Against a backdrop of persistently soft oil prices, the Kingdom of Saudi Arabia is pivoting away from the direct procurement of generation capacity and re-invigorating the privately-financed IPP model. As input costs fall and consistent with government policy a significant portion of such new capacity will come from solar. This represents a significant opportunity for local and international developers, contractors and suppliers.
The Saudi Electricity Company (SEC) has invited pre-qualified companies to submit proposals for two photovoltaic independent power projects, with a total capacity of 100MW. The projects are to be located in the northern region of the Kingdom of Saudi Arabia (KSA).
Local news sources are reporting that 18 companies have been pre-qualified to submit bids although the number of bidders will lessen as pre-qualified companies combine in consortia comprised of developers and EPC contractors / panel providers. The SEC is targeting a commercial close for each project of 1 May 2017, with financial close to occur very shortly thereafter.
In a departure from the SEC’s usual contract structure (discussed briefly below) the projects will be developed pursuant to a build own operate (BOO) scheme with a 25 year power purchase agreement (PPA) term and the winning bidders/sponsors will be permitted to own all of the shares in the project company.
The release of the above projects signals the re-invigoration of the independent power project (IPP) and independent water project (IWP) programme in KSA. That programme was largely shelved in 2011, as the Kingdom reverted to direct procurement on an EPC basis against a backdrop of high oil prices and competitive EPC terms. According to Middle East Business Intelligence (MEED) the Kingdom will procure 47GW of generation capacity by 2024, with a significant portion to be procured under the IPP model. The next significant conventional project will be the enormous PP15 plant (5.4GW), which is expected be released in the last quarter of this year. Advisors are also being sought for an IWP project to be powered largely by solar energy, a joint venture between the SEC and the Saline Water Conversion Company (SWCC).
Notably, too, the Vision 2030 plan targets the installation of 9.5 GW of renewable energy capacity in KSA by 2020.
The reversion to project financed IPPs reflects the reality of the current macro-economic environment in the Kingdom and other GCC countries and the likely prospect that oil will continue to trade in the current range in the short to medium term. Specifically, nearly all GCC markets remain heavily reliant on the contribution of oil exports to GDP. Existing pricing levels mean that governments will need to fund their budgets by drawing down on foreign reserves and sovereign wealth funds and raising debt in the capital markets. Indeed KSA will raise approximately $17.5BN in the sovereign bond market this year.
The relevant economic data may be summarised as follows:
- according to various sources the contribution of oil and gas to GDP is estimated to be as follows: 30% for the United Arab Emirates (UAE), 45% for KSA, 50% for Qatar, 44% for Oman, 66% for Kuwait and 20% for Bahrain;
- according to the International Monetary Fund (IMF) the fiscal breakeven oil price is, for 2016, over $90 a barrel for Bahrain, in excess of $75 a barrel for KSA and Oman, approximately $60 a barrel for the UAE and Qatar and approximately $50 a barrel for Kuwait;
- according to the IMF GDP growth has contracted sharply in each nation during 2016;
- again according to the IMF, each country will be in fiscal deficit through 2017, with the exception of Kuwait which will return to fiscal surplus in 2017. However, the level of such deficits expressed as a percentage of GDP is still far lower than the United States of America and United Kingdom.
In summary, although the overall cost of power and water under the independent power and water project (IPWP) model is relatively more expensive when compared with direct procurement, in the current environment it makes more sense for GCC governments to (i) avoid high capital outlays over relatively shorter construction periods, (ii) take advantage of private sector sources of finance and (iii) spread the cost of procurement over a 20 – 25 year project life. I would note that the same factors militate in favour of public private partnership (PPP) projects in other sectors.
The KSA IPWP procurement model traditionally closely tracks the Abu Dhabi IPWP model with developers having the benefit of government credit support for the payment obligations of the offtaker and a fairly comprehensive termination and termination payment structure, pursuant to which the offtaker is either (a) entitled to purchase the plant in certain circumstances (e.g. PPA termination for reasons of project company default) or (b) required to purchase the plant in a more limited set of circumstances (termination by the project company for offtaker default, termination of the PPA by the offtaker for reasons of long-term natural force majeure or termination of the PPA by either party for reasons of long term political force majeure). IPP projects in KSA traditionally feature a significant government shareholding, although day to day control remains with the developer, with certain key reserved decisions requiring a special majority resolution. Further, there is often a put and call option in the shareholders’ agreement linked to termination of the PPA for project company default, with the result that the private sector developer may be forcibly ejected from the structure.
As mentioned above, however, these two IPP projects are to be let as BOO projects with 100% sponsor shareholding.
Although we have not seen the RfP documents, it will be interesting to see whether the risk allocation will be adjusted to more closely accord with the risk allocation successful deployed by Oman under its IPWP model, which is the most comprehensive BOO scheme in the Gulf. Under the Omani IPWP model, the project company has no right to terminate the PWPA for any reason and, consequently, there is no provision for termination payments to the project company. Therefore, in the case of serious breach by the offtaker, prolonged payment default by the offtaker or prolonged political force majeure events, the project company is reliant on the offtaker’s continuing obligation to pay the capacity charge on an ongoing basis. Further, there is no requirement for the offtaker to purchase the plant on termination for project company default. The other outstanding features of the Oman IWPP model are (a) the absence of government guarantees (on the basis of the Omani offtaker’s credit rating (which has recently been downgraded by the ratings agencies)) and (b) a requirement to list a significant portion of the project company’s shares on the local securities exchange.
Other likely issues for developers are as follows:
- the glaring issue is the hyper-competitive nature of the sector. The winning tariff on the recent Sweihan IPP project in Abu Dhabi (350MW) was US$0.0242 per kWh and the four lowest bids were priced below the US$0.03 per kWh winning bid for Phase 3 of Dubai’s Mohammed bin Rashid Al Maktoum Solar Park (800MW). The price of panels has fallen by 25 per cent in the past year and is expected to continue to fall, largely as a result of overcapacity in Chinese manufacturing, but the margin for error, and to some extent return on equity, must be relatively low at those levels. Additionally, locally based developer ACWA Power looms colossus-like over the Saudi power market, making it difficult for smaller developers to take market share;
- given the long-term nature of the offtake, the author assumes there must be some risks around projected versus actual levels of replacement of solar panels;
- SEC will be extremely reluctant to accept any departures from its preferred risk allocation under the project documents. Accordingly bidders must ensure that they are able to pass risks through to their EPC and O&M contractors and seek to mitigate residual risks, e.g. through insurances. As a perfect pass through of risks is never possible (e.g. because of liability caps and sub-caps for delay and performance LDs, and exclusion of indirect loss, to state two obvious examples), bidders will unfortunately need to live with the residual risk at the level of equity;
- the bid timetable to financial close is extremely aggressive and if the scheduled closing date is not achieved other than for reasons attributable to SEC or political force majeure events, SEC may terminate the PPA and call on the full amount of the specified development security. A limited extension is also normally available where financial close is not achieved by the scheduled date but the developer is able to put short term bridge financing in place and issue a full notice to proceed to the EPC contractor;
- deemed capacity payments are unlikely to be available in circumstances where the plant is unavailable due to a natural force majeure event, although the term will be extended to the extent the plant is unavailable due to such cause and capacity payments will be made during such additional period;
- there will be mandatory requirements around the employment of nationals (this issue is most acute at the level of the operator) and these requirements are understandably becoming more stringent. Therefore the cost implications of training and employing nationals needs to be taken into account;
- the financing offer will be expected to (essentially) amount to a full underwriting and the bidder will be responsible for 100 per cent of the requisite finance. The availability of financing has decreased (particularly from local banks) and pricing has tightened somewhat on recent transactions the author has been involved in, although this will probably not be an issue currently in Saudi Arabia given its relatively strong sovereign credit position;
- ground risk is usually the project company’s/sponsors’ risk and the ability to achieve a full pass through of this risk to the EPC contractor is often contentious. Practically, this risk may be mitigated to a certain extent by the provision of ground and geotechnical reports with the RfP package, although the project company will typically be asked to rely on its own investigations and to assume the risk of ground and sub-surface conditions which are not disclosed or consistent with such reports. High water tables, poor soil conditions and, sometimes, man-made obstructions are common issues in the GCC countries;
- many civil works contractors have suffered significant project write-downs and losses and contractors are generally under pressure in the GCC countries. Some are taking a more prudent approach to pricing contingency as a consequence thereof and pricing negotiations should occur as soon as possible during the bid phase;
- regarding the financing of the project, funding may be provided by one or more of conventional/commercial and Islamic institutions and ECAs linked to host country procurement. Sponsors in this jurisdiction will normally work with their advisors (financial and legal) to optimise the capital structure for the project and the terms on which a financing will occur. Long-form financing term sheets must be submitted as part of the bid and these should be drafted by the sponsors’ lawyers;
- sponsors and their advisors will normally wish to embrace a number of techniques in order to make the bid competitive, including back-ending equity (supported by sponsor undertakings and collateral) or utilising equity bridge facilities and, if possible counting any available net EGRs towards equity funding. In addition to tenor and pricing, other key commercial terms will include the permitted debt to equity ratio for drawdowns (there are currently no thin capitalisation rules and minimal statutory share capital requirements) and cover ratios for debt sizing, distributions and defaults;
- bidding is accordingly a time and cost intensive process and the cost of external advisors must be factored into any decision to bid.