Mutually inclusive benefits

Dec 4, 2017-After more than a generation of false starts, Nepal’s highly touted hydropower sector has at long last taken its first stuttering steps towards realising its world beating 80,000 MW potential.

Although Nepal’s existing installed capacity currently sits at 800 MW, concession agreements signed with Korean and Indian investors are expected to add more than 2,000 MW in the next five to 10 years.

This will be supplemented by government-sponsored medium-scale hydropower projects and the projects of local independent power producers which will bring 1,700 MW of additional capacity. If these projects can be realised, not only will load-shedding be eliminated, rapid economic growth will be unleashed throughout the country.

But developing hydropower projects (HPPs) in Nepal is never easy. Private sector developers face huge capital, financing and offtake risks, risks associated with long gestation periods, engineering and construction risks and the ever present geological and hydrological risks.

Development becomes even more challenging where private financing is required. Since 1992, but with more impact from 2002, the government has promoted private sector investment under the build, own, operate and transfer (BOOT) model, in which developers are required to hand back projects after a 30-35 year concession period.

Finally, individuals, families and local communities are often required to surrender their land, possessions and livelihoods in order for the government to realise its ambitious infrastructure projects.

In most instances, it is not the government but the private sector that must secure the social buy-in from Project Affected People (PAPs) and communities. They do this using various benefit sharing methods.

Bad idea for a good cause

Nepal has employed a two-pronged approach to mitigate the damage to PAPs and communities, comprised of fair compensation for land, houses, assets and crops and royalty payments to the government.

Recently, new constitutional requirements have added another level of complexity to the developer’s burdens. The constitution grants local communities the right to make investments in natural resources.

As such, it contemplates that PAPs will have a right to invest in the equity of HPP companies. Although the constitution formalised the practice of selling shares to PAPs, HPP companies have long listed their shares and offered them for sale at par to PAPs for public trading.

To facilitate this unique approach, the Securities Exchange Board of Nepal (Sebon) issued regulations allowing PAPs to realise capital gains by selling shares and receiving share dividends.

Sebon now requires HPP companies to offer 10 percent of the paid-up capital for purchase by PAPs. While the approach seems logical, the direct equity share model has serious disadvantages.

First, equity ownership is not a risk-free proposition. PAPs and their families will be exposed to losses if an HPP fails to make profits. Given the hype that local shares in Nepal have experienced, they now run the risk of all investment bubbles, irrational exuberance. This risk inheres to the shares well before the project is handed back.

Second, foreign investors are chary of offering equity to PAPs. The main reason is that they have little or no interest in listing their shares on a local exchange. Cumbersome regulatory compliance and local reporting requirements reduce the foreign investor’s optimism even further.

The obligation to organise a shareholder’s meeting with literally thousands of people having little knowledge of corporate management would dampen the spirit of the heartiest investor.

Alternatives not up to par

For these and other reasons, foreign investors have asked for alternative models to direct ownership of project company equity by PAPs. One recommendation, the indirect approach, entails incorporating a special purpose vehicle (SPV) company comprised of PAPs holding shares in the HPP company itself.

Under this approach, a company with a relatively small number of PAP shareholders would be incorporated for the purpose of holding equity shares in the HPP company. This intermediary company would then offer shares to other PAPs that comply with applicable securities laws for listing on the stock exchange.

In other words, the company comprised only of PAPs, not the HPP company itself, will be listed on the exchange. 

The main difficulty with this approach lies in simply setting up the company. First, it is completely impracticable to create a company made up of thousands of promoters.

What method should be employed to select a small number of PAPs? Who will be responsible for running the company? How will members of the board be appointed? How will the staff be hired? Add to that recurrent expenditures of operating the company.

Most crucially, what happens to the PAP company when the HPP is handed back to the government? Then there are corporate taxes. For all of these reasons, the intermediary PAP company model is completely unworkable. 

A better path

Rather than use a PAP intermediary company, my recommendation is to establish one or more flow-through entities, such as a mutual fund. It would work in the following way. PAPs would be eligible to subscribe to units of a mutual fund.

That fund would purchase shares in the HPP company. The principal advantage of this model is that it addresses the developer’s interest in maintaining its private status, while also attending to the interests of the locals who seek a liquid market.

Other advantages include its simplicity, cost effectiveness, tradability and liquidity.

When compared to establishing an SPV of PAPs, creating a mutual fund is quite straightforward.

Mainly, it will require a fund sponsor and a fund manager. Nepali law requires the fund sponsor, the entity that establishes the mutual fund, to be a bank regulated by the banking regulatory authority. Similarly, Nepali law requires a fund manager, the administering entity to be a merchant bank licensed by Sebon.

The process would work as in the following way. For each HPP, the government would conduct a competitive bidding process to select the fund sponsor and the fund manager. The criteria for selecting the fund manager would be the least cost bid to manage the fund.

Once the mutual fund is created by the fund sponsor, the mutual fund units would be offered to the PAPs for purchase. The amount collected by the mutual fund would be invested in the equity shares of the HPP company.

Mutual funds also enjoy an inherent cost advantage. The resources that the fund managers will have to apply to the administration of the PAP mutual fund can be shared across many other funds.

PAPs can have confidence in the experience and the sound financial expertise that the fund sponsor and the fund manager can provide. Over and above this are the tradability and liquidity benefits that mutual funds bring.

Once the mutual fund units have been listed, PAPs will be able to sell whenever they chose, and they will receive a fair (market) price for their units. Significantly, the liquidity of a PAP mutual fund will not disappear merely because the HPP will be transferred back to the government.

PAPs will always have the option to diversify the investment from the mutual fund to other sectors. Nepal has taken a very progressive and unique step to ensure that PAPs get a fair deal.

This should not, however, deter investors. The mutual fund model, while preserving liquidity and tradability, can also reduce compliance with stock exchange listing requirements sought by investors.

- Dahal is an Advocate.