Part 1 of 2: The challenge of financing power projects

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.