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