Financing new build1 November 2008
Capital-intensive projects such as the construction of nuclear power plants involve a number of players and many potential risks for investors. By David Boyd
The nuclear renaissance is currently a hot topic in the UK, however it is over 20 years since the last reactor commenced construction at Sizewell B. Since then a completely changed power industry and financial landscape has developed in the UK such that older models of project delivery may no longer apply. A particular feature of major infrastructure projects in the UK over this recent period has been the advent of the private finance initiative and public private partnership deals of all kinds, involving widespread use of project finance lending.
Project finance lending is a type of lending where the lender’s principal and interest payments are totally dependent on a contractually defined revenue stream for a distinct asset, with limited or no recourse to the equity owners other than for the lenders to step in and take over the sponsor’s equity.
Projects range from public infrastructure such as schools, roads, hospitals etc to major private investment projects such as the Channel Tunnel Rail Link.
It has been suggested that the first of the new wave of nuclear power plant for the UK will not be procured with the private finance lending model but will be funded by large power utilities borrowing against their substantial balance sheets. Stand-alone projects funded entirely by project finance lending (so called merchant plants) are suggested as possibly being part of a second wave, but who can tell?
In any event whether on or off balance sheet and whether recourse or nonrecourse, it will be necessary for the sponsors to evaluate a particular set of risks and to develop a business model to satisfy their investment boards and to meet the needs of external lenders.
The project players
Nuclear projects are complex technical enterprises requiring a properly structured delivery organisation for their design and construction, as well as for operations.
A number of parties may become equity partners in the project and this will vary between projects depending on the lead party. They will be required to put in substantial equity to prime the project, which may include a consideration to reflect some of the development and permitting/ approvals costs of the reactor technology, a consideration reflecting site ownership and site permitting/ approvals costs, a consideration for other inputs delivered in kind and cash to fund the project until the lending is put in place.
If a project falters before it receives full approvals then all of the front-end expenditure can be at risk.
The permitting process is highly complex and needs to address both the technologies involved and site suitability. This is very time consuming and very costly, even in relation to permitting for other major projects of a comparable scale. There are a number of roles that typically exist within the delivery structure:
1. The sponsor organisation or client body. This may be a utility or group of utilities or a special purpose vehicle company created from a number of investors with interests in the project.
2. Specialist consultant advising the client on establishing the structure of the project, evaluation of alternative technologies and front-end concepts.
3. Programme manager contracted with the client to plan, manage and ensure delivery of the project to acceptable cost, time and quality.
4. Architect-engineer contracted with the client to develop the technical scope of the project, do concept design and prepare specifications for EPC (engineering, procurement and construction) contractors.
5. EPC contractor. Could be more than one on a major project such as splitting the nuclear island from the turbine island and site development/balance of plant, contracted to the client but managed by the programme manager.
6. Contractors and suppliers building parts of the project. Contracted to EPC and likely on fixed price/time certain contract with bonus/penalty linked to time and quality.
7. Operators. Contracted to the client for the operation of the plant, with payment linked to performance.
8. Operations support contractors, fuel suppliers and so on. Either contracted to the operator or directly to the client in the case of fuel.
10. Designers and specialists supporting all of the above.
Sometimes the roles get combined depending on how the funding is put together and what the sponsor can do themselves. In particular 2 and 3 may get combined as a managing agent role or 3 and 4 as a turnkey contract.
The main plant suppliers may have an involvement extending into operations and maintenance works, repairs and warranties. The operations phase will require fuel supply contracts and may also involve contracts for outage support during maintenance, upgrades or refuelling and there will be periodic inspections and safety reviews that will need to be undertaken.
Spent nuclear fuel (SNF) management will be another issue possibly requiring external contractors for in-pool storage, SNF conditioning, onsite dry storage or transportation offsite for reprocessing or downstream storage/disposal.
Eventually there will need to be decommissioning and dismantling contracts and associated radioactive waste disposal contracts.
How all these roles come together is project specific and depends very much on the in-house capability of the main project sponsor. Some major utilities have the capability to be their own managing agent and architect-engineer and some are existing operators. Others will rely heavily on the programme manager.
Technology vendors will invariably form delivery partnerships with key component manufacturers and local construction companies and all parties in the construction supply chain will try to work to as close to a neutral cashflow situation as possible.
This underlies the need for careful financial planning of the project, proper contractual arrangements and ensuring the availability of cash to fund the works.
Project Finance Lending
With project finance lending the debt is normally off balance sheet for the asset owners. That is to say that the cashflow from a single asset is dedicated to paying its own financing costs. And because the lenders can only look to that asset for repayment, the lenders will always insist that the asset be located in a single-purpose bankruptcy remote entity in which the lenders will have a complete collateral package pledged to them.
Generally, only large capital assets are financed with nonrecourse debt of this kind. The first user of project finance was the oil and gas industry. In the oil and gas business, a large capital investment must be made before a company can realise the cash that hopefully will follow when the wells are drilled and the oil or gas gushes to the surface. That is a risky business and the oil companies have learned to spread the risk by promising some of the production cashflow towards the repayment of the debt used for the exploration and production development.
Over 30 years ago an energy bill was signed into law in the USA that allowed non-regulated entities to build and then sell electricity to the local utility. These new independent power developers used the concept of nonrecourse lending that the oil and gas business had used and applied it to financing individual power plants. The developer would negotiate a power purchase agreement with the local utility that would state the amount of electricity the utility would buy from the plant and at what price. This legal contract promised a steady revenue stream that the developer was able to show to a lending group and therefore, borrow money against that future cashflow stream to build the plant. This is the so-called merchant plant model.
In the energy and power sector, we have seen nonrecourse lending for pipelines, gas storage facilities, power generation, electrical transmission lines, and of course oil and gas production.
But who arranges these deals and who are the players? In the early days, the oil companies went to their commercial bankers who arrange and syndicated the loan and this continued into the early days of the independent power developers. But there was only so much money the banks were willing to lend. In addition, the borrower looking to enhance his equity return wanted to have longer-term debt to match the long-term contracts and banks were generally limited to loan terms of about 10-15 years.
So, the commercial banks, not wanting to lose the business and especially not wanting to lose fee income, began teaming up with institutional lenders, who were willing to invest in nonrecourse debt and were willing to go long term (at least 15-20 years). As the size of the institutional market grew, the investment bankers saw a chance to make money and take away some of the business from their colleagues in the commercial banks, so they also formed project finance teams that would originate and underwrite project deals. Today, the market has evolved such that deal brokers source their borrowing from many different areas. These sources include commercial bankers, investment bankers, insurance companies, pension funds and private investors including sovereign wealth funds.
Project finance lending would normally start once a project receives approval from the permitting authorities allowing construction to start, but it needs to be set up long before that. There are several credit characteristics that go with the various transactions.
Since the asset being financed is considered a long-term productive asset, institutional lenders, will normally structure a deal that has a 20-25 year maturity, while commercial banks will structure their loans not to go beyond the 10-15 year horizon. However, since project finance is a cashflow based investment, lenders are very concerned about using excess cashflow to pay down debt. Therefore, amortisation of the loans generally begins very early in the production life of the asset.
If the deal involves both commercial banks and institutional lenders, then the banks normally would receive almost all of the earlier amortisation and the insurance-type lenders would receive higher amortisation amounts after the banks have been paid off. This is called being ‘back-ended’ and it can raise intercreditor issues regarding voting rights and voluntary prepayments of the debt.
The credit quality of these transactions is always a tricky issue, with the investment community looking at several factors. The most important of these is structure, which relates to how the money is spent on a project.
Cash is king in project finance deals and the lending group does everything possibly to ensure that they have a true say on how that money is spent by the project equity owners. This is critical for the simple reason that, in nonrecourse lending, once the cash has left the project through equity distributions, the lenders usually have no recourse to that cash if needed in the next years. Therefore, bank accounts are set up with the project’s collateral agent bank and all revenues earned by the project are deposited directly into one of the accounts. Then a priority of payments are made by the collateral agent from that account based on the financing documents and according to a monthly budget that the lenders have approved.
This ‘waterfall’ of payments usually is paid in this priority manner: first the project’s operating expenses, then the lender’s monthly interest and principal payments is either paid if due or the cash is set aside in its own debt payment account. If there is cash left at the bottom of the waterfall it can be distributed to the equity owners if certain production and/or financial tests are met. Because lenders and owners realise that capital assets require major maintenance and periodic capital improvements to maintain the plant’s efficiencies, the project will use reserves to set aside cash for major expenses that are expected to be incurred in future years. So a separate account is established for major maintenance. For nuclear projects in particular, cash will need to be set aside for decommissioning and waste disposal costs.
In addition, a debt service reserve account is always maintained with sufficient cash to pay at least the next six months of debt service. This is useful to the owners because it gives them a cushion if the plant is shut down unexpectedly for repairs, or if revenues fluctuate throughout the year.
These reserves can fall before or after operations costs in the priority of payment waterfall, but they will always be before the cash available for distribution, and will always be maintained in separate accounts. All the accounts will be assigned to the lenders, so if there is a default, they can direct the collateral agent to sweep the cash if they wish.
The third key credit issue is the projected financial strength of the project and the ability of those projections to withstand various stress analyses that are applied to the projections. The competitive position of the project relative to its industry is also key to determining the financial strength of the project. A project may have the best structure in the world, but if the project really isn’t competitive, there will always be problems.
Investors often view this asset class as an improving credit. That is, project deals involve a construction period followed by an operating period during which construction loans are converted to term loans and begin amortising. Generally, the construction period and the first few years of operations are the riskiest for a project. Therefore, the lenders require a spread premium (higher interest rates) for that risk since this is the period where the project probably has its lowest credit rating. However, after the project has been operating for a few years and has generated a solid track record, the market will upgrade the credit rating of the project. Investors are happy because they made an investment at a below investment grade spread and now that investment is of a higher credit quality.
In addition to the credit enhancements of collateral accounts and reserves, the lenders look at the covenant package, to ensure that no new debt or liens can be placed on the project, and that there are restrictions on the equity owners for change in control and for equity distributions.
“The main benefit of project finance lending is that the contractual rigour involved gets projects built on time”
The key to project finance is the collateral package. The lenders need to protect their asset since it is the only means of repaying the debt. It is here where the lawyers earn their fees because the protection is achieved through contract documentation. First, the lenders must make certain that the project has been organised in a separate special purpose entity away from the sponsor’s corporate business. This is to ensure that the only insolvency risk the lenders will have is the failure of the project and not the bankruptcy of the sponsor. The need to protect the project and its collateral value from extraneous, non-project risk is very important to the lenders. The special purpose entity will have strict restrictions, which usually limit business to operating the project and will require any merger or reorganisation not to undermine the entity.
Second, the lawyers will require that all contracts entered into by the project be assigned to the lenders and an acknowledgement of this consent is needed from the third party. This is to ensure that if there is a default by the project owners, the lenders will have the right to cure the default before the contract is rescinded. This is known as lender ‘step-in’ rights and is especially important with output sale agreements and operating agreements.
The most critical and most debatable lender requirement is the pledge of the special purpose entity’s stock, which some owners resist. Their argument is that the lenders can foreclose on the asset so the pledge is not needed. This however, does not give the lenders the best value for their collateral because the asset would probably be sold based on its liquidation value. By having a pledge of the stock, the lending group after a serious default, would be able to step into the shoes of the equity owner and maintain the project’s business. By doing this the lenders have several options regarding the collateral including owning the asset. But, in that case, the usual option would be for the lending group to sell the asset. However, unlike in a foreclosure, this would be selling an operating business, which would be sold at a price much higher than the liquidation value.
So to summarise, the credit characteristics of project finance lending for institutional investors, would be a long-term fixed rate investment, priced very attractively relative to its term loan credit rating. The project structure would protect the project lender’s collateral from extraneous, non-project risk, while ensuring the marketability of that collateral.
There are several project specific risks to be considered when reviewing a project finance transaction.
It is important that the project sponsor is an active participant in the business and that the project itself is an important strategic asset for the sponsor. The owner must have the technical know-how to run the plant and the financial strength to survive if the project runs into difficulties. This is particularly important in the nuclear context as the regulator will require the owner to demonstrate a capability as an intelligent customer.
Lenders are not in the business of owning assets, so they don’t want sponsors whose sole business relates to that project. Sponsors need to be able to weather the bad years along with the good years. In addition, the reputation of the sponsor is important. The lending community needs to believe that the sponsor will honour its obligations and work through problems when they arise. Sponsors elect to do nonrecourse financing because they want to isolate the operations and the financial and documentary obligations of this asset from their other businesses, but lenders expect the sponsor to live up to their moral obligations in the deal.
Who is buying the project’s output, for how long, and for how much? Does the term of the output contract coincide with the length of the debt offering? This is important because if there is a problem and it is necessary to extend the loan, the important contracts will still be in place. What are the events that will allow the buyer to terminate the contract? Can those events be quantified and evaluated by the borrower and the lenders?
It is not surprising that lenders like to see a strong financial buyer, an economically priced product and a strong need for that product in the sponsor’s business and in the marketplace.
In the UK currently, about 60% of generation comes from the six major vertically integrated utilities, which all compete with each other and with retail-only companies for retail customers including industry users. British Energy, several smaller players, merchant plants and many independent renewables generators make up the other 40%. Some mainly retail companies are increasingly attempting to take a position in generation but lack of grid availability is reportedly stifling such investment in some cases.
There is strong short-term trading of electricity between generators, wholesalers and retailers, running at about three to four times the volume of generation, but with a relative paucity of long-term deals coming forward. Any suggestion of a potentially increasingly volatile future power market is not helpful for capital intensive baseload deals like nuclear that cannot switch on and off to suit the market. Nuclear projects therefore need long-term deals, and thus lenders will want to see market stability in the future as much as possible. Also, any deals for power with an industrial user could substantially reduce the off-take risk for new plant and also reduce the user’s exposure to a potentially volatile future market, a ‘win-win’ deal. Such users may also become equity partners in new plant. Improved carbon trading with nuclear classified as a low carbon technology would also be beneficial to investment.
Fuel or feedstock risk
In power deals, the availability and cost of fuel is critical to the production of electricity. The current high cost of oil and gas and questions about the security of supply are making nuclear more and more attractive, but clearly uranium supply and fuel fabrication are important issues. Lenders will likely require the project to enter into contracts that provide the firm delivery of a specific amount of fuel at a stated price. Lenders like to see the price of fuel pass through with the price of power in the off-take agreement. This is important in fossil fuel plants when fuel or feedstock may represent a major portion of a project’s operating costs. The same concept may apply for nuclear plant project financing but the cost of fuel may be small in comparison to the construction cost and thus be a small portion of the selling price of the power.
Operating risk is analysed by looking at the technology being used and whether it is ‘off the shelf’ or new technology. Lenders are very conservative. They like tried and tested technology and resist being the first to try something new. And, because they realise that if the plant is not producing there is no cashflow, lenders like to see an operating contract with an experienced operator that links payments with performance.
Construction risk is minimised if there is a ‘turnkey, date certain’ construction contract with a reputable contractor. Significant liquidated damages are paid if expected performance levels aren’t achieved and/or the date certain is not met. Lenders will normally fund construction costs based on construction milestones being achieved, and this helps to monitor the progress of the construction relative to its schedule and budget.
In addition, the lender will likely engage an independent engineer (that the project pays for and is separate from the project architect/engineer) to aid in evaluating the operating and construction risk. The engineer will review the reasonableness of the operating assumptions used in the financial projections, and will review the project’s maintenance and capital improvement plan to ensure the project is being maintained and operated properly.
The lenders rely on the independent engineer to advise them on setting a reserve amount for future major maintenance expenses and improvements. During the construction phase of the project, the engineer will review the contractor’s request for payments with a physical inspection of the work completed and will advise the lenders on releasing the funds for payment. They will also monitor the progress of the contractor against the construction schedule (separately to the programme manager) and they will advise if the construction budget is adequate to complete the work. Since many lenders are technically challenged, a good independent engineer is critical to the lender’s evaluation of the technical aspects of the project.
The last project specific risk is really a conceptual one and that is contractual risk. To get the best out of project finance, it is important that there be an allocation of risk based on which party is best able to manage the risk and therefore, should bear the burden if the risk is not managed correctly. It is this concept that makes legal documentation for project finance transactions a nightmare for both the sponsor and the lenders, but heaven to the lawyers. This is because the allocation of risk is achieved by the project entering into a legal contract with a third party who will manage that risk. It could be fuel supply risk, off-take purchasing risk, transportation risk, operating risk, and so on.
It is the lawyers who must look to protect their respective clients by making certain the client understands the risk they are assuming and the consequences of not performing as agreed. This ‘sanctity of contracts’ is critical to the success of nonrecourse lending and it must be a principle that is foremost in the legal system wherever the project is located.
Liabilities and waste risks
Many industrial projects are required to set monies aside for decommissioning and site restoration. For nuclear plants this is a particular and substantial requirement and extends to disposal of radioactive waste and spent nuclear fuel or reprocessing. Usually a separate fund will be set up to cover these costs but invariably this will need to be linked to a fixed price agreement with a waste or SNF disposal/ reprocessing organisation where the costs are set at the outset of the project and the fund built up to meet these. Thus if the actual costs of disposal escalate for whatever reason, the project owners are insulated from this escalation.
In the UK, the Nuclear Decommissioning Authority’s (NDA’s) Radioactive Waste Management Directorate (RWMD) is responsible for developing a national waste repository and will set the disposal tariffs. Invariably though with this arrangement, the UK taxpayer will finish up underwriting any overruns in the waste disposal costs if the agreed funding arrangements prove inadequate to meet unforeseen circumstances. It is not reasonable either to set tariffs at some poorly postulated upper bound, as unrealistic tariffs could undermine the viability of nuclear new build. So, robust government policy is needed in this area.
Foreign project risks
There are additional risks which lenders face, if the project is not a domestic project.
The largest foreign risk is currency risk and this can be divided into exchange rate risk and convertibility and transferability risk. If the project’s revenues are in local currency, but some of its capital and operating expenses and financing expenses are in a different currency, the project must be able to convert the local currency into the different currencies needed to fulfil its obligations.
In those countries where convertibility is not certain, the lenders will normally require that the project receive assurances from the government. This promise from the government states that the project will not be restricted in its ability to convert its local currency into the currency needed to satisfy its financial obligations. Normally a procedure for the conversion is documented with the government stating how, when and where the project should make the currency conversion. The project should also not be restricted in its ability to transfer currency out of the host country and into another country.
The other part of currency risk that the lenders review is exchange rate risk. Both sponsors and lenders understand the need for the value of the local currency to reflect the fiscal and economic policies of the country and will attempt to forecast the change in the exchange rate over the life of the project and the loan.
Lenders and sponsors become more cautious when the project is located in countries where the government dictates the exchange rate and not the currency market. The uncertainty of forecasting the true impact of exchange rates on the ability of the project to cover its debt service can turn lenders away from lending to the project. Therefore, to make the project attractive to potential lenders, the sponsor will look to allocate the exchange rate risk to the off-take purchaser since in many of these situations the purchaser is a government owned entity. The off-take contract will usually be written stating that the purchaser must pay an amount in local currency sufficient to be converted into a specific foreign currency amount. The contract would also be approved by the appropriate government agency, which is usually the finance ministry and may be eligible for export credit guarantees.
The second foreign risk that lenders need to assess is political risk. This is a very broad category and includes assessing the general stability of the government and its political parties, the nation’s acceptance of foreign businesses and investors, and whether the country is one in which it is relatively easy to do business or whether there are roadblocks every step of the way.
If the off-take party is a government owned entity, then the lenders need to assess not only the ability of the entity to meet its financial obligations, but also its willingness to meet these obligations. For lenders it is this willingness to pay that is the most difficult to assess and the lending community will look at prior or even current experiences they or their colleagues have had in that country or in similar countries. Prior experiences become the benchmark for what they can expect. Lenders can accept and work with governments unable to pay, but are very unresponsive to those governments unwilling to pay. To mitigate political risk, lenders like to know that the project is politically and economically important to the country, that it enjoys broad public support and to the extent possible has local partners and local suppliers involved.
The last foreign project risk is legal risk. Since project finance depends on contractual laws and property laws, it is important that the country in which the project is located recognises these rights. The lenders must be able to enforce their collateral rights in the project if necessary, and the lawyers will work within the local legal system to ensure these rights. To the extent possible, foreign investors would like to see a transparent legal system that treats all parties equally and does not give preferential treatment to its own.
Why do project financing?
The main benefit of project finance lending is that the contractual rigour involved gets projects built, generally on time and to budget and with the specified functionality. The main downfall is time. Each transaction requires an inordinate amount of time and it is not unusual for the sponsor to spend years creating a delivery structure and developing a financial plan for the project. Similarly, selecting and buying a project site, filing and receiving the necessary permits, and negotiating the necessary supply and off-take contracts along with a construction contract is very time consuming and expensive.
Also a project that was feasible when the process started may become unfeasible later and thus may have to be abandoned, and thus the upfront development costs become non-recoverable. This is a huge concern for nuclear projects with high front end costs.
However, once the sponsor has received its permits and has signed the necessary contracts, it then has a financeable project that it can take to the lending community. Here more time is spent as lenders conduct their due diligence and prepare their credit reports for credit committee approval. Once the necessary funding is committed, the lawyers begin working on documenting the transaction. This documentation process will take several months. It is normal for the time a lender spends reviewing, closing and funding a project deal to be several months, and some deals may take over a year to close. Understandably, foreign transactions take the longest to close. A large part of these activities therefore need to take place in parallel with the permitting process, and options agreements and letters of intent will likely be signed in advance of the contracts proper.
One impediment is that some of the parties may be unfamiliar with the peculiarities of project finance documentation, so there may be an education process along the way. This whole process takes a large commitment of resources by the lender of its in-house lawyers and investment personnel. Thus a lender committed to this asset class must develop a team of specialised professionals dedicated to this type of investment and particularly to become acquainted with the peculiarities of nuclear plant.
Even after closing the deal the investment must be closely monitored during the construction phase when the main part of the funds are disbursed, and during the term of the investment. The analyst needs to make certain that the project is performing according to the financial projections agreed at the deal closing. In addition, since there is a reliance on legal contracts and agreements, the project finance staff will be constantly reviewing and approving amendments and waivers to those documents. It goes without saying that those approvals are always urgent. So along with the time commitment, the lending organisation must make a commitment of personnel and will also rely heavily on the technical advice of its independent engineer.
The last concern about project finance is the news-worthiness of the project. Since project finance is used for large capital-intensive assets in high profile industries like nuclear, the project usually receives much publicity. However, it seems that a project only receives bad publicity. There is always somebody opposing the project. It could be a grassroots group that doesn’t like the project in its backyard, or an environmental group that is complaining about something – it could be water, air, trees, animals. It could be the opposing political party or a competitor that lost the bid. Invariably the investor continuously has to justify the investment within its organisation, particularly through the construction period.
Nevertheless, the positives still can outweigh the negatives. The pricing of the investment is always at a significant premium compared to current public spreads and this makes it attractive to lenders, and the complex structure and the risky nature of the business warrant this. In addition, due to the very tight collateral package and the significant assets financed, project finance lenders historically have had a very high recovery rate on their debt if there has been a debt default. These ‘money good’ investments may take a tremendous amount of time and effort on the part of the lending group to work through the problems, but the end result is usually worth it as the debt is either repaid in full or is successfully restructured.
If flexibility is required to possibly do something different with the plant in the future (such as burning different fuels for instance) then that has to be built into the specification otherwise it might not be possible to introduce it later in the project. This is important in the context of project finance lending as the contractual rigour that is required forces a clear understanding of what has to be done and who is responsible for what. Because of this rigour, project finance projects do get delivered, generally on time and to budget and with performance that meets the specified function, but generally no more and no less.
Nuclear new build is a capital-intensive business for which sponsors will invariably seek external lending. The project delivery structure will depend on whether this is done on or off balance sheet, which will affect how the participants in the project are grouped together contractually and how risk is apportioned.
It seems likely that the first new build projects in the UK will be led by strong utilities using on-balance-sheet lending. Stand-alone projects (merchant plants) may come along later once lenders have experience and confidence in potential project players. However, whatever the model used, the same sets of risks will need to be evaluated and converted into contracts.
David Boyd, Strategy Director, Power, Halcrow Group Ltd, City Park, 368 Alexandra Parade, Glasgow G31 3AU, UKRelated ArticlesNDA gears up for UK geological repository
The main benefit of project finance lending is that the contractual rigour involved gets projects built on time