this DPC has to bear the risk of industrial force majeure, non domestic force majeure and some part of the political force majeure risk. ~2

Later development, scrapping and revival o f the project

When the construction of the project was going on there was a change of government in the state of Maharastra . The opposition party came into power and they have set up a committee to review the Dabhol power project cleared by the previous government. On the basis of the report submitted by the committee, Govt. decided to repudiate the first Phase and cancel the second phase of the project on 03.08.95. Therefore the DPC was given the notice by The G O M to stop the construction work at site. Various petitions were filed in the High courts and Supreme court of India. The supreme court upheld the validity of the contract quashing all these petitions. DPC has initiated the arbitration proceedings in London against the Govt. of Maharast ra in accord- ance with the provision of the State Support Document of June 1995. The amount claimed by DPC represents the company expenditure up to date and was not inclusive of the loss of profit which will be decided in the due course

Renegotiation process. The Govt. of Maharastra, in November '95 set up a group to negotiate the revival of the project with DPC. The scope of discussion was for the entire project including phase I and phase II. During these negotiations the company made the following offer to revive the project:

• The company would agree to the tariff that would be equivalent, after taking into consideration of the special infrastructure/tax implication of the DPP, to the best comparatively bid tariff given by the recently approved new power projects in Maharastra .

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Private power projects in developing countries: J P Gupta and A K Sravat

bullnum0;. The company would agree to use Naphtha or LNG sourced through Indian supplier and offer upto 30% equity in the project to either MSEB or an Indian party, which would signifi- cantly reduce the foreign currency out flow from the project.

• The company would agree to accept further sugges- tion from the government on the environment issues.

Foreign governments and investors perception. The Maharastra government decision to scrap the project raised serious concern among the foreign investors but subsequent decision to renegotiate the project with Enron and therefore showing their commitment to set the power plant has contributed to ally the initial fears.

Revival of the project*. The Government of Maharas- tra has cleared both tile phases of the project on 14.01.96. The capacity of the project has been enhanced to 2450. The fuel used would be Naphtha and the gasification plant has been removed. The ana- lyst in the power ministry have calculated that renegotiation of DPP has resulted in a 10.9% reduction in cost attributable solely to the reduced prices for plant and equipment.

This project is a good example of political risk and its management in the developing countries like India. The development and financing of projects in India require something more than the usual practice. The bureaucracy and political forces play a vital role. During the discussion the DPC officials informed that they have obtained 128 clearances including about 40 major ones. The legal system of the host country is very important in this kind of situation. In this case all the courts validated the contract and their role has been appreciated by developers including Enron. The dependence of parties on the project plays a significant role. In this case, not even the government but Enron was also patently keen to revive the project as it has a big stake in a massive gas project in Qatar which could be endangered if the Dabhol project does not goes through.

• Develop clear and prudent policies regarding the investment in the private power projects.

• The credibility/financial viability of the SEBs which are the sole power purchaser should be improved. The major reforms must be implemented.

• The competitive bidding with greater transparency is more suitable for these counties and it avoids cost padding by promoters.

• The economic/fiscal environment (interest rate, in- flation, currency exchange rate) needs much struc- turing and improvement.

• Credit enhancement mechanism should be developed and implemented till the necessary sectoral reforms are in place.

• The capital markets have to be developed if the privatisation has to be sustained. The statutory funds such as pension funds and employee provident funds should be directed to invest in the private power projects.

• The bureaucratic process and regulatory regime should streamlined to achieve the fast clearance for these projects preferably a single window clearance.

• The legally enforceable and fair commercial con- tracts between fuel supplier and transporter should be implemented

The financial institutions ~6 have to play vital suppor- tive role in the development of capital markets, fulfill- ing the need for underwriting various loans and securitisation of the debts for getting necessary funds for the power projects. The participation of the multilateral financial institutions by way of equity would greatly enhance the investor confidence and success of project financing of these projects. The government in India should ensure that similar incidents like Dabhol Power Project do not repeat and implement some initial project at the earliest, otherwise the investors would consider India as high risk country and the cost of international capital would go high.

Acknowledgements

The authors wish to express their deep gratitude to the European Community for funding this research study which involved visits to India, Malaysia and Singapore for collection of data and information.

Conclusions The project financing of power projects on limited recourse basis has gained wide application in this region. The power sector is opened for privatisation with the liberalization of the economies in the Asian countries. The various factors impeding the development of private power projects in these countries are high country/political risk, unstable economic/fiscal environment, highly bureaucratic system, poor credibility of power purchaser, fuel supplier and transporter which are state owned monopolies, immature capital markets especially the long term debt markets.

In order to improve the success of development and project financing of IPPs the following measures merit considerations:~6

*This section is based on the press reports.

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11. Howell, L. D., Chaddick, B. Model of political risk for foreign investment and t rade- -An assessment of three approaches, Columbia Journal of Worm Business, Fall 1994, Vol XXIX.

12. Li, L. Potential conflicts between interested parties and opti- mum funding structure in project f inancing--Case study of project financing in Asian countries: RSPR No. SM-94-15.

13. Haley, G. Private finance for transportation and infrastructure projects A view. International Journal of Project Management 10(2), 1992.

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15. Ansar, K. Project financing in India; Legal and conceptual issues, India Power '96 conference, January New Delhi, India.

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Jyoti P. Gupta graduated from Indian Institute of Technology, India in mechanical engineering. He received PhD from Manchester University, UK. He had worked in General Electric company and Morgan group as financial control- ler. He has served on many international forms in the area of finance. He is Professor of finance, group ESCP (Graduate school of Business) Paris, France. He has authored many articles and books in various of finance. His current areas of interest are capital markets and project .financing of infrastructure projects in Asia and Europe. Presently, he is Dean and professor, School of Management, Asian Institute of Technology, Bangkok, Thailand.

Appendix: Salient feature of Private power policy

Anil K. Sravat received Bachelor and Master degree in electrical engineering from University of Roorkee, India. He has worked in the large public sector corporations in the power sector in India for about 10 years. He was involved in the first HVDC project in India. Recently, he has completed MBA course in International Business from Asian Institute of Technology, Bangkok, Thailand. His area of interest are privatisation, project .financing and project management of large power projects. He is currently working as Senior research associate at Asian Institute of Technology, Thailand.

Private sector can take up distribution as licensees or can come in as generating company

• 60% of outlay must come from sources other than Indian public financial institutions and 100% foreign equity is permitted. A maximum Debt equity ratio 4 : 1 is allowed.

• Reduced custom duty on import of equipment, Tax holidays and suitable rariff structure to ensure appropriate return.

• Upto 16% return on the foreign equity included in the tariff can be provided in the respective foreign currency.

• Government of India can cosnider guarantee provisions on case by case basis.

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