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How to overcome foreign exchange risks in energy funding.

Summary: Currency volatility is a major problem for energy project developers. Hedging against foreign exchange risks is an increasingly popular solution.

The local financing ecosystem in underdeveloped African countries has traditionally been unable to cater sufficiently for those seeking energy funding. Poorly developed capital markets, illiquid markets, and rel- atively high interest rates for local loans are some of the challenges af- fecting project developers' efforts to raise finance locally.

So now, with the recent growth in renewable energy projects and initia- tives in Africa - spurred by abysmally poor levels of energy access and huge renewable resource endowments - fund seekers are looking towards offshore financing sources.

However, African economies harbour significant risks in terms of foreign exchange volatility, which is a major source of concern for offshore financiers. When the local currencies in which the borrower's revenues are received depreciate, the fulfillment of the borrower's obligations in foreign currencies such as dollars can be- come even more challenging.

In Nigeria, for example, the naira has depreciated by about 200% since summer 2015. Nigerian borrowers who have taken loans that are de- nominated in dollars and whose earnings are in local currency will be strained by the significantly higher amount of local money required to repay those loans.

When affected by this challenge, off-grid renewable power providers are pushed to consider tariff increases for consumers, which can have signif- icant negative effects on operations. What then is the nature of foreign exchange risks for renewable projects in these developing markets and how can they be mitigated?

Hedging the risk

Dirk Muench, managing director of Persistent Energy Capital, an emerg- ing market renewable finance com- pany, said during an October 2016 webinar that "if an operating com- pany 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."

Consequently, hedging foreign currency risks for renewable energy projects is now a growing practice. There are now several hedge service providers helping both lenders and borrowers to mitigate associated risks. And the usefulness of these intermediaries in the lender-bor- rower relationship cannot be over- emphasised. Trailing currency de- valuations on a continuous basis and effectively navigating their potential impacts on borrower's capacity to re- pay the lender can be a huge task and an operational distraction for many renewable project developers. This makes the use of hedging services necessary in several instances and safer for all parties.

While foreign exchange risk is a problem to on-grid and off-grid power project developers alike, the nature of the risks can vary slightly between them. With off-grid develop- ers, borrowers' revenues are denomi- nated in local currency, which makes the risks of increased liabilities more of a direct concern where the loan is denominated in dollars, pounds or euros.

In contrast, on-grid projects may be slightly shielded by the dol- lar denominated power purchase agreements (PPAs), which provide a guarantee that their direct rev- enue streams will be denominated in dollars. However, these on-grid companies still face the secondary risk of increased probability of pay- ment default by utilities that struggle to fulfill the terms of the PPA in a depreciating currency because they themselves receive their revenues in local currency.

To eliminate exposures to local currency volatilities, project develop- ers should seek local financing, where such funds will be denominated in the currency of their earnings. Ex- perts believe that having liabilities in local currency could be the safest strategy against the risks of currency devaluations. Where this is not pos- sible, models that allow offshore loans to be accessed in local currencies should be explored.

Muench advised that "in the ab- sence of sufficiently deep domestic markets, project developers can al- ternatively take on a local currency denominated loan from an offshore lender, like a development finance institution or another type of im- pact lender. The lender can hedge the foreign exchange risk on the local currency loan with an offshore hedge provider."

Healthy practice

Hedging the risks in foreign exchange transactions is a growing practice among borrowers and lenders and there have now emerged a number of institutions providing hedging services based on diverse models. While there is an obvious hedging cost, available data suggest that it is a healthy practice that will prove more beneficial in the long run, since an- nual currency depreciations of 10% or more are common in African coun- tries. Therefore, local renewable ener- gy developers can borrow in a foreign currency such as the dollar and hedge it against foreign exchange risks by working with hedge providers.

Another viable alternative accord- ing to experts is for local developers to borrow in foreign currency and use the dollar funds as collateral for ac- cessing funds from a local financier. In this case the direct liabilities are in the local currency, which is the currency of the developer's earnings.

Since the foreign exchange vola- tility in developing countries can- not be wished away and the case for growing energy access through re- newable energy solutions such as so- lar power is becoming even stronger in Africa, developers must continue to explore more creative ways of managing foreign exchange risk in other to optimally access offshore funds. Thankfully, the conversation is gaining significant attention and momentum among stakeholders in Africa.

The naira has depreciated by about 200% since summer 2015.

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Publication:African Banker
Date:Mar 31, 2017
Words:932
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