During the financial crisis, ‘flight to quality’ has been a frequent refrain in the global banking community. Assets such as the US dollar and gold have benefited as investors look for a safe place to park their capital.

A similar phenomenon has occurred in the Middle East project finance sector. Risky assets with exposure to variables, such as commodity prices, have fallen out of favour, and banks have instead concentrated their lending on the top-tier projects in the region, in particular power and water schemes.

Banks are attracted by utilities projects as they typically benefit from stable cash flows, with little or no competition from other providers, and they are also of strategic importance to their government sponsors. As one Dubai-based project finance head says: “The relative predictability of cash flows, the proven bankability, the strategic asset nature for the expanding local economies and the credit strengths of the government-related offtakers make independent power and water projects [IWPPs] very attractive to finance.”

“People always need electricity, and that makes IWPPs a good asset to finance,” adds another banker.

Liquidity crisis

A good gauge of the strength of appetite among banks to fund power deals is the fact that bidders on the myriad utility projects planned in the region have not struggled to get together a financing group to support their bid. Sources close to the PP11 independent power project (IPP) in Saudi Arabia say banks have been desperate to lend to the deal, despite it being fully underwritten during the bidding stage and not requiring any additional bank involvement.

However, that is not to say that utilities schemes have not experienced financing problems over the past year. The financing of the Ras al-Zour IWPP in Saudi Arabia collapsed in April 2009 as a result of problems with the equity funding, leading the government to decide to fund the project itself.

Power schemes are so attractive to develop, that banks have to choose which of several bidders … to back

Dubai-based project finance head

That change in strategy now looks premature. Since then, private developers in Saudi Arabia have managed to finance the Rabigh power project and are close to arranging financing for the $2.5bn PP11 scheme. Meanwhile, progress on Ras al-Zour has languished, despite the assurance of funding.

Abu Dhabi also found it difficult to get financial support for its power projects during the economic downturn, showing that even the strongest sponsors have not been immune to the liquidity crisis. The $2.6bn Shuweihat 2 scheme received funding in October 2009 after elements of the deals structure were changed.

In numbers

$10bn: Amount of project finance arranged for power projects in the Middle East in 2009

$20bn: Total amount of project finance arranged in 2009 in the Middle East

$2.5bn: Value of Saudi Arabia’s PP11 power scheme

Source: MEED

Bahrain, meanwhile, managed to successfully finance the $2.1bn Addur power scheme on 29 June 2009 although this deal was done using a ‘mini-perm’ structure, which involves borrowing for a short tenor under the expectation that it will be refinanced at a later date.

Just over $10bn of power project finance was arranged in the Middle East in 2009, about half the total $20bn project finance arranged that year in the region. The figures show just how important the power sector has become to the region’s project market. “2009 was definitely dominated by the power sector,” says one Dubai-based project lawyer.

But after a challenging 2009, the outlook for 2010 and beyond is better. In addition to the mature markets of Abu Dhabi and Saudi Arabia, new areas of development are emerging. Both Kuwait and Dubai have announced plans to develop their first IWPPs. But Kuwait’s history of failing to deliver on its potential and Dubai’s debt problems mean that success in attracting private finance for these deals is not assured.

“Without either explicit federal, Abu Dhabi or Abu Dhabi Water & Electricity Authority (Adwea) support, I don’t see a future for the IPP model in the Dubai,” says the head of project finance at one international bank. “Local banks have no capacity to lend long term, and international banks no appetite – unless perhaps enhanced by ECAs [Export Credit Agencies].”

Projects due to reach financial close in 2010
Project Country Project cost ($m) Capacity Financial adviser
Muharraq wastewater treatment plant Bahrain 400 100,000 cm/d HSBC
PP11 IPP Saudi Arabia 2,500 1,730MW Citigroup
Sohar 2 IPP Oman 1,000 650MW Bank Muscat/ Project Financing Solutions
Barka 3 IPP Oman 1,000 650MW Bank Muscat/ Project Financing Solutions
cm/d=Cubic metres a day. Source: MEED

It is still unclear whether there will be any federal involvement in the Dewa IWPP, but there is already a precedent in the UAE. The Fujairah F2 plant, developed in 2007, features an Adwea guarantee. Dewa is getting close to appointing a financial adviser for its scheme and sources close to the firm say it has an ambitious timetable for the project’s progress. But there is still internal disagreement about such a strategy change, with some Dewa senior figures continuing to favour direct procurement.

Kuwait has progressed further, choosing France’s BNP Paribas to act as financial adviser on its scheme. The firm has worked on several successful IWPPs in the region, so bankers are confident the government will get good advice on structuring the project to be bankable. The question will be how seriously they pursue the plans given the track record of disappointment with previous projects in the country. Although, as one Kuwait-based banker says: “The government is very serious about this project.”

Even though banks enjoy the benefits of strong offtake agreements and finance ministry guarantees for most power schemes, there are still a number of risks associated with the sector. Banks are getting increasingly frustrated at the amount of work they are putting in to support bidders on utility projects, only to discover they have not backed the developer ultimately selected to develop the scheme.

“One of the problems we face is that power schemes are so attractive to develop that banks have to choose which of several bidders they want to back. That means you often end up doing a large amount of work with a consortium that may not even be shortlisted,” says one power and water financier based in Dubai. For example, a total of eight groups submitted bids to develop the Barka 3 and Sohar 2 IPPs in Oman in December 2009. Of those, only two will actually be awarded a project to develop.

Power projects also present a number of other problems for banks. Developers are keen to ensure that the financing they have matches the tenor of the offtake agreement on a project, otherwise they face some front-loading of their liabilities compared with the income they will generate from a plant’s operation. But this forces banks into the position of having to commit funds for about 20 years on most power schemes.

Long-term lending

Having to take on such long tenors, particularly in the wake of the financial crisis, has become difficult for many banks. Impending new rules for banks’ liquidity could also put some off long-term lending, especially given the illiquidity of project finance assets. It also means banks look for regulatory clarity, as any shake-up of the power sector could have a dramatic impact on the profitability of power plants.

In the shorter term, banks are expecting to see the margin on loans fall and tenors extend. That will test bank appetite further. There is little sign of this so far, though. The financing for the Rabigh power project in Saudi Arabia has been a success, and banks are already demonstrating a keenness to get behind the bidders on the Shuweihat 3 power project in Abu Dhabi.

Although banks are sitting on a lot of liquidity … there is still limited appetite to …start lending again

Dubai-based project finance head

But so far progress in the project finance sector as a whole has been slow this year. By the end of April not a single deal had been closed, and only the PP11 scheme is expected to close in the first half of the year. With Ramadan due in August, much of the third quarter is also expected to be slow, potentially affecting progress on other deals. The pipeline for power deals to be completed this year shows that only about $5bn of deals are planned, as the focus of the project finance community shifts to two large oil refinery deals at Jubail and Yanbu in Saudi Arabia, worth about $10bn each.

“Although banks are sitting on a lot of liquidity at the moment, there is still limited appetite to go out and start lending again,” says the Dubai-based project finance head. “Banks are still very cautious.”

With a greater number of sponsors around the region now looking to develop IWPPs, more banks will be needed to start lending in the Middle East. Over the past year, the number of banks actively lending on Middle East projects fell to about a dozen, from about 40 in previous years.

As schemes in places such as Egypt, Jordan, Kuwait and Dubai, join the established group of project sponsors in Abu Dhabi and Saudi Arabia, banks will need incentives to get behind these new deals. One Bahrain-based project banker says: “If there are a number of projects in the market then banks will be most attracted to the strongest sponsors, such as Adwea and Saudi Electricity Company. That may be to the detriment of new players, such as Kuwait and Dubai, if they do not get the structuring right.”

Reassuring lenders and developers that Kuwait and Dubai’s Dewa are serious about developing independent power production, and that this is not just another initiative that will be scrapped later, will be key to the success of these projects.