The arrival of a rarely-seen 'pure' project financing in the Russian market is a demonstration that dealings with the infamous national champions need not be characterised by frustration.

Bullish expectations about the future of aluminium are currently driving a global wave of expansions and acquisitions. Amongst this sea of expectation, the arrival of the Khakas aluminium smelter expansion as a classical project finance deal is a sign of how much attitudes towards risk and financing in Russia are changing.

At US$750m it is easily one of the largest Russian project financings closed to date, and the first for RusAl. It is also an Equator Principles compliant project and the only primary production aluminium facility Russia has built in the last 20 years.

The Russians are no strangers to structured finance, but in recent years, classical project finance deals have been thin on the ground. 2006 marked the nadir of investor confidence, with the collapse of the Shtokman negotiations and rumours of political bullying in the sequence of events which led to Gazprom taking a majority share in the Sakhalin II project.

But stereotypes are changing. Russia now ranks 3rd amongst emerging markets as source of outward foreign direct investment, and this latest deal heralds a better way of doing business in a market which has hitherto been accused of complicated ownership structures, lack of transparency and a poor understanding of modern environmental, health & safety standards.

The Project

The plant is located on the site of RusAl's existing 500,000 tpa Sayanogorsk smelter in the Southern Siberian republic of Khakas. Originally planned as a 300,000 tpa aluminium smelting plant, it was running at well below capacity on 15 December 2006, when the first aluminium was produced at the plant. The closure of the deal clears the way for expansion work which will fulfil the capacity in accordance with the original expectations of RusAl. 

The smelter is one of the most technologically advanced in the world. It will use baked anode RA-300 units  which produce more than 2,050 kg of aluminium daily, and are one of the most modern and environmentally friendly aluminium production technologies currently available. The production mix will include ingots and T-bars.

The environmental credentials of the project are impressive. The Alstom-commissioned gas treatment plant on the project is the largest the contractor has ever delivered, treating 2.8 million m3/h of pot gas, and achieving a reduction of fluoride emissions of at least  99.5%.

All technological processes in the new smelter will be controlled by control systems, which allow the process operations to be efficiently regulated and the pots, GTCs, casthouse, anode plant, and auxiliary facilities to be permanently monitored.

Financing

On 14th March 2007, BNP Paribas closed a US$500m amortising limited-recourse term loan which will be used to expand the existing facilities and refinance existing debt associated with the project - a corporate loan from Sberbank.

Despite an unusually long tenor of 12 years, the project was able to benefit from competitive pricing of Libor + 120, rising to 200 by the end of the term. The deal was closed in a single-stage syndication with BNP Paribas as the sole MLA and bookrunner. The other participating banks were:

• Calyon
• BayernLB 
• HSBC 
• Mizuho 
• Natixis 
• Sberbank 
• SMBC
• Societe Generale. 

The banks were happy with the risk profile of a player as large as RUSAL. Supply risk was mitigated by RUSAL's  portfolio of bauxite supply projects in Russia and further afield: in bauxite, alumina and cathode production. The price of materials and outputs was subject to the tolling regime normal to all such Russian projects. This should be viewed as an accounting trick whereby revenues at the smelting plant itself are minimised in order to maximise revenues accruing to offshore affiliates of RUSAL which sell the actual aluminium, and which are not subject to Russian tax.  

A questionmark hung over the reliability of the Russian grid, although it is understood that arrangements were put into place which will mitigate this risk. RusAl is at any rate angling towards becoming a player in domestic energy markets, which will reduce reliance on federal energy supplies.  In a pattern mirrored by other energy intensive Russian industries such as Gazprom Neft, albeit on a rather larger scale, it has a $US10bn nuclear power plant planned - a move which will give it more security over energy supplies.

Ambitious Plans

The recent merger of RusAl, Sual and Glencore into United Company RUSAL, has created shockwaves throughout the industry. The deal created the largest Aluminium producer in the world with an output of 3.9 mtons per year, but perhaps more importantly created a company with an even more vertically integrated and diversified structure.

The implications for investors are profound. Firstly, this will help to reduce costs through efficiencies of scale. Secondly, a more vertically integrated business structure will increase natural offtake options and pricing power, which will reduce risk. Both developments will increase the attractiveness of the company to investors. 

RUSAL are currently engaged in an enormously ambitious expansion strategy which will involve spending over $USD 10 bn in aluminium projects alone by 2010.  (It spent over 1bn in 2006). These commitments are backed by an outlook of  rising commodity prices, domestic economic growth and access to low-cost resources. China will be a key player in this, with predictions that it will by 2015 consume one third of global aluminium output. RUSAL's proximity to this important market is a key factor in this strategy.

How this investment will be financed is unclear. The notoriously secretive board of directors announced publicly in March that they will hold an IPO within three years. But RusAl and SuAl have between them attempted two IPOs in London over the past three years, neither of which was a success. The issue here is that Rusal and SUAL do not issue detailed financial reports for public scrutiny - only an annual revenue figure (which is a measure designed to minimise their tax liability in Russia.) Project financing further expansion would provide RUSAL another avenue for funding without having to disclose sensitive data about their existing operations. Banks appreciate dealing with major players when it comes to standalone projects, as they benefit from greater backing, limited liability  notwithstanding. So it would seem that RUSAL and project finance specialists are a good fit for one another.

Tax dodging - big business in Russia

Whereas alumnium is clearly a less geopolitically sensitive commodity than, say, oil, the presence of a single conglomerate controlling upsteram and downstream operations in the Russian Aluminium market is bound to raise hackles with the Federal government, primarily owing to the mechanism with which aluminium producers have historically used to minimise their tax bill - namely, 'tolling'

Tolling is a a chain of contracts whereby a smelter accepts a processing fee for electrolyzing and smelting the metal, and the company which owns the alumina receives aluminium metal in exchange at rates unsupported by the going market rate for the metal. This is then exported for sale in the international market. Russian law regards such a scheme as legal if the alumina supply company, the owner of the smelter, and the companies which receive and sell the exported metal are legally independent of one another. However, if they are all owned in common by the same company, group, or shareholder, then it is considered that tolling potentially becomes a scheme of tax evasion, rasing the prospect of  accusations of corporate fraud, racketeering and lawsuits.

In the RUSAL case, this is clearly an issue. Russian regulators are aware of the sums at stake, and the Tax and Budget Committee of the State Duma commented ominously "There is only one issue – what [trading] scheme will be used. If this will be the tolling scheme which Rusal uses, we will get lower taxes. As to control of the tolling regime, the government already has some tools to prevent massive tolling and tax evasion".

So should foreign investors be worried? That RUSAL has been involved in tolling for the last few years is no secret to those in the industry, despite SUAL's protestations of innoncence. But so far it has been political will that has been the drivers between the major shocks in the Russian investment community - the Yukos breakup, as well as the well publicised Shtokman and Sakhalin II situations. The prominent victims have either been political opponents, or foreign companies. RUSAL is neither. A source close to the project privately confirmed that there is little risk that the government would act to jeopardise inward investment inflows, and that it is more likely that RUSAL will come to an understanding with the government over tax.

Conclusion

Given the consolidation evident in the major Russian commodities players, this project represents a template which could well become widely imitated in Russia as a whole.  Dolan Hinch of Calyon commented that 'with increased appetite for longer tenors apparent, project financings will become increasingly attractive in the Russian market'. He also remarked that dealing with major player such as Rusal represent an easier task for risk analysts, given their expertise, the synergies between the divisions in the company and their enormous size.

It is an added bonus to socially aware investors that United RusAl have a strategy that commits them to a course of social and environmental responsibility. That the project was Equator Principles compliant is a welcome surprise for a country that did not close a single compliant limited recourse deal in 2006.

RUSAL are an ambitious world leader with ecological and social credentials to their name. It is unlikely that they will fail to find a willing stream of investors willing to bankroll their future plans. And with this deal established as a template, it would be surprising if they did not bring a few more project financings to market in the coming years.

The project at a glance: