How Bankable is Uganda’s Energy and Extractives Sector?

A 2015 report on Ease of Doing business by the World Bank ranked Uganda 150 out of 189 countries. Uganda ranks below its East African community neighbours except Burundi, and according to the Uganda Investment Authority (UIA), Foreign Direct Investment (FDI) in 2013 was valued at USD 1.19 Billion mainly from India and China. The country’s energy and extractive sector has seen significant investment in the electricity sub sector through the on-going Karuma and Isimba Hydro Power projects and investment in oil and gas exploration.

The Ministry of Energy Strategic Investment Plan 2014/15 to 2018/19 indicates that currently less than 7% of the rural population has access to electricity services. The government aims at increasing this figure to 24% by the year 2019. Uganda is endowed with numerous natural resources, which if efficiently utilized would broaden the diversity of the energy mix and strengthen the country’s energy security position. Resources for potential exploitation include geothermal with more than 40 geothermal sites under exploration, solar and wind energy, nuclear, oil and gas amongst others.

Given that the country is grappling with limited access to cheap energy despite the abundant unexploited energy resources, how can the government attract more investment into the sector to achieve the goal of attaining middle income status by 2020?

In order to answer this, it is important to understand how investors structure their financing and what factors would positively motivate an investment decision especially in the energy sector that requires significant sums of capital. One of the most commonly adopted structures used to finance high cost projects is by setting up a “Project Finance” arrangement.

In simple terms, a project is considered bankable if lenders are willing to finance it. Project Financing involves financing a particular project in which lenders look initially to the cash flows and earnings of the project as the source of funds to repay the loan and to the assets of the project as collateral to the loan. Most project financings will involve limited recourse to the sponsor (Government) beyond the assets that are being financed. In other words, in case of failure to repay the loan, the lenders are almost restricted to only the project assets and have limited access to other non-project related assets to recover the loan. It is hence important for lenders and governments to properly review and address all the risks involved in project financing. The key to project financing is that lenders will not make an investment decision until the project is fully de-risked and there is guaranteed certainty that their funds will be recouped from the project cash flows.

Lenders will assess the bankability of a project, where there is an acceptable balance of risks and all possible risks can be analysed. The magic of project financing consists of distributing the different risks associated with a project to the various participants who have a particular interest in the success of that project, in such a way that each participant assumes a portion of project risks but none bears all. There are a number of risks that lenders/investors will look to eliminate especially in developing countries like Uganda.

Firstly, the completion risk; this is one of the fundamental risks in any infrastructure project involving construction such as power dams. The completion risk assumed by the lender arises in situations where for all practicable purposes, completion of the project or facility so that it operates to the full capacity and specifications originally planned proves to be futile. In Uganda, delays and late completion of energy projects is eminent as projects are more often than not, behind schedule. Such conditions are not favourable to lenders and have to be addressed to attract the right financing. This is normally mitigated through the adoption of completion guarantees and turn-key contracts to shift the risk to the EPC contractors.

Secondly, lenders/investors seek to address the market risk. The market comprises two elements, the existence of the market for what is generated from the project and confirmation that the price at which the products sold is sufficient to service the project debt. Lenders typically require a level of certainty as to the future demand and sales prices of the output to be produced by a project and justification that the project is capable of delivering its output at market prices.

In Uganda’s case for example, the 250MW Bujagali project’s bankability was strengthened by a Power Purchase Agreement (PPA) with GOU guaranteeing a market for the power produced by the dam. In addition, the investors sought a price of    USD 0.11/KWH (highest in East African Community) that is sufficient to service the project debt. The project was structured similar to a ‘take or pay’ arrangement where the power is sold at a pre-agreed price, which assures the lenders/investors of cash flows since there will be demand for the power as long as the agreement is in place and is honoured. Under take or pay arrangements, whatever agreed production is not consumed, is still paid for by the buyer under the PPA. This introduces the aspect of deemed energy because the producer is deemed to have generated power and sold it to government. In addition, the current low crude oil prices have made it challenging for the oil companies to make final investment decisions since production will only be profitable above the break-even price.

It should however be noted that such agreements can be costly to developing countries like Uganda if not well negotiated. Currently the government is seeking possible avenues of renegotiating the agreement so as to reduce the cost of power to at least USD 0.072/KWH.  Such renegotiations might reduce the tariff in the short run but turn out to be costlier in the long run in terms of interest payments since the lenders still have to be paid back the pre-agreed principal and additional interest, just over a longer period. The upcoming crude oil pipeline to Tanzania will also typically have an off take agreement in place to lock in the crude market and provide comfort to the financers on future cash flows.

Another major risk worth mentioning is the political and regulatory risk. When a project company fails to pay dividends or interest on its loans due to government restrictions on overseas remittance of funds, failure of the government’s banking system caused by civil war and conflict, government expropriation of the project or in certain instances breaches of the terms of key concessions, then this is political risk. Risks relating to changes in the law, regulation and tax regimes can’t be ruled out especially if a country is in an economic crisis. Lenders and investors are keen on such risks and in some cases contracts or concession agreements are structured with stabilization clauses to protect the investors from such drastic changes that suit the government at their expense.

Investors are obviously more attracted to stable political environments and countries with well-structured and incentivized fiscal regimes. In Uganda’s energy and mineral sector, the laws, regulations and tax regimes are under constant review either to encourage more investment or to ensure that the government generates the most out of such deals.  Case in point is the tax law on oil and gas, which has witnessed transformation to accommodate the expectations of investors and at the same time, stay in tandem with international bench marks. Further, Uganda’s mining policy is also undergoing revision to accommodate aspects such as artisanal mining and better management of licensing.

Environmental risks also play a significant role in today’s environmentally sensitive society. Investors are keen on the possible environmental impact and carry out such assessments to ensure that investment decisions are made after a thorough understanding is established. For example, under Uganda’s latest oil licensing round, parts of the Albertine Graben attracted no interest due to the environmentally sensitive nature of the license area.

With all these risks in mind, it is important to ask the question on what efforts can be made to address these risks so as to attract the much needed investment in the sector. The government has adopted a number of Public Private Partnerships (PPPs) and one of the most common ways of implementing PPPs in managing infrastructure is through the concession approach. This consists basically in transferring final design, construction, maintenance and operation of the infrastructure to a private consortium, in exchange for which that consortium receives the right to charge a fee to the user or to the government on behalf of the user, for a period of time contractually agreed in advance. (Usually 20 to 30 years)

The concessions to UMEME, ESKOM and Tibet Hima Mining Ltd in the electricity and mining sectors in Uganda are examples of government efforts to attract sector investment through PPPs. However it is also arguable on whether the concessionaires always achieve the expected targets within the pre-agreed timeframes. Case in point is the concession of the Kilembe Mines Limited’s assets to the Tibet Hima Chinese consortium. Reports from Kilembe mines indicate that the concessionaire is yet to adhere to several concession terms and minimum capital investments.

In conclusion, much as it is important for the government to attract the right kind of investment, it is critical to understand the country’s investment risk profile in the eyes of potential investors. Quality and timely due-diligence is critical if the country is to continue with concession arrangements to mitigate the risk of under-performance by the concessionaires. The government should allocate funds to carry out its own feasibility studies by internationally reputable firms to ascertain the potential of its own resources. Additionally, extensive capacity building should be championed to enable government have able and qualified representation at the negotiating table to achieve maximum benefit from such deals. Once this is established, the right policies can be set up to de-risk the country thus making energy and extractive sector projects more bankable.

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