Risk Mitigation Instruments for Infrastructure Finance
In recent articles we have spoken about credit enhancement to accelerate infrastructure investment. Our experience in the African market has shown that credit enhancement is critical to attract foreign direct investment towards infrastructure. In this article we describe a few risk mitigation instruments that are typically used in credit enhancing infrastructure transactions.
Most bankers and investors would already be familiar with these; the challenge being to get project sponsors and Governments to understand them as well. Such instruments are used extensively around the World, but we believe that they could be used even more in the African market to accelerate infrastructure investment. There is need to develop deeper understanding of these instruments, the requirements of the organisations that issue them and deeper understanding by project sponsors and Governments to structure transactions that meet the requirements for securing such risk mitigation instruments.
In most cases, these risk mitigation instruments require the host Governments to provide commitments through Sovereign Guarantees and Letters of Support. It is important for Governments to understand this and actually create structures that allow such commitments to be provided.
Importance of risk mitigation
Risk mitigation addresses investors’ concerns over potential losses that are often significant in infrastructure projects. Being physical, more visible and not moveable once constructed, it is difficult for project developers to abandon the project if it encounters problems. For example, the high visibility of large projects means they have important political implications. This exposes them to political interference. This increases the risk of regulatory changes that could impact the operations and revenues of the project.
Coupled with this, complex financing arrangements are often involved, including Special Purpose Vehicles (SPV) that are set up specifically to invest in and oversee a given project, with a number of parties with different interests participating. The long gestation period of infrastructure projects also increases the likelihood for unforeseen events taking place, which could undermine the successful completion of a project cycle.
The significant upfront capital costs of developing a project concept, in addition to high construction and operating costs, do not help the situation either. Then funding projects in Africa is often in foreign currency with the project earning revenues in local currency that is often volatile. Currency depreciation would, therefore, increase the investors’ risks. There are then other force majeure risks, such as accidents, uncontrollable situations and extreme events that all need to be covered.
Risk Mitigation Instruments available
Various risk mitigation instruments have been developed by development finance institutions such as bilateral and multilateral organisations, commercial insurers and export credit agencies among other players. These include Partial Risk Guarantees (PRGs), Partial Credit Guarantees (PCGs), Political Risk Insurance (PRI), Currency Risk Coverage and Export Credit Guarantees (ECGs).
Different providers have different eligibility requirements for them to issue these instruments. It is those requirements with which African Governments and project sponsors must familiarise in order to structure bankable projects that attract foreign direct investments. The availability of cover and the cost of such cover is often highly correlated with how the project is structured and the risk management structure in place given the location of the project and the commitments of the host Government.
The instruments are structured to credit enhance a transaction leading to better financing terms such as long tenure and lower interest rates compared to what a borrower or project would ordinarily obtain if there were no guarantees. Depending on how they are structured, the instruments effectively substitute the borrower and project risk such that the investor is less exposed in the event of problems with the project. This provides access to the international capital markets, broadening the sources of funding available to African Governments and project sponsors. The instruments, and what they typically cover, are discussed briefly below.
Credit Guarantees cover losses in the event of loan default, regardless of the cause of default (i.e. commercial or political). The coverage can be partial, covering only a part of the loan, or full, covering the whole amount.
Partial Risk Guarantees cover losses from a loan default as a result of political events. These include losses as a result of (1) expropriation of investments by government actions reducing or eliminating the investor’s ownership, control and rights to the investment; (2) war and civil disturbance causing damage or destruction to infrastructure; (3) currency/transfer risk relating to restrictions on the ability to repatriate foreign currency earnings or to convert local currency into foreign currency; and (4) breach of contract relating to government action to amend or cancel a contract leading to financial losses.
Currency Risk Coverage: These instruments cover foreign currency exchange risk for most infrastructure projects funded by foreign currency but earning revenues in local currency. The Currency Exchange Fund (TCX) is a special purpose fund that offers currency hedging products which mitigate currency and interest rate risks through medium to long-term swap agreements. The shareholders of TCX include most development finance institutions in the World and a number of specialised micro finance investors. It operates predominantly in emerging and frontier markets that include Africa.
Export Credit Agencies (ECAs) Cover: Government agencies, called ECAs, typically provide their cover to investing companies and exporters from their countries. The aim is to support exports from their home companies abroad; insurance for investments abroad that are beneficial to the home country; and guarantees against political and commercial risks that can adversely impact on investments and loan guarantees so that buyers can purchase goods and services from exporters.
There are both challenges and benefits in using these risk mitigation instruments that potential users need to be aware of, hence the need to invest in understanding these instruments and how they work. Benefits include giving investors a measure of control over political and commercial risks associated with their investments, obtaining longer term loans, obtaining lower interest rates, and supporting a country’s development efforts due to increased investments.
Some of the challenges with securing and using these instruments include restrictions to only strategic projects of national and regional importance, short term nature of the instruments provided by some of the organisations, high transaction costs due to the detailed due diligence, high contract monitoring costs once an instrument has been issued, and the difficulty of determining the circumstances under which a guarantee is called.
The benefits of using these risk mitigation instruments seem to far outweigh the challenges, so their use requires significant attention to accelerate infrastructure investment in Africa. National Standard Finance’s funding model in Africa is geared towards the use of these instruments in promoting foreign direct investments. These are typically required to support a Direct Pay Letter of Credit from major international banks upon which National Standard’s funding model is based.
Michael Tichareva is Principal & Managing Director of Africa operations at National Standard Finance, LLC. Mr. Tichareva can be reached at MTichareva@NatStandard.com.
The website can be accessed here: www.NatStandard.com
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