The Spanish power market has long been hailed as the next big area for power project deals in Europe, but progress has been slow. However, the first of the long-awaited mandates to arrange financing for a gas-fired IPP is set to be awarded as Project Finance goes to press. AES and ESB have been the two vying for first place in a race between a handful of international developers also including Entergy and Intergen. ESB is tipped to come in first, having overtaken a counterpart that has been dogged by apparent problems in securing gas supply. The key, it seems, is tolling.

Gas-fired IPPs have been on the cards for some time in Spain. With its environmental and efficiency benefits, gas has long been hailed as the answer to Spain's demand for power, which is increasing at roughly three times the European average. And with de-regulation kicking in, the market has been mentioned as one with great potential for international developers. Permits have been issued for upwards of 35GW and project financiers have been watching closely. But developments have been disappointingly slow. High gas prices, insufficient capacity and infrastructure, lengthy permitting procedures and the snail's pace of gas market liberalisation have frustrated many potential plants.

The first domestic-sponsored combined gas turbine plants (CCGTs) are online in a testing phase and incumbent utilities are diversifying from traditional power activities into gas distribution and supply. Most interesting for the international financing community, however, is whether ESB's mandate will set a precedent for other developers to follow it to the markets. A tolling agreement should provide sufficient lender comfort for long term, non-recourse financing, although a question remains over whether tenor could extend beyond the length of the tolling contract.

The only IPP to have secured project financing in Spain to date is the 335MW Elcogas Puertollano integrated coal gasification plant ? financed in 1993. Sponsored by a number of major European utilities including Endesa, EdF and Iberdrola, it was described by participants as very difficult to close. Since then, financing activity in the power sector has been largely restricted to renewable plants.

Naturally, all eyes have been on AES and ESB. But market sources suggest that successful close of both of these will only signal resolution of individual negotiations rather than the impact of gas supply reforms. There is still no real market, no history of gas and electricity price linkage. In addition ?there are two separate stories for CCGTs,? says Diaz del Rio, head of project finance in Madrid for SG, ?the domestic incumbents and the international IPP developers.? The former have the upper hand when it comes to market knowledge and as they forge ahead in securing as much generation capacity for themselves as possible, some question how significant a role will remain for the independents.

A question of gas

CCGT take off in Spain has been retarded by the country's historically low natural gas consumption. There are practically no domestic reservoirs and only five points of entry: three LNG facilities and two international pipelines. The capacity of these latter two is said to be fully committed to existing contracts, although plans exist to enhance compression. A fourth LNG facility is currently under construction at Bilbao and talks are underway amongst a group of private sponsors for a pipeline carrying Algerian gas to Southern Spain.

But sourcing gas is only half the story. Sufficient capacity is also dependent on transportation infrastructure and Spain's network is fairly underdeveloped. Again, work is underway, with transportation company Enagas having recently secured authorisation to begin building the Malaga-Estepona pipeline. This is seen as an important step forward for basic gas infrastructure in the south. But these developments take time.

Moreover, the Spanish natural gas industry has been dominated since the early 1990s by Gas Natural, which owns over 90% of the gas distribution market through gas transportation company Enagas. Following the 1997 Electricity Law, and in accordance with EU advice, it became apparent that gas liberalisation was necessary for power de-regulation to be effective. Electricity companies lobbied hard and the same year saw rules issued on third party access (TPA) to gas infrastructure. In 2000 the process was accelerated further and full liberalisation is scheduled for 1 January 2003.

Gas Natural is selling off Enagas through an IPO scheduled for June 2002, which is taken by many as a positive step. Goldman Sachs, Santander Central Hispano, BBVA and La Caixa have secured the mandate to co-ordinate the offering. SSSB is advising Gas Natural. February saw two ministerial orders outlining the new tarrifs and charges for TPA and the standard remuneration for gas infrastructure.

These are encouraging developments for growth in the number of gas-fired IPPs. ?Things are set to change,? agrees Juan I. Gonzalez Ruiz, partner at Uria & Menendez. ?But in the short term there are still difficulties. The access to infrastructure probably won't be resolved until 2005, the permit process is very long and complicated and the regulatory system has not dealt with certain issues referred for IPP developers.?

Enron's frustrated attempts last year to be the first with a CCGT IPP up and running illustrate the inadequacies inherent in the system. Enron was looking for a tolling agreement for its Arcos de la Frontera plant but Enagas refused access to its Huelva LNG regasification plant and associated pipelines until 2004 on the grounds that there was insufficient capacity. Enron appealed, saying that Enagas had neither acted transparently nor proven its claims. In the end regulator CNE forced Enagas to offer access but the project was put on hold as lengthy negotiations ensued as to the terms of the contract. The whole ordeal raised serious questions over the procedures, or rather lack of them, for monitoring TPA access. Arcos de la Frontera was recently snapped up by Iberdrola.

Despite this year's new regulations, AES appears to have been confronted with similar problems at its Cartegena plant. The generator has complained fiercely that the project has been held up by Enagas, with whom it is understood a re-gasification and transportation agreement was signed in January.

ESB has been more successful because they opted for a tolling agreement with an independent supplier, Shell, and it is widely seen as a significant benchmark a significant benchmark. Shell has taken on the risks associated with both gas and power price. ESB's significant history of CCGT development in Ireland is likely to have provided the expertise to negotiate this route.

Tolling is undoubtedly a good solution to the problem of raising project financing in a market in the early stages of de-regulation. Short-term agreements can certainly be found but are not sufficient to back long-term financing. Banks will not take on the pool price risk and developers are averse as well. So long-term contracts in the form of tolling become the answer and if Enagas lacks the capacity, then independent suppliers may well. ?This could well be repeated,? speculates one market player. ?But how many gas suppliers will be prepared to do it? And how many developers will they do it for? Some are viewed as more of a credit risk.?

Incumbent power

Foreign developers trying to get a foothold in the Spanish CCGT market are also up against fierce competition in the shape of domestic incumbent utilities. All potential plants in Spain face the same problem on the surface. Insufficient capacity and inadequate regulatory mechanisms are not restricted to foreigners. But incumbents are certainly moving faster. Endesa has two coming on line and Iberdrola is close behind. Union Fenosa and Hidrocantabrico have also managed to obtain permits.

In a race where less than 50% of the commissioned capacity is ever likely to come to fruition, the domestics are taking advantage of first mover advantage. They know the market, they have access to the best sites and their local lobbying power is much greater than that of the IPPs. Moreover, they are well placed to swallow the risks associated with this young market for two main reasons.

Firstly, all four already have substantial and diverse asset bases in the Spanish power market, offsetting risks borne by new ventures. This diversification is set to spill over into the gas industry itself as the incumbents ensure they get a foot in the door of the de-regulating distribution and supply markets. Secondly, the Spanish utilities can get a head start because they do not typically look for project finance in their domestic market. They have historically had very good relationships with Spanish banks, who know the industry very well, and prefer to finance on balance sheet. There are signs that this is changing in some sectors, notably infrastructure, but for the moment the power giants are sticking with tradition when it comes to new plants. Although this does not mitigate the need for gas supply contracts, it does mean that it is not necessary to have long-term agreements in place from the start. Thus due diligence and potential negotiations with Enagas are accelerated.

A particularly sore point for many IPPs is Gas Natural's venture into generation. It has an 800MW CCGT plant at San Roque in Cadiz due to come on line by the end of this quarter and another one at Sant Adria del Bessos following closely. Allowing the gas monopoly to secure gas-fired generation capacity is seen as flying in the face of otherwise positive attempts at reform.

Way ahead

The market is unlikely to see more CCGTs emerging than the few already in the queue. But many in project finance believe that they do have an important role to play in a market that is maturing, albeit very slowly. Diaz del Rio at SG believes it is a question of size. ?The IPPs are likely to be the larger plants, of more than 800MW, while the domestics will dominate the playing field at the smaller end of generation.?

Sourcing supply should become easier as new terminals and pipelines come online. Even re-gasification facilities sponsored by domestic utilities, who may be looking to tie capacity into their own plants, must adhere to recent regulations stipulating that at least 25% is available for short-term contracts. It is understood that some independent operators are looking to establish take-or-pay contracts for gas direct with Algeria.

And as the market opens, so financing techniques will develop accordingly. At the moment there is demand and promised supply, but there is no market mechanism. There is no reference for gas price and only limited hedging opportunities. But, looking forward, this will change. ?Tolling may only be the first step and more sophisticated methods will develop,? suggests Diaz del Rio. ?For instance, as has been seen in the UK, gas suppliers could start linking long term contracts to electricity pool prices.?

Another market player points to a possible hybrid of tolling and merchant structures. Lenders would look to have operating costs and debt service covered by tolling capacity and then surplus could be sold on a merchant basis.

The terms of the ESB mandate will give some indication of what the markets will take on at present and help establish a framework for acceptable risks. In addition to IPPs, project financiers may have their attention grabbed by LNG facilities and possibly even refinancings by domestics. ?We are definitely seeing some things moving,? concludes Graham Donnell. ?We have been geared up to advise on such projects for a while.?