WORKING PAPER

Energy Project in Emerging countries

A critical view on financing and evaluation methods

Prof. Patrick GOUGEON

ESCPEurope

October 2010

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ABSTRACT

Increasing the energy supply is a necessity, particularly in fast growing countries. But will this be achieved? With a lower risk appetite on the sponsors’ side while at the same time lenders are less willing to engage in highly leverage ventures in a perturbed environment, underinvestment is a serious threat. In this context it is necessary to reflect on current investment analysis and evaluation practices in order to enhance rationality by the promotion and dissemination of new ideas and methods. It is all the more crucial because current practices often appear to be over-conservative. Theoretical developments have enriched the tool box of decision makers, up till now though these seem reluctant to change. Stressing the relevancy of new approaches as well as their user friendly aspect is all the more important when investment is urgently needed. In this paper we analyse the weaknesses of the dominant NPV (Net Present Value) and to better demonstrate the superiority of alternative approaches such as the Adjusted Present Value and Real Options.

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1 -INTRODUCTION

Increasing energy supply is a necessity, particularly in fast growing countries. But will this be achieved? A number of serious obstacles may hinder the evolution towards an extended cleaner energy capacity. Hereafter are the main influential factors:

  • Some argue that the financial needs are far too high in comparison with what investors are ready to contribute today due to an increase in risk aversion
  • Because National Oil & gas Companies (NOCs) have now supplanted International Oil Companies (IOCs) a lower part of oil and gas revenues is now devoted to investment. In most oil rich countries NOCs are seen as an easy source of cash to cover budget needs while IOCs receive less and less of the revenues coming from oil and gas production.
  • Most new resources are non conventional and necessitate the use of new non proven technologies so that the risk for investors is increased
  • Inconsistent energy policies and hesitation of regulators contribute to ambiguity that also deter investment
  • Finally, complex geopolitical issues deteriorate the business climate in many parts of the world, another deterrent restraining investment.

Thus, the idea that energy supply might lag behind demand is a serious concern today.

In this context it is necessary to reflect on current investment analysis and evaluation practices in order to enhance rationality by the promotion and dissemination of new ideas and methods. It is all the more crucial because current practices often appear to be over-conservative.

In part two the focus is placed on project financing to give a clear idea of the position of the various stakeholders and stress the conditions for the viability of a project. Risk analysis is a key point; this is addressed in part three. The Net Present Value (NPV) - together with the Internal Rate of Return (IRR) - is the most used evaluation criteria, yet there are many pitfalls that may well explain conservatism (part four). Considering the characteristics of most energy projects, there are good reasons to suggest other approaches to evaluate investment opportunities. There is a need to go beyond NPV. In particulara reference to the Adjusted Present value and real options seems most relevant (Part five).

The conclusion is a summary of our observations and remarks leading to few suggestions.

2- PROJECT FINANCING: RATIONALE & LIMITS

Project financing in the broad sense refers to complex financial schemes where lenders provide most of the funds needed with no or limited recourse, counting on the project’s potential revenue streams to repay the loans. As such, project finance appears as a powerful financing technique and indeed fast growing countries are making an extensive use of it (Razavi 2007, Thumann and Woodroof 2008, Pollio 1999). As far as emerging countries are concerned, project financing is attractive for the following main reasons:

  • To boost infrastructure development with little impact on budget deficit. Transport, energy and telecom infrastructures are a prerequisite for rapid growth and a condition to attract foreign investments. Considering the high cost of developing such infrastructures and the scarcity of public financial resources, project finance is most helpful. It should also be noted that project finance is now commonly used in the privatisation process.
  • To improve the trade balance by increasing local supply toreduce imports and by building up an export capacity, particularly in oil rich countries for which oil & gas exports represent a major source of income
  • To enhance technology transfers.

Project finance consist in segregating the project in one or several special purpose vehicles (SPVs), with“sponsors” providing equity funds usually representing a small proportion of the total amount needed. Therefore, due to the large proportion of debt, project finance is workable only if the risk forlenders is clearly perceived as reasonable. First risks need to be identified and assessed. Then, as much as possible, risks will be transferredto the many stakeholders involved in the project through contracting in order to have more players sharing the risks and end up with a residual risk exposure for the SPV that is acceptable to sponsors and lenders (Figure 1). Thus, project finance can be seen as an optimal risk allocation process, since risks are transferred to these best able to bear them. So, transaction costs resulting from agency issues and information asymmetry are best handled.

Whether contracting is efficient is an important question, the quality of contracts is crucial for the project performance. An abundant literature exists on transaction costs and contracting with Williamson [5] as a precursor.Most authors insist on the importance of “relational contracts” based on trust building as a complement to formal legal contracts (Lyons and Mehta 1997; Gougeon 1998), particularly in emerging countries where the legal system is not well established.

Today the need of funds in emerging countries to finance energy projects, either to develop electricity supply or to increase oil and gas production, is huge. Though in the past the energy sector was dominant in project finance activity, whether today funds will be available to meet all that needs remains a question.

First, the financial crisis has put an end to abuses in debt financing – at least for the moment. Minimising your equity stake to maximise the expected return on equity is no longer workable since financial markets are no longer ready to absorb and disseminate – some would say dissimulate – the resulting risk. Borrowing with little equity has become very expensive if possible at all.

Figure 1

Project structure and risk sharing

On the other hand, investors have to accept more risk. Risk has increased for many different reasons including:

  • Technological uncertainty and lack of experience in renewable energy,
  • Use of frontier technologies in the oil and gas industry, both expensive and risky
  • Volatility affecting financial and foreign exchange markets
  • Severe lack of well established legal system weakening the strength of contracts
  • Increased political risk due to the willingness of local public authorities to keep control and capture most of the project value.
  • Geopolitical issues

In this context, a focus on risk analysis is crucial to better understand how risk affects the project value and imagine how it can be mitigated and shared between the various groups of investors.

3 – PROJECT RISK ANALYSIS AND FINANCIAL STRUCTURE

The risk management process (Figure 2) starts with the identification phase, that is an in depth investigation to list and assess the severity of all possible adverse events likely to affect the project performance – investment cost, timing and revenue streams. Whether similar projects have been implemented in the past is of course of great importance since experience provides a valuable basis for scrutiny. This is the main reason why project finance is normally used in the case of proven technologies or widespread infrastructure projects with the involvement of experienced sponsors. As already noted, in the energy sector in many circumstances past experience is no longer transferable. New technological challenges have to be faced, and past routines are obsolete. Furthermore, the business environment has become more complex and the ability to anticipate all the more limited.

Indeed, experts helped by number crunchers have developed sophisticated statistical methods, combining multiple scenario and estimates, to provide decision makers with a probability distribution indicating the likelihood of getting a particular range of return, and most importantly the probability of failure. Numbers are powerful since they are believed to provide an objective view on which rationale decisions can be based. We have learnt from the recent past that numbers can be misleading. Indeed these tools should not be abandoned, but today our recommendation is: mind unexpected events and be ready to cope with ambiguity, without numbers.

Figure 2

The Project Risk Management Process

We also need to consider that risk varies over time. For each project one can imagine a “risk resolution pattern”. Time and experience provide valuable information that helps predicting the future more accurately. Experts usually consider three main phases when implementing a project, the completion phase followed by the start up phase and then the operating phase, each of which corresponds to particular degree and sources of risk (Figure 3.1).

Following a distinction made by G. Pollio [4], during the completion phase project sponsors are concerned with “intrinsic risk”, that is « unforeseen problems that emerge only as the scope of the project is more precisely delineated ». It may have to do with technical and/or administrative problems resulting in delays and cost overrun.

Once equipments and infrastructures are ready for use major uncertainties are then resolved, the start up phase begins. One can however still worry about technical efficiency which may be lower than expected, again time will tell how it goes. Finally, provided all difficulties have been dealt with, the project enter the operating phase with the following risks to consider:

-Economic risk: risk relating to changes in prices or exchange and interest rates

-Political risk:asset confiscation, constraints affecting cash-flow transfers

-Management risk: organisational and behavioural risks, relates mainly to the capability of the organisation to cope with contingencies

How much is at risk is also important, the higher the amount of capital employed the higher the possible loss for investors (figure 3.2). To start sponsors invest their reputation, an intangible asset that is too often underestimated. Then funds are progressively invested all along the completion phase to reach the full amount of capital employed which then starts decreasing.

Figure 3

Project risk exposure over time

The risk exposure results from the combination of both the level of uncertainty (3.1) and the capital at risk (3.2). It changes over time with a peak period, when uncertainty is still high while a large amount of capital has already been invested. Then it decreases since future revenues can be anticipated with higher accuracy and capital at risk decreases.

The evolution of the risk exposure as described above is essential to understand the complex and changing financial structure of the project company. Sponsors need to get in fist with their equity contribution. But their risk appetite is usually too little to provide a large proportion of equity, thus the availability of debt financing is a condition for the project to be implemented. Not any kind of debt however. In the early phase of the project the risk exposure remains high for would be investors, hence they will be proposed high yield junior debt or any other type of “hybrid” instruments between equity and senior debt. There exist a wide range of such instruments constituting “mezzanine” financing. This can be seen as a temporary source of funds, very close to equity as far as risk taking is concerned. In the recent past, this type of instruments became very popular because of the comparatively high yield they could offer to investors. No need to say that it also represents an attractive source of fee revenues for banks, also keen to promote these complex financing schemes. Things have changed.

Once the risk exposure has decreased significantly, that is when the project is running efficiently – which may never happen – so that future cash flows can be predicted with enough accuracy, then the time has come to substitute expensive mezzanine financing by cheaper “no or limited recourse” debt. It means that lenders count on future project cash flows only for the payment of the debt service since the project assets are often poor collaterals.

From this presentation we can draw two major observations. First, due to the changing risk exposure and capital structure, choosing the appropriate discount rate to value the project come up as an extremely difficult question. Then, contemplating the information flow that contributes to change the perception of the project over time, one needs to integrate this dimension in the evaluation methodology. In particular flexibility, the capacity to reorient the project if necessary, should be valued. Both remarks lead to the conclusion that the traditional NPV approach is not appropriate and need to be reconsidered.

4 - NPV PITFALLS

The Net Present Value is usually presented in finance textbooks as the most relevant criteria to guide investment decisions, and it makes sense from a theoretical point of view. NPV is a measure of value creation. A positive NPV means that the present value of all future expected cash flows of the project exceeds the amount to be invested to implement it, and then it should be.

(1) NPV = - I0 + ∑ FCFt/ (1+k)t

With discount rate k = Risk Free Rate + Appropriate Risk Premium

The simplest expression of the NPV is indicated above (1). For each period t the expected Free Cash Flow (FCFt) is discounted at rate k – where k is a measure of the required rate of return which should be aligned on the cost of capital reflecting investors’ expectations. Then the total investment, which is here assumed to be one single immediate instalment at date 0 (I0), is deducted from the sum of all discounted cash flows. The difference is a measure of the value created immediately by the project. A positive value also means that the expected return is higher than the required rate.

Practically, however, determining future expected cash flows with minimum accuracy and choosing the appropriate discount rate are at least tricky tasks, if not impossible sometimes. Furthermore, the amount to be invested, as well as the timing of the instalments, is often treated as a known element. That is obviously far too optimistic for large infrastructure projects in emerging countries (Bruner et al. 2002). Indeed these are not good reasons for abandoning the NPV approach. It remains a source of rationality since it forces decision makers to raise the right questions. Yet there are good reasons to believe that there answers might lead to highly conservative decisions. In particular there is a tendency to adopt a conservative attitude when estimating future expected cash flows to account for risk. At the same time high return, including an excessive risk premium, are required. Counting risk on both sides with low expected cash flows and a high risk premium included in the discount rateobviously results in systematic underestimation and is far too pessimistic.

For energy projects in emerging countries, getting the correct numbers is even more complex. Even if specialists have a good understanding of the revenue generation model and can accurately predict expected free cash flows, there are specific difficulties to choose the discount rate.

The cost of capital, which is normally the reference, cannot be determined easily when the capital structure is complex and changing over time. In particular the reference to a target debt equity ratio for a simple capital structure made of traditional debt and equity cannot apply.

Most energy projects are multi-currency projects. Again there are theoretical solutions proposed to deal with this kind of complexity, but they are far from being satisfactory in real life.

In addition to the above mentioned difficulties, one also needs to discuss the particular case of off-shore projects exposed to “country risk”. Country risk relates to the likelihood that changes in the business environment will occur in the country where the project takes place with an adverse impact on future cash flows and/or project s’ assets. To which extent should this type of risk be integrated in the risk premium required is a question without a clear answer. Academics have proposed a wide range of solutions (see Pollio 1999), among them Damodaran ( ) has become popular by providing estimates of country risk premium for a large group of countries which many would take as a reference. However, one can argue that country risk should not be included at all. Why?