By Fiona Wilson | August 17, 2022
Sovereign guarantees are a fantastic lens for learning about project finance but are regionally specific and familiarity with the concept is likely dependent on your regional focus. Even those working in regions where sovereign guarantees are considered a requirement for securing project finance may not have an in depth understanding of how they function. So, what is a sovereign guarantee, and why is it important to understand its role in project finance?
In short, a sovereign guarantee is a legal guarantee from a government to backstop the obligations of a state-owned entity (SEO), such as a utility. For example, in a renewable energy IPP project, the Special Project Vehicle (SPV) signs a Power Purchase Agreement (PPA) to deliver electricity to a national utility over the course of 20-30 years. In this context, a sovereign guarantee means the host government is contractually committing to step in and compensate the SPV if the utility defaults on its payments or obligations in the PPA.
So, when is the additional security of a sovereign guarantee – on top of a standard PPA – required?
In some markets sovereign guarantees are rarely if ever used, but in other regions, such as Sub-Saharan Africa, sovereign guarantees are considered the norm (if not a requirement) for utility scale projects. The difference is the perceived risk of default by the off taker, which affects investors and lenders’ willingness to commit funds to a project.
Those of you who have taken Pivotal180’s Renewable Energy Project Finance Modeling course know that a project finance transaction is underpinned by a secure, stable and long-term cashflow, and a financial institution will not want to lend to a non-recourse project without this secure cashflow. In the context of a renewable energy IPP project, the key cashflow is the payment for energy delivered to a utility at a contractually guaranteed price. If lenders and investors perceive the PPA counterparty (the offtaker) to be less creditworthy, or at a greater risk of default, the cashflow is perceived as less secure. In addition to non-payment by the offtaker, a sovereign guarantee may also address other factors key to the project such as permits and licensing, changes in tax law, and currency convertibility[1]. Sovereign guarantees therefore serve as a “de-risking” measure and are yet another clear example of how a legal contract (or provision of a contract) directly impacts a project’s bankability.
If you would like to learn more about this instrument, the market characteristics determining where it is commonly used, and how it impacts governments, we will soon be releasing a video discussing sovereign guarantees on the African continent. This is the first of our new interview series, Pivotal180 in Conversation.
The conversation will feature an interview with Gadi Taj Ndahumba, Head of Power Sector at the African Legal Support Facility about the nuances of how sovereign guarantees function in project finance and the concerns that African governments may have around use of this tool. The discussion is a unique and in-depth perspective that goes beyond the typical talking points about sovereign guarantees. Gadi’s legal and financial expertise provides an invaluable window into both why this instrument is so essential to project finance on the African continent and the complexities that governments must navigate in order to offer a sovereign guarantee. We will discuss the intended purpose of a sovereign guarantee, how it does (and does not) impact governments’ debt limits or ability to borrow, and the advantages a sovereign guarantee can provide to both the private sector and the government.
Above all, the conversation is an important insight into the government perspective on sovereign guarantees. As private sector actors – whether investor, project sponsor, or developer – we do not always have a full understanding of the competing pressures on the government stakeholders who play such a critical role in the success of energy or infrastructure projects. I really encourage those “on the other side” of PPAs and sovereign guarantees, including investors and project sponsors, to check out the interview. I suspect you will come away with a new understanding of and heightened respect for governments and their representatives as well as sovereign guarantees as a de-risking tool.
[1] https://www.irena.org/-/media/Files/IRENA/Agency/Publication/2020/Jan/IRENA_RE_Sovereign_guarantees_2020.pdf
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