A word of advice12 January 1998
Project financing and risk mitigation are increasingly seen as keys to the success of private hydropower schemes. Yet there are many complex risks involved in hydropower projects. Mike Nash* offers some advice on risk assessment to potential developers.
PLANNING assumptions in hydropower projects are often made based on imperfect knowledge, such that potential projects are subject to a high degree of uncertainty. Hence, when these business investment decisions are made, a hydropower developer is always faced with numerous elements of risk. ‘Risk analysis’ looks at which risks are significant, analyses their likely impact and attempts to identify and provide solutions to mitigate such risks. ‘Risk management’ is the management system by which the developer ensures control of the risk analysis process.
A well structured risk management model is crucial in order to ensure that the financial model of the project should provide a true reflection of the ‘raft of risks’ to the project sponsors. Moreover, with the increasing need for private sector project finance, risk assessment has become even more important - especially since financiers are inherently cautious and will require adequate projections of sufficient cash flows.
Mitigating hydro risks
Hydropower projects are viewed by the financial sector as being particularly risky, especially on a technical basis, a perception that has been heightened recently by blunt and negative coverage of some high-profile schemes. As part of Malaysia’s Pergau and Bakun projects, for instance, the ‘aid-for-trade’ debacle and political mismanagement severely hit the industry’s reputation worldwide.
In response, analysts understand that the key to solving the hydro project risk problem is through adequate planning and construction of a deal - especially for those consortium members who assume the role of high risk mitigators, whereby they are responsible for shouldering much of the risk.
The risk management process starts at the feasibility stage with a basic risk assessment, usually conducted by the developer or, if there is insufficient information, via an independently commissioned study. The project’s risk profile is assembled and a ‘probability rating’ - often scenario-based - can be assigned using a number of methods with a variety of sophisticated forecasting and modelling techniques.
Following this initial process, analysis of cost implications and the potential mitigating actions can then begin. Apportioning risk can be done in two ways: by contractual mechanisms between parties involved in the development; and by transfer to the insurance market.
Looking at figure 2, risk identification at stage one must involve the collection of relevant documentation and information such as tender specs, drawings, draft contracts, grid connection, O&M agreements and PPAs. Baseline information such as this is crucial and can then be analysed in order to identify the ‘raft of risks’. Stage 2 analyses risks through likely loss scenarios, lead time projections, estimates of probability of events occurring and costs involved. Risks are then allocated at stage three to members of the consortium, based on which element is best equipped to manage those risks, by instigating a combination of contractual and insurance risk.
Some analysts believe that the project risk for large hydropower projects is not significantly greater than for oil and gas exploration projects. Others disagree. Nevertheless, possible measures include using community-based solutions regarding resettlement and greater local involvement such as the provision of local water supplies. Accountability is another factor, including the need to address hydropower as a commercial business.
Successful private sector participation in the worldwide hydropower market depends on implementing sound projects that are as environmentally benign as possible, yet still making financial sense in terms of return on investment and profitability for shareholders. Moreover, actual project size is important. In China for example, multiple medium-sized projects are financially more viable because of shorter lead times, less civils and smaller reservoirs being required.
Historically, the determining factor underscoring hydropower projects has been the objective to maximize electricity output from a given hydrological regime. However, given the new emphasis on cost monitoring, obtaining a better return per dollar invested has been considered by some developers to be more appropriate. In many cases, this could mean having to reduce plant size below that which would normally be considered optimum.
Also, this means that less land would be required for inundation. Traditionally, large reservoirs are created so as to avoid seasonal fluctuations in water flow in order to maintain electricity supply. The need to increase hydro installed capacity could also be reduced if used in conjunction with other turbine types such as gas.
Strong reservoir design is necessary in order to trade off the environmental and cost disadvantages of large reservoirs against the benefits of greater flood control. Most issues regarding both the location and construction of power houses and dams can be alleviated through measures designed to limit the impact on wildlife, including fish passes and turbines that allow certain types of fish through. Moreover, visually pleasing amenities can be maintained via careful architectural design and placing power houses underground where possible.
Reduce potential objections
In all cases, genuine attempts to design the project so as to mitigate unnecessary environmental impacts, organize compensation for those affected and consult - as far as is possible - with recognized environmental bodies are likely to serve to reduce potential objections later on in the project.
Hydropower development has historically been assumed to inevitably carry above-average risks. Yet, this need not be the case. Provided that the risk components are both realistically assessed, managed and apportioned, then there are potentially substantial profits to be made by those who understand and accept their role in risk mitigation.
Although there have been recent cases where one or other of consortium members have been reluctant to shoulder their burden of risks, this is increasingly untenable given the present climate of worldwide public sector withdrawal. Risks won’t go away. Instead, proper risk management can mitigate these risks to make projects more financially viable.
New business report
Such aspects of hydrofinance are one of the many areas to be covered in the new International Water Power & Dams Business Report 1998. This is being produced by Market Tracking International, in conjunction with IWP&DC.
The report offers a balanced appraisal of the forthcoming prospects for hydropower and dam construction across the world’s major emerging and refurbishment markets. It also provides a comprehensive and detailed assessment of the challenges, opportunities and risks facing potential investors, developers, operators and suppliers.
International Water Power & Dams Business Report 1998 is some 500 pages in length and covers 25 of the world’s high-opportunity markets. It includes around 200 key statistical tables, charts and graphs, providing at-a-glance essential market information. The report will be available at the end of this month. For more details contact Nick Fielder on +44 1322 277788, Fax: +44 1322 276474.