One night, not too long ago, I was sitting at a bar with a friend of mine. He complained he had just finished a contentious two-week night and day negotiation of a power purchase agreement for a power public-private partnership (PPP). So, as a sensitive and caring friend, I said, “Quit your whining! Power generation PPPs must be the easiest PPP around. You’ve got a tried and tested kit, clear demand, a commercially and socially valued product, a sophisticated sector with strong sponsors and keen financiers, an accepted standard model for PPPs, not too much land. As long as you can get fuel and connect to the grid, all is OK. In fact, the offtaker often takes fuel and grid risk. Easy, right?”
My friend was not amused. His response, while slightly hyperbolic, brought a lot of perspective:
“The only hitch with your sunny view of power generation PPPs is the offtaker. In some countries, selling power to the local utility is like being a drug baron and selling drugs to a local dealer who is broke and isn’t very good at math, so he sells to his customers at a loss. In other words, he loses more and more money by the day. The only saving grace is that the dealer still lives with his parents, and they bail him out from time to time. Of course, ironically, it’s the parents that enable the kid to sell at a loss—so customers get cheap drugs and the parents get popular.”
He explained further: “In some countries, the government has a system in place to bail out the offtaker in a transparent manner, by trying to get it to cut its own costs, only sell to customers who pay, find other sources of revenues, whatever. This gives us a little more comfort that the offtaker will pay its bills, but not much.”
“Investors may also ask the government to allow the offtaker to raise its tariffs. This sounds like a sensible business proposition, but it often isn’t. If the offtaker raises costs, it may find some of its best customers (the ones who actually pay their bills) go to some other source of energy like their own generation, or a rival independent power producer delivering directly. You see, the offtaker has borrowed from various lenders, often local and/or public banks, to keep electricity tariffs low to please the government. The offtaker is often more of a political than commercial animal, not incentivized to use good commercial practice, but instead to satisfy political agendas. This results in inefficiencies, low collection rates, and high theft.”
“And this means what?” I asked.
“This means its costs may be higher than some of the other potential suppliers of electricity,” he answered. “It’s true even though they do not benefit from economies of scale, plus the quality available from smaller scale solutions may provide better quality services as compared to the offtaker—I’m talking about problems like brown outs, blackouts, and surges.” Here he leaned forward and pointed at me for emphasis. “Raising prices, unless and until the offtaker improves the quality or quantity of services it is providing, may result in the loss of its best customers.”
I nodded in agreement, but noted the obvious: “OK, so how about a guarantee from his government,” I said. “They are bailing the offtaker out anyway, why not pay the investors and lenders directly?”
“This is the usual approach,” he responded with a smile, “but not one the government likes. Their utility is in trouble and needs to sort itself out. If they provide a guarantee it just reinforces bad behavior and may even incentivize non-payment since the government will take care of it. Plus, increasingly governments have to disclose such guarantees, which may result in higher interest on the government’s other debt, or reduce the amount of debt to which it has access.”
“Fine,” I countered, “but how about an escrow of revenues? The investors and lenders can grab the money the offtaker earns selling electricity across its grid, and hold it to make sure they get paid first.” I knew this was usual practice, having seen this structure a number of times.
Taking the last swig of his drink, he replied, “Good idea. But of course we cannot be sure the money the offtaker earns will actually make it to the account, since it is often obtained through cash-based transactions, and cash has a tendency to find its way to other uses. Plus, the offtaker is having a hard enough time making ends meet without its cash flow being constrained. Even with a generous definition of ‘permitted costs,’ an escrow arrangement may make the situation worse.”
He knew he had me stumped, so he continued, “The offtaker has learned over many years that the government is soft, it may threaten and complain, but it rarely follows through on its threats to cut off subsidies. The country still relies on the offtaker to supply most of its electricity, so they are unlikely to do anything drastic. And, of course, the bad boy act works well with the government, so reform might actually be against the offtaker’s self-interests in the short to medium term.”
He was right of course. The security structures we tend to create, in an effort to protect lenders and encourage them to lend, can actually undermine these same utilities. Unfortunately, as investors we often ignore these issues and instead focus on what it will take to close the deal. Would we be better off working closely with the utilities to help them, which would then enable those same utilities to be more credit-worthy and do more PPPs?
Looking beyond the project to the entire system when formulating a security package might be harder work, and more burdensome, but may be much more sustainable and better business.
I thought carefully, mulled over this complex situation, and came to one resounding, profound conclusion… it was time for another drink.
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