How will the world’s power needs be project financed?
The energy infrastructure market has been hit by what could be termed a perfect storm.
First, the need for new power facilities has rarely been greater. A huge amount of investment is needed to either replace or build new ones. In the Middle East alone it is estimated that US$200 billion will be required over the next ten years. In the UK, estimates for financing the recent round of offshore wind farms are in the area of £100 billion. In Africa a recent headline in the South African press reported the need for US$115 billion investment in the power sector.
With similar requirements in other parts of the world, the amounts required are truly staggering.
Secondly, increasingly the nature of the facilities needed are being dictated by climate change concerns. The political will behind new technologies is stronger than ever. In itself, this is of course needed and welcome, but the impact it has on costs is worrying. There is no escaping the fact that greener power projects cost more. And although financial incentives granted by governments or, for example, by the EU’s NER300 process are welcome, they barely scratch the surface of the funding requirements.
Thirdly, utilities globally are capitalconstrained and are under balance sheet pressure. We have seen many utilities announce strategic reviews and disposal programmes. Management teams at many utilities across the globe are having to make hard decisions as to which projects will go forward, which will be delayed and which will be cancelled.
Fourthly, boom has become bust in the banking sector, and there is a limit on the levels of bank capital available. Most bank balance sheets are constrained and are likely to be further affected by the requirements of Basel III. The requirements of Basel III may also restrict the kind of long term funding that is ideal for projects in the power sector. This is at a time when much of the short term funding (finance with tenors of three to five years) that was put in place in the immediate aftermath of the credit crunch is due to come up for refinancing.
Fifth, infrastructure funds and specialist funds (such as renewable energy funds) have not been able to raise fresh funding at levels approaching what they could raise during the boom period. There is hope that fund raising conditions will improve in 2011 for funds with a proven track record but we cannot expect that these funds will fill the capital gap.
Finally, power is not the only sector vying for attention. Other major infrastructure projects are providing serious competition when it comes to parting investors from their money, with Crossrail in the UK to name but one high profile example. Put these factors together, and many in the community feel we are in the midst of a perfect storm. Let’s have a look at some of the ways we can navigate it.
This briefing was first published in Infrastructure Journal on 12 November 2010
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Recourse to bond markets
Historically, the use of bonds to finance greenfield projects in the power sector has been limited. The activity we did witness over the last ten years was generally in the infrastructure/PPP sectors and almost always has been on the back of a monoline wrap.
Bonds are not ideally suited to Greenfield projects for a number of reasons. Putting it simply, the bond markets do not like construction risk. Greenfield projects also usually require advances of funding on a number of milestone dates during the construction period – something the bond market isn’t set up to deliver. Then there’s the difficulty presented by bond trustees needing to monitor compliance during the operation period.
Making decisions can also be a problem. Most projects often require decision-taking by lenders, particularly during the construction period, and calling for a vote of bondholders is a cumbersome process. Since the retreat of the monolines, we are starting to hear calls for a "super trustee" role – which we all spent lots of time considering ten years ago before the monolines came along and de facto assumed that role.
Consequently bonds are generally much better suited for refinancing a project once it is complete and there is a secure cash flow, or perhaps bundling together a number of projects into a special purpose vehicle and securitising the whole. Using the bond markets for these purposes would of course have the benefit of freeing up liquidity more generally in the market.
One recent trend is the use of export credit agencies to wrap project bonds. The recently announced SACE wrapped bond for Sunpower’s Italian solar PV portfolio is an example of what can be done with a flexible agency and innovative structuring.
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Investment in infrastructure projects, including power, seems an ideal repository for pension funds. If there is a guaranteed offtake arrangement by a creditworthy entity, then providing a guaranteed return for a number of years is exactly the sort of asset pensions should be investing in. If there is a tariff which is inflation linked (which is the case with some feed-in tariffs and the UK renewable obligation certificates) then on paper this also attractive for pension funds.
However, direct investing requires pension funds to have the resources to undertake due diligence and then behave as asset owners going forward. Not all the large pension funds are geared up to do this.
There is a role for banks and specialist advisers to assist the pension funds to make the move towards greater levels of direct investments. We believe that the direct investing route will increase, especially with concern expressed by these investors over the incentivisation and fee structures derived from the traditional private equity model.
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The financial crisis has reduced flows into infrastructure funds. We believe that the model is moving towards more open-ended funds and less leverage is being sought at the project and fund level. In most cases the infrastructure funds prefer operational assets rather than Greenfield projects so they do not provide the solution for funding construction costs.
We have recently seen some infrastructure funds successfully list and raise secondary capital such as HICL and IN PP with John Laing Infrastructure expected to achieve its IPO. To date these funds have not been actively involved in the wider power sector but we expect that this will change over time, especially as more utilities and other players such as oil companies concentrate on higher margin areas of the sector and divest traditional business such as transmission and distribution, renewables and contracted generation.
Infrastructure debt funds were touted as a possible saviour but to date there are limited examples of them providing significant levels of capital. One of the most high profile has been Industry Funds Management in Australia which provided a significant tranche of debt for the Victoria desalination plant.
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Take out funding
With many commercial banks likely to focus increasingly on short term lending, some have mooted the possibility of them funding projects during the construction period with a guaranteed take out post completion by long term debt.
This could be structured by way of a government guarantee (assuming the government has the necessary credit standing) of the debt, with a bond issue to raise the refinancing amount or funds set to invest long term on low risk.
This way the commercial banks could fund the start of the project on a short term basis, and the project would benefit from long term “guaranteed” cheaper debt post completion. For its part, the government would benefit from a contingent liability on its balance sheet and would not be required to lend funds from the public purse. Alternatively, the long term funding could come from pension funds.
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Local currency lending
For projects that struggle to raise US$ on the inter-bank markets, local banks could be a promising option. Local banks will have access to local currency deposits which could be used as effective project finance. Of course, this may not work for everyone, and in some cases it may only ease rather than close the funding gap, but it has already been proven to work well when the circumstances are right, for example on Saudi Arabia’s PPII project. One of the most significant local funding markets over the last year has been Brazil and we understand most of the projects developed in the power sector during this period in Brazil have been funded largely from the local market.
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The ECAs (and other institutions such as EI B, EBRD , IFC , AfDB and AD B) will continue to be an important and necessary source of funds. Not only in terms of providing much needed liquidity, but also by providing political and commercial risk guarantees to enhance the bankability of projects.
Could these institutions play a greater role? They could provide guarantees to support some of the take out funding referred to above, either to enable or to enhance bankability where a government credit rating is insufficient. We have recently seen KfW of Germany come out with an innovative loan guarantee structure for the German offshore wind sector.
They could also develop other products to ease the fear of finance. For example, giving guarantees against change of law risk (as was recently seen on the Abengoya JGC solar project in Spain) or giving local currency guarantees to facilitate lending by local banks – a role Guarantco currently undertakes.
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Forward payment facilities
This taps into the essential necessity of power projects. We are all reliant on power, whether we like it or not. It isn’t like building a car factory, where you’re not sure if you’ll be able to sell all the cars you produce. Power projects all have offtaker(s) that will use the power they generate. Where those offtakers are cash rich, some form of prepayment could be agreed, essentially selling the electricity before it’s generated at a discount, and using the proceeds to fund the building and construction of the project. A structure along these lines has been used in France on the Exeltium transaction. The commercial banks financed a 24-year contract with EDF that is used to supply electricity to the three dozen companies that are shareholders in the Exeltium consortium. They include metal manufacturers ArcelorMittal, Rio Tinto Alcan, chemicals groups Air Liquide, Rhodia, Solvay and Arkema and paper manufacturer UPM Kymmene.
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A number of projects (primarily In the Middle East) have benefited from Islamic funding. In many areas of the world, this remains a largely untapped possibility.
However, most institutions participating in the Islamic market suffer from the same constraints on their balance sheets and lending as the commercial lending market. So although Islamic funding is likely to provide additional tranches of debt, to some extent it may only replace, rather than be in addition to commercial debt.
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The oil and gas market is used to seeing co-lending by sponsors. There is no real reason why such an approach couldn’t be brought to the power market to good effect as well (this would of course be in addition to equity contributions and subordinated loans).
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There’s no getting around it, it is one of those “difficult truths”. The worldwide demand for power is set to increase, and the ways by which we provide that power needs to change. The infrastructure in many markets is groaning and needs to be upgraded. Catering for all these facts is an expensive business, and the money will have to come from somewhere.
The last ten years have seen major technological advancements in the power sector. Innovation has been the name of the game, with engineers, scientists and garden-shed inventors working hard to rise to the challenge. The solutions they have come up with are varied and often brilliant.
A similar challenge now faces the project finance community. Finding the money for these projects will take just as much innovation and just as much imagination as the projects themselves. There will be no single answer, no golden bullet. But the ideas are there, and many of the doors are already half open.
I’m optimistic. Maybe it isn’t such a perfect storm after all.
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