Chapter 6
Analysis and Financing of Renewable Energy Projects
Project finance can be a cost efficient means of financing private capital investment projects on a nonrecourse or limited-recourse basis. International project financing is also an important financing mechanism that facilitates the development of large infrastructure projects, which are often critical to a country's economic growth. Despite these potential benefits, a project financing might negatively affect the host country by wasting natural resources, degrading the local environment, or displacing local communities unless project sponsors act responsibly to avoid these negative externalities. Host countries cannot solve this problem by themselves, and the international project-lending community has endorsed standards intended to prevent, or at least minimize, these adverse effects.
This book has noted that new applications of project financing, such as independent power projects, have emerged. Renewable, or sustainable, energy projects are another exciting and highly productive application of project financing to power generation. Renewable energy comes from sunlight, hydropower, wind power, tides, or geothermal heat. Renewable energy projects generate about 19 percent of the world's electricity, and they are a growing source of global electricity generation as the world becomes increasingly concerned about the environmental cost of mining fossil fuels as well as the risk of eventually running out of them.1 Renewable energy projects are often based on large-scale technologies for which project financing is an appropriate technique.
As a result of the potential harm that can result from the misuse of project financing and also in recognition of the value of project finance as a mechanism for promoting responsible international economic development, the international project lending community has developed standards designed to ensure that projects are carried out in an environmentally and socially responsible manner.2 To supplement host country laws and regulations pertaining to international projects, international lenders, including both multilateral lenders, such as the International Finance Corporation, and large commercial banks, have adopted standards in the last decade setting forth environmental and social requirements that project companies must meet in order to receive debt financing. These standards, which are described in this chapter, are designed to promote only those projects that commit to follow acceptable environmental and social risk management practices. The chapter also illustrates their application to a hydroelectric power project in Chile.
What Is Special About Renewable Energy Projects?
Renewable energy projects are attractive when using renewable energy results in smaller emissions of greenhouse gases than alternative facilities that burn fossil fuels.3 Renewable energy comes from natural resources that are naturally and continually replenished, such as hydropower (water), wind power, solar energy (sunlight), tides, geothermal heat, biomass, and biofuel. Renewables provide about 16 percent of global energy with biomass accounting for about 10 percent and hydropower about 3 percent. Figure 6.1 shows that renewable energy sources furnish about 19 percent of global electricity generation with hydropower accounting for about 16 percent of global electricity production. At least seven countries obtain most of their electricity from renewable energy sources: Iceland and Paraguay (100 percent), Norway (98 percent), Brazil (86 percent), New Zealand (65 percent), Austria (62 percent), and Sweden (54 percent).
Figure 6.1 Renewable Energy Share of Global Electricity Production, 2011
Source: “Renewables 2011: Global Status Report, Renewable Energy Policy Network for the 21st Century,” Paris, 2011, p. 18.
The energy in water can be harnessed and used to generate electricity. Water is about 800 times as dense as air, so even a slow moving stream of water or a moderate ocean swell can produce a considerable amount of energy. Large-scale hydroelectric projects utilize hydroelectric gravity dams, such as the Grand Coulee Dam, which is the largest electric power producing facility in the United States, with 6,809 MW of installed capacity. The Three Gorges Dam in Hubei, China has the largest installed capacity of any electric power project, 25,615 MW. Micro hydro systems with capacities of up to 100 kW of power are often developed in water-rich remote areas. Run-of-the-river hydroelectric systems, like the La Confluencia Hydroelectric Power Project discussed later in this chapter, derive kinetic energy from a river, the ocean, or glacial run-off without using a dam.
Airflows can be used to power wind turbines. Power output increases with the cube of the wind velocity, so a turbine's power output increases dramatically as the wind speed increases. Wind farms are usually located where winds are strong and fairly steady, such as offshore and on mountaintops. Wind power is growing about 20 percent annually, and the long-term technical potential could be as great as 40 times total current global electricity demand.
Solar energy is derived from the sun's radiation. Solar-powered electrical generation relies on photovoltaic cells to generate electricity. The largest solar thermal power station has a capacity of 354 MW and is located in the Mojave Desert. Biomass, which consists of plant material, ultimately derives energy from the sun. Plants capture the sun's energy through photosynthesis and release this stored up energy when the material is burned, functioning like a natural battery. Biomass is primarily used for heat generation. Biofuels, derived from biomass, are used mainly for transport fuel. Ethanol fuel derived from sugarcane provides 18 percent of Brazil's automotive fuel.
Geothermal energy is thermal energy that originated either from the formation of the planet or the decay of radioactive materials. The geothermal gradient drives a continuous flow of thermal energy in the form of heat from the core of the planet to its surface. The extremely high temperature and pressure cause the surrounding rock to melt, creating magma convection upward. The magma heats rock and water in the earth's crust, often to very high temperatures, and this heat can be used for space heating or to run turbines to generate electricity. Worldwide, 24 countries have geothermal electric power plants with a combined installed capacity of 10,715 MW. Geothermal power is reliable, sustainable, environmentally friendly, and cost effective but generally limited to those areas where there are geothermal wells.
Global investment in renewable energy electric power generation projects doubled between 2008 and 2011, growing from $130 billion to $257 billion. Table 6.1 furnishes the amount of installed electric power generation capacity in gigawatts (GW) for the three main forms of renewable energy used in electric power generation. Hydropower is dominant but wind power and solar energy continue to grow very rapidly. Renewable energy projects, especially for electric power generation, are likely to attract increasing project finance activity in the future as the world shifts from fossils fuels to renewable energy for electricity generation. In addition to electricity generation, renewable energy is also replacing conventional fuels for water and space heating and rural (off-grid) energy services. Both types of energy projects could lend themselves to project financing, although generally on a smaller scale than electricity generation. For example, renewable technologies are well suited to rural and remote areas where it can be very expensive to bring in conventionally generated electricity.
Table 6.1 Renewable Energy Electricity Generation Capacity, 2008–2011.
Renewable energy can be especially suitable for developing economies. Transmission and distribution of electricity generated from fossil fuel to remote areas can be very expensive. Smaller dispersed renewable energy projects are often a viable alternative.
International Standards for Promoting Environmentally and Socially Responsible Investing
Increasing concerns about the potentially adverse impact that a large project, such as one that consumes a valuable natural resource deposit, can have on the environment of the host country and on the quality of life of its citizenry have led to international efforts to bring about more socially responsible investing. When a project entails significant social costs, the private net present value—the value of the project to its sponsor—exceeds the true net present value, namely the combined value to all the affected constituencies inclusive of the social costs. These externalities should be taken into account when evaluating a project but a project sponsor left to their own devices may have little, if any, economic incentive to consider these costs. In that case, some combination of legal restrictions, regulatory oversight, and the active intervention of responsible third parties, such as project lenders, is needed to prevent this undesirable behavior. In recent years, international organizations, multilateral financial institutions, and commercial bank project lenders have all taken a more active role in promoting socially responsible project financing.
Organisation for Economic Co-operation and Development Guidelines
The Organisation for Economic Co-operation and Development (OECD) is an international organization whose member governments pledge to work together to meet the economic, social, and environmental challenges facing the global economy. It provides a forum for member states to compare their economic, social, and environmental policies, identify best practices, and coordinate their efforts to improve their domestic and international economic policies.
The OECD created the Guidelines for Multinational Enterprises (OECD Guidelines) to encourage sustainable development through a framework of principles and standards that project developers should follow.4 The OECD Guidelines, which were first adopted in 1976, were updated for the fifth time in 2011. They provide recommendations for responsible business conduct by multinational enterprises (MNEs). They have been endorsed by 44 governments in all regions of the world whose economies account for about 85 percent of foreign direct investment. In signing on to the OECD Guidelines, a member state agrees to promote their implementation by the MNEs and their project companies that do business within its territory.
Table 6.2 briefly summarizes the OECD Guidelines, which have important implications for project sponsors. The General Policies section specifically encourages MNEs to facilitate the host country's sustainable development, and more generally, to behave as a good corporate citizen. The Disclosure section promotes financial and operating transparency. The Employment and Industrial Relations section of the OECD Guidelines prohibits discrimination on the basis of race, sex, religion, and so on; prohibits the use of child labor; and encourages MNEs to hire local personnel where possible. The Environment section encourages forward-looking environmental risk management over the entire life of a project. The Science and Technology section encourages MNEs to contribute to the technological development of the host country, which should include helping to develop a well-trained local work force.
Table 6.2 Summary of OECD Guidelines for Multinational Enterprises.
Adherence to the OECD Guidelines is voluntary; it is not legally enforceable because the OECD has no legal recourse against a member nation who does not promote the OECD Guidelines. However, every member state should have an interest in promoting the OECD Guidelines because they have become an international standard and requiring compliance by project developers will reduce the potential environmental cost. Furthermore, the OECD has developed mechanisms to make it easier for member states to comply with the OECD Guidelines.5
The potentially more troubling issue concerns the willingness of MNEs to comply voluntarily. They might not be as motivated as member states to act in an environmentally friendly manner, especially when compliance would significantly increase project capital cost or operating costs. The OECD encourages business enterprises to abide by the OECD Guidelines and encourages parties to voice complaints about noncompliant behavior to the relevant legal or regulatory authorities. Moreover, the best way for member states to secure compliance with the OECD Guidelines is by incorporating the principles and standards embodied in the OECD Guidelines into local law and by denying licenses to any firm that fails to satisfy these requirements or that exhibits a history of noncompliance. Securing the support of the international project lending community has also helped enormously.
Environmental and Social Regulations Adopted by International Project Lenders
A project must conform to the environmental laws and policies of the host country. It must also comply with any environmental or social responsibility standards that project lenders may impose as a condition to lending to the project. As explained in Chapter 3, large projects are typically initially financed 70 percent or more with debt. Two of the main sources of debt funding for large projects are multilateral development banks, such as the International Finance Corporation (IFC), and multinational commercial banks. Many of these lenders make their loans contingent upon the borrower committing to comply with the principles and standards they have adopted to address the host country's social and environmental concerns by limiting the potential for social or environmental damage.6 The IFC has adopted its Performance Standards on Social and Environmental Sustainability (IFC Performance Standards), and the commercial banks rely on the Equator Principles. Both sets of standards are discussed next.
IFC's Performance Standards on Environmental and Social Sustainability
The IFC is a member of the World Bank Group, which is described in Chapter 13. It provides financing for private sector investments and raises capital for large projects in the global capital markets. The IFC promotes long-term sustainable economic growth in developing countries by making financing renewable energy and clean technology projects a priority. To qualify for IFC financing, a private sector project must be located in an IFC member country. It must be technically viable, economically viable, and beneficial to the local economy. It must also be environmentally and socially sound, according to the standards of both the IFC and the host country.
The IFC has established its IFC Performance Standards, which it applies when evaluating a proposed project. Table 6.3 briefly summarizes these standards.7 A project that meets these standards should have an acceptable social and environmental impact on the host country and be able to attract private sector financing. The IFC Performance Standards fall into eight categories:
Table 6.3 Summary of IFC Performance Standards.
The IFC views the IFC Performance Standard 1 as the most important for a project seeking IFC financing. IFC Performance Standard 1 underscores the importance of managing the environmental and social impact of the project by requiring project sponsors to identify and mitigate environmental and social risks. IFC Performance Standards 2, 4, 5, 7, and 8 address the potentially adverse social consequences of the project. They require the project sponsor to treat the employees fairly, avoid adverse impacts on the health and safety of the community, try to avoid displacing persons and making sure that those who are displaced are not disadvantaged, respecting the rights of indigenous peoples who might be affected by the project and securing their free consent to any adverse impact from the project, and protecting the affected region's cultural heritage from harm. IFC Performance Standards 3 and 6 address the need to avoid any environmental harm from the project, such as water or air pollution, avoiding any harm to the local ecosystem and promoting the sustainable development of living natural resources in the affected region.
A project sponsor who desires IFC funding must submit an application that furnishes the following basic information: project description, sponsor's financial information, construction plan with breakdown of project capital costs and a timetable for financing and constructing project facilities, operating details with information about the markets for the project's output, financial structure of the project along with financing plan, identification of applicable government regulations and any host country incentives, and an economic feasibility study for the project, which must provide the sponsor's expected return on the investment. The IFC reviews this application to identify any environmental or social risks the project poses and to assess whether the sponsor has an adequate plan to mitigate any adverse environmental or social impact of the project.8
IFC assigns a project-appraisal team, composed of an investment officer who is familiar with the country, an engineer who has the technical expertise to evaluate the proposed project, and an environmental specialist, to assess the technical, financial, economic, and environmental aspects of the project. Project appraisal includes assessing compliance with the eight IFC Performance Standards. If the IFC commits to lend to the project, it will monitor the project to ensure continued compliance with the IFC Performance Standards, typically requiring the project sponsor to furnish quarterly project status reports. The IFC's detailed project appraisal and monitoring process is designed to promote long-term sustainable development by restricting financing only to those projects that have manageable environmental and social risks and that are expected to benefit the host country and adequately promote its economic development.
The Equator Principles
Most of the large commercial bank project lenders have adopted the Equator Principles, which are a set of compliance standards that are designed to ensure that the projects to which they lend are socially responsible and reflect sound environmental management practices.9 Like the OECD Guidelines, the Equator Principles are a general, voluntary framework of principles and standards; adoption is not legally binding. Financial institutions that adopt the Equator Principles agree to finance only those projects that are consistent with these principles.
While there is no formal compliance enforcement mechanism, certain factors do encourage financial institutions that have adopted the Equator Principles to uphold them. As the world becomes more aware of our environment's vulnerability, there will be increased pressure on commercial banks to do more to help protect the environment. For example, while agreeing to support the Equator Principles would have distinguished a commercial lender from its competitors a few years ago, compliance with the Equator Principles is now becoming the rule rather than the exception. Commercial banks agree to abide by the Equator Principles to be seen as socially and environmentally responsible financial institutions and build reputational capital.
Financial institutions that adopt the social and environmental standards set forth in the Equator Principles agree not to lend to a project unless it complies. Before the financial institution agrees to lend, Principle 1 requires it to conduct due diligence to evaluate the project's potential environmental and social impact. Based on this review, the project is classified in one of three categories:
Table 6.4 briefly summarizes the Equator Principles. For projects in Category A or Category B, the project sponsor must comply with certain additional requirements to obtain funding according to the Equator Principles. Principle 2 requires the project sponsor to conduct a social and environmental impact assessment to identify fully the project's significant social and environmental impact and to propose steps that are satisfactory to project lenders to mitigate each adverse impact. Principle 3 requires compliance with the IFC Performance Standards or suitable, similar, industry-specific social and environmental standards. Principle 4 requires the project sponsor to devise and implement an acceptable action plan to address all significant social and environmental risks posed by the project. Principle 5 requires the project sponsor to consult with the affected community about the project's social and environmental impact, and Principle 6 requires it to establish a grievance mechanism to address any future community concerns. In potentially severe cases, Principle 7 directs the project sponsor to engage independent social and environmental experts to examine the project, review the environmental impact report, and assess the adequacy of the sponsor's mitigation plan.
Table 6.4 Summary of the Equator Principles.
Principle 8 governs how the lenders can obtain assurances from the project company in the loan agreement that the project will maintain compliance with the Equator Principles. Table 6.5 provides the covenant requirements. The project company must agree to comply with the host country's social and environmental laws and regulations and all project permits. It must also agree to follow its own action plan to mitigate all the project's significant social and environmental risks during both construction and operation. The project company is required to provide the lenders with proof of its compliance with the Equator Principles by furnishing regular compliance reports at least annually. The project company also must agree to decommission the project facilities at the conclusion of the project according to an acceptable decommissioning plan.
Table 6.5 Covenant Restrictions to Support the Equator Principles.
Lenders incorporate the four covenant requirements in each loan agreement to achieve continuing compliance with the Equator Principles for the life of the project loans. Noncompliance with one of the covenants would be an event of default, which would give the lenders specified remedies, including the ability to accelerate loan repayment.10 Thus, a project sponsor has a strong incentive to ensure that the project remains in compliance with the Equator Principles' social and environmental standards. Note, however, that the Equator Principles only apply to a project while a project loan containing these covenants remains outstanding. Once the project company repays the loan, the covenants are no longer operative.
Effect of the International Standards for Promoting Environmentally and Socially Responsible Investing
The international standards just discussed recognize that a project sponsor may not have an adequate economic incentive to incorporate the environmental costs and other social costs of the project in its evaluation of the project. Of more concern, a project sponsor's economic interests and those of the surrounding community may be in direct conflict. The project sponsor's incentive may be to lay off as much cost as possible on the surrounding community even when doing so spoils the environment. For example, it will be cheaper to discharge waste into the ground or into an adjacent river than to dispose of it in an environmentally sound manner if the surrounding community fails to detect the waste discharge or if it becomes aware of the waste discharge but does not charge the project company the full cost it imposes on the community to compensate the community for bearing this cost. In some cases, the problem may not be detected or its full scope fully understood for many years, by which time the project may be near the end of its useful economic life without enough value left to cover the cost of cleanup.
The OECD Guidelines, the IFC Performance Standards, and the Equator Principles are all designed to force project sponsors to disclose the potentially adverse environmental and social effects of their project and to agree to bear the cost of dealing with them before the project receives its debt funding. This approach internalizes the project's environmental and social costs, which should reduce the likelihood that a project receives an implicit hidden subsidy through society having to bear unwanted and uncompensated environmental or social costs.
Evaluating the Viability of a Renewable Energy Project
Evaluating the viability of a renewable energy project, or almost any sustainable technology project for that matter, involves at least three complications in addition to what is typically encountered in a project financing. First, such projects are often rich in real options, especially when a new technology is involved. These options must be correctly valued to achieve a reliable assessment of the economics of the project. Real-options analysis, which is discussed in Chapter 12, can be used for this purpose.
Second, when the project will utilize a new technology, there is a heightened level of technological risk and also greater completion risk. New technologies are experimental to a certain degree, and while they may hold great scientific and economic promise, they may also entail greater risk. The project financing structure needs to be designed with the more extreme risk-reward profile in mind. As with all projects, the nature of the risks, how they are allocated, and how the parties who bear those risks are compensated are threshold issues for the design of the project financing.
Third, also because of the new technology but also due to the socially desirable sustainable nature of the project, sustainable projects are often subsidized. Such projects often furnish a social benefit in addition to the direct economic benefits to the project sponsors. For example, demonstrating the technical viability of a new technology on a commercial scale, which leads to the more efficient utilization of the world's scarce energy resources, can have huge societal benefits. It may not be possible for the project sponsors to capture all those benefits for themselves through their pricing of the project's output, nor is it necessarily desirable from society's standpoint to have a small group of promoters control a critical new technology for their own private benefit. In that case, the host government can provide subsidies in the form of a cash grant, which lowers the sponsors' required capital investment and thus assumes part of the investment risk, or lend at a reduced interest rate to reduce the project's cost of funds. The host country might require the sponsors to agree contractually to license the technology to others so that the benefits could be shared if the new technology works.
Example: The La Confluencia Hydroelectric Power Project
In 2004, Pacific Hydro Pty Limited (Pacific Hydro) and Statkraft Norfund Power Investment AS (SN Power) entered into a joint venture agreement concerning the development of the La Confluencia Hydroelectric Power Project.11 The project involved the construction and operation of a run-of-the-river hydroelectric power plant in Rio Tinguiririca, Chile, which is about a 3-hour drive from Chile's capital, Santiago. The project, which cost approximately $400 million, illustrates how a rapidly developing country can pursue an important infrastructure project without compromising its commitment to protecting its environment.
La Confluencia would have 158 megawatts of installed capacity, which would generate an average of 672 gigawatt hours of electricity per year by diverting water from the Tinguiririca and Azurfe rivers.12 The plant would operate as a base load unit in the summer and as a peaking unit in the winter. The water to power the plant would come mainly from glacial and snowmelt, allowing La Confluencia to produce more energy than other hydroelectric plants during the drier summer months. The electric power La Confluencia generated would enter Chile's Central Interconnected System (SIC), which at the time provided power to 93 percent of Chile. Importantly, the project would reduce greenhouse gas emissions (as compared to a fossil-fuel-burning plant) by roughly 402,000 tonnes per year.
Background on Foreign Direct Investment in Energy Projects in Chile
Before delving more deeply into the particulars of the La Confluencia Hydroelectric Power Project, this section of the chapter provides some background concerning energy projects in Chile. The discussion illustrates the importance of understanding the host country's legal and regulatory environment before undertaking a large project.
Private investors consider the host government's receptivity to foreign direct investment, the fairness and effectiveness of the country's legal system, and the attractiveness of the available investment opportunities when deciding whether to invest in a country.13 Chile's economic and political stability, effective rule of law and legal stability, openness to foreign direct investment, favorable business climate, participation in international agreements that support economic development, and ample availability of natural resources make Chile attractive for foreign capital investment.14 Chile is widely regarded as having one of the most business-friendly economies in South America; as of October 2010, Transparency International ranked Chile fifth among 41 countries rich in natural resources according to its index of transparency in economic activities.15 In 2010, Chile received more than $18 billion of foreign direct investment, a 43 percent increase over 2009.
The Energy Industry in Chile at the Inception of the La Confluencia Project
Despite being rich in certain natural resources, Chile does not have large quantities of fossil fuels. As a result, it is largely dependent on imported sources of energy. In the past decade, the Chilean government has sought to reduce this dependence and has taken steps to develop its own energy infrastructure. The Chilean government's National Energy Commission and its Production Development Corporation have tried to diversify Chile's electric grid by developing alternative and renewable sources of energy. In 2006, President Bachelet announced that Chile intended to have 15 percent of its energy come from alternative or renewable sources by the end of 2010.
Hydropower is currently the world's second largest source of renewable energy after biomass. It provides about 3 percent of global energy and about 16 percent of the world's electricity. Hydropower does not consume imported fossil fuels, and it does not emit carbon or otherwise pollute the environment. Hydropower projects are becoming more prominent in Chile, as well as in other jurisdictions with streams and rivers that can power the hydroelectric generating plants, as governments seek to reduce their reliance on imported fossil fuels to generate electric power. Hydropower projects are capital intensive but are environmentally friendly and have long, useful, economic lives. Their electric output can be sold under long-term power contracts, which makes them good candidates for international project financing.
To accomplish its ambitious hydropower goal, the Chilean government has tried to attract foreign direct investment for its energy infrastructure. The Chilean government privatized the energy industry and liberalized the investment requirements, which stimulated private foreign direct investment in the Chilean energy sector. In the 1980s, Chile had privatized its electricity industry and limited the government's role to regulation and inspection. Privatization attracted substantial private investment. More recently, Chile has taken further legal measures to improve the investment climate, which has succeeded in attracting foreign investors to this market.
Chile has also sought to stimulate foreign direct investment in its energy infrastructure by joining important international economic organizations. Chile was the first South American country to join the OECD in May 2010. OECD membership allowed Chile to observe the policies of other member countries giving it the opportunity to identify policies and strategies it might use to successfully stimulate its economic development while respecting social and environmental concerns. Chile is also a member of the International Finance Corporation (IFC), which provides investments and advisory services to support important private sector projects that will lead to long-term sustainable development. The IFC's lending policies promote clean technology and renewable energy, as described earlier in the chapter.
Legal Incentives for Foreign Investment in Chilean Renewable Energy
The General Electricity Act of 1982 is the law governing the electricity sector in Chile. In order to promote alternative forms of energy and to attract foreign investment in the energy sector, the Chilean government has amended the General Electricity Act in recent years. These amendments contain policies to promote market forces and incentivize private enterprise. They have significantly increased private investment in Chilean infrastructure, particularly the renewable energy sector. Chilean law has continued to promote renewable energy.16
The Chilean National Energy Commission (CNE) is part of the Ministry of the Economy and is the lead governmental agency for the energy sector. CNE creates the rules and policies for the purchase and sale of energy. It also calculates and sets the prices at which energy can be purchased and sold in each of Chile's three distinct markets—regulated, unregulated, and spot markets. So, although CNE does not have any regulatory power over a private company's investment, its actions do affect a private company's decision whether to invest in Chile's energy infrastructure.
The 2005 Amendment to the General Electricity Act changed the way in which CNE sets prices by allowing it to better consider market fluctuation. CNE's increased flexibility in price setting has allowed CNE to set higher prices for energy and to provide long-term stability of these prices. As a result, power generators in Chile can now receive higher prices for the energy they produce and be free from unexplained price changes that could threaten the profitability of their power project. The amendments to the General Electricity Act also encouraged the development of renewable energy power stations by eliminating some of the tolls paid in the delivery of the energy and by establishing a dispute resolution mechanism to settle disputes within the energy sector.
In 2008, President Bachelet signed into law a bill whereby new energy contracts must require power projects to receive at least 5 percent of their energy from alternative sources.17 The change in Chilean law in favor of renewable sources of energy and private investment has greatly increased the amount of foreign investment in Chilean infrastructure, particularly through project financing.
Legal Requirements for International Project Finance Transactions in Chile
While Chilean energy law creates an attractive market for international project financing, investors must satisfy Chilean environmental law and obtain necessary governmental licenses before they can proceed with their project. Chile's National Environmental Commission (CONAMA) is responsible for assessing a project's compliance with relevant environmental regulations. The Chilean Law of Environmental Basis establishes the procedure for project sponsors to follow in applying for and obtaining necessary permits. A project company must obtain a General License or Declaration of No Environmental Impact.
After conducting a thorough investigation of its proposed project and its effects, a project company must first submit an Environmental Impact Declaration (EID) or an Environmental Impact Study (EIS) to the Chilean government for review. An EID states that the proposed project will have no environmental impact. According to the law, project companies must submit an EIS if the proposed project will be located in proximity to a populated area or if it might pose a risk to the health of the population, have adverse effects on sources of renewable energy, or pose any other risk to the surrounding community.
Because most proposed projects have the potential to impact the environment, most project companies must submit an EIS. The EIS must provide a detailed description of the proposed project; an evaluation of the likely environmental impact of the project, including any risks; a description of the measures that will be taken to minimize any adverse impact; and a plan for complying with the applicable environmental rules and regulations. The EIS is published in a national newspaper to raise public awareness of the project. Members of the community who might be affected by the project can voice their opposition, and often a public hearing is held for this purpose.
CONAMA, along with other governmental agencies, reviews the EIS. CONAMA will engage legal advisors and members of the affected community, who will submit their comments on the project. The government then provides a consolidated report from CONAMA, other agencies, legal advisors, and members of the affected community that contains an assessment and a list of open issues for the project company. The project company will then provide the government with its response. Finally, CONAMA will make its decision on the project company's request for a license.
Once CONAMA has completed its review and granted a license, it has no authority to monitor the project. While CONAMA will usually require a project company to disclose any unforeseen issues that arise during the construction and operation of the project, it has no way to enforce this obligation. So, while CONAMA takes steps to ensure that a project will not adversely affect the environment, its inability to monitor the project for compliance after issuing the license is potentially worrisome.
The La Confluencia Hydroelectric Power Project and Responsible Investing
The La Confluencia Hydroelectric Power Project illustrates Chile's commitment to protecting its environment.
Project Sponsors
Pacific Hydro is an Australian renewable energy company and one of the world's leading clean energy independent power producers. SN Power is a Norwegian partnership of Statkraft, with 60 percent ownership, and Norfund, with 40 percent ownership, that develops and operates sustainable hydropower projects in emerging markets. Statkraft is Norway's public power utility and Europe's largest generator of renewable energy with heavy reliance on hydropower. Norfund, a Norwegian sovereign fund, invests in emerging markets. SN Power combined the hydropower expertise of Statkraft and the financial capability of Norfund, which made it an effective partner for Pacific Hydro.
Project Agreements
The project agreements allocate project risks to those best equipped to bear them, as described in Chapter 7. The project contracts define each party's role, specify their responsibilities, and identify their liabilities. They also determine the returns each party can expect to receive through their participation in the project. The two most noteworthy agreements for the La Confluencia project are the construction agreement and the offtake agreement.
Construction Agreement
The project was expected to cost $379 million. The project sponsors faced the risks that the project's construction costs might exceed the agreed budget, that completion might be delayed beyond the target completion date, and that the completed project might not meet the agreed performance standards. Pacific Hydro and SN Power entered into a turnkey engineering, procurement, and construction (EPC) contract with Constructura Hoctief-Tecsa for the construction of La Confluencia.18 Construction began in the first quarter of 2007, and the project was completed in the third quarter of 2010. The EPC construction agreement assigned liability for all these completion risks to the construction contractor.
Offtake Agreement
The offtake agreement is one of the most important project contracts because it is the main source of revenue for a project. Even if the project becomes operational, there is risk that the project revenues might be insufficient to repay project debt. This risk will materialize if the demand for the project's power decreases or if a competitor later enters the market and is able to sell the power at a lower price. The offtake purchaser faces a risk that the project will not produce enough energy to meet market demand, which might reduce the offtake purchaser's potential profits and cause customers to switch to competitors.
The sponsors of the La Confluencia project negotiated a power purchase agreement (PPA), which is the primary form of offtake agreement for energy projects. A project company typically enters into a PPA with the local electric utility company, which agrees to purchase an agreed portion of the project's output for the term of the contract at a cost that is usually either fixed or determined by formula. Since the PPA is the primary source of the project's revenues, the project company will want to ensure that the purchaser has sufficient creditworthiness and the need for the contracted quantity at the agreed price. PPAs for independent power projects typically provide for a power purchase price that has a fixed component designed to cover the overhead costs of the project and a variable component designed to cover the variable project operating costs, which depend on the level of production. Independent power producers usually try to negotiate a minimum purchase quantity large enough to cover all of the project's fixed costs after paying all the variable costs of producing the minimum quantity of electricity. They also typically seek assurances from the offtake purchaser that it will either buy the minimum amount of energy or else pay a fixed sum to the project company each period under a take-or-pay agreement to guarantee a minimum amount of revenue per period.19
Pacific Hydro and SN Power entered into a PPA with Chilectra, the largest electric utility in Chile. Chilectra agreed to purchase 375 gigawatt hours of energy a year from La Confluencia. The project company would sell the balance of its electricity generation on the spot market. Thus, Pacific Hydro and SN Power, as well as the lenders, would face a risk that La Confluencia would not achieve its potential profitability if it could not sell the balance of the electricity at an acceptable price. However, Chile's energy demand had been increasing rapidly in recent years, Chilean government energy policy called for reducing Chile's reliance on imported energy, domestic electricity demand was projected to double by 2020 if the country achieved its goal of 6 percent annual growth, and the La Confluencia project would be connected to the largest electric power grid in Chile. Thus, it appeared unlikely that the project company would face a lack of demand for the power in the spot market.
Operating Risk
Once a project is constructed, there is a risk that it will not operate as expected because of faulty design, construction, or operation. The project may operate at a higher cost than expected, causing the operating profit from the project to fall short of what was projected. There is also risk that the project's operations will be interrupted, causing it to produce less than expected. This risk depends mostly on the quality of the operator. A natural disaster, such as the February 2010 earthquake that destroyed parts of the Chilean infrastructure, might also interrupt the project's operations. Operating risk for the La Confluencia project was low because it had an experienced operator.
Run-of-the-river hydroelectric power projects depend on a continuous flow of water to maintain operations. A drought could reduce a hydroelectric project's output because of its dependency on water flow. The La Confluencia project relies on river water, which is more abundant during the summer months than for a typical hydroelectric project because the river water comes from melting glaciers.
Regulatory and Political Risk
Hydroelectric power projects require governmental approval in Chile. Thus, these projects carry a risk that requirements for such approval will change during the course of construction or operation, with the result that the project no longer qualifies for the license. However, regulatory risk in Chile is considered low because of Chile's openness to foreign direct investment.
Political risk can be a concern depending on the country in which the project is located. Political risk generally includes expropriation by the host government, nationalization of assets, currency transfer restrictions, and war. Political risk cannot be allocated through contract, but there are other options available to mitigate this risk, including political risk insurance. Chile is generally considered a very safe country for foreign investors, carrying little risk of expropriation and political violence.
Project Financing
The project was estimated to cost $379 million. Projects in Chile were eligible for IFC financing because Chile had been a member of the IFC since 1957. The IFC arranged $208 million in debt financing for the La Confluencia Project. IFC customarily arranges private funding to accompany its project loans. IFC extended an $83 million Term A Loan and arranged for participating private lenders to extend a $125 million Term B Loan. La Confluencia would also have had to satisfy the Equator Principles to receive financing from those financial institutions that have adopted them.
To obtain IFC financing, Pacific Hydro and SN Power had to comply with the social and environmental requirements of both the IFC Performance Standards and Chile's CONAMA. CONAMA approved the project's Environmental and Social Impact Assessment (ESIA) in 2004. The IFC conducted a thorough evaluation of La Confluencia's environmental and social impact according to the IFC Performance Standards. The IFC signed financing agreements with Pacific Hydro and SN Power on October 23, 2007. Its board approved the La Confluencia Project on October 4, 2008, and the IFC invested in the project on December 29, 2008.
La Confluencia qualified for IFC funding for several reasons. The project had the support of national, regional, and local authorities in Chile. Second, it would generate power at relatively low cost and in an environmentally friendly manner. In particular, it would meet environmental standards because it would operate underground, beneath land that is nonproductive and that would not be negatively affected by the project, which satisfies IFC Performance Standard 1. Third, the project would help Chile achieve its goal of diversifying its energy sources while augmenting Chile's alternative sources of energy. Fourth, the project would create jobs, provide economic stimulus, and improve infrastructure within a poor local community with few job opportunities and poor infrastructure, which satisfies IFC Performance Standard 4. Fifth, it would not adversely affect any indigenous communities, which satisfies IFC Performance Standard 7.
Significance of the La Confluencia Project
The La Confluencia Project was formally dedicated at a public ceremony in October 2010, which was attended by Chilean President Sebastián Pinera. The project will benefit the local community where it operates by creating vital infrastructure, producing energy, and creating jobs without negatively affecting the environment or displacing the local population. The project stands in contrast to the Pangue Dam Project on the Bío Bio River in Chile, which about 10 years earlier had displaced much of the indigenous people in the area and faced enormous public criticism.20 The difference between the La Confluencia Project and the Pangue Dam Project was due, at least in part, to the change in Chilean law governing foreign investment in energy infrastructure and also to the development of the IFC Performance Standards and the Equator Principles.
Conclusion
International public opinion surveys reveal that there is strong support for promoting renewable sources of energy to generate electricity, such as wind power and solar power. There is a growing willingness to require utilities to tap renewable energy sources or to buy electricity from such projects even if doing so would increase the cost of electricity to consumers. There seems to be great optimism that this strategy will pay off economically over the long term because traditional fuels are likely to become more expensive as stocks are depleted, and renewable energy is likely to become relatively less expensive as the technology improves.
The adoption of reasonable environmental and social impact standards by leading project lenders has affected nearly all international projects because of the important role these financial institutions play in providing long-term project debt financing. Commercial lenders and the IFC may have more power than the host country's government agencies to ensure that projects remain environmentally and socially responsible because of their lending relationship with the project company. They can include covenants in the loan agreements that require the project company to maintain compliance with the IFC Performance Standards or the Equator Principles. Consequently, these standards play an important role in promoting socially responsible infrastructure development in the emerging economies. By adopting the IFC Performance Standards and the Equator Principles, large international project lenders have endorsed the importance of considering the potential environmental and social impact, not just the economic feasibility, of international projects.