Is project financing for water projects in the Middle East headed for uncertain times?

“Given the dramatic restructuring of the financial sector post-2008, can we still look to privatisation to drive the quest to deliver competitively priced water? Has this (restructuring) forced a rebalancing of the risk appetite? Has the cost of financing increased? Are funds still really available for water and power projects? If so, where? ” These formed a part of bunch of questions posed by Paddy Padmanathan, President & CEO of ACWA Power Projects as he, together with session co-chair, the venerable Ghassan Ejjeh, Director of Six Construct, prepared the ground for the roundtable on ‘The relevance of private finance in delivering competitively priced desalinated water’ at the IDA World Congress session on ‘Financing, privatisation, economics and project delivery’ which they were co-chairing. The round table panellists were Usha Rao Monari, Senior Manager, Utilities and Private Public Partnerships, International Finance Corporation (IFC); Ravi Suri, Head of Project and Export Finance, MENASA, Standard Chartered Bank and Alexandra Boleslawski, Managing Director, Global Head of Power, Project Finance, Calyon.

Privatisation can be rightfully regarded as the key contributor to the development of a booming desalination market in the past five years. It has been credited with diversifying the technology (as the mix of RO, MED and MSF high capacity plants within the IWP and IWPP framework bear out), striking a balance between technical risk, reliability and price competitiveness, and most important, putting the spotlight on the true cost of water or as Padmanathan delicately put it, “the true cost of water affected and possibly diluted by fuel price.” Has the financial crisis discredited privatisation? Given the funding squeeze and the ongoing restructuring of the financial sector, can privatisation deliver competitively-priced water? What are the consequences of the focus on bulk IWPs and IWPPs that privatisation basically encouraged?

As water and power sector privatisation ran its course in the Middle East, the cost of desalination dropped from around $5/m3 to nearly $1/m3, though the true price of desalination could be much higher given the fuel price embedded within the $1/m3 figure. The question is: Did this reduction come about purely due to technological innovation or did financing cost reduction too contribute to it?

During the years leading to the current crisis, project finance had matured, risks got understood better and lender’s margins had dipped below 100 basis points (bps) before 2008 re-balanced everything. Does this mean that the limited private financing capacity post-crisis is causing an increase in the cost of desalinated water? While growth of new water capacity in countries who can afford $1/m3 or over is fine, what about the really under-served countries? Can the private-sector really serves them or are they to be denied the efficiency and through that the lower cost of water that privatisation is able to bring? Is there a role for multilateral agencies like IFC in hedging country and currency risks?

Padmanathan felt that the focus on increasing water availability through bulk IWPPs and IWPs addresses less than half the real cost of inefficiencies within the sector. “Are opportunities for optimisation – particularly demand management and distribution losses – getting ignored along the way because we are focussed on putting more and more water into the system?” he wondered. Moreover, the average daily water consumption per capita in a water starved region like the GCC is 1,000 litres, in stark contrast to 90 litres for a city like Munich in Germany. The bottom line is: How long can this subsidisation of water be sustained?

Padmanathan also drew attention to the issue of carbon footprint and energy consumption associated with desalination. He suggested that “we are better off using this resource for treating and re-using wastewater effluent,” and invited Monari of IFC to kick off the discussion.

The cost balance

Monari chose cost of supply side infrastructure (which includes desalination, wastewater plants, related transmission & distribution networks) as her starting point, observing that the two major supply side costs are a) the cost of energy used to pump out or desalinate or re-use water, and b) the financing cost or the overall cost of the contractual/financing arrangement. To contain supply infrastructure costs, IFC is supporting innovative solutions, like using alternative energy to power desalination and wastewater plants on the technology side and putting together new instruments and funding packages on the finance side.

At the same time, IFC is also putting equal emphasis on demand management and more efficient use of water. Monari explained, “If we produce a lot of water – by developing the supply infrastructure or by reducing desalination costs through technology – but lose 60-70% in the distribution system, what have we really achieved? The issue of getting water out to the largest number of people still remains open. Also, not many financial institutions are ready to put their money into or influence the demand side of water.”

Alive if not kicking

Boleslawski of Calyon asserted that even during the worst period of the current financial crisis, the project finance market didn’t shut down except that deals took a bit more time and creativity to structure, like for example, the use of bridge loans where sponsors had to shoulder a degree of refinancing risk to close the funding till the time liquidity was restored. Al Dur in Bahrain, Rabigh in Saudi Arabia, Shuweihat 2 in Abu Dhabi and Astoria Energy II project in the US were some of the major power and water deals that were closed in the midst of the financial crisis.

Boleslawski also contended that the financial crisis didn’t challenge the benefits of privatisation or project finance. “Project financing continues to remain the best method of allocating risks among different players. It is a straightforward way of raising money in a consortium rather than the corporate debt route and brings with it the benefit of excellence and discipline in the contractual structure,” she noted.

On the cost of financing going up, she felt that crisis has resulted in a dynamic situation where the market changes quickly. “You need to be flexible enough to be able to capture this dynamic. One of the lessons that emerged from this crisis was that for a very large transaction, we need to think of multiple things, like mixing diverse sources of financing and building some redundancy in the financing plan so as to get to the optimal structure.”

Suri debunked what he described as the three big myths of project financing prevalent today – first, project financing is dead; second, it is expensive and third, the risk allocation is not healthy for banks. The shrinking of the project finance market, catalysed by the financial crisis, means that only correctly structured projects, with strong sponsors and in sectors where sector laws have been passed or unbundling correctly carried out can get financing, unlike the heady pre-crisis days when lenders were less disciplined.

He also dismissed the perception on project finance becoming more expensive after the credit crisis. He continued, “If one looks at the tenor of the debt and the ballooning of the structure one can get in debt, it works out to be very attractive from an equity ROI standpoint. Bank debt in the GCC can go longer than 20 years, which is longer than the bond market. So it is very attractive, even though the coupon may be higher.” During the financial crisis, while margins did increase, this was offset by the decline in Libor. “The Libor plus spread cost, even during the peak of the crisis, was pretty much close to what it was before the crisis as Libor had come down though margins had gone up. So project finance debt continues to be attractive and is not expensive,” Suri explained.

The third and biggest myth of project finance, Suri continued, was that the risk profile of project finance not being healthy for banks. Pre-crisis, the risk profile was skewed with EPC contractors, who typically exit after construction, enjoying huge profits, while the sponsors and lenders, who remain around for a longer period, had to be satisfied with very low margins. Post-crisis, the EPC market has become much more competitive and there is much better risk sharing between all the parties involved, helping balance short term and long term interests. “With Basel II coming into play, banks have also started pricing project financing risks appropriately,” Suri concluded.

However, Monari cautioned that the perception of project finance being ‘not dead’ varied depending on which part of the world one was talking. She argued that post-financial crisis, project financing more or less dead in the not-so-strong markets, where even well structured projects have country risks and if the country doesn’t have risks, the project is not well structured.

Monari reminded the audience about the Asian financial crisis of the late 1990s, which resulted in a ‘lost decade’ when infrastructure projects in many Asian countries died from lack of finance. Putting those lessons to use, IFC and its peers have set up crisis facilities to avoid a repeat of the Asian experience as stories about projects not getting financed or getting closed or project pipelines getting shut down because sponsors are afraid of starting a project and worrying about finance began to re-surface.

However, Suri disagreed that development status of a country is a yard stick for availing limited recourse project finance, reiterating the point he made earlier that post-crisis, only good projects get financed. As an example, he cited the successful closing of limited recourse project financing in Djibouti, where his bank was involved.

Co-chair observations

Session co-chairman Ghassan Ejjeh contended that Suri’s observation about EPC contractors making fat profits was incorrect given that EPC contractors have to deal with huge projects and related risks too. “We are asked to do things which are not within our power or meet deadlines even if things happen that are beyond our control,” he argued. Ejjeh also chided banks for pushing financial models that make it very difficult for engineers to introduce innovations like nano-filtration that improve the performance of desalination plants, unless these innovations or improvements behave within the model. He suggested that financial models be reworked to introduce new and beneficial technologies.

Ejjeh blamed the impact of subsidised or low energy costs, especially in the Gulf States, for distorting the power and water markets in the region leading to artificially low prices. “If we don’t get rid of the energy subsidy, we are distorting efficiency in the productions which is again of great importance. Why should a developer bend backwards and pay over the odds for capital cost when he is getting his energy practically at no price. Though he will have a minimum design with some efficiency, he is certainly not going to pay the cost of having greater efficiency for the love of country or the environment. At the end of the day, he has to balance his books,” Ejjeh observed.

He was also emphatic that demand management cannot happen in the absence of an appropriate cost recovery mechanism. Such a mechanism would also help develop an income stream which, in the long run, would help governments in the region to meet the payment responsibilities towards IWPPs they have piled on themselves.

Ejjeh said unless Gulf States show real intent at some stage to go for cost recovery and an income stream to support the IWPP, fear of future financial crisis may deter developers from investing in the region.

Vital interface

Contract structures in the water sector, and the interfaces between the different water facilities were the key themes in a series of questions posed by an audience member to the round table panel. As he put it, in a typical project financing scenario, thinly capitalised SPVs with ‘take or pay’ contracts look after the front end i.e. water production and also the back end i.e. sewage works. In between, there is the city with its political risks, volume risks and billing & collection risks. The main issue, the questioner continued, is how to sweeten out the losses that come from take or pay availability payments when all these risks are bundled in the middle (leaving out production side). Without linking the two, it is not going to be easy to reduce the inherent losses in contract structures, he contended, adding that “the water industry seems to be the one industry that proves by exception all of the laws of economics in relation to bundling.”

He painted a scenario where, the city’s municipal water company is owned by a municipality, everything is bundled together, and privatisation takes the form of lease mechanisms or similar arrangements in relation to reducing costs every 15 years or so, the situation would be one “where we can lend and evolve at a much lower cost to a municipal service company. This might be an alternative form of private finance which comes into the sector in the future in order to drive efficiencies.” He also wondered about the practice of banks taking security in relation to the assets in place. “There is not a lot you can do with a big water treatment facility or wastewater treatment facility other than that. But surely, the value is in the customer database,” he concluded.

Appreciating the points raised by the questioner, Paddy drew his attention to the Ajman sewerage project in the UAE, which he described as truly retail wastewater concession in this region and possibly around the world, and which faced a lot of the problems alluded to by the questioner. The Ajman sewerage project was structured to develop a brand new sewage collection and treatment system substantially funded by user tariff, connection fees and service fees to replace the traditional septic tank soak-a-way system which was incapable of handling the emirate’s growing population pressures. Teething problems included convincing people to pay for a service they had never paid for before and getting the buy in of lenders in the absence of underpinning sovereign guarantee. The latter had to be convinced they were better off taking security across 50,000 customers (a majority of them foreigners who wouldn’t break the sewer law that underpinned this project) instead of a quasi-sovereign guarantee support. Agreeing with Padmanathan, Monari pointed out that even IFC believes that ring fencing of account receivables is a much more powerful security than the underlying pipes and water treatment plants. To strengthen the municipalities, IFC is also directly reaching out to them. Instead of financing at the sovereign level for fund disbursal to the municipal water entities, IFC has adopted a more direct approach through municipal finance to make them much stronger off takers. Usha also declared that municipal finance will transform the way contracts and regulations are framed in the future in the water sector.

Unsustainable subsidies

Agreeing with Ejjeh’s earlier observation about the un-sustainability of subsidies, Suri said whatever lending institutions do in terms of risk mitigation is basically “band-aid’ because the panacea lies in making water cost effective. In that sense, water sector privatisation is expected to tread the same route as power, but at a slower pace given greater political sensitivity of the topic. Ravi pointed out that in the early and mid-1990s, mega power projects like Dabhol in India, Paiton in Indonesia and projects in China were partial to debt. However, the ultimate tariff was very high and a lot of money and time went into ensuring that the risks were well mitigated. Most, if not all of these deals, got re-negotiated not because the country declared a default, but due to lacunas in the project contracts.

Today, in the power sector, banks and sponsors tend to take a close look at the ‘merit order dispatch position’ in the grid and examine the competitiveness of the tariff before taking a decision on financing. Suri predicted that water sector too is heading down the same path. He said, “Ultimately, the tariff has to be increased and passed on. In the case of Abu Dhabi, privatisation of water sector was motivated by the need for efficiency, not capital. They got the tariff structure right, from the beginning.”

Boleslawski concurred with Suri on the importance of an acceptable the tariff scheme. She said, “If a project looks expensive, we will look to what extent it is competitive compared to existing source of power or water. However, there are many instances where such projects proved to more competitive than existing ones. If a project is not competitive, it probably means that it is not the right technical solution to implement.”

Alternatives to project finance

Citing a contrary experience to Suri’s contention about lower Libor keeping a lid on financing costs, an audience member said that he was compelled to ask his off taker to increase tariffs to compensate the higher financing costs. He observed that new technological developments and improvements were driving down EPC and O&M costs; but except banks, all other parties in the project seem to be taking on more risks. “Are there solutions other than traditional project finance?” he asked.

However, Padmanathan disagreed with the observations made by the questioner about higher cost of financing. He pointed out that during the past four and half years, which spanned the full cycle of ups and downs in the world economy and ran right through the financial tsunami, he was involved in structuring nearly $12.4 billion of project financing, with the most recent closing – a four-month-old $2.5 billion deal – technically taking place in the middle of the crisis. He continued, “The cost of financing, defined as interest rate plus risk margin charged by the lenders – taking into account the upfront fees and thus valuing it on a holistic basis – actually went down in the case of Rabigh IPP project which we closed four months ago. The total cost of financing Rabigh was lower than that for Shuqaiq, which was done during the ‘pre-crisis’ period. So I beg to disagree.”

Suri noted that during the liquidity overhang days preceding the financial crisis, lenders were giving money for projects on very loose terms and easy interest rates, an unsustainable situation which the financial crisis set right. This in turn led to a rebalancing of risk and re-alignment between what equity can take and what banks can take. Post crisis, sponsors have taken a small hit on the equity IRR, EPC contract prices have come down and lenders have become a bit pricier, but overall, the financial markets have undergone a healthy correction. Suri repeated his earlier Libor argument that today costs have come down though tenors have got elongated, with average life longer than the bond markets. “Though banks don’t go longer than 20 years, it has been the other way round in the GCC,” he said.

Commenting on the alternatives to project finance, Ravi pointed to corporate banking debt, where one borrows on the sponsor’s balance sheet, as an option used by many companies in the region. However, most prefer to mitigate risk and save their balance sheet for further expansion using the tried, tested and well accepted project financing route. Boleslawski proposed re-financing as another alternative. Post-construction, once a project is up and running and proved to be working well and efficiently, sponsors could look at refinancing options like bonds so that banks can free their capital for financing new projects.

An SWCC official from the presenter panel preceding the round table underlined the importance of adopting integrated water resource management (IWRM) in the Gulf region to meet the region’s future water demand instead of relying on IWPPs alone. Ejjeh agreed that IWRM is not a matter of choice but a must for the Middle East region, holding up Singapore as the role model to emulate. He noted that even financiers who are not directly concerned with IWRM stand to benefit from it because the sustainability of water resources that IWRM promises helps make analysis easier and the risk matrix a lot better.

Monari proposed a more cautious approach towards IWRM because despite its good intent, IWRM’s hasn’t worked particularly well in most of the countries that tried to put it into practice, primarily due to the fact that responsibility for water was vested in a maze of ministries and power centres. She advised governments considering IWRM to seriously think about how far up the political totem pole they want to push water and also bring the different ministries together. But she also appreciated IWRM holistic approach to water, which fleshes out the risks much more clearly. “Five years ago, many of IFC’s clients didn’t regard water as a risk; they thought it was infinite resource which they could get wherever and whenever they wanted it. However, today, in any risk analysis that IFC does for projects it is setting up, water is considered as one of the top business risks,” she pointed out. Boleslawski added that in project financing, water projects have always been a bigger challenge than power projects; so an efficient and streamlined management process as well as decision making process at the government level is critical for the financial community to be able to progress on the financing of these projects.

Fixing the risk

An audience member pointed out that a major problem faced by investors in the water sector is currency exchange risk to which Monari proposed local currency financing as a viable solution. “We have tried to put in place a series of products that provide the sponsor with local currency financing,” she said. In the emerging markets that IFC is involved in, local currency financing if available, is too short to provide the matching financing needed for the long term nature of assets in water projects. Therefore, IFC either finances banks to finance sponsors or guarantees them or enters into pre-agreed swap facilities with the central bank of the country which enables sponsors to get long term local currency financing directly from IFC. Boleslawski added that sponsors should optimise these swaps to get a fix on the interest rate for the longest period possible.

A Japanese EPC contractor representative wanted to know which party is responsible for cost escalation risk during the construction period. Ravi pointed out that in the case of limited recourse project financing, EPC contracts for power and water projects are typically in the form of lump sum fixed price turnkey agreements, where the cost escalation or inflationary risks have to be borne by the EPC contractor. Hedges against cost escalation risk has to be incorporated into the price that the contractor charges. If the EPC is complicated or entails new technology as is the case in refining or petrochemical industry, sponsors are expected to provide debt service undertaking and associated risks which then get passed on back to back to the contractor.

Padmanathan noted that that the issue of material price escalation got out of control during 2007-08; but the fact remains that the people best placed to manage that risk are EPC contractors themselves because the decision-making responsibility for procuring whatever is needed for timely execution of the project ultimately rests with them. “Competent EPC contractors manage the risk through different instruments and ultimately price it,” said Padmanathan. Moreover, EPC contractors also have the benefit of buying in large volumes across the various projects they are executing.

During 2007-08, the prices that EPC contractors were starting to apply to manage their risks increased significantly and disproportionately, forcing developers/sponsors to talk to their EPC contractors on how to share that risk. Paddy said, “Quite frankly, the only two parties who can have this discussion are the sponsors and the EPC contractor. There is no logic in expecting the lender to share it because the lender’s job is to deliver the lowest cost of finance. In order to do that, they have to get out of as much of risks as possible.”

Where sponsors have to step in to share cost escalation risk with the EPC contractor, they may be compelled to impose supervision, guidance and monitoring on the EPC contractor to see whether the latter is managing and mitigating the risks efficiently and effectively. But such an approach can be counterproductive since it restricts the flexibility and freedom of the EPC contractor in executing the project. “We weren’t very successful in coming up with ‘out of the box’ solutions other than increasing the advance payments which gave the EPC contractor an opportunity to lock in the raw material prices in the early stages and therefore, minimise the time period over which they are carrying the risk,” Padmanathan concluded.

The approach adopted by the Saudi authorities of tendering EPC contracts for power and water projects despite the current economic environment came in for praise from Ejjeh, who commended SWCC for deciding to go ahead with Ras Azour on EPC basis and revisit the situation as the global economy recovers. Ejjeh pointed out that in the current economic scenario, projects stand to benefit from lower costs and risks, the spare capacity available EPC contractors and ready suppliers.