A Creative Approach to Tackling Foreign Exchange Risk
Exhibit 1: Clean Energy Project Funds Flows with Exchange Rate Coverage Facility
Source: Columbia Center on Global Energy Policy
Key Points: A newly-suggested Exchange Rate Coverage Facility integrates carbon credits, multilateral bank guarantees and long-horizon commercial and philanthropic capital to lessen the expense of protecting against local currency depreciation. Some version of this blended facility concept can plausibly help stimulate more international investment into clean energy.
Proposing the ERCF. A team from Columbia University’s Center on Global Energy Policy and the World Economic Forum earlier this month released a discussion of a proposed Exchange Rate Coverage Facility. The ERCF is designed to lower, or potentially eliminate, the cost of hedging foreign exchange rate (FX) risk for clean energy development in emerging economies by creating insurance to be paid directly to the foreign (currency) lenders (see Exhibit 1). By mitigating FX risk, a key challenge for international investors and lenders, it is hoped more capital can be directed to clean energy development.
The authors offer that the ERCF may potentially be used in conjunction with, and therefore its structure (described below) may be adjusted to fit around, existing hedging mechanisms. In other words, a version of the ERCF might be applied when existing commercial hedging is too expensive or unavailable (e.g. for some % range of devaluation for a given currency). Separately, the authors note that the product is likely financially more attractive for participants as a portfolio of projects across countries, which diversifies away exposure to any one currency.
Envisioning a ladder of funding support. The intention of the mechanism is to fully hedge/insure against local currency depreciation. The energy projects the ERCF seeks to support generate revenues in local currency (selling power to local customers) while their debt service obligations are in a foreign currency. As the local currency devalues, payments to be made in the foreign currency get more expensive, putting economic stress on the project owner.
The authors propose a ladder of coverage, with different sources of support “covering” the full range of potential local currency depreciation (see below and Exhibit 2).
Exhibit 2: The “Ladder” of Coverage for Local Currency Depreciation in the ERCF
Source: Columbia Center on Global Energy Policy, Payne Institute
Carbon credits are proposed to provide the first and last coverage. As proposed, the first 20% of a local currency’s depreciation relative to an agreed reference rate (i.e. a decline to 80-99% of its reference value) and the last 20% (i.e. a decline to 0-20% of its reference value) would be covered by revenues generated from carbon credits. As envisioned, the credits would be issued under the auspices of Multilateral Development Bank (MDB) programs such as the World Bank’s Carbon Initiative for Development, which could provide a guaranteed price floor and purchase agreements. The credits could be a portion of total carbon offset credits generated for the project. When monetized, they can be banked for potential future use.
In between, a combination of guarantees and institutional/philanthropic capital. The proposal includes three types of coverage for the devaluation range in between what is covered by carbon credits. The presumption is that the providers of capital for these slices would be remunerated in some form for providing guarantees.
- If the currency declines in the range of 20% to 35% versus its reference value, it would fall to MDBs to cover this “slice” of the value decline; the host country, however, would have to provide a counter-guarantee, thus exposing the country/government to this degree.
- For currency value declines of more than 35% and up to 50%, MDBs would again guarantee financial support — for this slice, however, there would be no host government guarantee.
- For currency devaluation of more than 50% and up to 80%, financial support would come from private capital, which is presumed to include some philanthropic capital.
10/12/2022