"2006 was particularly significant for us," says Rajit Nanda, CFO SEI Middle East, Asia & Africa. "In Bahrain we completed the acquisition and financing of Al Hidd power station and we signed the contract for the Barka II and Rusail plant in Oman. Together with the Gulf Investment Corporation, our partners in Al Ezzel, and the Saudi company Acwa Power, we won the contract for the Marafiq independent power and water project [IWPP] in Saudi Arabia, the biggest project of its kind in the world."

Both the Barka II and Marafiq projects signaled a step-up in the scale of SEI's activities in the gulf region. Both are large projects, especially the Marafiq complex which is the largest IWPP in the world. The project entails the construction and operation of power generation capacity of 2,750 MW and desalination capacity of 800,000 cu m/day.

"Marafiq is our first contract in Saudi Arabia and we are thus making our entrance into the largest market within the Gulf Cooperation Council [GCC]," says Nanda.

Suez is well known in the region as having a strong structuring capability as reflected in the combined Rusail & Barka II IWPP deal. Although Marafiq is the world's largest IWPP and was banked by a $3.4 billion multi-sourced debt package, the joint Rusail & Barka II IPP/IWPP was more challenging.

The transaction, closed in February 2007, was the first power deal in Oman since the electricity and water sector was unbundled in May 2005, the first to combine the development of a greenfield IWPP with the acquisition and rehabilitation of an existing power plant, and one of the most complex deals banked in the Middle East to date.

The complexity centered on the Omani government's requirement that the two projects were ring-fenced from a security standpoint so that there could be no cross-default between the projects, whilst at the same time the deal benefited from a cash pooling mechanism at the holding company level. The mechanism allowed the deal to be banked as a mini-portfolio structure enabling a cash pooling account to compensate for revenue shortfalls in either project company.

Despite these challenges, the Rusail & Barka 2 transaction was banked with 70 days between execution of project agreements and financial close including a seasonal holiday. Within Suez, the financing is sometimes affectionately known as the '70 day deal'.

Looking forward

Today, in the Middle East, Suez has a direct equity interest in 8,200MW and 1.9 million m3 of water per day making it the leading private power developer in the Gulf region ahead of closest rivals IP and Marubeni. The total investment cost for SEI's Middle East assets amount currently stands at around $8 billion.

Suez has recently submitted a bid for the Ras Laffan C project in Qatar – a greenfield (build own operate transfer) independent power and water project of 2,730MW and 60 million gallons per day of water.

Unlike the standard model for IWPPs in the region, where developers secure a committed line of underwriting from banks prior to the award of preferred bidder, for Ras Laffan C Qatar Petroleum (QP) is raising around $2.5 billion with the help of its adviser RBS in an attempt to secure more competitive terms. As well as Suez, International Power and Marubeni Corporation are in the running for a stake in the project. QP will own 20%, the winning consortium will hold 40%, and Kahramaa will hold the remainder.

One potential drawback, if the template was to take hold across the region, could be the loss of structural innovation formed by negotiations between private developers and banks such as that seen on Barka II.

There are also a number of other IWPPs in the pipeline that will be conventionally tendered. These include: Ad Dur IWPP in Bahrain, Salalah 2 IWPP in Oman, Ras Az-Zour, Marafiq-Yanbu in Saudi, and Shuweihat 2 IWPP in the UAE. In total, including Ras Laffan C, the funding requirement for these projects is likely to total around $10 billion.

Such volume puts stresses on both the bank and EPC markets. At a time when many sponsors are entertaining price flex in the fallout of the US subprime crisis, power projects are largely impervious to calls from banks for flex clauses due to the reluctance of powerful state co-sponsors and private sponsors to set such a precedent. "The credit turmoil had little impact on the various financings and underwritings that we are seeking to obtain in our region," says Nanda. While there has been an uptick in debt pricing it has not been as severe as in other sectors, with an increase of around 10bp to 15bp typical.

Power and IWPPs in the region are strong credits with a quasi-sovereign entity always an offtaker and usually a shareholder, so competition among banks remains strong despite the drop in the size underwriting commitments.

The other story regarding the funding mix is JBIC's involvement in the Middle East power sector. Both Suez and its closest rival International Power (IP) face the same concerns about JBIC's presence in the region and its ability to offer its competitive overseas investment loans (OIL) to Japanese rivals like Marubeni. A natural consequence of competitive JBIC facilities will be an increasing incidence of Japanese firms in the equity on deals and as contractors.

The dilemma for Suez and IP is whether to continue to try and beat them or join them; Marubeni and IP each have a 20% stake in the Fujairah IWPP, the financing for which is currently in the market. Earlier in 2006, Suez, IP and Sumitomo formed the winning consortium for the acquisition of Al Hidd in Bahrain with the Japanese partner qualifying for a 60% JBIC Overseas Investment Loan, that saw its way in to the transaction. Nanda is diplomatic on the issue: "For deal sizes that continue to be over $1.5-2 billion, the importance and attractiveness of JBIC as a competitive and liquid source of funding will continue to be tapped."

Capital costs

A far more significant impact on the power sector in the Middle East, over and above the bank liquidity issue, is the impact of capital cost inflation. There seems no sign of abatement as EPC costs move higher – in the last three years EPC costs have increased by 30%-40% with the most constricted bottleneck being the supply of turbines given the competing demand from Asia. Nevertheless, unlike less critical projects, power has so far resisted any moves to the cost-reimbursable model for contractors.

"The capital cost inflation and volatility of the commodity markets is leading to a market of uncertainty and increased costs for the EPC contracts," says Nanda. "However, in the Middle East, the offtakers and the government utilities are still requiring an EPC framework for construction risk allocation, more so in jurisdictions where the government directly/indirectly participates to the shareholding. In other words, there is yet no departure to a cost reimbursable or hybrid model as seen in the LNG liquefaction or the petchem industry."

There is evidence that the trend for larger and larger projects to take advantage of economies of scale is being checked by capital cost inflation. There are fewer contractors that can wrap mega projects, so projects may start to be procured through phases where possible or 'descoped' from their original plan.

"EPC contractor markets will remain competitive in the coming months notwithstanding the volatility in the EPC contracting/pricing," says Nanda. "It is also leading to the emergence of new companies from Europe and Asia willing to go out of their home market and dabble in the GCC EPC business."
The Ras Az-Zour IWPP may be illustrative of capital cost pressures, with the Water & Electricity Company (WEC) reducing the power capacity from 3,000MW to around 1,000MW. After a royal decree legislated that all coastal power plants must use oil instead of gas, WEC decided that oil-fired capacity of 3,000MW would be too expensive. The water component is 220 million gallons a day and bids are due in 10 February 2010.

While 2006, was a pivotal year for Suez, 2008 could be even bigger, with potentially seven IWPPs to be tendered. It also seems Dubai and probably Kuwait will entertain the IPP model. "The Middle East region offers abundant possibilities for power and desalination developers and investors with operational skills," says Nanda. "The projects here offer interesting and predictable contribution to results, with organic growth potential."

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SEI's track record in the GCC
Suez Energy International is the division of Suez responsible for the group's energy activities outside Europe. It develops and manages electricity and gas projects, providing energy and related services to industry and commercial customers.

Suez has a long and established presence in the Middle East. Known in the project finance market for its structuring aptitude, Suez is able to back up its financing expertise through synergies with subsidiaries Tractebel Engineering and with Degrémont, a specialist in reverse osmosis desalination.

Suez's engineering and environment divisions have been active in the region since the 1970's. In 1994 SUEZ Energy International (SEI) began to operate and invest in the region with the development of the first independent power project (IPP) in the Gulf, the 289MW Al Manah plant in Oman.

Since that time SEI's track record has been a series of regional project milestones. In Abu Dhabi, SEI is one of the original shareholders in Taweelah A1, the 1,350MW, 84 MIGD plant. In 2004 the group won the public tender for both the Sohar IWPP in Oman and the Al Ezzel IPP in Bahrain.