This overview was funded by PAMIGA
As the installed base of Pay As You Go solar companies in East Africa surpasses 1,000,000 households this form of consumer financing has come to dominate discussions of solar energy equipment lending. Previous growth strategies of working through partnerships between MFIs and non PAYGO solar companies have generated far less access over a longer timeframe. However, while PAYGO companies are currently successful as stand-alone companies they face difficult growth hurdles unless they can match costs of funding at bank levels, borrow in local currency, and negotiate a light touch approach to inevitable regulation. The early competitive advantage of running a dual finance and distribution model will be eroded as agency banking models are adopted by microfinance and other banks and transaction costs are driven sharply down. Governments and large scale multilateral funding programs seeking to achieve massive scaling of energy access with financing need to encourage a new partnership model where MFIs embrace fully the potential of digital finance and become expert at large scale vendor financing. The best allocation of resources is where MFIs handle credit while PAYGO solar companies provide distribution and manage the software interface for payments and equipment control.
The Pay As You Go Solar business model represents a breakthrough in energy access and equipment financing. The combined portfolios in sub Saharan Africa are already in excess of 1,000,000 households less than 10 years after launch and continue to grow.
Connected equipment provides on/off control of equipment and substantially reduces equipment risk. Connectivity also provides valuable data about usage which improves portfolio management and feeds into credit scoring models. The ‘airtime’ model for loan repayment is cheap, flexible and enables matching of repayments to pre-existing household energy budgets, even down to daily instalments. Equity and debt financing has crowded in to the few companies that have successfully deployed the model to date.
Affordable access to electricity through the medium of PAYGO solar has huge potential to expand – so how can this best be supported beyond the crowding in of equity and debt to a limited number of start-ups? This short piece looks at some of the obstacles to massive and how to overcome them. In particular it proposes a revised role for MFIs to engage with the technology and play a fundamental role in expansion.
2. PAYGO is Transformational for Equipment Lending
Pay As You Go models for the purchase of [solar] equipment combine the supply, service and financing of solar equipment in the same company. What takes this beyond classic consumer financing arrangements such as car financing is connectivity. Solar equipment is under the control of the PAYGO company until fully paid. Various technologies from Bluetooth to mobile phone allow a two way data exchange between the equipment and the PAYGO operator. In turn data can be managed to enable control of the equipment, switching it off when instalments payments are not made, thus brining the mobile phone ‘airtime’ model to solar. Where mobile money is available, payments can be made in very small amounts at a very high, even daily frequency.
Connectivity: The ability to turn off the equipment when a customer does not pay has substantially reduced the downside of equipment risk while adding upsides of better screening and information about usage. In the absence of cost effective repossession, disabling the equipment is a powerful message to the borrower that default has consequences. Switch off happens immediately a payment is missed and is therefore much more effective than negotiation over days and weeks that is typical of a bank led collections process. With solar, but also with any income generating asset, the loss of the benefit of light is a powerful incentive to resume payments in the very short term
Data: Connectivity allows data to flow from software platform to equipment and vice versa. Data flowing to the equipment controls not only the ‘on/off’ state but can be programmed to achieve far more. Most notably it can control the operation of the equipment in direct proportion to the payment made – just as airtime on a mobile phone. Data flows the other way, from the equipment back to the software management platform communicate how the equipment and even its various components are working. Information about usage aids proper management and maintenance of the system. This allows a customer service function to help rural households get the best from their equipment without the need for a visit from a technician. Data collected about the installed base and how it is actually used by consumers allows for better design by manufacturers. Data about customers combined with equipment usage feeds credit scoring models, pricing and marketing
Mobile Money: As mentioned above data and connectivity together allow equipment usage to be tied exactly to the amount paid by the customer. Mobile money, or mobile banking apps bring a critical third element to bear which is the payment in very small amounts, at very low cost. The affordability issues of paying for a $100 system are solved only in part by turning this into 12 payments of eg $10 per month. For a rural household finding and saving $10 is a challenge of itself. Apps that allow payments in very small amounts can match the actual spending on eg kerosene, candles and batteries, so that no ‘saving’ is required. Payments for solar energy can be made at the same frequency and in the same amount as payments for previously used energy sources.
The triple effect of connectivity, data and low cost micropayments are what take PAYGO consumer financing models into breakthrough territory from a sales and customer acquisition point of view. However, the scaling of a company goes beyond a successful product and customer interface
3. How MFIs Contributed to the Emergence of PAYGO
Financial inclusion and energy access have been the focus of government and international development lending and support for over two decades. They overlap in programs that seek to use microloans to enable rural households to purchase solar equipment to replace kerosene and achieve basic levels of electricity provision. The rationale for the involvement of MFIs in solar lending includes their presence in rural communities; their social mission to improve the lives of their clients; their core activity of lending and their access to social funding.
However MFIs have not developed substantial activities in solar lending in Sub Saharan Africa.
- The cost/quality equation of solar equipment has only reached an affordable level in the last 5 years. Prior to this good quality equipment was too expensive and poor quality equipment did not last long enough for loans to be recovered without equipment failure causing collections issues. Equipment risk has been too high for MFIs
- Equipment financing requires a formal partnership between two completely different types of company – a bank and a technology distribution company. Without strategic intent on both sides to a systematic approach of shared customer acquisition, customer service and collections, significant volumes cannot be achieved. Where MFIs have tried to create and run distribution themselves, they have found the second business model too different from their core business to manage effectively
- The transaction costs for both financier and supplier have high and can only be reduced through scale and good management. Suppliers must be able to source, deliver and support equipment across large territories and over a long period of time. Banks must be able to make sufficient margin when repayment amounts are small and disproportionately expensive to process
The cumulative effect of poor experience over more than a decade has made MFIs and banks uninterested to engage at a time when digital finance was transforming the model for solar lending. When new entrants to solar distribution sought partnerships from banks to launch PAYGO models they encountered very little understanding and no enthusiasm. This contrasts with the early interest of the mobile network operators who recognised the transformative potential of solar powered phone recharging and who moved quickly to make partnerships in Kenya, Uganda and other markets.
As a result new PAYGO companies set out to understand and incorporate the financing challenge of large scale solar distribution in house. By combining connectivity, data and mobile money they created a consumer financing model that exists in the digital finance space and outside the regulated activities of banks and MFIs.
In retrospect MFIs have been critical to the development of PAYGO. Their absence from the market has left a gap that others have filled.
4. There are Real Barriers to Scaling Stand Alone PAYGO
There is exuberance at the early success of solar PAYGO business models. In December 2016 Lumos in Nigeria announced $90MM of investment to roll out this business model in Nigeria based on the potential market in Nigeria, its partnership with MTN, its technology platform and the track record of its founder in running technology businesses. As with other companies in the sector it highlights the sales and technology aspects and downplays the financial service elements. However, a company that plans to finance multiple millions of customers cannot long avoid the realities of vendor finance – cost of funds, credit risk management, regulation and currency risk where funding is raised in dollars and euros when customers will be repaying in naira.
Cost of Funding: Small companies pay more for financing than larger companies. Commercial companies unless they have a ‘cash cow’ in their group, generally borrow higher than banks and MFIs that can leverage customer deposits. In addition the market will price in a premium if it feels that it is operating a credit based business without the systems and management appropriate to the activity as found in a bank or MFI. If banks and MFIs get into the business of solar lending at scale, they will have a sustainable and long term advantage of lower cost of funding.
Credit Risk Management: Equipment financing when done ‘in house’ is based on a tension between adding customers and collecting from them – between the short term and the long term. Financing makes the acquisition of customers easier, but the company only survives if it can collect all the payments due. Losses must be covered, and provisions push up the price. It is easier to create an installed base than to collect all the monies due over 2 or 3 years. While software and connectivity are new tools for managing this tension, ultimately management teams must embrace and include credit risk management into their core strategy and competence. In the global sector of vendor finance far fewer distribution companies achieve this than choose a partnership route where credit management [and financing] is outsourced to a bank
Regulation: The regulation of vendor financing in Africa is less well developed than in in other markets. While it is true that the risk of credit losses in companies that retain financing in house is ultimately borne by the shareholders and lenders, there is an overarching risk of abusive practices such as complex and predatory pricing, and upgrades that prolong hugely the indebtedness of the customers. At present PAYGO companies are not subject to regulation and are seeking to preserve this situation by claiming that they are engaged in ‘credit sales’ or rentals rather than in financial transactions such as leasing, hire purchase or indeed lending. As their scale grows it is unlikely that this situation will remain unchanged, particularly given the support from multilateral development organisations that promote fair financial inclusion. The adjustment when it comes will have a price and an administrative effect as PAYGO companies adjust their models to what banks and MFIs already do
Currency Risk: PAYGO companies are raising money mainly in dollars and euros, but have ever larger customer bases paying in local currency. In uncertain economic environments this results in a mismatch where at best profitability is impacted, and at worst loans cannot be repaid in full and the company defaults. Generally banks and MFIs are better matched due to their access to funds in local currency
In summary, the initial exuberance of a sector that has defined an exciting and important way to finance solar equipment must be balanced with a view on how they are positioned to deal with the medium and long term challenges of funding, credit risk management, regulation and currency risk. Distribution is a short cycle business, and financing is a long cycle business. Doing both of these in the same company requires a level of management skill that goes beyond sales and technology. Globally the vendor finance sector has delivered scale more through partnership than though on stop shop distribution finance companies.
5. Partnership … but not as we have known it
Despite the unpromising start to partnerships between the financial sector and solar distribution companies – even to the extent of solar companies going it alone and creating the PAYGO model, a future restructured partnership seems to promise the best long term outcomes for clients and for both PAYGO companies and banks.
The barriers to partnership in the past were very real for banks, just like the barriers to future scaling for PAYGO companies are also very real. While it is possible for a PAYGO company to become a large scale, well funded, regulated fully integrated distribution and finance company, it hard to see this being the dominant model in 5 years. Investors will become more knowledgeable about the true embedded costs and will price their investments accordingly. Some PAYGO companies will get the sales/credit loss balance wrong and will fail.
More compellingly a positive incentive to partner with banks and MFIs will emerge. Financial institutions will catch up with digital finance developments and become much more effective at the finance ‘side’ of the vendor finance equation. Commercial PAYGO companies will look at the challenge of scaling PAYGO across SSA as a dual function company, and they will conclude that a partner that can offer a cost effective and integrated solution for the funding and credit activities frees them up to concentrate on expanding their footprint and bringing new products to market.
The partnerships of the future will be different, and there will be fundamental requirements for banks/MFIs before they can be considered ready. Some of the requirements:-
- Hugely expand mobile banking
- Engage fully with digital finance encompassing substantial reductions in transaction costs that can be passed on to end users
- Catch up with new credit assessment techniques based on large data analysis and behavioural factors
- Lend based on cost savings and embrace equipment control in place of collateral
- Become expert at partnership with PAYGO companies
- Develop a PAYGO offer that is compliant under Islamic finance principles
The new partnerships will have to explore which tasks should sit in which organisation. Both PAYGO and new digital finance enabled banks will both be software and data fluent, so potentially either could manage the platform that controls payments and equipment function. The value of data generated by payments and by equipment needs to be allocated through negotiation. Differences in initial scale and network need to be accommodated. In summary a detailed and serious process of match making and partnership will need to be defined to marry separate but utterly complimentary activities and organisations.
But in the short term, banks and MFIs need to make the strategic leap and commit resources to this enormous market, and supporters need to encourage them.