In recent years, the African continent has undergone an unprecedented wave of modernisation, with foreign direct investment rising around 10% annually (reaching £46bn in 2018). Much of this has come from Chinese companies who are hedging their bets, seeing Africa as the last great untapped market for commercial expansion.
However, a fundamental problem has continued to drag on the viability of essential power projects in a number of Sub-Saharan nations, whose plans are repeatedly scuppered by issues stemming from Counterparty Credit Risk.
What is it?
Counterparty Credit Risk is defined by the Bank of International Settlements as ‘the risk that the counterparty to a transaction could default before the final settlement of the transaction in cases where there is a bilateral risk of loss’.
Every Sub-Saharan nation is different, and so too is every energy project, but there are a few core similarities which cause entry-level problems in the project finance stage.
The common structure of such projects involves a Special Purpose Vehicle (SPV), funded wholly or partially by a foreign investor which agrees to establish a power facility in the host country. The state will then agree to an offtake agreement, whereby another state subsidiary will purchase the goods produced by the facility for a full year.
For example, an imaginary American private equity company agrees to fund a project with the government of Côte d’Ivoire, forming a SPV which will produce concrete to help build a highway network for the country. As part of the agreement, the government establishes a subsidiary which is party to an offtake arrangement where it will purchase 100% of the concrete produced annually. In theory, these plans can then be brought to commercial creditors who will help to support the project through the issuance of credit.
Where do the problems arise?
Most Sub-Saharan African power sector offtakers are owned or controlled by the state, and the majority of these companies do not have verified ratings by credit agencies, or ample evidence of financial security. To compound this, countries in this region have a record of particularly perilous balance sheets, with high tariffs, poor financial flexibility, weak infrastructure, and high levels of political instability.
These factors in combination have meant private sector lenders and investors in the energy industry seek external credit support to protect themselves from liabilities if the offtaker fails to meet its obligations.
The absence of such support often leads to projects being classed as unbankable, with the issue of counterparty credit risk holding back much development in the region.
The role of commercial lawyers
Where commercial problems arise, it is the job of commercial lawyers and Project Finance departments to find solutions.
Traditionally, the issue of counterparty credit risk would be resolved by the host government agreeing to support lenders and/or investors and shoulder the burden of any potential liabilities if the offtake agreement fails. However, this kind of support is becoming increasingly difficult to secure with Sub-Saharan African governments, as there is a greater recognition of the potential impacts upon national balance sheets and the country’s financial standing. Contingent liabilities can expand rapidly, racking up government debt and creating inflationary pressures upon the currency.
In replacing this form of credit support, there are a number of alternative solutions that you should be aware of:
- Liquidity support: whereby the offtaker will procure and then offer security to the project in the form of liquidity; requiring an agreement on the appropriate amount and the risk involved in its continuation if such support is required.
- Multilateral Guarantees: whereby multilateral organisations such as the World Bank or the African Development Bank will agree to a Loan or Pay-Out Guarantee – protecting the investors and lenders from the government defaults. These agreements can have steep time implications and require an indemnity from the government.
- Public Political Risk Insurance: for example, the Multilateral Investment Guarantee Agency (MIGA) provides coverage against currency inconvertibility, expropriation, conflict, political disturbance, and a state’s failure to honour its financial obligations. Certain countries have established their own MIGAs to provide such coverage to their own citizens, such as the United States International Development Finance Corporation.
- Private Political Risk Insurance: whilst rarer than public political risk insurance, it is possible to secure this without the public eligibility requirements and apply it to a broader range of potential projects.
- Export Credit Agencies: these agencies are becoming globally-recognised as sources of support through a guarantee or insurance policy. However, these require strict contractual compliance, often presenting restrictive challenges for lenders and borrowers alike.
- Development Finance Institutions: these institutions, such as the International Finance Corporation, have a two-pronged role; providing funding, but also generating stability as these organisations often have close relationships with countries in the region. This means that failures to honour obligations can lead to financial penalties – i.e. cross-defaults or the withdrawal of funding to existing national projects.
- Contractual comforts: projects can be further protected through contracts and investment structuring by lawyers; creating space for international arbitration, contractual protection in the event of political change, or treaty protection.
The market for project finance in Sub-Saharan Africa is rich in potential, but the prevalence of counterparty credit risk has halted many potentially-beneficial projects in their infancy. This has created a vast space for ingenious and problem-solving in commercial legal work, which can provide the added layers of comfort necessary to secure important commercial financing within this region.