Investing in the African electricity sector Kenya

Financial institutions Energy Infrastructure, mining and commodities Transport Technology and innovation Life sciences and healthcare Investing in the African electricity sector Kenya Ten things to know

Investing in the African electricity sector: Kenya 01 Why consider Kenya? Kenya is the seventh most populous country in Africa, with an estimated 44 million people and a 16 per cent electrification rate. The total installed generating capacity in Kenya is 1,429MW, but the peak load is projected to grow to about 2,500MW by 2015 and 15,000MW by 2030. To meet this demand, Kenya s Vision 2030 requires that installed capacity increases gradually to 15,000MW by 2030. Kenya has one of the most well-established power sectors in Sub-Saharan Africa. A small but successful independent power project (IPP) procurement programme has been running since the mid-1990s, when Kenya Power and Lighting Company (KPLC) started to procure power from IPPs. Today, the most significant development in Kenya s power sector is its geothermal procurement programme. Kenya is Africa s largest producer of geothermal power and is continuing to invest heavily in this sector. Geothermal energy currently accounts for 13.2 per cent (approximately 180MW) of Kenya s total installed capacity and unexploited geothermal resources are estimated to be between 7,000MW to 10,000MW in the Rift Valley province alone. The Government of the Republic of Kenya (Government) has set an objective to reduce the country s dependence on fossil fuels and also hydropower, which is vulnerable to drought, by exploiting the country s geothermal resources. The Government aims to increase the total electricity generating capacity from geothermal resources to 5,000MW by 2030. In November 2012, Kenya Electricity Generating Company (KenGen) initiated a procurement process for a series of geothermal power projects on a public private partnership (PPP) basis. KenGen plans to develop up to 560MW of geothermal power in the Olkaria field in four phases of 140MW each, on a PPP basis. Geothermal Development Corporation (GDC) has been exploring in the dormant Menengai crater, 200 kilometres southwest of Nairobi. A 400MW plant is expected to be completed by 2016, and GDC estimates that there is enough potential geothermal capacity for a total 1,600MW. GDC has also studied the Bogoria-Silali block in the Central Rift Valley and estimates its potential at 3,000MW. It has already announced plans to develop 2,000MW at that location by 2023. 02 What is the structure of Kenya s power sector? The power sector in Kenya has been undergoing restructuring and reform since the mid-1990s, culminating with the Energy Act 2006. Under the Energy Act, the Ministry of Energy is responsible for formulation of policies through which it provides an enabling environment to all operators and other stakeholders in the energy sector. As a result of the Energy Act, the Energy Regulatory Commission (ERC) was established in 2007 as an autonomous, independent energy sector regulator with powers to formulate licensing procedures, issue licenses and permits, make recommendations on regulation (to be implemented by the Minister of Energy), formulate, enforce and review environmental, health, safety and quality codes and standards, set, review and adjust electricity tariffs, approve power purchase and network service contracts, investigate complaints between parties, protect stakeholders interests and prepare an indicative national energy plan. On recent IPPs, the ERC has also issued a comfort letter to assist with the requirements of project finance lenders. KenGen is the leading electrical power generation company in Kenya, supplying the country with about 80 per cent of its electricity. KenGen is a publicly listed company and is majority-owned by the Government. KenGen provides electricity from numerous energy resources, such as hydropower, wind, geothermal and thermal. KenGen owns and operates the Olkaria I and II geothermal power plants. KPLC is a publicly listed company that transmits, distributes and retails electricity to customers throughout Kenya. KPLC is also responsible for ensuring that there is adequate line capacity to maintain power supply and quality over the Kenyan electricity network, covering approximately 41,486 kilometres. Kenya Electricity Transmission Company (KETRACO) is the Kenyan national grid operator and its main business is to plan, design, build, operate and maintain new electricity transmission lines and associated substations. 02 Norton Rose Fulbright

GDC is a 100 per cent state owned special purpose company set up to fast-track the development of geothermal resources. Part of its mandate is to enhance geothermal exploration in Kenya. GDC has a 10-year US$2.6 billion exploration plan which will involve drilling 566 wells and locating 2,336MW of geothermal energy. These potential energy reserves have been located in 14 high-potential areas and estimates of their value are around US$30 billion. Whilst the GDC has this mandate of exploration, it also tenders contracts for IPPs, such as a recent expression of interest regarding the development of a power plant to process 400MW of reserves in the Menengai field and an open tender for an 800MW geothermal plant at Bogoria- Silai. GDC will harness steam discovered and this will be sold on to IPPs who will construct power plants to process it. 03 Does the Government participate in IPPs? The Government has not, to date, taken equity in Kenya s IPPs. However, as part of its PPP geothermal procurement programme, KenGen (which is 70 per cent owned by the Government) contemplates a joint venture structure as one of two options to attract private sector investment in its geothermal projects. KenGen s expression of interest document indicates that the private investor would be the majority shareholder. In relation to geothermal power projects, the Ministry of Energy s geo-exploration department formulates fiscal, legal and regulatory frameworks and policies, including setting the feed-in tariff for geothermal projects, and conducts geological mapping, acquisition, analysis and exploratory drilling. Licences for exploration and drilling in relation to geothermal IPPs would have to be negotiated and obtained through the Ministry. The Government has performed a vital role in Kenya s thermal IPPs to date, issuing letters of support to project companies and their lenders to facilitate the financing of projects using World Bank support. This has enabled IPPs to be financed using International Development Association (IDA) partial risk guarantees, in conjunction with Multilateral Investment Guarantee Agency (MIGA) political risk cover. 04 How are tariffs established? Pursuant to section 45 of the Energy Act, tariff structures in Kenya are set in accordance with the principles prescribed by the ERC. It is a requirement that such tariffs be set in a just and reasonable manner. As such, in performing this function, the ERC encourages inter alia the views of stakeholders, including KPLC. Electricity tariffs are treated in slightly different ways, depending on whether the tariff is in respect of the supply of electricity by KPLC to its end users, or whether it is in respect of the bulk supply of power from IPPs to licensed offtakers (predominantly KPLC). Tariffs applicable to the supply of power by KPLC to end users The ERC is mandated to publish a schedule of electricity supply tariffs in a Gazette Notice, which sets out the tariffs, charges, prices and rates to be charged by KPLC to end users of electrical energy. The Gazette Notice also specifies the date from which such tariffs will take effect. In computing the fixed electricity tariff, the ERC has established formulae for different categories of electricity consumption, being domestic consumers; non-domestic consumers; small commercial consumers; commercial and industrial consumers; interruptible off-peak supplies; and street lighting. Tariffs applicable to the bulk supply of power by IPPs to licensed offtakers The tariffs at which IPPs are permitted to sell power to licensed offtakers (which is most commonly KPLC) are established in one of two ways. For small scale renewable energy projects, including wind, biomass, small hydros, geothermal, biogas, solar and municipal waste to energy projects, with an installed capacity of less than 10MW, a feed-in-tariff applies. Feed-in-tariffs were established by the Ministry of Energy Feed-in-Tariff Policy on Wind, Biomass, Small-Hydro, Geothermal, Biogas and Solar Resource Generated Electricity (the FiT Policy), issued by the Ministry of Energy in March 2008 and revised on two occasions, in January and December 2012. Norton Rose Fulbright 03

Under the FiT Policy, the offtaker is required to guarantee priority purchase, transmission and distribution of all electricity supplied by small renewable energy projects, with an installed capacity of up to 10MW, for a certain period of time. However, the purchase, transmission and distribution of electricity produced by renewable energy projects with an installed capacity exceeding 10MW is subject to the terms of each negotiated power purchase agreement (PPA). The FiT Policy provides a technology-specific methodology of designing and establishing tariffs which takes into account the following factors: the investment costs for the plant (including the costs of feasibility studies, site development, construction costs, and the costs of connecting to the transmission system, including transmission lines, substations and associated equipment) the operation and maintenance costs fuel costs, where applicable financing costs (including interest during construction) and a fair return on capital invested (the availability of debt finance will be taken into account when establishing such costs) the design life of the power plant. Further regulations have been proposed in respect of electricity tariffs, which were published for public comment in February 2013. It is anticipated that these regulations will introduce positive reforms by improving the existing tariff setting mechanism. For thermal power projects and renewable energy projects with an installed capacity of more than 10MW, tariffs are set by agreement between the IPP and the licensed offtaker. The tariffs are set out in the relevant PPA, which must, in turn, be approved by the ERC. When reviewing and approving tariffs for large scale grid-connected renewable energy projects, the ERC will customarily have regard to the cost components described above in relation to the FiT Policy. Whilst the basis for setting tariffs on KenGen s 560MW geothermal procurement programme is not yet finalised, it is understood that they will be set by the procurement competition (ie, the successful bidders will be determined, among other things, on the basis of the tariffs offered). 05 Is regulatory reform ongoing? The electricity sector in Kenya has gradually developed from a monopolistic system to a relatively open/competitive system. In the past, generation, transmission and distribution of electricity were the exclusive responsibilities of KPLC. Today, generation of electricity has been liberalised, with several licensed IPPs now in operation, and the transmission function of KPLC is now vested in KETRACO. The reforms set in motion by Sessional Paper No. 4 on Energy, led to the enactment of the Energy Act as the main statutory instrument in the energy sector. The enabling provisions of the Energy Act are designed to create an environment in which further positive reforms will be achieved. For example, it is anticipated that the proposed regulations in respect of electricity tariffs, published in February 2013, will further stimulate reform in, and the development of, the electricity sector. Considering the key role that land rights play in the energy sector, it is anticipated that recent reforms in Kenya s land laws will have a knock-on effect on the energy sector. The Land Act (No. 6 of 2012), the Land Registration Act (No. 3 of 2012) and the National Land Commission Act (No. 5 of 2012) came into force on 2 May 2012. These Acts have introduced a new land law regime, by repealing all the previous substantive and procedural land laws. When read together with the Constitution of Kenya, a regulatory nexus has been established between land rights and environmental management and conservation obligations. All energy related activities (eg, electricity generation, transmission and distribution) must be carried out in a sustainable, environmentally acceptable manner. Further, in addition to existing regulatory institutions, the National Land Commission has been established to oversee compliance with these new land laws. The potential for renewable energy sources to play a significant role within Kenya s electricity sector has attracted significant support from various multilateral agencies, which results in additional pressure for reforms. It is considered that over reliance on hydro power and the importation of crude oil and petroleum products will, if not mitigated, constrain economic growth in Kenya. As such, the future of Kenya s electricity subsector will be shaped by a number of positive reform initiatives, all of which are aimed at improving the sustainability of the electricity subsector and the energy sector as a whole. 04 Norton Rose Fulbright

06 What is the typical risk allocation for IPPs in Kenya? KPLC has a well established form of PPA that has been developed on its IPPs in Kenya to date. KPLC has entered into PPAs with a number of IPP s generating power from heavy fuel oil, wind and geothermal sources. KPLC pays for plant capacity that is made available and electrical energy delivered by the generator (including during commissioning). Start-up charges are also payable where the number of requested starts (as opposed to starts following a forced outage) exceeds an allowance specified in the PPA. For thermal PPAs (most of which use liquid fuel), fuel charges are payable to the generator on the basis of the theoretical fuel demand of the plant. The fuel price paid by the generator is passed through to KPLC under the PPA. The calculation of capacity payments is based on the tested capacity of the plant and then adjusted for actual availability. Unusually for an emerging market PPA, KPLC is not required to pay for capacity to the extent that KPLC is unable to utilise the capacity as a result of outages in the transmission system caused by force majeure events. Adjustments to the capacity charge are also made for under generation (ie, a failure of the generator to deliver the level of power required by dispatch instructions). The generator bears the construction risk associated with the project. As the sole remedy for delays in completion of construction, the generator is required to pay liquidated damages to KPLC. Ultimately, if commercial operations are not achieved by a longstop date established in the PPA, KPLC may terminate the PPA. Where the start of commercial operations is delayed as a result of a breach of the PPA by KPLC, a failure by KPLC to provide the connection to the transmission system or to provide sufficient load and dispatch for plant testing, KPLC is obliged to make payment of capacity charges on the basis of capacity that is deemed to be available, calculated using the contracted capacity of the plant. These deemed capacity charges are set off against capacity charges payable by KPLC at the end of the PPA term, so as to prevent an over-recovery of capital costs by the generator. However, the generator has no right to claim such revenues where the start of commercial operations is delayed by reason of a force majeure event affecting the transmission system. Until now, change in law and change in tax risks have essentially been borne by the Government under a letter of support issued by the Ministry of Finance in respect of each project. In the first instance, the generator is permitted to seek approval from ERC to amend the tariff to cover increased costs arising from changes in law or changes in tax. Where such changes are not permitted, or where they do not result in full compensation being paid to the generator, the generator may seek redress from the Government under the letter of support. Where the Government fails to resolve the change in law/tax or provide adequate compensation, the generator may elect either to require the Government to acquire the plant, or extend the term of the PPA as a way of increasing its revenues, in order to cover increased costs arising from changes in law/tax. The measure of compensation payable by the Government for the acquisition of the plant in these circumstances is sufficient to cover project costs (including financing costs, fees and interest) and to provide an element of return on equity to the project sponsors. Other political risks, such as expropriation, war or acts of foreign enemy and riot, insurrection or civil commotion occurring in Kenya, are also treated in the same way. In all cases, the Government has up to 180 days to try to eliminate the event before the generator is permitted to issue a notice to the Government, requiring it to acquire the plant. As to whether the Government will continue to provide such support letters in the future remains to be seen. It is, however, clear that the Government will not provide sponsors or lenders with any form of guarantee. The form of build-own-operate-transfer agreement to be used by KenGen on its new PPP geothermal procurement programme is, as yet, unknown. However, given the successful track record of KPLC in implementing projects using its form of PPA and the fact that it has been approved by the ERC for use on numerous projects in the past, it seems unlikely that KenGen would depart radically from KPLC s risk allocation. Obviously certain modifications would be required to introduce a transfer component at the end of the term. KenGen s invitation to interested parties to pre-qualify for participation in its 560MW geothermal programme describes two alternative contracting structures. The first is a joint venture structure, under which the successful bidders will enter into a joint venture with KenGen for the development and financing of the project. The joint venture company will sell power to KPLC, with steam being supplied to it by KenGen. KenGen s desired shareholding is not yet clear, but it is understood that KenGen expects to take a minority interest in the joint venture company. Norton Rose Fulbright 05

The second structure is an energy conversion arrangement, under which KenGen will toll steam through a plant that has been developed and financed by the successful bidder, and KenGen will offtake power which it will then sell to KPLC under a PPA. In both cases, KenGen has stated that it will develop production and/or reinjection wells and guarantee the steam supply for the duration of the project. In an attempt to reduce costs incurred by small renewable energy producers, the FiT Policy also provides a standardised form of PPA for grid connected renewable generators with an installed capacity of up to 10MW. 07 What governmental approval is required for PPAs? All PPAs are required to be approved by the ERC prior to their execution, in accordance with the provisions of the Energy Act. The application for approval must be submitted in such form as may be prescribed in regulations made by the Minister for Energy. In considering an application the ERC is required to ensure inter alia the reasonableness of the rates and tariffs prescribed under the PPA and the satisfaction of the minimum criteria as set out in the Energy Act, as well as to consider any other issues which may have a bearing on the operations of the undertakings. In particular, the ERC will have regard to the proof of land acquisition, access or usage rights, grid connection plan and a full technical and economic feasibility study. Before the PPA is approved by the ERC or a power project commences, the project must also be approved by the National Environmental Management Authority of Kenya (NEMA), which will issue an Environment Impact Assessment (EIA) Licence, setting out the conditions attached to such licence and relating to the project. The purpose of this licence is to ensure and monitor an operator s performance with respect to environmental protection. After approval of a PPA by the ERC, the generator must also apply for a generation licence to be issued in accordance with the Energy Act and the Energy (Electricity Licensing) Regulations 2012. 08 What protections do foreign investors receive? The electricity sector in Kenya operates in a liberal market regime and there are no specific protections, incentives or privileges for foreign investors. In particular, and perhaps by contrast to many similar jurisdictions, the repatriation of funds from Kenya does not require any regulatory approval. Further, there are currently no sector specific requirements as to Kenyan participation in projects, or mandatory employment limits or policies in the electricity subsector. The issuance of work permits to foreign nationals is subject to the general provisions of the Kenyan Citizenship and Immigration Act. It is the Government s policy that the economy of Kenya should be manned by trained and competent citizens. Permits are issued to foreign nationals with skills not available at present in the Kenyan labour market, only on the understanding that effective training programmes are undertaken to produce trained citizens within a specified period. 09 What is the scope of a typical Kenyan security package? Kenyan law closely follows the principles of English law. Accordingly, the security package for an IPP would not be dissimilar to what one might expect in other common law jurisdictions. Kenyan law security interests available to lenders to power projects include: (a) an all asset fixed and floating debenture incorporating an assignment, by way of security, of certain licences and contract rights; (b) a legal charge over the immovable property on which the project is situated; and (c) share charges over shares in the generator, as appropriate. This security package would be complemented by direct agreements with KPLC in respect of the PPA, as well as other project agreements such as the engineering, procurement and construction contract and the operation and maintenance agreement. 06 Norton Rose Fulbright

Enforcement of local law security would typically occur either through the share charges or by the appointment of receivers and managers under the debenture. Kenyan law does not require the filing of a suit for foreclosure in order to exercise any of the foregoing rights. Enforcement of the legal charge, by contrast, would occur through a statutory power of sale, exercisable by the relevant chargee. Acknowledgments of assignment from the relevant contractual counterparties will also be required, allowing the chargee to transfer the relevant rights to a third party. Where possible, commitments from the ERC and KPLC are obtained prior to financial close, to ensure that a transfer of interests under the generation licence and PPA to a third party is permitted on an enforcement of security by the lenders. Naturally, the third party must be reputable and capable of performing the obligations of the generator under the generation licence and PPA. The transfer of a generation licence to the lenders by way of security (or to any other party duly nominated by the lenders, pursuant to the terms of the financing agreements) will also be pre-approved. 10 Dispute resolution Kenyan courts will generally recognise a contractual choice of law. Typically, IPP transactions in Kenya select English law and Kenyan law as the governing law of the different project agreements, though the PPA and government letter of support will be governed by the laws of Kenya. Subject to a few qualifications, Kenyan courts will recognise judgments obtained in certain other jurisdictions, including judgments obtained in England. Notably, there is no reciprocal enforcement of judgments obtained in the courts of any other European jurisdiction or the USA. Kenya is a signatory to the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards 1958 and accordingly, foreign arbitral awards are, subject to a few qualifications, enforceable by registration in Kenya. Prepared by in conjunction with Walker Kontos Advocates. Kenyan law recognises the concept of trusts. Accordingly, where a transaction involves syndicated loans, it is possible for security interests to be granted in favour of a security trustee. A number of Kenyan trust corporations capable of performing this function now exist, and it is not necessary to look outside the jurisdiction for these services. Finally, an important factor for consideration when establishing the scope of a security package for an IPP in Kenya is the cost associated with stamp duty. The Kenyan Stamp Duty Act provides that no instrument that is, under that Act, subject to stamp duty, can be adduced in evidence in a Kenyan court unless it is duly stamped. Stamp duty is levied at the rate of 0.1 per cent ad valorem and accordingly, where possible, it is important to structure securities so that stamp duty cost is minimised, to the extent possible. Norton Rose Fulbright 07

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