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Since, in some African markets, it’s not uncommon to see average annual currency depreciations of 10 to 30%, foreign exchange volatility is a huge risk factor towards the actual ROI of a renewable energy project.
Dirk Münch is managing director of Persistent Energy Capital, an investor in early stage companies in the off-grid energy sector. He explains: “This currency volatility represents a significant problem for companies that usually bear their liabilities in hard currency (e.g. USD or EUR) while their revenues and assets are in local currency. If an operating company based in a local economy has its liabilities in hard currency and the local currency depreciates, its hard currency liabilities will increase in local currency terms. This results in a foreign exchange loss on the loan liability and can potentially have a substantial negative impact on the liquidity of a project.”
Looking at the possible solutions for lenders and project developers, Münch notes that the first option would be to borrow money in local currency in the debt and capital markets of the country concerned. He also notes though that in shallow, less developed financial markets this is often a difficult, if not impossible, route.
In the absence of sufficiently deep domestic markets, project developers can alternatively take on a local currency denominated loan from an offshore lender, like a development finance institution or an other type of impact lender. The lender can hedge the foreign exchange risk on the local currency loan with an offshore hedge provider like TCX in illiquid markets or, in more developed markets, possibly even with a commercial bank with emerging market focus.
A third option might be to use a back-to-back structure in which money is borrowed from an offshore USD lender in the form of a USD denominated loan,where the borrower uses the USD proceeds of that loan as collateral for a local bank, against which it then borrows in local currency.
A last option would be to take a USD denominated loan from an offshore lender and then hedge the foreign exchange risk directly with a hedge provider. This option may not be feasible for smaller companies however, in view of credit risk issues and operational complexity.
Per van Swaay is Sr. Vice President Structuring of The Currency Exchange Fund (TCX), a development finance institution that promotes local currency funding. He explains how on-grid and off-grid projects differ in the way they deal with exchange rate volatility. On-grid projects typically rely on USD power purchase agreements (PPAs) to ensure a USD denominated revenue streams. Off-grid structures however, sell directly to consumers and typically earn a local currency revenue stream.
Lenders and project developers of on-grid projects are often not concerned by foreign exchange issues, since they are not as affected as other entities further down the supply chain. Due to USD denominated PPAs the risk is mainly borne by utilities, who are usually backed up by a sovereign guarantee. The utilities in turn can choose to transfer foreign currency volatility and losses to consumers by increasing tariffs.
TCX makes the point, however, that certainly when more power is installed and more USD PPAs are signed, the ability of utilities to effectively shoulder or transfer foreign currency risk will be increasingly impaired. The system can simply not bear these losses without limit. Therefore project developers and lenders should realize that, while these risks might be contractually transferred to off-takers, the risk of off-takers failing to comply will also significantly increase.
For off-grid structures, assuming USD equity or debt, the situation is different as companies and developers are directly and fully exposed to foreign exchange risk. In those situations lenders may simply require that the companies hedge the USD loan. Alternatively the developer is left the choice whether he should hedge against foreign exchange risk.
Invariably, the “cost” of hedging is a big factor in such decisions. Van Swaay argues that there is a general misunderstanding about hedge “costs”. He prefers to avoid that term altogether and argues that borrowers should focus less on the “perceived cost” and more on the benefits of hedging. These include stable and predictable cash flows, better credit terms, higher leverage, full insurance against shocks and the absence of currency risk related managerial stress.
Hedge costs should be well understood in terms of perceived and actual cost differences between borrowing in local currency (domestically or offshore, but hedged) and borrowing in USD (the unhedged option). Van Swaay concludes that even though borrowing in local currency is done at (sometimes significantly) higher nominal interest rates than borrowing in US dollars, the two options are in general equally attractive from a pure financial cost point of view (see Figure 1).
Figure 1. Structure of interest rates on debt
Van Swaay adds that, while in expectation the two options are similar, the hedged solutions are characterised by more stability, as major unpredictable variables such as currency shocks and volatility are eliminated. Getting rid of such uncertainties reduces the exposure to currency fluctuations and therefore provides companies with more stable, predictable and reliable cash flows.
When a decision to fund in local currency is made, the logical choice is to first turn to the local debt markets to acquire capital in local currency. Douglas Bennet, COO of GuarantCo, explains how his company assists with accessing domestic capital markets. GuarantCo is a development finance institution that focuses on supporting the funding of domestic infrastructure in lower income countries with domestic funding sources in local currency, through the provision of credit enhancement guarantee products.
Where local banks are not willing or able to provide the required financing, local currency funding can alternatively be sourced from international lenders. They can provide local currency denominated funding by working together with foreign exchange hedge providers, such as TCX and MFX. MFX is an intermediary company dedicated to providing microfinance lenders with hedging instruments, but without requiring collateral. MFX intermediates between clients with hedging needs on the one hand and TCX or certain commercial hedge providers (banks) on the other. President and CEO Brian Cox explains how MFX transfers both the credit and market risks for distributed energy companies or solar projects (Figure 2).
Figure 2. Risk allocation
Companies that collaborate with MFX are - thanks to guarantees available to MFX from OPIC and FMO - not required to post collateral. This removes operational complexity and a claim on liquidity. The market risk, or in other words the potential depreciation of the local currency, is also managed by MFX through the collaboration with TCX or other banks.