Private investment in transmission – ITPs (part 1)

By Ryan Ketchum and Chris Flavin.  Ryan is a partner at Hunton Andrews Kurth LLP.  Chris is Head of Business Development at Gridworks Development Partners, a development and investment platform principally targeting equity investments in transmission, distribution and off-grid electricity in Africa.

The first article in this series discussed the need for increased levels of investment in electricity transmission systems to reduce costs, facilitate the transition to energy systems that are less carbon intensive, increase system stability, and reduce the level of generation reserves that are required to maintain system stability.  It also briefly introduced four business models that can be used to unlock new sources of capital by facilitating private investment in transmission infrastructure across most of Africa (and in emerging markets more generally).  Those four business models are:

• whole of network concessions,
• independent transmission projects (“ITPs”), which are also known as independent power transmission projects,
• privatizations (a sale of shares by a government in a state owned utility or transmission company), and
• merchant lines.

In this article we will examine ITPs, including the circumstances in which an ITP may be attractive to both host countries and investors and some of the challenges that are typically encountered in structuring these transactions.

Overview

Although experience with ITPs in Africa is virtually non-existent, they have been used extensively in Latin America, India, the U.S., and the U.K.  An ITP is a good way to attract capital into the transmission sector to fund key infrastructure and to transfer risk (such as construction risk) to the private sector. To implement an ITP, a host country grants a project company established by an investor or group of investors the right, and the obligation, to construct, own, and maintain a specific piece of transmission infrastructure.  This is most commonly a single transmission line or a group of transmission lines, but the principle can be applied equally to substations or storage assets.  This grant of rights (and obligations)  can take a number of forms but is usually set out in an agreement between the state owned enterprise that is responsible for transmission (the “state owned transmission company”) and the project company.  The most common names for such an agreement are a Concession or a Transmission Services Agreement.  At the same time, the ministry that is responsible for overseeing the electricity sector, or the regulator, grants a license to the project company to carry out transmission activities.

Unlike a broader whole of network concession, in an ITP the project company is not obligated to expand the transmission infrastructure it will construct and own.  This means that an ITP can be a relatively narrow intervention in the electricity sector.  A discrete project can be scoped and allocated to an investor or developer.  Although the aim of many countries is to reach a point where a transmission utility may conduct an auction for packages of lines, in order to drive down construction and financing costs to the lowest possible level, it’s likely that the first such ITPs in many jurisdictions will be bilaterally sourced.  Many transmission utilities in sub-Saharan Africa are at present bilaterally sourcing a portion of their transmission infrastructure under an EPC, plus financing a model in order to pass development risk to the private sector, which is also responsible for conducting feasibility studies and scoping the project.  This model can be applied to the financing of IPTs and there are helpful fiscal policy advantages to using private sector models rather than traditional forms of financing that require sovereign guarantees.

In order to support the ability of the project company to be financed at attractive rates – which ultimately benefits consumers by lowering cost of the capital required for the project, which in turn lowers the payment made to the project company – the project company is typically paid for the transmission line regardless of the quantity of power that flows over the line.  These fixed payments mean that only limited regulation is required once a project is established.

Arrangements for the maintenance of the line for the duration of the Concession or Transmission Services Agreement will be agreed when the project is designed and this may be the responsibility of either the project company or the state owned transmission utility.  If it is the responsibility of the project company, then the cost of maintenance will be reflected in payments made to the project company by the state owned transmission facility.  In this case, the payments may also be based on the “availability” of the line for the duration of the concession so that the project company is rewarded for maintaining the line appropriately and penalized if the infrastructure is not available to be utilized at the agreed level.  If the project company is not responsible for maintenance then payments for the line are more likely to be characterized as lease payments or an annuity.

A unique feature of ITPs is that they are operated as part of an integrated transmission system, not by the project company.  The state owned transmission utility or transmission system operator (if those functions have been separated) operates a transmission line developed as part of an ITP by dispatching generation and balancing the system of which the transmission line is a part just like it would operate any other transmission line.  This feature may be particularly attractive where there is some reluctance to allow the private sector to control the dispatch of generation resources.

An ITP may be appropriate if a host country:

• is, as a general matter, pleased with the performance of the state owned transmission company and desires to see the state owned transmission company continue to operate in its current form;
• desires to construct a significant transmission project or a group of transmission projects without assuming the construction risk for those projects;
• would like to use private capital to fund those transmission project(s);
• would like to unlock sources of debt financing that are not available to the state owned transmission utility; or
• would like to avoid on balance sheet borrowing by structuring the projects to achieve off balance sheet treatment.

An ITP may be less attractive to a host country that:

• has access to sufficient funding to meet its sector financing needs on suitable terms; or
• is looking for a new operating model for the wider network because its existing system operator has not been able to achieve performance indicators, service levels, or other commonly used performance benchmarks.

As a country considers whether an ITP is an appropriate tool for achieving its objectives, it should also consider how electricity sector participants and other stakeholders will be affected, and how to engage with those stakeholders to build support for the transaction.

Enabling environment

One of the benefits of ITPs, particularly in comparison to concessions or privatizations, is that they can be implemented in enabling environments that would present some challenges for concessions or privatizations.  In other words, the requirements on the enabling environment are significantly easier to meet.  Ideally, the legislative position in the country and other aspects of the enabling environment would include a suitable licensing regime and a clear authority from government to the sector regulator or the state owned transmission utility to award ITPs to project companies.

Note that an independent regulator is not necessary.  Neither is it necessary for the host country’s utilit(ies) to have been unbundled into separate utilities responsible for generation, transmission, and distribution.  Although they would be useful, clearly defined codes that govern the conduct of sector participants (such as a grid code, a distribution code, or a dispatch code) are not required either.  As a result, the independent transmission project model is inherently flexible and can be deployed in countries that would find it far more challenging to implement a concession or a privatization.

Contractual structure

There are many similarities between an ITP and an independent power project.  Both structures involve a single project (a generation plant or transmission infrastructure), or a small group of projects in the case of an ITP.  Both structures are designed to separate a stream of cash flows, rights, obligations, and risks in order to facilitate the use of project financing techniques.  Given these similarities, it should not come as a surprise that there are similarities between the contractual structures for ITPs and independent power projects.  Given the widespread market acceptance of independent power projects across Africa, we suggest that the following contractual structure would, as a general rule, be appropriate for the ITPs in Africa.

In such a structure, the Transmission Services Agreement or Concession would, among other things:

• obligate the project company to design, engineer, procure and construct, the project;
• obligate either the project company or the state owned transmission utility to maintain the infrastructure;
• obligate the project company to make the capacity of the transmission infrastructure that constitutes the ITP available to the state owned transmission utility; and
• obligate the state owned transmission utility to purchase the transmission capacity and make the payments that are specified in the Transmission Services Agreement or Concession.

The state owned transmission utility would be obligated to purchase and pay for the transmission capacity made available regardless of the quantity of energy that is actually transmitted by the project.

 If the project company is responsible for maintenance, then the payments that are payable by the state owned transmission utility would be reduced to the extent transmission capacity is not made available.  The reductions to the availability payments would be weighted by the amount of time the transmission line(s) are not available and, in the case of a partial de-rating of a transmission line, the extent of the de-rating.  This type of mechanism will facilitate the use of project financing techniques and ensure that the project company has an appropriately firm incentive to properly maintain the transmission line(s) and make transmission capacity available to the state owned transmission utility.

The government support agreement would contain terms that are similar to those found in a government support agreement entered into in relation to a generation project.  The agreement would also include appropriate termination payments.  Those termination payments could take the form of a put option and a call option of the type that would typically be found in a put and call option agreement.  For a discussion of put and call option agreements, see this article.  For a discussion of how to calculate termination payments and purchase prices, see this article.

Like all projects that are financed using project finance techniques, allocating risks properly – to the party that is best able to manage the risk and, to the extent that no party is best able to manage a risk, to the party that is best able to bear the risk – is essential to attracting debt financing on terms that will result in good value for money to the offtaker (in this case, the state owned transmission utility).