What is District Energy (“DE”)?

District Energy is the collective term given for the centralised production and distribution of heating or cooling energy. DE plants are built to service an entire city “district” of buildings or other large scale geographical area.

For district cooling systems, a centralised plant produces chilled water which is pumped through an underground pipeline network throughout the applicable district. The pipeline connects to each building, and chilled water passes through an energy transfer station (where it is used to chill the air within the buildings). The water is then returned to the chilling plant through a separate pipeline network where the chilling process is repeated. District heating systems work in the same way, except that the circulating water is heated instead of chilled.

What project delivery models are used for DE projects?

Traditionally, building owners have procured their cooling or heating needs by contracting to build a DE plant and pipeline networks and then contracting with a separate utility company to operate the DE system. Another model that has become common in the Middle East market over the last decade involves a building owner contracting with a utility company to build and operate the DE plant and the pipeline networks, with the building owner paying the capital expenses (“capex”) and operating expenses (“opex”) of the DE system (which includes a profit for the utility company).

One new model that has been introduced to the DE industry is the privately financed public-private-partnership (“PPP”) concession model. PPP differs from traditional models in that the private sector partner (which may be a consortium comprising a utility company and an infrastructure fund) undertakes to finance (through debt or equity) the capex and opex of the DE system. The key distinction to the traditional models is the money flow—the building owner/end user is no longer paying the up front costs.

Why do Public-Private-Partnerships have the potential of becoming the “new standard” for District Energy deals in the Middle East?

Several reasons: first, PPP has a proven track record internationally with lenders and is a structure that lends itself well to utility infrastructure. Second, Middle East finance markets are familiar with the application of the PPP model to independent power projects (“IPPs”), independent power and water projects (“IWPPs”) and wastewater treatment plants (“WWTPs”). District Energy has similarities to other utilities such as power, water and wastewater, so the PPP model is, in some respects, a natural extension for DE deals.

King & Spalding has helped introduce a PPP concession model which has been used on several recent Middle East DE deals. In some cases, this model differs from those used on IPPs, IWPPs, and WWTPs, where the public sector grantor often takes the complete offtake of power, water, or wastewater in exchange for the private sector ensuring that the utility is made “available”. The key difference is that the DE PPP concession model allows for an “end-user pays” regime. Under this model, the private sector party is granted the right or “concession” to collect revenues directly from end users of the DE system. Other concessions may also be granted to the private sector party, such as the right to use an established network or the provision of subsidised make up water for the DE plant. In return for these concessions, the public sector party receives a royalty payment from the private sector partner. If the DE system is project financed, then for “bankability” reasons, the lenders may require deposits by end users and/or other enhancements to mitigate credit risk.

What are some key considerations in applying the PPP model to a DE project?

PPPs should not be applied to every project. PPPs bring benefits if the public sector achieves value for money. This value will be achieved if the private sector can deliver services more cost efficiently than the public sector. However, other factors in determining whether the public sector achieves value for money include obtaining optimal transfer of risks to the private sector, whole of life costing, and harnessing innovation from the private sector.

DE deals also require careful due diligence on end users’ demands for energy. For IPPs, if there is excess power produced by the plant, this excess capacity can be sold to the grid. DE systems, however, service “captive” markets, and excess chilled energy cannot be readily diverted to different end users. This means that all end users are identified up front, and new end users can only join if they are within the serviced area.

Finally, debt finance in the current global market is a challenge for greenfield infrastructure projects. However, the PPP concession model is attracting a lot of attention and lenders are becoming increasingly more comfortable with the PPP concession model and DE technology. In addition, DE plants are now being built in phases, allowing smaller tranches of debt to be drawn down commensurate with the capex for the capacity then installed.