Eurasian power sector investment by China
April 2018 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2018 Issue
One of the hottest topics in China – in major publications and social media, among other outlets – is the Silk Road Economic Belt and the 21st Century Marine Silk Road initiative (known as the Belt and Road initiative). The Belt and Road initiative is primarily a development strategy proposed by the Chinese government that focuses on connectivity and cooperation between Eurasian countries. Investment in infrastructure sectors in Eurasian countries by Chinese state-owned companies has surged in recent years due to various direct or indirect incentives from the government to promote the initiative.
Power sector investment
One sector which has been particularly active investing in the Belt and Road initiative in recent years has been the power sector. One example is the boost to Pakistan’s independent power plant sector by Chinese investors. Following the signing of the agreement on the China-Pakistan Economic Corridor Energy Project Cooperation in November 2014, Pakistan’s power sector, which was reported to be facing a serious energy shortage, is now forecasting power generation capacity.
Equity investment structure
Investment structure has evolved throughout the years. Investment began with pure Chinese engineering, procurement and construction (EPC) contractor involvement, evolved into Chinese EPC plus Chinese export credit financing, and then became the recent Chinese equity investment plus Chinese financing model.
Traditional Chinese EPC contractors that worked closely with international sponsors on similar projects in past decades are now switching their roles to becoming sponsors. A sponsor role allows them to have greater control over the EPC contractor selection process and benefit from the considerable equity return offered by host countries, in addition to its EPC price compensation.
Technical expertise gained through decades of cooperation with international sponsors and lower local costs also allow contractors to provide a lower EPC price. Relationships with Chinese lenders also assist the financing process. These factors, plus promotion by the Chinese government through various treaties and reciprocal dealings, gives Chinese equity investors advantages in securing projects in Eurasian countries.
Apart from encouragement from the Chinese government, what attracts Chinese investors most is the almost guaranteed high equity return, along with hosting governments’ various concessions and protections.
Investment in power projects is capital intensive and host countries are keen to attract international sponsors and lenders to invest. The tariff structure of these projects is therefore required to secure the return of equity and repayment of debt, and is often structured as a bifurcated tariff, which comprises of a ‘capacity’ component and an ‘output’ component. The capacity payment will be sized to cover the debt repayments, shareholder return on equity, as well as fixed operation and maintenance costs, and is typically available to the power generator independent of the electricity generated.
This guarantees a minimum return on equity and repayment of debt, so long as the project can be completed and the project company does not default. The output component usually only reimburses the power generator against variable costs and is therefore viewed as being financially less significant to investors than the capacity component.
The tariff is also often indexed to mitigate price escalation. Tariffs in some jurisdictions, such as Pakistan, also provide protection against currency exchange and interest rate fluctuation. Concession agreements by a host country often include additional protections, such as monetary compensation available for a change in law, a change in tax and governmental force majeure.
The financing of projects has traditionally been undertaken by Chinese export agencies or policy banks such as the Export-Import Bank of China and the China Development Bank. An increasing number of Chinese commercial banks are now participating in this sector and see more mixed consortiums than ever before. The lending consortiums mix not only different types of Chinese lenders, but also Chinese lenders and foreign lenders. In the recent $3.4bn Hassyan coal-fired project, the lending consortium was a combination of Chinese lenders and international lenders, as well as regional and local commercial banks.
The model of financing is being changed from the traditional parent guarantee-backed financing toward more internationally-accepted project finance.
Why project finance?
More Chinese sponsors are switching from traditional corporate finance to project finance or working in that direction. Unlike traditional corporate finance, project finance only requires very limited recourse to the sponsors of a project and is therefore typically referred to as non-recourse financing or limited recourse finance. Project finance focuses on the revenue and risk of the project itself, instead of the ability of the sponsor or parent company to provide repayment guarantees. It therefore allows a relatively larger size debt, without the need for a sponsor to provide backstop for the entire debt. This means a higher debt to equity ratio than a project can leverage and allows a sponsor to undertake multiple projects at the same time. This also removes liability from a sponsor’s balance sheet, which is particularly welcomed by Chinese state-owned enterprises (SOEs) from a listing rule compliance perspective, since a majority of them are now listed public companies.
Special Chinese financing elements
While Chinese sponsors are pursuing a limited or non-recourse model without exception, Chinese lenders are slower following this trend. Compared to a simple reliance on parent guarantee in the traditional parent guarantee structure, in-depth analysis of the structure of the project itself and related repayment risk seems to exceed a traditional Chinese lender’s comfort zone. As a compromise, we perceive unique models offered by Chinese lenders in the market that are different from, but based on, those an international lender is used to.
The first unique element is the completion guarantee. The more typical completion guarantee structure requires a sponsor to provide a repayment guarantee covering the whole debt. The triggering event of the guarantee is usually limited to a project’s failure to achieve completion before a certain date. Compared to a traditional loan-life guarantee model, this structure limits the sponsor’s exposure to only the construction period. This is more favourable to projects with a shorter construction period, but will likely be pushed back by sponsors that are undertaking a longer construction period project, such as hydros.
The most recent trend we have seen is completion guarantees being built into EPC contracts. Instead of having a sponsor provide a repayment guarantee, the parent company of the EPC contractor will provide a parent guarantee covering all the obligations of the EPC contractor under the EPC contract, and the EPC contract will be revised so that not all risk is capped under the relevant liquidated damages caps. Failure to complete within a long-stop date will only be subject to the cap sized at the entire EPC price. Since the parent company of the EPC contractor will often be an affiliate of, if not the same entity as, the sponsor, and that the EPC contract price will often be equal to or higher than the debt amount, this new structure is more commonly accepted by Chinese lenders.
The second feature Chinese financing typically has is a Sinosure insurance policy. This is equivalent to the Multilateral Investment Guarantee Agency (MIGA) partial risk guarantees (PRG) that international lenders are more familiar with. The basic Sinosure insurance policy coverage is political risk coverage against expropriation and currency exchange. An extended Sinosure insurance policy also covers any breach by governmental entities within a hosting country. Both the basic and extended coverage can cover up to 95 percent of the investment amount.
Since most counterparties to project documents in such transactions are governmental entities, extended coverage is more commonly seen and is often required by investors. Sinosure may also provide advanced insurance policies which, in addition to the basic and extended coverage, provide protection against commercial risk, such as breaches by non-governmental counterparties. The advanced policy cover is not common and is usually capped at only 50 percent of the investment. The highest cap we have seen is 70 percent. In the most recent transactions we have seen, Sinosure agreed (on a limited basis) to pay the insurance proceeds before an arbitral award is obtained for extended and advanced covers. This exceeds the usual benefit a MIGA policy or other PRG would offer, which only allows a payment after the insurance holder obtains a winning award.
Claude Jiang is an associate at Shearman & Sterling. He can be contacted on +86 21 6136 5020 or by email: email@example.com.
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