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.