The first Israeli project financing to be funded entirely by international banks, on November 11 the Hadera desalination plant secured Eu331 million from Calyon, Banco Espirito Santo and the EIB – and at a discount of around 50bp compared to local bank offerings.

The major international involvement signifies both a reduction in the perceived political risk of Israel and a new level of sophistication in the way Israel is managing PPP.

Israel's inauspicious start to PPP was the NIS1 billion ($260 million) Carmel tunnel project. Following delays due to difficulties getting statutory building permits, in August 2002 Discount Bank declared it was to withdraw from the financing agreement it had signed in 1999. An enforcement order from the Tel Aviv District Court obligated Discount Bank to the project, but the delays proved costly to the state; concessionaire Carmelton demanded a reduction in royalty payments due to the state, from NIS267 million to NIS167 million. Tender documentation took too long to draw up, risk allocation was handled badly and tenders were cancelled three months after being awarded.

On the upside, the chaotic deal spawned some radical PPP reform. Standardization of tender documentation and concession agreements has made the tender process much quicker. Risk allocation is distributed between the public and private sector in ways that play to the strengths and weakness of each party – the government typically takes political, force majeure and geological risk, while the private sector typically takes cost, timetable, quality and design risk, with demand risk shared. Guarantees against tender cancellations are also now millions of shekels stronger.

Post-Carmel Israel has since had a succession of large, successful PPP projects: the $1.35 billion Cross Israel highway, the $250 million Ashkelon desalination plant, the $350 million Jerusalem light rail and the $360 million Highway 431.

International lender interest has always been elusive, however. A $250 million tranche of the Cross Israel Highway was lead-arranged by Canadian Newcourt Capital, to be syndicated to the North American market, but following the intifada of 2000, international interest in Israel disappeared for five years. The Highway 431, closed in July 2006, saw the first signs of renewed international bank involvement in Israel, with HSBC providing a NIS419 million 2.5-year bridge loan.

International lenders return

The reason international banks are being drawn back to the country is that Israel's credit rating is strong (currently at A- with a positive outlook from Moody's, and recently upgraded by Standard & Poor's to A with a positive outlook) on the basis of a track record of never defaulting – proof that any government support for projects is solid.

And although terrorist attack is not treated as force majeure as in other markets, it is heavily guaranteed against by a compensation fund that covers both destruction of property and partially covers interruption to revenue streams.

The Israeli government is also keen to source funding from the global banks. General Director of the Ministry of National Infrastructure, Hezi Kugler, describes the international banks as bringing "sophistication" to the country's project financing. The past project finance lending duopoly, comprising Bank Hapoalim and Bank Leumi, has, according to some sponsors, unnecessarily lengthened negotiation periods on projects before financial close (Hadera achieved the fastest close ever for a project finance deal in Israel), and single borrower limits in such a small market necessitate a broader base of funding. The smaller local banks see the potential disturbance to the market as an opportunity to piggybank onto deals by allying with the international entrants.

Local non-bank lenders also struggle to meet long-term tenors. The biggest long-term shekel lenders are Israel's institutional investors, but they are hampered by the unusual Shaarei Ribit system set up by the Israeli government.

This sees prospective bond purchases by the institutional investors priced by a third-party, the Shaarei Ribit company. Government bonds are used as an underlying base reference rate, over which Shaarei Ribit issues a declaration of how far above or below any particular investment will pay. The system creates a distorted market for project financing as the Shaarei Ribit sample is not representative – the bonds rated against lack long-term maturity.

Banks do not have to deal with this system, but the local banks lack the depth of liquidity to be big long-term lenders, so sharp increases in the amount of financing required will see the international banks become an increasingly important funding source.

Hadera hurdles

The Hadera project's international financing caused its sponsors unexpected problems, as they found the Israeli concession agreements were aimed specifically at shekel-denominated funding. Every project deal done in the region until Hadera had been in fixed-rate shekel loans, so this floating rate euro loan meant new interest rate mechanisms were required. The result was a debt structure that comprises the basic Euro-denominated bank loan, a 23-year swap, as well as a hedge against interest rate changes, as opposed to the one, fixed, indexed loan that would have existed for an Israeli, shekel-denominated debt. Inadequate tender documentation contributed to a 4-month delay to financial close.

Sources outside the deal feel that Hadera should have taken the brunt of the difficulties as the first deal, but for sponsor Housing & Construction Holding (HCH) the complications, and costs, of reworking the agreements were so great it is reluctant to pursue an entirely international option in the future. For a number of upcoming projects, the tender documentation has already been drawn up, and so will not benefit at all from the lessons learnt in Hadera.

Hadera came as a shock to the system for the local banks – not only were they priced out, but "baffled" by how low Calyon and BES were able to price. Some Israeli bankers suspect the sponsors enjoyed artificially low pricing, with the lenders looking to get a foot-in-the-door in the region. Calyon dismisses any such suggestion, citing stringent return targets, but also pointing to the size of the Hadera deal in relation to the Israeli market – the $740 million Highway 531 and the Dorad Energy IPP are the only coming projects with larger debt provisions than Hadera.

Whilst the government is keen to attract international funding, there is also a need to protect the local banks' ability to lend. An increasing number of smaller PPP projects – the Petach Tikva court house, the Beer Sheva prison, an army township, a centralised police training academy – are taking place, which are simply too small to draw the interest of outside lenders. Strong local banks are needed to fund such projects, and Israeli bank action is almost non-existent abroad.

Traditionally the Israeli banks offered the advantage of local expertise; the local banks have always been more comfortable with the protection measures put in place by the state than banks with a less developed understanding of the region.

A growing number of international banks are acquiring a local presence, however. BNP Paribas, Calyon, Citi, Deutsche Bank, Dexia and HSBC all have operations in Israel. Whilst they do not have the experience of the Israeli banks, a source close to the Hadera deal at Calyon notes that the advantage of being "on the ground down there" may not be unique to the local banks for long, and that at the least, sponsors and the government are likely to become increasingly interested in a combination of local bank knowledge and international bank liquidity.

IPP development

Israel's new need for project financing is to fund a plethora of IPPs. The government is keen to introduce IPPs to replace Israel Electric Corporation's monopoly with a competitive electricity market, in a bid to improve the efficiency of the sector and drive down costs.

Accordingly, as far back as 1996 the government enacted the Electricity Sector Law to replace IEC's 70-year concession to generate, supply and distribute electricity, and introduce a regime of license. Under the new system, the prospective builder of a new plant simply has to meet a set of criteria to prove itself capable of building and operating a plant, such as proving financial capability and securing rights to a site, and is then automatically granted a license.

The largest, and furthest advanced is Dorad Energy, an 800MW power plant to be built in Ashkelon. With supplies of Israel's own off-shore gas stock owned by the Yam-Thetis corporation all sold out to IEC, Dorad and all future IPPs will buy gas from the EMG pipeline connecting Israel with Egypt.

Progress on the IPPs has stalled, however, due to the government failing to create the right environment to convince lenders that the projects carry an acceptable level of risk. Prospective plants with a total capacity of around 2,000MW, approximately 20% of current capacity, are failing to progress to construction stage. The primary need lenders have is for power purchase agreements (PPAs), to bring the risk of the projects in line with the off-take deal supported water plants. There is also a view that the government should be offering subsidies as incentives to lenders, such as the tax credits offered for clean energy plants, or investment grants to be injected at the construction stage.

Hezi Kugler says that the problem is one of different approaches. The government has offered debt coverage guarantees on all capital expenditure funding, but the lenders are looking for guarantees against a minimum level of profitability. Frustrated contractors have accused the government of a mentality of minimizing short-term expenditure, at the cost of long-term progress.

Delays to the construction of IPPs have been a major blow to the government's competition initiative. In a volatile political climate, it is risky for Israel not to have significant electricity capacity spare, but an annual growth of 6-7% in electricity demand between 1995 and 2005 has created a desperate situation, whereby capacity has almost been reached.

Power emergency plan

Consequently, an emergency plan has been drawn up – an approved increase in IEC capacity. Planned plants totalling 1,000MW are set to start operating within three years, including a 250MW plant in the South, and a combined cycle plant in Haifa within 18 months.

Additionally, whilst the electricity sector is now privatized, the state still sets rates, and has been criticised for underestimating the cost of producing electricity by as much as 40%, with rates correspondingly too low. The state is adamant that rates do not need to rise.

Construction cost estimations have also been criticised, contributing to unrepresentative rates and difficulties with bond pricing. Rates and bonds are linked to the CPI, but consensus amongst constructors, banks and lawyers is that this is completely inadequate in protecting against actual cost rises. EPC costs have risen so sharply in recent years that HCH estimates it has missed out on annual growth of 20-30%. As well as commodity price rises (steel costs have risen around 20% in the last year), soaring demand for labour has been the major contributor.

One theory is that a basket of price indices, tailored to reflect the various costs of each individual project, is required to provide lenders security in projects with a long construction period and high risk of cost change.

Future PPP diversification

Successful projects have caused Israel's enthusiasm for PPP to soar, spreading interest to the unlikeliest of projects: for example Shrem, Fudim & Kelner has been approached regarding project financing for the construction of a new football stadium – for a municipality with a population of 120,000.

For now Israel's PPP future hinges on government decisions as to how it will secure lenders for its IPPs in the short term, and how it will secure lasting international and local bank cooperation in the long term. If it is successful, Israel's PPP endeavours, particularly in attracting long-term foreign funding, could create a model for other emerging markets dogged by similar risks.