Power project financing activity in Poland has been negligible in recent years and reflects the slow pace of growth in the demand for electricity throughout the country. This has resulted in only a handful of new plants being commissioned in recent years and investment in refurbishment and modernisation of existing plants being neglected. This is about to change.

Poland's economic fundamentals have improved. Industrial growth rates are increasing and an aggressive privatisation program has begun. These factors have boosted investor confidence in the Polish power sector and a host of big name power project sponsors are sniffing the sector for opportunities.

As Matthias Russwurm, vice-president, project finance at Deutsche Bank says: "Over the next few years, Poland will provide a lot of opportunities for investors into the electricity sector. Progress with regard to the privatisation of distribution companies and (regarding) the establishment of a power exchange will improve the marketing possibilities for power, which should improve the conditions for limited-recourse financing."

Power demand growing

According to Poland's Treasury Ministry demand for power is expected to reach 65,000MW by 2020. A doubling of current installed capacity of 34,000MW is needed and an additional $30 billion is required. Generating plants will consume $16 billion and transmission and distribution lines $14 billion.

Many of Poland's plants are 20-30 years old, operate with obsolete technology and do not comply with current or planned air pollution standards. Environmental management is one of the prime pre-conditions for Poland's entry into the EU. Investment is needed to make structural and technological changes for refurbishment and modernisation, which is where most financing activity will be focused in the short-term. Greenfield opportunities will be few as significant surplus capacity already exists in the system.

Modernisation and upgrading by 2001 alone will require $900 million to $1.5 billion, stretching the current capabilities of Poland's largest banks and way beyond the means of most power plants. The power industry's tariff structure, and hence its electricity supply revenues, will also not be able to generate the quantum of funds required to fully finance the above investment program.

Inflow of foreign funds is therefore essential. It also gives the government some breathing space in managing its budget deficit. This will hopefully allow the government to increase domestic electricity prices to an economically viable level in a gradual, as opposed to erratic, manner in the future.

Polish banks have for many years lent significant sums to the power sector, but deals have been on a corporate as opposed to a project finance basis. The expected increase in deal flow augurs well for local institutions, providing them an opportunity to further enhance existing project finance skills and therefore participating more aggressively in future deals.

Mobilising large amounts of Zloty funds for limited recourse projects is expected to become easier as Poland's financial markets become more sophisticated and a deeper and larger Zloty pool becomes available for investment. The current market is liquid and capable of raising amounts up to $200-250 million Zloty equivalent for tenures of between 12-14 years.

Raising these funds has proved challenging. Polish banks are not keen on tenures above 14 years, the cost of Zloty funds at 16%-17% is high and many Power Purchase Agreements (PPAs) allow forex risk pass through which encourages greater usage of dollar denominated debt.

The recent Turow phase III deal demonstrated how far local banks have come in raising funds on a project finance basis. Four Polish banks, Handlowy, BRE, PKO and PEKAOSA have raised $250 million with a 14 year tenure as part of Turow power plant's $670 million revamp program. Project financing for this deal was given added comfort by the 14 year PPA negotiated with the national grid. A $400 million facility is being raised by Credit Lyonnais, Citibank and West LB for the project.

The Turow project has brought a new dimension to the power sector as it is expected that the adjacent lignite mine is expected to be transformed into a joint stock company soon and after its merger with the 1,440 MW plant might seek a stock market listing. This merger could see the beginning of a raft of similar such mergers and the eventual vertical integration of the industry.

Project financiers have continued to search for other ways of raising debt for power projects, including floating power project bonds. However, subscribing to such bonds has not attracted much interest from local financial institutions, although international investors are showing some interest. A bond offering, the first one of its kind for Poland's power sector is currently being formulated and is expected to raise $250 million for Turow power plant's Phase I refinancing. If successful this could herald a raft of similar such offerings being launched on the international markets.
With the above vibrant scenario emerging, a slow but steady stream of project finance activity is now happening. PSEG Global through its investment in ELCHO Sp z.o.o is raising $320 million for the 220Mwe and 500MWth combined heat and power plant. It is expected that 60% of the EPC contract (awarded to Foster Wheeler) will be spent in Poland. A large portion of the project debt is expected to be Zloty-denominated. Financial closure is expected in the first quarter of 2000 with commercial operations beginning early 2003. PSEG Global will hold 90% interest in ELCHO with EC Chorzow and other Polish companies holding the remaining interest.

Polskie Sieci Energetyczne (PSE) has signed a long-term PPA with ELCHO and power is to be delivered into the GZE local distribution system. PEC Katowice has also committed to purchase ELCHO's 500MW thermal capacity under a long-term agreement.

PSEG is particularly bullish on Poland as Mr. John Protasiewicz, Director, Project Development, of PSEG Global says: ?The Polish market is an attractive one and the current privatisation process is a step forward in the right direction. A major challenge now is the future development of the energy regulatory regime and the creation of an energy exchange to provide a greater degree of market transparency?.

New plants are also coming on-line, including Enron's Nowa Sarzyna project a 116 Mwe, 70MWth gas-fired heat power station which begins full commercial operation in early 2000. Enron signed in 1998 a PPA for the facility which was awarded through a competitive tender process. The project had the distinction of being the first greenfield private project-financed entity established on the basis of concluded contracts, rather than government guarantees.

In addition to supplying power to the grid, Enron plans to distribute the high and low pressure steam produced by its steam turbine generators to the Organika-Sarzyna chemical company and to the City of Nowa Sarzyna. A 4.5 kilometre local gas pipeline connects the facility to the nearby Polish Oil and Gas Company (POGC) gas transmission pipeline. Although over 95% of Poland's plants are run on coal, the government is increasingly interested in fuel diversification towards gas based plants.

As the power sector becomes more competitive, the cost of producing power is expected to reduce. Currently Poland does export a small amount of power, but an increase in exports will depend on how quickly the privatisation process is completed, which will impact the country's ability to generate low cost power.

Export to countries east of Poland is out of the question. Power is heavily subsidised in those markets and prices as low as 1 cent/KwH prevail. Poland's own prices at around 2.3 cents/KwH however have made it possible to export over 6000MW per year to the Czech Republic, and this is expected to grow in the future.

Privatisation

The sector's future is very much dependent on the success of the government's privatisation program. Poland has no integrated electricity enterprises and all 33 regional distribution companies are separate corporate entities, their only activities being distribution. Power production is controlled by 34 enterprises whilst PSE owns and operates the grid, acting as the de facto single buyer of electricity from the generators.

Apart from the few shareholdings in generation that have already been sold, the sector remains entirely state-owned. Minority stakes in each distribution company will also be sold off and trade unions will be awarded up to 15% of the shares, while the State Treasury will keep the residual share.

The privatisation process is essential for the government as it will bring competition and best practice to the industry and move the burden of future capital spending for these plants to the private sector. But progress has been slow.

However, the government's cautious approach is vindicated particularly given that power is such a strategic industry, employing thousands of people and where trade unions need to be sensitively managed.

Privatisation is expected to take the form of a sale of assets to a strategic investor or flotation on the stock exchange. The government's goal is to privatise 12 enterprises in the period 2000-2001, estimated to yield $1 billion. A further 9 power plants and 10 distribution companies are expected to be sold off by 2003.

Lek and Patnow Adamow Konin (PAK) Poland's largest power plant is being privatised and has already been sold to EdF and Elektrim respectively. Elektrim is paying $88 million for a 20% stake. Power developers and strategic investors in general have followed a process by which an initial minority stake is taken in the project and incremental equity built up through investing additional funds in the plant's refurbishment and modernisation.

Plans are also underway to privatise Elektrownia Belchatow, a 4,360 MW lignite powered plant. Belchatow needs $1 billion to upgrade 6 of its 12 units, internal accruals and bank loans are expected to cover $800 million of this, whilst a possible flotation on the Warsaw Stock Exchange could be an option to raise the additional $200 million.

Considerable interest has been shown from institutional investors such as Poland's 20 private pension funds in investing in such a flotation. Pension funds have traditionally been restricted from investing in certain industries particularly in unlisted companies, these regulations however are in the process of review to encourage a more open investment policy.

Other recent developments in the sector include National Power's bid for the Rybnik power plant in southern Poland and the government's decision to choose Tractebel as its preferred bidder for the 1800MW Polaniec plant. RWE is also in negotiations to construct a new 600MW plant at Belchatow II. However this is currently on hold pending Bechatow I's privatisation.

Evidence that international investors are also shifting their sights towards purchase of distribution assets is not borne out by the recent failure of the tender for Bialystok CHP. However industry observers point out it could simply have been time pressure for bid preparation that resulted in no tenders being furnished.

Future state of market

A traded wholesale power market is currently not in existence. There is an absence of any clearly defined electricity trading arrangements and the URE (Energy Regulatory Authority) has failed to meet its statutory duty to promote competition. In response to this the government has asked a consortium led by Endesa of Spain and Elektrim to help set up a power exchange by the end of June 2000. Although a fully competitive market is still some way off, unbundling has begun. Competition is emerging as prices are freed from the Ministry of Finance's control.

In the short term the lack of a market will create problems as the State Treasury has found to its cost. The Treasury will find it difficult to maximise potential revenues from privatisation of state assets because investors currently have no wholesale electricity reference price against which to make asset valuations. The existing prices are numbers that are administratively set to allocate costs across the sector. Therefore even if investors do invest, they are likely to expect significant discounts to compensate them for these additional risks.

Lack of a spot market and a shift towards financing projects on a merchant basis will also raise new challenges, particularly those relating to the creditworthiness of future off-takers. However, privatisation of major distribution companies is expected to create a number of new creditworthy enterprises with which off-take contracts can be negotiated with. The need for government guarantees and other credit enhancement support has not been encouraged in the sector.

As Tom Maj, Associate Director, Global Structured Finance at West LB says: "The Polish financial markets are growing in sophistication and quality deals are coming to the market. Unlike other emerging markets, the involvement of multilaterals and export credit agencies is negligible; guarantees and other forms of credit enhancement are not needed as projects are encouraged to stand on their own two feet."

However, international investors may insist on discounts, in the case of Elektrim's PAK deal last year, it was rumoured that Elektrim only agreed to the acquisition on the basis of a discount, in the absence of a power purchase agreement being in place for the output of the plants.

Vattenfall's acquisition in January 2000 of a stake in ECW, Warsaw's CHP plant also confirmed the trend towards low sales prices (when measured on an adjusted $/kW basis). Vatenfall is to take a 55% stake in the ECW group and plans to invest $340 million. ECW supplies over 95% of the thermal energy consumed in Warsaw representing 24% of the domestic heating market. Although the deal will be financed using Vatenfall's balance sheet project financing is expected to be used in the future.

The reforms of the sector are finally happening, albeit at a slower than expected pace. However progress is being made and bodes well for the industry's and country's future. As Andrew Kozlowski, senior partner, CMS Cameron McKenna Sp. Z.o.o. says: "Many project financiers are now comfortable with Polish risk, and future funding of power projects will in most cases be on a merchant basis. A power exchange is now in the offing together with the development of energy trading activities including the introduction of derivatives." Kozlowski adds: "We also expect all 33 distribution and 34 generating companies to be sold off together with a float of PPGC, but with the government continuing to be a strategic shareholder."