Sovereign Guarantees in an African Context

This post is Part II of our series on sovereign guarantees; if you didn’t catch Part I you can access it here: Sovereign Guarantees in an African Context, Part I

This week we released a fantastic conversation with Gadi Taj Ndahumba, Chief Legal Council at the African Legal Support Facility. This is the first of Pivotal180’s new interview series, Pivotal180 in Conversation.

Watch the interview here: Sovereign Guarantees with Gadi Taj Ndahumba

This interview explores sovereign guarantees, and Gadi offers us an incredibly knowledgeable and unique perspective on this instrument. Sovereign guarantees are a great tool for deepening your understanding of project finance, because they are a clear example of how risk perception and the legal structure of a project affects its bankability. Additionally, in this conversation, the discussion of sovereign guarantees gives us important insight into a project’s macroeconomic impact on the host country and the host government’s strategic decision making.

The interview covers a lot of in-depth information and nuance that you may not have heard before. Here is a recap of the key takeaways from the interview:

• Market characteristics drive use of sovereign guarantees: Use of sovereign guarantees varies by region and boils down to perceived risk related to the offtaker’s creditworthiness. For example, in Sub-Saharan Africa (where sovereign guarantees are common) utilities are typically state-owned and require some sort of government subsidy or support, meaning they are not financially viable on their own. IPPs – and their lenders! – may be concerned that the utility will not follow through with its obligations in the PPA (payment or otherwise) and request that the host government guarantees to step in and fulfil these obligations in the case of default by the offtaker.
• Lenders are a key driver for sovereign guarantees: It is not just IPPs and investors that find sovereign guarantees beneficial – it may also be a requirement from their lenders. For IPPs to offer an attractive tariff ($ per kWh), they typically need high leverage and will seek debt for around 60%-80% of project costs. Additionally, many of these projects use non-recourse financing, meaning that lenders can only seek repayment from the project itself, not its sponsors. In addition to serving as further security of repayment, lenders want to see a sovereign guarantee because it implies that the government is fully aware of and supportive of the project. Energy and infrastructure projects are not implemented solely through the offtaker – they also require coordination and cooperation with multiple government agencies. By issuing a sovereign guarantee, the government signals it is fully aware of the project and will support the steps necessary for its implementation.
• Governments have concerns about sovereign guarantees’ impact on sovereign debt limits and their ability to borrow: Many governments are wary of issuing sovereign guarantees because they are told that the guarantee will be seen as a contingent liability and would therefore impact their ability to raise debt for other social programs or infrastructure. This is a difficult position for governments, especially because they are typically advised (by the IMF or other DFIs) to outsource financing of infrastructure – like power generation – to the private sector when possible. Outsourcing energy generation to IPPs meets that objective and should increase their ability to raise financing from these institutions, but governments are then warned that a sovereign guarantee may affect their borrowing ability.
• Sovereign guarantees are typically contingent liabilities, NOT direct liabilities: Despite the common phrasing that sovereign guarantees impact the government’s balance sheet, this is not usually the case. Sovereign guarantees are contingent liabilities rather than direct liabilities, meaning the liability is “contingent to” a certain occurrence (in this case, default by the offtaker). Unless it becomes likely or certain that the offtaker will default (requiring the government to step in) the sovereign guarantee remains a contingent liability and therefore is not listed on the government’s balance sheet.
• Not offering a sovereign guarantee does not avoid a contingent liability: In Sub-Saharan Africa, regardless of whether a government offers a sovereign guarantee, a State-Owned Entity’s (SEO’s) obligations – including those in a PPA – will still represent a contingent liability for that government. This is because public finance in Sub-Saharan Africa is highly influenced by the IMF’s assessments under Article IV. The IMF’s assessments of the country’s economic status and government’s financial strength consider not only the direct liabilities on the government’s balance sheet but also the direct liabilities of its SEOs (including the national utilities). This practice is due to the assumption that some SEOs (like an electricity utility) are so critical to a country’s economy and society that the government will have no option but to step in and “bail out” these institutions in the case of their default. Therefore, even if the government does not offer a sovereign guarantee, it still takes on the contingent liability of its SEOs liabilities. The sovereign guarantee rather converts an implicit contingent liability to an explicit contingent liability.
• Sovereign guarantees allow governments to structure the inevitable contingent liability: One of the benefits to governments of offering sovereign guarantees is that it ensures the government engages in the project at an early stage and can, in Gadi’s words, “put a framework on the contingent liability.” The government can then shape the process and timeline for notice and cure periods, and make sure they align with its internal processes. One reason this process is beneficial is because if the government is notified immediately of an event that could lead to default, it can intervene and attempt to remedy the situation (and, for example, avoid a large termination payment). In the worst-case scenario, the government will have more notice and realistic timelines to make the required payments.

We hope you have found this recap useful, and that your interest is sparked to watch the interview if you haven’t already. The perspectives in the interview are useful for understanding the broader context around infrastructure development in Sub-Saharan Africa, and it is a must-watch for professionals interested in working on the continent. We hope you come away with newfound understanding and respect for the complex issues governments need to consider when planning infrastructure projects and deciding whether to offer a sovereign guarantee.

If you’d like to get in touch with Gadi, please reach out to: sales@pivotal180.com

Please use links below to find out about Pivotal180 and our financial modeling courses and  experience the Pivotal180 difference.

• Project finance and infrastructure financial modeling
• Renewable energy project finance modeling
• Tax equity modeling
• Introduction to Battery Storage