ISLAMABAD: The Power Division has constituted a seven-member committee to identify an appropriate benchmark to replace LIBOR after June 30, 2023 as LIBOR will cease to exist from forthcoming financial year 2023-24, well-informed sources in the PPIB told Business Recorder.

The committee will comprise of Shakeel Qadir Khan, Additional Secetary-1 Power Division (Convener), Aamir Nazir Gondal, Joint Secretary, Finance Division(Member), Yahya Khanzada, Joint Secretary, EAD (Member), Shah Jahan Mirza, Managing Director, PPIB (AEDB)(Member), Rehan Akhtar, CEO CPPA-G(Member) Masood Ahmad CFO, GHCL, Islamabad (Member), senior representative SBP (Member) and senior representative, NEPRA (Member).

The Committee may co-opt any other member or an expert as deemed appropriate for completion of the ToRs. Further, the ToRs of the Committee will be as follows: (i) to identify an appropriate benchmark to replace LIBOR after June 30, 2023; (ii) in case LIBOR is to be replaced with SOFR, to determine which SOFR, ie, Term of Arrears will be adopted for IPPs borrowing; (iii) to debate the rationale for and to negotiate the Credit Adjustment Spread (CAS) with the IPPs and their lenders; (iv) to put up final recommendation(s) to the competent Authority for approval; (v) to review any other associated matter which be considered essential by the Committee; (vi) the Committee will give its recommendations in two weeks; and (v) Secretariat support will be provided by the PPIB.

USD LIBOR to SOFR: DFIs concerned at transitioning delay

Sharing the details, sources said, numerous power generation projects that are currently being undertaken, and those that have achieved Commercial Operation Dates (CODs) and have procured foreign loans from various Multilateral Development Banks (MDBs), Development Financial Institutions (DFIs) such as, ADB, IFC IDB and other commercial banks have urged US Federal Reserve Bank to devise a road map to transition to a more robust benchmark rate replacing LIBOR - LIBOR, a widely used benchmark was manipulated by a panel of banks.

Fed’ s Alternate Reference Rate Committee (ARRC) based on their findings, proposed Secured Overnight Financing Rate (SOFR) which constrains panel of banks from lending (interbank) without posting a collateral (ie, US Treasury Security) and advised banks and financiers to gradually transit to SOFR with pre-established timelines (ie, on or before June 30, 2023) for both legacy and new loan contracts. Now owing to such changing regulatory and global economic environment, the existing applicable benchmark rate (ie, LIBOR) has been planned to be discontinued by June 30 2023.

Foreign loans, especially those contracted with MDBs/DFIs, various IPPs on behalf of their lenders have approached PPIB for facilitation. “Once such transition is agreed with the IPPs/lenders, it will have some cascade effect to the projects Security and Financing Agreements requiring amendments which will be duly ratified by the government, other terms and conditions remaining the same,” sources added.

Accordingly, in response to IPPs requests on this issue, PPIB had taken-up the matter with Ministry of Finance and SBP for guidance and advised to form a committee to reach a meaningful conclusion. Ministry of Finance, however, in light of the PPIB’s request held a meeting with the SBP, and decision taken thereon was conveyed through furnishing a record note.

The SBP apprised that SOFR is better than LIBOR since SOFR is transaction based and LIBOR was based on markets’ views. SOFR is an overnight rate generated on the basis of actual transactions. Currently, rate of SOFR is slightly less than LIBOR, however gradually this gap will be bridged.

On question of how the transition to SOFR will be done for contracts which were entered into in the past and will continue beyond June 2023 SBP stated that an addendum clause may be added to these contracts which will allow shift to SOFR when LIBOR ceases to exist; and SBP further contended that SOFR term rates are being quoted by CME which are approved by Alternate Reference Rates Committee.

On a question regarding whether overnight SOFR or Term SOFR will be used for long term financing agreements it was noted that the term SOFR will be used which is a daily set of forward-looking interest rate estimates, calculated and published for 1-month,3-month, 6-month and 12-monlh tenors.

Regarding bilateral and multilateral financing it was stated by SBP that the new financing agreements are already entered into using SOFR rates and these agreements are donor driven so transition from LIBOR to SOFR will be done in accordance with their global policy for all countries. EAD may like to lead in negotiating the new terms and conditions based on SOFR with development partners.

The sources said, in order to bring more clarity on the matter, PPIB has also held a consultative session on February 27, 2023 which was inter-alia attended by representatives of various Financial Institutions (FIs) and MDBs along with Government and Regulatory, private sector representatives, namely IFC,ADB, IDB) and other lenders, NEPRA, Economic Affairs Division (EAD) and participants from IPPs.

SOFR is further bifurcated into Term SOFR and Compounded SOFR in arrears. Term SOFR is designed as a forward-looking projection of daily SOFR in arrears, calculated using data from futures. On the other hand, daily compounded SOFR in arrears is actual, transaction based, backward-looking rate. Further, various financial and capital markets experts, including lenders, are of the opinion that SOFR, which is now backed by Treasury Security, has now become a risk-free rate.

Thus, banks’ lending on SOFR (whether it’s Term or Compounded) does not cover banking credit risk. Whereas, outgoing benchmark (i.e. LIBOR) rate along with being forward looking has had premia for such banking risk implicit in its rate.

So, to equate SOFR with LIBOR, and to compensate lenders to cover-up for such banking risk, ARRC’s or International Swap & Derivatives Association’s (ISDA’s) recommended spreads of varying magnitudes and accordingly being demanded by lenders for different maturity/tenors of 1,3.6 and 12 months for both legacy and new loan contracts. These ISDA spreads are worked-out while using 5 Years Historical Median Difference between the Term SOFR and LIBOR rate. Thus, the existing composition of the interest rates based on LIBOR benchmark, ie, “LIBOR + Borrower’s Credit Spread” is to be changed to “SOFR+ Credit Adjustment Spread+Borrower’s Credit Spread”.

While opening all the issues for discussion in the consultative session, lenders representatives (i.e. ADB, IDB and IFC) in their presentation argued that Term SOFR in lieu of compounded SOFR i.e. SOFR in Arrears would be an appropriate alternate benchmark rate for transition from USD LIBOR to SOFR keeping in view the current power sector’s dynamics and indexation mechanism followed by NEPRA.

During the meeting it was observed that in case Compounded SOFR over Term SOFR is opted, the latter being backward looking rate, may complicate the commercial settlements between the IPPs, Lenders and Power Purchaser. Further, SOFR being risk free rate and in order to equate it with USD LIBOR, that may capture the banking credit risk, may require some Credit Adjustment Spread (CAS) over SOFR in light of ARRC’s (ISDA’s) recommendations(i.e. 11.448, 26.161, 42.826 bps for one, three and a half and six-months tenors respectively).

Lenders representative had also revealed that, so far, sizeable amount of their loans on varying tenors have been transitioned strictly in accordance with the CAS proposed by ISDA, while opting Term SOFR.

According to PPIB, there had been difference of opinion among the stakeholders regarding opting between Term SOFR and Compounded SOFR in arrears and applicability of CAS over SOFR rate. Accordingly, the meeting was concluded upon request to the participants to provide their views/ comments on the issue in writing which will further be deliberated in light of the responses furnished thereon.

Presently IPPs have the foreign lending of approximately $ 12 billion, such loans have to be transitioned from USD to LIBOR to SOFR (regardless of whether Term or Compound SOFR) on or before June 30, 2023. Further, applicability and magnitude of CAS over SOFR may also have financial implications for power sector’s loans/debt servicing. Any CAS below and equal to, as suggested by the participants, may yield saving or an additional financial cost.

Copyright Business Recorder, 2023

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