Enhancing the attractiveness of private investment in hydropower in Africa

In the past two decades, hydropower development has picked up after a
substantial decrease in the 1990s. Though most construction was in
Asia, the potential for hydropower is greatest in Africa. Only one-third
of Africans have access to modern energy, and the population is growing
rapidly. This is an investment opportunity for all kinds of power
technologies, but especially for hydro, since only 8 percent of Africa’s vast hydro resources have been developed.

Large hydropower projects can become important drivers of sustainable
economic growth in Africa. With useful lives of more than 50 years,
they are an excellent complement to shorter-lived thermal plants and can
provide greater and more predictable power than solar and wind, while
providing benefits such as flood control, irrigation, and steady water
supply. Hydropower plants can also act as “peakers,” using their
reservoirs to store water and generate electricity at peak hours or when
intermittent sources such as solar and wind are not producing. However,
they are complex undertakings with a number of constraints and
challenges.

Contrary to thermal plants, which are standardized and pose few
construction risks, hydropower plants are site specific, with high
geological and hydrological risks that need to be shared equitably among
private developers, lenders, and utilities, as well as governments when
sovereign guarantees are required. They also generally require
significant land area, with commensurate mitigation and compensation for
environmental and social impacts. In addition, the construction phase
is unpredictable and lengthy, and represents a significant project risk.

For these reasons, hydropower requires a long and complex development
phase. To be successful, developers must have the requisite experience
and a thorough understanding of the challenges, and work with equally
strong and experienced stakeholders, including construction contractors.
This is crucial for minimizing risks to obtain the best possible
financing, since construction costs are high, with frequent overruns
that can represent a big percentage of original estimates.

Challenges to financing hydropower projects

Many private investments in large hydro projects in emerging markets
have shown that there is a disconnect between the lifespan of hydro
plants and the debt maturities that are offered by their financiers.
While plants can be exploited for more than 50 years, debt tenors from
development finance institutions (DFIs) and commercial institutions have
rarely been longer than 15-18 years. Therefore, tariffs have been
heavily front loaded to meet debt service obligations, with debt-equity
gearing driven down to preserve higher debt-cover ratios. This has made
privately funded hydro power less competitive than many other power
sources.

These private financing challenges are key constraints that explain
the limited number of private investments in hydropower in Africa. The
only large privately financed hydropower project is the Bujagali plant
in Uganda, which reached financial close in 2007 under a complex
project financing structure. By contrast, many publicly financed
projects have been and are being successfully implemented (Grand
Renaissance, Inga 1 and 2, Gibe III, Adjalara, Isimba, Manantali,
Kaleta, etc.). These often benefit from concessional financing with long
maturities, which results in nominally lower tariffs.

Conversely, when debt servicing has been completed, hydro becomes
disproportionately inexpensive, to the point that other forms of
generation may not be able to compete. This can distort tariff
structures and inhibit the development of other types of power plants.
Clearly, no new plants can compete with the likes of Aswan (Egypt) or
Akosombo (Ghana) which, at the half-century mark, have long been
amortized. They can deliver power at a fraction of the cost of potential
replacements, with decades of operations to go.

Lengthening loan tenors to make private hydro projects more attractive

At a time when there is a growing consensus to increase private
investments in infrastructure, more efficient financing structures are
needed for private investment in hydropower to better align debt
maturities with the useful life of plants. Extending loan tenors for
private or public-private partnerships (PPP) hydropower from the typical
15-18 years to 25-30 years would enhance the attractiveness of such
projects for all stakeholders, since it would lower generation and
end-user tariffs. Longer loan tenors would also allow higher
debt-to-equity ratios that would provide room for further tariff
reduction. We estimate that, under the new financing framework we are
proposing for hydropower, tariffs could decrease by approximately 20
percent. For a hydropower project with a cost in the $500 million range,
this could represent a $20 million annual saving for the first 10-15
years of operations.

One way to convince lenders to extend loan tenors is through
increased risk mitigation by DFIs, for example, by using partial risk or
credit guarantees. Many DFIs operating in Africa are familiar with the
structures that have been used to extend debt maturities in project
finance transactions, particularly for local currency funding. It is
possible to build on these or design new ones that would enable maturity
extensions to the required 25-30 year range. Some of the new approaches
may require crowding-in institutional investors with long-term
investment horizons and appetite for infrastructure assets, as well as
deepening local capital markets to enable the issuance of long-term
securities to fund these projects.

This will require cooperation by all hydro stakeholders. Governments
should grant longer-term concessions and Power Purchase Agreements;
private sponsors, investors, and lenders should accept longer-term
commitments; and all parties should accept a fair allocation of residual
risks stemming from the implementation of these structures (e.g.,
refinancing risks).

All this is possible and can be done. The Bujagali project, which is
currently restructuring its debt, significantly lengthening the tenor,
demonstrates the need to structure longer tenors during project design
to avoid costly, unplanned refinancing later.

Africa50, with almost $1 billion in capital and substantial project
development experience, can help implement these structures, working
closely with the African Development Bank, which can take the lead in
arranging project debt financing and the required credit enhancement
instruments with the features advocated in this piece. This would secure
the much-needed longer debt maturities to generate reliable and
affordable electricity to power homes and industries.