Contracts with IPPs, tariffs and ‘SOFR’: ECC tells PD to analyse impact of change, financial implications

ISLAMABAD: The Economic Coordination Committee (ECC) of the Cabinet has directed the Power Division to analyze impact of change in contracts with the Independent Power Producers (IPPs) and tariffs including financial implications involved in shifting from LIBOR to SOFR, official sources told Business Recorder.

On September 19, 2023, Power Division informed the forum that the IPPs and Independent Transmission Company (ITC) had obtained foreign financing from various International Financial Institutions (IFIs) 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 had been reflected in the project documents (Financing Documents, Tariff Determinations, Implementation Agreements (IAs) and Power Purchase Agreements (PPAs) and Transmission Service Agreement (TSA).

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

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

The Federal Reserve’s Alternative Reference Rate Committee (ARRC) had selected the Secured Overnight Financing Rate (SOFR), which was 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, ie, SBP, Finance Division, CPPA-G and NEPRA for transition from LIBOR to SOFR.

The Power Division further informed that SOFR mainly consists of daily SOFR: (a) Daily Simple SOFR which is based on weighted average of daily SOFR; (b) 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 (c) 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 and six months).

It was highlighted that SOFR was considered more resilient and robust than LIBOR and, therefore, LIBOR and SOFR were 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 was 42.826 bps, for 3-month 25.161 bps and for 1-month tenor 11.448 bps respectively.

The CAS based on the historical median difference between USD LIBOR and SOFR over a five-year period had 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 would be added to underlying SOFR based rate to make it more closely equivalent to LIBOR.

The Finance Division in consultation with SBP held deliberations and conveyed the decision taken thereof. The DFIs including ADB, IDB and IFC were of the view 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 was not negotiable.

The Chinese Sponsors including their lenders argued that due to various reasons including registration process, they were only allowed to opt for Daily Simple SOFR and CAS over SOFR which was 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, CPPA-G, PPIB along with its TORS.

The committee in its two meetings had detailed deliberations on all aspects and reached a general consensus that negotiating Credit Adjustment Spread (CAS) was not feasible keeping in view the cost and benefit and, therefore, there was no sound basis for hiring a consultant to negotiate the CAS. Power Division submitted following proposals for consideration of the ECC: (a) Project lenders of IPPs/ITC are allowed to adopt SOFR as replacement to USD LIBOR as follows: (i) Term SOFR plus applicable CAS; ii) Daily SOFR plus applicable CAS; ( b) 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, the same shall be effective from July 1, 2023; and (c) PPIB, AEDB, CPPA-G and NTDC may also be authorized to execute appropriate amendments to the respective agreements, i.e., IAs/PPAs/TSA, etc, to cater for change from USD LIBOR to SOFR.

During the ensuing discussions, the EEC observed that such proposals should not discriminate against borrowers and their financial implications be backed by suitable possible simulation. It was observed that the summary should clearly delineate whether there will be saving or otherwise as a result of adopting SOFR.

The ECC also noticed that exception for China contracts has not been mentioned in the proposed decision. It also noted that there is no mention in the summary as to which type of SOFR is preferred and why.

The ECC further observed that if legacy contracts/loans carry some CAS then this should be supported by some financial analysis to provide for its rationale. It was observed that this should also be analyzed as to what would be the impact of this change on contracts with IPPs and tariffs.

Further, the ECC emphasized that the minutes of the two committees mentioned in the Summary should be brought in sync after reconciliation.

Copyright Business Recorder, 2023