FnergyPolio3'.Vol. 23. No
8. pp. 669 675. 1995 Copyright ~c) 1995 Elsevier Science Ltd Printed in Greal Britain All rights reserved (}301-4215/95 $10(~0 + 000
TT ERWO RTH INEMANN 0301-4215(95)00060-7
The BOT option Conflicts and compromises A K David Polytechnic University, Kowloon, Hong Kong
P N Fernando Asian Development Bank, Manila, the Philippines
The build, operate and transfer (BOT) and the build, operate and own (BOO) arrangements have emerged as the most important private power investment options in developing countries. Although there is a huge market for such arrangements, since they are complex to negotiate, involve perceptions of risk that are not always properly understood and involve unusual cost, contracting, cash flow and returns to equity issues, the number of projects successfully launched have been few. This paper is concerned with exploring these issues in a systematic way, dispelling certain myths and discussing how mutually useful arrangements can be reached between a host utility and private developers on a fair and level playing field. Kevwords: Economics;
Planning; Private power
The interest in large scale private power generation, especially through build, operate and transfer (BOT) and build, operate and own (BOO) arrangements, although present for over a decade, has had a further fillip very recently with the entry of India on a large scale, and the visible renewal of interest in China, the Philippines, Pakistan, Indonesia and a number of other Asian countries. Asia's economic dynamism has injected a high degree of credibility into the private power approach and the high powered and exclusively priced, 'summits', symposia and conferences which have been held during the last year in Kuala Lumpur, Hong Kong and New Delhi bear witness to this trend. However, the contradictory information flow prevalent at times at these events and the foggy articulation of conflicts of interest underline the difficulties experienced by negotiating teams attempting to put independent power projects together in various countries. There is a need for a clear delineation of issues and trade offs, by distinguishing between real and imagined risks, and by appreciating the cost and cash flow implications of the available options. If this paper makes a small contribution towards clarifying these issues it would have served its purpose. When only the term BOT
is used in the text, much of the discussion is relevant, mutatis mutandis, to the BOO option as well. The scope of this paper is limited to private sector participation in electric power generation in an environment where a host utility is the buyer of the generated power, the owner of the transmission system and the seller of electricity to ultimate consumers. The private investor is usually, but not necessarily, foreign and the host utility is invariably a state organization or a statutory corporation. The technical and financial performance of the host utility and the need for its continuous improvement leading to its corporatization/commercialization to be listed in the stock market to access capital markets is also a major issue. However, restructuring the electricity supply system, or dismemberment of vertically or geographically aggregated monopoly structures, lies outside the scope of this paper. The BOT/BOO
s t r u c t u r e in o u t l i n e
Why private sector power? Although the initial impetus for private sector participation in developing countries in power projects may have come from international capital sources seeking Ener¢t, Poli~3, 1995 Volume 23 Number 8 669
The BOT option: A K David and P N Fernando
investment opportunities in new markets during a near decade long recession in the West, the situation since has changed significantly. The pressures now come as much from developing country governments, seeking investment funds, that is additionality of financial resources, as well as from international agencies, such as the World Bank and the Asian Development Bank (ADB), seeking wider economic agendas. It is estimated that the growing demand for electricity requires about US$100 billion a year for power system expansion in developing countries in the next 10 years and taking a broad view, in a rough order of importance, the factors motivating private sector participation may be enumerated as follows:
is emerging as the most suitable interface for mobilizing private foreign capital while selling production output to a local monopoly purchaser. BOO, in particular, resembles past private foreign flows into many branches of manufacturing and services and many limited recourse projects have been undertaken in the past, facing a variety of risks. However, what is different about power sector project finance at the present time is that the seller is captive to a monopoly buyer whose behaviour, in turn, is affected by a variety of organizational, subsidy related and political constraints, arising from the crucial nature of the product (electricity) being marketed. Identifying the key issues
(1) Developing countries' governments are unable to raise the massive finances needed for large-scale infrastructure development, usually in the context of rapid economic growth. (2) There is pressure from donors of official development assistance to undertake major structural reforms of the economy, wind down the infrastructure development role of the government and implement market based pricing practices. (3) Power utilities in most developing countries are operated under monopolistic conditions and their efficiency can be improved by encouraging competition. Since some of these issues are politically controversial the sine qua non for a successful BOT project consists of two factors: a stable and supporting political environment with a sound legal and administrative framework, and a fair and objective selection procedure of experienced, reliable and financially acceptable BOT sponsors. What is BOT and BOO?
In the simplest terms a BOT arrangement is one where a private power development consortium, usually foreign, raises the finance and builds a power station whose output is purchased by an electric power utility in the host nation. At the end of a period, known as the franchise period, typically between ! 0 and 25 years, ownership of the plant is transferred to the host utility or government, usually for a token payment. The BOO arrangement differs from this in that ownership of the plant is retained in perpetuity by the private developer. A multitude of contractual arrangements and variations are possible and flexibility is limited only by financial, legal and political constraints. In most developing countries since the monopoly character of the national power utility remains intact, an arrangement by which the output of the private power producer is sold to the utility rather than directly to consumers is necessary. Given the pressure for private investment described previously the BOT/BOO structure 670
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The main issues that need to be resolved in the process of negotiating a successful BOT project may be summarized as follows: (!) The pallem of the investment, including such issues as the debt to equity ratio and whether the project is a joint venture incorporating a component of equity from the host side or whether the equity is wholly financed by the private power developer. (2) Arrangements for financing the project and setting up the company that will implement and operate the project. (3) Project implementation agreements covering the construction phase and the operation phase. (4) Other agreements such as those for power purchase, fuel procurement, project construction, operation and insurance, and loan servicing. (5) The energy pricing formulae including a basic price and adjustments for fuel prices, exchange rate fluctuation, inflation and so on. (6) The basic energy quantum to be purchased (usually denominated as a percentage plant load factor) and pricing agreements for additional tranches of energy. (7) The operational procedures and standards including issues such as, start up frequency, reserve allocation and plant dispatch. (8) The financial model for the project demonstrating satisfactory cash flows and inter alia an adequate rate of return on equity to the private developer. (9) Quantitative risk analysis based on the extent of exposure of the various parties. Parties to the arrangement
There are basically three sets of parties, or sides, to a BOT project as depicted in Figure I. The importance of the banks (or investment houses) which provide a large part of the funding for the project (a typical debt:equity ratio may be 75:25) will become apparent when risk and cash flow analysis are considered later in the paper. The
The BOT option: A K David and P N Fernando
Host • Buys power •
,, • •
Raises finance Builds plant Operates plant
Equity investors Contractors Plant suppliers Plant operator Third parties Commercial banks Multilateral ex/im banks Fuel suppliers Insurers Escrow agents
Figure 1 Parties to a BOT arrangement
interests of these senior lenders are no less important than those of the two primary parties in determining the terms of the contracts. Multilateral agencies such as the ADB, the World Bank or the International Financial Corporation often show interest in providing equity and/or loan financing in qualifying projects. The motivating considerations of such participants are significantly different from those of ordinary capital market participants and are focused towards the realization of the project on a sound basis. A variety of fuel supply arrangements are encountered in BOT projects. In the Philippines there are cases where the host utility undertakes the responsibility of purchasing and supplying fuel, in such cases the BOT plant becomes a pure converter of energy. In many cases the fuel must be purchased from a national fuel supply utility and the cost is passed through to the purchaser of power. There are also cases where the fuel pricing is based on the international price of oil or coal which is used as a benchmark. Insurance plays a more significant role in BOT projects than in conventional power projects for two reasons. First, because more onerous insurance requirements are specified by lenders and investors due to the more complex nature of project implementation itself, and second, because of the long duration of the franchise period, there is a desire to guard against risk exposure from issues such as plant failure and fuel supply disruption and exchange rate fluctuations. Therefore, it is safe to say that BOT projects, in general, incur insurance costs which are much higher than conventional power projects. In the past a large portion of this 'insurance' element has been borne cost free by the state. However, the ability of governments to provide sovereign guarantees could be limited by fear of compromising international creditworthiness ratings if the number of BOT/BOO projects rises.
Organizational and contractual structure The structure of a BOT arrangement is centred on the
project company (PC) which is established in and under the laws of the host country by sponsors. The PC's sponsors consist of the consortium of companies intending to carry out and benefit commercially from the project. Usually they consist of a construction company (possibly a large civil and electro-mechanical engineering contractor), a plant supplier(s) intending to supply the boilers, turbines, generators, switchgear and the like, a power station operating agency which plans to operate and maintain the plant throughout the franchise period, and finally, equity investors wishing to take an entrepreneurial stake in the enterprise. The lower part of Figure 2 which depicts the typical structure of BOT power projects, shows the sponsors, the centre and middle-upper part show the third parties, the most important of whom are the lenders, and the topmost part o f the figure shows the host side of the arrangement. It is clear from this figure that the negotiating process in setting up a BOT project is going to be extremely complex and that numerous contractual and legal documents cannot be avoided. The number of contracts, several of them enforceable over long terms, are in fact more numerous than depicted in this simplified figure. Indeed, the complexity of the negotiations - a major disincentive of the BOT process - is such that they often extend for more than two years, and in one example in Turkey dragged on for seven years. As more experience is gained and with the facilitation of multilateral agencies, it should be possible to expedite and standardize some of the procedures.
Risk analysis Perceptions of risk Risk in BOT projects is perceived by both the investor and the host, although the former has been more widely discussed. The list below summarizes the main categories of risk perception which are discussed further in the following paragraphs. It is reasonable to expect such risk to be assumed by the party within whose control the risk most lies while guarantees or financial incentives will be sought according to the importance of risk to each party.
Non-recourse financing Construction phase risks No-take risk Fuel supply and price risks Plant and system reliability Remittance and exchange rate Inflation Force majeure and political risks
Non-competitive bidding High return on equity Take-off risk Failure to deliver Failure to maintain plant Dispatch inflexibility Reserve inflexibility Deviation from least-cost plan Complicated negotiations
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The BOT option: A K David and P N Fernando
, National electric __ Power purchase _ _ utility agreement
Fuel # suppliers - -
Project implementation - agreement
Fuel supply contracts - -
Plant + operator
Operating services agreement
Senior # lenders
I Escrow agreement L
Escrow agent #
Sales contracts - -
All lenders #
Plant suppliers + Private investors +
I * Hosts + Investors # Third parties
Sponsors Investors + Plant suppliers Contractors Plant operators
Figure 2 Structure of a typical BOT power project
A major concern of the lenders is the limited recourse available to them in the event of the failure of the project company to service debt. If the project were to collapse the only recourse available to the lenders would be to acquire the plant (probably non-functional) and seize the assets of the company (probably bankrupt). The assets of the companies holding equity investment in the project company may be large, but the lenders would have no legal recourse to them since the loan agreements are with the PC which is a separate legal entity established in and under the laws of the host country. This aspect of project risk explains one of the major issues complicating the financing. Lenders may ask for sovereign guarantees against, not only force majeure, but other risks as well - for example take or pay power contracts guaranteed by the host government may be sought. The latter, in turn, may be reluctant to provide sovereign guarantees against eventualities which it perceives to be purely commercial elements of risk, pointing to commercial rates at which interest is payed and the high return on equity encountered in BOT projects. Compromise on these issues is essential if the project is to get off the ground. Factors that need to be taken into account include the credit rating and sovereign risk of the country, and what is covered by sovereign guarantees and what is deemed to be commercial risk shared between developers and the host utility. 672
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Most BOT projects are highly ieveraged with debt to equity ratios of the order of 75 to 25. Equity investors require as much as 20 to 30% return and the more equity a project has, the higher the power price it would require. While equity is relatively easy to find, long-term debt is hard to find especially in highly leveraged projects. The project revenue being in local currency, poses, in most cases, foreign exchange risk. This, however, can be mitigated by the PC purchasing foreign exchange risk insurance from the Central Bank of the host country for debt service and profit repatriation. Alternatively, the power sale agreement can be indexed to exchange rate depreciation. The host government is likely, in most circumstances, to guarantee the power purchase agreement between the PC and a public power utility that is the sole buyer of power. Apart from charging a higher interest for limited recourse, the lenders would typically want provision for cost overrun, escrow arrangements, turnkey contracting and special operation and maintenance personnel as a source of comfort. A fuel supply contract for the duration of the concession period can mitigate fuel supply risk. The host government providing a dedicated coal or gas field can also be an effective alternative. To cap it all the host government would normally indemnify the PC against specific force majeure risks. Catering for these investor perceptions of risk, of course, has a sharp impact on the cost of the power from the project.
The BOT option: A K David and P N Fernando
It is relevant to note here that agencies such as the ADB, World Bank and the International Financial Corporation do have instruments to cushion commercial banks against certain categories of country risk. The Multilateral Investment Guarantee Agency under the World Bank umbrella provides insurance against specific risks such as war and civil disturbance, currency convertibility and transfer, expropriation and breach of contract by the government. Higher equity investment will be reassuring to lenders and host alike as an indication of enhanced investor involvement in the project but has the disadvantage of raising project cost overall since the expected return on equity (say 25%) is higher than what will be paid as interest on project loans (say 12%). The no-take and take-off risks are complementary and refer to investor fear that the host may fail to purchase energy and host fear of making a commitment to energy that may not be needed at the agreed price in future years. These risks depend on economic trends and future demand growth, the likelihood of cheaper energy becoming available in future years, plentiful hydro availability in certain years and competition from other power producers and energy alternatives. Arrangements from a cast iron take or pay contract backed by a sovereign guarantee, to risk sharing incentive contracts between investor and utility are possible. In general, the dynamic economic climate and prodigious demand for electricity in Asia implies that the no-take risk is small in the region and investor apprehension on this score is unwarranted - it is, more often, a bargaining chip than a real concern. After the initial exercise of going through the solicitation of proposals, evaluation and selection of sponsors in a transparent manner for a BOT project, the host and sponsor lock into a one to one protracted negotiating posture with limited opportunity for competitive procurement of equipment and services. This difference from conventional power projects leads to cost increases. Even when some measures to increase competitiveness can be taken, due to the greater return on equity than usual in public utilities and the fact that commercial credits available to BOT projects have maturities ranging from 5 to 15 years, far shorter than the 20 to 40 year economic life of plant, extensive resort to BOT projects could create short-range cash flow difficulties for utilities and distort the pricing of electricity sale over time. Utilities are also usually concerned about possible deviations from the least-cost generation expansion plan due to private sector participation since private developers may prefer to modify the size, timing or technology of options in the least cost development sequence to meet their own financial or technical capabilities.
It is of course quite evident that if plant availability declines or the heat rate falls off below expectations with time, both equity investors and lenders face difficulties as earnings fall off. The former faces a decline in earnings on investment, while any undermining of the projects ability to discharge its debt servicing obligations is of concern to lenders. Some technical concerns voiced by host utilities include potential operational inflexibilities with BOT plant due to limited dispatchability, unequal sharing of spinning and stand-by reserves resulting in the utilities own plant carrying more onerous duties and also how well the BOT plant will be maintained, especially in the later years nearing the end of the franchise.
Risk sharing and incentives In this section of the paper several suggestions will be offered as to how the major risk related issues discussed above may be addressed and practical compromises achieved. A general principle that may be useful is to distinguish between debt servicing and return on equity. Guarantees in respect of the former, backed up where appropriate by government or international agency assurances are justified since, essentially, they involve a third party. Government assurances in respect of this component of the annual cost will need to cover not only elements such as.force majeure and political risk but also foreign exchange remittance and rate cover, and possibly disruption of fuel supplies, disputes between the project company and the utility, and unforeseen legal or environmental restraints on the operation of the plant. Return on equity, however, is much more a commercial matter and equity holders often have the opportunity to earn more than the minimum agreed rate of return and some risk and benefit sharing between equity holders and the utility can be meaningfully processed into some incentive contract form. Obviously, if plant operation falls below specified expectations the project company must face the threat of loss of earnings if competition is to have any meaning. Risk in respect of long-term fuel price fluctuations, fuel supply, inflation, and foreign currency rate fluctuation are suitable candidates for the application of a risk sharing approach where benefits and losses above or below a norm may be shared in accordance with formulae contained in the reference financial model of the power purchase agreement. For example, it may be agreed that fuel price variations within a certain range of an agreed benchmark are not passed through but the effects of larger fluctuations are shared. A major avenue for additional earnings, to which many investors give consideration in deciding on a BOT investment, is the income from the sale of electricity in excess of the minimum amount specified in the contract as described in the next section. EnerKv Poli~y 1995 Volume 23 Number 8
The BOToption: d K David and P N Fernando
Table i Pricing schedules in constant 1990 US$/MWh for selected years Year I Year 11 Year 20 Year 21 Year 26 Operations 22.0 22.0 22.0 22.0 22.0 Equity 7.78 8.78 8.78 8.78 0 Debt 6.58 6.58 6.58 0 0 Interest 15.80 7.91 0.79 0 0 Total 53,16 45.27 38.15 30.78 22.0
A simplified example is now introduced to illustrate some key issues relating to BOT projects. Although the example is simplified by neglecting factors such as inflation and other time dependent variations, and by reducing the number of items considered to an essential few, the figures themselves are quite realistic and the issues discussed important. Example
Consider a fossil fuel fired BOT project of say 1000 MW o f conventional steam power plant with a franchise period of 25 years and with all financial data supplied in typical constant 1990 US dollars. The capital cost of the plant is US$1000 per kilowatt installed and the debt to equity ratio of capital financing is 75:25. Assume that the return on equity is agreed at 20% and that the debt component consists of just one loan with a 20-year repayment period. For simplicity assume that the loan is repaid in twenty equal instalments and interest is charged at a constant annual rate of 12% on the balance outstanding at any stage. Typical prices for fuel and other O&M costs are used in deriving Table I which is on a US$/MWh basis assuming electric energy sent out corresponds to 65% plant factor. The item 'Operations' in the table is the sum o f fuel and variable O&M costs with fixed operating costs included in an approximate manner. In order to keep the size of the table to manageable proportions only a few selected years are displayed. The first matter of interest is that after year 20 the debt is paid off and the repayment and interest items disappear from the table thereafter. In a real project there will be several loans on different interest and repayment terms and such a discontinuity will occur as each loan is paid off. A similar point of interest is that from year 25 onwards, that is after the transfer of the project to the host, payment of return on equity ceases. These points help emphasize the complex nature of the cashflow account of BOT projects as highlighted by the large variation of total cost per megawatt hour with plant life as shown in the last row. The host pays at a premium rate in the early years in anticipation of lower payment in later years for electricity purchased. However, if this project is large in comparison with the total size of the host system, either cashflow problems or distortions of electricity pricing to final consumers may be difficult to avoid. 674
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Typically, debt servicing and return on equity investment are fully met once the 65% plant factor energy is sent out and payment received. Hence, if the plant were to produce and sell additional energy the incremental cost incurred would be only US$22/MWh. Quite clearly therefore there is scope for a mutually beneficial incentive pricing of such additional tranches of electricity. In the first year, for example, any price above US$22 and below US$53. i 6/MWh would provide additional returns to the investor (that is additional to the 20% return on equity) and also provide lower-cost electricity to the utility. The pricing of such additional tranches of electricity should be weighed up in the context of the whole risk sharing arrangement given that the numerous issues of risks and benefits are inseparable from each other. Higher prices for the additional tranche would motivate plant operators to achieve higher standards of availability and plant maintenance, while lower prices would encourage the utility to take larger amounts of additional electricity from this particular plant. A more complete version of this table would show local and foreign components of the costs (and incomes, if any) separately and would be the basis o f arrangements for debt servicing, profit repatriation and exchange rate related matters. Inflation and other time indexed issues, for example an agreed decline in expected plant heat rates, would also be incorporated in a full reference financial model. The importance of a realistic and transparent reference financial model can, however, be clearly appreciated from this simple example. The model contributes to an overall appreciation of the factors involved and provides a foundation for risk analysis.
Conclusion Experience gained thus far indicates that contrary to some initial expectations, BOT projects do carry a premium. This is, however, not altogether surprising since (I) a more attractive return than usual in regulated utilities has to be offered to raise equity, and (2) loans come mostly from commercial sources resulting in higher interest rates and shorter maturities than those usually obtained by the utilities from official sources. The situation is aggravated in countries with high sovereign risks, poor credit rating and, consequently, little or no access to world money markets. These cost increases are difficult to offset by higher private sector efficiencies in project implementation and operation, and underlines the need for such projects to be of an additional rather than substitute nature. Under such circumstances, BOT projects are justified if it is clear that because of implementation obstacles, inefficiencies and time constraints, the power utility would not be able to undertake the clearly needed capacity expansion. Even if this justification can be provided, it is still necessary to
The BOT option: A K David and P N Fernando
assess whether the higher price to be paid to the project sponsors is commensurate with the investment risks facing them, as well as with the expected benefits to the country. In this context the risk sharing methodologies advocated in the paper have a special role to play in minimizing the impact of the cost of BOT based electricity on electricity pricing to final consumers. The discussion in this paper has highlighted some of the complexities of negotiations and risk allocation. There is a move to overcome some of these difficulties by restructuring the power sector in developing countries.
Clearly, separating the distribution sector is a sine qua if private capital is to be attracted into distribution reinforcement and expansion, while the separation of existing generation plant into one or more enterprises (not necessarily accompanied by privatization) may be required if it is desired to establish a situation in which competitive private power can go beyond the BOT/BOO option. It is, however, desirable that the transmission system, because of its economic and technical natural monopoly character, remains a socially owned power highway.
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