Financing waste to energy plants

Anthony Woodward

Waste-to-energy projects are going ahead in the UK, they are being project3nanced, and they will make a valuable contribution to environmentally acceptable waste disposal and clean energy. However, waste-to-energy projects do not f;t easily with the business priorities of major suppliers of funds. To improve that fit, the author suggests that the projects must be reworked so that a more favourable opportunity can be oflered to potential funders. Keywords; Waste-to-energy; Funding; Risk

In November 1990 I delivered a paper to the CHPA in Sheffield on the economics of refuse-based CHP. True to the gloomy nature of my topic and the inevitable pessimism of my profession, my message was thoroughly down-beat. Its sub-text was how I have failed to finance waste projects in places as diverse as Miami and Manchester, Greenwich and Guiana. Birmingham and Brussels, Lewisham and Long Island.

Today, my message is very different and I am forced to admit that waste-to-energy projects are going ahead in the UK, they are being project financed and they will make a valuable contribution to environmentally acceptable waste disposal and clean energy within the UK. The South East London Combined Heat and Power project - SELCHP - is a shining example of what can be achieved. Bob Wheatley, the Managing Director of SELCHP, is to speak to you this afternoon and I shall leave it to him to boast of insurmountable problems surmounted, and of immovable objects moved by his and his colleagues’ irresistible force. It is with relief, therefore, that I can return to the pessimistic and present today’s sub-text.

‘Why should I put any money in your damn project?’

My premise is that project sponsors must compete for funds and, therefore, it behoves the project sponsor

The author is Director, Project Advisory Services, Lloyds

Bank plc, 6-8 Eastcheap, London EC3 MILL, UK.

This paper was presented at the seminar entitled ‘Waste from Energy: Clean, Green and Profitable’, which was organized by the Institute of Energy, and held in London in October 1991.

Final manuscript received 9 October 1991.

to adapt his proposal to the needs of the investor rather than the other way around. The starting point, therefore, must be an understanding of the basic raison d’etre of a category of investor. Financial institutions are much like other private sector corporations with defined products and business plans which, in large part, reflect the demands of their own funding structure. Although they will, and must, adapt with the market, a single opportunity will not persuade them to change their chosen business sector. There is no more logic in approaching a venture capitalist for a short-term money market loan than there would be in asking a tractor manufacturer for a motorbike.

Waste-to-energy projects, in which for the purposes of this paper I do not include landfill gas, have certain characteristics which should be considered in terms of their fit to the requirements of investor groups. The characteristics are:

(i)

(ii) (iii)

(iv)

(v) (vi)

(vii)

(viii)

(ix)

a long-term plant life, usually in excess of 30 years; high initial capital costs; a 2-3 year construction period during which time no partial operation can take place; the existence of aggressive and flexible alterna- tive waste disposal competition; the use of proven technology; an uncertain future structure of the electricity market;

uncertain future legislative requirements for waste disposal; the potential availability of long-term contracts covering refuse disposal; and a significant impact upon the local community.

I have categorized the potential providers of funds as ‘investors’. This should be enlarged to include lenders

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Financing waste to energy plants: A. Woodward

and I would split the group into two: ‘passive’ investors and ‘active’ investors. The former group consists of those institutions whose only interest in a project is on the direct financial return which is generated. Venture capital companies, insurance companies/pension funds and commercial banks make up this group. ‘Active’ investors cover that group whose main interest in a project is not the return on their direct investment; rather it is the opportunity to earn profits from selling, goods and services to the project or to obtain favourable services from the project. This group is usually made up of the project sponsors whose direct investment can be more properly characterized as deferred profits from their commercial contracts. This contribution is often vital, but it is the passive investors who are expected to provide the bulk of the funds for project development.

Venture capital companies are usually funded by other financial institutions who make an equity investment in the company. By this investment the parent company takes a controlled, modest stake in high risk, high return business. The venture capital company justifies risk by having a portfolio spread of high yielding investments. There is a preference for investing in enterprises which offer an early ‘exit’, ie a return of capital via a share issue or other refinancing. In addition, venture capital companies do not like ‘green fields’ projects preferring to fund major developments for proven management. It can be seen, therefore, that waste-to-energy projects do not fit venture capital requirements. The amounts are too large for effective portfolio investment management, the risk return profile is inappropriate and the life of the project requires stable long-term funds.

The investment requirements of pension funds and, possibly, insurance companies give a better fit with the risk return profile of waste-to-energy projects. This source of funds is prepaid premiums and their liabilities are future claims. A steady, long-term

investment income flow meets the actuarially calculated forecast of future claims. The present barriers to such investment are tradition and liquidity. Fund managers have traditionally held a portfolio of equities, fixed interest government stock and property. Their skill is in balancing these overall categories one with another and in maximizing the returns within each category. Liquidity of investments has been a prime requirement of such portfolio management. Should waste-to- energy projects grow in number in the UK, an investment instrument which has a secondary market could emerge, but only if such investment has a return which justifies its risk vis-a-vis other investment opportunities. The minimization of uncertainty is an

important factor in that judgment. The minimization of uncertainty is also a key to the

availability of long-term commercial bank debt. Banks have long advertised themselves as being in the business of providing project finance, but this should not be interpreted as meaning that banks take project risk. Banks are funded by short-term deposits pro- vided by depositers who believe themselves to be making very low risk investments. These deposits are supported by a capital base which represents perhaps 5% of a bank’s total funding. Bad debts make for a large share of the banking industry’s media coverage but if the experience of default was, in reality, a high percentage of loans made then no bank could survive. Banks are not in the risk return business; they are more likely to lend to projects with high earnings because the earnings provide cover against a business downturn not because they, the banks, share in these higher earnings. Bank provided project finance does not, therefore, imply the taking of project risk; rather it is the acceptance of a reasonable banking proposi- tion which is achieved by understanding risk and by allocating unacceptable risks away from the project via commercial contracts. The greater the level of uncertainty, the less likely that bank loans will be available.

It can be concluded from the above that waste-to- energy projects do not fit easily with the grain of the business priorities of major potential suppliers of funds. To improve that fit, the projects must be reworked so that a more favourable opportunity can be offered to potential funders. This can be achieved

by:

l improved economics; l a reduction in risk; and l a reduction in uncertainty.

Improved economics is a matter of reducing costs or enhancing revenue. To begin with costs, it is accepted that project sponsors can design the most cost-efficient plant configuration. The problems come from the conflict of interest within most project sponsors who, as we pointed out above, look to their commercial contracts with the project for a major part of their return. By following their reasonable commercial instincts, sponsors can mitigate against a project’s optimum cost structure. In particular they may:

l design a project to fit sponsor equipment which might not be the most appropriate;

l negotiate a price which would be improved upon in a fully competitive environment; and

l negotiate less than optimum performance criteria.

It is imperative that a consortium sponsoring a project builds in a system of controls and rewards which most closely incorporate market disciplines. This is best

234 ENERGY ECONOMICS July 1992

achieved at the outset of a consortium’s existence. Our experience is that it should incorporate an early evolution of the consortium into a company with independent management and advisors. This implies a significant commitment of funds which in turn demands an initial, very critical view of the project’s potential. Also, negotiated contracts should be per- mitted only with rigorous open-book controls and with sub-contracts competitively negotiated.

The level of capital costs is also dependent upon planning and regulatory authorities. Suffice it to say that they must be satisfied that a plant meets an acceptable standard but that excessive requirements will prevent some incineration projects going forward, possibly to the detriment of the overall environmental balance.

Project economics can also be improved by en- hanced revenues. In theory electricity prices and tipping fees are fixed by market forces. In practice both are heavily influenced by central government ‘activities’, in particular the competitive rules set out for the second tranche of the Non Fossil Fuel Obligation and the requirements for Waste Disposal Authorities to go out for competitive tender under the terms of the 1990 Environmental Protection Act.

Whatever the returns offered by a project, it becomes more financeable the more risk and un- certainty are reduced. These two areas are clearly closely related. For present purposes we assume that risk reduction covers the tightening of commercial contracts to pass risk away from the investment/loan vehicle and reduction in uncertainty covers a need for more efficient information flows and a more settled and predictable regulatory environment.

Major risks which funders will be unwilling to accept include those involved in the construction and operation of the plant. Commercial contracts from project sponsors can effectively transfer most of the risk away from the project company. There are, however, certain problems which remain.

Inadequate liquidated damages: neither ‘passive’ investors nor contractors are willing to accept the ultimate cost of project failure. Solutions to this problem are through a mix of taking out commercial insurances, writing a structure of penalties and rewards into the contracts, seeking standby equity funds from project sponsors and using technical reports which define the probability of default. Inadequate overlap of commercial contracts: it has proved impossible to exactly determine respons- ibility for failure. Sub-contractors are also unwilling to sign liquidated damages for amounts many times the value of their contracts. The problem can be reduced, but not eliminated, by greater under- standing of the technical risk and the acceptance of

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Financing waste to energy plants: A. Woodward

this by the investor/lender. Commercial insurance and steady equity also have a role to play.

Planning and regulatory requirements: lenders/ investors will not advance any funds until all governmental requirements have been met in full. Experience is that the planning/regulatory process has been very time consuming.

The question of a premium price for non-fossil fuel generated electricity was discussed above. Alongside the matter of price, is a question of market availability. The 1983 Energy Act and the present pool arrange- ments gave, or give, some level of assurance that electricity, if produced, will be purchased for a market price. In addition, however, comfort would be gained if the RECs were prepared to guarantee offtake at market prices in the event that legislation was further amended and the present assurances of market availability was removed.

A more fundamental issue lies with the contracts required for refuse supply. It was stated earlier that passive funds would not be available for incinerator projects built on a speculative basis. This is a very fundamental point which should become clear on a reconsideration of the objectives of those potential funders we have identified. The refuse contract is a key part of the external support which funders will look to in making risk acceptable. Complicating factors are as follows.

Contract signature will pre-date major fund raising and, therefore, plant construction. Waste Disposal Authorities must commit themselves to a project up to three years before it is able to accept refuse. The basic economics of waste-to-energy projects are such that long-term funds are required. Funders will expect the refuse contract to cover at least the period of debt, which could be up to twenty years. Indexation of the refuse contract must reflect that included in the operating contract. Electricity generation depends to a great extent upon the make-up of the refuse. Considerable negotiation on the responsibility for this is required before contract signature.

can be seen from the above that landfill operators enjoy far greater flexibility in terms of available volumes, delivery times, length of contract, and waste make-up. The requirements of the Environmental Protection Act for a competitive tender adds significant uncertainty to a project’s progress. It rules out a negotiated gate fee based upon project costs and puts the onus on Waste Disposal Authorities to compare short- and medium-term options with long-term incineration. The present circumstances of imperfect knowledge on future landfill costs adds a serious

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impediment to the decision-making process and thus to a commitment to incinerator projects.

To conclude,

6)

(ii)

(iii)

Project sponsors should consider the commercial requirements of ‘passive’ funders before setting their financial stretegies. Waste-to-energy projects do not comfortably fit the investment or lending criteria of venture capitalists, institutional funds or commercial banks. ‘Passive’ funds can be made available to finance waste-to-energy plants but this will usually in-

Finunciny wuste to energy plants: A. Woodward

(iv)

(v)

volve very significant levels of sponsor support and abnormally onerous contractual obligations. Projects sponsored by entrepreneurs with limited financial resources must enjoy very strong economics to attract ‘passive’ funds. Therefore it is essential that a rigorous and realistic assessment of a project be carried out at the earliest possible stage to ensure that the available returns meet the requirements of all the interested parties: contractors, refuse disposers, electricity offtakers, operators, sponsors and funders.

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