By Gadi Taj Ndahumba
It is well known that energy projects in Africa are often hard to finance and that to reassure potential lenders, their legal structure will require more security instruments than in developed countries. To address this requirement, independent power producers (IPP) will commonly seek the issuance of a sovereign guarantee by the host government. However, the question as to whether a government should accept to guarantee the offtaker’s obligations is not to be taken lightly, especially in the time of increasing African government debt burdens.
In African electricity production projects, sovereign guarantees will typically guarantee the obligations of the offtaker under the power purchase agreement (PPA). These obligations can range from pure financial obligations such as the routine or termination payments to undertakings to provide the infrastructure connecting the power plant to the national grid. Any of such risks could be allocated in a different manner but sovereign guarantees are particularly attractive for lenders because they create a direct obligation of the host government toward the project company and, by extension, its lenders. Thus, the project company is able to partly or fully borrow directly against the guarantee, which in cases where the offtaker’s credit worthiness is weak, might ease the capital raising process and allow the project to be bankable. The direct contractual link between the government and the project company may also become particularly important in the ‘worst case scenario’ where a state owned utility company defaults under the auspices of an unstable or uncooperative government. In this situation, the instrument may provide a significant advantage if it includes arbitration or forum selection clauses allowing the project company (or lenders) to seek an award against the host government without going through the country’s legal system. Furthermore, where the offtaker will typically only have assets in the host country, the government is more likely to have foreign assets against which the project company (or lenders) may request seizure and enforce an award.
On the side of the governments, a guarantee is also an appealing tool to reassure lenders as, unlike traditional spending, it does not require any extension of hard cash nor impose express budgetary constraints (other than in the event of a default from the offtaker). Furthermore, even if the government does not issue a guarantee, it is the ultimate owner of the offtaker’s assets (assuming the offtaker is a state owned company) and remains to some measure responsible for the PPA’s obligations, with or without the guarantee. Therefore, the IPP is likely to argue that the guarantee does not create significant additional exposure for the country if the government does not intend to become uncooperative in the event of a defaulting offtaker.
Nevertheless, there are valid reasons why some African countries such as Kenya have categorically closed the door on sovereign guarantees for energy projects. A sovereign guarantee is, for accounting purposes, a contingent liability on the host government's balance sheet, i.e. a potential future financial obligation whose conversion into an actual financial obligation is dependent on the occurrence (or absence) of one or more future events, which may be outside of the government’s control. The risk associated with contingent liabilities is therefore not easily identifiable or quantifiable. In both the recent global financial crisis and the European sovereign debt crisis, the complexity of contingent liabilities has proven to engender significant uncertainties in the public debt sustainability of several countries, and ultimately led investors to unfavourably revise these countries’ creditworthiness. It is therefore important to consider the consequences of a sovereign guarantee on a government’s overall public debt levels, cost of borrowing and various financial covenants under its domestic and international debt obligations.
Part of such analysis is to determine what contingent liability disclosure process is used within the country. Most African governments manage their accounts on a cash account basis allowing them to decide whether or not to disclose sovereign credit support. Although more than 30 African countries have clearly expressed their intention to comply with the Cash Basis International Public Sector Accounting Standard (IPSAS), which requires specific disclosure procedures for contingent liabilities, it has proven to be impracticable to keep up with the required standards for most of them. Hence, without evidence of compliance to the Cash Basis IPSAS or a full and clear commitment from the government in respect of its contingent liabilities, investors are unlikely to assume that it has disclosed the full extent of its financial liabilities.
Moreover, another part of the analysis is to assess the country’s capacity to evaluate and manage its contingent liabilities and whether it has set out a clear policy framework for monitoring and accounting treatment of such guarantees. In addition to project specific or macroeconomic risks, the risks inherent to contingent liabilities may be systemically related—e.g. guarantees under a series of different PPAs could potentially be called at the same time if there are serious credit issues within that offtaker. In this sense, adequate expertise is necessary in establishing the underlying assumptions and selecting the appropriate model that will be used in the measurement of the contingent liability risk (e.g. actuarial, option pricing, econometric or other financial models). Furthermore, the assumptions will need to be regularly updated to keep reserve accounts properly funded. Hence, the valuation of each contingent liability is a complex process and the government will need suitable capacity to avoid or limit potential negative fiscal consequences linked to the issuance of a sovereign guarantee.
In sum, the decision as to whether a government should accept to issue a guarantee must be carefully considered. One of the main arguments for the rise of IPP projects in Africa (and of PPP projects in general) is their ability to decrease the financial strains on the public finance of African countries. However, sovereign guarantees may impose undue financial hardship on a country’s ability to borrow for investments in the other public sectors less attractive to private interests by restricting its access to capital markets or to viable interest rates. It may be the case that the benefits of a project outweigh the impact on the borrowing capacity of a country that has already little or no access to the bond market or other alternative funding. Nevertheless, beyond the importance of the project for the country’s economy, the long-term impact on the creditworthiness of a country should always be assessed prior to the issuance of a sovereign guarantee.
Gadi Taj Ndahumba is a Legal Counsel with the African Legal Support Facility
The views expressed in this article are those of the author and do not necessarily reflect the views of the ALSF.
 Andy Wyne, “What Accounting Standards for Governments of the Global South?”, Public Financial Management Blog, posted on IMF Website on May 30, 2012: http://blog-pfm.imf.org/pfmblog/2012/05/what-accounting-standards-for-go...