E N E R G Y A N D M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R P A P E R N O . 9 D E C E M B E R 2 0 0 3 Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries Tomoko Matsukawa, Robert Sheppard and Joseph Wright THE WORLD BANK GROUP The Energy and Mining Sector Board AUTHORS DISCLAIMERS Tomoko Matsukawa (Tmatsukawa@worldbank.org) is Senior Financial Officer of the Project Finance and Guarantees unit The findings, interpretations, and conclusions expressed in of the World Bank. She has worked on various power and this paper are entirely those of the authors and should not be water projects, structuring public-private risk-sharing schemes attributed in any manner to the World Bank, to its affiliated and implementing World Bank guarantee transactions. Prior organizations, or to members of its Board of Executive Directors to joining the World Bank she worked at Morgan Stanley, or the countries they represent. Citicorp and the Chase Manhattan Bank; she holds MBA from Stanford Graduate School of Business. The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, Robert Shepard (projfin@bellsouth.net) is a an independent electronic or mechanical, including photocopying, recording, or consultant working on ways to improve access to capital inclusion in any information storage and retrieval system, without markets for developing country infrastructure projects. the prior written permission of the World Bank. The World Bank He was previously responsible for project finance capital encourages dissemination of its work and will normally grant markets at Banc of America Securities and is a member of permission promptly. For permission to photocopy or reprint, the North Carolina Bar and of the American Bar Association. please send a request with complete information to the Copyright He is a graduate of the University of North Carolina Clearance Center, Inc, 222 Rosewood Drive, Danvers, MA (Juris Doctor and MBA). 01923, USA, fax 978-750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Joseph Wright (jwright1@worldbank.org) works on energy regu- Office of the Publisher, World Bank, 1818 H Street N.W., lation, energy reform and rural energy issues in the World Bank Washington DC, 20433, fax 202-522-2422, e-mail: where he is presently assigned to the South Asia Energy and pubrights@worldbank.org. Infrastructure Unit. He is co-author of Mitigating Regulatory Risk for Distribution Privatization ­ The World Bank Partial Risk Guarantee, a discussion paper in this series. Prior to joining the CONTACT INFORMATION World Bank he was adviser to the Government of Uganda. To order additional copies please call the Energy and Water Help Desk 202-473-0652 energyhelpdesk@worldbank.org This paper is available online www.worldbank.org/energy/ The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or inclusion in any information storage and retrieval system, without the prior written permission of the World Bank. The World Bank encourages dissemination of its work and will normally grant permission promptly. For permis- sion to photocopy or reprint, please send a request with complete information to the Copyright Clearance Center, Inc, 222 Rosewood Drive, Danvers, MA 01923, USA, fax 978-750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street N.W., Washington DC, 20433, fax 202-522-2422, e-mail: pubrights@worldbank.org. THE WORLD BANK GROUP The Energy and Mining Sector Board The World Bank 1818 H Street N.W. Washington, D.C. 20433 USA E N E R G Y A N D M I N I N G S E C T O R B O A R D D I S C U S S I O N P A P E R P A P E R N O . 9 D E C E M B E R 2 0 0 3 Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries Tomoko Matsukawa, Robert Sheppard and Joseph Wright The World Bank, Washington, DC THE WORLD BANK GROUP The Energy and Mining Sector Board Copyright © 2003 The International Bank for Reconstruction and Development/The World Bank. All rights reserved CONTENTS INTRODUCTION..............................................................................................................2 1. WHAT IS FOREIGN EXCHANGE RISK?.....................................................................2 Interest Rate Parity Theory .........................................................................................3 Purchasing Power Parity Theory.................................................................................3 Forecasting Exchange Rates .......................................................................................3 2. FOREIGN EXCHANGE RISK ALLOCATION ...............................................................4 Investors ......................................................................................................................4 Consumers ...................................................................................................................5 Government.................................................................................................................5 Risk Allocation among Investors in Infrastructure Projects.......................................5 3. ALL INDUSTRIES FACE FOREIGN EXCHANGE RISK: WHAT'S SPECIAL ABOUT INFRASTRUCTURE?.........................................................6 4. MECHANISMS FOR THE ALLOCATION AND MITIGATION OF EXCHANGE RATE RISK ........................................................................................7 Local Currency Financing............................................................................................7 Local Capital and Bank Market Development ............................................................8 Local Currency Fund Schemes...................................................................................9 Local Currency Credit Enhancement..........................................................................9 iii MLA Local Currency Instruments .............................................................................11 Currency Hedges .......................................................................................................11 Mechanisms That Allocate Exchange Rate Risk to Government .............................12 Fixed Exchange Rates..............................................................................................12 Public Sector Lending in Local Currency ..................................................................13 Exchange Rate Guarantees .....................................................................................13 Tariff Indexes.............................................................................................................15 Foreign Exchange Index ..........................................................................................16 Inflation Index ........................................................................................................17 Regulatory Risk Mitigation.......................................................................................18 Liquidity Facilities......................................................................................................20 Escrow Accounts .....................................................................................................20 Liquidity Facilities Dedicated for Exchange Rate Risk Mitigation................................20 Suspension of Investment Programs ........................................................................22 5. SUMMARY OF FINDINGS ........................................................................................23 APPENDIX 1: CURRENCY CONVERTIBILITY GUARANTEES.......................................25 APPENDIX 2: DESCRIPTION OF OPIC'S REAL EXCHANGE RATE LIQUIDITY FACILITY..............................................................................26 APPENDIX 3: AN INTRODUCTION TO HOW RATINGS AGENCIES EVALUATE FOREIGN EXCHANGE RISK...............................................27 iv FOREWORD The importance of the infrastructure sectors in achieving growth, poverty reduction and the Millennium Development Goals is well established. Meanwhile, private financing of infrastructure projects in developing countries has decreased and private participation in the power sector has not reached the levels originally anticipated. Foreign exchange risk has been identified by private financiers as a major factor in their reluctance to invest in developing country infrastructure projects, especially in the wake of the East Asia financial crisis and the Argentine and Brazilian currency crisis. Foreign exchange risk is as much a concern for the financial sustainability of public infrastructure projects as for private projects. This paper explains how foreign exchange risk affects v power and water infrastructure projects. It analyzes the effectiveness of various mechanisms that have been used to mitigate the risk of local currency depreciation and examines how these may be improved, with a view to suggesting a variety of potential roles for donor agencies in facilitating foreign exchange risk mitigation. There is a range of approaches to mitigating and allocating foreign exchange risk and the best approach for each project will be determined by the specific project structure and the sector and country circumstances. We expect that paper will provide some insights for policy makers, stakeholders, private financiers and donors in meeting the challenge of mobilizing private financing for developing country power and water projects. Jamal Saghir Director, Energy and Water Chairman, Energy and Mining and Water and Sanitation Sector Boards Suman Babbar Senior Adviser/Acting Manager, Project Finance and Guarantees Infrastructure Economics and Finance Department ACKNOWLEDGEMENTS The paper benefited from reviews and comments of World Bank Group staff, in particular Issam Abousleiman, Aldo Baietti, Timothy Irwin, Joan Midthun Larrea, Angela Paris, and Usha Rao-Monari. The authors would like to extend their appreciation to Jamal Saghir and Michel Wormser, former Director, Private Participation and Finance (Project Finance and Guarantees) for their valuable support and guidance. We would also like to thank officials of regional multilateral agencies and private financiers who have provided valuable information. ACRONYMS AND ABBREVIATIONS IFC International Finance Corporation vi IPP Independent Power Project IRP Interest rate parity MIGA Multilateral Investment Guarantee Agency MLA Multilateral agencies OPIC Overseas Private Investment Corporation PCG Partial Credit Guarantee PPP Purchasing power parity PRG Partial Risk Guarantee INTRODUCTION It is important to note that in many cases the magnitude of other project risks will be too great for the The objective of this paper is to explain how foreign infrastructure project to obtain private financing exchange risk affects power and water infrastructure regardless of how foreign exchange risk is treated. This projects, to analyze the effectiveness of mechanisms that paper concentrates on foreign exchange risk because have been used to mitigate foreign exchange risk and private infrastructure financiers have identified it as a examine how they may be improved, and to suggest major factor in their reluctance to invest in developing roles for donor agencies in facilitating foreign exchange country power and water projects, especially in the wake risk mitigation. A key theme of the paper is that the of the East Asian financial crisis (1997) and the most appropriate mechanism for mitigating foreign Argentine and Brazilian currency crises (2001­2002).1 exchange risk will be determined by the specific The paper does, however, explore the relationship circumstances of the project and country in question. between foreign exchange risk and other related risks, The paper is designed to serve as an introduction to regulatory and political risks in particular. foreign exchange risk for stakeholders in the development and financing of infrastructure projects-- government officials, consumers, sponsors, investors, 1. WHAT IS FOREIGN EXCHANGE RISK? and donor agencies--and as an aid for designing foreign exchange risk mitigation mechanisms for specific Foreign exchange risk has the following components: 1 projects and countries. · Exchange Rate Risk: Exchange rate risk exists where a The occurrence of currency crises has coincided with project's revenues and costs are denominated in sharp reductions in private investment in infrastructure in different currencies. Exchange rate risk naturally has developing countries. Currency crises tend to have a an upside as well as a downside, but the experience negative effect on all the key stakeholders in an of most developing countries has been a local infrastructure project. In addition to financial loss, the currency depreciation against more stable industrial experience of investors is that contractual arrangements country currencies. for infrastructure projects have been broken or re- negotiated. Even when projects are financed on a non- Power and water projects typically generate revenues recourse basis, a currency crisis in foreign markets can in local currency, while their financing costs and fuel negatively affect an investor's credit rating as the value costs for thermal power projects are denominated in of foreign assets and their expected revenues decline U.S. dollars or other hard currencies.2 Depreciation in and investors face the choice of financing losses or the exchange rate can therefore result in revenues that writing-off their investment. Currency crises also are insufficient to cover costs. negatively affect consumers, for example, when the consequence is that service is interrupted, quality of · Convertibility Risk: Convertibility risk is the possibility that supply is impaired, or investment programs are a firm will be prevented from exchanging local currency suspended or postponed. for foreign currency by a policy action of the government to restrict access to foreign exchange, i.e., administrative Foreign exchange risk is as much a concern for public allocation of foreign exchange (rationing). projects as private ones. Private financiers, however, usually require infrastructure projects to be structured to · Transfer Risk: Transfer risk is the possibility that a firm mitigate foreign exchange risk, whereas this is not will be prevented from transferring foreign exchange always the case for publicly financed projects. While the out of the country. It is conceptually distinct from focus of this paper is how to mitigate foreign exchange convertibility risk but in practice rather similar, as risk sufficiently to attract private investment, many of the governments that have restricted convertibility have examples and findings are equally relevant to public also tended to limit transfer. projects and utilities. Private firms canvassed by the World Panel on Financing Global Water Infrastructure raised foreign exchange risk as a particular concern. 1 For brevity, this paper uses "dollars," except where noted, as the U.S. dollar is the most widely used foreign currency in infrastructure 2 project financings. There are several well-tested guarantee instruments rate between two countries equals the ratio of the price available to protect investors and lenders from level of a fixed basket of goods and services in each government actions to restrict conversion and transfer; country. Relative PPP is concerned with the rate of they are described in Appendix 1. This paper focuses change in price levels (inflation) and states that the rate principally on exchange rate risk. of depreciation of a currency is equal to the difference in inflation rates between the home country and a Interest Rate Parity Theory foreign country. Therefore, when a country's rate of inflation increases relative to others, its currency may be Interest rates and exchange rates determine the relative expected to depreciate in order to return to PPP. returns on assets denominated in local and foreign Empirical evidence tends to support this theory over a currencies. Interest rate parity (IRP) theory states that a medium-term (3- to 5-year) horizon. If PPP holds, it change in the interest rate differential between two implies that if a project's revenues are indexed to local countries will be off-set by an appreciation (depreciation) inflation, over the medium- to long-term the effects of of one currency against another currency, making the foreign exchange risk should be neutral.3 returns on local and foreign currency investments equivalent (thereby eliminating opportunities for Forecasting Exchange Rates arbitrage). If interest rate parity theory holds, interest rate 2 and exchange rate risks should be equivalent. There is, In addition to the IRP and PPP theories, there are others however, little empirical proof of IRP theory for the period that also offer useful insights. Although theories help us after the 1980s. Contrary to the theory, currencies with understand exchange rate movements, their predictive higher interest rates characteristically appreciated rather power is limited.4 While investors manage foreign than depreciated (possibly on the reward of future exchange risk at a portfolio level and in doing so have containment of inflation and a higher yielding currency). to form expectations about future exchange rates, when appraising investment in an infrastructure project In reality, investors do not consider assets denominated investors normally assume that future exchange rates in different currencies to be perfect substitutes. Assets will maintain the existing real exchange rate (i.e., that denominated in developing-country currencies tend to future exchange rates will reflect PPP, with the current carry a risk premium that reflects, among other things, period as the base for measuring PPP). They will, the risks of government interventions to restrict however, seek to structure a project that is sustainable convertibility and transfer and the difficulty in hedging and achieves a minimum internal rate of return, even in against exchange rate risk for currencies with the event of a "worst case" currency depreciation. undeveloped financial and currency derivatives markets. Empirical evidence supports the existence of a large risk premium and indicates that the value of the premium 2. FOREIGN EXCHANGE RISK ALLOCATION can be volatile. An important conclusion to be drawn from this is that foreign investors that accept foreign Extensive literature on risk allocation is premised on the exchange risks will factor this risk premium into their idea that a risk should be allocated to the party that expected rate of return on investment. controls it or is best able to manage it at the least cost. The problem with foreign exchange risk, and the reason Purchasing Power Parity Theory it is of perennial concern to investors, is that it is not directly in control of any of the parties, nor is it clear Purchasing power parity (PPP) theory states that which party can best manage it. The remainder of this exchange rates between currencies are in equilibrium section discusses the principles of risk allocation among when their purchasing power is the same in each of the project stakeholders as a basis for the later analysis of two countries. Absolute PPP states that the exchange the sustainability of various risk mitigation mechanisms. Whether a project can be sustained during the time it takes for exchange rates to adjust to their PPP level is another question, discussed 3 in section 4. For example, monetarist theories stress the importance of expectations in determining exchange rates and the value of reducing 4 informational asymmetries, for example, with regard to government policy intentions. Sticky price theories suggest exchange rates will continually over- and undershoot their equilibrium levels, further suggesting that whenever a project is financed, the local currency is likely to be under- or overvalued. There are three principal groups of stakeholders in an (described below), and if such opportunities exist, it may infrastructure project: investors, consumers, and be reasonable to expect that equity investors share in government. A risk allocated to a government may be foreign exchange risk in order to give them incentives to thought of as a risk borne by taxpayers (or future be innovative in its mitigation. taxpayers). In many developing countries where large proportions of the population do not have access to Section 1. notes that investors will expect a higher rate of electricity or water supply, consumers and taxpayers may return on their investment as compensation for bearing well be different sets of stakeholders (depending on the foreign exchange risk. Typically, an investor will endeavor to distribution of the tax burden). achieve this higher rate of return by paying less for privatized assets or by requiring higher tariffs. Consumers Government policies influence foreign exchange rates or the government (taxpayers) may therefore question through monetary and fiscal policy and foreign currency whether they are getting "good value" when the exchange market interventions. A government's policy orientation risk is allocated to investors, if they can bear the risk at a and its track record of macroeconomic management lower cost. are therefore of key concern to investors. However, even a country with good policy and sound macroeconomic Consumers management is exposed to the risk of currency depreciation caused by an external shock.5 This risk is There are two basic arguments for allocating exchange rate 3 especially acute in least developed countries, which risk to consumers. The first is that they are numerous and often (a) derive foreign exchange earnings from diversified and the risk would therefore be spread thinly exporting a limited set of basic commodities and (b) are over many individuals with none suffering significantly (a oil importers. There is also the risk that "contagion"--a similar argument is made with regard to taxpayers). The generalized failure of confidence in emerging market second is that consumers should pay the full cost of supply, currencies--may affect the value of a currency for including foreign exchange costs, as this price signal reasons beyond government control. Therefore, because encourages efficient demand-side responses, e.g., reducing foreign exchange risk is not directly controlled by any consumption or substituting a cheaper source of supply. single entity, the question turns to which party-- The problem with the former argument is that for poor government, investor, or consumers--is best able to households expenditures on energy and water supply form bear the risk. a large part of household income (often in the region of 20 percent). The problem with the latter argument is poor Investors consumers have limited potential to reduce consumption below a minimum that provides for basic needs. Also, It is sometimes argued that investors should be willing alternative types of supply are not perfect substitutes (e.g., to bear foreign exchange risk because they are able piped versus unprotected water supply), and there are often to hedge the risk in financial markets. However, barriers to substitution (e.g., the high capital cost of derivatives markets do not exist for many currencies. switching from electric power to gas). A second argument is that investors should bear foreign exchange risk because they are able to diversify Government this risk by owning a basket of assets denominated in different currencies. However, there are few if any Investors often argue that government is better able to bear multinationals active in power and water and large foreign exchange risk because it has an informational enough, or indeed with a broad enough range of advantage (due to knowledge of its own future policy investment opportunities, for this to be an effective intentions and its ability to use policy instruments to strategy.6 There are, however, a number of ways in influence the exchange rate). In this case a simple policy which exchange risk may be mitigated at the project level prescription is for the government to disclose as much of As important as the prevailing economic policy is a government's policy response to an external macroeconomic shock. 5 The argument may be extended by saying that even If foreign exchange risk cannot be mitigated at the corporate level, the company's 6 ultimate shareholders are able to diversify the risk exposure at the portfolio level. However, while the shareholders will seek to diversify their risk in this way, it does not follow that boards and management of companies will be indifferent about their own foreign exchange risk exposure. this information as possible.7 However, while this equity investment from the standpoint of the approach will engender greater confidence among developing country). investors, it is not a complete solution because there is uncertainty about (a) the policy a government will adopt It is easier for sponsors to use corporate funds or in response to an external shock and (b) policies that guaranteed project-level debt to finance infrastructure may be adopted by future governments. Therefore, one assets, but few do so (even in industrial countries). reason for the government to share in foreign exchange The reasons for this preference are the capital- risk is better to signal its policy objectives and to intensive nature of these assets and a desire to share demonstrate that it has an incentive to observe project risks with lenders and fixed-income investors. prudent policy. In the typical case, where the project sponsor finances a developing-country infrastructure project with non- A second argument is that the government should recourse debt, lenders or fixed-income investors will bear foreign exchange risk because taxpayers8 are require a transaction structure that would mitigate numerous and diversified, so the risk is spread thinly foreign exchange risk. Lenders and fixed-income over many individuals with none suffering significantly. investors will not generally assume exchange rate risk The difficulty with this is that governments typically (although they have of course found themselves in carry a lot of foreign exchange risk (e.g., foreign debt) transactions where the structure failed to mitigate such 4 and in a currency crisis foreign currency obligations to risk). A key issue is the extent to which equity may be infrastructure projects may fall due at a time when the expected to bear exchange rate risk. While equity government is least able to manage them. Hence, sponsors are expected to take more risk (and earn lenders are quite often skeptical about whether higher returns) than lenders, their preference is to government foreign exchange guarantees will be bear risks they can control, such as construction or honored (see Mechanisms That Allocate Exchange commercial risks, rather than exchange risks that they Rate Risk to Government below). cannot mitigate. Certainly the appetite of equity sponsors for exchange rate risk is lower today than it A third argument is that the government must bear was in the mid-1990s. This appetite may return if foreign exchange risk simply because the other there is a period of greater stability in emerging stakeholders to a project are not willing to. If investors market currencies and more positive investment consider the foreign exchange risk to be too great, they experience. Meanwhile, it is reasonable to expect that can choose not to invest. It may also be that the social equity sponsors will require at least partial protection costs of requiring consumers to bear the full cost of from exchange rate risk. exchange rate changes is too great, so the government must bear the risk as the last resort. In summary there is no conclusive argument that any single group of stakeholders to a project should bear Risk Allocation Among Investors in foreign exchange risk in its entirety. Moreover, there Infrastructure Projects are several reasons for sharing foreign exchange risk among a project's stakeholders: (a) it gives Sponsors that wish to acquire existing infrastructure government an incentive to signal its policy objectives assets or build new infrastructure projects in and live up to them, (b) it gives equity investors an developing countries have a choice of recourse or incentive to mitigate a project's foreign exchange risk non-recourse debt. Recourse debt can be incurred at exposure, and (c) it gives consumers price signals that the project level and guaranteed by the sponsor or encourage demand-side responses. However, can be incurred by the sponsor at the corporate ultimately financiers and rating agencies will level (usually in the financial markets of the independently assess the allocation of foreign sponsor's home country) and down-streamed to the exchange risk, and their views will determine the project company (with the sponsor's investment in availability of financing. Whereas governments and the developing-country asset appearing as an all- consumers consider power and water supply a See Mas 1997 7 This includes present and future taxpayers. To the extent that all citizens enjoy public services and public finances are affected by 8 government exposure to foreign exchange risk, a risk to government is a risk borne by all citizens. necessity, financiers can always choose to invest in other commitments of private operators during the projects and sectors. It is reasonable to expect that (a) concession period also involve foreign exchange risk. foreign currency lenders will always require foreign exchange risk protection and (b) sponsors (equity · Assets Difficult to Re-Deploy: Power and water investors) will in most cases expect at least partial projects are capital intensive, and most assets may protection from foreign exchange risk. not be re-deployed once they have been installed. In addition, regulations often restrict the sale of power and water assets. It is therefore more difficult for 3. ALL INDUSTRIES FACE FOREIGN investors to exit from their investment in order to EXCHANGE RISK: WHAT'S SPECIAL ABOUT minimize foreign exchange losses. An important INFRASTRUCTURE? consequence of this is the weak bargaining position investors have in the event of a contract Most foreign investors face exchange rate risks; renegotiation following a financial crisis. An off-taker however, for the reasons described below, exchange usually has an incentive to ensure the project has rate risk is of special concern to investors in power and sufficient revenue to cover its operating costs in order water projects. None of the factors described below are to ensure continued supply; however, because the exclusive to power and water projects, but taken together assets may not be redeployed, the off-taker is less they tend to increase exposure to exchange rate risk:9 concerned that the project is able to meet its fixed 5 costs (debt service and equity returns). · Financing Needs Exceed Local Markets' Capacity: In many developing countries the financing requirements · Non-Tradable Outputs: With the exception of some of power and water investments are large relative to export-based power generation schemes, the output the size of local capital markets. Undeveloped capital of power and water production projects and the markets typically do not provide credit with tenors long services provided by distribution businesses are not enough to match the lives of power and water assets. tradable on international markets. This may be Infrastructure investors are therefore more likely to compared to investments that produce tradable goods have to turn to international markets to raise capital. or services that have some protection from foreign exchange risk because local currency depreciation · Long Pay-Back Periods: Power and water assets are makes the goods or services cheaper on international often depreciated over 20­30 years, meaning that markets, leading to an increase in sales and revenues. investments tend to be recovered over a longer period and increasing the risk that a currency crisis · Regulated Prices: Because water and power will occur at some point during the project's life. distribution networks are characterized by economies of scale, the market can only support one distribution · Dollar-Denominated Inputs and Expansion Costs: network in a given geographical area. Prices for Thermal power generation projects have the major network services are therefore regulated to protect component of their operating costs (fuel) consumers from the abuse of monopoly power. denominated in hard currencies (this is less of a Moreover, water and electricity supply is considered concern for water production, sewerage treatment, valuable to the welfare of households, so the pricing and renewable energy generation projects, which of these services has a political dimension. In times of have lower operating costs). In developing countries financial crisis when households are exposed to the expansion of service is a major objective of privatized effects of higher interest rates, unemployment, and water and power distribution networks. The plant and inflation, the risk that the government will fail to apply equipment required for network extension are often earlier pricing agreements is significant. manufactured outside the host country and priced in hard currencies, which means that staged investment Other infrastructure sectors share many of these features, and where fewer of them apply, exchange rate risk exposure appears to be of 9 less concern. For example, these features apply for telecommunications except that (a) the pay-back period is generally shorter and (b) prices are often unregulated. These features apply for buildings except that (a) the size of investment is likely to be better matched to the depth of local markets, (b) assets are easily re-deployable, and (c) prices are also typically not regulated. 4. MECHANISMS FOR THE ALLOCATION AND local currency financing for infrastructure. Others (e.g., MITIGATION OF EXCHANGE RATE RISK possibly India, Peru, and Brazil) have emerging long-term debt markets, where interventions can be made to extend This section describes several ways of mitigating foreign the tenors available or to enable infrastructure projects to exchange risk, which may be categorized as follows: (a) access long-term debt (or currency swap) markets from reducing the problem by matching the currency in which which they may otherwise have been excluded. This expenses--especially the project's financing costs--are section discusses a number of approaches to facilitate incurred to the currency of the project's revenues ("local local currency infrastructure financing. It is important to currency financing"), (b) governmental macroeconomic note that local and foreign currency financing are not policy and, specifically, undertakings regarding exchange mutually exclusive, and even a small tranche of local rate policies, (c) standardized financial instruments that currency debt may improve the sustainability of a project are publicly traded or can be purchased with enhanced in a currency crisis. terms on a one-off basis in a private transaction ("hedges"), (d) contractual or regulatory provisions Local Capital and Bank Market Development ("tariff indexes"), and (e) liquidity facilities or other contingent financial commitments ("liquidity facilities"). Market capacity can be a significant issue for the Each of these approaches results in a different allocation financing of water and power projects, given their large 6 of risk among the stakeholders (government, consumers, capital requirements. Moreover, in many capital markets sponsors, and lenders) in an infrastructure project. the available tenors for debt are too short to match with the project pay-back periods. The development of a Local Currency Financing bank market offering long-term loans in local currency typically requires that banks be able to finance Local currency financing is attractive because it themselves on a long-term basis in local currency; if this eliminates the potential currency mismatch between a is not feasible, banks offer short-term local currency project's revenues and its debt service.10 Some developing financing.11 A similar problem arises with interest rate countries (e.g., Chile, Malaysia, and Mexico) have risk; unless there are markets in long-term, fixed-rate domestic markets that can provide long-term, fixed-rate instruments (e.g., government bonds) then longer-term debt will have a floating rate. BOX 1. The Gujarat Torrent Power Plant Efforts to promote local currency financing must respond to the specific constraints to local capital This was the first large private power project in India market development and infrastructure finance in the to achieve financial closure without a sovereign country in question. Possible constraints may include: guarantee (though there was a state guarantee of the off-taker's obligations). The Rs 24.55 billion project achieved financial closure in 1995 and was · Lack of experience of infrastructure or project finance financed with a debt-equity ratio of 70:30. Indian lending financial institutions and banks provided Rupee term loans of Rs 3.01 billion (12 percent of project costs) · The absence of long-term government bonds to and foreign currency loans of Rs 5.72 billion (23 provide a basis for pricing long-term debt percent), plus commercial guarantee cover for the remaining debt, which was provided in foreign · Government borrowing that crowds the private sector currency by international lenders. out of capital markets To facilitate mobilization of funds from the banking · Government lending that inhibits local finance for sector, the Reserve Bank of India relaxed the infrastructure, e.g., lending to infrastructure at below- exposure limit for the banking sector and funds for power project investments. market rates or to projects that would not be considered creditworthy by local investors, thereby This will not eliminate exchange rate risk where other project inputs (e.g., fuel) are denominated in foreign currency. However, given the 10 magnitude of the capital costs in infrastructure projects, local currency financing will be a major part of the solution to exchange rate risk. Local banks could obtain long-term financing in dollars, but this approach merely transfers the risk from the borrower to the lender. 11 reducing incentives for sponsors to present bankable long-term bond markets and water investments (though projects in the future these have been municipal projects, which carry implicit or explicit government guarantees). The Infrastructure · Legal constraints and prudential regulations with Development Finance Company of India, which has a respect to diversification and asset classes, perhaps similar structure, has also participated in the financing owned by institutional investors, such as pension of power sector projects. funds and insurance companies. Local Currency Credit Enhancement The development of local capital markets is a long and gradual process, and it is beyond the scope of this Partial Credit Guarantees paper to fully explain this issue. The remainder of this section discusses interventions that governments and/ or Partial credit guarantees (PCGs) can be structured to donor agencies may take to assist infrastructure projects mitigate specific credit risks for local banks and bond in mobilizing local currency debt in situations where investors and may be applied to facilitate financing in there is a market in local currency debt, but (a) the debt situations where the borrower can access the local is not sufficiently mature to be useful for financing credit market but cannot realize sufficiently long tenors. infrastructure projects or (b) long-term local currency A PCG may be structured as follows: financing would be available if investors could be 7 protected from other risks. · To cover later maturity payments; this may be appropriate where long-term debt instruments exist Local Currency Fund Schemes but lenders are uncomfortable with the duration of infrastructure investments. Fund schemes may facilitate local currency debt financing by (a) providing additional security to lenders, · To cover a certain amount of debt service payments (b) diversifying project risks, and/ or (c) reducing over the life of the credit; this guarantee could be transaction costs. Typically, a fund scheme would use its provided on a rolling basis which, if not called, will initial capitalization--which could be provided by be moved to subsequent debt service payments; this private investors, donor agencies, or the government12 may be appropriate where there are long-term debt --as a reserve fund. It would then issue bonds, using markets but financiers are deterred by concern about the proceeds to lend to infrastructure projects, with the temporary interruptions to the project's ability to reserve fund securing bond debt service payments. The service debt. fund therefore acts as an intermediary, facilitating supply of domestic capital market funds to infrastructure. By · As a put option or call of take-out financing, in enhancing credit quality (by providing additional security particular where banks and institutional investors are and diversifying project risks), such funds can enable unwilling to commit to long-term assets due to the infrastructure projects to access long-term local currency lack of matching funds. With a put option the lender debt markets from which they otherwise may have been makes a long-term loan but has the option to sell the excluded. By aggregating several infrastructure projects, loan to the guarantor at an earlier date. Brazil's they may also permit smaller projects to access local development bank, BNDES, provided put instruments capital markets where transaction costs otherwise would for two power transactions (see Box 2). With take-out have excluded them. Such a fund can mobilize domestic financing13 the guarantor commits to extend credit to finance by providing expertise in the appraisal of (a) the borrower in lieu of the initial creditor upon infrastructure that may not have previously been present take-out or (b) the lender to enable it to extend long- in the capital markets. The Infrastructure Finance term credit by protecting it from re-financing risk. Corporation of South Africa is one example of a fund scheme that has been a successful intermediary between Sponsors could provide additional security to lenders by providing contingent reserve funds or subordinated loans. 12 Take-out financing is different from a guarantee in that it could be structured as a loan, while under a guarantee the guarantor would have 13 a right to be subrogated to claim repayment from the defaulting party on demand. Take-out financing could be structured to trigger a take-out upon events other than debt service defaults; while financial guarantees are called upon defaults. BOX 2. BNDES Put Structures BOX 3. Mexico: Talnepantla Municipal Water Project (2003) Brazil's development bank, Banco Nacional de Desenvolvimento Econômico e Social (BNDES), has A Mexican trust ("the trust") was set up to issue up provided puts for two power transactions and two to $8.8 million in local currency bonds (Certificados transport sector projects. The power transactions Bursatiles) in the domestic capital market to make a were Ita Energetica (R$84 million) and Machadinho loan to the Municipality of Tlalnepantla de Vaz and Energetica (R$320 million), both announced in its municipal water utility to finance water December 2000. (Machadinho also featured a conservation projects. The municipality pledged guarantee of the project's debt provided by the property taxes, and the municipal water utility project's sponsors, which are prominent Brazilian pledged its water fees to secure the loan from the corporations.) The put in each of these transactions trust. IFC provided a partial credit guarantee to the is exercisable on a date certain, but only if the trust (for the benefit of bond holders) up to $3 project's debt is not in default. Local investors are, million, alongside Dexia Credit Local Agency N.Y., therefore, required to take all project risks until the which issued a letter of credit for up to $5.3 million. date on which the put is exercisable. The transaction is IFC's first direct municipal finance deal and facilitates the municipality's access to local Following the completion of these transactions, capital markets by alleviating credit risk for 8 BNDES became concerned that the puts would be institutional investors. exercised by investors, not for project-specific risks, but rather as a result of issues affecting an entire sector. BNDES worried that if all outstanding puts application by having its call made conditional upon were to be exercised, it could experience a liquidity certain external events (such as local currency crisis. Purchase of the securities pursuant to the puts devaluation) or borrower performance of certain could require BNDES, with little notice, to access commercial obligations. financial markets at a time when market conditions might be unfavorable. BNDES has no current plans The International Finance Corporation (IFC), for example, to offer this structure for new transactions. has started offering a local currency PCG which may be employed to mobilize longer-term local currency debt and recently provided its first PCG to a water project in Mexico14 Such credit guarantees can be extended by a state- (see Box 3). owned financial institution, if its credit is perceived as adequate by the market. Donors may play a guarantor Partial Risk Guarantees (PRGs) role when commercial institutions require greater credit strength than that of the state-owned guarantor. Donors Local financiers may be expected to have a greater appetite may also provide up-front funding or a funding than foreign financiers for political and regulatory risks in their commitment for government-sponsored credit guarantee home countries because they have a better understanding of schemes to enhance the credit of the local guarantor. local conditions; however, they still may consider these risks to be too great to invest long term. In such instances partial risk Partial credit guarantees could be extended to both guarantees or political risk insurance could be used to public and private infrastructure projects or mobilize longer-term local currency finance where local municipalities to help them access local currency currency commercial creditors are willing to take commercial commercial debt. The guarantee coverage should be project risks but are deterred by uncertainty in the political set to balance the needs to mobilize term debt financing and/ or regulatory environment.15 To this end, PRGs can be and encourage local creditors to increase risk taking. extended by a state-owned financial institution and may be The selection criteria, pricing, and security mechanism backstopped by multilateral agencies (MLAs), many of which should be developed to avoid moral hazard on the part offer this type of instrument. of the borrower. The PCG could be limited in its IFC local currency PCGs have also been used to finance non-infrastructure projects in Thailand and India. 14 PRGs can also be used to guarantee the performance of regulatory agreements, which provide protection to foreign creditors against 15 foreign exchange risk. BOX 4. GuarantCo: A Local Currency BOX 5. Chile­Santiago-Valparaiso-Vina del Mar Guarantee Facility Toll Road Concession Project (2002) Several donors (including the governments of The project is a concession for construction/ Britain, the Netherlands, Switzerland, and Sweden, rehabilitation and operation of toll roads with the IFC, and the World Bank) are supporting the foreign sponsors. The Inter-American Development establishment of a local currency guarantee facility Bank/Private Sector Department (IDB/PSD) provided (GuarantCo) to facilitate access to local financial a full-wrap guarantee for the equivalent of $300 markets for sub-national borrowers--they may be million of three-tranche Chilean UF-denominated, sub-national governments, utilities, or private firms limited-recourse project bonds. IDB/PSD has taken engaged in infrastructure projects. The donors on $75 million equivalent of debt service on its intend initially to contribute some $130 million book (up to its institutional limit) and serves as the towards a target capitalization of $200 million. guarantor of record for FSA, a monoline insurer, to GuarantCo will be a global facility providing partial provide a guarantee umbrella for the private co- guarantees to eligible borrowers without guarantor. The guaranteed bonds were issued with requirement of sovereign government counter- a 23-year maturity, the longest achieved for Chilean guarantees. Details of the facility design and infrastructure bonds, and a fixed rate of 5.8 percent, administrative arrangement are being prepared. the lowest coupon rate achieved by local currency 9 Chilean infrastructure bonds. The full guarantee enabled the private concession project to attract local institutional investor capital in a sizable amount. Also, an international guarantee fund is being developed to provide partial credit/ risk guarantees for infrastructure projects (see Box 4). (a) in currencies where cross-currency swaps can be Comprehensive Guarantees made to hedge the MLA's exposure or (b) when the donor can raise funds in the same currency in order to match its One approach to lengthening tenors in local currency exposure. IFC, for example, is lending in local currency to financing is to improve the credit profile of the borrower projects in developing countries where it can fully hedge by eliminating all project risk and decoupling fund its foreign exchange exposure back to dollars in the providers and risk takers (see Box 5). With this currency swap market.16 approach, a long-term loan in local currency is made to an infrastructure project by a local financial institution, Some MLAs such as IFC also intermediate currency but the loan is guaranteed by an international/ regional swaps to convert foreign currency loans to local bank that has experience with project financings. If the currency. As with local currency loans, such instruments international bank is concerned about political risk in are usually available only where currency swap counter- the host country with respect to issues such as stability of parties are available in the market for the MLA to hedge the regulatory framework for the sector, this risk can be its position. Swap intermediation by an MLA can be mitigated by undertakings of the host country valuable (a) where the borrower is not sufficiently government, backstopped by a partial risk guarantee creditworthy to become a counter-party in the swap from an MLA. market (typically swap market participants are highly credit sensitive) or (b) where the borrower's transaction MLA Local Currency Instruments costs would be high because it lacks experience in the derivative markets. Some MLAs have started lending in local currency and are seeking opportunities to make local currency loans to infrastructure projects. Due to risk control requirements of MLAs, local currency loans are most likely to be available IBRD cannot offer a loan in the local currency of the borrower, but once funds are disbursed out of the loan, the borrower can choose to 16 convert the disbursed and outstanding amount used to finance local expenditures into the local currency to the extent that a cross- currency market exists. Currency Hedges Argentina provides the most recent example of the consequences of a country's being forced to abandon a In theory, infrastructure projects could eliminate foreign fixed exchange­rate regime. Equity investors in exchange risk by entering into a series of forward Argentina's privatized infrastructure assets (and the exchange rate agreements. Such an agreement would lenders and fixed-income investors that financed these enable the project to purchase for future delivery the entities without recourse to their foreign owners) regarded amount of dollars needed to make each scheduled debt the peso's peg to the dollar as sufficient assurance of the service payment in return for delivery of local currency dollar value of projected cash flows. When Argentina in amounts determined by the forward exchange rates in abandoned the peg, the resulting sharp devaluation so effect at the closing of the project's financing. However, reduced the dollar value of local currency cash flows that long-dated forward exchange rates exist for only a many firms defaulted on their dollar-denominated debt. handful of non-OECD countries and are almost The effect of the devaluation was exacerbated by the exclusively limited to countries with investment-grade ratings. Forward rates of five years or longer are readily available for Chile, Malaysia, and Mexico, among BOX 6. Argentina's Devaluation and Its Impact on upper-middle­income countries (and for certain Utilities investment-grade countries in Eastern Europe); for 10 China, the Philippines, South Africa, and Thailand, Until January 2002 the Argentine peso was pegged among lower-middle­income countries; and for India to the dollar, and utility tariffs were effectively and Indonesia, among low-income countries. In these indexed to the foreign exchange rate, thus protecting investors with foreign currency debt from lower-middle and low-income countries, it is unlikely the risk of currency depreciation. Between January that forward foreign exchange transactions could be 2002 and January 2003, the peso lost 70 percent of arranged at an affordable cost with sufficient tenor to its value following the removal of the peg. The serve as the basis for financing an infrastructure project. government initially banned implementation of tariff As a practical matter, forward foreign exchange indexation mechanisms for utilities, freezing tariffs transactions have not been used to finance infrastructure at their January 2002 peso levels (with the intention projects in developing or industrial countries. of reducing inflationary pressures and protecting consumers amid a sharp economic downturn). The Mechanisms That Allocate Exchange Rate Risk examples of Aguas Argentinas (the Buenos Aires to Government water and sewerage provider, 35 percent owned by Suez Lyonnaise des Eaux S.A.) and Edenor (northern Fixed Exchange Rates Buenos Aires electricity distributor, 90 percent owned by Electricité de France [EdF]) illustrate the impact on utilities, as follows: (a) suspension of In theory, a fixed exchange rate removes foreign investment programs, (b) debt defaults, (c) credit exchange risk from an infrastructure project's owners, downgrades, (d) provision for losses at parent lenders, and customers and places it on the government company level, and (e) inability to fund operation (taxpayers) of the host country. Although fixed exchange and maintenance expenses leading to a rates have been maintained for reasonably long periods deterioration in service quality. when measured by the needs of trade finance, these periods of stability are much shorter if viewed against Under pressure from the utilities and MLAs, the the needs of infrastructure projects financed with 10- to government made several attempts to increase 15-year debt. Fixed exchange­rate regimes are capable utility rates in November 2002 and January 2003 of driving nominal exchange rates to levels that are both of which were blocked by Argentine courts. dramatically different from market-determined rates. For The proposed increase in average electricity tariffs of 9 percent was considerably less than the countries that are forced to abandon a fixed exchange minimum 30 percent requested by utilities. The rate rate, the volatility of the real exchange rate immediately increase was also designed to protect low-income following devaluation is typically far greater than the residential consumers, with 40 percent being volatility associated with floating or managed-float systems. exempt. Industrial consumers on the other hand were expected to face a 25 percent increase. government's decision to freeze tariffs, denying any exchange risk exposure, there is a risk that the spread increases that could have provided even a partial offset may not be sufficient to cover the losses caused by a for the decline in currency values. For project sponsors severe currency depreciation (this is similar to the and lenders to infrastructure projects, Argentina has limitations of exchange rate guarantees, discussed provided a particularly instructive lesson in the interplay of below). As a general principle, if it is specifically currency risk and regulatory risk (see Box 6). foreign exchange risk that is being targeted, then government resources are likely to leverage more Whatever benefits fixed exchange rates may have, private finance through a more carefully focused because they have not proven sustainable, they guarantee or liquidity facility arrangements (see represent the worst choice of exchange rate regime for Section Liquidity Facilities Dedicated for Exchange the successful financing of infrastructure projects.17 The Rate Risk Mitigation below). consequences of the collapse of fixed exchange­rate regimes are likely to be severe because of the Exchange Rate Guarantees magnitude of ensuing depreciation. An alternative approach is for the government to Public Sector Lending in Local Currency guarantee the exchange rate for a specific project. Theoretically, such a scheme fully protects lenders and One common solution to the absence of local long- sponsors from exchange rate risk. The scheme also 11 term debt markets or difficulties in allocating exchange protects the off-taker and/ or consumers from cost rate risk to consumers and foreign investors has been increases caused by exchange rate changes. However, in local currency lending by the government. Loans may practice an exchange rate guarantee is not likely to be be made either directly or indirectly through state- sustainable. As with government local currency on-lending owned financial institutions. In countries with a broad of foreign currency loans, an exchange rate guarantee is range of sectoral risks (in addition to foreign exchange usually provided because long- term local debt is not risk) that serve to prohibit private financing of power available and markets do not exist to hedge the risk. If and water infrastructure, public financing may well be this is the case, then the government will also not be the only alternative. However, in this case governments able effectively to price or hedge its exposure. In the should be careful not to use public financing as a event of a devaluation, the guarantee will be one of substitute for reforms that would facilitate private multiple calls on the government's foreign exchange financing. In particular, governments should be wary of reserves. Given that governments often do not properly providing capital that crowds out private investment or disclose and account for contingent liabilities such as that, by assuming greater levels of risk, inhibits the guarantees, they can also serve to amplify financial development of a pipeline of projects that could be crisis by draining foreign exchange reserves and limiting financed by the private sector. Public financing may, government policy options. A further problem is that a however, be used to leverage private investment, for fixed exchange­rate guarantee sets a bad precedent for example, when the loan from the government is future projects (in the power sector and others). There is subordinated and under some output-based aid a risk that similar guarantees would be provided to schemes. When a government provides long-term, other projects, thus increasing the government's overall fixed-interest rate local currency debt, it is accepting the risk exposure and making all guarantees (and the foreign exchange risk in its entirety (along with other government) less creditworthy. Exchange rate project risks). In instances where a government is able guarantees can crowd out local financing in countries to borrow from donors on concessional terms to finance where a market for term debt is emerging. Lastly, the water and power projects, if it on-lends the funds to presence of an exchange rate guarantee also inhibits projects at a higher interest rate, then it may use the the development of projects with alternative foreign spread between the foreign currency fixed-interest rate exchange risk mitigation mechanisms. Despite these loan and the local currency loan on-lending rate to drawbacks, an exchange rate guarantee for a specific provide partial cover against devaluation risks. However, project (a "pioneer" project, for example) would be if the government cannot properly price its foreign preferable to government financing of the project, This statement should be qualified in its application to small countries that have tied their exchange rate to that of a dominant trading 17 partner. In such cases, the smaller country's currency is less likely to become overvalued relative to the dollar or other major currencies. because the exchange rate guarantee exposes the While government exchange rate guarantees for government to a single risk rather than the full range of infrastructure projects have often not been sustainable, project risks. there may be situations where they are unavoidable. In particular where local capital markets are undeveloped, During the 1990s, the government of Pakistan guaranteed foreign investors would rather invest elsewhere than bear foreign exchange-indexed tariff agreements for a group of the risk, and the social cost of allocating the risks to electric power generating projects (see Box 7 for a consumers is unacceptable (or politically unsustainable). description of this scheme as applied to the HUBCO Nonetheless, the assumption of foreign exchange risk is a project). Most governments, even prior to the Asian crisis of liability (in the case of a foreign currency loan) or a the late 1990s, were reluctant to issue such guarantees, contingent liability (in the case of a guaranteed exchange and those that did so viewed them as a means of rate) that affects the government's creditworthiness. jumpstarting the sector, rather than as permanent policies. Therefore, if guarantees are to be credible, it is important that the government fully understands and manages its own risk exposure, in particular by properly valuing and BOX 7. Pakistan Foreign Exchange Risk Insurance disclosing its contingent liabilities. Programs can also be Scheme designed to mitigate this risk by, for example, promoting the development of markets that enable the government to 12 Pakistan employed the foreign exchange risk price its risk exposure better, charging a premium for insurance scheme (ERIS, formerly called FERI) for the guarantees that reflects this price, reducing the magnitude country's first IPP, Hub Power Project, in 1994 to mitigate foreign exchange risk associated with the of guarantees over time, and applying guarantees in a way foreign currency debt service of the project that leverages uncovered investment. company, HUBCO. The exchange rate was fixed for each loan currency at project completion in 1997 at Tariff Indexes the weighted average of actual exchange rates at the time of loan disbursements. HUBCO pays semi- Long-term contracts for the sale of output from power annual fees (e.g., 6.7 percent per annum for dollars plants or water treatment facilities and regulatory to 9.1 percent per annum for Japanese yen) to the agreements that determine power or water distribution central bank, SBP, which serves as the insurer. If the prices generally provide a mechanism for adjusting tariffs actual local currency debt service amount at the on a periodic basis. In some instances the tariff may be spot rate exceeds the insured amount, SBP pays the adjusted by a single index (e.g., the foreign exchange rate difference to a remittance bank; and if the actual or local inflation). However, more commonly the tariff amount required is below the insured amount, the bank pays the difference to SBP. The HUBCO power adjustment formula categorizes the project's expenses and purchase agreement permitted it to pass on the applies an appropriate adjustment index to each ("complex foreign exchange insurance fees to the off-taker, tariffs"). For example, fuel expenses may be adjusted by an Water and Power Development Authority. The international fuel price index,18 locally incurred operation Rupee's depreciation turned out to be greater than and maintenance expenses by the local inflation rate, and that expected by SBP with the result that the fixed the component representing foreign currency debt service fee was not adequate compensation for its risk and equity returns by the foreign exchange rate. exposure. As a result ERIS was discontinued. Contract terms for all IPP's were re-negotiated after As a general principle investors are better protected by the 1997 currency crisis. This example illustrates the frequent tariff adjustments to reflect cost changes. With less limitations to a government's ability to accept frequent adjustments an investor faces greater risk of losses foreign exchange risks where it is not able to hedge during the lag between currency depreciation and tariff such risk. adjustment. Brazilian power distributors, which can only increase tariffs annually, were faced with this problem until 2001 when an arrangement was made to track the The fossil fuels used in thermal generating plants are normally priced in dollars, and these prices tend to reflect world market prices, with 18 appropriate adjustments for fuel quality and transportation costs. Financial instruments to hedge fossil fuel prices are widely available for long tenors, but these instruments provide a hedge against fluctuations in the dollar price of the fuel. They do not offer a means of hedging the price in local currency. BOX 8. The Manila Water Concessions differences (positive and negative) between actual and allowed power purchase costs and enable them to be Tariff regulation for the two Manila water and recovered at the annual tariff adjustment. The risk with such sewerage concessions, which were let in August a "tracking account" approach, however, is that the annual 1997, includes several of the features discussed in tariff increase may be larger as a consequence, increasing section 4. It allows for an extraordinary price the risk of popular opposition and political intervention. adjustment (EPA) in response to changes in The distributor also faces the additional cost of financing exchange rates which affect debt service payments the increased costs in the lag before the retail tariff made by the concessionaire relating to debt that adjustment. Nicaragua has responded to this problem by pre-dated the privatization and new loans taken allowing a tariff adjustment when the value of the tracking out by the concessionaire. The tariff adjustment was account exceeds a defined threshold.19 to allow the concessionaires to recoup foreign exchange losses over the remaining life of the 25-year concessions. In order to obtain an EPA, the The way in which the index is calculated also affects the concessionaire must submit to the regulator a allocation of exchange rate risk. For example, an index statement of debt service expenses for the year based on a daily spot price is likely to produce a more stating (a) the currency of the loans (b) the exchange volatile tariff than one based on a moving average rate for each currency at the tariff calculation reference calculated over several months. Reduced price volatility is date, December 1996, and (c) the exchange rate generally in the interests of consumers (or off-takers) as they 13 for each loan for the date on which debt service will face more predictable energy and water prices and will payments were made. If the difference between the be better able to budget for them. However, from the exchange rate at the start of the concession and perspective of project sponsors an index based on an the rate at the time of the debt service payment is average will require them to arrange additional financing greater than 2 percent then an adjustment is (or accept reduced equity returns) for the period during which permissible. EPA requests were made following the the average index is lower than the prevailing spot rate. A East Asian financial crisis; however, it was four years before a price adjustment was approved, during sustainable tariff index is likely to be one that protects which time there was a lengthy period of arbitration. consumers from excessive price volatility without placing Both concessionaires requested real-time, automatic onerous requirements on the project for additional financing. and quarterly adjustment of tariffs to reflect foreign exchange movements. Maynilad, one of the Another feature of some tariff indexes is a dead-band, concessionaires covering the west part of the city, which can serve to share risks between a project and its inherited 90 percent of the MSWW's $800 million off-takers. In this case the tariff would be adjusted only by debt at the time of the concession in 1997, which it the amount that the index change exceeds a defined agreed to pay through the monthly payment of the threshold during a given period. This has the effect of concession fees. In early 2003 Maynilad filed to allocating to the project the risk of index escalation up to terminate its concession claiming that, among a the threshold. Any change in the index in excess of the number of disputes, the EPA mechanism was not threshold would be passed on to consumers. If, for implemented according to the concession agreement and that the adjustment was not sufficient to example, the threshold were +/ - 5 percent and the index cover the costs of currency depreciation. The other increased by 9 percent, the tariff would be adjusted by 4 concession, Manila Water Co with much lower percent and the project would bear the first 5 percent of inherited foreign currency payments, also requested the cost increases. Such an arrangement where the project and received rate hikes beyond the EPA and seems takes the "first cut" of the index change risk could give the to have faired better. sponsors an incentive to reduce their exposure to the risk by, for example, reducing foreign currency costs as a proportion of total costs.20 This section draws on B. Tenenbaum et al., "Regulation by Contract", (2003) World Bank Energy and Mining Sector Board Discussion 19 Paper No. 7, World Bank. An alternative way of structuring a dead-band is for the tariff to be adjusted by the full value of the index change once it exceeds the 20 dead-band. For example, if the index dead-band were +/ - 5 percent and the index increased by 4 percent, there would be no tariff adjustment. However, if the index increased by 6 percent, there would be a corresponding 6 percent tariff increase. This approach is less likely to be sustainable because it has the effect of amplifying tariff volatility: it passes on to consumers only the large cost increases, when smaller, incremental increases would likely be affordable. Foreign Exchange Index BOX 9. Examples of Projects with Tariff Indexes Most commonly, developing-country infrastructure FX RISK PROTECTION projects financed with foreign currency debt feature a PROVIDED BY TARIFF license or contract that adjusts tariffs by a foreign COUNTRY/ PROJECT INDEX exchange index. This applies especially for power generation projects that were financed in both the bank China, Tangshan IPP Tariff is indexed to dollars market and the capital markets during the 1990s. Such and adjusted for agreements contractually shift the risk of devaluation exchange rate changes from the project to its customers. During periods when over 5 percent/ year. the local currency is strengthening in real terms, a Honduras, ELCOSA IPP Fixed financial and foreign exchange-indexed tariff provides off-takers with operation and a declining real cost (measured in local currency) for maintenance components the service provided by the project.21 Conversely, during of tariff are indexed to periods when the host country's currency is weakening the dollar. in real terms, a foreign exchange-indexed tariff forces Mexico, Samalayuca IPP Payments are off-takers to pay an increasing real cost (measured in 14 denominated and paid in local currency). dollars. Pakistan, Uch IPP Portion of tariff relating to In practice foreign exchange-indexed tariffs have not foreign currency costs is held up well under stress. Following major devaluations indexed to exchange rate. in Indonesia and Argentina,22 political authorities Philippines, Sual IPP Tariff is denominated and refused to permit tariff increases sufficient to paid in dollars. compensate for the decline in the dollar value of project Turkey, Birecik IPP Payments are revenues resulting from the devaluation. The denominated and paid in fundamental difficulty with foreign exchange-indexed deutsche marks. tariffs is the risk that when the time comes to increase India, Jegurupadu IPP Portion of tariff relating to prices to consumers by much more than the rate of foreign currency costs is inflation (which will certainly occur at some point during indexed to exchange rate. a multi-year agreement), political authorities may Indonesia, East Jakarata Portion of tariff related to intervene to hold down consumer prices or, in the case Water Lease the dollar debt service of electric generators or bulk water suppliers, the off- costs is indexed to taker may default on the agreement and seek to exchange rate. renegotiate. Even if consumers have had the benefit of Argentina, West Buenos Tariff denominated in declining real prices during a period when the local Aires, Water and dollars and indexed to US currency strengthened, these prices will tend to be Sewerage Concession CPI. regarded as "normal" and subsequent price increases Gabon Electricity and Foreign currency costs are above the rate of inflation will naturally be unpopular Water Concession indexed to CFA exchange and cause hardship. rate; quarterly adjustment; exceptional adjustment allowed if escalation exceeds 50 percent. Financing for infrastructure projects is typically based on contractual structures which at the closing of the project's financing produce adequate 21 projected debt service coverage ratios, assuming that the real exchange rate for the host country remains constant throughout the tenor of the project's financing. The performance of a foreign exchange­indexed tariff will depend upon whether the host country's currency is overvalued or undervalued when the base price of the foreign exchange­indexed tariff is established, although little, if any, effort by sponsors or lenders is directed at determining whether the currency of the host country is overvalued, undervalued, or fairly valued at the start of the transaction. By pegging its currency to the dollar, Argentina converted its utility tariffs to the equivalent of foreign exchange-indexed tariffs. 22 Water production or power generation projects BOX 10. Light: an Example of an Inflation ("suppliers") usually sell their output under long-term Index Tariff contracts23 that pass on the foreign exchange risk exposure to the off-taker by pricing the output in dollars When Light, a Brazilian distribution company, was or by indexing the local currency price to foreign privatized in 1996 with a tariff adjusted annually exchange rates. However, this is not a complete solution based on local inflation, AES and Houston Industries to the foreign exchange risk problem because the (now Reliant) financed their purchase of equity supplier's credit rating will be a function of, and capped interests in Light in the bank market. However, it by, the credit rating of the off-taker. Even if a particular should be noted that Light, like other distribution supply project has low foreign exchange risk exposure, it businesses, had a lower debt-to-equity ratio than will still be at risk if the off-taker's foreign exchange risk most generation projects. The additional equity exposure is large (for example, if it has large dollar- provided by the sponsors gave lenders comfort that denominated debts or contracts with other suppliers24). the sponsors would not abandon the company if it were to experience a temporary liquidity problem as a result of currency depreciation. If rising power purchase costs under long-term contracts are placing the off-taker under financial stress (e.g., if it is not able to pass on these increased costs), the risk of adjustments in line with inflation, especially when rates of governmental intervention to modify the terms of the inflation are high and incomes are not increasing at the 15 contracts may increase. If the single off-taker is state same rate. With an inflation-indexed tariff, it is necessary owned (as in Indonesia, Pakistan), investors are likely to to have an estimation of the real value of the host perceive even greater risk of government intervention to country's currency when the base price of the tariff is alter the terms of the contract (as compared to contracts established if the project sponsor is to have an accurate between two private entities). estimate of the dollar value of equity returns from the project. An overvalued currency will lead to disappointing Inflation Index returns for the project sponsor unless the base price is increased to compensate; conversely, an undervalued A second major alternative for tariff indexation is the currency will lead to superior returns. inflation rate of the project's host country. This form of indexation can be applied to the component of the tariff Some distribution companies have raised financing on the that covers debt service and equity return as well as all basis of inflation-indexed tariffs (see Box 10). However - operating expenses except fuel.25 With this approach, such tariffs have not normally provided a basis for foreign exchange risk associated with non-fuel costs financing generation projects, which typically require remains with the project, and consumers in the host longer-term financing than distribution businesses. Unlike country are insulated from the effects of exchange rate foreign exchange-indexed tariffs, which are intended to be changes (though the rate of inflation may also be high, a standalone solution to foreign exchange risk, inflation- especially following a severe depreciation). One benefit indexed tariffs are in most circumstances unworkable of an inflation-indexed tariff is that, relative to an without an additional mechanism to enable the project to exchange rate­indexed tariff, it reduces the risk of default mitigate the risk of devaluation. The only mechanism that or renegotiation of the regulatory agreement, because has thus far been devised for this purpose is the foreign consumers face a constant real cost of service. This is exchange liquidity facility, discussed in Liquidity Facilities not, however, to say that consumers will not object to Dedicated for Exchange Rate Risk Mitigation on next page. There are very few examples of privately financed merchant power projects in emerging markets. Two examples are Chivor, a 23 hydroelectric project (which will be dispatched prior to thermal plants) and TermoCandelaria, a thermal project with a large amount of subordinated debt, both located in Colombia. The foreign exchange risk exposure of a merchant generator will be determined by its foreign currency cost structure relative to that of the generators, which set the marginal price. Generators in a competitive market may also derive some comfort from the belief that a government is less likely to interfere with a market mechanism than it might be to seek to renegotiate or breach a long-term contract. Rating agencies will view foreign currency-denominated purchase obligations as analytically equivalent to dollar-denominated debt. A 24 distribution company's foreign currency rating is therefore a more appropriate indicator of its ability to make these payments than is its local currency rating. Fuel inputs are nearly always priced in dollars, and for a thermal plant to remain in operation it must at least have an energy tariff that 25 reflects changes in the local currency cost of fuel caused by exchange rate changes. BOX 11. Regulation and the Allocation of Foreign Exchange Risk in Brazil's Power Sector Brazilian electric power generation can be divided into three segments: older generators, which are state owned or have been privatized since 1996 (mostly hydroelectric); new generators (mostly thermal); and Itaipu, Brazil's large hydroelectric joint venture with Paraguay. Brazilian distribution companies are, with certain qualifications, able to pass through the cost of purchased power from each of these sources. Older generators which had been or were to be privatized were assigned PPAs ("initial contracts"), which index the price of power to Brazil's inflation rate. New generators are permitted to sell power on an unregulated basis, but distribution companies are only able to pass through to their customers the full cost of power which is purchased at a price between 95 percent and 105 percent of the Valor Normativo (or VN). Agência Nacional de Energia Elétrica (ANEEL) the electric sector regulatory body, periodically re-sets VN at a level intended to enable generators to construct, operate, and earn a reasonable rate of return from new projects. Separate VNs are established for hydroelectric and thermal plants. Although a portion of VN may be indexed to foreign exchange rates, a minimum of 25 percent of the price of power must be indexed to Brazilian inflation, and price increases may occur no more frequently than annually (as is also true for increases under the initial contracts). 16 Although VN is intended to protect Brazilian consumers from the full force of FX indexation, it can do so only after the construction of an individual plant. As Brazil's currency depreciates, VN must be increased to enable prospective generators to purchase capital equipment from foreign suppliers, to obtain fuel, to pay the cost of dollar- denominated debt service, and to earn an adequate return. Foreign exchange risk is transmitted even more directly to Brazilian consumers by the power supplied by Itaipu, which is fully FX indexed with its costs shared among all distribution companies. Itaipu's power poses a continuing problem for distribution companies because the government frequently delays the pass-through of its cost increases. For expenses other than purchased power, privatized distribution companies were to retain all savings resulting from improvements in operational efficiency for the first several years of privatized operation, with this portion of their tariff increasing at approximately the rate of inflation. However, each utility will eventually undergo a regulatory review, which will determine the portion of savings (termed "the X factor") to be passed through to the public in the form of lower rates. Brazilian regulators had hoped that rate reductions from application of the X factor would help to offset anticipated increases in the cost of purchased power. However, power shortages and rationing during 2001­2002 and the resulting reduction in total electric demand have forced all participants in the power sector to re-evaluate their strategies. Regulatory Risk Mitigation problem of regulatory risk is compounded by the fact that regulatory frameworks in developing countries are often A regulatory agreement26 that gives an investor protection relatively new and lack a track record of good against foreign exchange risks is not sufficient in itself: performance. Also, there is a risk that new governments utilities must also be confident that the agreement will be may not respect agreements made by their predecessors. honored. Distribution companies in particular are Enhancing confidence in regulatory arrangements is exposed to regulatory risk because they usually27 have a therefore an important element in mitigating foreign direct relationship with the consumer and are therefore exchange risk29 and attracting investment in infrastructure. most likely to be the subject of opposition to price The following sub-sections discuss a number of increases and political interference in tariff setting.28 The approaches to enhancing the credibility of regulation: A regulatory agreement may take a number of forms, for example, a license issued by an independent regulatory agency, a concession 26 granted by the government, or secondary legislation. It is beyond the scope of this paper to discuss the merits of each. The discussion here concerns ways to improve the prospects that such a regulatory agreement will be honored. Except where retail is separated from distribution. 27 As discussed in Foreign Exchange Index above, a mechanism that protects distributors from regulatory risk also benefits their suppliers 28 whose credit quality is determined in part by the rating of their off-taker. Enhancing the credibility of regulatory frameworks is, of course, an important factor in mitigating a much broader range of risks, but this 29 section is concerned primarily with foreign exchange risk. Understanding affordability and poverty impacts: As agreement has been breached. However, in many discussed above, a regulatory agreement that protects developing countries a government guarantee will be of investors while placing costs that are politically or little value to investors because the government itself socially unacceptable on consumers, is likely not to be does not have a good credit rating. In such honored in times of currency crisis. Conversely, circumstances, a multilateral agency could provide a regulatory agreements that are sensitive to issues of guarantee to backstop that provided by the government30. affordability are more likely to be respected. There are A key issue in designing guarantees against regulatory several mechanisms to mitigate the impacts of price risk is the extent to which equity should be covered in increases on consumers, including: addition to debt.31 · Tariff methodologies that reduce price volatility: for Co-Financing example, (a) moving average tariff indexes and (b) implementing adjustments to compensate for As an alternative to tailored guarantee instruments, exchange rate changes over a longer period. bank market transactions often feature a pari passu tranche of financing provided by a bilateral or · Tariff structures that provide special protection to the multilateral agency or by an export credit agency in poor: for example, a cap on increases to the first step addition to commercial tranches with political risk cover. of the block tariffs that utilities frequently employ to In the event of political intervention or an attempt to 17 provide low-cost service to meet the basic energy and renegotiate the project's off-take agreement(s) or water needs of poor households. concession agreement, these agency lenders and guarantors are expected to bring substantially greater · Contingent subsidy schemes whereby in the event of a clout to the bargaining table than commercial bank sharp tariff increase the government makes funds lenders alone possess. available for use in mitigating the impact of the tariff increase on poor households. Such arrangements are Credible Regulatory and Appellate Institutions usually implemented by default rather than by design, for example, where governments allow utilities not to Regulatory agencies that act in the interests of service debt owed to government rather than increase consumers and utilities, independently of political tariffs to cost-recovery levels. Transparent schemes interference, will engender greater confidence among would make more efficient use of subsidies and better investors that regulatory agreements will be respected in target them to the most vulnerable. the event of a currency depreciation. Key factors in establishing a credible regulatory agency are its legal Government and Multilateral Guarantees of separation from government, the appointment of its Regulatory Agreements directors and staff, its source of funds, the competency of its personnel, and transparency in its operations. Where regulatory frameworks are new or untested, a government could provide a guarantee to mitigate Liquidity Facilities concerns about regulatory risk. The guarantee would provide extra security to the investor and additional A liquidity facility is a form of project support that is disincentives for the government to default. For such an funded in a separate escrow account, or available on a arrangement to be effective, the agreement should be contingent basis from a third party, and that may be well defined and include clear procedures (such as utilized only under defined circumstances. Liquidity international arbitration) for determining whether the facilities are intended to assist the project in coping with The extent of the guarantee coverage may vary by project and country; however, the following considerations apply: (a) it should be of a 30 value adequate to deter the government from violating the regulatory agreement rather than increase consumer prices and (b) rating agencies have generally required credit support in an amount equal to 40­50 percent of the amount of debt covered by the credit support to increase a transaction's rating to investment grade if, without the credit support, the transaction's rating would be significantly below investment grade. The World Bank can provide partial risk guarantees for government obligations in relation to regulatory risk; Multilateral Investment Guarantee Agency (MIGA) Breach of Contract and Creeping Expropriation coverage can also provide protection against regulatory risk. A PRG requires a government counter-guarantee whereas MIGA cover does not. World Bank PRG cover, for example, is not provided for equity. MIGA does provide cover for equity. 31 problems that are believed to be temporary. The impact of price increases on consumers (or off-takers). A amount of a liquidity facility is usually much less than liquidity facility should not obviate commitment to sound the amount of the project's senior debt and is used to tariff policy and a willingness to implement adjustments enable the project to pay debt service until the problem in accordance with regulatory agreements. Use of a is resolved. Unlike contingent equity contributions, liquidity facility should therefore be conditional upon the liquidity facilities are expected to be repaid, either by existence of a credible regulatory framework. While a refilling the escrow account or by repayment of liquidity facility can smooth the impact of devaluation on advances made by a third party, and they can differ project cash flows, the retail tariff should ultimately widely in the terms governing repayment. reflect the full cost of infrastructure service provision, including foreign currency financing costs. The facility Escrow Accounts could be provided on a project-specific basis or for a series of projects in a given country or sector. The Escrow accounts are funded from a portion of the liquidity facility could operate as follows: proceeds of the project's senior debt and constitute a self-insurance. The amount placed in a debt service · The standby credit facility would ideally be provided by reserve account is typically equal to six months' debt a local financial institution. If the facility provider is not service (normally, the largest amount of interest and sufficiently creditworthy, its contingent funding 18 principal to be paid in any semi-annual period). Debt commitment could be backstopped by an MLA service reserve accounts are drawn upon to cover debt guarantee instrument. service shortfalls and therefore are exposed to all project risks, including the risk of adverse exchange rate · Funding from the liquidity facility would be made movements. An escrow account is typically costly available to the project when a devaluation (in excess because it is funded with a portion of the proceeds of of a defined magnitude) is not immediately the project's senior debt. compensated by the agreed tariff adjustment formula and this negatively affects the project's ability to service Alternatively, a debt service reserve account could be debt (and reduces returns on equity). established by the sponsor32 and/ or filled with the project's free cash flow from operations (i.e., after debt · The facility would be structured to ensure that project service but before equity distributions) to cover foreign operational risks, which could also result in reduction exchange risk for the benefit of lenders. This type of in revenues and therefore erode debt service capacity, debt service reserve enhances the project's debt service are separated from the devaluation risk. Such capacity at the expense of equity return. The sponsor's operational risks should not be covered by the facility. obligation to replenish the reserve could be triggered by a defined exchange rate depreciation, and increases in · The liquidity facility will be repaid over a number of years free cash flow caused by a local currency appreciation through (a) phased tariff adjustments to return tariffs to a could be deposited in the reserve.33 cost-recovery level or (b) a special levy on consumers. In this latter case the project could serve as the Liquidity Facilities Dedicated for Exchange Rate collection agent of the levy for the account of the Risk Mitigation municipality, state, or government, as the case may be. A liquidity facility could provide standby financing to · Responsibility for repayment of the facility could rest with enable a project to continue to meet its current debt the project sponsor (e.g., in circumstances where the service obligations (and possibly provide minimum equity facility was covering debt only) or with the municipality, returns) while spreading the tariff impact of exchange state, or government. The state would likely be preferred rate changes over longer periods, thus reducing the by investors to the extent that action by regulators or A sponsor may use a letter of credit backed by its balance sheet to save the cost of extra reserve. 32 In the AES Tiete transaction (see Box 12), for example, special escrow accounts were set up to be drawn for debt service prior to the 33 liquidity infusion by Overseas Private Investment Corporation(OPIC). A facility reserve account was required to be maintained for the transaction's first three years, funded with $5 million from the project sponsor. Deposits to an Intra-Period Inflation Reserve Account in amounts up to $40 million are required if, during any six-month period, the annualized inflation rate exceeds 30 percent per annum. BOX 12. The AES Tietê OPIC Exchange Rate Liquidity Facility The first (and, to date, only) use of a standby credit facility to mitigate devaluation risk was the AES Tietê transaction, which closed in May 2001. AES Tietê is a ten-dam hydroelectric generation project located in the state of São Paulo, Brazil. A controlling interest in the project was purchased by AES in a privatization auction held in 1999. AES Tietê sells power pursuant to power purchase agreements (PPAs) which index the price of power to Brazil's inflation rate for a tenor equal to that of its capital markets financing. Through the Tietê Certificates Grantor Trust, the AES subsidiaries that control AES Tietê issued $300 million of 11.5 percent certificates ("the certificates"), due in 2015. The issue benefited from coverage provided by OPIC to protect investors against the inconvertibility or devaluation of Brazil's currency. The devaluation coverage, structured in the form of a standby credit facility ("the Real Exchange Rate Liquidity Facility") in the amount of $30 million, together with transfer and convertibility coverage of $85 million, enabled the certificates to achieve investment-grade ratings from Moody's (Baa3) and Fitch (BBB-), piercing Brazil's then-current sovereign credit ratings (B1/BB-). The OPIC coverage is described in more detail in Appendix 2. Despite the fact that AES Tietê closed following Brazil's major devaluation in 1999, Brazil's currency has subsequently undergone a further steep drop in value. AES Tietê has not yet received a draw from the Real Exchange Rate 19 Liquidity Facility, but it may do so later this year (2003). On the other hand, the transaction has been downgraded by Moody's and Fitch to its current ratings of Caa1/BB- (versus Brazil's current foreign currency sovereign ratings of B2/B). These rating actions were primarily a consequence of the downgrade of Eletropaulo, its major power purchaser. Although Eletropaulo's local currency rating at the closing of the AES Tietê transaction was Baa2/BBB-, its credit deteriorated as a result of the reduced revenues and regulatory uncertainty created by Brazil's rationing program in 2001­2002, together with its high level of short-term debt (a significant portion of which is in US dollars). A further reason for the downgrade of AES Tietê is the failure of Brazilian authorities to implement a functioning spot market for the sale of electricity. Although AES Tietê anticipated receiving only a minor portion of its revenues from spot market sales, the existence of the spot market would have provided an alternative to reliance on sales to Eletropaulo. The transaction illustrates the importance of regulatory risk and its effect on the credit strength of distribution companies as an essential element in project structures. governments to increase the tariff is required to generate Suspension of Investment Programs sufficient revenues to repay the facility. Another common method of coping with currency · If project cash surpluses are generated by tariff levels depreciation is for the investor to suspend an on-going (e.g., strengthening of the real exchange rate without an investment program. This type of response to a currency offsetting decrease in tariffs), the project could fund a depreciation is feasible for a distribution utility, as these reserve to be the first line of recourse in event of a typically have on-going programs of investment in devaluation, or it could transfer excess cash flows to the rehabilitation and expansion, but not for green-field liquidity provider to re-pay the facility or pre-pay it if it power generation and water production facilities, which has not yet been drawn. are commonly single asset projects.34 Suspending investment is a common outcome of severe currency · The size of the facility would be determined by a depreciation because (a) a utility's ability to contract number of factors, including (a) the relative share of new debt is constrained by debt service coverage ratio foreign currency financing in the project's capital covenants with lenders, (b) there is insufficient cash flow structure, (b) the project's debt service coverage ratio, after operating costs and debt service to fund new (c) historical evidence and expectations concerning investment, and (c) sponsors will prefer to pay dividends exchange rate volatility, and (d) the tariff regime and rather than retain profits for re-investment in an uncertain proportion of equity returns to be covered, if any. economic environment. Suspending investments as a response to currency convertibility and transferability of foreign currency, depreciation is more often done by default rather than exercising prudent macroeconomic management, and by design. However, regulatory or concession sharing information about its policy intentions. agreements could be designed to make this a permissible course of action, for example, by lowering Where long-term, fixed-rate local currency debt is available quality of service or network expansion targets in the to finance power and water projects, it should be the event of a defined level of currency depreciation. preferred option for mitigating foreign exchange risk. Suspension of investment as a response to currency crisis can negatively impact the quality of service to In countries with undeveloped local capital markets, a consumers (see Box 13), underlining the importance of trade-off usually exists among local currency interest rate sustainable arrangements for the sharing and mitigation risk, re-financing risk, and exchange rate risk (if one of foreign exchange risk. resorts to foreign currency debt). In such environments local currency fund schemes and guarantee instruments can sometimes be employed to facilitate fixed-rate, long- 5. SUMMARY OF FINDINGS term financing for infrastructure. Where there are undeveloped local capital markets for infrastructure, A key theme of this paper is that the most appropriate finance governments should also be careful not to inhibit 20 mechanism for mitigating exchange rate risks for power the development of local currency financing for and water projects will largely be determined by country infrastructure. circumstances. Nonetheless, at the most general level a government is best served by maintaining an Given the magnitude of investment required to meet environment supportive of foreign exchange risk Millennium Development Goal (MDG) water goals and mitigation by others, for example by ensuring the projected demand for electricity, coupled with low savings rates in many emerging markets and the fact that local capital market development is a gradual BOX 13. Suspension of Investment Programs: process, foreign private capital will have a major role in Jakarta Water financing power and water projects in the foreseeable future. Foreign investors should be encouraged to Municipal water utility PAM Jaya entered into 25- accept foreign exchange risk; however, this is likely to year cooperation agreements with two foreign attract investment only where the investor is able to consortia in 1997 for the operation, expansion, and improvement of water supply services for the east mitigate the risk or the perceived magnitude of the risk and west parts of Jakarta, respectively. The private is small. Where neither is the case, it is likely to be operators' contractual charge is based on an necessary to protect at least the debt, and possibly indexation formula, and tariffs were to be set by the some portion of the equity, from exchange rate risks. In provincial government. Subsequently, a drastic this regard, it is suggested that: devaluation and an inflation rate of over 150 percent substantially increased financing and · Tariff regimes that are designed with sensitivity to issues operating costs for water services. In 2001 water of affordability (or the credit quality of the off-taker as charges were raised by 35 percent, and the utility the case may be) are more likely to be sustainable. and operators are requesting a further tariff increase The type of index used and the frequency with which it to upgrade services. Despite substantial increases of is implemented can also enhance sustainability to the customer connection since the introduction of private extent that it reduces tariff volatility. operation, cash shortfalls led to delays in the investment program, creating the perception of inadequate services and water quality by the public · Credible regulatory and appellate frameworks with a and political difficulty for further tariff adjustment. record of good performance will engender greater confidence that tariff regimes will continue to be Single asset projects do not usually generate revenues until they are completed, as financing needs to be arranged up-front to start 34 construction and interest costs are capitalized until commercial operation. respected in the event of a currency crisis. Where · Where these emerging capital markets do not exist regulatory frameworks are new, government and but there is potential for private financing of donor guarantee instruments can be employed to infrastructure, the near-term options are to (a) support bolster confidence. guarantee schemes that backstop the performance of tariff regimes that provide protection against exchange · Projects can be structured to cope better with severe rate risks, (b) support regulators in designing tariff devaluation, for example by employing liquidity facility structures that are more sensitive to the impacts of arrangements or permitting suspension of investment exchange rate changes on tariffs and consumer programs in the event of a severe currency depreciation. welfare, and (c) support specialized liquidity facilities. If projects are not able to attract private finance at all · Where there is no, or very limited, prospect of private because of exchange rate risk, governments can borrow financing, donors may support governments by and on-lend in local currency, and charge a fee to off- providing capital that can be used to leverage private set their own currency exposure. However, this should investments or be on-lent to utilities in local currency not substitute for reforms that would enable projects to with governments charging a premium to off-set attract private finance. foreign exchange risk exposure. Providing this type of government support should not substitute for reforms Sharing foreign exchange risk among a project's that would facilitate local and foreign private capital 21 stakeholders has better prospects of sustainability and investment in power and water. additional benefits: (a) it gives the government an incentive to signal its policy objectives and live up to them, (b) it gives equity investors an incentive to mitigate a project's foreign exchange risk exposure, and (c) it gives consumers price signals that encourage demand-side responses. There are several ways in which donor agencies can help developing countries promote private investment in power and water by assisting in the mitigation of exchange rate risk. Assisting governments to develop domestic capital markets and establish credible regulatory frameworks will be the key to mitigating exchange rate risks in the long run. The near-term options will depend on the circumstances of each country: · Where there are emerging markets in long-term debt, donors can assist in lengthening the available tenor and enabling infrastructure projects to access these markets using guarantee, swap, and lending instruments and by providing support to local currency fund schemes. APPENDIX 1: CURRENCY CONVERTIBILITY this form of analysis, coverage in an amount equal to GUARANTEES 18 to 24 months' debt service is frequently sufficient to obtain a rating in excess of the sovereign ceiling. Currency convertibility guarantees may be provided by the host country government, bilateral and multilateral Currency convertibility guarantees are not designed to agencies, or private insurers. A currency convertibility and address the risk of devaluation. A government whose transferability guarantee for an infrastructure project from currency is under stress can preserve its reserves of the host country government provides for explicit priority foreign exchange by ending its fight to defend the value access to the government's supply of foreign exchange. As of the currency and accepting devaluation. In such a in the case of preferred credit,35 government currency situation, while the convertibility guarantee is honored, convertibility guarantees, to be effective, are dependent a project may still face a significant problem in meeting upon the host country's not having too great a share of its dollar-denominated debt service obligations. debt covered by guaranteed (or preferred creditor) transactions. The convertibility guarantee cannot prevent a country from running out of foreign exchange or assist an infrastructure project located in a country that has been forced to suspend convertibility. 22 Currency convertibility and transferability guarantees provided by bilateral and multilateral agencies protect infrastructure projects from the risk of restrictions on transfer and convertibility imposed by the host country government. Coverage may be purchased for both debt and equity investments and may not require a project- specific currency convertibility guarantee from the host country government.36 Payment of claims is based on the financial strength of the insurer and not on priority access to the host government's supply of foreign exchange, although the amount of coverage is subject to an upper limit which each agency imposes for each transaction and country, reflecting its views of government capability in maintaining convertibility. The form of coverage offered by private insurers is similar to that provided by bilateral and multilateral agencies; however, its availability is not as extensive as that provided by multilateral agencies. Bank lenders typically require coverage equal to the full principal amount of a project's senior debt. In the case of capital markets transactions, rating agencies analyze the host country's record of imposing exchange controls to determine the necessary coverage amount. Based on For example, in an A Loan/ B Loan structure, a multilateral agency serves as "lender of record" for the loan (i.e., the A Loan, together with the B 35 Loan). The agency retains the A Loan, funding it with its own resources, and sells the B Loan to a group of commercial lenders. This structure depends on the "preferred creditor" status of the agency which is the lender of record serving as an implicit currency convertibility guarantee. Some donor agencies do not require a counter-guarantee of the host government to such agency institutionally but, depending on perceived 36 currency risks, may require an explicit government convertibility guarantee for a project to enable the agency to provide a convertibility guarantee for financiers. APPENDIX 2: DESCRIPTION OF OPIC'S REAL Repayment of advances under the Real Exchange Rate EXCHANGE RATE LIQUIDITY FACILITY Liquidity Facility is made only when the project has a positive cash flow after paying its senior debt service. OPIC's Real Exchange Rate Liquidity Facility requires The liquidity facility thus functions as a revolving credit that the project sell its output pursuant to a long-term facility, with payments of interest and principal to the contract for payment in local currency, with price liquidity facility being subordinated to the project's changes indexed to the host country's rate of inflation. senior debt service (except in liquidation, where the The devaluation coverage is based on a "floor value" outstanding balance of the liquidity facility ranks pari for the dollar value of a project's cash available for passu with the project's senior debt). Appreciation of the debt service. Throughout the tenor of the project's real exchange rate therefore benefits OPIC by providing financing, the dollar value of the project's cash the cash flow with which to repay previous draws under available for debt service is determined by two factors: the liquidity facility. (a) the local inflation rate and (b) the then-current exchange rate used to convert the project's local Although OPIC's pricing for the liquidity facility used in currency cash flow into dollars to pay debt service. the AES Tietê transaction reflected a number of features that were specific to the project and its devaluation OPIC's devaluation coverage is based on evidence that coverage, the cost of the devaluation coverage was the economic concept of purchasing power parity is modest compared to the spread required by the fixed- 23 reasonably accurate if taken on an average basis over income investors that purchased the project's securities. the medium-to-long run. Real exchange rates (i.e., The pricing on a contingent liquidity facility reflects the where inflation and the nominal exchange rate are both fact that it is exposed to a narrowly defined foreign taken into account in determining relative values) exhibit exchange risk, rather than to all project risks, which are substantially less volatility than nominal exchange rates. captured in the spread for the project's senior debt. This volatility can be managed by an appropriately sized liquidity facility, which can be drawn upon to cover Following the completion of the AES Tietê transaction temporary cash flow shortfalls resulting from exchange that employed OPIC's coverage, Sovereign Risk rate movements. The necessary size of the liquidity Insurance Ltd., a Bermuda-based provider of political facility is a function of the volatility of the real exchange risk insurance, announced that it would offer a similar rate of the host country and of the project's debt service structure under the name "REX" or "Real Exchange Rate coverage ratio. A higher debt service coverage ratio Liquidity" product. reduces the chance that currency depreciation or devaluation will be severe enough to prevent the project from servicing its debt. The OPIC coverage is structured to isolate currency risk from conventional project-operating risks. A pro-forma calculation is performed to measure whether the real exchange rate has declined to a level below the floor values established at the time of closing the project's financing. OPIC permits draws under the Real Exchange Rate Liquidity Facility only if (a) the real exchange rate at the time of a scheduled debt service payment has fallen below the corresponding floor value and (b) (only if) the project is otherwise unable to meet its scheduled debt service payment. The floor values are set at dollar values which provide the equivalent of a debt service coverage ratio that would support a contractually based project financing (e.g., an average debt service coverage ratio of 1.4 to 1.0). APPENDIX 3: AN INTRODUCTION TO HOW Rating agencies apply a different form of analysis to RATINGS AGENCIES EVALUATE FOREIGN each structure for piercing the sovereign ceiling. The EXCHANGE RISK amount of PRI coverage necessary is determined on a country-by-country basis, depending on factors that Rating agencies use a foreign currency debt rating to include the host country's previous implementation of evaluate issuers of capital markets debt in a currency exchange controls and the period(s) during which other than that of the issuer's host country. This rating controls remained in effect. In most countries where this captures the risk that the issuer will be unable to meet coverage has been used, 18 to 24 months of debt its foreign currency debt obligations as a result of service coverage has been considered adequate by restrictions on the convertibility of local currency into rating agencies. foreign currency and/ or on the transfer of foreign currency from the host country to other jurisdictions. An A Loan/ B Loan structures depend upon the preferred issuer's foreign currency debt rating may be contrasted creditor status of the agency that is the lender of record. with its local currency debt rating, which evaluates the Although preferred creditors typically have agreements issuer's ability to meet obligations denominated in local with the host country, the benefits of preferred creditor currency. Typically, an issuer's local currency rating will participation in a project are regarded as stemming be at least equal to--and frequently, greater than--its from the reluctance of governments to allow the 24 foreign currency rating, but this need not be the case. preferred creditor's loans to go into default and the corresponding willingness of the Paris Club to exempt A government may impose exchange controls as a such loans from the comparability-of-treatment means of obtaining access to all foreign exchange principle in restructurings. generated by its nationals and may make its own determination concerning how to apportion the available The agencies generally regarded as possessing foreign exchange to meet its debt service obligations and preferred creditor status are: those of its nationals to which it chooses to grant access to its limited supply of foreign exchange. The · World Bank government's credit rating typically sets the "sovereign · Inter-American Development Bank ceiling" or "country ceiling," i.e., a limit on the ratings of · Asian Development Bank issuers located within the government's jurisdiction. The · African Development Bank sovereign ceiling is analytically distinguishable from the · International Finance Corporation foreign currency credit rating of the government, but in · Multilateral Investment Guarantee Agency practice they are usually the same. · European Bank for Reconstruction and Development · Corporacion Andina de Fomento Rating agencies have recognized three mechanisms for mitigating transfer and convertibility risk: (a) political risk Preferred creditor structures, to be effective, are insurance (PRI) or partial risk guarantee, which will dependent on the host country's not having too great a provide payment in dollars in the event of government- share of its debt covered by such transactions. Rating imposed restrictions on transfer and convertibility, (b) A agencies will factor this ratio into their analysis of a Loan/ B Loan structures, where the A Loan provider is transaction utilizing an A Loan/ B Loan structure. the lender of record and is a preferred creditor, and (c) partial credit guarantees provided by preferred creditors. One form of partial credit guarantee is the provision of If structured appropriately, each of these approaches is a "reinstatable rolling" guarantee of one or more debt capable of enabling a transaction to "breach the service payments by the multilateral agency. As in the sovereign ceiling," i.e., obtain a rating higher than the case of A loan/ B loan structures, the presumption is sovereign ceiling, because the limiting factor of transfer that the issuer is capable of generating sufficient local and convertibility risk has been removed as a rating currency to service its dollar-denominated debt, but constraint. If transfer and convertibility risk has been would be unable to do so as a result of restrictions on satisfactorily mitigated, the transaction's foreign currency transfer and convertibility if it were not to benefit from rating will equal its local currency rating. the preferred creditor status of the agency providing the partial credit guarantee. The rating agencies' analysis is based on an assumption that the government will from lowering its rating. If the issuer is a supplier to a normally allocate whatever foreign exchange is distribution company, the liquidity facility will require the available so as to ensure that a default does not occur. issuer to sell its output pursuant to an inflation-indexed The value of this structure was substantially reduced supply contract; the distribution company's ability to when the World Bank elected in 2002 not to require fulfill its obligations under this agreement will be immediate repayment by Argentina under indemnity measured by its local currency debt rating, rather than upon guarantee call, and other transactions utilizing by its foreign currency debt rating, as in the case of reinstatable rolling partial credit guarantees were foreign exchange indexed supply agreements. downgraded as a result. Although foreign exchange liquidity facilities and Foreign exchange risk also affects the local currency debt structures to breach the sovereign ceiling can improve rating of infrastructure transactions because contractual the foreign currency rating of an infrastructure project, mechanisms are frequently used in an attempt to shift the actual rating will be determined by the transaction's foreign exchange risk to a project's off-takers and/ or to local currency rating, which, in turn, may be capped by the public. Where water supply or electric power the local currency rating(s) of its off-takers. Sectors such generation projects have entered into supply contracts as water and electric power that are crucial for public with distribution companies, the debt rating(s) of these welfare are likely to be subject to political intervention to output purchasers typically cap the debt rating of their benefit consumers at the expense of projects and their 25 suppliers. If output prices in supply contracts are indexed bondholders. Although rating agencies differ in their to the foreign exchange rate, the resulting obligations views as to how closely the water and electric sectors will be analytically equivalent to dollar-denominated are linked to the government, all view the prospect of debt, and the purchasers' foreign currency debt ratings adverse government intervention to hold down will be a more appropriate measure of their ability to consumer tariffs as highly likely in the event of honor these obligations. Unless the host country has an devaluation or a currency crisis tied to capital flight and investment-grade foreign currency debt rating, the declining central bank reserves. The prospect of this foreign currency debt ratings of these purchasers type of intervention creates substantial uncertainty about normally will be below investment grade. the revenues earned by suppliers and distributors in the water and power sectors, which in turn makes it difficult With the exception of the San Pedro De Macoris electric for firms in these sectors to obtain investment-grade power project in the Dominican Republic, which ratings on a local currency basis. Although regulatory featured a multilateral political risk guarantee, no risk may appear to be a separate issue from foreign electric power sector transactions in a below exchange risk, in practice they are closely related investment­grade country had achieved an investment- because government intervention may prevent the grade foreign currency rating prior to the AES Tietê operation of contractual provisions related to foreign transaction in 2001. All previous electric power exchange risk, and even in cases where such provisions transactions had been capped at the sovereign ceiling are absent, government intervention is most likely to and, unless affected by project-specific risks, their ratings reduce an issuer's local currency revenues immediately were downgraded (in the case of several countries) or following a devaluation or foreign exchange crisis. upgraded (in the case of Mexican transactions) as the sovereign rating of the host country changed. A foreign exchange liquidity facility, such as that used in the AES Tietê transaction, if used in conjunction with PRI/PRG coverage or another method of mitigating transfer and convertibility risk, can enable a project with local currency revenues and dollar-denominated debt to achieve a rating higher than the sovereign ceiling of the host country. If the issuer is a distribution company, the liquidity facility can prevent the mismatch between the currency of the issuer's revenues and its debt service