Part 2 of 2: The challenge of financing power projects

Part 2 of 2: The challenge of financing power projects

Hardiv H Situmeang, Jakarta

Though project finance is not cheap, it remains the most
promising mechanism for financing new generating capacity in
Indonesia. Most of the IPPs developed during the 1990s relied on
project finance. Yet the question remains as to why it is so
difficult to attract project finance in the current environment.
The project financing offers now trickling in require strict
covenants, hefty premiums and comprehensive security packages.
These arrangements strain the PLN balance sheet through security
requirements that require cash or standby loans. Although they
are better than full recourse financing, they are still not the
best value financing offers.

PLN needs to work toward securing the lowest financing cost,
minimizing its project liabilities, avoiding the need to pledge
assets, not distorting the liabilities side of the balance sheet
with massive debt, and negotiating for the highest level of
control possible over the project while taking into account the
lender's constraints.

International experience indicates how PLN can achieve these
objectives. A study conducted by the World Bank in 2003 shows
that the top priority for investors looking to invest in the
power sector in developing countries is legal certainty regarding
the rights and obligations of each party to the transaction. The
next most important priorities are consumer payment discipline
(i.e. that revenues forecast on the basis of retail tariffs in
fact materialize), the availability of government or multilateral
guarantees, the existence of independent regulation, and
administrative efficiency in processing proposed projects.

Concern about consumer payment discipline presupposes that
tariffs are at a level that supports the financial viability of
the purchaser of the power (i.e. the off-taker). If retail
tariffs are not sufficient to maintain the financial viability of
the off-taker, investors will remain wary of financing projects
that produce output for sale to that off-taker.

Similarly, an IPP best practices workshop conducted by APEC in
1997 concluded that there are four critical success factors
needed to successfully attract IPPs: Transparency,
predictability, reduction of risk and promotion of competition.
Reduction of risk in this context means the elimination of
uncertainties and other factors that could unnecessarily increase
the cost of IPP development.

A key element of this risk is the ability of IPPs to recover
a reasonable wholesale price for the electricity generated, which
in turn depends on the existence of a commercial pricing
environment for retail as well as wholesale electricity supply.
The encouragement of competition does not necessarily mean the
creation of power markets, but at least implementation of sound
processes for competitive bidding in new projects.

Lenders and private investors are seeking a secure legal
framework, adequate tariffs at both the IPP and consumer levels,
collection discipline, administrative efficiency and competitive
bidding processes to select project investors. Once these
conditions are achieved, then PLN will have achieved two major
coups.

First, broader financing options, more lenders and private
investors will come to the market. The market will change from a
lender/investor market to buyer/borrower market.

Second, as there is more interest, the cost of financing will
be reduced. Interest rates will go down to near sovereign risk
levels, security requirements will relax and negative covenants
will soften.

The challenge of project finance in the Indonesian power
sector is therefore not really a financing problem, but an issue
of sector governance and performance. We need to return to the
programs and principles we identified more than a decade ago, and
now implement them. Specifically, a program to enhance the
project finance environment and secure adequate electricity
supply in the future must be built around the following three
elements:

o Re-establish legal certainty. As The Jakarta Post pointed
out in its lead editorial of May 26, "not a single investor will
be interested unless the government restores legal certainty for
investment in the power sector, especially after the
annulment ... of Law No. 20/2002 ...". While the new legislation
must recognize the role of the state in supplying electricity, it
must also provide transparent and streamlined processes that
enable the state to draw on the financial resources of the
private sector, relying on the power of competition rather than
opaque state administration.

o Ensure economic pricing of power. The new legal framework
must provide for economic pricing of power and transparent
subsidy mechanisms that oblige our elected leaders at both the
national and regional levels to decide whether and, if so, how
state funds will be used to subsidize power instead of providing
other social services or meeting other national needs. Further
movement away from a uniform national tariff to regional pricing
would help.

Given PLN's unique role as the sole state undertaking
supplying power, investors will evaluate opportunities based on
PLN's quality as a purchaser of power produced by their projects.
If retail tariffs are insufficient to ensure PLN's financial
viability, investors will remain on the sidelines.

In fact, PLN's operating losses have fallen from Rp 8.16
billion in 2002 to Rp 4.15 billion in 2003, and it had been
predicted that PLN would make a profit in 2004. But this remains
to be seen, especially given runaway fuel costs and delayed
tariff rationalization. And in the absence of institutional
mechanisms to guarantee economic pricing in the future, investors
will remain wary.

o Compel efficiency and transparency within PLN. Economic
pricing of power is acceptable only if PLN can demonstrate that
it is operating as efficiently as possible. Sound practices and
coordinated and transparent processes for least-cost planning,
selection of financing mechanisms, preparation of "bankable"
project documentation that accords with international standards
(including Power Purchase, Operation and Maintenance, and Fuel
Supply Agreements), competitive project solicitation, and timely
and transparent evaluation and negotiation are required to ensure
optimal capital spend.

PLN must understand project cost in great detail and model it
so as to take into account a wide range of sensitivity cases that
will enable it to develop optimal negotiating positions and
strategies. PLN must have in-house resources that are able to
manage the whole process, provide the best financial advice, and
negotiate the best deals. These in-house resources will manage
advisors and counsel to get the best value and also provide clear
direction that meets PLN objectives.

Looking farther ahead, PLN must devise marketing strategies to
more effectively project itself in the financial markets. PLN's
culture and capabilities must also further evolve to improve and
promote operating efficiency.

The future reliability of electricity supply in Indonesia
depends upon our ability to secure project finance, which in turn
depends on the legal certainty, commercial sensibility, and
efficiency we create in the sector.

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