Managing FX risk in energy sector investments in developing countries.
raditionally, developing economies relied on “hard currency”, that is a strong currency such as the USD or the Euro, to fund and pay investments in their energy sector. First, because most equipment is imported and paid in “hard currency”, and second, because the funds (equity and debt) required for the high initial investment associated to energy infrastructure typically come from abroad, denominated in the mentioned currencies.
But the end-users of the system, the consumers, get their income and pay for electricity in their domestic currency, leading to a risky asymmetry between the currencies in which revenues and expenses are denominated. Such risk is typically borne by the developing country, directly or indirectly, exposing its economy to foreign exchange risk.
The simplest way for electricity consumers in developing countries, and the companies supplying them, to eliminate these FX risks would be to increase local currency borrowing for new IPPs and power companies. However, this is not likely to be feasible in the short to medium term, at least not completely. The resources available on the local markets are usually both insufficient and too short term. Moreover, power sector equipment has to be imported and as such has to be paid for in FX. However, the potential to move toward increased local borrowing should not be dismissed and this is a further reason for power stakeholders and government in developing countries to work to increase the opportunities for local longer-term borrowing.
Even knowing the aforementioned difficulties in dealing with FX risk exposure, there are multiple strategies implemented worldwide to alleviate the impact of FX risk on the electricity sector and on the overall national economy.
ome countries have adopted models that allow the utility to transfer exchange rate related increases in costs directly to consumers through tariff surcharges. This contributes to cost-reflectiveness of the tariff and financial sustainability of the utility. However, it also leads to erratic tariff increases that were absorbed by households and companies. These consequences are no fault of the utility, the government, or the consumers. Faced with the need to manage the exchange rate risk, a choice must be made between transferring the cost to consumers for free or to the government or capital markets in exchange of an insurance premium.
A further way of managing this risk would be to establish national forward currency markets on which electricity sector agents could hedge their risks. Such markets operate in many developing countries but not in all of them. The likely counterparty could be, for example, an exporter with costs denominated in the domestic currency who wished to ensure that it earned adequate revenue to cover its costs. Development partners may be able to offer technical assistance to support this process.
There are a number of ways in which countries can improve the management of these costs and risks. Local manufacturing of plant and equipment can avoid foreign exchange costs. Policy may favour projects that have significant local content. For example hydro-electric projects with their large civil works component often have larger local content than thermal plants. Greater availability of foreign exchange for power project imports can also help to make costs local rather than in foreign currency.
But it is project financing that shows the greatest scope for potential changes. Power projects are very long term and local financial markets often do not offer scope for selling very long term securities with terms of twenty years or more. However, Kenya already has a market for long term treasury securities and an active pensions sector which is investing in projects such as buildings. There is therefore clear scope for creating long term securities to finance the power sector as well. This will require inputs from across the economy including government, power companies, pension funds, financial market makers and banks. But the potential to raise more long term local finance for power projects is clear and has the potential to reduce the foreign exchange risks in projects.
For further information please contact Alejo Loira (email@example.com)