North American Clean Energy article: Managing Project Risk in Emerging Markets

Due to a variety of economic drivers, lack of deal flow, and declining returns, many renewable energy investors are being compelled to transition from mature markets like North America and Europe, to emerging market investments. This trend is well illustrated by Ernst & Young’s 2016 Renewable Energy Country Attractiveness Index, in which half of the markets listed represent emerging markets.

What are emerging markets?

Emerging markets evolve economically, and successful investments favor early (though not necessarily first) movers. There is a window between economic growth and incentives to sufficiently overcome market risk; as the market grows, investor competition naturally reduces project returns. The eventual entry of utilities further accelerates this decline in investor returns. As emerging markets mature through growth, returns typically decline faster than risk. Late movers into emerging markets may find deal flow, but returns at this point are typically less than the risk exposure.

For example, many Latin American renewable energy investment opportunities are too mature to yield sufficient investor returns. Southeast Asia, on the other hand, currently fits squarely in the window of an attractive risk/return ratio. Instead of relying on precedent, investors seeking emerging market opportunities often mistakenly turn to mature markets, because they either don’t understand their true nature, or don’t have the capacity to identify and manage emerging market risks.

Emerging market risks

Early mover investors looking to leverage that “sweet spot” in the risk-to-returns ratio face unique challenges due to their experience in more typical, mature market investments. In other words, these investors will not have a precedent to reference. The diversity of cultures, business practices and languages in these new markets, as well as shortfalls in the existing legal frameworks, can create a sense that risks are unidentifiable.

However, the rapid growth in emerging markets indicates these risks can and are being managed successfully by well-prepared investors. Successful investors in this market segment implement a robust, integrated risk management approach, leveraging advisors with emerging market experience and a comprehensive risk management strategy.

The risk management team
Investors prefer to see risks transferred, either to the contractor or project insurers. This requires a lawyer and insurance broker. However, the one person commonly overlooked is the project manager. The project manager uses his or her experience of building and operating renewable energy projects to bridge the gap between technical and commercial in identifying project risk, plans, and integrates risk strategies between project plan, contracting, and insurance, and manages the risk during project execution. Without a project manager experienced in emerging markets, legal and insurance risk strategies are developed in “silos”, presenting gaps that ultimately manifest themselves as cost and schedule overruns in construction, and revenue losses in operations.

• Project Manager – The root cause of typical technical problems on emerging market projects is the gap in understanding between experienced foreign advisors and local technical professionals. From a European perspective, renewable energy (specifically wind) is a 35-year-old industry, and technical advisors from mature markets tend to interact in emerging markets from that perspective. Local engineers can reinforce this perspective, as most local engineers are very bright and capable. They just don’t have the years of experience to know where the typical pitfalls in renewable energy projects lie. In other words, local engineers don’t know what they don’t know. Meanwhile, foreign engineers don’t ask what would be considered the “dumb” questions – basic things that are unique to renewable energy projects: design, logistics, construction methodology, and off-taker interfaces. A knowledgeable project manager with experience of building renewable energy power plants in emerging markets is critical to evaluating project risks, expecting the unexpected, and developing a robust risk plan.
• Project Attorney – Too often we see a contract “template” being used. An approach that assumes the next project will be identical to the last is dangerous, as, while there are similarities, each project has a unique risk profile. In emerging markets, general assumptions on risk mitigation cannot be taken for granted, and it is important to remember that the market may be developing legally as well as economically. Bonds may be difficult or impossible to call on if they are with a bank that doesn’t have strict compliance regulations. Permitting will likely be unclear in a developing country, since emerging market regulatory authorities will have little previous experience. It’s critical to have an attorney with experience contracting as well as contentious litigation experience, while focused in emerging markets. Understanding what went wrong in previous, similar projects helps ensure those lessons learned are brought to the next project.
• Insurance Broker – Insurance is often an afterthought, parked during contract negotiations, and settled directly by project insurers and lender’s insurance advisor, to meet the lender’s minimum insurance requirements. However, the gap between contract caps, warranties, and exclusions, and the extent of insurance coverage is a very common cause of investor losses. Again, the risk profile of each project is unique. Insurance coverage and interfaces with contracting should be contemplated prior to start of contracting, to ensure this gap is resolved. Given the risks involved in emerging markets, additional insurance coverage could be a wise investment. For a relatively minor increase in premiums, LEG3 coverage warranties defects in design, material, and workmanship. Requiring contractor professional indemnity coverage is a contractor cost. Coupled together, investors are protected against direct and consequential losses associated with latent defects, which could be catastrophic to investors should these “hidden” quality issues emerge.

In conclusion, the growth of renewable energy projects in emerging markets continues apace. Successful investors that leverage the high risk/return period of market evolution are those who move early and employ advanced risk management methodology. The key to risk management in emerging markets is a risk team with emerging market experience: a project manager, attorney, and insurance broker who work seamlessly to identify, plan and manage project risk comprehensively.