Part 1 of 2: The challenge of financing power projects

Hardiv H Situmeang, Jakarta

Since the financial crisis of 1997, power demand in Indonesia has grown by some 7 percent annually, and is expected to continue growing at this rate over the coming decade. At this rate, power demand (and the generating capacity required to serve it) will double every 10 years or so. Given that the construction of new power plants may take two to five years, new power plants must be planned and developed well in advance of the time when they are needed.

The media, industry officials, and the public all recognize that Indonesia needs to build more electricity generating capacity to ensure that this growing demand is fulfilled to avoid a power crisis. The State Electricity Company (PLN) has forecast that Indonesia must add some 1,500 MW each year over the next decade to accommodate moderate electricity demand growth. To put this in perspective, the total installed capacity of PLN's Muara Karang power plant is 1,200 MW.

For Indonesia, the principal challenge to adding this capacity is difficulties in financing these plants. The capital cost of a new power plant is incurred over the two to five years of construction, but to keep the power produced by that plant affordable, repayment of those costs must be spread out over a much longer period. Financing therefore provides most of the capital required in the short term in exchange for a stream of smaller payments over the long term. In the early 1990s, PLN began to contract for power from Independent Power Producers (IPPs) who brought the ability to finance the new generating capacity needed to supply Indonesia's economic development.

One impact of the depreciation of the rupiah during the financial crisis was that PLN could no longer service the dollar- denominated payments due to the IPPs from the rupiah-denominated tariffs PLN received. PLN therefore launched an IPP rationalization program in mid-1998 to realign PLN's ability to pay and the financial obligations of the IPPs. Most of the IPP contracts have now been renegotiated on a mutually acceptable basis.

Through efforts such as this, Indonesia's investment climate has improved since the dark days of the financial crisis. Indonesia is currently rated B+ by Standard and Poor's and BB- with positive outlook by Fitch Rating. This is still far from the A rating from Fitch in 1997, when Indonesia made it to investment grade. But Indonesia is now in a better ratings position than during our economic nadir.

Despite this progress, Indonesia faces difficulties in financing new power plants. The need for new capacity is recognized by all, and we have gone a considerable length to demonstrate our ability to work with investors to solve problems arising from unexpected events like the financial crisis on a mutually acceptable basis. But many of the new projects that have been identified cannot proceed because of a lack of financing.

In theory, there are many ways that new projects can be financed, but a review of the options indicates that limited recourse or project finance remains the most feasible option. The simplest way to finance a new capital project like a power plant would be to do so directly from PLN's cash flow. However, given the need to maintain electricity tariffs at affordable levels, and the sheer scale of the capital expenditure required for new capacity in a rapidly growing power system like Indonesia, this option is not feasible.

Another option is corporate or full recourse financing. Under such an approach, PLN would issue bonds or take out corporate loans that would be secured by the strength of PLN's balance sheet. By using this mechanism to finance new plants, PLN takes on all risks associated with the new projects regardless of whether PLN is the best equipped to manage those risks. In the event PLN defaults on repayments to corporate lenders or bondholders, those investors would have a claim on PLN's assets.

Full recourse financing would be a more appealing option if PLN not only earned an operating profit, but also earned an economic return on capital (e.g. 14-18 percent return on equity in rupiah terms). Such a level of earnings would make PLN both attractive to commercial lenders and the capital markets. Earning an economic return would provide PLN with the equity capital base upon which to comfortably leverage debt. Clearly, that day is a long way off given current tariff levels vs cost of service.

Currently, PLN is only able to fund small-scale capital investments -- say, substations, distribution service improvements, ongoing maintenance improvements -- not big generating plants. Moreover, PLN has only a finite amount of assets and, from an investor's perspective, claiming the relevant assets is not a realistic solution. In addition, the balance sheet can only support so much full recourse financing before ratings slip to a level that make the cost of such debt unaffordable.

Full recourse financing is in this sense a "last resort" which should only be used when capital spending cannot be financed by other means. Sovereign guarantees of PLN debt could expand PLN's ability to take on such debt, but at the expense of the government's ability to take on debt for other pressing needs such as health, education and other social services. In the absence of sovereign guarantees, PLN would likely need to pledge or otherwise encumber a significant portion of its operating assets -- an unsavory proposition that could work in the short term but would severely limit PLN's options to fund more projects, both big and small, in the long term.

By contrast, project or limited recourse financing is secured on the basis of the cash flow generated by the individual project developed with the financing provided. Such projects can be structured to ensure that risks are allocated to the parties that have the best ability to manage those risks. Most importantly, limited recourse financing segregates project liabilities from the corporate balance sheet by creating a special purpose vehicle to undertake the project (hence reducing the restrictive covenants on the corporate balance sheet arising from the project's debt financing).

Project finance also requires that the investment stand on its own merit, akin to starting a new business. This new business must stand up to the scrutiny of both the lenders' analysis as well as that of the board of directors of the equity investor. This enforces discipline in the planning, construction and operation of the project in a way that simply adding another asset to the huge PLN pot cannot.

The writer is a senior advisor to PLN. This article reflects his personal views.