This chapter focuses on instruments aimed at mitigating specific investment risks, including political, credit, currency and liquidity risks. It explores solutions emanating from both the public and private sectors.

It primarily targets project developers, with the objective of providing a global overview of the available schemes that currently exist. In addition, it targets policy-makers as well as public and development agencies, exploring some solutions capable to increase the use and improve the accessibility of those schemes in the clean energy sector.

The chapter starts by targeting guarantee instruments and insurance, as well as their availability in the clean energy sector. In particular, it focuses on solutions to improve the accessibility of such mechanisms for small- and medium-scale projects and companies.

Moreover, emphasis is put on the currency and liquidity risks, considering the complexities of sub-Saharan African contexts and the energy sector. Indeed, those two investment risks are critical for many project developers and capital providers. Therefore, this chapter presents different actions in order to manage and mitigate those risks, using either internal or external solutions.

7.1 Guarantee Instruments and Insurance

By providing financial protection against events that negatively impact a project or a company, guarantee instruments and insurance give the opportunity to make investment opportunities more attractive for private capital providers while using limited financial resources. Guarantees and insurance can be issued by public and private entities. In the former case, potential financial losses are transferred to the public sector.

Guarantee instruments and insurance may cover a broad range of investment risks relevant for the clean energy sector. Nevertheless, moral hazardFootnote 1 is a well-known potential consequence associated with those risk mitigation instruments, that may compromise their initial objectives and lead to substantial additional costs for issuing institutions. In order to reduce moral hazard issues, two options are available for guarantee and insurance issuers:

  • Conduct a rigorous due diligence process before issuing guarantees and insurance, thus rewarding high-quality projects

  • Provide a partial coverage of potential financial losses to decrease financial exposure

Even though guarantee instruments and insurance are widely used in project finance and the fossil fuel industry, their use is still moderate in the clean energy sector (IRENA, 2016). A study realised by IRENA highlights the following factors as the main barriers to the use of guarantees and insurance in clean energy investments (ibid):

  • Little financial resources dedicated to those instruments in public financial institutions

  • Elevated transaction costs

  • Lack of product awareness among project developers

  • Time-consuming and complex processes

  • High due diligence requirements

In addition, guarantees and insurance are sometimes not available in specific geographic areas and/or for small investment sizes. Therefore, the clean energy sector has today a limited experience in using those potentially powerful instruments to mobilise private capital.

The public sphere has an important role to play in the deployment of guarantee instruments and insurance reflecting specific requirements of clean energy initiatives. More resources should be devoted to those mobilisation tools. In addition, solutions adapted to smaller investment tickets are needed. Public entities may for instance create guarantee funds to meet the needs of the off-grid and clean cooking sectors.

7.1.1 Guarantees Issued by Governments

Before investing in developing countries, private investors often require guarantees issued by public authorities to reinforce the financial viability of targeted projects. Indeed, governments have a competitive advantage in backing certain investment barriers such as currency and political risks, as well as credit risk associated with state-owned companies.

However, governments’ financial constraints and sometimes low creditworthiness may prevent the state’s ability to provide guarantee instruments, forcing capital providers and project developers to look for other issuers like development agencies, export credit organisations or the private sector.

7.1.2 Political Risk Guarantees and Insurance

Coverage focuses on risks related to governments actions or inactions and may include political turmoil, currency convertibility, asset expropriation, breach of contracts involving a public entity and change of policies and regulations without negotiations. Moreover, political risk insurance provides the opportunity to enhance creditworthiness of state-owned companies such as public power utilities, by covering grid interconnection risk and financial default.

Multilateral and development agencies are well-positioned to issue political risk insurance thanks to their strong creditworthiness and close relationships with member states. Currently, the largest issuer of political risk insurance in terms of volume is the Multilateral Investment Guarantee Agency (MIGA), a member of the World Bank Group. Other providers include export credit agencies and private insurers.

7.1.3 Credit Risk Guarantees

Those guarantee instruments mitigate the credit risk as they cover losses in the event of a default on debt obligations, without differentiation of the cause(s) of non-payment. Those mechanisms may help borrowers gain access to commercial capital and potentially decrease the cost of debt.

The available instruments include:

  • Partial credit guarantees, covering part of the debt service

  • Full credit guarantees, covering the entire amount of the debt service

  • Export credit guarantees, insurance covering losses for exporters or lenders financing projects tied to the export of goods and services

7.2 Currency Risk Mitigation

Efforts to mitigate the foreign exchange risk faced by private investors and project developers can be categorised into two distinct areas: (i) approaches that directly deal with the foreign exchange rate and (ii) methods to facilitate local currency financing and support the development of the bank market.

The public sector, including national governments and multilateral agencies, as well as private players, has the following options at their disposal:

  • Hard currency PPAs

By offering power purchase agreements (PPAs) in hard currency, governments bear potential financial losses linked to a devaluation of the local currency. Therefore, the currency risk is passed on to the public sector.

This option may potentially incur high costs for public finance and is not applicable for small-scale electricity projects and the clean cooking sector, as they usually do not use PPA mechanisms.

  • Currency risk guarantee funds

There are special-purpose funds created by public entities and aimed at covering the difference in exchange values over a period of time. Governments can use public money or charge fees to participants to access guarantee funds.

They offer less expensive options compared to traditional hedging instruments (see next point) and allow access to currency risk mitigation tools for small-scale projects. However, this option does not enable the public sector to hedge its exposure and may therefore be expensive in the event of strong local currency devaluation.

  • Currency hedging instruments

Commonly provided by the private sector, hedging instruments such as foreign exchange swaps and forward contracts allow to lock the differential between two currencies in advance, thus artificially eliminating value fluctuations.

Currency hedging is generally expensive and thereby increases the overall financing costs. Moreover, those mechanisms are usually available for large-scale investments and for certain currencies.

  • Local currency financing

Local currency financing may be provided by the public sector, through state-owned financial institutions, multilateral agencies and development banks. Moreover, investors located in African countries are increasingly becoming an important source of capital (World Bank Group, 2014). They include domestic financial institutions, such as banks, as well as institutional investors (i.e. pension funds,Footnote 2 insurance companies, sovereign wealth fundsFootnote 3). The latter usually finance large-scale projects and/or invest indirectly through funds, thus requiring developed capital markets.

Stimulating domestic investment entails several advantages. It avoids foreign exchange exposure, contributes to local economic prosperity and helps develop local financial sectors. In addition, domestic sources of capital may potentially add significant value by bringing their experience and knowhow of the local contexts and engaging their network to build strong pipelines.

Even though the interest among local capital providers in clean energy initiatives is on the rise, several barriers still exit to increase their commitment. Most of the time, they do not have a proper mandate for clean energy access financing. Additionally, they may lack experience in investing in this sector, making the assessment of risks and deal structuring complex. Finally, some local financial institutions may have a limited access to capital, preventing them to enter young sectors (such as the clean energy sector) and waiting until they reach maturity.

To overcome those barriers, different solutions exist, first by strengthening capacity building among local investors as well as informing them about available de-risking strategies and innovative financial mechanisms. Moreover, public authorities can establish fiscal incentives and finance policies such as priority sector lending. Governments or public development finance institutions may also increase their use of mobilisation tools like nonperforming buyoutsFootnote 4 and guarantee instruments.

In addition, multilateral agencies and development banks (sometime also national governments, depending on their creditworthiness and financial constraints) can provide access to capital to local financial institutions through on-lending structures. Those facilities may have a significant impact on the financing of clean energy activities in sub-Saharan Africa. By using their high credit rating and access to international financial markets, public financial institutions provide capital at lower cost to local banks and make it available for particular development sectors. Therefore, the banks’ costs are reduced and liquidity is increased. This lower cost of capital can thus be on-lent to local projects and companies at lower rates than what was previously possible, without currency mismatch.

Those revolving lines of credit are better adapted for short-term financing (i.e. working capital, seasonality) and are usually targeting small- to medium- scale investments. In order to increase the efficiency of these mechanisms, on-lending facilities may include training and consultancy services to ensure a proper understanding of the investment environment. An example of on-lending facilities in Africa is the World Bank’s Tanzania Energy Development Assistance Program, which intends to provide medium- and long-term loans to projects engaged in energy access, applying more favourable financial conditions (WB, 2016).

Regarding larger investment sizes, co-lending,Footnote 5 through direct investing or specialised funds, may reduce the risk perception of lenders, by distributing risks and limiting financial exposures. Local lenders may be more willing to participate in clean energy financing using this structure.

7.3 Liquidity Risk Mitigation

Several clean energy projects may face liquidity constraints and cash-flow shortfall periods, increasing the risk of payment default. Different options are available to enhance creditworthiness and decrease the risk perception of potential capital providers.

7.3.1 Public External Liquidity Facilities

Public external liquidity facilities usually concentrate on power generation plants. Indeed, their revenues strongly depend on future payments generally stipulated under a purchase power agreement (PPA), therefore decreasing uncertainties regarding sale price during a predefined period of time. However, power off-takers, often public power utilities, frequently face financial difficulties, causing cash-flow issues and making the provision of cash collateral difficult (IRENA, 2016).

Accordingly, the liquidity risk hinders access to affordable financing for project developers, as investors may price a liquidity premium, thus increasing the financing costs for power generation plants and affecting projects’ competitiveness.

Usually provided by multilateral agencies and development banks, external liquidity facilities are created to improve a project’s liquidity profile by covering potential off-taker defaults. They aim at loosening the tensions on public utilities’ financial statements, providing a credit line or letter of credit to IPPs, thereby resolving short-term liquidity concerns without requiring additional cash from power off-takers. This should thus decrease the liquidity risk for capital providers, and therefore facilitate financial closure and access to affordable capital.

Such facilities could also be created for small-scale projects, following the model of currency risk guarantee funds but applied to liquidity constraints in the off-grid and clean cooking sectors. Public financial institutions can create a central liquidity facility available for clean energy companies active in a predefined territory. This special-purpose fund could be backed by public entities and act as lender of last resort in case of difficulties faced to pay capital providers on due time. A membership fee might be covered to companies to benefit from this facility. The challenge here is to determine the amount of this fee.

7.3.2 Liquidity Guarantees

High perceived risks combined with a lack of experience in investing in the clean energy sector may create maturity mismatch between capital providers and project developers. For instance, the construction of a power generation plant requires long-term financing. However, some investors may propose financial terms not necessarily aligned with the timing of such projects. In addition, certain jurisdictions restrict the maximum duration of lending activities.

Liquidity guarantees allow to extend tenors when necessary, reducing the refinancing risk linked to power generation plants and improving cash-flow management. Generally used by multilateral agencies and development banks, this mechanism permits the repayment of a debt instrument when due through a new loan, automatically increasing the entire duration and matching the financial requirements of power generation plants.

Similarly, put options allow commercial lenders to sell their bonds at maturity in exchange for a premium to multilateral and development institutions. The latter repay the principal and ensure that financial obligations are honoured at maturity.

7.3.3 Internal Liquidity Facilities

Project developers and operators can undertake various actions aimed at mitigating the liquidity risk linked to their specific project or company. This will help ensure timely payments to capital providers, bridge short-term cash-flow issues and cover unexpected expenses.

A first easy-to-implement solution is to establish a separate reserve account, by accumulating cash above what is require by the business itself, including financial expenses. It can of course be done once operations have started and revenues are earned. It will thus improve the liquidity position of the company or project.

Over-collateralisation, meaning that more collaterals than required are posted, is another option to secure financing and potentially lower the cost of capital. It can be difficult or unfeasible in certain situations such as project finance where a special-purpose vehicle (SPV) is created. The assets of the originator, not involved in the new legal entity, can indeed not be used as collaterals.

Any form of contingent equityFootnote 6 may also reduce the liquidity risk. In this case, when a predefined occurrence happens, debt-like instruments and shares with fixed dividends are converted into common equity, thus reducing fixed financial obligations associated with certain forms of financing.