Foreign aid via 3-Party Covenant Financings of capital-intensive infrastructure

Abstract

Purpose

The purpose of this article is to analyse electricity supply in the Solomon Islands face extraordinarily expensive electricity tariffs – currently set at 96 c/kWh – making them amongst the highest in the world. Power is supplied by a fleet of diesel generators reliant on imported liquid fuels. In this article, the authors model the 14,100 kW power system on the island of Guadalcanal and demonstrate that by investing in a combination of hydroelectric and solar photovoltaic generating capacity, power system costs and reliability can be improved marginally. However, when the authors model a 3-Party Covenant (3PC) Financing structure involving a credit wrap by the Commonwealth of Australia, electricity production costs fall by 50 per cent, thus resulting in meaningful increases in consumer welfare.

Design/methodology/approach

This study’s approach uses an integrated levelised cost of electricity model and dynamic partial equilibrium power system model. Doing so enables the authors to quickly analyse the rich blend of fixed, variable and sunk costs of generating technology options. The authors also focus on the cost of capital that is likely to be achieved under various policy settings.

Findings

The authors find that a 3PC Financing policy can substantially reduce the production costs associated with capital-intensive power projects in an unrated sovereign nation. Such a policy and associated prescriptions are not specific to the Solomon Islands or power generation. The conceptual framework and associated financial logic that underpins the initiative can be generalised to other “user pays” infrastructure projects and to other developing nations. The broad applicability of 3PC financing means that it is not country specific, project specific or asset class specific.

Research Limitations/implications

It is important to note that the analysis in this paper has a number of limitations in that the authors do not deal with rural electrification or distribution network costs. The focus of this paper is to identify policy interventions that are capable of making profound changes to the cost and the reliability of wholesale electricity production.

Originality/value

The focus of this paper is to identify a policy intervention capable of making profound changes to the cost and the reliability of wholesale electricity production. While there is nothing novel associated with a 3PC Financing per se, the authors are unaware of its direct use as a form of delivering foreign aid. A 3PC Financing has the effect of shifting the source of aid funding from fiscal account surplus/deficit (i.e. cash outlays) to balance sheet (i.e. credit wrap). However, this is not a “magic pudding” – 3PC Financing creates an asset-backed contingent liability and will have the effect of reducing the donor country’s own debt capacity by a commensurate amount, holding the nation’s credit rating constant.

Citation

Simshauser, P., Smith, L., Whish-Wilson, P. and Nelson, T. (2016), "Foreign aid via 3-Party Covenant Financings of capital-intensive infrastructure", Journal of Financial Economic Policy, Vol. 8 No. 2, pp. 183-211. https://doi.org/10.1108/JFEP-11-2015-0067