WtE – Smells like success in Sharjah
Years of economic prosperity, population growth and rapid urbanisation have led to the nations comprising the Gulf Cooperation Council (GCC) becoming some of the highest (per capita) producers of municipal solid waste (MSW) in the world. By Iain Elder, Europe and Middle East Project Development & Finance Team Leader,Ibrahim Bakhurji andSam Ogunlaja, senior associates in the project development and finance practice, Shearman & Sterling.
Historically, the bulk of MSW in the GCC has gone to landfill – this being an inexpensive method of disposing of MSW in a region that has an abundance of, literally, deserted open space.
However, recent years have seen increased environmental awareness and an increased focus on sustainable and green energy production in the GCC, and budgetary pressures caused by the recent low oil price environment has led the GCC countries to start diversifying their energy mixes away from hydrocarbon-dependent technologies.
Waste to energy (WtE) projects can provide a solution. While there are a number of proven WtE technologies, at one end of the spectrum, simply by burning MSW to generate electrical power, the amount of waste sent to landfill is reduced and an alternative energy source is created.
Although other options are available, burning MSW has a role in waste management strategies and at different times over the last decade all of the GCC countries have announced strategies to develop a number of WtE projects across the region.
Some progress has been made in this regard, with a WtE facility being constructed in Qatar and WtE projects under development in Abu Dhabi, Dubai, where the region’s largest WtE facility is expected to be completed in 2020, Bahrain, Oman and Saudi Arabia. These projects all appear to be government-procured.
While conventional independent power (and water) projects (I(W)PPs) in the GCC were initially government-procured, it is becoming clear that it will be very difficult for the GCC countries to develop significant WtE capabilities, and successfully implement their WtE strategies, if they are dependent solely on government funding. This is especially true in an era when GCC government spending power has been curtailed by reduced oil revenues.
In the current circumstances the question is whether WtE projects be developed in the GCC using a public-private partnership (PPP) structure, and financed on a limited recourse basis.
GCC governments have attempted this before, with the Kabd WtE Project in Kuwait being a recent example. However, despite significant initial progress, this project, and others attempted before it, all stalled – well short of financial close.
More recently, encouraging signs emerged from the Emirate of Sharjah, where the Abu Dhabi Future Energy Company (Masdar) and Sharjah Environment Company (Bee’ah) are developing a 30MW multi-fuel WtE project, the Sharjah project. While not technically a PPP project, the Sharjah project is being financed on a limited recourse basis and is expected to reach financial close before the end of 20181.
Given this imminent milestone, what lessons can developers, lenders and host governments learn when considering project financing WtE projects in the GCC?
The Sharjah project
Masdar and Bee’ah are developing the Sharjah project on a 50/50 basis, with Bee’ah supplying MSW and the power produced being purchased by the Sharjah Electricity and Water Authority (SEWA).
The Sharjah project will be located adjacent to Bee’ah’s existing landfill site in Sharjah, and, once completed in 2020, will incinerate approximately 300,000 tonnes of MSW, and displace almost 450,000 tonnes of CO2 emissions, per year. It will contribute to Sharjah’s effort to reach its “zero waste-to-landfill” target by 2020 and the UAE’s goal of diverting 75% of MSW from landfills by 2021.
Although WtE is not new technology, with established markets in Europe and the US, WtE is still very much in its infancy in the GCC. The fact that there is a lack of project-financed WtE projects in the GCC, meaning there are no established precedent projects, undoubtedly impacts developers when considering these projects.
In practical terms, potential lenders to GCC WtE projects will, not surprisingly, be looking for developers and contractors with a proven track record of developing, constructing and operating WtE facilities in the region, if not in the specific jurisdiction. However, given the infancy of WtE in the GCC, it is likely to be difficult to find developers or contractors with specific, relevant experience.
As a result, experienced Middle Eastern developers may instead partner with experienced European WtE contractors who bring their specific industry expertise to WtE projects in the GCC. For example, for the Sharjah project, Masdar and Bee’ah engaged Constructions industrielles de la Méditerranée (CNIM) to construct and operate the project. CNIM has successfully developed WtE projects around the world, including projects in France, the UK, Azerbaijan and Turkey.
Developers will also want to bear in mind that, given the frontier nature of WtE in the GCC, there will be few lenders that have provided, or attempted to provide, financing for WtE projects in the region. As a result, lenders considering financing WtE projects in the GCC may, due to a relative lack of WtE experience, be more risk-averse than when financing conventional I(W)PPs; such lenders are also likely to want the robust contractual framework and risk allocation seen on conventional GCC I(W)PPs.
WtE projects, although beneficial, are not a simple solution to waste and energy challenges. A number of key factors contribute towards a successful WtE project, including an appropriate site; a well-functioning waste management system, with a stable supply of MSW with a sufficient minimum energy content; and a suitable environmental, regulatory and legislative framework in the host country or the desire to develop one.
For example, a key consideration in any WtE project will be the location of the WtE facility itself. For obvious reasons, it is not desirable for a WtE facility to be located too close to urban or residential areas; however, this must be balanced against the fact that, to operate successfully, WtE facilities need to be reasonably proximate to infrastructure (eg, gas, water and roads) which, in rural areas in certain GCC countries, may be challenging.
The location of the WtE facility also has to facilitate connection to the power transmission system, allow for the construction of any required interconnection facilities, and synchronise with the logistics of the existing waste management system to ensure a consistent supply of MSW feedstock.
The Sharjah project addressed this issue by locating the WtE facility on Bee’ah’s existing landfill site. This meant that the WtE facility did not cause any additional disruption to the local community and, being built on a working site at the centre of the Emirate’s waste management system, it was able to utilise existing utility and grid connectivity.
The location of the Sharjah project also addressed potential concerns regarding the availability of sufficient quantities and quality of MSW. The project will be surrounded by a readily available supply of MSW that can, notwithstanding contractual liabilities for supply failures, be used as back-up fuel.
Careful consideration of all of these factors, as well as any resulting issues, particularly environmental issues, is required prior to commencing a WtE project, making them more complex from a planning perspective than typical GCC I(W)PPs. Any potential lender to a GCC WtE project will want to ensure that thorough due diligence has been undertaken and that a robust project implementation plan is in place.
From a technological perspective, WtE remains both complex and expensive compared with landfill and conventional I(W)PP technology. Although there are various WtE technologies in use in developed WtE markets, such technology is not proven in the GCC and is only available from a limited pool of contractors and equipment suppliers. As a result, construction and operational costs of WtE facilities in the GCC remain relatively high.
These high development costs mean that, despite the WtE strategies being developed and promoted by GCC countries, there has been little economic incentive for developers, or GCC governments, to develop WtE projects in the GCC.
If the GCC countries are to fulfil their WtE strategies, and encourage private sector participation in the WtE sector, their governments will need to create this incentive by ensuring that the price paid for power produced by WtE projects reflects the increased development costs of WtE projects, generates sufficient revenues to support a limited recourse financing and provides the developer with a worthwhile equity return.
This may be counter-intuitive for GCC governments while landfill remains a cheap and viable option and conventional power tariffs in the region are at an all-time low, in part through the availability of other sources of renewable energy such as solar PV.
Contractual framework and risk
A number of the financing concerns that arise in GCC WtE projects are similar to those in conventional I(W)PPs and prospective lenders will be looking for a bankable project structure with a risk allocation that de-risks the generator to the greatest extent possible.
As a result, potential lenders to GCC WtE projects are likely to attempt to replicate, so far as is possible, the typical risk allocation found in conventional GCC I(W)PPs.
The key contracts on a WtE project are typically the waste supply agreement (WSA) and the power purchase agreement (PPA). One of these agreements typically also functions as a concession or PPP agreement, which grants the generator the right to construct and operate the project, although a separate concession or PPP agreement may be used.
Lenders will typically require the generator to be party to both a long-term WSA and PPA, each of which should outlast the tenor of any debt with a sufficient tail period and be with creditworthy counterparties or with appropriate credit support. The Sharjah project has a WSA with Bee’ah and a PPA with SEWA each with 25-year terms.
Lenders to WtE projects in the GCC are likely to want to replicate the features of a typical GCC I(W)PP, as illustrated by the fee structure in the Sharjah project.
As well as providing for the supply of MSW to the project, the WSA also provides for the waste supplier to pay the generator a fixed monthly fee, a gate fee, provided that the generator is available to accept deliveries of MSW. The PPA also provides for the offtaker to make variable payments to the generator based on actual quantities of power produced.
This fee structure replicates the tariff model on a conventional GCC I(W)PP, where the generator typically receives an availability or capacity payment for being available to generate power and a variable payment for power actually produced.
Ideally, in a project-financed WtE project, as in a conventional I(W)PP, the gate fee would cover the generator’s fixed costs, eg debt service, and fixed operation and maintenance costs, etc. This fee structure differs from a typical European WtE project model, where no availability payment is made and generation revenues are the main source of revenue.
MSW supply risk
As well as replicating the I(W)PP tariff structure, prospective lenders to GCC WtE projects are also likely to expect project risks to be addressed in the same way as in a conventional GCC I(W)PP.
For example, in a GCC I(W)PP, fuel supply risk is typically allocated to the government offtaker and the generator is kept whole with respect to losses arising from a fuel supply failure – likewise, in a project-financed WtE project, lenders would expect supply risk with respect to MSW, the fuel or feedstock, to be addressed in the same way.
Addressing MSW supply risk in a WtE project also gives rise to specific interface issues between the WSA and PPA. The generator can only generate power, and receive revenue under the PPA, if it receives sufficient quantities of MSW under the WSA and the amount of power and revenue that the generator can produce will vary depending on the quality or calorific value of the MSW delivered.
As a result, lenders will likely require the waste supplier to: (i) guarantee the volumes and quality of the MSW to be delivered (at acceptable levels, consistent with modelled revenues); and (ii) compensate the generator for revenues lost under both the WSA and the PPA if it does not deliver the contracted quantity or quality of MSW. Lenders will also need to be satisfied as to the extent of the compensation and the creditworthiness of the waste supplier.
This risk-allocation is logical where, as is the case on most GCC I(W)PPs, the waste (or fuel) supplier and power offtaker are both government, or government-related, entities. The converse is also true and implementing such a risk allocation where the waste supplier and power offtaker are not both government and/or government-related entities – likely to be the case in more developed/diverse WtE markets such as the UK and Continental Europe – is likely to be incredibly challenging.
However, this is unlikely to be an issue in most GCC countries, where bulk waste management and utility procurement are typically government controlled.
In the GCC, it is possible that procurement of the WtE project, waste supply and power offtake may be undertaken by separate government entities, each with different experience of limited recourse project-finance transactions. Ensuring coordination between government entities with a well-aligned approach to risk allocation will be key to the success of a project-financed WtE project.
Lenders may be able to get comfortable without the typical GCC I(W)PP risk allocation in respect of MSW supply if: (i) waste studies (required as part of the technical due diligence) indicate that waste to be supplied is likely to be of sufficient quantity/quality and there is a well-developed waste management/supply system serving the WtE project; and/or (ii) the gate fee paid to the generator is sufficiently sized to cover debt service and project contingencies (and the waste supplier is sufficiently creditworthy) meaning that the lenders are less concerned with PPA revenues.
Default and termination
As with any project-financed transaction, lenders to WtE projects in the GCC will want to ensure that default and termination risks are adequately addressed. Lenders will expect the generator to be excused from failures to perform where a failure is beyond its control and, in certain circumstances, receive compensation where it is prevented from generating.
More significantly, in line with GCC I(W)PP models, lenders typically expect the project company to receive termination payments, covering at least senior debt, in any circumstance where the main project document – typically either the WSA and/ or PPA, but possibly a separate concession or PPP agreement – is terminated, including for generator default.
The potential liability to make termination payments represents a significant exposure for GCC governments hoping to procure WtE projects on a PPP basis. Although such liability may be common on conventional I(W)PP projects in the GCC, the increased project costs and increased termination payments makes this a material consideration on a WtE project.
As with a conventional I(W)PP, lenders will also need to consider the termination payments in the context of the creditworthiness of the contracting counterparty, which may, as is the case in the Sharjah project, result in the need for credit enhancement by way of government guarantees.
Sharjah project financing aspects
The senior lenders to the Sharjah project comprised a mix of international and local banks including Abu Dhabi Commercial Bank, Siemens Bank, Standard Chartered, Sumitomo Mitsui Banking Corporation and Abu Dhabi Fund for Development.
The Sharjah project, with a total deal value in excess of US$175m, was structured on a limited recourse basis, with a 25-year PPA with SEWA as offtaker, providing comfort over the longer term and enabling the project to benefit from being structured as a soft mini-permanent financing.
Unlike a hard mini-perm where project sponsors absorb 100% of the refinancing risk – since a refinancing must be effected by a fixed time – the soft mini-perm structure allows the sponsors added flexibility by providing an option to refinance, in this case within five years of financial close, the target refinancing date, if the pricing environment allows.
If the sponsors elect not to refinance by the target refinancing date, available cashflow generated by the project – being excess cash available to the project company after payment of all operating and maintenance costs, financing costs, debt service and other costs and expenses incurred in the day-to-day operation of the plant – will be used from the target refinancing date onwards to pay down the principal outstanding.
The swept cash will be applied in prepayment of the senior debt in inverse chronological order of maturity against the remaining repayment instalments, bringing in the tail – the intention being to allow the project company to repay the senior debt prior to its stated maturity.
While the appeal of WtE projects in the GCC, from a policy perspective, is clear, what is also clear is that, with decreased oil revenues and government balance sheets becoming more strained, GCC governments cannot rely on self-funding WtE projects to make their ambitious WtE strategies a reality.
As a result, private sector participation in the GCC WtE sector will be necessary and the Sharjah project is an excellent example of how this can be accomplished. However, increasing private sector participation in a sector where projects are complex, expensive and heavily regulated will require significant investment, and risk-sharing, by GCC governments.
GCC governments need to weigh the environmental and policy benefits of WtE against the costs of such investment, especially in the context of cheap landfill and conventional power solutions, and risk exposure; and, in this regard, it remains to be seen whether GCC governments will be truly willing or able to embrace private sector WtE and all of the strings that are attached.
1 – As at the date of writing, the Sharjah Waste to Energy Project was expected to reach financial close by November 29 2018.