Download Relevance of Derivatives and Related Debt Instruments to Public

Relevance of Derivatives and Related Debt Instruments to
Public-Private Sector Financing of Energy Resources in Nigeria
Yemi Oke
Introduction
Energy as a prerequisite for economic growth and development is widely
acknowledged.1 As the Federal Government of Nigeria strives to stimulate private sector
investment in energy and infrastructural development,2 a major challenge is that government
policies are bedeviled by needless bureaucratic bottlenecks that often make attracting private
sector funding difficulty, though not impossible. Most affected is financing of the trinity sector
of oil, gas and electricity in Nigeria (hereinafter referred to as the “energy resources”).3 While
research reveals the fact that resource wealth can hamper development, the range of policy
measures to stimulate financing in the energy resources sector to generate more revenues for
the state to promote socio-economic development, are relatively less amplified.4 Solving
certain resource-based, economic problems in Nigeria, as in other developing countries, require
adopting good financial management strategies. This paper argues the need for gap-bridging
policies in public-private partnership financing of the energy resources sector, through the
adoption of more sustainable alternatives like derivatives and other debt financing options.

Dr. Yemi Oke had his LL.M and PhD degrees from Osgoode Hall Law School, York University, Canada;
LL.B from University of Ilorin, Nigeria; B.L. from the Nigerian Law School, Abuja. He is a Law Lecturer
in the Faculty of Law, University of Lagos, Nigeria. Contact: [email protected].
See E. Gnansonuou, “Boosting the Electricity Sector in West Africa: An Integrative Vision” (2008)
International Association of Energy Economies, Third Quarter, at 23.
1
2
See the Infrastructure Concession Regulatory Commission (Establishment, etc) Act 2005 provides for the
participation of the private sector in financing the construction, development, operation, or maintenance of
infrastructure or development projects of the Federal Government of Nigeria through concessions or other
contractual arrangements.
3
The term “Energy Resources” is used in this paper to denote oil, gas and electricity.
See for example Randall Dodd, “Protecting Developing Economies from Price Shocks” in Svetlana Tsalik
and Anya Sciffrim (Eds.) Covering Oil - A Reporter’s Guide to Energy and Development (New York, Open
Society Institute, 2005) at 87.6
4
Nigeria and the Challenge of Energy Financing
Inability of the Nigerian Government to meet, as and when due, demands for
counterpart funding in the petroleum sector, otherwise called “cash-call”5 is not
necessarily due to the lack of funds or unwillingness. Rather, it is due largely to the
nature of state politics and regulatory environments occasioned by budgetary formalities
and legislative procedures for passing appropriation laws in Nigeria.6 By virtue of the
provisions of the Constitution, no moneys shall be withdrawn from the consolidated
account7 or other public fund8 unless in the manner authorized by the National Assembly9
in line with procedure for budgeting and appropriation.10 As NNPC statutory corporation
responsible for a substantial part of the earnings of the all three tiers of governments in
Nigeria, the budgetary and appropriation procedures has made it difficult for the NNPC
to meet its joint venture obligations. By law, it pays all its revenues into the Federation
Account to be appropriated yearly under revenue allocation or appropriation statutes.
This is the conclusion reached by the Supreme Court while interpreting Section 162 of
the 1999 Constitution in the case of Attorney-General of the Federation v. AttorneyGeneral Abia &35 Ors.11
5
Most provisions on funding of the cost of the Joint Operations in the Joint Operations Agreement (JOA)
usually contain cost obligations for each party to contribute its participating interest share of all funds
required for the joint operations. This is what is known as “cash call” obligations, and requires each party
to pay its respective share of the cash call amount which is undisputed, into designated joint operations
account. See G. Etikerentse, Nigerian Petroleum Law (2nd Ed.) (Dredew Publishers, 2004) at 30-31.
6
By virtue of the provisions of the Constitution of the Federal Republic of Nigeria (CFRN), 1999 (as
amended), all revenues and paid into a central account and requires appropriation or authorization by the
legislature to spend for any projects including for meeting call obligations. For example, the CFRN
provides:
80 (1) – All revenues or other moneys raised or received by the Federation (not
being revenues or other moneys payable under this Constitution or any Act of
the National Assembly into any other public fund of the Federation established
for a specific purpose) shall be paid into and form one Consolidated Revenue
Fund of the Federation.
7
Ibid, at sub-section 80 (2).
8
Sub-section 80(3).
9
Sub-section 80(3).
10
See generally sections 81, 82, 83 and 84 CFRN (as amended) for the budget procedure and authorization
to spend public funds of the Federation including for meeting cash calls and other obligations.
11
See Attorney-General of the Federation v. Attorney-General Abia &35 Ors (2002) 6 NWLR (pt. 764)
542.
The above case compares with the case of Attorney-General Ogun State vs.
Attorney-General of the Federation &35 Ors,12 where the Supreme Court relied on the
provisions of Section 7 and 9 of the NNPC Act,13 to the effect that NNPC does not have
to pay all its revenues into the Federation Account. The apex court reasoned that, NNPC
is excluded to the extent that deduction of expenses from gross income is legal where
such items of expenditure are prospectively included in the budget of NNPC as approved
by the Federal Executive Council pursuant to Section 7(2) of the NNPC Act; or where
same is retrospectively included in the audited accounts of the NNPC.
Aside the petroleum industry, electricity sector is also faced with funding
challenges arising from the spill-over effect of inadequacy of government funding. Thus,
the history and development of electricity regulation in Nigeria has been regressive in
terms of ability to effectively deploy legal and policy frameworks to bring about effective
administration and management of the power sector in the country. The journey of
electricity governance in Nigeria has been bumpy and tortuous. From 1896 when
electricity was first produced in Ijora, Lagos by the British Colonial Government, up till
the era of the Nigerian Electricity Supply Company (NESCO), the Public Works
Department (PWD), the Electricity Corporation of Nigeria (ECN) and the Niger Dams
Authority (NDA) and the National Electric Power Authority (NEPA). Power generation,
transmission and distribution in Nigeria has been abysmally poor, unstable and grossly
unreliable, as series of legal and policy frameworks from 1896 till date seem incapable to
solving the problems. The current regime under the EPSR Act, 2005 brought about the
Power Holding Company of Nigeria (PHCN), which is also being unbundled, liquidated
and re-structured into 18 companies. In achieving its objective, the on-going power sector
reforms also rely heavily on private sector funds.14
12
(2002) 18 NWLR (pt. 798) 232.
13
See the Nigerian National Petroleum Corporation (NNPC) Act, Cap N123 LFN 2004.
14
According to a report, the Federal Government has unbundled the Power Holding Company of Nigeria
(PHCN) to the private sector. The policy implementation implies the liquidation of PHCN. Eighteen power
generation, transmission and marketing companies are expected to evolve following the policy. See
“Federal Government Liquidates PHCN: 18 Companies Take Over Control” The Nigerian Tribune, January
11, 2012, pp 1 and 4.
Trends in Energy Project Financing in Nigeria
Energy investment in oil, gas or electricity requires huge, long-term capital.
Generally, Africa attracts very little project finance.15 Over-dependence on the
insufficient public sector funds was a problem of the Nigerian banking sector, making
banks vulnerable to the volatility of change in Nigeria’s oil-dependent revenue. Due to
low capital base among other deficiencies, Nigerian banks were incapable of funding
huge, capital intensive projects like energy resources. Till date, the Nigerian banking
sector is still going through series of amalgamation, transformation and restructuring
either through consolidation,16 merger and acquisition17 or nationalization.18
Prior to 1970, the norm was that international oil companies financed petroleum
projects in developing countries through their internally generated funds. However, with
growing government participation in the petroleum industry and reaffirming of
Leighland, J, & William, B., “Reform, Private Capital Needed to Develop Infrastructure in Africa:
Problems and Prospects for Private Participation” Gridlines series No. 8. PPIAF Washington, D.C. (2006),
cited in ‘Funding Energy Projects In Developing Countries: Is This The Dawn of Local Lending In Project
Finance?
A
Nigerian
Perspective’
by
Emilomo
Unuigbe,
on-line
at:
<http://www.dundee.ac.uk/cepmlp/gateway/files.php> accessed 23 August, 2011.
15
16
In July 2004, the then Governor of the Central Bank of Nigeria (CBN), Prof. Charles Soludo announced
that the new minimum capitalization for banks in Nigeria shall be N25 billion (approximately $181m) and
all banks were expected to comply with this directive by December 2005. Charles Soludo rationalized the
consolidation policy of the CBN as inevitable, to strengthen the Nigerian banks and reposition them for
meeting long term financing obligations with regards to crucial sectors of the economy like energy and
infrastructure. See Charles Soludo, “Central Bank of Nigeria-Consolidating the Nigerian Banking Industry
to
meet
the
Challenges
of
the
21st
Century”
on-line
at
<http://www.gamji.com/article5000/NEWS5080.htm> accessed September 10, 2011.
17
Pursuant to the CBN consolidation policy, mergers and acquisitions scenarios such as peer mergers,
acquisitions/mergers by the strong, regional mergers, root mergers, subsidiary acquisitions/mergers, foreign
capital infusion, reverse acquisitions among others were created. Banks that have the wherewithal to meet
the required capitalization, such as Firstbank, UBA, Zenith Bank and Guaranty Trust Bank and others also
seized the opportunity to acquire or merge with other banks, as in the case of UBA and Standard Trust
Bank. See Alder Consulting, “Consolidation in the Nigerian Banking Sector: Brand Scenarios &
Implications” on-line at:
< http://www.nigerianmuse.com/20090328090201zg/nigeria-watch/from-thearchives-consolidation-in-the-nigerian-banking-sector-brand-scenarios-implications> accessed September
17, 2011.
18
Nigeria's asset management firm, AMCON took over three banks, namely Springbank, Afribank and
Bank PHB after the CBN had revoked their banking licenses for failing to recapitalize despite the bailout.
Their assets and liabilities were transferred to newly formed 'bridge banks' by the Nigeria Deposit
Insurance Corporation (NDIC). The nationalized banks are: Mainstreet Bank (formerly Afribank),
Keystone Bank (formerly Bank PHB) and Enterprise Bank (formerly Spring Bank). See Chijioke Ohuocha
“Nigeria's
AMCON
Takes
Over
3
Nationalised
Banks”
on-line
at:
<
http://www.reuters.com/article/2011/08/06/nigeria-banks-idUSL6E7J603U20110806> accessed September
17, 2011.
sovereignty over petroleum reserves, government budgets were used to fund projects. In
the 1970s, there was a shift in the pattern of financing due to a decline in government
participation. The oil majors’ support began to diminish as they felt the need to share
project risks, principally political risk.19
Funding of energy resource in Nigeria during the colonial era was largely through
foreign capital, as the Mineral Oil Ordinance gave monopoly to British oil companies.
The Mineral Oils Ordinance provides that: “[T]he entire property in and control of all
minerals, and mineral oils, in, under or upon any land in Nigeria, is and shall be vested in,
the Crown”.20 By virtue of section 6(1) (a) of the Mineral Oils Ordinance, the grant of oil
exploration and production is exclusively reserved for the British subjects, both natural
and corporate.21 This gives a British oil giant overwhelming advantage in the Nigerian
energy resources sector till date.22 Following the repeal of the Ordinance, the door
became opened for multi-jurisdictional funding in the energy resource sector of Nigeria
through capital injections from American and other energy companies from European
countries, who had to compete for acreages along with the British oil company.
19
Razavi, H., Financing Oil and Gas Projects in Emerging Economies (United States of America:
Pennwell Publishing Company, 1996), cited in ‘Funding Energy Projects in Developing Countries: Is his
the Dawn of Local Lending in Project Finance? A Nigerian Perspective’ by Emilomo Unuigbe.
20
Mineral Oil Ordinance 1948. See W. McElroy, West Africa and Colonialism (Pt. 1-3) at 11, online at:
Freedom Daily <http://www.fff.org/freedom/fd0410d.asp>, accessed December 2008. See also I. Bagudu,
et. al., Oil and Gas Exploration: Reconciling Contending Issues in Simpson & Fagbohun (Eds.,)
Environmental Law and Policy (Lagos: Law Centre, 1998) at 310.
21
See also the colonialist laws before the Mineral Ordinance of 1948. For example, the provisions of the
Colony and Protectorate Mining Regulations (Oil Ordinance) of 1907 were basically similar to the
preceding Mineral Oil Ordinance of 1914. The significance of the later is that it exclusively reserves oil
mining for British companies and related interests. Some of the clauses in the 1907 Ordinance were also
retained under s. 6 of the 1914 Ordinance. It provides:
6 (a) no licence or lease was to be granted except with the approval of
the Secretary of Sates;
(b) no licence or lease was to be granted except to a British subject or a
British Company registered in Britain or a British Colony having its
principal place of business within Her Majesty’s Dominions. The
Chairman, the managing director, if any and the majority of other
directors must be British Subjects.
See Yemi Oke, “Africa and the Quest for Mining Sustainability: A Comparative Evaluation of the
Mineral Law of Nigeria with South Africa and Ghana” (2008) 15 South African Journal of Environmental
Law and Policy [SAJELP], pages 183-215 at 183-5. See also Yemi Oke, “Public International Law and
Sustainable Utilization of mineral Resources: The Case of Sub-Saharan Africa” (2009) 21 [No1] Sri Lanka
Journal of International Law, pages 85-107 at 92-99, and A. Akinrele, Nigeria Oil and Gas Law (Oil, Gas
& Energy Law Intelligence-OGEL, UK, 2005) at 5.
22
Under this regime, one hundred percent concession was granted to the Federal
Government of Nigeria, putting the burden of funding squarely within the domains of the
government. With this development, government as owner of the energy resources
entered into contractual arrangements by way of joint-venture, which creates funding
obligations on the Federal Government of Nigeria. The government soon got faced with
the challenge of “cash-calls”23 making the imprudence of the funding structure apparent.
This also makes it inevitable to explore new, sustainable alternative sources of funding
from both public and private sector players, using derivatives and other debt financing
options to supplement traditional equity financing models in the sector.
In Nigeria, financing gas investment is, in relative terms, a recent development.24
Generally, financing of energy resources is either by private sources or a joint venture
between private and public companies.25 In the past, the four main sources for generating
funds for energy projects were international loans; grants from multilateral and bilateral
sources; international private sector investments; and public sector investments; and
private sector investments.26 Currently, new instruments are being employed in financing
projects. A good number of energy projects are funded by private sources of equity and
debt financing either on non-recourse or full recourse bases.
Contemporary sources of financing energy projects are multilateral development
institutions through global institutions like the World Bank, the International Finance
Corporation (IFC) and regional banks like African Development Bank (ADB). Bilateral
investment agencies such as the export-import banks of industrialized countries also lend
to both state and private entities to venture into energy sector. Commercial banks and
institutional lenders, equity markets, bonds, and specialized energy funds also
complement institutional funding in the energy sector while ad hoc sources such as
equipment suppliers’ credit, project contractors’ financial contributions, equity and debt
financing by purchasers of the project output also constitute veritable sources of
financing in the energy resources sector.
23
Supra note 5.
24
See generally L. Afsegbua. “A critical Appraisal of the Transfer of Petroleum Technology in the
Nigerian Oil Industry” (1993) OPEC Review, (Winter), vol. xvii. No. 4 477 – 485 quoted on page 197 of
Oil & Gas Laws in Nigeria by the same author.
25
See Gerald Greenwald, “Encouraging Natural Gas Exploration Policies,” in Nicky Beredjick & Thomas
Walde (Eds.), Petroleum Policies in Developing Countries (Grahna & Trotman, 1988), 175 at 176.
26
Razavi, supra note 5.
Bankability and Pre-financing Considerations
Financing techniques have evolved rapidly to meet the opportunities, needs and
challenges of energy resources particularly for resource-dependent economies like
Nigeria. Multiple approaches to structuring or financing of energy resource development
have arisen in response to increasingly dynamic nature of the sector in the developing
countries.27 The investors; local or foreign, would need to be sure that the energy
resource project is bankable. The term bankability is a technical word denoting
commercial expectations and assurances that an investor will recoup the investment
capital with gains. In the Nigerian energy sector, bankability often becomes very
crucial.28 According to a scholar, the process of making investment decisions is as much
idiosyncratic as it is scientific. This often leads to piercing through the sometime
deceptive incentives for a careful consideration of the political, social and other factors
that would make investing in a country a reasonable business decision.29
Much of the debates on investment in the energy sector of Nigeria have tended to
give comparatively significant attention to the conflict of interest between the state, civil
society or local
communities, and private business
especially multinational
corporations.30 Host community hostility to energy resource projects is gradually
becoming significant, if not already an issue of overwhelming importance in a country
like Nigeria, being a new generation of risk to energy resource financing.31 According to
Akpan, until recently, foreign (and sometimes local) investors rarely consider host
See Christopher Carr and Flavia Rosembuj, “Structuring and Financing Project” in Paul Q. Watchman
(ed) Climate Change- A Guide to Carbon Law and Practice (London, Globe Publishing Limited; 2008) at
39.
27
Yemi Oke, “Financing Solid Minerals Business in Nigeria: An Appraisal of the Socio-Political Aspects
of the Requirements of Bankability” in Legal Aspects of Finance in Emerging Markets (Durban, South
Africa: LexisNexis Butterworths, 2005) at 107-118.
28
Robert Pritchard, “Safeguards for Foreign Investment in Mining” in Bastiba, E.; Walde, T., and WardenFernandez, J., (Eds.) International and Comparative Mineral Law and Policy: Trends and Prospects (The
Hague: Kluwer Law International, 2005) at 73.
29
30
M.A. Mohamed Salih, Environmental Politics and Liberation in Contemporary Africa (Dordrecht:
Kluwer; 1999), at 1.
George S. Akpan, “Host Community Hostility to Mining Projects: A New Generation of Risk?” in
Bastiba, E.; Walde, T., and Warden-Fernandez, J., (Eds.) International and Comparative Mineral Law and
Policy: Trends and Prospects (The Hague: Kluwer Law International, 2005) at 311.
31
community hostility to energy resource investment potential hindrance to the success of
the projects.32 Therefore, where pre-financing issues like project bankability and risk
analyses are resolved in favour of energy resource financing, the next most significant
step is determination of the financing model and structure that best suits the project.
Energy Resources Financing
Generally, energy resources companies possess all the powers of a natural person
of full capacity pursuant to section 38 (1) of Companies and Allied Matters Act (CAMA)
including power to borrow money;33 and can borrow locally or from abroad like other
companies in the economy. However, where borrowing either local or internally relates to
a public institution like the Nigerian National Petroleum Corporation (NNPC), Nigerian
Gas Company (NGC) or National Electricity Regulatory Commission (NERC) which are
the main public (regulatory) institutions in the energy resource sectors- oil, gas and
electricity; two statutory provisions will, in addition to other relevant statutes, be
complied with, namely the Borrowing by Public Bodies Act,34 and the External Loans
Act35 among others.
A crucial issue in energy sector financing is the identification, analysis and
allocation of the risks the project may entail. Attendant risks in energy projects may
include exchange rate risk, completion risk, permitting risk, price risk, operating risk,
environmental risk, political risk, interest rate risk among others.36 Energy projects
generally have high initial costs. Without adequate financial incentives, investing in
energy sector in Nigeria might be difficult. In allaying investment-related fears,
unhindered transferability of investment yields or funds is guaranteed to investors under
32
33
34
35
Ibid. at 312.
See also Section 166 of Companies and Allied Matters Act (CAMA), Cap C 20 LFN, 2004.
See Borrowing by Public Bodies Act, Cap B10, LFN, 2004.
See External Loans Act, Cap E23, LFN 2004
See Konyi Ajayi, et. al., “Oiling the Wheel of Progress: Issues in Project Finance in West Africa” in
Legal Aspects of Finance in Emerging Markets (Durban, South Africa: LexisNexis Butterworths, 2005) at
3-19 at 10. Paper earlier delivered at the IBA Conference, 18-20 April, 2005 at the Ritz Carlton, Pentagon
City, Arlington, Virginia, USA.
36
the Nigerian law.37 However, it has been observed that in energy resources endeavors,
investors are wary of the booby trap incentives provided in the legislation to attract them
in making investment. According to a scholar:
“…An average investor knows that investment is easier
made than unmade. This leads to piercing through the
sometime deceptive incentives for a careful consideration
of the political, social and other factors that would make
investing in a country a reasonable business decision. It
makes good business sense to invest in a politically stable
and socially reliable country with little or no incentives
than embark on irrational and expensive decision of
investing under a turbulent and politically volatile
atmosphere on the guise of distorted, wooly “incentives”.38
Financing is crucial to realizing the Federal Government’s energy policy.39 In
funding electricity for instance, the Nigerian government has identified a number of
mechanisms including the Renewable Electricity Trust Fund, which aims to promote,
support and provide renewable electricity through private and public sector
participation.40 This entails construction of independent renewable electricity projects,
especially in rural and remote areas; establishment of domestic production of
technologies for the development and utilization of renewable electricity; provision of
resources for micro financing; support to research and development and construction of
pilot projects.41 Other sources of financing include equity, debt financing, grants and
micro finance in addition to private funding by way of Independent Power Project (IPP)
investment in the electricity sector in Nigeria.
37
See the Nigerian Investment Promotion Act, Cap N117 on incentive for foreign investment in Nigeria.
For example, s. 22 provides for unconditional transfer of funds through authorized agent while ss. 22 and
25 respectively provides for incentives for special investments and guarantees against any expropriation.
38
See Yemi Oke, supra note 28 at 113-5.
39
See Renewable Electricity Policy of the Federal Government of Nigeria, 2006.
40
Ibid.
41
See Ibid, at 17 para. 6.1.
Federal and State Governments in Nigeria often resort to the issuance of bonds
and other debt financing instruments for crucial projects like oil, gas and electricity.42 In
Nigeria, debt instruments like bonds, being market transactions, involve two forms of
marketing: primary marketing and secondary marketing. The former is by bringing new
issues into the market, while the latter is by trading same as securities after they have
been introduced on the floor of the Nigerian Stock Exchange.43
A bond is a debt security issued by a corporation or government in order to raise
money.44 A conventional bond consists of regular annual or semiannual payments of
interests known as coupon-payment and a final payment of the entire principal upon
maturity.45 Bond markets thrive on the integrity of the system. The socio-political
structure of Nigeria or the standing of the particular state government issuing the
instrument would likely determine the success or level of subscription of a particular
bond. This is one of the several overarching issues to be borne in mind in devising
strategies for attracting funding in the energy sector of Nigeria. Socio-political factor is a
distinct category of risk in financing oil, gas or electricity projects as it constitutes the
danger that government action or inaction would adversely affect the viability of the
sector in terms of cash flow generating capacity of the project among others.
Financing for the energy sector of Nigeria may also take the form of project
finance, or limited recourse financing. In case of default, recourse is to the project or the
project vehicle to recoup funds. The global demand for infrastructure has dragged project
42
The Federal Government of Nigeria uses a variety of securities including bonds in raising the capital
needed to finance projects. Like the Federal Government, State Government bonds made their debut into
the Nigeria Capital market in 1978 through the first (old) Bendel State N20m bond issued through NAL
Merchant Bank. It was a 10 year bond maturing in 1988. Ogun State issued its first two bonds in 1985
(N15m 12% loan stock) and in 1987 (N15m 121/2% loan stock). Debt instruments like bond issues (being
market transactions) involve two forms of marketing: primary marketing and secondary marketing. The
former is by bringing new issues into the market, while the latter is by trading same as securities after they
have been introduced on the floor of Nigerian Stock Exchange.
43
See for instance the Lagos State Bonds which primarily targets infrastructure development such as
electricity generation under the Independent Power Project (IPP) scheme.
44
In Welco Industriale S.P.A. v J.I. Nwanyanwu & Sons Enterprises (Nigeria) Limited (2005) 32 WRN 133
at 152, the Court of Appeal offered a judicial definition of a bond as “a contract under seal to pay money (a
common money), or a seal in writing distinctly acknowledging a debt, present or future.
45
See Randall Dodd, supra note 4 at 93.
financing from its hitherto restrictive arenas of mining and rail development in the
medieval ages to new sectors like electricity, oil and gas, pipelines, telecommunications,
transportation among others. However, for emerging markets of Nigeria and elsewhere,46
bankability of a project is central to making energy investment.47 This is because,
according to a scholar, the process of making investment decisions is as much
idiosyncratic as it is scientific. This explains why there are never any absolute or
universal standards of legal adequacy for foreign investment in the energy sector, as it is
always a question of what will satisfy a particular investor and whether the project will
satisfy the requirement of “bankability.48
Political risks also constitute as source of apathy to energy investment in Nigeria
and other sub-Saharan countries. However, the risk of political uncertainties appears
diminishing in Nigeria due to stable democracy. Nonetheless, at the international arena,
the risk of political uncertainties could be obviated by recourse to Political Risk
Insurance (PRI). It must however be noted that the premiums payable on such insurance
policy would be contingent on extent of risks to be underwritten. To augment domestic
inadequacies in terms of comprehensive insurance cover, (foreign) and local investors
making definitive investment in energy projects in Nigeria might be able to explore the
Multilateral Investment Guarantee Agency (MIGA) to provide political risk insurance
cover, as Nigeria is both a signatory and subscriber to the MIGA Convention.49
According to scholars, “the global demand for infrastructure has pulled the techniques of project
financing from the annals of mid-century mining and rail development. Having been tested for a decade in
the United States’ independent power industry in the 1980s, refined in Europe, the Middle East, Latin
America and Asia through the 1990s, these techniques are now being applied in a wide range of industries
including power generation and transmission, petrochemicals and oil and gas, pipelines, mining and
materials, telecommunications, transportation, and in ever more ‘emerging’ regions. See M.Tweed, Hadley
and McCloy, “A Legal Guide to International Project Finance” at 1, cited in Legal Aspects of Finance in
Emerging Markets (Durban, South Africa: LexisNexis Butterworths, 2005) at 6.
46
47
Yemi Oke, supra note 28 at 107-118.
48
Robert Pritchard, “Safeguards for Foreign Investment in Mining” in Bastiba, E.; Walde, T., and WardenFernandez, J., (Eds.) International and Comparative Mineral Law and Policy: Trends and Prospects (The
Hague: Kluwer Law International, 2005) at 73.
49
See Schedule A of to the Convention establishing the Multilateral Investment Guarantee Agency Act
1985, online at: MIGA http://www.gwb.com.au/gwb/news/mai/miga.html >, accessed 13 July 2008.
Public-Private Financing Model
Financing of energy projects posed relatively little problems in the past, as the
state usually owned the utility company, which simply financed its new projects from the
government balance-sheet with the support of lending institutions like the World Bank.
The Work Bank is not only involved in financing of energy resources, it has also been
involved in funding emissions from energy operations through its carbon finance
programmes.50 Generally however, global commercial realities favour investment models
that encourage synergetic funding through public-private sector collaboration or
partnership. This is to give the private players a better sense of belonging and higher
stakes through a flexible structure now referred to as Public-Private Partnership (PPP).51
The prospects of energy financing in Nigeria have shifted from the conventional
government interventionist approach to public-private, joint financing models due to
capital intensiveness of the energy sector. The PPP structures are strategic institutional
arrangements between public and private entities for energy investment particularly in the
electricity, liquefied gas projects or delivery of infrastructure services. The models are
seen as a way of raising additional funds for investments.52
In America for instance, the PPP’s are contractual relationship between the public
and the private sectors that brings together the strength of both parties to provide services
or infrastructure in a cost effective manner. 53In Canada, PPPs are contextualized in form
50
The basic concept of World Bank carbon fund is reduction of emission from energy and other projects
though generation and distribution of funds to entities that contributed to the fund on pro-rata basis. The
World Bank’s carbon finance programmes include carbon funds and facilities. Designated trust funds of the
World Bank have grown in number in the past years in response to the desire to help manage broad global
initiatives through multilateral partnership, such as the Global Environment Facility, the Heavily Indebted
Countries (HIPC) initiative, and the Global Fund to Combat AIDS, Tuberculoses and Malaria. See also S.
Smyth, “The Prototype Carbon Fund: a New Departure in International Trusts and Securities Law” (2005)
2:2 Sustainable Development Law & Policy, at 28.
51
See Kemela Okara and Tamuno Atekobo, “Private Sector Participation in Developing Public
Infrastructure
in
NigeriaThe
Legal
Framework”
on-line
at
<http://www.sskohn.com/downloads/infrastructureandprivate/01.pdf > accessed 23 July 2011.
52
See Jeffrey Delmon, Private Sector Investment in Infrastructure Project Finance (Kluwer Law
International, 2009) at page 7.
53
The ideals of PPPs within the American Concept and Definition are:
1.
The profit motive in Private sector does not necessarily force a reduction in
the quality of Public Service because of level of Government control.
2.
The Private Sector can become more accountable to the public because of
the same Government control. Jobs are not necessarily lost in a partnership.
3.
Private Sectors can often bring useful management skills, technology and
resources to a partnership.
of: “a cooperative venture between the public and private sectors, built on the expertise of
each partner that best meets clearly defined needs through the appropriate allocation of
resources, risks and rewards.”54 Therefore, the concept of PPPs in Canada captures
government involvement in public utilities and delivery of social services.
Nigeria has also embraced the PPP model for purpose of encouraging private
sector participation and partnership in the energy sector, both in the up-stream, midstream and down-stream sub-sectors. This option is both a matter of global commercial
trends and domestic economic realities, due to global financial meltdown that occasioned
dwindling energy prices and attendant budget constraints in Nigeria and elsewhere.
In some types of PPP, the government uses tax revenue to provide capital for
investment while running operations jointly with the private sector or under contract. In
other models, particularly the private finance initiative, capital investment is made by the
private sector on the strength of a contract with government to provide agreed services.
Government contributions to a PPP may also be in kind, through the transfer of existing
assets or structure like the national grid as in the case of private-public sector partnership
in electricity generation, transmission and distribution.55 In projects that are aimed at
creating public goods like in the infrastructure sector, the government may provide a
capital subsidy in the form of a one-time grant, so as to make it more attractive to the
private investors.56 In some other cases, the government may support the project by
providing revenue subsidies, including tax breaks or by providing guaranteed annual
revenues for a fixed period. A good example is the Electric Power Sector Reform Act
2005 (the Act) which provides a number of statutory incentives for energy investment.57
Scholars have argued that incentivizing investment could lead to negative effects like
See Saidu Njidda, “About Public-Private Partnerships (PPPs)” at <http://www.fpppn.org/aboutppp.html>
accessed 23 August, 2011.
54
See Canadian Council for Public-Private Partnerships: <http://www.pppcouncil.ca/aboutPPP_definition>
accessed 23 August, 2011.
55
See Tinsley, R. Advanced Project Financing (1st Edition) (London: Euromoney books, 2000). See also
Andrew H. Chen & Jennifer Warren “Unleashing Latent Potential in Africa: Removing the Barriers in
Financing Infrastructure” June 2006 at http://www.conceptelemental.com/chen-warren.pdf> accesed 23
August, 2011.
56
Chen and Warren, ibid.
57
See Electric Power Sector Reform Act 2005.
“pollution haven”, “regulatory chill”, the “race-to-the-bottom”58 and other phenomena
associated with competition.59 Beyond doubt, the need to attract foreign direct investment
(FDI) in Nigeria is one of the primary aims of its energy policy.60
In Nigeria, the Federal Government and some of the states have recently enacted
laws in the area of private sector participation in the development and maintenance of
public infrastructure. The Lagos State Roads, Bridges and Highway infrastructure
(Private Sector Participation) Development Board Law is one of such laws.61 Other laws
include the Lagos Water Sector Law and the Federal Government-sponsored
Infrastructure Concession Regulatory Commission (Establishment, etc) Act 2005.62 The
above enactments aimed at promoting privately financed resource and infrastructure
projects in line with the recommendations of the United Nations Commission on
International Trade Law (UNCITRAL) on model legislative provisions for privately
financed infrastructure projects.63
See for example T. Johnston, “The Role of Intergenerational Equity in a Sustainable Future: The
Continuing Problem of Third World Debt and Development” (1998) 6 Buffalo Environmental Law Journal,
pp 36-80, at 58; and Madeline Cohen, “A Menu for the Hard-Rock Café: International Mining Ventures
and Environmental Cooperation in Developing Countries” (1996) 15 Stanford Environmental Law Journal,
130 at 154. But see and compare David Wheeler, “Racing to the Bottom? Foreign Investment and Air
Pollution in Developing Countries”, (Paper Written for Development Research Group, World Bank, 2001)
at 5.
58
59
For detailed discussion and overview of literature on the issue of investment theories, see
“Environmental Issues in Policy-based Competition for Investment: A Literature Review”,
ENV/EPOC/GSP (2001), 11; A Report of the Organization for Economic Co-operation (OECD), 4 April
2001,
online:
OECD
<
www.oecd.org/findDocument/0,2350,en_2649_34313_1_119666_1_1_37465,00.html>, last visited on 20
July 2011.
See “Environmental Benefits of Foreign Direct Investment: A Literature Review ENV/EPOC/GSP
(2001), 10; A Report of the Organization for Economic Co-operation (OECD), 5 April 2001, online: OECD
< www.oecd.org/findDocument/0,2350,en_2649_34313_1_119666_1_1_37465,00.html>, last visited on 20
July 2011 for detailed discourse and review of literature on the environmental and other benefits of FDI
which seems to justify foreign investment in natural resources including mining, at 10-24.
60
61
See Lagos State Roads, Bridges and Highway Infrastructure (Private Sector Participation) Development
Board Law, No. 3 of 2005
62
63
See the Infrastructure Concession Regulatory Commission (Establishment, etc) Act 2005, supra note 2.
The UN General Assembly recommends the model law for due consideration by member states when
revising or adopting legislation on private participation in development and operation of public
infrastructure. See UNCITRAL model Legislative Provisions on Privately Financial Infrastructure Projects,
2004, at pages ix-x.
The Lagos State Roads, Bridges and Highway Infrastructure (Private Sector
Participation) Development Board Law64 represents a classical example of domestication
of the UNITRAL model law in Nigeria. The law provides a legal framework for private
sector financing of certain infrastructure, being the first time in Nigeria that any
government has enacted a law specifically to regulate private sector financing for
infrastructure development and maintenance.65 Further, though there may have been
private sector participation in the financing and provision of infrastructure especially in
the power sector by way of independent power projects 66, these were done without any
specific enactment. After Lagos, a regulatory framework was put in place by the Nigerian
Government through the enactment of Infrastructural Concession and Regulatory
Commission (ICRC) Act.67 The Act gives legislative and regulatory backings to the
various models of PPP initiatives being agreed and implemented by parties in the funding
of energy and other infrastructural projects in the country.68
64
Supra note 61.
See Kemela Okara and Tamuno Atekobo, “Private Sector Participation in Developing Public
Infrastructure
in
Nigeria.The
Legal
Framework”
on-line
at
http://www.sskohn.com/downloads/infrastructureandprivate/01.pdf > accessed 23 March, 2011.
65
66
The independent power projectors were executed primarily by the multinational oil majors in Nigeria.
These were done in part to utilize the huge gas resources that were being flared.
67
See Infrastructural Concession and Regulatory Commission (ICRC) Act, supra note 2.
68 Some of the frequently used PPP modes are as follows:
Management or Operation and Maintenance (O & M) Contract – where a private
entity provides some operation and maintenance services for a fee, usually based on
delivering satisfactory services. This may include isolated services or the whole of the
utility functions.
Affermage – where a private entity builds and/or refurbishes and operates a service
usually delivered directly to consumers, and the grantor finances any major capital
expenditure. The private entity generally collects tariffs directly from consumers.
Lease – where existing assets and/or land is leased to a private entity for construction of
new assets or refurbishment of existing assets to be used to provide services to a single or
small group of large off takers or directly to consumers.
Concession – where a private entity finances, builds and/or refurbishes and operates a
service usually delivered directly to consumers. The private entity generally collects
tariffs directly from consumers.
Divestiture – where the assets are sold to a private entity, which provides services
directly to consumers and collects tariffs directly from consumers.
Design-Build (DB): The private sector designs and builds infrastructure to meet public
sector performance specifications, often for a fixed price. The risk of cost overruns is
transferred to the private sector.
Design-Build-Finance-Operate (DBFO): The private sector designs, finances and
constructs a new facility under a long-term lease, and operates the facility during the term
of the lease. The private partner transfers the new facility to the public sector at the end of
the lease term.
Models of Energy Resource Financing
There are various options open to financing energy resources in Nigeria. This
paper focuses on options other than financing from equity capital, and singles out
derivatives and other debt financials given their sustainability and largely because they
represent off-balance-sheet financing. Debt financials is strategic in the development of
the energy sector both in public and private sector developments given their range and
flexibility, making them readily adaptable to meet the peculiar need of the sector.
Debt financials could be long and short term loans, mezzanine finance,69or
bonds,70 and they could be obtained from various sources local and foreign, including
commercial lenders, institutional investors, export credit agencies, bilateral or multilateral
organizations, bondholders and sometimes the host country government, state
governments or local government councils. Unlike equity contributions, debt
Build-Own-Operate (BOO): The private sector finances, builds, owns and operates a
facility or service in perpetuity. The public constraints are stated in the original
agreement and through on-going regulatory authority.
Build-Operate-Transfer (BOT): A private entity builds, operates and transfers
ownership to the Public Sector after some years of operation.
Build-Own-Operate-Transfer (BOOT): A private entity receives a franchise to finance,
design, build and operate a facility (and to charge user fee) for a specified period, after
which ownership is transferred back to the public sector.
Buy-Build-Operate (BBO): Transfer of a public asset to a private or quasi-public entity
usually under contract that the assets are to be upgraded and operated for a specified
period of time. Public control is exercised through the contract at the time of transfer.
Joint-Venture Operate (JVO): Public and Private Entities form joint venture equity and
the private entity operates the entity perpetually. JVs provide technical assistance and
capital which facilitate oil and gas investment.
Operation License: A private operator receives a license or rights to operate a public
service, usually for a specified term. This is often used in projects, solid minerals and oil
& gas drilling.
Outsourcing: Public entities usually give out non-core operations of its activities to
private entity to handle.
Finance only: A private entity, usually a financial services company, funds a project
directly or uses various mechanisms such as long-term lease or bond issue.
69
Mezzanine contributions for project finance transactions can be obtained from shareholders, commercial
lenders, institutional investors and bilateral and multilateral organizations. Similarly, private equity funds
can play an important role in providing mezzanine financing. The nature of intervention by a private equity
fund will depend largely on the nature of the designated fund.
70
Bond financing allows the borrower to access debt directly from individuals and institutions, rather than
using commercial lenders as intermediaries. The issuer (the borrower) sells the bonds to the investors. The
lead manager helps the issuer to market the bonds. A trustee holds rights and acts on behalf of the investors,
stopping any one investor from independently declaring a default. Bond financing generally provides lower
borrowing costs, if the credit rating for the project is sufficiently strong. See Randall Dodd, supra note 4 at
93-4.
contributions have the highest priority amongst the investors. Repayment of debt is
generally tied to a fixed or floating rate of interest and a programme of periodic
payments. As with equity, there are many institutions involved in debt financing of the
private-public sector and more importantly the energy projects. The range and flexibility
of debt financials make it suitable and preferable for the purpose of energy financing.
Bonds as a Debt Instrument
A bond is a debt instrument issued for a period of more than one year for the
purpose raising capital by borrowing. Governments, corporations and other sector players
could issue, list and sell bonds for the purpose of energy financing, after compliance with
the regulatory procedures.71 Generally, a bond is a promise to repay the principal at a
specified date (maturity).72 Some bonds do not pay interest (coupons), but all bonds
require a repayment of the principal.73 Bonds are usually classified into different
categories based on tax status, credit quality, issuer type, maturity and secured/unsecured.
But for the purpose of this paper, broad categorisation of bonds into two, as conventional
bonds and commodity bonds is preferable for the purpose of analysing their essential
features in energy resources financing in a developing country like Nigeria.
Conventional and Commodity Bonds:
A conventional bond is tied to the repayment of the principal and periodical
coupon payments. A conventional bond consists of regular annual or semi-annual
payments of interest and a final payment of the entire principal upon maturity.74
71
For detailed procedure for the issuance of bonds see Investment and Securities Act (ISA) Cap 124, LFN
2004 and the Securities and Exchange Commission (SEC) Regulations, 2005.
72
See Randall Dodd, supra note 4 at 93.
73
Ibid.
74
Ibid.
Commodity bonds:
A commodity bond75 is different from a conventional bond because it is structured
so that either its coupon payments or principal payment is adjusted according to the price
of a specific underlying commodity. Holder of commodity bond is entitled to be paid the
principal or interest, as determined by the price of the underlying commodity.76 The price
of conventional bonds is determined by the current value of all the future coupons and
principal payments. In practice, since future payments are worth less than current
payments and payments in the far future are worth less than those in the near future, the
bond’s value is determined by properly discounting the future payments so as to arrive at
their present value.77
Commodity Bonds and Price Volatility:
One of the merits of public-private sector financing of energy resource projects
through debt financials is that bonds may be structured solely for the purpose of
protecting a commodity from price volatility and fluctuations, especially in a resourcedependent nation like Nigeria where price volatility or fluctuation could spell doom of
the nation’s economy. Commodity bonds are particularly relevant in energy financing for
the peculiar need of curtailing price volatility. There are two types of commodity bonds:
commodity-indexed bonds and commodity-linked bonds.
Commodity-indexed bond is a form of commodity bond in which coupon
payments or principal payment are adjusted to reflect specific underlying fluctuations in
commodity price.78 Thus, the borrower will obligate to repay less money at maturity if
prices are low than if prices are high, as in fluctuations in oil prices from developing
country borrowers like Nigeria. The implication of the above is that if the price rises,
75
Commodity bond are distinguishable from conventional bonds in the sense that their coupon payments
and/or principle are adjustable depending on the price of the underlying commodity. Ibid at page 93.
76
Underlying commodity could be crude oil, liquefied natural gas, gold, wheat, foreign or domestic
currencies, treasury bonds, company stock, among others.
77
Pricing of bonds or determination of bond prices depends on whether the bond has an underlying
commodity or is commodity-indexed. The price of the underlying commodity would be determined by the
common forces of demand and supply, while the pricing is determined by market forces. Pricing of
conventional bonds is determined by taking other variables into consideration, such as cash-flow.
governments will be liable to pay more, which obligation could be easily met since the
government makes more money for its oil exports due to the oil price increases.
Commodity-linked bonds could provide a potential means for less-developed
countries (LDCs) to raise money on the international capital markets, rather than through
standard forms of financing. The issuing of this type of bond could provide an
opportunity for commodity-producing country like Nigeria to hedge against fluctuations
in their export earnings. The value of a commodity-linked bond increases as the price of
the commodity indexed to the bond rises.
Commodity bonds are suitable for raising money to finance energy in Nigeria due
to the fact that oil prices are extremely volatile. In the past few years, the world seems to
have entered into an era of higher crude oil price volatility. Many arguments have been
put forward to explain the extreme movements in oil prices,79 some hinged it on the fact
that OPEC has no monitoring system to oversee production and shipments and more
importantly no punishment mechanism to deter cheaters.80
Nature of a Bond
By nature, a bond in law of finance,81 is a debt security in which the authorized
issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay
interest (the coupon) and/or to repay the principal at a later date, termed maturity. It is a
formal contract to repay borrowed money with interest at a predetermined, fixed period.
78
For instance, if an oil commodity bond might have its principal set to equal 1000 barrels times the market
price of oil at the time of maturity. At $25 a barrel, it amounts to a $25,000 bond. If the price of oil were to
fall to $20, then the borrower who issued the bond would only have to repay $20,000.
79
Scholars argue that high oil price volatility is due to the fact that “the thermostat of a competitive market
has been turned off” and then predicts that “price volatility will continue higher than in other markets so
long as price is fixed high by collusion in the cartel. See Randall Dodd, supra note 3 at 89-90. See also
Garcia, P.A.M., “OPEC in the 21st Century: What Has Changed and What Have We Learned” (2005)
Oxford Energy Forum, Issue 60, Oxford: Oxford Institute for Energy Studies.
80
See Zakir Hussain, “Oil Price Volatility and India’s Energy Security: Policies and Options” Institute for
Defence Studies and Analysis (IDSA), Strategic Comments on January 09, 2009. See also Adelman, M.A
“Oil Prices: Volatility and Long Term Trends”, MT Centre for Energy and Environmental Policy Research,
August 1999 and Weston, P and MR Christiansen, “OPEC: Market Stabilizer or Disruptive Influence”
(2003) The Economist, published 29 May, 2004.
81
In finance law, bond is a form of debt security otherwise called debt financial.
A bond is like traditional loan. The issuer is the borrower; the bond holder is the lender.
The coupon is the interest payable loan.
Bonds are a means of providing the borrower with external funds to finance longterm investments like energy resources of gas, petroleum or electricity. It may also be
used for other purposes as in the case of government bonds raised or issued to finance
expenditure of the government. There is a peremptory obligation to repay bond at fixed
intervals over a period pre-fixed. Aside from insulating the project actors against personal
liabilities, debt financials by way of bond and other structures constitute sustainable
funding alternatives to energy resources, particularly in the petroleum, gas and electricity
sub-sectors. One of the benefits of bond and other debt instruments in financing energy
projects structured in public-private partnership is to curtail the incident of price
volatility. Bonds are pre-agreed and repayment of the coupon is, in most cases,
irrevocably guaranteed.82 This makes the project self-sustaining and is a major
consideration in funding energy resource projects.83 Thus, when fully operational, a
project could also issue bonds in its corporate name; that is in the name of the project
vehicle otherwise called “Special Purpose Vehicle- SPV84 as highlighted below.
Highlights of Project Finance:
Project finance is the financing of long-term infrastructure and industrial projects
like energy resources, based upon a complex financial structure where project debt and
equity are used to finance the project, rather than the balance sheets of project sponsors.
Usually, a project finance structure involves a number of equity investors, known as
sponsors, as well as a syndicate of banks that provide loans to the operation. The loans
are most commonly non-recourse85 loans, which are secured by the project assets and
82
For example, where coupon is guaranteed by ISPO- Irrevocable Standing Payment Order from the
borrower issued against project account(s) or allocations, as in the case of government issued bonds by the
federal, states or local governments.
83
Project finance is the financing of long-term infrastructure and industrial projects like energy resources,
where project debt and equity are used to finance the project, rather than the balance sheets of project
sponsors.
84
See Clifford infra note 85. See also Tinsley, infra note 86.
85
Clifford, C. Project Finance (London: IFR Books, 1991).
paid entirely from project cash flow, rather than from the general assets or
creditworthiness of the project sponsors. The financing is typically secured by all of the
project assets, including the revenue-producing contracts.86 Project lenders are given a
lien on all of these assets, and are able to assume control of a project if the project
company has difficulties complying with the loan terms.87International project finance is
particularly beneficial to the project sponsor and investor as investment risk is shared.
In energy resource financing through project finance structure, the risk of the
project does not apply to previous businesses of the project sponsor and the issue of
collateral is not of primary concern to the lender as, most times, the project jurisdiction is
different from the location of the lender.88 Generally, a special purpose entity is created
for each project, thereby shielding other assets owned by a project sponsor from the
detrimental effects of a project failure. As a special purpose entity, the project company
has no assets other than the project making capital contribution commitments by the
owners of the project company sometimes necessary to ensure financial stability of the
project. Traditionally, project financing has been most commonly used in energy, mining,
transportation, telecommunication, and for public utility industries.
In case of non-recourse or limited recourse,89 the loans are made directly to a
special purpose vehicle. Lenders rely on the cash flow of the project for repayment of the
debt; security for the debt is primarily limited to the project assets and future revenue
stream. Project finance technique relies on bankability of the project and projected cashflow as collateral. This is one of the potent arguments that, in actual fact, there are nonrecourse lending; only a difference in motive and extent of recourse.90 Energy resource
financing enables both private and public equity partners or investors reduce substantially
86
Tinsley, R., Advanced Project Financing (1st Ed.) (London: Euromoney books, 2000).
Banani, D., “International Arbitration and Project Finance in Developing Countries: Blurring The
Public/Private
Distinction”
on-line
at
www.bc.edu/schools/law/lawreviews/metaelements/journals/bciclr/26_2/08_FMS/htm > accessed 13 June, 2011.
87
Richard, A. et al., “Using Project Finance to Fund Infrastructure Investments” Journal of Applied
Corporate Finance 9 (3), 25-39, also on-line at http://blackwell-synergy.com/links/doi> accessed 13 June,
2011.
88
An agreement will be classified as “non-recourse” if the factor assumes the credit risk on debts purchased
by it. This means that repayment of a particular debt cannot be recovered from the customer. The factor is
not entitled to seek repayment of the relevant amount from the trader. See Ajayi, O. “Soldier Ants in
rugged Terrain: An Overview of Natural Resource Project Finance” in Legal Aspects of Finance in
Emerging Markets (Durban, South Africa: LexisNexis Butterworths, 2005), at 85.
89
90
In actual fact, recourse of sort exits. As against recourse to project sponsors, in project finance, resource
is to the project. The lender makes recourse to the cash-flow of the SPV for repayment.
their equity investment through debt leverage and exposure to liability in energy project
financing, thereby reducing total project cost.
Derivatives and Energy Resource Financing
While bonds are used to manage price risk in the oil and gas industry, the use of
derivatives to hedge the commodity price volatility91 is another financial mechanism to
strengthen energy resource financing in Nigeria, being a more effective and less
expensive device. A derivative is a financial instrument which value is derived from
another (underlying) asset, such as an equity, bond or commodity.92 Derivative products
are a generic term used to describe future options, swaps and various other similar
transactions.
Apart from interest swaps, most derivative contracts are structured as
contracts for differences- the difference between the agreed future price of an asset on a
future date and the actual market price on that date.93 The main types of derivative
contracts are forward, future, option and swap derivatives.
Forward Contract is a derivative contract in which the terms are very similar to a
cash-and-carry agreement, except that delivery and transfer of ownership of the
underlying commodity is in future. In a forward contract, the credit worthiness of both
parties is critical to performance of the contract.94
Futures Contract on the other hand, is a contract under which one party agrees to
deliver to the other party on a specified date (the “maturity date”) a specified asset at a
price (the “strike price”) agreed at the time of the contract and payable on the maturity
date.95 A futures contract is similar in intent to a forward contract, but has some
91
See generally James A. Daniel, “Hedging Government Oil Price Risk” IMF Working Paper 2001.
See generally Randall Dodd, “Primer: Derivatives” in Financial Policy Forum (Washington, DC, 2002),
on-line at: http://www.financiaalpolicy.org/dscprimer.htm > accessed July 12, 2010.
92
Ibid. See also Randall Dodd, “Derivatives Instruments” in Financial Policy Forum (Washington, DC,
2004), on-line at: <http://www.financiaalpolicy.org/dscintruments.htm> accessed July 13, 2010.
93
94
Forward contract derivatives like futures, are obligations to buy or sell a specified quantity of named
items at a specified price at a time in future. The difference is that future contracts are standardized,
publicly traded and cleared through a clearing house.
95
See Randall Dodd, supra note 4 at 95-9.
important differences. A future contract has standard terms and is traded on organised
exchanges. It specifies trading a particular quantity of the underlying commodity at a
particular price, at a particular time. Although the contract can be settled at expiration in
the physical commodity, it is more normally settled in cash through the exchange.
Options Contract gives the owner the right, but not the obligation, to buy or sell
quantities of the underlying asset at a fixed price.96 The two basic options are calls and
puts. Not only are options available on futures contracts directly linked to the underlying
physical commodity, but they are also available on critical spreads or differences that
affect profit.
Swap Contract complements the above forms of derivatives. It allows the two
parties to the agreement to exchange streams of returns derived from the underlying
assets. Ownership rights, if any, remain intact and the physical asset is not exchanged.97
For example, in energy resource financing; a refiner and an oil producer might agree to a
five year contract with scheduled periodic payments. The payment, which might either be
paid out or received by the firm, is equal to the difference between a negotiated fixed
price and the currently prevailing spot price for a given amount of oil.98 If the spot price
is above the fixed price, the producer pays the refiner; if the spot price is below the fixed
price, the refiner pays the producer the difference. The intent is to ensure that both parties
to the contract have predictable, stable costs and revenues.
Managing Risk with Derivative Contracts
Unlike a stock or securitized asset, a derivative contract does not represent an
ownership right in the underlying asset. The asset that underlies a derivative can be a
physical commodity like crude oil, gold, wheat, foreign or domestic currencies, treasury
96
Ibid, at 98.
97
Swap contracts allow the two parties to an agreement to exchange streams of returns derived from the
underlying assets. Swaps represent some of the best, and most common, examples of over-the-counter
(OTC) contracts. See Randall Dodd, supra note 3 at 95. See also Robert L. “Pirog’s Derivatives, Risk
Management and Policy in the Energy Markets” published on May 16, 2003
98
See Randall Dodd, supra note 4 at 98.
bonds, company stock, indices representing the value of groups of securities or
commodities, a service, or intangible commodity among others.99 What is critical is that
the value of the underlying commodity or asset be unambiguous; otherwise, the value of
the derivative becomes ill-defined. When used prudently, derivatives are efficient and
effective tools for reducing certain risks through hedging.100
Hedging through Forward Contracts is a simple extension of cash or cash-andcarry transactions. In oil and gas industry, an oil refiner may enter into forward contracts
to secure crude oil for future operations, thereby avoiding both volatility in spot oil prices
and the need to store oil for extended periods. Forward contracts vary with the parties
using them. However, they all tend to deal with the same aspects of a forward sale. All
forward contracts specify the type, quality, and quantity of commodity to be delivered as
well as when and where delivery will take place. In addition, forward contracts set a price
or pricing formula. By setting a price, the buyer and seller are able to reduce or eliminate
uncertainty with respect to the sale price of the commodity in the future.
Hedging through Futures Contracts
Forward contracts have problems that can be serious at times.101 Unlike a
forward contract, buyers and sellers of futures contracts deal with an exchange, not with
each other. Futures contracts are firm commitments to make or accept delivery of a
specified quantity and quality of a commodity during a specific month in the future at a
price agreed upon at the time the commitment is made. Futures contracts trade in
99
Ibid.
100
Ibid. See also Philip R. Hood, “Title Finance, Derivatives, Securitization, Set-off and Netting” at 207,
para. 15-1, James A. Daniel, “Hedging Government Oil Price Risk” IMF Working Paper, November 2001.
101
First, buyers and sellers (counterparties) have to find each other and settle on a price. Finding suitable
counterparties can be difficult. Discovering the market price for a delivery at a specific place far into the
future is also daunting. Second, when the agreed-upon price is far different from the market price, one of
the parties may default (“non-perform”). Third, one or the other party’s circumstances might change. The
only way for a party to back out of a forward contract is to renegotiate it and face penalties. Like a forward
contract, a futures contract obligates each party to buy or sell a specific amount of a commodity at a
specified price.
standardized units in a highly visible, extremely competitive, continuous open auction. In
this way, futures lend themselves to widely diverse participation and efficient price
discovery, giving an accurate picture of the market.
Hedging reduces exposure to price risk by shifting that risk to those with opposite
risk profiles or to investors who are willing to accept the risk in exchange for profit
opportunity. Hedging with futures eliminates the risk of fluctuating prices, but also means
limiting the opportunity for future profits should prices move favourably.102 Hedging
through derivatives in the oil and gas industry is generally through the use of futures,
forward or swap contracts. Both futures and forward contracts are an obligation to buy or
sell a specified quantity of a specified item at a specified price at a specific time in the
future. The difference is that future contracts are standardized, publicly traded, and
cleared through a clearing house.
Hedging through Options:
If the government does not wish to use either futures or forward contracts and
thus give up potential gains from a sudden rise in oil prices, it can use options instead to
buy itself “insurance” against a drop in prices. With options, the government pays a
premium to the option seller or “writer” that guarantees a minimum price for the oil.103
This protects the government on the downside, and the investor would absorb the loss.
The advantages of hedging through derivatives are that it is inexpensive. It also allows
the government to borrow through conventional debt instruments instead of paying a
premium to tap into smaller pools of investors who are willing to invest in commodity
102
A hedge involves establishing a position in the futures or options market that is equal and opposite to a
position at risk in the physical market. For instance, a crude oil producer who holds (is "long") 1,000
barrels of crude can hedge by selling (going "short") one crude oil futures contract. Hedges work because
cash prices and futures prices tend to move in tandem, converging as each delivery month contract reaches
expiration.
103
For example, a government may determine that it will run into serious financial difficulties if the price
of oil were to drop below $25/barrel. The government would hedge against this possibility by buying a “put
option” with a strike price at $25/barrel. If the price remains above $25, then the option is not exercised; if
the price falls below $25, then the options writer would pay the difference between $25 and the lower
market price. See Randall Dodd, “The Structure of OTC Derivatives Markets” (2002) 9:4 (1) The
Financial, vol. 9, also available on-line at: <http://www.financiaalpolicy.org/dscprimer.htm> accessed 23
July 2005.
bonds. The disadvantage is that futures contracts give up the gains of future price
increases in energy resources. Regrettably, the Nigerian Investments and Securities Act
(ISA)104 does not have sufficient provisions to accommodate the various types of
financial instruments in the derivative market. Due to this gap, the Nigerian oil and gas
industry is left at the vagaries of price volatility in the international oil and gas markets.
Conclusion:
Energy as a prerequisite for economic growth and development is globally
acknowledged. As Nigeria strives to stimulate increased private sector investment in the
energy sector of oil, gas and electricity; this paper suggests gap-bridging policies in
public-private partnership financing of the energy sector, through the adoption of more
sustainable alternatives like derivatives and other debt financing options. It contends that
a whole range of financial re-structuring is inevitable in the energy sector to create
sustainable funding alternatives through debt financials or instruments. This becomes
inevitable as the bond market in Nigeria is underdeveloped unlike other countries. A
derivative market is also technically non-existent in the country, to say the least. Usage of
debt financials, as those explored in this paper, has not been successfully in Nigeria,
particularly to stimulate increased private sector involvement in the energy sector. This
paper therefore concludes that, it is expedient for appropriate legal, regulatory, policy and
institutional frameworks to be put in place for the development of debt financials like
bond and derivatives markets to stimulate increased private-public sector financing of
energy resources in Nigeria.
------------------Yemi Oke
104
See Investments and Securities Act (ISA), Cap 124 LFN 2004.