Project financing in the Japanese domestic market has gone through an evolutionary process since the mid-1990s. Leading industries where project financing is utilized to finance new investments are in the municipal (non-industrial) waste disposal industry, as well as the IPP and other power-related industries. Such a movement is driven by a tightening of environmental regulations and by the need of the public sector to seek new financing schemes such as the Public-Private Partnership (PPP) and Private Finance Initiative (PFI). These new trends have sparked the rise of the domestic project finance market in parallel with growing eagerness by the private sector in these public-private initiatives. Mizuho Corporate Bank (MHCB) has closed 2 municipal waste-to-power projects in Kyushu, and is working on several other waste disposal projects, which are at the second stage of financing.

Case study 1 ? the Omuta RDF Project

This project closed in March 2001, and has a total project cost of ¥10.4 billion ($88 million). The sponsors are Fukuoka Pref., J-Power (EPDC) and Omuta City, and the borrower is Omuta Recycle Power (ORP). ORP will dispose 315 tonnes per day of refuse-derived fuel (RDF) from 28 municipalities and plans to generate power at a capacity of 20,600kW for 15 years commencing 1/2004. The EPC contractor is Kawasaki Heavy Industries while J-Power is in charge of operations. The 28 municipalities form 7 unions and pay tipping fees to ORP. These unions have their own RDF producing plant and carry RDF to ORP under a consignment contract. MHCB is a co-lead arranger with the Development Bank of Japan (DBJ).

Case study 2 ? Fukuoka Clean Energy Project

This project closed in March 2002, with a total project cost of ¥38 billion. MHCB acted as a co-lead arranger with DBJ for Fukuoka City's Refuse Incineration and Power Plant project. Fukuoka Clean Energy (the borrower) is sponsored by Fukuoka City (51%) and Kyushu Electric Power Co. (49%), and plans to dispose 900t/d of municipal waste (from Fukuoka City) via power generation at a capacity of 27MW. The tipping fee from Fukuoka City is the main revenue stream, which is secured by a consignment contract to move most of revenue risks out to the consignor. The EPC contractor is Kawasaki Heavy Industries, and operation starts in October 2005 after a 3.5-year construction period, and will continue for 25 years. Joining the syndication were Fukuoka (arranger), SMBC, Nishinippon, Yamaguchi, Fukuoka-City Bank and Sumitomo Trust & Banking.

Background

Underpinning these project developments lie some common conditions:

1) Tightening of Environmental Regulations

(anti-dioxin regulation)

Japanese anti-dioxin regulations will be strengthened by December 2002, requiring non-compliant facilities to cease operation. As a result, renovation and rebuilding of incineration plants has been a boom activity over the last couple of years. New facilities are tending to become bigger in size and novel in technology. While untested technology is often a barrier to project financing, there is growing market in engineering consultants to help financiers assess these technical risks.

2) Introduction of PFI (PPP) for Public Financing

PFI law in Japan was officially introduced in 1999, but both PPP and PFI schemes have been chosen to promote new projects by a number of municipal governments. Governments who are conscious on their fiscal strategy are often eager to consider such schemes in an effort to manage and finance their waste disposal facility renovation or rebuilding projects employing private sector efficiencies.

3) Development of the Domestic Project Finance Market

Project finance itself is an emerging finance method for domestic players. The epoch-making project was Kobe IPP which closed in 2000 ? the biggest domestic project finance (¥235 billion) in Japan involving a large number of financial institutions. Development of industry-recognized contractual arrangements played a key role in supporting the use of project finance. Another key motivation is on the part of the project developer who seeks for off-balance sheet financing in line with its overall corporate financial strategy.

New Trends and Challenges

The Japanese waste management system can be divided into two areas: 1) municipal waste, which municipal governments are responsible for handling and treating, and 2) industrial waste, for which generators are responsible. The two projects above, as well as other current projects, involve the treatment of municipal waste, thus, financiers quickly recognized a pattern for such municipal government financings. Nevertheless, challenges remain as government, developers, and financiers think about how to best handle the residual industrial waste generated by these projects.

There are three major problems in industrial waste treatment. Firstly, the availability of final disposal facilities for industrial waste is scarce. Current available capacity is estimated to be 3.7 years nationwide, and only 1.2 years in the Kanto area. Accordingly, life extension of the projects and the reduction of waste ash are important policy targets for local governments. The second problem is illegal dumping which is reported to be as much as 400,000 t/y out of 400 million t/y (total industrial waste). Some waste-disposal companies maintain their competitiveness by accepting abnormally low prices, and then dumping waste into prohibited areas (often sub-urban). Another problem is transboundary movements from the Tokyo metropolitan area to neighboring jurisdictions. Tokyo gives more than 5m t/y of industrial waste away to Chiba, Kanagawa, Saitama, and even as far as Fukuoka. Prefectures who receive such waste are starting to show reluctance and are asserting claims of producer's responsibility.

Some municipal governments (see below) responsible for planning industrial waste treatment are eager to raise private finance. These projects are already familiar in the market:

1) Kurashiki PFI Project

This project, located in the Mizushima Industrial Complex, is going to be the first PFI project for an industrial and municipal waste mixed-disposal facility. Industrial waste will come from the Complex internally and municipal waste from Kurashiki City.

2) Saitama Sainokuni Industrial Waste PFI Project

The Sainokuni project will be the first pure industrial waste PFI project in Japan. ORIX and its affiliates will run the project to commence in 10/2006. ORIX group has created a network of waste-disposal companies around the Kanto region, which enabled it to win the bidding process against 4 competing PFI partners.

3) Tokyo Super Ecotown Project

The Tokyo Metropolitan government has a plan, called ?Super Ecotown,? to revitalize the Tokyo Bay area. It says, ?the problem of waste in the region is in a state of crisis, and the availability of final disposal facilities for industrial waste is tight. In response, Tokyo and the three neighboring prefectures will work together to encourage companies to develop new recycling facilities?. It will choose one consortium to sell a part of its landfill area for a plant site by March 2004.

Financing of an Industrial Waste Incineration Project

At least three points below should be taken into consideration:

1) Consignation contract.

A long-term, take-or-pay contract with a high credit consigner eases project structuring, but such arrangement does not yet exist in the current market situation. This is because such sector has layers of medium and small-sized waste transfer/disposal/grinding companies that are not well known to project financiers. As treatment of industrial waste is the generators' responsibility under the concept of Extended Producer Responsibility (as per the OECD guidance manual), financiers must look at each generator's credit, even though such generator may not be paying the actual tipping fee to the project company. Thus, such a market structure may make financiers seek some form of credit enhancement.

2) Market Analysis.

It will be easier for financiers to take some market risk if the market is analyzed as widely as the oil and gas sector. Unfortunately, there is a limitation in the industrial waste sector in obtaining raw data for analysis and in finding the appropriate independent consultant for lenders. Implementation of new laws for material recycling should result in new trends to be analyzed.

3) New Technology.

As stated above, meeting environmental restrictions and the reduction of waste ash are key factors for plant makers' sales. Therefore, it is often the case that the technology is not yet commercially proven and that the operational risk is difficult to measure. Technological improvement is also a standpoint from which to evaluate a project's competitiveness.

The search for risk capital and mezzanine financing

Overall, an industrial waste incineration project faces more difficulties compared to municipal projects from a financing point of view. But at the same time, it has a positive side in that it can benefit from upside cash flow. Municipal waste disposal management is a public service, thus private sector players cannot seek too much profit due to political constraints. Meanwhile, the industrial waste business has the potential to become very lucrative based on current market needs. Some market players forecast that the level of tipping fees for industrial waste may hike as much as three times in a couple of years due to the limited number of disposal companies. Long-term commitments for consignment are not welcomed by a disposer (project company) expecting future fee hikes. As a result, increased cash flow volatility may not be perfectly suitable to the combination of only senior debt and equity. Rather, use of third party subordinated loans and/or preferred stock financing which can share in the upside cash flow will be more advantageous.