Financing Power Projects: A Primer on IPPs and Power Purchase Agreements

“Up NEPA”; a phrase that most persons in my generation and indeed most Nigerians are all too familiar with. It is one of those peculiar Nigerian statements which connotes a restoration of power supply. However, on a deeper level, it is also an indication of the epileptic nature of power supply and the failures of the Nigerian electricity sector. For as long as I have existed, Nigeria has had issues with electricity generation and transmission. In a 2020 report by PWC on ‘Solving the Liquidity crunch in the Nigerian Power Sector’; operational inefficiencies, non-cost reflective electricity tariff and liquidity constraints, inadequate and obsolete distribution infrastructure and limited transmission lines, were listed as some of the problems plaguing Nigeria’s power sector.

These problems are nothing new, in fact, they have arguably existed since the independence of Nigeria from colonial rule. Several policies have been enacted to combat these issues but despite these policies, consumers are still left with power cuts and outages. Nigeria has one of the worst power sectors in the world, producing about 5,000 MWs for a population of about 200 million people. This number is clearly inadequate. It was inadequate to serve Nigeria’s power needs in the 70s and is certainly insufficient given today’s population. Given Nigeria’s inability to generate enough power for its citizen’s needs, Independent Power Projects (IPPs) became (and are still) a necessity. Independent Power Producers are non-utility generators of power. They are entities that are not public utilities, which invest in generation of electricity. They are not owned by the country’s National Electricity company and they supplement a country’s power and energy sector, especially where the country does not have the required financial capacity to make the heavy investments required in the power and energy sector. These entities make huge financial investments into the generation of power and typically recover their costs and make profit from the sale of electricity to consumers. IPPs have also helped drive the transition to use of renewable energy sources to generate energy; they currently own majority of the world’s renewable energy generating capacity. IPPs aid in attracting investors and capital to meet the country’s electricity needs without placing a heavy burden on the country’s financial capacity. They also reduce electricity costs for consumers in the long term (market forces and competition pressures).

Nigeria’s first IPP is the Azura-Edo IPP. The project began with feasibility studies carried out in 2009 and the parent company was incorporated sometime in 2010. The project was designed to help Nigeria close its 10,000 MW energy gap, stabilize the country’s national grid and provide affordable electricity to consumers. The project is designed as an open cycle gas power plant, generating electricity from Nigeria’s extensive gas resources. This reliance on gas to produce electricity is a profitable move for all parties involved in a country like Nigeria, which has one of the most extensive gas reserves in Africa, with reserves of about 206.53 trillion cubic feet worth over $803.4 trillion. The project’s financing was obtained from 16 financial institutions in about 9 countries. The International Bank for Reconstruction and Development (IBRD) and the Multilateral Investment Guarantee Agency (MIGA) (both under the World Bank Group) provided partial risk guarantees and political risk insurance respectively.

The Azura-Edo IPP, which is a 461MW independent power plant located in Edo State, currently generates about 453 MW and contributes about 8% to the electricity supplied to Nigeria’s national grid. The project cost nearly $900 million dollars to build and did not become fully operational until 2018, five years after the execution of the power purchase agreement. As with any capital investment or project, independent power projects come with huge risks for investors. Independent Power Producers have to consider various risks; ranging from revenue security, currency stability, market structure, tariff framework, delays in contract procurement, technical performance and political risks. The electricity sector is a high risk sector, and Nigeria is an equally or perhaps even more high risk country for investments. Therefore, it is critical for any independent power producer to find ways to curb the risks associated with such capital intensive projects like IPPs. To mitigate these risks, IPPs typically require sovereign guarantees and also execute Power Purchase Agreements (PPAs) setting out key terms, rights and obligations of the parties, and in the case of Azura-Edo, a Pull Call Option Agreement was also executed.

A Power Purchase Agreement is a commercial agreement between two parties for the sale of electricity. In a PPA, one party called the seller (usually a private entity) agrees to generate electricity and sell same to the purchaser or offtaker (typically a public owned utility). The PPA sets out the terms for the sale of the electricity, payment, operation of the power plant and possible termination of the agreement. They are long term agreements which are used when financing a power deal. It provides guarantees for the Seller and also helps the Purchaser get security of supply of electricity. The PPA is one of the central and perhaps most critical document in the construction and development of an independent power project, and is also a key instrument in obtaining non-recourse financing for the project (non-recourse simply means the lender is entitled to repayment from the profits of the project and not the other assets of the borrower).

Under the Agreement, the parties agree on the quantity of power from an energy source which will be produced by the Seller over a period of time, at an agreed price. The parties have to discuss the economics of the project and the terms agreed on will be reflected in the PPA. For example, Parties have to discuss fuel costs i.e., the energy source being converted to electricity, as this will determine pricing and viability of the project. The Parties will also typically negotiate development milestones, implementation and operational date of the project. There are different types of PPAs: on-site, virtual and off-site PPAs. In an on-site PPA, the plant supplies power directly to the buyer's consumption point. The plant is also located close to the consumer and supplies power directly to the consumer. An example of this would be a company that installs an electricity generating system on its roof to supply power directly to the company. In an off-site PPA, the electricity producer (the plant) supplies electricity through the national grid. So for example, electricity generated by the Azura-Edo plant is purchased by the Nigerian Bulk Electricity Trading PLC (NBET) which then transmits same to distribution zones operated by the Transmission Company of Nigeria (TCN).

Whatever type of PPA is agreed on by the parties, there are certain terms which feature in any standard power purchase agreement. The first is the Term of the agreement. This clause delineates the length of the contract and also the commencement date. The PPA also typically contains Sale of Power provisions: which outline the agreed capacity of the power plant and how the energy generated will be delivered and sold. The agreement also makes provision for Pricing. Under this clause, the parties allocate revenue and risk in respect of the project and determine what charges are payable by the parties. The electricity rates are also agreed upon and the Electricity regulators usually regulate the price. Under the Operation and Metering clauses, the Seller takes responsibility for the maintenance of the power generation plant. The Purchaser also typically requires the Seller to conform to a certain standard and guarantee that the project will meet certain performance and output standards. The PPA also contains provisions on legislative amendments. This is especially crucial for IPPs investing in unstable regulatory regimes where arbitrary legislative changes can be anticipated. This provision addresses prospective changes in laws and protects the investors and the project from the risks associated with such changes. As with most contracts, force majeure clauses are also a feature of PPAs. This clause anticipates the occurrence of any event which could lead to the non-performance of the agreement. PPAs also contain termination clauses, dispute resolution, liability and indemnity clauses to deal with a possible violation or breach of the Agreement.

Another very key clause, which has become an important feature of PPAs and has been the subject of controversy in recent times in Nigeria, is the Take or Pay clause. It was recently reported that the Nigerian House of Representatives Committee on Finance has queried the monthly payments being made by the government under the take or pay clause in the Agreement for power generated. It has also been suggested that this clause was only a ploy to inveigle the Nigerian government into unnecessary spending and is not beneficial to the country. Contrary to these assertions however, a take or pay clause is a pretty much standard clause in supply agreements. It is a provision in a supply agreement which obligates the Purchaser to buy or take delivery of a minimum amount of goods or pay the seller for any shortfalls. They are commonly employed in energy contracts because of the substantial costs incurred by Suppliers and Sellers to provide or generate energy.

One of the major considerations for any infrastructure project, especially on the African continent is bankability. There are a lot of risks (both real and perceived) associated with investing in Africa. It is therefore important for investors to safe guard against loss. Many of these infrastructure deals take place in frontier markets in Africa (Azura was the first of its kind in Nigeria) with very little track record. With the Azura-Edo IPP for example, the purchasing entity NBET was a new entity, incorporated in 2010 and at the time of negotiation, had no credit history. Thus, the take or pay provision provided an incentive for potential investors by providing them with an assurance that they will be able to sell their product and thus, make returns on their investment. Thus, whatever electricity is produced by the plant will be bought by the government, whether or not the government is able to distribute or utilise it.

Another way investors mitigate the risks arising from a power purchase agreement is the execution of a Put Call Option Agreement (PCOA). As earlier mentioned, investors tend to request sovereign guarantees from the government before financing power projects. However, governments are sometimes reluctant to give such guarantees as it hinders their borrowing capacity. A PCOA may be executed to guarantee the investors' investment and reduce/escape the strain a sovereign guarantee could place on the government's balance sheet. Under the PCOA, the government guarantees that if the agreement (PPA) is terminated as a result of the government's failure to pay, the government will have to pay out a huge sum (about $1.2 billion in this case) to the project's investors and take over ownership of the asset (power plant).

With infrastructure deals, everything has to be upfront. The investors have to practically do everything before they can break even. Under the Azura-Edo IPP, the investors took on all of the construction risk and provided capital of nearly $1 billion dollars for the project. With such huge capital investments being made, it is inevitable that investors want solid guarantees, so that, in spite of political risks or any potential operational challenges which may arise from the Purchaser's end, they would still be able to make returns on their investment. In the Azura case, it certainly makes little economic sense for the investors to be punished for Nigeria's inability to set up proper distribution channels for the electricity being generated. It must be stated that many African countries who have similar take or pay provisions in their infrastructure contracts are seeking to renegotiate such clauses to take and pay clauses. This take and pay clause imposes an obligation on the Purchaser to both take a minimum agreed volume of electricity and to pay a contract price based on that minimum agreed volume on a yearly basis. Although this may seem like a better option, failure to take the agreed volume of electricity will amount to a breach of the Agreement and this will, of course, come with serious financial consequences. The clause will also likely be unattractive to potential investors and many African countries, particularly Nigeria, cannot afford to finance these infrastructure projects using government funding alone.

In all, it is important for the Purchaser (the government) to carry out proper due diligence on the volume of electricity required and the volume it can distribute given its existing channels and reflect this the power purchase agreement. This will prevent a situation where the IPP is generating more electricity that the purchaser can offtake. PPAs demonstrate commitment to the project and serve as an important guarantee for investors bringing in capital to the power sector. Although some of the guarantees which have to be given to attract investors may seem onerous, it is hoped that as Nigeria continues to meet its obligations under these infrastructure deals, investor confidence will improve and we will have to pay less of a premium to attract investors.