What utilities ought to know
before doing business overseas.
Electric utilities and other power developers are re-configuring their formulas for measuring the host of dynamic risks associated with making large investments outside of their home countries. Even if there is a cyclical predictability to some of these risks-like the prices of basic commodities-other risks are largely unforeseen: that the United States would suffer a massive terrorist attack, that a company the size of Enron would fail, or that California regulators could get deregulation so wrong.
Foreign investments likely will be considered risky business as long as there are still projects to be done in a utility's home market that are considered to be economically viable. But as markets like the United States or the United Kingdom mature, and as regions like North America and the European Union exhibit slower electricity demand growth rates, higher growth-if more volatile-foreign markets seem appealing. In a good year, while gross domestic product is up 2 percent or 3 percent in the U.S., it may be up 7 percent or more in a fast-growing country in Asia or Latin America.
Still, for some companies, many of the risks abroad are no less challenging than some of the risks faced at home. "Political risk is everywhere, as opposed to the assumption by most investors who think it's safe to invest in the United States and not safe to invest outside the country," points out Ken Woodcock, a senior vice president and the head of investor relations for AES Corp., in Arlington, Va. With projects in more than 40 countries, AES has seen a number of the twists of risk in developing a project at home. For example, the company lost its environmental permit for its Cedar Bay, Fla., project due to "local opponents" after a year's work, he says. Other U.S. utilities that invested in the United Kingdom-a relatively mature market-were hit with an unexpected profit tax, which unilaterally changed the terms of deals done years earlier.
For some utilities, risk management is so natural that enumerating the variables may be a simplistic exercise. For others, new risks are emerging every day.
The Top 10 Risks of Foreign Investment
1) Diversification Risk
Part of the risk of investing overseas is determining what percentage of a utility's portfolio should be diversified geographically, outside of the country. Multilateral banks establish value ceilings for country lending based in part on the growth in those countries and the likelihood of repayment. But there is no hard and fast rule for such diversification for investor-owned utilities. Indeed, shareholders and other equity stakeholders may push a company overseas for higher returns, despite higher risk.
Regardless of the mandate to diversify, the quality of the country or regional risk has to be determined on a case-by-case basis. "If a utility has 20 percent of its investments in the United Kingdom, that's a lot different from 20 percent in Pakistan," says Susan Abbott, the managing director of project and infrastructure finance, at Moody's Investors Service, in New York."We haircut utilities' foreign investments, because when they say, 'We are getting so much from Argentina,' we say, 'No, you are not,'" she explains.
The strategy of geographic diversification may be a function of the perceived term of investment with the associated long-term growth in demand rates. With power generation concessions carrying 20-year to 30-year terms, there are ample opportunities to amortize investments. "In looking at possible investments, we take a long view and look at a whole range of variables in a very disciplined approach before deciding to enter a market or pick up an asset. That provides the best risk management," says Stephen Morrisseu, a spokesman for Duke Energy.
Just how much money is being risked in overseas electric generation, distribution and transmission plants? A bundle, reckons Bill Reinhardt, the editor of the 2001 International Projects Survey, which has tracked public-private partnership investments in infrastructure since 1985, including concessions and privatizations. Combining all forms of energy projects for the past 15 years, he calculates that there are 724 projects in various stages of planning, development, or operation globally, worth an estimated $314.2 billion. Of these, only 282 had been financed by October, tapping an estimated $145.3 billion. The trend of late is for governments to contribute little-if anything-to such development, placing the burden on the private sector.
Of course, the 724 projects are only a fraction of the investments made by the private sector globally. But experts believe 724 projects are probably a close number for those private sector investments in lesser-developed countries-which are usually done in partnership with a government or multilateral development institution. Also, private-sector investment banks are more comfortable with making loans for energy projects when the development institutions are involved, say analysts.
Regionally, the spread of the funded projects tracked by Reinhardt creates some surprising shapes in the bulge brackets. Asia accounts for 135, worth $80 billion; Latin America accounts for 83, worth $30.9 billion; Europe accounts for 39, worth $23.9 billion; Africa and the Middle East account for 12, worth $5.9 billion; and North America accounts for only 13 projects, worth $4.6 billion, says the Harrison, New Jersey-based publisher. The as-yet-unfunded project tally is far higher for all the regions, suggesting that competition for funding is a race that constantly is accelerating.
With the United States and the European Union perceived to be the most stable markets in the world, it is not surprising that a high volume of investment flows between the two regions, albeit in different economic seasons. "Five or six years ago, everybody in the United States was looking for diversification in foreign projects, but a lot of them didn't achieve the earnings they expected, and in many cases, they got burned. So, assets traded hands with a blurring speed," says Phil Kassin, a partner in the Energy Utility Practice at PricewaterhouseCoopers Consulting, in New York. "Now we are seeing a reverse where some of the major global European utilities like E.ON, Centrica, National Grid and PowerGen have run out of running room in their own back yard and the United States is the land of expansion," he says.
2) Political Risk
The variations of political risk are many, given the levels of federal, state or local power that can come into play to affect a project. Federal or sovereign risk is perhaps the most compelling of political risks, especially in countries where there is a weak or divided congress. While Colombia's fiscal and monetary policies are such that the country deserves an investment-grade rating from international risk assessors-like Fitch, Moody's and Standard & Poor's-such a high rating has eluded other countries-like Mexico-for years. If a government will not back the political risk in a project-from problems as basic as nationalization-then others will have to pay for the risk. In general, sovereign governments don't assume country risk these days: "Why should they if they don't have to?" asks Abbott, playing devil's advocate.
Still, some countries recognize that assuming country risk helps attract badly needed foreign investment, so governments take this extra step to assure inbound cash flows. "The government may accept political risk, as in Colombia, which permits commercial banks to come in for loans," observes Woodcock. But there are few countries in the world like Colombia, where a pipeline may suffer hundreds of bomb attacks per year.
Although the issue of the personal security of expatriate workers apparently has not yet been raised markedly in most countries, some multinational utilities are taking additional precautions against factors like sabotage, terrorism and kidnapping. "We've increased vigilance on security steps we already were taking, even with routine measures," says Robert Stibolt, the senior vice president of risk management and energy trading at Tractebel North America, in Houston.
3) Regulatory Risk
A large subfunction of general political risk, regulatory risk, can be a function of a fickle government, or a function of a nascent regulatory regime, where concession and privatization implementation practices are evolving with virtually every deal. "We often coach governments for five years before they get their rules right," says AES' Woodcock. "They get the idea that they want to privatize, but the rules are unattractive to foreign investors. So, we may work with heads of state, with energy ministers, or with privatization ministers for as long as it takes to get a set of rules that allow us to put a good business together in a country," he says.
In situations where governments set a rate of profit return for a project, those utilities that find conditions do not match concession contract terms can be left out in the cold for years. But foreign currency guarantee clauses, guaranteed floors and ceilings for business volumes, and other mechanisms are making the rate anticipation game more tolerable.
4) Economic Risk
Even the longest bull market in the world has to slow down at times. When Argentina adopted parity for the peso with the U.S. dollar years ago, the move was heralded as a milestone of economic progress. But today, the country is on the fiscal ropes, Argentina has defaulted on its debts, its currency has been de-coupled from the U.S. dollar, and is sapping the economic strength of the entire Common Market of the South, or Mercosur trade bloc, including neighboring Brazil, Chile, Paraguay, and Uruguay.
Still, outside of the United States, the regions that have grown the fastest over the past few decades tend to continue to grow the fastest. "We have three main regional targets overseas-Europe, Latin America, and Asia-Pacific-where we see liberalizing gas and power markets, and where we think the market economies and political conditions are conducive to the kinds of businesses we want to build," says Morrisseu.
Apart from economic threats to the ability to operate an asset in a given country, the physical operation of the unit can sometimes be a challenge. Securing expensive imported spare parts can at times require a special understanding with local customs officials. And gas supplies suddenly can be diverted to domestically owned customers rather than a utility, for example.
5) Credit Risk
Customer and supplier risk can be crucial, even when a seemingly secure fuel or power purchase agreement is in hand, stamped and approved. When a supplier or customer-particularly a government-is unable to supply or to pay, the legal recourse may provide little comfort to a utility with tough lender covenants. "If I lock in a price on natural gas, but it goes up, whether I benefit or not depends on the credit quality of the supplier. Enron had a lot of these contracts, but now if they go into Chapter 11, the value of those contracts is brought into question," says Stibolt.
Similar to credit risk, collections risk is an issue for companies involved in distribution, particularly in countries where theft of service is a standard deviation, one executive says. In the slums of Rio de Janeiro, for example, gangs that control some of the poorest neighborhoods have in the recent past threatened the lives of linesmen who make calls to correct illegal connections.
6) Interest Rate Risk
When a utility seeks to develop a project, it normally borrows a hefty portion of the price from private lenders, banks, insurers or other financial service entities. Depending on the perceived risk of the developing company, the cost of borrowing may go up or down hundreds of basis points-or thousandths of one percent, regardless of country risk. "If you look at what are classified as utilities, an average rating might be A3, but if you look at developers, it might be Baa3," estimates Abbott. "They want to leverage as much money as possible to do as many projects as they can," she explains. Thus while a company might be able to use balance sheet financing for a project, liquidity positions may necessitate increased borrowing. Apart from cash needed to move a project through construction completion, ongoing operating expenses may also necessitate interest rate hedges. "We hedge against interest rates over a longer term, so we're not taking advantage of some of the lower rates now; but 15 years rates haven't come down that much," one utility executive says.
7) Commodity Pricing Risk
Energy trading companies are as important to a utility as their generation facilities. The pricing of fuel sources, electricity rates, and other factors affecting these prices, like weather, must be hedged carefully to avoid peak expenditures. "If it takes a typical 6.8 million BTUs to make a kilowatt-hour of power and the market ratio is 7 million, you're not making any margin; but if there's a ratio of 15, you're making lots of money," says Stibolt.
For regions dependent on hydroelectric generation-like the Northeastern or Northwestern United States, or Brazil-rainfall can mean anything from cheap power to 20 percent rationing. "Weather can influence demand, be it a function of heat, cold, or rainfall," says Woodcock. "We've done a lot of thinking about these factors since our revenues were affected this year," he notes.
8) Foreign Exchange Risk
Trillions of dollars in foreign exchange are traded around the world daily, and the volatility in the variations can impact both utility suppliers as well as its customers. Derivative hedges against fluctuations are a standard part of any foreign business, and these exposures frequently are reported on a real-time basis up to regional if not global centers, where the costs of protecting against relative geographic risks can be measured with the same financial stick. If protection against currency devaluation is acquired in the country where the risk arises, placing the risk there limits the exposure of a parent company elsewhere in the world.
9) Repatriation Risk
Hedging against a currency shift is one thing, but managing to repatriate the protected profits is another matter, points out Abbott. "You can push currency risk into a country by way of derivatives, but the answer to the question of whether that means the risk of repayment is adequately dealt with is no. A third party may guarantee a contract and (dollar-based) payments, but not necessarily the debt service to the (offshore) lenders," she says. In early December, for example, Argentina placed controls on bank withdrawals and foreign remittances in an effort to stop capital flight. Such moves keep profits captive in a country, forcing a company to reinvest or to convert profits from local currency to physical products that can be exported. Under a prior government in Brazil, when currency repatriation was heavily taxed, international companies routinely purchased gold or food products to ship value back to a parent company.
10) Containment of Risk
Some utilities operate each individual project like an island, with risk management handled locally, to shield the parent from any false moves-as well as shielding the subsidiary from a capsizing mother ship, as has been a danger with Enron. Other country risk managers compare similar country risks on at least a regional basis, to take advantage of higher volumes when it comes to costs and exposures. Some managers also will report risks to a global center, where a corporate-wide prioritization of the risks can be undertaken and protected. "In North America, we have played a role in the risk methodology used more widely," says Stibolt. The sophistication of risk models employed today are both a function of the evolution of the art of risk management and of the evolution of the software tools now available to develop models, he says.
Sharing Risks and Risk Management
The collection of investment risk takers in foreign projects can include a host of types of businesses and financial entities. Multilateral banks and commercial banks both make loans and take equity positions. Insurers, exporting suppliers, other public and private investors, and finally the developing utilities themselves take on a variety of risk elements. Breaking overall risk into bite-sized components and types is what may make a successful deal work; premiums are paid for those who take the greater risks, and limits to exposure can come from corporate bylaws, from outside risk analysts, or from the good business sense within the utility's development team.
Should utilities hire top consulting guides when venturing overseas? Should they form joint ventures with local partners or specialized financial entities? Or should they just build expertise in house? It all depends on the complexity and size of the project, says Kassin. "A lot of project developers have amassed in-house capabilities, while others have outsourced risk management expertise with a variety of bankers like Morgan Stanley or Goldman Sachs. There is a high cost of setting up a trading system, so out-sourcing or forming an alliance may work best."
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