Second generation moves forward
Vincent de Rivaz, senior executive vice-president of EDF's financial division
Geoff Knox, director, international finance at ANZ
Investment Bank
James Nyham, Shell
Jacob Worenklein, global head of project finance at SG
What are the main risk in financing a power project?
Jacob Worenklein: Choose your poison. Endless things can go wrong.
But the fact that few projects actually fail is a tribute to the
combination of market need, thoughtful structuring, good
sponsorship and adequate capitalization of most projects.
A few rules of thumb I have applied:
Be sceptical of the value of contracts as the primary basis for
the financing of a project. What counts most is the economic
incentive to perform, so the future economics of the project. When
purchasers no longer need or want the power, even the mighty walk
away. They walk away even from iron-clad contracts. And not just in
emerging markets but even in the US ? as did the US Government's
BPA in Tenaska's Washington State project and Philadelphia Electric
in the Grays Ferry project). Thankfully contracts do mean
something, as both BPA and Philadephia Electric found when they
were brought to account through litigation and forced to pay. But
in the meantime the projects were in deep trouble.
Requirement contracts generally are a poor basis for financing.
Those who bargain for the ability to walk away do so for a good
reason. Scott Paper's decision to close its pulp mill in Mobile,
Alabama and thus eliminate its energy requirements bankrupted
Southern's Mobile project and provided a strong lesson for the
future.
Projects using unconventional fuels often don't work either
physically or economically, and liquidated damage provisions in the
turnkey construction contracts are often inadequate. More power
project loans have gone bad because of technical problems burning
solid waste, wood waste, rice hulls, manure, tires, culm, and other
unconventional fuels than any other single cause to date.
Vincent de Rivaz: The recent financial crisis in many emerging
markets has shown that the ability to raise local currency
financing is a natural hedge against foreign exchange risk, and
then this becomes a critical issue for the success of a project.
Availability of and access to local funding are therefore key
issues to be dealt with to ensure a sound financing
structure.
Geoff Knox: In emerging markets projects, sovereign risk and
offtaker credit risk. Events in Pakistan and Indonesia have served
to emphasize underlying sovereign risk in independent power
projects and the eventual outcome of restructuring initiatives
currently underway in both of these countries will be important in
determining lender perception of risk. In particular, it remains to
be seen whether there is real comfort in lending to power, a
fundamental requirement of any developing economy and the extent to
which the substantial equity base in emerging market deals protects
lenders against significant loan losses.
The Indian independent power market continues to be hampered by
the weak credit condition of State Electricity Boards, the slow
pace of World Bank ? compliant power sector reform and the
reluctance of the authorities to negotiate acceptable senior lender
security arrangements for example charge on receivables, central
government guarantees of offtaker credit risk.
James Nyham: Each project has a unique configuration of risks and
so "main risks" is liable to mislead. However, one would expect any
list of main risks to be considered in the context of the long-term
strategy and cover both general issues and project related issues.
General issues would include political, regulatory and country
issues, such as legal, jurisdiction and litigation, market, risk
concentration and the availability of appropriate resources.
Project related risk issues would include any partner matters,
health, safety and environment, counterparties, technology, legal,
site, power (and steam) sales arrangements, fuel supply, finance,
insurance, construction arrangements and operations and
maintenance.
Vincent de Rivaz: The ability to provide an attractive tariff
structure is in most of the cases a condition for project
developers to being awarded the development of a power project.
Moreover, tariff structures which look attractive to a power
purchaser, very often require the implementation of relatively flat
tariff profiles.
However typical loan repayment structures offered by the market to
a project company present debt service requirements which are very
much front loaded. Therefore, obtaining long term financing with
adequate repayment profiles is one of the key target and challenge
for a project developer.
Which countries/regions do you think are the most tempting?
Why?
Geoff Knox: ANZ's natural focus is South Asia and the Middle East
because of our strong on-the-ground presence in these regions. ANZ
does not espouse "suit case banking". We are particularly excited
about Middle East opportunities, such as further combined power
& desalination projects along the Taweelah A2 model in Abu
Dhabi and the opening up of Saudi Arabia's power market. ANZ was an
underwriter for CMS Energy's $600 million project loan.
James Nyham: Shell takes a perspective which is based on a
long-term outlook on the development of growing energy markets. In
this regard, a great many areas are of interest including Latin
America and Asia.
Jacob Woronklein: There is opportunity everywhere that markets are
being deregulated and competition is being fostered. Euroland will
experience the greatest competitive opening in the next few years
and the reshuffling of assets there is just beginning.
Vincent de Rivaz: EDF being a French developer it is now natural
to consider Europe as its prime development area. Today customers'
needs extend beyond the borders, the recent deregulation in the
European electricity market abolished the boundaries inside the EU
and then the "domestic" electricity market for EDF must be now
thought on a European scale.
Despite the recent financial crisis some emerging markets still
offer significant potential for growth. EDF has identified some
priority areas for its international development and therefore the
company is looking more especially to Latin America, Northern
Africa and Middle East and continental South East Asia. EDF's
development is carried out through independent power projects but
also through acquisitions. Acquisitions are a key growth prospect
for us in countries where the potential for new independent power
producers seems limited today such as in some south-east Asian
countries.
Which power markets do you consider are off limits? Why?
Jacob Woronklein: No country is completely off limits if adequate
political or commercial support can be provided through
multilateral, export credit, ECA, sponsor or other credit
enhancements. In the absence of such mechanisms, power projects as
a general rule can be financed in the bank or capital markets if
the sovereign itself can raise financing. This is because the most
fundamental risks of a power project in an emerging market relate
to such country risk issues as devaluation and inconvertibility of
currency, which are key risk issues in the credit of the country
itself.
Our challenge is to broaden the availability of financing by
creatively increasing the options sponsors have for solving the
most pressing country risk issues. These may include such
mechanisms as pinpointed sponsor, miultilateral, and other
political risk guarantees for the very specific risks of greatest
concern , the establishment of jointly owned political guarantee
institutions, interest guarantees, and other mechanisms that
address a project's specific needs.
James Nyham: Shell operates in over 130 countries. Where the
regulatory structure permits, in principle, no markets are
considered off limits but, from time to time, markets go through
phases when projects are difficult to realise
Vincent de Rivaz: However EDF is also interested, on a case by
case basis, in any power project elsewhere which provides a sound
economic basis and a structure which complies with the market
requirements for financing such projects.
What funding options do you consider when financing a power
plant?
Jacob Woronklein: This leads to the litany of usual suspects. But
as to capital markets debt financing I would say that the surge in
bond offerings for projects in the US and UK in recent months
brings the situation back to normal from the hiatus we experienced
in most of 1998.
Geoff Knox: In emerging market deals we prefer a mix of local bank
and offshore bank risk-taking or the involvement of multilateral
agencies to manage country risk. The former can take the form of
local currency loans and/or guarantees.
James Nyham: Each project is considered on its merits. Given the
range of Shell activities and the very wide range of funding
options used, there is an open mind. For power projects, the best
option would be agreed in conjunction with our partner in a
particular project, InterGen or another specialist power partner as
the case may
Jacob Woronklein: The fact is that over the long term, bond
financings should increase dramatically from the approximately 10%
of total project debt represented by bonds in 1997 and 1998. The
reason simply is that bond investments represent the flow of funds
from the largest source of capital in the world ? institutionally
managed capital, including pension funds, mutual funds, insurance
companies and other professional money managers.
McKinsey estimated a few years ago that by 2000 global savings
will amount to close to $90 trillion. A large portion of this is
under professional management and theoretically available for
long-term debt financing (among other investments). This amount far
exceeds the total capital available for bank lending.
There are still many challenges to overcome in the development of
the bond market, including disadvantages to issuers stemming from
negative arbitrage during construction, penalties for
prepayment,and lesser flexibility in restructurings, amendments and
the like. Similarly, from the investors point of view, more work
needs to be done to expand the market of potential investors and
greater liquidity needs to be provided by market makers in bonds so
that investors can in fact exit at a price they accept as
realistically reflective of the market,. In addition, defaults
experienced in several bond issues in the past year (not just in
Indonesia but in the US as well) have increased the caution of
buyers.
But despite the challenges, bond financings will increase
dramatically in volume and in market share in the next few years as
a result of the simple flow of capital into institutional managers
and the relative value afforded by project bonds as compared to
sovereign and corporate bonds.
Vincent de Rivaz: In principle all funding options are open to us
when considering the financing structure for a project. This goes
from corporate finance to pure limited recourse project finance
schemes. The appropriate option is chosen on a case by case basis
depending on the project specific structure: country profile,
shareholding structure, roles performed by EDF ? investor/owner's
engineer/constructor/operator, type of debt financing available,
adequacy of debt pricing, i.e. pertinence of risk assessment by the
potential lender.
When selecting the possible project lenders and guarantors,
careful attention is given to minimising the number of financial
sources and to the procedure which will be followed by these
institutions during their project appraisal. Keeping close control
of time management, which implies a proper management of the
various lending parties, is a critical issue for a project
developer and a suitable financing structure will take this
parameter into account.
What new financial instruments are being used to finance power
deals? Could you explain them?
Geoff Knox: Since the Asian financial crisis of 1997 the financial
community's appetite for emerging market exposure has been limited
and the emphasis has been in getting deals done at all. This has
not been the right environment to introduce new instruments. In
fact the old stalwart sources such as export credit agency ?
supported loans have seen increased usage and have become more
attractive to sponsors following the changes in the OECD consensus
last year to extend tenors and harmonise exposure fees.
Vincent de Rivaz: We have not used new financial instruments to
finance our projects. Innovation does not always help to overcome
the complexity of project financing and more often innovation must
be considered as generated by a different and new combination of
already existing instruments.
But we are closely looking to the bond market to bring much needed
long term financing. In addition, as it was done last year on the
Shandong power project in China, we tend to privilege local
financing where it is available to mitigate the foreign exchange
risk. The Shandong project can be considered as an innovative
project, in the sense described above, as it combines for example
foreign and local debt, breaking new ground for China project
finance.
Jacob Woronklein: Corporate financing techniques are increasingly
being applied to finance major power transactions, particularly
acquisitions of systems of generating assets with their greater
diversity of risk. Thus, for example, in the financing by US
Generating of the New England Electric System assets, the borrowing
vehicle, rated investment grade, issued commercial paper supported
by revolving credit commitments, resulting in significant savings
in borrowing costs. This financing was part of a trend during the
past year in the US of financing acquisitions with short-term
maturities to increase the size of the bank market and reduce cost.
This is an approach utilized by Sithe in the Boston Edison
acquisition and Mission in the Homer City acquisition and
implemented by NRG for its East Coast acquisitions.
In part, these financings are bridges to capital markets takeouts,
which has enabled the deals to close initially with banks taking
much higher hold positions than normal, recognising that a major
part of the positions will be off their books in a short period. An
extreme example of this was Enron's acquisition financing for Cogen
Technologies several months ago, where our position was funded and
on our books for all of one week before we were repaid by a bond
refinancing. Here is the rest of what I promised to send. 6. How do
you think the export credit agencies and multilaterals can provide
more support for power deals in emerging markets? They could
greatly expand the amount of capital committed to power projects by
adding the risk of defaults arising from currency devaluations and
the risk of defaults by governmentally-owned entities, such as
power purchasers or coal suppliers, to their political risk
coverage packages.
How do you think that the export credit agencies and multilaterals
can provide more support for power deals in emerging markets?
Vincent de Rivaz: A lesson from the recent financial crisis is
that adequate political risk cover, including appropriate currency
risk hedging instruments (such as local funding), is a key lenders'
requirement in most of the emerging markets. Naturally developers
tend to turn to export credit agencies and multilaterals as a
source of political risk cover.
Such support from these institutions can still be expanded by
improving the availability of extended political risk cover ?
extended to cover contractual obligations of governmental bodies.
Flexibility on the kind of risk coverage offered is greatly
appreciated. An appropriate instrument which should be more broadly
on offer would mirror what is granted by the World Bank under its
Partial Risk Guarantee program.
In addition, longer average maturities would be of great help for
power deals. Although the OECD consensus rules for project financed
transactions, as modified last year, now potentially allows
extension of the repayment period up to 14 years. The constraint on
the average repayment life is such that it does not help a lot in
profiling the loan repayment structure, which is of key importance
to achieve suitable tariff structures.
It also appears that agency financing may appear as an expensive
source of funding, as the risk premia charged by some agencies
prove to be onerous for covering emerging countries risks.
James Nyham: It is inevitable that those involved in developing
projects will always seek more support from these agencies.
However, a certain realism in recognising the constraint imposed by
the wider aims and objectives of these agencies is necessary.
Jacob Worenklein: They could greatly expand the amount of capital
committed to power projects by adding the risk of defaults arising
from currency devaluations and the risk of defaults by
governmentally-owned entities (such as power purchasers or coal
suppliers) to their current political risk coverage packages.
Geoff Knox: Export credit agencies and multilaterals have stepped
in to partially compensate for the reduction of commercial
bank/bond market appetite for emerging market risk although the
aggregate support from these sources is restricted by manpower
constraints and the slowness with which project appraisal is
typically conducted.
Do you think the power purchase agreement is redundant in
developed markets? If yes, explain why.
James Nyham: In liberalised mature markets, for conventional large
scale thermal plants, the current answer is probably yes. The
answer is not so clear where progress towards energy policy
objectives for promoting renewables and other technologies, such as
distributed energy or fuel cells, may require some variant on power
purchase agreements.
Vincent de Rivaz: I don't think so, at least on the short run.
There are very few countries in which the spot market is the only
supply basis for the power market even if it tends to become the
benchmark. It is true that electricity prices are currently
dropping, partially because of very low gas price. There is no
certainty on the long run that this trend will continue. Some
purchasers may prefer to secure power prices on a very long run, to
the extent that they are fixed at an attractive level.
In the US and the UK, there have been a series of merchant power
plants in the past year, what are the main challenges financing
such plants?
Jacob Woronklein: The primary risk is the price curve ? will
prices be as projected, a serious issue in all global deregulated
markets given that prices have generally fallen below initial
expectations. In the US the first season's results in New England
and the Mid Atlantic (PJM) area suggest that prices (particularly
capacity prices) were lower than expected under sponsors' base case
models in New England (but not lower than the more conservative
forecasts we used as lenders in the financings of these assets) and
higher than expected in PJM. This is not a science although we are
approaching the pricing projections as scientifically as we can
based on very detailed models of demand and supply.
How has the development of merchant plants changed the way lenders
finance power projects?
Jacob Worenklein: Relying as we must on power revenues from a
competitive power market, we have become experts on complex pricing
models integrating the most relevant supply and demand factors,
including estimates as to future supply increments. The great
challenge has been to do so with a sufficient margin of error to
avoid the risk of default in bad times. Such factors as high
sponsor equity levels, fuel supplier support through partial
subordination of fuel payments, diversification of supply risk
through a system of multiple units,etc. have helped us get
comfortable with these risks.
Geoff Knox: While emerging market power deals are still being
closed on the basis of long-term contractual arrangements, bank
credit committees are equally focussed on the fundamental credit
and competitive strengths in relation to other generating
assets.
Vincent de Rivaz: It seems that the lenders, for obvious reasons,
are much more sensitive to the fuel supply agreement, or to the gas
market when there is no contract. The ability of the sponsors to
ensure an optimal operation of the plant is also a more scrutinised
issue.
In any case, the existence of a spot market in addition to the
power-purchase agreement (PPA) scheme is an incentive for the
sponsors to propose the most competitive electricity price. The
lenders are more and more sensitive to the intrinsic economic value
of a project and how it ranks in a power system. Only "low cost"
projects, which remain competitive on the basis of long run avoided
costs of a given power system, will probably be financeable, as
they mitigate the risk of re-opening the tariff levels set out in a
PPA.
Are you involved in any renewable energy projects? What are the
advantages/disadvantages of such projects?
James Nyham: Yes, we are active in forestry, biomass, solar and
wind projects on various parts of the world. Shell is committed to
developing renewable energy as a core business.
Vincent de Rivaz: The key advantage of renewable energy projects
is obviously the limited impact that they have on environment;
environmental issues being a basic priority for EDF.
Another key advantage of renewable energy projects is also
obvious: they are not affected by variation in worldwide fuel
price. In a power market which tends today to be purely driven by
gas fired power plants ? sustaining competition with low cost gas
projects being a challenge today for other energies ? power
regulators may consider mitigating their exposure to long run fuel
price by considering more carefully renewable energies.
EDF has recently closed a 50 MW wind-mill project in Morocco
comprising 84 wind turbines. One advantage of such technology is
that the technical risk is spread over a large number of individual
wind turbines thus reducing the average probability for major
outage.
EDF is also looking to some "good" hydro-power projects where the
economic value of such projects can to some extent compare to the
average cost of electricity produced from gas fired plants.
In addition, EDF is keen to promote clean coal generation
technologies, such as the integrated gasification combined cycle
power plant developed in Spain (Elcogas Project) and the fluidised
circulating bed technology of the Gardanne Project in France. At
last, let's mention that EDF's nuclear power plants provide a
environmental friendly source of electricity.
What advantages or disadvantages do you think integrated oil/gas
and power companies have over traditional power companies?
James Nyham: The advantages that integrated oil and gas companies
have over some traditional power companies relate to relative
balance sheet strength and creditworthiness, potential flexibility
in managing take-or pay issues and whatever arbitrage opportunities
may arise from diverse fuel and geographic positions.
While we may have a certain view on the advantages such as our
ability to manage fuel supply issues and good local market
knowledge through other business activities , it is, as always, a
matter of horses for courses. In certain cases, the wider scope of
integrated oil/gas companies' interests may enable a different
perspective to be taken on risks that may be assumed.
Geoff Knox: By combining fuel and power sales, these companies are
able to move away from the heavily regulated power sector towards
the more open hydrocarbons sector. For example, Enron's Dabhol LNG
receipt , storage and regasification terminal and power plant in
India will be delivering natural gas to third party industrial and
power plant customers in addition to power sales from its own
plant. Integrated oil & gas companies also have the opportunity
to monetize marginally economic gas reserves by delivery directly
into power plants. We expect to see this model used in markets such
as Bangladesh, India and Saudi Arabia.
Vincent de Rivaz: Integration enables the developer to mitigate
the global project risk by gaining control over the fuel chain. It
gives the ability to secure alternative sources of fuel for a power
project, in addition to the primary fuel which is generally made
available to a tendered independent power producer under a Fuel
Supply Agreement with the national fuel company.
Jacob Woronklein: The issue is whether these companies have both
the will and the skill to compete and to succeed.
As to will, integrated oil/gas companies need to make a decision
as to whether they wish to be serious players in this business.
Most oil companies that originally announced their intention to
compete on a broad front have pulled back because of concerns over
the inadequate strategic alignment of the power business with other
parts of their business. The truth is that integrated energy
companies with major gas reserves are already exposed substantially
to the risks of the power business, which is the main user of their
gas. They are therefore in the power business already from a risk
standpoint. By being more active players they have a greater
opportunity to create and control markets for their gas.
Having reached this point of decision, as many have, they need to
decide whether they can be successful as highly focused players or
whether the skill sets they need to compete effectively need to be
honed on a broader, larger playing field. The skills to compete and
to succeed will follow from the decision on objectives. The issue
is one of tactics of execution -- there are various viable ways to
achieve these skills once the companies have decided what they
really want to do. Energy companies will be able to succeed
formidably (including through the acquisition of powerful players
in the power business, all of whom are much smaller than the major
integrated companies) if they decide that it is important to do
so
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