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IPPs - Tendering & Structuring

22 February 2010

Paul Eardley-TaylorHead of Energy, Utilities & Infrastructure Coverage - South Africa & Africa

Tel: +27 11 636 3229; E-Mail: paul.eardley-taylor@standardbank.co.za

2Table of contents

SECTIONS

1. - Introduction

2. - IPP Tender Process

3. - IPP Structuring Considerations

4. - SA Issues & Conclusion

5. - Differences between IPPs and PPPs

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1. Introduction

4Current electricity business context

� There has been an underinvestment in new generation capacity for 20 years

� Underinvestment in capacity is widely perceived to be retarding national economic advancement

� There is a need to diversify a generating portfolio traditionally dependent on a single source

� Demand growth was projected to be 5% pa for 2006-2010, before declining to c.4% between 2010 and 2020

� To meet increasing demand, the business is undertaking a huge capacity expansion programme, challenging organisational structures and funding ability in a different global power procurement environment

� This is the position for UES in Russia, but it coul d be many countries in Africa

5Why do IPPs exist?

� IPPs exist for a number of reasons, with the key strategic driver differing according to the individual market

� Means to procure new generating capacity often (but not always) more efficiently (speed / cost / operational benefits) than through the state utility

– Examples: Asia (e.g. Philippines); Middle East (e.g. Abu Dhabi, Egypt, Oman); Mexico

� Part of global trend towards markets, privatisation and deregulation

– Examples: UK, US and Australia (1990s)

� In some jurisdictions, partly a political driver – to limit power of State monopolies with spin-off benefits (e.g. reduced corruption)

– Examples: China, Indonesia, Pakistan, Thailand

� To reflect industrial requirements for reliable power (e.g. inside the fence or cogen). Examples: Italy (IGCC)

� More recently, a key means by which countries can achieve renewable energy targets (principally through onshore wind IPPs). Examples: Global

� A key point regarding IPPs is that their financing process is an output of the associated commercial development and / or tendering process, i.e. finance does not lead but follows the process

6Who are the IPP customers?

� For countries evaluating whether to go down the IPP procurement route, it is important to know who your customers would be. Typically investors fund 20 - 30% of the capital structure of an IPP with the balance funded by third party debt (a.k.a project finance)

� Influenced by technology and capacity purpose

– Peaking power would result in fewer bidders than base load…

� Influenced by risk profile

– Developer preference is to bid hard for “financeable” risks. Why? Several have lost money in markets such as Argentina, Brazil, Pakistan and learnt their lessons

� Utility spin offs…

– Examples: Suez Energy, International Power, CLP

� Independent Developers….

– Examples: Globeleq, AES, Intergen

� Trading Houses….

– Examples: Marubeni, Mitsui, Sumitomo, Tata, Mitsubishi

� Infrastructure Funds…

– Examples: Arcapita, AIIM, GIP

� Local Participants

– Examples: Insurance Companies, BEE Funds

7IPPs: Success or Failure?

� IPPs have not been a universal success. Globally, for every 7 successes, there have been 3 failures (our assessment)

� However, it is often hard to separate “IPP failures” from wider political / economic failures in the relevant market (e.g. impact of Asian crisis)

� IPP Pros include:

– Proven ability to procure capacity (e.g. base load, dedicated industrial, renewable) which remains there through subsequent economic cycles

– In many markets, offers cost savings, increased operational expertise and know-how, and establishment of financing benchmarks

– Proven ability to attract FDI whilst achieving public policy objectives (e.g. localisation)

– In country, an ability to spread ownership stakes and develop local supplier bases

� IPP Cons include:

– Less compelling advantages if there is a strong incumbent utility (e.g. France, South Africa (traditionally))

– IPPs are not insulated from political risk or “subsequent events” (e.g. Asian Crisis)

– An easy target for political opponents in-country (e.g. PPAs can be argued as “soft deals” to foreigners rather than as consideration for huge, long-term FDI in a single, stranded asset)

– The hardest risks for the incumbent utility are often the hardest for the private sector to take (e.g. commodity price exposure), especially when linked to a single asset not a portfolio

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2. IPP Tender Process

9IPP Tender Process: Summary Activities

Estimated Timeframe:

3 - 6 months

PHASE 5

1. Negotiation of Project Agreements

2. Achieving Financial Close

Estimated Timeframe:

2 months

PHASE 4

1. Bid Evaluation

2. Bid Clarifications

3. Preferred Bidder selection

Estimated Timeframe:

5 - 7 months

PHASE 3

1. RFP Clarifications

2. Tender Period

- Bid Preparation

- Bid Submission

Estimated Timeframe:

2-3 months

PHASE 2

1. Pre Qualify Bidders

2. RFP Development

3. RFP Issuance to Pre Qualified Bidders

Estimated Timeframe:

2 - 3 months

PHASE 1

1. Prioritise Key Project Objectives

2. Agree Project Concept

3. Obtain Stakeholder Approval

Within the IPP process chain, there are many delay opportunities, risks of inappropriate deal structur e, no interest and process abandonment ���� leading to grid capacity shortfalls, tarnished IPP reputation, expensive temporary solutions and

high opportunity costs

10How do you get a successful IPP tender?

� Alignment of expectations as to what IPPs can deliver against competing procurement alternatives

– Contrast results of Middle East IPPs against the utility’s new build programme

– Key benefits of fixed price EPC contracts only becomes apparent in cost overrun environments, which some new build programmes may experience

� Understanding of Risk versus Reward dynamic in IPP context

– Given rewards are capped by a tariff, Developers and Lenders will not take:

► Unlimited Liability

► Unquantified Risk (e.g. primary energy costs)

� Developers and Lenders only wish to take risks they can control, pass to someone else or at least mitigate. Why? They only have one asset to get their money back from - the opposite of portfolio diversification

� Risk Allocation is critical

– Development risk

– Political risk

– Environmental risk

– Completion risk

– Cost increase risk

� Reward is not a mitigation for unsatisfactory risk. The transaction’s risk allocation would feed back through the pricing / IRR, but beyond a certain point would impact on whether a developer would bid at all

� Could you persuade your Board of Directors to take commodity risks for an infrastructure return?

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2. IPP Structuring Considerations

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What I want is…… ...

The Project Parties

The Awarding Authority

• Will this guarantee Security of Supply?

• Will this give me the Lowest Electricity Cost?

• Will this be a Successful Tender? Cannot afford to be seen not to succeed

The Developer • What will be my equity return?

• Where is my return coming from?

• What is the potential for additional equity upside?

• What is the risk to my investment?

The Lender • We lend cash out, we want cash back…. plus a bit more

The EPC Contractor

• What will be my profit margin?

• Will I get paid?

• Does this fit my order book?

• What are my liabilities ?

The Employee • But aren’t we building a power station?

The challenge is to develop and then document an IP P structure that can represent an acceptable balanc e between the various stakeholders

13Typical IPP Contractual Structure (Wagon Wheel)

Investors Lenders

Contractor(s)

OperatorShareholders Agreement

Fuel Supplier

Government

Project Company

Gas/Coal Supply Contract

Support Agreement(s)

Operation and Maintenance Contract

EPC Contracts)

Equity Guarantees FacilityAgreements

Power Purchase Agreement(concession)

SecurityAgreements

Offtaker / utility

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The Power Purchase Agreement

The PPA grants the concession and sets the tariff. It is the primary document all should focus on. To some extent all the others are secondary

� Grants the concession

� Specifies ownership

� Sale and purchase of capacity

� Sale and purchase of energy

� Indexation (of FX / Inflation / Energy price movements)

Performance criteria

� Specifications and performance standards of the plant

� Revenue write down provisions for non-performance

� Delays LDs for late commissioning

Third party responsibilities

� Water and power transmission interconnections

� Supply of gas / coal / fuel

� Permits

Force majeure / politicial events

� Natural Force Majeure

� Political Force Majuere

Termination

� Termination

� Credit support

15The PPA: Tariff structure

� A number of different tariff structures are feasible – here we have focused on the most commonly used structure: ‘Availability’ payment structure

� The RFP for an IPP tender will specify the tariff structure which bidders must adhere to and will form the basis of payments to / from the Project Company (Generator) and the offtaker (Procurer)

� Each bidder will be invited to bid a number of Charge Rates

– Occasionally charge rates can be firmly fixed and bidders would have to target LEC (Levelised Electricity Cost) based on an Asset Value (Brownfield acquisitions)

� For an availability driven tariff, payments will typically be split between Capacity and Output

– Capacity Payments are designed for recovery of all the fixed costs of the plant, including debt service, taxation, levies, equity return and fixed O&M costs. Typically deductions for non-availability and / or poor plant performance would be netted off against these capacity payments

– Outputs Payments recover the variable operating costs of the plant and may also include (1) an adjustment for fuel consumption or (2) a recovery of fuel costs)

� In the case of a merchant plant, the tariff structure is much simpler. Revenue = Plant Output (MWh) * Market Price (ZAR/MWh)

Tariff

Capacity Payment

Base capacity component Fixed O&M component

Output Payment

Fuel (adjustment) payment

Variable O&M payment

16Other Project Agreements

Shareholder Agreement

• Equity Financing Commitments

• Formation and Control of Company

• Share Transfer Restrictions

• Deadlock and dispute resolution

EPC Contract • Engineering, Procurement, and Construction

• Lump sum turnkey

• Liquidated damages - delays and performance

• Right of rejection

• Testing regime

• Must be bankable - good credit risk or credit worthy guarantor

Operation and Maintenance Agreement

• Allocates plant operational risks

• Balance between incentives and penalties

• Fixed price v cost plus

• Operator must be bankable - experienced, creditworthy

Finance Documents • Loan Agreements, Common Terms Agreements, Inter Creditors

• Security documents - mortgages, charges, assignments

• Direct Agreements

The other documents would largely be the responsibi lity of the developers to draft and execute

17Non-documentation issues

Fuel • Security of Fuel Supply

• Volatility of Price

• Technical Specification Risk

• Efficiency of Fuel Utilisation

Environmental • Environmental Impact Assessment

• Environmental Management Plan

• Equator Principles

• Permitting

• Flue Gas Desulphurisation (coal-fired)

• Compliance costs

Localisation (CSDP, NIPP, ASGISA, BEE)

• Disincentives to international bidders if overly onerous obligations

• Compliance

• Change in law provisions re future legislative changes

Project-on-Project Risk

• Interdependence on other projects - Fatal Flaws

Macroeconomic Risks • Interest Rate risks

• Foreign Exchange risk

• Inflation risk

Other risks

18Capital Structure

Sponsor(s)

Project Company

Project Finance lender(s)

20-40% equity participation

80-60% debt funding

• The minimum equity required in an IPP is subject to several factors, including the technology (impacts availability / capacity factors) and interest rates in the jurisdiction (impacts cost of servicing debt). South Africa is likely to require 30% equity

• Majority stake commonly held by private sector. Minority stake by BEE / Government-linked shareholders. Due to the volumes of funding required for IPPs, most are funded off the Sponsor / shareholder balance sheets at Project Company level through Project Finance-based structures

BEE ownership could occur directly in the Project Company or via a BEE company holding interests at Sponsor / Consortium level. Minority stake could be held by Government-linked shareholders……

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4. SA Specifics & Conclusions

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Known Knowns

� Demand exists

� The installed fleet is old and the cost of using the reserve margin is expensive

� South Africa’s power sector must change

Known Unknowns

� Siting – the preferred location of plants

� Enabling laws / regulations – this is perhaps one of the biggest stumbling blocks to progress

� Fuel supply / feedstock – will this be a pass through

� Tariff indexation (e.g. currency components) – will this be a pass through

� EPC price increases - who takes this risk

� Pass through of costs to consumer (Cost Recovery Mechanism)

� EIA approval times and content

� Bidder appetite given numerous “false dawns”

� Grid connection capacity / constraints

� Depth of stakeholder commitment

Unknown Unknowns

� Unseen hurdles

What’s Donald’s views on South African IPPs?

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Indicative Commercial Structuring Considerations:

� Offtake Concepts

� Fuel Supply Concept

� Shareholding Concept

� Credit Risk and Support Concepts

� Indexation Risk Concepts

� The first deal sets the precedent

Indicative Legal Discussion Points:

� EIA risks for mine (fuel source) / plant / transmission lines

� Working within ASGISA / CSDP

� Working within BEE

� PFMA Requirements

� Eskom / Single Buyer Office / Stakeholder Approvals and Authorities

� Licence / Permitting

Structuring Considerations

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Minister Hogan stated in late 2009 that Eskom is, i ndeed, keen to finalise agreements with independent power producers (IPPs) "but can only do so in a supportive enabling environment whe re it can be in a position to enter into long-term power purchase agreements“

Some elements of this enabling environment include the development of a comprehensive public participa tion integrated resource plan by the Department of Energy (IRP2), "which would indicate which capacity is allocated t o IPPs” – the current IRP1 (3 pages) incorporates REFIT and MTPPP (which has been cancelled) and stat es that a determination in respect of other new gen eration capacity initiatives (IPP Bid programme) will be done in due course

Government has committed to the creation of an ISO by 2010 year-end, with clarity required on the SBO ’s ownership

�Worth considering:

– Market interest in the power sector has been stimulated on many occasions in the last 6 years. On none of these occasions, has there been a conclusion to any of the DME, NERSA or Eskom initiatives. Investors are growing weary

– There are approximately 27 bidders interested in the Baseload IPP programme. Their process has been delayed by 8 months to date and they are growing weary. Total interest is about 4,000MW

– There is about 3,500MW of interest in the renewable energy space in the form of interest from 20+ developers

�The interest from these Stakeholders is not finite and they are all becoming edgy about the commitment from RSA Incorporated to accommodate them in the energy sector

�Note that the 31 December 2009 IRP includes 343 MW from MTPPP and REFIT by year end 2010, it is already to late to commission those MWs this year, but we hope that, with momentum, it will be possible to sign PPAs for those MWs this year

�There is a considerable weight of expectation from Stakeholders that the SBO will be in place and operating under the Cost Recovery Mechanism by late 2010 – today, in February, this could still be achievable, but action needs to be taken NOW.

�THE COUNTRY NEEDS A NEW “SUPPORTIVE ENABLING ENVIRO NMENT” AND IT NEEDS IT IN 2010, NOT IN 2012?

Legal Considerations

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� Positive Differences:

� Clear commercial demand for underlying product. Electricity has a price which is usually paid by consumers.

� This is not always the case with PPPs (e.g. Government Buildings)

� Easier to facilitate large FDI into iPPs (e.g. worlds largest IPP is USD 3.6bn)

� Negative Differences

� Exposure to risks of fuel availability, quality, volume and pricing

� Exposure to consumption at significant non-sustainable resources (e.g. fuel, water) plus assorted environmental emissions (CO2, SO2)

� Higher exposure to operational and maintenance risks (as opposed to facilities management)

� Higher exposure to commodity risks (e.g. foreign exchange, fuel prices)

Differences between IPPs and PPPs

24Conclusion

� Although not an unparalleled global success, IPPs have clear benefits provided that policy-makers are clear what they what from them

� Provided the awarding authority can determine key aspects of Projects’ siting, capacity, dispatch, specification and documentation, it should have sufficient strategic “control” and “influence” - it’s your call, you can determine the “rules of the game ”

� Regarding tendering strategy, we would recommend a coherent, sequential tender process (i.e. bidders work on one IPP bid preparation at a time), which procedure tends to produce the best results

� Within IPP contractual structures, the key document to focus upon is the PPA. Assuming this is commercially satisfactory, and legally binding, much of the rest of the transaction can fall naturally into place

� Within the SA context, particular challenges for IPPs arise due to: a historically non-integrated approach to energy policy-making; a non-enabling IPP regulatory environment and a limited role for non-Electricity Co generation. However, given projected energy shortfalls, there remains potential investor appetite for SA IPPs, whether greenfield or brownfield

25Conclusion

� Although not an unparalleled global success, IPPs have clear benefits provided that policy-makers are clear what they what from them

� Provided the awarding authority can determine key aspects of Projects’ siting, capacity, dispatch, specification and documentation, it should have sufficient strategic “control” and “influence” - it’s your call, you can determine the “rules of the game ”

� Regarding tendering strategy, we would recommend a coherent, sequential tender process (i.e. bidders work on one IPP bid preparation at a time), which procedure tends to produce the best results

� Within IPP contractual structures, the key document to focus upon is the PPA. Assuming this is commercially satisfactory, and legally binding, much of the rest of the transaction can fall naturally into place

� Within the SA context, particular challenges for IPPs arise due to: a historically non-integrated approach to energy policy-making; a non-enabling IPP regulatory environment and a limited role for non-Electricity Co generation. However, given projected energy shortfalls, there remains potential investor appetite for SA IPPs, whether greenfield or brownfield