Benchmarking the New EraWed, 02/22/2017 - 12:50
Q: How do Clifford Chance clients view the new contracting system?
MM: Our clients inevitably compare the new PPA with the old PPA, which is still in operation. The new PPA is, broadly speaking, bankable but there are several aspects that concern our clients, such as the risks private companies must now take on, some of which were previously managed by CFE. One of the most concerning issues is the uncertainty around the credit risk of off-takers. CFE is expected to be involved in most of the PPA transactions in the short-term, acting either as off-taker or as jointly liable with the off-taker. Doubts remain about how to manage the credit risk of other companies seeking to participate in the market as buyers and to what extent banks will consider the off-taker’s credit-worthiness, since the PPA does not directly tackle this issue.
AH: As long as CFE acts as off-taker or assumes any payment obligations under the PPA, financiers will place special consideration on their overall credit risk. Let us not forget that most of these banks are probably already lending to CFE in some capacity, which increases their overall exposure vis-a-vis CFE and consequently the overall risk involved in the transaction.
Q: How did companies participating in CFE’s first power auction overcome these risks?
MM: That CFE is still in the picture gives confidence to the market because it presents a similar structure to what was done previously. Once private companies start participating in the auctions as purchasers, we expect to see a shift to portfolio financing structures similar to what happened in Chile, which has one of Latin America’s most developed spot markets. This approach mitigates the “single off-taker credit risk” because companies have diversified portfolios with several off-takers instead of just one. Grouping a number of projects with different offtakers eases project financing because it makes lenders more comfortable with the company’s revenue streams.
Another factor to consider is that most companies winning the first power auction are probably capable of financing their projects on a balance-sheet basis. They are big international market players. We are not aware of any winning company requiring external nonrecourse project financing to develop its project. That will not be the case for all companies willing to enter the Mexican market.
Q: What will be the key challenges to financing energy projects in Mexico besides off-taker credit risk?
MM: Merchant risk will be one of the major issues for financing energy projects in Mexico because the uncertainty in this aspect hinders the development of a simple legal or commercial solution. Energy assets last up to 25 years but the PPA establishes only 15 years of contracted revenues, so banks have no certainty about the rest of the period. This situation will make it harder for energy companies to obtain long-term financing, especially as the current global macroeconomic conditions also add to bank reluctance. We are nonetheless observing a proactive approach from multilateral lenders that are betting strongly on Mexico. We see a special commitment from those multilateral banks in which Mexico is a stakeholder. US export credit agencies also are looking south of the border and already have mentioned their interest in ramping up their ability to finance deals in Mexico.
AH: We also see a number of European credit agencies willing to invest in the country’s nascent energy industry. The old self-supply PPA worked as a platform to attract foreign investment to Mexico’s power sector and to build large financing deals. Because of that, non-American institutions now have the confidence to invest in new energy projects in Mexico. The interest of multilateral banks and export credit agencies in financing these types of projects will probably help to close the gap that merchant risk creates for other institutions. Commercial banks are working to structure solutions to deal with merchant risk but there is no consensus on the best approach to take. Larger debt service reserves, cash sweeps or other similar pre-payment mechanisms and even mini-perm financing structures are some of the options. In fact, we would not be surprised to see mini-perm financing with the option to refinance without penalty as the mostused structure in the first PPAs backed by international project financing. Project bonds may also come into play as a viable option, depending on what the market’s appetite is for this type of risk. In general terms, project developers will have to get used to structuring more complex financing deals, including different financing schemes to fund one single project.
Q: What are the main concerns for developers looking for the best financing plan for their projects?
MM: The main concern for project developers is deciding the amount of equity they want to bring into the deal and when. Companies need to be clear about their ambitions regarding their desired internal rate of return (IRR). Project developers looking for short-term IRRs and to cash out soon may be shooting themselves in the foot because banks want to see equity supporting the risk as long as the debt is outstanding. Developers looking for international financing need to use a conservative approach. Another solution might be to not use international financing alone but to look for a combination of different financing sources. In any case, our key message to developers is to remain conservative. We do not expect to see exceptional financing offers coming soon from international bankers. They still are cautious about the Mexican market, particularly as the new contracting schemes have never been tested.
Q: How would you benchmark Mexican PPAs in comparison with similar Latin American countries?
AH: The termination regime set forth under the Mexican PPA differs from what we have seen in other parts of the region. For instance, the PPAs launched by Uruguay’s government when it decided to implement its aggressive renewable energies program a few years ago provided for a termination payment even in the case of force majeure or a default. Peru’s PPAs, on the other hand, typically provide for low termination payments because it has a spot market already in place. In the case of Mexico, investors are curious to see how the termination payment under this new PPA will work. Under the financed public works (PIDIREGAS) regime, CFE took responsibility and agreed to pay a lump sum to the contracted party in the event of a termination. The new regime provides a different structure: in the case of termination due to the off-taker’s default, the off-taker is required to pay on a monthly basis the difference between the spot market price and the estimated revenues that could have been obtained during the contracting period. The new structure could add uncertainty to potential financiers because it is novel and untested.