To be applicable from July 1, 2023: Govt set to approve transition of LIBOR to ‘SOFR’

ISLAMABAD: The government is all set to approve transition of London Interbank Offer Rate (LIBOR) to Secured Over Night Financing Rate (SOFR) to be applicable from July 1, 2023 after the NEPRA nod, sources close to MD PPIB told Business Recorder.

However, Chinese sponsors including their lenders maintain that due to various reasons including registration process, they are only allowed to opt for daily Simple SOFR and CAS over SOFR is not negotiable.

The issue will be placed before the Economic Coordination Committee (ECC) of the Cabinet, in its meeting scheduled to be held on Tuesday (today).

Tariff determination: Nepra backs ‘SOFR’ benchmark in place of Libor

Sharing details, Independent Power Producers (IPPs) and Independent Transmission Company (ITC) have obtained foreign financing from various International Financial Institutions including Development Financial Institutions (DFIs) such as ADB, IFC, IDB and other commercial banks based on LIBOR as an applicable benchmark rate and accordingly the same benchmark has been reflected in the project documents (financing documents, tariff determinations, Implementation Agreements (IAs) and Power Purchase Agreements (PPAs) and Transmission Service Agreement (TSA).

However, due to manipulation of several financial institutions and weaknesses in governance oversight, the UK’s Financial Conduct Authority (FCA) announced that US$ LIBOR will cease to be applied as benchmark for financial transactions after December 31, December 2021 and will no longer be available for quoting after June 30, 2023.

The Federal Reserve’s Alternative Reference Rate Committee (ARRC) has selected the Secured Overnight Financing Rate (SOFR) which is more robust benchmark and risk-free rate (backed by US Treasury as a collateral) to replace LIBOR for both legacy and new contracts to be entered in future.

Accordingly, several IPPs together with their lenders approached PPIB including other stakeholders i.e. SBP, Finance Division, CPPA-G and NEPRA for transition from LIBOR to SOFR.

The SOFR mainly consists of: (i) daily SOFR;(ii) daily simple SOFR which is based on weighted average of daily SOFR;(iii) SOFR compounded in arrears based on daily simple SOFR convention but includes the element of compounding each day of interest during the accrual period; and (iv) term SOFR based on forward-looking SOFR rate, uses SOFR futures and benchmark SOFR derivatives to provide a forward rate for a given time period (e.g., one, three, six and twelve months).

According to Ministry of Energy, it is important to highlight that SOFR is considered more resilient and robust than LIBOR and therefore LIBOR and SOFR are not equivalent requiring adjustments being unsecured versus secured benchmark rates.

Therefore, the International Swaps and Derivatives Association (ISDA) recommended Credit Adjustment Spread (CAS) to equate the difference between LIBOR and SOFR for various tenors on legacy contracts including the methodology to calculate spread adjustments.

Accordingly, the proposed CAS for 6-month tenor is 42.826 bps, for 3- month 26.161 bps and for 1-month tenor 11.448 bps respectively. The CAS is based on the historical median difference between USD LIBOR and SOFR over a five-year period has been widely adopted in the international market for both derivatives and loans and Islamic Financing as financial transactions transition from LIBOR to SOFR-based rates. Consequently, in line with ISDA proposals for a smooth transition, CAS will be added to underlying SOFR based rate to make it more closely equivalent to LIBOR.

The DFIs including ADB, IDB and IFC argue that term SOFR 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. It was also highlighted that the recommended CAS over SOFR is not negotiable.

The Chinese sponsors including their lenders maintain that due to various reasons including registration process, they are only allowed to opt Daly Simple SOFR and CAS over SOFR is not negotiable. In order to resolve and to select an appropriate benchmark for all stakeholders, Power Division constituted a committee with representatives from Finance Division, Economic Affairs Division, SBP, NEPRA, CPPAG, PPIB.

The committee in its two meetings held detailed deliberations on all aspects reached a general consensus that negotiating Credit Adjustment Spread(CAS) is not feasible keeping in view the cost and benefit and, therefore, there is no sound basis for hiring a consultant to negotiate the CAS. In light of discussion and decision taken at different forums, Power Division has proposed to the ECC that project lenders of IPPs/ITC be allowed to adopt SOFR as replacement to USD LIBOR as follows: (i) term SOFR plus applicable CAS; and (ii) daily SOFR plus applicable CAS.

It has also been recommended that NEPRA may finalize all the modalities related to the amendment(s) in the tariff determination/indexation mechanism with regard to SOFR at the earliest, whenever concluded, it shall be effective from July 1, 2023.

Power Division has also recommended that PPIB, AEDB, CPPA-G and NTDC may also be authorized to execute appropriate amendments to the respective agreements, ie, IAs/PPAs/TSA, etc, to cater for change from USD LIBOR to SOFR.

Copyright Business Recorder, 2023