FX Hedging Facility

Status: Endorsed
Cycle: 2015-2016
Type of instrument: Hedging facility
Focus area: Renewable energy (utility-scale, distributed, and off-grid)
Goal: To facilitate large-scale foreign investment into renewable energy in India by providing a cheaper currency hedging solution
Private finance target: Foreign institutional investors, retail investors and other private equity; Foreign and local commercial banks
Instrument proponent: RR Corporate Ltd

The Government of India has set targets to achieve 175 GW of installed renewable energy capacity by 2022. To meet this target, around USD 189 billion of investment will be required from 2016 to 2022. It would be extremely difficult to meet this investment requirement through domestic investment only.

Foreign investment is a potential source of significantly more finance for renewable energy in India. However, currency risk, which is unexpected devaluations when using a foreign currency, is a major deterrent to many foreign investors, resulting in reduced investments in the country due to the higher perception of risk, and necessitating the use of a currency hedge (or foreign exchange swap) to protect against the devaluations, which can add significant costs to transactions.

If currency risk is broken down into different tranches, then there may be a stronger argument to subsidize the foreign exchange (FX) tail risk, as the FX Hedging Facility does, rather than partially subsidizing the overall currency risk, as is the case for subsidized cross currency swaps.

The FX Hedging Facility possesses the following benefits compared to a commercial cross currency swap:

  • Elimination of counterparty credit risk and liquidity risk: The transaction structure and the upfront availability of the guarantee fee can reduce the cost of currency hedging by ~50 basis points (bps). With the donor making the upfront payment of the FX tail risk premium and no need for exchanging notional payments, the credit risk which otherwise gets charged in a currency swap gets eliminated. Also, the cost of liquidity risk gets implicitly subsidized without requiring any donor grant.
  • Better targeting of public grants: The FX Hedging Facility is a more efficient use of public grants, or subsidy, as it covers or targets only extreme currency depreciation. The annual cost of this subsidy is ~134 bps.
  • Additional benefits to donors or users: If the currency depreciation is lower than expected, then the upside benefit remains with the FX Hedging Facility, which can be transferred to the donors or user later. This is a more optimal use of donor capital as compared to what would have been required in a commercial currency swap.

As a result, the FX Hedging Facility has a leverage factor of 9 with more than 50% probability that the entire subsidy will be recovered, while a cross currency swap has a leverage factor of 6 with no option of any recovery of subsidy.

The FX Hedging Facility can be structured for both debt and equity, depending on the user’s requirement. The design for a debt transaction would involve a risk capital facility (“hedging facility”) backed by an FX tail risk guarantee. The hedging facility will hold the FX tail risk guarantee fee to be paid to the guarantor upfront. This facility will take certain annual payments from the project developer/investor for the risk coverage up until a certain currency depreciation rate – we used 4.5% per annum for our analysis. Beyond this depreciation rate, the coverage will be provided by the FX tail risk guarantee. The upside benefit due to currency depreciation being lower than expected will remain with the hedging facility, and can be returned either to the donor or the user after the tenor of the debt.

The transaction requires two separate contract agreements by the project developer/investor:

  1. One agreement with the hedging facility to cover currency risk up until the customizable annual currency depreciation rate; and
  2. Another agreement with an FX tail risk guarantor to cover currency risk beyond that rate till P99.7.

The equivalent annual cost of currency depreciation from 0% to the set rate will be paid by the project developer or investor to maintain the risk capital for the mentioned risk coverage. When compared to a commercial swap, the depreciation rate that we used of 4.5% translates into an annualized cost of ~528 bps. The cost of the FX tail risk guarantee was calculated as 134 bps.

161117-fx-graphic

While the numbers are available for the debt transaction, further work will be required to arrive at the numbers for an equity transaction.

For an equity transaction, one of the largest clean energy private equity investors is looking to invest USD 500 million into utility scale renewable energy projects in India and wants to hedge its return from FX risk. It is willing to pay a fixed premium of ~300 basis points as a cost of currency hedging. This is different from the debt transaction discussed earlier where the user is expected to pay a fixed premium of ~528 basis points. For optimal use of donor grant and for robust risk management of the hedging facility, the fraction of the upside equity returns will have to be shared by the equity investor which would be estimated using and advanced risk-return assessment of the hedging facility.  Such an assessment will simultaneously account for the distribution of equity returns and its volatility, the distribution of power generated, and currency risk.

“I submitted my idea to mitigate currency risk and reduce the cost of debt funding to the India Lab because of its ability to bring together the most important and influential stakeholders in climate discussions from finance and government, both in India and internationally, to one platform, said Ravindra Rathee, Principal, RR Corporate Ltd and idea proponent of the FX Hedging Facility, in a statement.

For more information about the FX Hedging Facility, please contact Saurabh Trivedi at saurabh.trivedi@cpidelhi.org