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Alternatives to government guarantees for power purchase agreements

Risk mitigation for investors to overcome the lack of government guarantees supporting power purchase agreements.

African governments are reaching capacity in providing guarantees for power purchase agreements (PPAs) — the contracts that specify how much energy will be bought, sold, and generated by an asset. Reductions in this type of support can impact the ability of project developers to reach financial close.

There are alternative ways, however, that investors can consider to help manage off-taker performance and payment risk without such guarantees, which will be critical to mobilizing capital to fund the infrastructure gap, as discussed in part one of our Renewable Energy in Africa series.

Why matching funds to projects can fail

Bridging the infrastructure gap is key to many African countries delivering on their Sustainable Development Goals (SDGs) — and providing a better quality of life for their citizens. Bridging the funding gap in the energy sector as efficiently as possible is even more crucial in the context of growing climate risks and the impact that these are projected to have across the region.

A 2018 report by the Infrastructure Consortium for Africa (ICA) found that between 2013 and 2017, the average annual funding for infrastructure development in Africa was US$77 billion. In order to close the infrastructure gap, the McKinsey Global Institute has estimated that this will need to double, to US$150 billion by 2025.

Despite over US$100 trillion being held by pension funds, sovereign wealth funds, mutual funds, and other institutional investors with theoretical appetite for new and existing projects in Africa — and a pipeline of infrastructure projects estimated by McKinsey to be around US$2.5 trillion,  the infrastructure gap still remains.

This is because less than 10% of projects achieve financial close, and 80% of projects fail at the feasibility and business-planning stage.

McKinsey identified six key areas stemming from failures within early stages of project development that can explain the poor success rate of these infrastructure projects:

  1. Limited high value, high impact and long-term infrastructure project pipeline.
  2. Weak feasibility studies and business plans.
  3. Delays in obtaining licenses, approvals, and permits.
  4. Inability to agree on risk allocations.
  5. Inability to secure off-take agreements and guarantees.
  6. Poor program delivery.

Decreasing ability of governments to guarantee PPAs

Further, many African governments face rising debt-to-GDP ratios, which will constrain their infrastructure spending in the years ahead. World Bank borrowing carries conditions and may limit the ability of governments to fund and guarantee projects beyond certain limits. Given the need to bridge the infrastructure gap, such constraints mean that African governments are unlikely to be able to accommodate traditional forms of project risk allocation and mitigation, in the form of off-taker payment guarantees, that investors may be used to.

Alternative support for off-taker obligations

That said, investors do have alternative solutions that could be structured to manage the lack of government guarantees supporting the off-taker obligations.

Investment political risk insurance from private and multilateral financing institutions, for example, can potentially provide adequate risk mitigation for investors to overcome the lack of government guarantees supporting the PPA. Although, there are important conditions for this support, notably adequate state ownership of the utility and strong international dispute mechanisms in the PPAs.

If these options are explored from early project phase development, the optimum solution can be established, making the route to execution clearer.  

Project preparation is vital

The answers to solving the complex challenges concerning mobilizing private capital for infrastructure investment in Africa are not straightforward and will require greater effort and innovation from all stakeholders. Developing infrastructure projects will be even more challenging in the aftermath of the COVID-19 crisis. Governments, for example, are likely to view infrastructure as an economic stimulus measure and could be under enormous pressure to produce quick results. Such timings may not necessarily serve developers’ best economic, workforce, or other interests.

Getting infrastructure development right starts with good project preparation in line with best practices. The involvement of private finance, insurance institutions and advisors, as well as multilaterals such as development finance institutions, helps ensure that best practices and high standards are observed, increasing project attractiveness to potential investors. Investing in project preparation can be one of the most effective ways to ensure quality and sustainability and maximize the likelihood of successful project closure as the ability of governments to support and guarantee projects changes. 

The Renewable Energy in Africa series considers themes at this year’s Africa Energy Forum titled “Africa for Africa: Building Energy for the Just Transition”.

To find out more about insuring a renewable energy project in Africa, please contact your Marsh advisor.

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