By Nato Oosthuizen
The increasing conversation around refinancing of existing Independent Power Producers (IPPs) shows that the renewable energy sector in South Africa is growing and developing. Elsa Strydom, senior project manager at the Independent Power Producers Office (IPPO), states that “although the participation in the refinancing initiative is voluntary, by the end of May 2020, 70% of South Africa’s 64 IPPs had indicated a positive response to the process.” Clearly indicating the sector’s appetite and confidence in the success of projects in the renewables space.
During the historical Renewable Energy Independent Power Producer Procurement Programme (REIPPPP) bid windows, prices were proposed by the IPP’s based on the then existing cost and capital structures that incorporated the maturity and perceived risk of the renewable industry in the South African market. During the initial years of the REIPPPP, technology, expertise and funding were not at the more developed stages as at current. Therefore, the costing and subsequent pricing offered by the IPP’s were higher. In the most recent bid windows, the IPP’s offered prices much lower than those in the initial bid rounds.
The improvement of the technology and local expertise within the renewable energy industry means that the generation cost (frequently referred to as a cost per Megawatt installed) is becoming cheaper. In addition, the reduction in the perceived risk of the renewable industry in the South African market by equity and debt funders reduces the cost of capital that is required for the significant capital investments to be made in constructing these generation assets.
So what does this mean for the existing REIPPPP IPP’s and their government client?
There are certain events that are viewed by the government (the client) as “changes in contract” in the world of IPP’s. A list of such events was issued by government, with elaboration and clarifications being communicated throughout. ”Change in contract” in financial terms could mean IPP’s getting an improved borrowing rate from the external funders (e.g. bank), or the external funders easing restrictions on the IPP’s reserve accounts (e.g. Debt service or maintenance reserve accounts), releasing cash flow into the project company that the shareholders didn’t anticipate having. These additional cash flows are then eligible for distribution to shareholders, whether through repaying shareholder loan accounts quicker or distributing higher than expected dividends. In whichever case, when higher or earlier than expected cash flows are distributed to shareholder, it leads to a higher than expected Internal Rate of Return (IRR) on their investment made.
Therefore, any increase in return above the initially proposed margins are to be shared with the government (the client), and a new bid (in the form of a financial forecast) needs to be created to reflect a greater than expected returns due to the current successes of IPP’s. For example, if you calculate that for the remaining period of the Power Purchase Agreement (PPA) you will make a return of 18% instead of the 16% that you predicted, the agreement is that you must adjust the price (i.e. the price per kilowatt hour charged to ESKOM) of the PPA downwards until your return (IRR) is only 17%, which basically represents half of what the upside was from 16% to 18%.
Essentially, the government is entitled to 50% of the extra 2% that you made over the period. The market has agreed to this as they understand that if their initial intent was to generate an IRR of 16% and presented a PPA price accordingly.
These IPP’s realistically only have one shot at re-evaluating and restructuring their project and creating a new proposal in the form of a financial forecast with adjusted returns, as this is quite an expensive exercise that requires assistance from various third-party industry experts.
The first thing to consider when taking the refinancing route is creating a new financial model. IPP’s need to engage with their existing funders and notify them of their intention to embark on this journey, taking into consideration existing contracts and agreements that were signed between the original funder(s) and the IPP’s. There are several items that the IPP will have to look at, including whether they are allowed by their funder to refinance at all, or what the conditions are for the IPP to seek out new funding from other financial institutions and the potential penalties that could be involved. It is worth noting that local and international commercial banks have seen the benefits of funding renewable energy projects of this nature and are more open to financing and/or refinancing them.
The new financial model would outline all updated technical, financial and economic assumptions that form the basis of the updated forecasts that have been made. The funders require these financial models to be audited by a third-party audit firm to ensuring the arithmetic accuracy, consistency and logic of the calculation as well as the accurate and most recent International Financial Reporting Standards (IFRS) and Tax laws and interpretation notes. The most recent tax updates and interpretations are of specific importance as there were some uncertainties among the IPP’s on the tax treatment of certain capital expenditure during the earlier REIPPPP bid windows (i.e. whether it was tax deductible or not).
A lot of clarity has been obtained now and IPP’s need to get their auditors, tax specialists and management involved to ensure that they are accounting for the correct tax treatment going forward and incorporate that into the financial model, which might not have been as accurate at its inception.
Further operational matters that will have to be assessed include the different types of funding changes.
The interest rates that were used in the initial IPP’s proposals were mainly based on the Johannesburg interbank agreed rate (JIBAR) or Prime interest rate plus a margin and banking cost. Most of the commercial banks were offering these types of rates, with international funders offering the London Inter-Bank Offered Rate (LIBOR). In more recent years, the banks have started charging interest rates based on a Consumer Price Index (CPI) adjusted rate. This is beneficial to the IPP’s as the cost of debt aligns with the economic risk of the PPA. This is because the rate (per kilowatt hour) that the IPP charges ESKOM is set to increase with the average annual CPI. By having both the debt and the sales linked to the same index, the economic risk is minimised. Currently the IPP’s are mostly required to hedge either partial or all their floating interest rate debt. With the natural hedge between the CPI increases on debt and sales, it also leaves the door open for less risk that requires hedging, which will bring the cost of financing down as well.
The government has also indicated that that IPP’s who will be undergoing this process will be allowed to relook the other operational expenses as well. There might be some operating expenses that the IPP’s omitted or underestimated in their initial financial forecasts or certain costs that was set to change in future, but the extent of the changes was uncertain at the time. Most notable cost that can better be defined with aging projects are the Operating and Maintenance (O&M) costs. More O&M providers are entering the local renewable energy market in anticipation of the further roll-out of the REIPPPP in the coming years. This is likely to lead more competitive pricing and better service delivery as skills are developed and retained in the local market (in comparison to requiring international experts). Other changes could include the investments in working capital that the IPP’s didn’t estimate correctly. The IPP’s can now build these changes into the new financial forecast.
The costs associated with this endeavour are not cheap, with all the third party financial and legal consultants that will be needed for the process, it is essential that the pros vastly outweigh the costs. IPP’s are not advised to go this journey alone, as a misstep will mean that the process must be started from the beginning, with more costs to be incurred.
Nato Oosthuizen is Partner at BDO South Africa