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Tapping liquidity

A look at project finance in the water infrastructure sector.

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Kuawait has established a government body to assess the viability of PPPs.
Kuawait has established a government body to assess the viability of PPPs.

In the wake of the financial crisis, governments are looking to project finance to meet the increasing need for water infrastructure, says Ashok Sukumaran, MWH.

The water needs of Middle Eastern countries are growing at a significant rate. The cost of providing this valuable resource is increasing, while non-renewable water reserves are shrinking. In the wake of the financial crisis, traditional concepts of funding water infrastructure to are being challenged.

In this context, project finance mechanisms are increasingly used to achieve good quality service provision and value for money, putting paid to standard public sector spending and borrowing considerations that were established in the mid-1990s.

What is Project Finance?
Project finance is used where the public sector or government agency chooses to procure a large infrastructure scheme or project using private sector participation.

It entails the creation of commercial structures and financing packages for major infrastructure projects by sponsors with their contractors and other project parties, to provide infrastructure facilities which deliver goods and services and generate operational cashflows. Private sector participation can range in the form of short-term contractual service provision through to long-term concession arrangements.

Project finance differs from corporate finance, which is primarily lent against a company’s balance sheet and projections extrapolating from its past cash flow and profit record.

In project financing, the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. In this situation, the credit risk associated with the borrower is not as important as in an ordinary loan transaction – what is most important is the identification, analysis, allocation and management of every risk associated with the project.

Risk assessment - the crucial first step
 
As financiers are only able to recoup their investments through the project, and would not be recompensed in case of a commercial failure, governments will do well to prove that this investment is worth the risk.

Governmental agencies should understand that the key to the development of such schemes is that the entire scheme must be ‘bankable’. A bankable deal is where investors and lenders have gained a sufficient level of comfort with the key features of the transaction and the associated project risk profile.

Only if the infrastructure project is bankable will it attract investors and lenders with sufficient investment funding and debt finance on acceptable terms to enable projects to proceed.

This highlights the importance of identifying risks during the conception of an infrastructure project and the need to understand the ownership of the risks. Risk is typically the first item that investors and bankers alike look to assess.

Risk allocation – getting it right
It is fundamental requirement to allocate risks clearly and with as much transparency as possible.

The general approach should be to allocate project risks to the party best able to understand, manage and bear the risk at the least economic cost to the project. Unreasonable allocations of risk to a private sector project company by the public sector will inevitably lead to sponsors and developers including a price for that risk.

This would mean that tariffs or prices for project company outputs will be higher than necessary, a price which the offtaker will have to pay.

Typically, the public sector has a statutory duty with regard to a risk – for example providing sufficient water treatment capacity to ensure the supply of potable drinking water or wastewater treatment facilities.

In having this duty, any attempt to transfer the system demand risk which is substantially the demographic risk in the supply or catchment area beyond reasonable limits may be considered an unreasonable open-ended risk transfer which the private sector would price higher than the public sector body.

Other risks in a project finance scheme are risks associated to delays in construction, the ability to meet effluent quality, and risks associated with demand and supply.

Demand risks require a detailed assessment of the adequacy of the offtake contracts (for example, purchase agreements for treated water by farms) and the tariff structure for the purchase, the effect of inflation on the tariff, and so on.

These serve to drive the forecasting of output revenues and operating cashflow, and in the case of treated sewerage sold to farms, the overall creditworthiness of the offtakers.

Supply or input risks are related to the costs of input stocks, such as the supply of raw water or wastewater but also costs associated with fuel and electricity for operations.

Flow variations in water or wastewater supply, in particular, can be detrimental for water treatment projects and this risk must be assessed thoroughly and carefully so that sponsors provide the necessary amount of clarity on the ownership of that risk.

Why use Project Finance?
Project finance is attractive for various reasons. Public sector clients or government agencies, benefit from the ability to transfer risks for cost overruns, delays and low project performance to the SPC.

The can also use private sector resources such as operational skill and capabilities, project management and design.

In addition, they are able to tap into private sector investment funding and debt finance resources for the project preparation and development phases, which can often run into millions of dollars, depending on the size of the project.

Limited recourse structures are attractive for sponsors and investors because the project company bears the project risks and the sponsors’ exposure is limited primarily to their equity investment.

More groups are able to participate and greater competition results. Governments making use of project finance take advantage of the fact that debt is cheaper than equity, simply because lenders are willing to accept a lower return (for lower risk) than an equity investor and therefore permits the financing to be much more heavily geared.

Limited recourse project financing structures have now become very familiar to both lenders and public sectors bodies granting concessions for water or wastewater infrastructure.

Some downsides
Project financing, as seen by the sheer structure and nature of relationships that need to be established, is complex. 
The timeline for the development of the project from its inception is much longer that traditional procurement methods using public sector funds.

This is primarily due to the due diligence process which is often slow but a necessity for lenders. The element of time needs to be considered carefully by government agencies if they are looking to take this approach.

Besides being slow and complex, some loss of control of the project from a technical standpoint must be accepted and clients should also be aware that project finance is generally more expensive than traditional corporate finance.

It is important for sponsors and government clients to gain the proper advice before launching into a project financed approach for their infrastructure projects. Ultimately, such projects succeed only if they are properly conceived, developed and implemented.

Ashok Sukumaran is business director at MWH Global, a wet infrastructure consulting firm, in the UAE.

Typical characteristics of a project-financed scheme

  • Project finance comprises two elements: Equity, provided by investors or sponsors in the project, and project finance based debt, provided by one or a syndicate of lenders.
  • It is offered for a ring-fenced project through a special purpose company (SPC) whose business is solely the project.
  • They are generally highly leveraged or geared (i.e high debt-to-equity ratio).
  • It is limited or non-recourse finance, so the SPC bears the project risks and the sponsors endeavour to limit their exposures to those set out in project agreements and to the extent of the recourse required by commercial lenders. No further guarantees are required from sponsors or governmental agencies, and the credit worthiness of the sponsor or the value of its non-project assets do not come into consideration.
  • The cashflow from the project is key for project sponsors, investors, and lenders. Generally the only way the lenders will get their loans back and the investors a return on their equity is from the project’s net operational cashflows. Consequently the focus is on the cashflow amounts, timing and certainty of payment and receipt.

Project finance in the Middle East
The Sulaibiya water reclamation facility in Kuwait is one example of a successful water infrastructure project which engaged the private sector in early 2000. Kuwait has since established the Project Partnership Authority (PPA) as a governmental vehicle to look into the viability of financing upcoming projects in a partnering approach.

In 2007, the Abu Dhabi Water and Electricity Authority (ADWEA) adopted a project finance approach for the Wathba and Saad wastewater treatment plants (WWTP), as have many other GCC countries in the last five years, such as Saudi Arabia,
Bahrain and Qatar.

More recently, Dubai’s Electricity and Water Authority (DEWA) has released the tender for consulting services for the emirate’s first Independent Water and Power Project (IWPP) in Hassyan.

This latest announcement regarding the Hassyan IWPP indicates that the Dubai government and DEWA have decided to change the procurement process and turn a traditional EPC contract into a private venture (financing, construction, operation and maintenance).

The announcement followed the economic downturn that affected Dubai and highlights the importance for the utility not to overload its balance sheet at this point in light of their capital investment plans for the next five years.

A typical water infrastructure project finance structureThe diagram shows a typical project finance structure, and shows the level of complexity involved and the extent of stakeholder involvement right the way through from development to financial close.

It highlights the mix of sponsors, investors, host government (federal or state), construction groups, offtakers or purchasers of project services or output, suppliers of raw materials, operators or facilities managers, insurers, lawyers, engineers, financial analysts and lenders.

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