Despite expectation mid-year that Middle East energy project margins could not go much lower, the market – particularly in the GCC – continues to tighten, and the power sector is no exception.

Competition between lenders at international, regional and domestic level – and the growing number of banks active in the region – has forced pricing for the top Middle East power and energy credits to an all-time low. And now project sponsors are diversifying their funding base into cheaper corporate-style debt for project refinancing, and bond/project debt hybrids for greenfield development – that means both lower margins and, as exemplified by the recent TAQA refinancing, lower or no arranging fees.

While banks are feeling the pinch, sponsors continue to pile on the pressure – driven largely by a substantial increase in EPC costs – and are forcing banking sector innovation.

As Rajit Nanda, CFO of Suez Energy for the Middle East, Asia and Africa, says: "I feel that the Middle East is at the cutting edge of project finance in terms of creativity and the appetite of the bank market to try out various forms of risk allocation. It is one generation ahead of the project finance market in Asia and Latin America, for example, where banks follow a very classic structure, and their appetite for deviating from copybook risk allocation structure is very limited.

"In the Middle East, the bank market experiments and works out unique and creative structures. Every deal has its own creativity – for example the Al Rusail Barka 2 structure is mould-breaking for Suez," (for more details on Suez see box).

Regionals feel international pressure

International banks remain the biggest source of liquidity for projects in the Middle East. As Mark Yassin, global head of corporate finance at Arab Bank, says, "To some extent most of the regional and local banks are becoming bystanders, watching what the international banks are doing in the market. International banks are coming with huge amounts of funding and they can afford to do it at very low pricing, which is far beyond the capabilities of the regional and local banks."

But for Nanda the regionals are still an important source of funding and thinking. "We work with a whole host of international and regional banks, and while on Rusail Barka we only worked with international banks, for Marafiq we are working with regional, Saudi and international banks. We work with banks that put in the most competitive proposal and banks that show flexibility in their thinking and creativity. This is our criteria.

"The regional banks have matured a lot over the last five or six years, have developed a sophistication within their structuring, and are able to read the appetite of the banking market. I have developed a lot of respect for them – they've come a long way. One of their constraints is size, and a lot of sophisticated banks are limited by underwriting capability. That's why you have to work with other banks as well, to close the underwriting gap."

How low can you go?

The competitive nature of the project finance banking market means that the region is a borrower's paradise. The average pricing for deals with government guarantees and solid sponsors is around 35bp during construction (Qatargas 4 got as low as 30bp) for roughly 10 or 15-year debt, rising to 65-75bp. Nanda admits, "It's a delight to be on the sponsor side, but the fundamentals, the success of IPP programmes in the region since 1994, building a strong track record coupled with a well tested template for risk allocation, are also guiding the pricing".

There is some sense in the market that the pricing war cannot continue for much longer. For example Sembcorp's $1.5 billion Fujairah IWPP deal in the UAE recently struggled in syndication. Launched via bookrunners Barclays and Societe Generale, the fees were upped on the top $75 million take by 20bp to 80bp. Says a banker that looked at the deal: "Fujairah had pricing that had not been seen in the power sector before. It was a shock to the system."

In the past political events have cause turnarounds in pricing levels – the last instance being the Gulf War. But today the regions long-term economic fundamentals are so solid that any upset is unlikely to last long. Furthermore, local banks have grown in size and would be able to step up and soak up any shortfall from the internationals in funding demand.

Islamic debt

Islamic debt has become more popular, particularly with the Saudi market opening up, but international commercial debt is still the preferred option. International banks have the funding resources to sustain low pricing, and have the ability to lend both on an Islamic and conventional basis – thus there is little need for them to include Islamic banks. The only reason to now tap Islamic banks, say most lenders, is to access an additional pool of capital.

Nanda sees tenor as being the main issue for Islamic financing: "Islamic debt is not really the flavour at the moment. There is a lot of Islamic liquidity in the market but this liquidity exists between five to 12 years. Typically, in this part of the world, the project financing requires 20 years, so they have this huge mismatch, without the appetite for long-term paper".

TAQA and bond market potential

The bond market has rarely been used GCC power project financing, because the bank market has been so competitive and more convenient for sponsors. Says Nanda, "I do see the bond market coming slowly, but I see it more in refinancing transactions rather than greeenfield. It's simply not possible to do a bond deal and still meet strict deadlines. With bank market pricing and liquidity so competitive, you're better off not going to the bond market and taking the time to find out whether there is a competitive market there. However it is an option that every sponsor should consider for negotiated petrochemical deals, LNG terminals or refinancing power deals where either construction risk is limited, non-existent or mitigated through sponsor completion support."

Yassin says although the bond market is slowly catching up, "the bank market is much more active. The bond market can only be done by a few international banks, whereas project debt can be done by everybody". That said, the margins drop has catalysed a spate of power refinancings, the most recent of which – and least popular with banks – is the innovative TAQA bond refinancing.

In September, TAQA – a listed vehicle formed to own Abu Dhabi Water and Electricity Authority's (ADWEA) stakes in a range of IWPP projects – launched the first $6.5 billion part of a $10 billion capital markets programme to refinance its 51% share in existing joint IWPP projects and fund future acquisitions. The deal's underwriter was Goldman Sachs and Moody's rated it Aa3. TAQA raised the funds and extended them as intra-group loans to the various project companies without charging arranging fees – a plan that has made banks squirm with discomfort.
Says one banker: "There's no real reason for this structure. I don't think they've thought it through – how do you refinance a project in which you're only the 51% owner? You can't just refinance without the other shareowners taking part in it, or being clear about what you're raising it for."

Another banker shares the concern. "They're talking about raising capital markets debt and funding individual projects with that debt. This is all well and good for the capital markets but the banks will be disenfranchised and the sponsors will be at the mercy of this loan from the Abu Dhabi authority, without the benefit of an international syndicate of banks. If a political problem arises, the sponsors would be more interested if a bank syndicate were involved rather than capital markets raised through the parent company. It won't go down well with the banks or the sponsors."

Nevertheless, TAQA's debut issue sold strongly. The first tranche of the programme consisted of a Eu750 million ($960 million) seven-year bond, which priced at 45bp over mid-swaps, a $1 billion 10-year tranche, which priced at 110bp over Treasuries, and a $1.5 billion 30-year tranche, which priced at 160bp. The 30-year issue is the largest ever long bond from the Middle East, and the seven-year is the largest euro benchmark from the region.

The immediate future for Middle East power project financing looks good for sponsors, and while pricing is at an historic low, it will likely remain this way for some time. Nanda predicts that "shorter PPAs will become prevalent and banks could start taking limited merchant risk. In transactions with 25-year PPAs I expect banks to put pressure on the tenor. Pricing has reached its bottom, and I don't see it going any further down. Margins will not go up in the short- to medium term however."

Says Yassin: "Five years ago we expected the capital markets would have to come and take out project finance debt to make room for new project finance structuring and lending. However because of the competition in the banking market amongst international, local and regional banks, long-term debt can be raised in the banking market at rates very similar to capital markets. So we should ask ourselves, why go to the capital markets to get 20- or 30-year maturities for bonds? The banking market is able to go out to 20 years at very competitive rates – from that perspective it appears to be a complete reverse logic, but this is what the reality is".

The ultimate evolution of the corporate cycle in the Middle East may be for sponsors to raise short-term debt for construction projects with a quick bond or corporate debt take-out post-construction. But the risks of this strategy are evident – if the lending climate were to change, project companies risk having to refinance at higher rates.

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Suez powers up

When its current deals reach financial close Suez will be the single biggest international power developer in the Middle East.

Suez was appointed winning bidder for the Al Rusail Barka 2 IWPP project in October this year, against competition from AES and Marubeni. Al Rusail Barka 2 comprises two different assets in Oman sold under a combined privatization process – Al Rusail is a 687MW existing plant with a government guarantee for the offtake contract. Suez paid $130 million to buy it, and now the developer will spend a further $770 million in order to build Barka 2.

The $900 million total funding requirement includes $750 million in debt, and is being led by HSBC and Sumitimo Mitsui Banking Corporation (SMBC). HSBC and SMBC also supported Suez on the bid for Mesaieed, which was subsequently won by Japanese developer Marubeni.

In April 2006, Suez, along with lead developer International Power and Sumitomo, closed financing for the Al Hidd IWPP project in Bahrain, which included $1 billion of debt, of which 60% came from JBIC, and 40% from commercial banks. The deal comprised acquisition of an existing facility plus an obligation to build new water facilities.

A Suez-led consortium is also in exclusive talks with Marafiq, the power and water utilities company for Jubail & Yanbu. Suez's bid was 20% cheaper than its competitors', it is now going through process of clarification. The deal has long-term debt featuring cover from the Korean export agency, KEIC.

The project comprises a 2,500MW greenfield IWPP which will sell power and water to Marafiq. Marafiq will then onward sell to the industrial complex in the region, including facilities run by Aramco and ConocoPhilips. The concession contract features a government guarantee from the Ministry of Finance for both payment and termination.

The concession should be signed at the end of year (the PWPA is due on December 20), with financial close in February 2007. When closed, the $3.5 billion transaction will be biggest IWPP in the world, comprising $3 billion debt. Banks leading the deal include BNP Paribas, Gulf Investment Bank and Samba Financial Services.

Also due to close by the end of year is the refinancing of the Taweelah A1 IWPP in Abu Dhabi. Calyon and BNP Paribas were appointed to lead the $1.2 billion debt package, which will refinance an existing facility and fund a $250 million expansion. Calyon and BNP will be asking banks from the original deal to commit on the refinancing.