Project finance for mini-grids

Project finance has been instrumental in scaling large, grid-connected renewable energy projects, with well-established approaches that have facilitated trillions of dollars in lending to the sector. The result has been access to low-interest, long-term financing. This is exactly what mini-grids need to achieve similar success and growth. Like large-scale renewable power systems, mini-grids are critical infrastructure, yet they face unique challenges, particularly the risk associated with selling power at the retail level. Additionally, mini-grids differ from large-scale renewable projects in their stakeholder structures.

In this episode, Kellie Murungi, Head of Business Africa at INENSUS, joins host Nico Peterschmidt, CEO of INENSUS, to explore the principles of project finance and discuss what it will take to make mini-grids viable for this type of financing.

Discover why a wave of mergers and acquisitions is anticipated in the mini-grid sector, and how diversifying revenue streams through rural industrialization, edge computing from surplus electricity, and renewable energy certificates can make mini-grids more attractive for project finance.  Additionally, learn how, over time, the financing sector may become more familiar with mini-grids as a new asset class.

LinkedIn: https://www.linkedin.com/company/inensus-gmbh/mycompany/
Visit www.inensus.com for more info.

Transcript

Speaker 1 0:09

Solar mini-grids have turned from small pilots to an electrification wave. We were there when mini-grid regulation was established, when financial transactions were closed. We saw new technology thrive and companies fail. This is where we tell the stories. This is where we discuss the future the mini-grid business Powered by Inensys.

Speaker 2 0:36

Hello, this is Nico. Welcome to our episode on Project Finance for mini-rids with Inensos, head of Business Africa, kelly Murungi. Hi, kelly, hello Nico. Kelly, the financial modeling episode you and I recorded earlier this year is one of the episodes with the highest number of downloads and listeners in the Minigrid business podcast space so far, which is exciting because this shows to me that our listeners are really interested in educational content. People obviously like the way you explain complex subjects too, and therefore I'm excited to have you on today. Let us see if we can do the same for mini-grid project finance as we have done for the mini-grid financial modeling.

Speaker 3 1:29

Sure, nico, you're very kind to say this, but I'm missing Diego. I'm sure he did a lot of the heavy lifting, but I'll do my best, so yeah.

Speaker 2 1:39

Okay, Okay, yeah, project financing is a subject that is heavily discussed in the mini-grid space. We're seeing that especially African mini-grid companies are turning towards project finance, whereas international companies run a mixture of project and corporate finance, which is an interesting development. Today we want to discuss project finance specifically and then potentially also discuss the difference between project finance and corporate finance and where, which part and which type of finance fits best and can be used best. So let's start with the question what is project finance? Kelly?

Speaker 3 2:25

Yeah. So I will go with a pretty textbook definition of project finance and then I will break it down. And what we say is you know, project finance is what the lawyers call non-recourse financing. And when we say non-recourse financing we mean that any investment, whether debt or equity, that is made into a project under a project finance structure, its liabilities are restricted within the project, so within the company that owns the project. So we say it's a non-recourse financing where the debt and equity that are raised for the project are paid back from the cash flow generated by the project.

Speaker 3 3:06

Now the reason why the non-recourse bid and the payment from cash flow are important is that generally, project finance is used for infrastructure, longer term projects.

Speaker 3 3:19

Typically these tend to be quite capital intensive, they cost a lot of money, and what this means is that then, if you finance them under the traditional business corporate financing structure, they will not be very attractive for the developers or the sponsors or the entrepreneurs who come up with these projects. And so the project finance structure was created to manage this risk, so that then the sponsor or the originator of the project is not afraid that if this massive road project fails, then the lenders and the equity investors will come after my personal assets or my other business assets, and so, with project finance, a special company is created, what we call a special purpose vehicle, which owns the project assets but also collects all the money that is raised for the project, and then any revenue and extra cash flow it makes is what then is used to repay back the debt. The sponsor is not held personally liable or is not required to then bring in its corporate assets into the project. I'd say that's more or less a definition of project finance and why you use it generally.

Speaker 2 4:27

Yeah, and in project finance, where you put everything into a special purpose vehicle which does not hold any other assets than the project's assets and cannot really provide any external collateral. The diligence required to fund this, the analysis that financiers make, the documents that are required are probably much more comprehensive compared to a corporate finance structure.

Speaker 3 4:58

Yes, absolutely so. You know, in a normal corporate debt transaction, for example, we say that the most important document is the loan agreement. And then, you know, in a normal corporate debt transaction, for example, we say that the most important document is the loan agreement, and then, of course, they will do a due diligence I wouldn't even call it a due diligence, but basically evaluation of the company's assets to see whether this company can actually support this loan. It's pretty straightforward.

Speaker 3 5:19

But when it comes to project finance, as you rightly say, the company owns nothing else other than the project assets. And bear in mind that they only own the assets when the assets actually are constructed. So at the beginning, the company owns nothing but one very important thing bunch of contracts. That's what makes the company, because, remember, the equity and the debt funders will fund the assets. So, as they are coming on and agreeing to fund the assets, the only thing they have to look at are the contracts. And these contracts are not only quite specialized but they are also quite extensive and, as you rightly said, they then need deeper due diligence than we would see in a standard corporate debt transaction.

Speaker 2 6:07

But in return that means that the contracts, which basically are representing the developed projects, have a certain value don't they?

Speaker 3 6:20

Absolutely. They do have a value. And, nico, if you'll allow me, I will mention a few of the core contracts so that we can see where they derive their value from. And I will stray away from mini-grid financing for a moment and I'll go to the sister sort of financing, that is, the on-grid financing, because that's where we have a history of project finance contracts for the energy space. And here you will see if you're doing an on-grid project.

Speaker 3 6:49

The first contract that we talk about is the power purchase agreement or the off-take agreement that, together with what we call a concession agreement or implementation agreement, depending on the country. These come from government or government-related entities. So the power purchase agreement or the off-take contract typically is from the utility. It is a long-term contract 20 to 25 years and it states that the utility, which is supported by the government in many cases, will buy all the power that is generated from this project at a given tariff for 20, 25 years. So it's a locked in sale contract.

Speaker 3 7:31

Then, on the other hand, the concession agreement is a direct commitment by the government on the project. So it says that as government, we support this project Should there be changes in law, should there be changes in government or changes in tax, the returns that are anticipated from this project will be held, the same meaning that the government will step in to compensate the funders. So I'll stop with those two and just hope that to our audience, that you hear the weight of these two contracts. It means that even if I am walking around town with a concession agreement and a power purchase agreement, I'm holding on to some value because I'm holding on to government commitment to my project and, secondly, I'm holding on to committed guaranteed revenue from the offtaker.

Speaker 2 8:19

Which is significant right, and there are companies out there which specialized on exactly this. They develop this kind of contractual framework for a project and then afterwards they sell the projects. We're seeing that in the on-grid energy space. We're not seeing that really in the mini-grid space, but that may be a future way of doing business in mini-grids also. But let's stick to the on-grid space for now.

Speaker 3 8:49

Yes, absolutely yeah. It happens, and there has been a debate on whether this is a good thing or a bad thing, because of course, especially in the continent, in Africa, knowing how political energy is, there has been questions on how are these contracts obtained, but thankfully, because of development of systems, we're seeing a more transparent sort of procurement structures and systems in most countries. So we've talked about the two, the offtake and the concession agreement. But then the other key contracts that make up this company that has no assets but needs money is one the construction contract, or what we call the EPC contract. Now, on the on-grid space, again, projects tend to be large and we're seeing also that slowly becoming the case in the mini-grid space, and the lenders or investors will say if it is beyond a certain size, we need an independent contractor to do the EPC.

Speaker 3 9:43

Why is this One? Because risk management. The biggest risk in most projects is that they take too long, longer than planned, and they cost more than planned. Now lenders do not want to take this risk on. They want a third party who will then pay penalties or bear responsibility if the project takes too long or it costs too much, because, again, remember, the sponsor or the originator of the project takes too long or it costs too much Because, again, remember, the sponsor or the originator of the project is not liable for any liabilities within the special purpose vehicle, within the project company. So if the sponsor is doing the EPC and then they take very long and they are penalized by the utility, or it costs three, four, $5 million more, which happens the lender will say I'm not able to collect on this if this happens and therefore I need you to take that risk and allocate it to somebody else.

Speaker 2 10:32

Yeah, and this is probably one of the main differences between the on-grid electricity generation space and the mini-grid space, because in the mini-grid space, mini-grid operators really like to develop the projects themselves but also construct the assets themselves. Many of the mini-grid companies are active as EPC companies in this African solar sector and they say, yeah, well, why shouldn't I also install my own generation and distribution assets in my own mini-grids? But that would somehow contradict what you just presented, Kelly, right?

Speaker 3 11:14

Yes, and you're right, we see a lot of that One because of, I believe, the size of the projects. They're relatively small in the mini-grid space and, as you rightly say, many developers even start off as EPC companies and then become originators or sponsors of projects. It does contradict project finance principles, or it complicates it, because the lender still will need their risks managed, and so it's a question from a legal standpoint or from even a commercial discussion how does the sponsor plan to manage these risks? So what sort of plan do they present to the lender to say, yes, I'm going to do this myself. I am aware it could cost more and it could take longer, which means higher interest costs. I'm aware that you're giving me a fixed loan, but here is my plan Now, the typical plans, what they'd look like, and we'll go through this.

Speaker 3 12:05

When we get to securities, some lenders will say we need a corporate guarantee from the mini-grid company that covers us in case of any cost overruns.

Speaker 3 12:16

Other lenders will say you have an equity funder. We need your equity funder to give us a guarantee, because what a lender doesn't want? Because once a loan is approved, it cannot be increased, so they do not want to be stuck with a project that is not completed. The other thing a developer does is demonstrate track record of having executed projects at the right cost and on schedule and successfully, and the lender will then come back and say, okay, I will hire an independent technical advisor to go to your sites and confirm that your mini grids are actually working to the standard you say they are, that your procurement was up to standard, that the components the solar PV components, the battery components you know work as is expected and that sort of gives lenders the comfort that this developer has capacity to execute the project. But underlying all this is that the financiers know that projects take longer than planned and they cost more than planned. So a developer must think who will cover these extra costs, because the lender will not.

Speaker 2 13:18

Yeah, but, Kelly, we already said that project finance is limited to the special purpose vehicle. Now the developer is usually a company that created that special purpose vehicle for implementation of a project. So couldn't the special purpose vehicle hire the implementer or the developer as an EPC to install the assets?

Speaker 3 13:47

Yes, they could, and they often do, but the contract, nico, has to be an arm's length contract. So it means that the same penalties that would be imposed on a third party contractor would be imposed in this case, but that would resolve the issue.

Speaker 2 14:01

Yeah, if it was structured like that case. But that would resolve the issue. Yeah, if it was structured like that.

Speaker 3 14:04

Yes, it would, especially if the developer company then has track record but also the financial muscle to bear any penalties that may arise.

Speaker 2 14:15

I see yeah.

Speaker 3 14:17

So unfortunately this we can say sort of puts smaller developers at a disadvantage, but it can be cured by then getting an equity investor who is able to give the same sort of comfort to lenders.

Speaker 2 14:31

Good, let's continue with the next contract, if any.

Speaker 3 14:36

Yes. So the next contract is the shareholders agreement. I have mentioned the equity investor or the equity funder and what the expectation usually is, that, as they're putting equity into the SPV, then there's an agreement of how the affairs of the SPV will be carried out, because they would be a shareholder, the developer would be a shareholder. Now, with on-grid projects, we find that there are certain restrictions in the off-take agreement about, say, selling shares. You don't want equity shareholders to come in and then jump out even before the project is complete. So the shareholder agreement then is a governing document for equity funders. And then the other, I would say interesting contract would be supply contracts, epc being one, but where the developer is doing the EPC themselves, you'll find that then the SPV will contract with certain suppliers to bring in the items that are needed for the project. Then the other contract, nico, is the operations and maintenance agreement, and when I explain this one I'll need you to jump in and give context for mini grids because again, just like the construction contract, things work differently here.

Speaker 3 15:47

With an operating and maintenance agreement, the expectation for large projects is that again, a third party would do this contract. Why One? Because with many projects, especially solar projects. The lender and the offtaker require performance guarantees, because the lender is lending based on a promised sort of revenue level and cash flow level and the offtaker has done their planning in terms of electricity supply based on the output that the developer has promised, and so they will require that the O&M contractor or supplier then give certain guarantees and they can penalize them. There are damages for underperforming. So again here, for a very large project it means that when you underperform there is significant financial risk, hence the need to offshore that to a third party. But, nico, I understand, for mini-grids this is not the case.

Speaker 2 16:42

It's different. Yes, it's completely different, because in an on-grid generations project and system you basically as O&M, just maintain the generation assets, like in a large scale multi-megawatt solar photovoltaic IPP, so to say independent power producer. You make sure that the PV panels are clean, you make sure that the grass below the PV panels is cut and that it does not shade the PV panels, you make sure that all the electric connections are well established and maintained, so to say. If something breaks, then we basically check before it breaks and then you fix the connection. And after all, you verify at any point in time that the inverters are feeding in the electricity that they are supposed to feed into the network. And then you may have a transformer or so which may require some maintenance every now and then, every few years maybe, but it's relatively limited and only comprises technical aspects.

Speaker 2 17:58

In a mini-grid, operation and maintenance does not only have technical aspects on the generation side but also on the distribution side.

Speaker 2 18:09

Like poles and wires could fall and bend, lightning strikes could destroy transformers, household connections could be damaged by heavy rains or storms or by wrong usage also of appliances inside the houses. So after all, you have a lot to do with assets and with technical maintenance beyond generation and on top and that is usually the largest part of the operation is the customer service. Customers who get electricity connection for the first time have questions about how to use that electricity, have questions about how to use that electricity, how to activate electricity flow, how to use electricity efficiently, productively, how to reduce the monthly bill, these kind of things, or sometimes even regarding the appliances that they use inside their houses. They may call the electricity supplier and say hey, my radio is not working anymore, what's going wrong? Well then usually the utility says, yeah, but this is your appliance. It's not our job to actually support you with the repair of the appliance. But in the mini-grid case, mini-grid companies would actually be expected to provide that service. Therefore, yes, it's a completely different deal. Operation and maintenance is different in mini-grids.

Speaker 3 19:49

And typically then it means the developer has to do the operations and maintenance. So generally that is inbuilt into the structure. We wouldn't expect to see an O&M contract. Is that the case?

Speaker 2 20:03

Yes, exactly, because the developer had shown their faces, so to say, to the community. And the community would not expect anyone else to come into the community and operate the system other than the developer. And it is also a matter of building a trust relationship with the community and with each individual customer. And once you've developed a mini-grid, you have, to a certain extent at least, also developed that relationship which you need to maintain now during your operational period of 20, 30, 40, 50 years. So, yes, exactly, the developer is usually also the operator here.

Speaker 3 20:51

Understood, and I mean for a lender, then it means they have to look at this as an advantage. You know, instead of insisting on the standard project finance, operations and maintenance contract, they would then look at what is the depth of relationship that the developer has built in the community. You know, how else are they planning to be even more involved in the community? You know we talk about productive use being one, but the second is, you know, rural industrialization, for example. So the more embedded a developer is to the community, the better it is for the lender, because then it improves the chances of the project working. Isn't that the case, nicole? Yes, absolutely.

Speaker 2 21:30

And this brings us back to the very first contract that you mentioned, which is the power purchase agreement, which does not exist in mini grids, right? Because electricity customers develop their electricity demand over time, they cannot guarantee that they take a certain number of kilowatt hours from you because they want to purchase, so to say, pay as you go, or consume as you go as the demand occurs, and then pay according to the amount of kilowatt hours that they had consumed. After all, this leaves a consumption risk, a retail risk, to the mini-grid company, and that, of course, is the second major difference of a mini-grid compared to a main-grid. Connected renewable IPP.

Speaker 3 22:25

Absolutely, that is very true, and I mean it's interesting. When I've spoken with lenders that are more accustomed to traditional project finance, they first ask about payment risk. You know is the payment risk because in the on-grid space, while the off-take risk is not there, all the electricity that is produced will be sold and it will be billed for. There's often a significant payment risk where, say, the utility is owned by the government and it could go broke, or is broke, as many are right now, and the lender will ask, as you're doing, a due diligence, assess the payment risk of this utility. So when they come to the mini-grid space with the same lens, then we almost want to turn that a little bit, because one for mini-grids, on the positive side, the payment risk is minimal Because, in our context, for example, the mini-grid developer installs prepaid meters, so customers are paying before they consume. But on the other hand, though, the off-take risk is significant, as you rightly say, because there is no guaranteed consumption and, as we discussed in the financial modeling episode and many other episodes have talked about this, is that no one is yet to figure out how to project 10 years of demand and how that demand will grow. And then, when it comes to the tariff, again there is some uncertainty there in that we do have a tariff, but we know the issue of price elasticity of demand. We know that households have a fixed pocket or budget for electricity, no matter the tariff. So for the lender, again it brings us back to.

Speaker 3 23:57

You must not ask the standard questions. Instead you ask the developer what are your strategies to increase demand, to grow demand within the community? You know, away from the financial model, which is long-term, is largely textbook. This is more qualitative due diligence, so to speak, and like the standard due diligence, which is very legal and very formalized, so to speak, and like the standard due diligence which is very legal and very formalized, yeah, but after all, is that not contradicting project finance fundamentally, so that, after all, project finance would not even apply to mini-grids?

Speaker 3 24:33

Aha, that is interesting, Nico. So project finance would not apply to mini-grids, but we wanted to apply it to mini-grids.

Speaker 1 24:41

So what do we?

Speaker 3 24:41

do we really do? Because mini-grids are infrastructure investments right, any kind of electrification is infrastructure. It's high risk and it costs a lot of money. Change has to come from both sides. On the lender side, lenders have to modify the project finance documents or structures they've had for the last 50 years and look at then what do we need to modify or contextualize for mini-grids? Developers then have to look at their responsibility in ensuring some sort of consistency in cash flows for the length of the project. So it's no longer just getting the CAPEX funded or accessing certain grants. It's about thinking if I'm going to access a 10-year loan as opposed to a three-year bank loan, I have to think how does this mini-grid repay this loan over 10 or even 15 years? So change has to be both sides.

Speaker 2 25:39

Yeah, and I think that is where Inensos usually comes in and proposes yes, we can diversify the cash flow by involving rural industrialization and making sure that if, in a worst case scenario, the revenue from electricity sales decreases, then at least you have your second cash flow from your agricultural value chain or your mining value chain or your timber value chain or whatever fish value chain, beef value chain, these kind of things that would potentially smoothen out the cash flow and make sure that loan service can always take place.

Speaker 3 26:26

Exactly, and I mean for developers. Now, of course, it means even before you think about the loan, even on conceptualizing the project, you already know you have excess day power. So it's a question of how can you efficiently use this excess day power and, as you rightly say, it comes down to, you know, industrialization, so that even as the lender comes now with this big question that you will not be able to sell all the power you generate, it is already answered in the way the project is designed.

Speaker 2 26:55

Yeah, and the other option we usually propose here is edge computing right. So whenever you have surplus electricity, you need to sell it to somewhere, to someone, yeah. And if there is an edge computer taking off the surplus electricity, even if it doesn't pay much, maybe that is already enough to repay the loan. It will probably not create a big margin, but it stabilizes the cash flows. And that is, after all, what banks financiers are looking for to provide project finance without recourse to the mother company.

Speaker 3 27:32

Yes, precisely, and I mean the other innovation we can talk about here is renewable energy certificates. Precisely, and I mean the other innovation we can talk about here is renewable energy certificates. You know, these are again long term contracts which lenders will love, because then they may have a small revenue component, but that is for the entire period of the project. So again they're assured and there's usually a mechanism to assign those benefits to the lender. So the lender is assured that for the length of this project whatever money is coming in, whether it is piece REX or D-REX, will come directly into my bank account.

Speaker 2 28:07

So I'm at least assured of that if I'm lending to the project For each kilowatt hour that you sell, right? If you don't sell the kilowatt hour, then you don't get the REX.

Speaker 3 28:12

Yes indeed.

Speaker 2 28:14

So therefore it's's again some kind of retail risk here. But after all, kelly, do you think a diversification of revenue streams for the mini-grid company would encourage project financiers to actually sign a contract? Yes, because I've also seen the opposite. What I have seen is that project financiers consider mini-grid projects too difficult for project finance because they require a diversified income stream Everything that we just mentioned, from households, from the different types of customers, from productive use, from sales of appliances, maybe from rural industrialization, from RECs and from edge computing. And then they say, yeah, but they all are interlinked and therefore the complexity is too high and we don't want to dive into this. We don't understand this anyway.

Speaker 3 29:12

Yes.

Speaker 2 29:13

What is your position here? Is it helping or is it not helping this diversification of income streams?

Speaker 3 29:20

Honestly to the traditional project finance. I mean there's a reason. So far at least until the last five or so years, mini-grid companies or mini-grid projects were considered corporate or venture projects. They were considered businesses with the same sort of risk a regular business would have. But there has been a change, nico, and I want to pause it and say it's not that they like it. I don't think any institution likes change because, as I said, they'd have to start looking at mini grid projects different from on-grid projects. But then, nico, there's a strong call.

Speaker 3 29:54

Sdg 7, affordable and clean energy means that we have a call or a mission to electrify and I think across the sector we agree that the mini grids and off-grid electrification is key if we are going to achieve 100% electricity access. And that is why, nico, as much as project finance lenders traditionally will view this as a risk, we are seeing more curiosity from them looking into mini-grids. We don't yet have 20-year mini-grid loans, but I mean we have seven years, we have 10-year loans in the market. But then it means that on the lender side they have to modify the way they look at revenue, because here we don't have an off-take contract, so the more diversified and the more contracted. Look at revenue, because here we don't have an off-take contract. So the more diversified and the more contracted the revenue is, the better.

Speaker 3 30:42

Because, remember, project finance at the end of the day is a bunch of contracts. So where we don't have a customer off-take contract but we have a P-REC contract and we have an edge computing contract and maybe we have convinced a certain factory to come and set up a factory where we supply them the solar energy but they also provide employment and many other things to the community, that is again another long-term contract. So, as you can see, these other sources of revenue away from households, what they are doing is they are adding to our pot of contracts that strengthen the project. But again, what I say, this has to be a sectoral shift, because it's hard for each mini-grid developer to walk to a lender and convince them as an individual If the lender already hasn't studied, decided to understand mini-grid projects.

Speaker 2 31:31

Yeah, and, as you said, this sectoral shift. We are seeing this happening right now, especially thanks to the SDG 7 rules that don't just affect impact investors but basically all the investors and financials that are here on the market, because, after all, their investors basically the people who provide them the money will also ask for them meeting the requirements of SDG 7. So, after all, coming back to the contracts that you just mentioned, looking at a classic IPP, can we summarize what a mini-grid actually copies from that traditional way of handling project finance and where mini-grids deviate and how?

Scaling Mini-Grid Project Finance

Speaker 3 32:26

Yes. So in terms of how mini-grid project structure is similar to the typical project finance structure is one it has a fixed project life. So, unlike a business we usually say that business entities are assumed to exist into perpetuity For a mini-grid, mini-grid developers will be issued a license for a fixed term, can be 10 years, on the lower side some 15 years, but ultimately, really, if we're talking even about solar PV mini grids, we know that the panels have a defined life. So this means that the balance sheet of the SPV, in terms of actual assets, the longer the project is in existence, the less valuable those assets are, because the operation of the assets pegs on the license that the mini-grid operator has gotten from the regulator. Then the other thing is that with venture financing or corporate financing, we always, I want to say, have this optimism that if we put in money into a business, it will grow. Now, on the venture capital side, we see 10x, 10 times, 7 times, you know, over 5, 6, 7 years. Basically, the equity investors especially, but also the lenders, expect growth of the business from the first year all the way up. Now, on the project finance side, there is very little upside. Now, on the project finance side there is very little upside. Remember that the project has a power purchase agreement, the tariff is fixed, sometimes has a little inflation adjustment, but there is no seven times, eight times growth.

Speaker 3 33:59

Now I will caveat here and say this is true there isn't a significant potential upside for mini-grid projects. But where the developer is entrepreneurial and innovative enough, we can see this happening. Where they start off and the expected demand is from the households and the small businesses in the village and such, but then they build around the principles we've talked about industrialization, edge computing and others, and we can see their revenue then even go above what was projected. But generally energy projects do not make billionaires, unfortunately. You know these are development projects. The mission really is towards delivering development to people, and the people paying for this electricity, of course, are the rural poor. So we cannot expect to make 10x, 15x returns.

Speaker 3 34:51

So the other bit I will say that now on the other side there's something that mini-grids have that resembles private or corporate businesses is that mini-grids have unpredictability in revenue, and we've talked about that. Where on-grid or typical project finance companies, their revenue is predictable. The uncertainty is around collecting the money and that can be protected against with certain tools. So those are the ways you know. On both sides you can see, mini grids are infrastructure in nature. They are for a fixed period of time. There's very little opportunities to generate massive profits, very little opportunities to generate massive profits. But then also they have almost venture business-like sort of risk and unpredictability?

Speaker 2 35:35

Yeah, basically like any type of utility after all. Yes, and now my question to you, kelly are utilities using project finance approaches?

Speaker 3 35:45

Aha One, yes, I will say yes, but it depends for what. So, for example, where we have transmission, distribution, expansion of connection, that is funded through project finance but also through concessional loans and grants. So that is how our transmission and distribution companies are able to extend the grid and that sort of infrastructural investments. Now, of course, we know, when it comes to generating power, depending on how country is structured, sometimes we see that the same entity that distributes also generates. For that bit they're also using project finance, but they're not using project finance to run their day-to-day operations. Yeah, so to pay salaries and such, they're tending again to move back to using regular corporate debt.

Speaker 2 36:34

Which means, after all, they separate out certain assets generation assets, distribution assets into separate SPVs, right? And these SPVs then acquire project finance and provide a service to the mother company. Do I get that correctly? Yes, yes, correct, I see. And could we potentially use that approach for the mini-grid sector? Or do you think the assets in the mini-grid sector are too small?

Speaker 3 37:06

So, yes, the asset size is an issue, but there's a way I believe is being done. It's not, as I want to say, well-defined as the utility side, but you find that for many mini-grid developers who have multiple projects, they are able to hive off the day-to-day operations into a holding company and then they surcharge or they charge those operating costs to their different mini-grids. This has been a good way of achieving economies of scale, to be able to efficiently manage mini-grids. But, nico, for this cost to actually be economical for mini-grids which are very small, it means that then the developer has to have many of them, possibly hundreds of mini-grids, that then each contribute a small amount towards running the operations of the main company. So in that sense, that would help in terms of helping the mini-grid SPVs attract capital, because they will not be paying all the costs of running the mini-grid the IT costs, the tech people, the management team and such. They will just be sharing a small amount of that expense, which then improves the viability of the mini-grid.

Speaker 2 38:16

Yeah, and that is similar to what we discussed in our very first episode of this podcast, together with InfraCo Africa and Crossbound Reaccess, who both support this type of splitting the assets from the actual operation type of project financing approach.

Speaker 3 38:39

Yes, it makes sense, but, nico, then I want to throw this back to you then when does that leave the small developers? But also, is there a minimum size of mini-grids that when you combine the operational costs then start to make sense for the individual mini-grids?

Speaker 2 38:56

Yeah, well, I guess there is a certain minimum threshold regarding sizing that mini-grid companies must meet, and I anyway want to prepare a separate episode on the subject of mergers and acquisitions in the mini-grid space, which I believe we will be running into pretty soon, because, as we all know, mini-grid operations and also development and construction requires scale, and this scale, of course, can either be established through planning large enough, acquiring large enough capital, like capital at a certain magnitude and then implementing step-by-step or all at once, step by step or all at once.

Speaker 2 39:53

Alternatively, you can reach scale by having a range of mini-grid companies, mini-grid developers, all developing their own projects and then merging them afterwards into larger companies, which then also means that you have a large number of connected customers operated by a small team. That generates some overhead costs, which then can be distributed through a large number of kilowatt hours sold. Yeah, and I believe this will happen. Right, you probably have also the opportunity to show your track records and your profitability to a financier, which may then expose, so to say, after construction and installation of assets, be able to finance your assets in your asset co, and I believe that could be an option for smaller African companies. I believe this is the only way out of the issue that we're seeing right now that various smaller mini-grid companies in Africa are currently suffering from small banks that then can't attract capital and then have too much to be able to access the longer term cheaper capital.

Speaker 3 41:11

So it's my hope you know, developers are entrepreneurs after all so they will come to these solutions as capital continuously, you know, becomes more available for the sector, which is what we're seeing.

Speaker 2 41:22

Kelly, I would like to go back to the principles of project financing once more and ask you how this repayment, the loan service, actually works in operation, because I believe even there there is some difference between corporate finance and project finance. Right, because I understand that in a project finance approach, the financiers have much more say in how the cash flow is actually being used. Correct.

Speaker 3 41:56

Yes, correct, and this applies whether it's traditional project finance or if it's mini-grid project finance, and my hope is that we'll have a bit of time to look at what lenders are asking for for mini-grid project finance. But, as you rightly say, in traditional debt financing remember the lender stays out of the corporate structure, they're not part of the company and so for them, their concern is they monitor the bank account that you hold with them and they collect their money off there. But then for project finance, the lender is part of the contracts, the bunch of contracts that make up this project. So they have a voice and in technical terms we call this a cashflow waterfall. But they dictate how money should be used. The first level that they dictate is that you're supposed, or the SPV is supposed, to have certain reserves in place even before the money is accessed. They will ask for a reserve we call the debt service reserve account. This is an account held with a bank. Typically it holds between three to six months worth of debt repayments. The second thing they may ask for is a maintenance reserve account, again, because projects are typically large but also sometimes may have breakdowns and need repairs that cost substantial amounts of money. The lender wants to make sure that, before they give money to the project, the sponsor and the equity funder have put aside money for these repairs. So that's in terms of reserves.

Speaker 3 43:26

The second thing is that then they will look at certain ratios. They'll say, for example, what we call the debt service coverage ratio. This is the amount of cash flow that is expected to be left over after all expenses are paid. They expect that this cash flow is enough to pay the loan, say over one year or over 1.5 years. They will set that ahead of time. Then, when it comes to dictating how the money will be used, they will of course look at how much OPEX or operating expenses do you expect to have, and is it legitimate project operating expenses? Because they do not want the developer then to start paying themselves before the loan is repaid. So you'll have your revenue, then you'll have the operating expenses and then, right after that, the debt provider wants to be paid their principal and their interest installments.

Speaker 3 44:20

Then, once they are paid that, they'll tell you look, go into your debt service reserve account and your maintenance reserve account.

Speaker 3 44:27

If they've been used within this period, top them up to the required levels and then, if you've done all that as a project, I don't want to say as a developer, because, again, this is within the project.

Speaker 3 44:39

If the project SPV has paid its operating expenses, it's paid its principal and interest, it's topped up its debt service reserve account and maintenance reserve account, then whatever money remains can go to the equity holders and the shareholders, which includes the originator or developer. So this is embedded into the loan agreement and often you will find that the SPV bank account also has certain mandates where the lender can't step in and take over this bank account. So that's the main difference, nico, really. And why is it that lenders have this much control? Because for typical project finance transactions we will see up to 75% of the project cost is funded by the lender. With mini-grids, if you remove the grant component and you look at what is funded by equity and debt, the debt is even higher, even as high as 95%. So it means that the lender has the most exposure in this project and hence their need to control as closely.

Speaker 2 45:40

Yeah. Does the control stop on the financial level, or do lenders go as deep into the numbers and technology as looking into how the systems are being operated, how many kilowatt hours are being sold where, or how satisfied the customers are with the operator service?

Speaker 3 46:05

So at the start of the project, the due diligence stage, lenders will want to go into all that detail and even further Nico onto the environmental and social aspects of the project. So they want to be sure that the technology to be used, of course, is good enough, the project plan is good enough, the developer has capacity to deliver, but also that their interaction with the community will not cause harm and that even to take it a step further, will bring benefits to the community. Now in the industry there's what we call, you know, the IFC and World Bank Environmental and Social Standards, ens standards. I believe there are nine of them.

Speaker 3 46:48

The developer is supposed to demonstrate that their project has taken care of each of these standards, and these standards cover environmental damage, community disturbance, so dust and sound, issues of exploitation of minors and women, but also, on the other side, positive impact to the community through, maybe, job creation, casual and permanent jobs, and then long-term investment. So the lender at the beginning really wants to be sure that this project will not only be technically and financially viable, but also it will be a net good to the society. Now, when it comes to the operating side of things, many lenders unfortunately do not have the capacity to go into as much detail as to go to the end user and the customers, but they will require the sponsor of the project to report periodically on certain agreed upon key performance indicators that of course include this. And then of course, I mean cashflow is king, right? If the sponsor is not doing well and is not operating the mini-grid well, it will of course show in the way the cashflows are looking for the SPV.

Structuring Mini-Grids for Project Finance

Speaker 2 47:58

Yeah, all right, thanks, kelly. I think that was quite insightful. Can you summarize once more the takeaways, so to say, of our discussion today and your presentation? How would we need to structure a mini-grid to be applicable for project finance?

Speaker 3 48:18

Yes. So the first thing is, of course, our mini-grids have to be technically sound. The design and the components that we use and the project itself. The way we plan and implement the projects has to be at a professional level. But also, as we're talking about the bunch of contracts, we have to look at the licenses or the concessions that we're getting, that they are for a sufficient period 15 years and above preferably and that there are protections in that license around the change of law to make sure that the project is protected.

Speaker 3 48:50

And then lenders are looking for tariff predictability, and while we cannot give them this, we have to then have thought entrepreneurially and innovatively around how to include other contracts into our license, through rural industrialization, edge computing, renewable energy certificates and so on, so that then we are presenting to the lenders a good enough diversified revenue stream.

Speaker 3 49:14

And then we need to have received commitments from either results-based financing grants or other grants in writing, because also lenders want to know that if you're getting 30% grant, that money will be available for the project.

Speaker 3 49:28

And then the second last thing is you know a committed equity funder for the project, Again to make sure that any sort of guarantees or supporting financing that's needed for the mini-grid is available to the project before the lender puts in money. And then, finally, you know what we have said in terms of efficiency in operations, we need to think ahead. If we are going into development as new developers, we should be thinking at scale, and then existing developers need to be creative in either merging or partnering in ways that optimize the operating costs. I think that makes for the summary, Nico, and to say that financing is available. It's not 15-year financing, as we'd see with on-grid finance, but we are seeing seven-year project loans, 10-year project loans and we are also seeing bridging loans, so loans that enable the developer to construct the project and then, when they receive their grant, they pay off that loan. But those things that I've mentioned have to be in place for the developer to access financing.

Speaker 2 50:28

Yeah, thank you, kelly, and I hope that with more and more success stories from Project Finance coming up in the mini-grid space, we will also see longer tenors, going towards 15 years or 20 years or in that range, and that may, after all, be the opportunity for grant funders to, step by step, reduce their contributions and hand over to long-term loans, potentially concessional loans, and this may, after all, help scaling up mini-grids in Africa and beyond. Thanks, kelly, it was fun and I'm looking forward to our next episode.

Speaker 3 51:09

Thank you for having me, nico. It's been a pleasure and, yeah, I hope our listeners will find this useful.

Speaker 1 51:15

Bye, bye. This episode of the mini grid business has been brought to you by Enensis, your one stop shop for sustainable mini grids. For more information on how to make mini grids work, visit our website, enensiscom, or contact us through the links in the show notes. The mini grid business Powered by Enensis.