they may often still be able to help, either
by working through their branch organization or by working with you in
approaching other financial institutions.
In many cases a simple technical and financial appraisal is all that will be
required. The level of interest that you will be charged on your loan will,
as a rule, depend on the size and type of the loan, prime central bank
rates, the degree of risk involved in the loan and the financial strength of
the borrower.
Debt Finance
Debt is usually a conventional
commercial bank loan, although in some circumstances debt may also be
provided by institutional investors, most commonly insurance companies.
Borrowers pay interest, i.e. the cost of the debt, and repay the principal,
i.e. the loan amount. Lenders normally charge a pre-determined rate of
interest which is set by adding an "interest margin" to the bank’s standard
inter-bank lending rate. The interest margin is generally expressed in
‘basis points’ representing the banks' return on investment or income. In
some countries interest payments on debt may be tax deductible and this is
one of the reasons debt is thought of as ‘cheaper’ then equity.
The lender does not have a share in the project and therefore has no
"upside" potential. The "upside" is that if a project does well, there will
be more cash and profits for the equity investors. No matter how well the
project does, a lender will never receive more than the interest and
principal repayments. The downside risk is that the lender faces losing 100%
of the loan to the project if the project does not perform. Lenders and
banks have little or no opportunity to increase returns and face the
possibility of losing entire investments. Thus they focus closely on all
aspects of risk, and want to take the least risk of all parties involved.
Risk management is discussed elsewhere.
Equity Finance
Equity represents the investment on
the behalf of the owners of the project, and usually comes from individuals,
companies involved in a project such as project sponsors and equipment
manufacturers, or sometimes from institutional investors like insurance
companies or energy investment funds. These bodies are expected to take some
form of capital stake in the project.
There is an expectation on the part of debt providers that all projects will
be at least part-financed through equity. Typically, for well understood,
relatively low risk investment the equity stake may be as low as 30%, but
for less well understood (and hence riskier) investments, such as those in
renewable based capacity, the required equity stake may rise to over 50% of
the total project cost. Equity can take the form of direct capital
investment by the borrowers, or as third party capital inputs (e.g. in the
form of cash grants and capital subsidies). However, lenders demand that
borrowers take an equity stake in their own right (to build their commitment
to their stake holding). In practice lenders normally look for a minimum of
around 20% of the project cost to come in the form of borrower equity.
Equity differs from debt in that it receives the profit from the project. If
the project does well, the equity pay out could be significant. If the
project under-performs or becomes bankrupt, however, equity investors are
the last to be paid, after the banks and other claims on the project. Thus
equity takes a higher risk and potentially receives higher returns to
compensate.
Subordinated Debt
Subordinated debt is debt that ranks
below the main (senior) debt in terms of its priority of payment or in
liquidation. The senior debt is usually bank debt, and there may be several
layers of subordinated debt between the bank debt and equity. Subordinated
debt principal and interest is paid only after the senior debt principal and
interest is paid. In insolvency, subordinated debt holders receive payment
only after the senior debt is paid in full. Interest paid on subordinated
debt is normally tax deductible. Subordinated debt can be provided by
companies involved in the particular power project, or can be from third
parties.
Subordinated debt may or may not be secured. It is flexible and can be
tailored to be deeply subordinated to the senior debt; in this case it may
almost take on the characteristics of equity. When calculating debt or
equity ratios, often bankers will consider subordinated debt as
‘quasi-equity’ and include it as part of the ‘equity cushion’ which supports
the senior bank debt. For example, a project with 70% debt, 10% subordinated
debt and 20% equity, sometimes may be viewed as a project having roughly 70%
debt and 30% equity.
"Mezzanine finance" is a general term used to describe various financing
arrangements that rank below the senior debt. There is no one definition for
mezzanine finance; it may or may not be from third parties, but in general
is more likely to be so. It may also have certain features that allow the
debt to be converted into equity.
Bonds
Bonds are interest-bearing instruments
issued by companies, governments or other organizations, and sold to
investors in order to raise capital. They are a type of debt. Bonds tend to
be long-term obligations with fixed interest rates and repayment schedules.
Bonds are usually issued and sold in the public bond markets, although
increasingly some are sold directly to institutional investors in which case
the financing is known as a "private placement". Bonds sold directly to
institutional investors may have the designation 144a, which refers to the
rule in US Securities Law under which they are issued. The 144a rule allows
US and foreign entities to raise capital in the US through a private
placement without having to go through the full formal registration process,
and allows such bonds to be traded. Rule 144a was first used in 1992 by a
few pioneering IPPs, and has since become a favored route to capital markets
for large scale, conventional projects as it provides more flexible
financing than normal full public bond issue.
Public bonds, and some private issues, are graded by credit rating agencies.
Different nomenclatures are used, but generally AAA or AA+ are the top
ratings, with BBB- being the lowest investment grade bond rating. As long as
they can achieve an investment grade credit rating, bond issues have
advantages over bank debt in that they can provide a source of longer term
money, and sometimes they may also have better commercial terms. However
bonds are less flexible than bank financing. In addition, for projects in
the developing countries, or those countries seen as more risky, the credit
rating is affected by the host country's investment rating.
Grants
Grants are non-returnable source of
funding which are provided to projects or exporters to cover capital costs.
Bodies, with an interest in seeing the projects developed, use grants to
encourage developers to consider projects which have high risks and
uncertain returns. They can be used in order to reduce the risk exposure of
the commercial lenders and investors, or to cover incremental capital costs.
Grant programs have to be operated carefully in a way that will not distort
market forces or lead to market collapse on withdrawal. Typically a lender
will accept a maximum of 30 to 50% of the total equity requirement of a
project from grant sources.
Insurance Guarantees
While strictly speaking not a type of
funding mechanism, insurance guarantees are vital components in
financing. For any project, a full insurance package must be in place before
financing will be finalized. Lenders will have specific insurance
requirements, and insurance documents will be part of the overall financing
documentation. Two particular needs for insurance that are particularly
relevant in the context of this work are: export insurance concerning the
risks particular to doing business in other countries, and technology
insurance concerning the risks particular to the performance of the
technologies.
A range of appropriate insurance covers is commonly provided by export
insurers such as export credit agencies (ECAs) and their private sector
counterparts. Loan guarantees are very important, particularly for project
financing. They provide the insurance cover for loans, guaranteeing the
exporter payment from the loan and guaranteeing the financing bank the loan
value in the event of default due to political or commercial risks. Loan
guarantees are often a vital prerequisite for banks to be willing to lend to
projects. However, very few of these funds are tied to the energy sector.
Hence if energy projects are to gain access to such funds they need to give
a better return than other investments (assuming that there is competition
for the funds).
Technology insurance is very important
for newer technologies, such as renewables. Lenders are wary of
technological risk especially for new technologies or new applications of
old technology. To cover the technological risk, manufacturers often provide
performance guarantees or bonds. If the manufacturer is not a large
creditworthy company, additional support may be required from commercial
insurance policies or bank guarantees.
Ownership
For projects where new facilities are
being developed independently of the local or national utility, the legal
control and ownership of the facility can be described by various acronyms:
