China's 'One Belt One Road' Policy Increasing The Ambitions Of Its Energy Contractors.
Legal News & Analysis – Asia Pacific - China – Energy & Project Finance
10 January, 2016
FOCUS: China's energy project contractors are beginning to expand their ambitions as they move from providing construction services to investing in and operating full projects.
The introduction of the country's 'one belt one road' (OBOR) economic development plan in 2013 has acted as a major catalyst in this development.
OBOR aims to create economic integration between countries on the former 'silk road' trading route through central and west Asia, Europe and the Middle East, and with regions on maritime trade routes including southeast Asia, Oceania and North Africa.
The OBOR programme includes a wide variety of energy projects, from gas pipelines to wind farms, but conventional power projects using coal, gas and oil are likely to be particularly popular with Chinese contractors, who are now very experienced in designing and constructing such plants after spending the past two decades delivering large numbers of them across China and Asia, and in parts of Africa.
In the absence of subsidies conventional power plants are still cheaper per kilowatt hour (kWh) of electricity generated compared to renewable generation technologies, use tried and tested technology and are relatively quick to build. Coal-fired plants, in particular, are an area of strength for Chinese contractors, with large numbers already delivered in various regions of the world.
Traditionally, Chinese banks have financed the construction of power stations using a 'buyer's credit' structure, where the bank lends the capital costs to the developer on the condition that the developer engages a Chinese contractor. These funds are commonly lent on a government to government basis, rather than directly to private developers.
This structure will no doubt continue for many projects under the OBOR banner, and particularly in markets with which Chinese contractors are not so familiar, or where political or economic risks are high. However, new finance structures are beginning to be seen.
A 'seller's credit' structure has also been used but is far less common than buyer's credit. This involves the Chinese contractor entering into a deferred payment arrangement with the developer, and self-financing the construction using loans from Chinese lenders. The developer will generally pay the contractor under a payment schedule that extends beyond the completion date. The contractor is in effect operating as a bank, and bears the risk of the developer defaulting on repayments. Security therefore becomes a critical issue in such projects.
New finance structures
A newer and increasingly common option in conventional power projects involving Chinese contractors is a project finance structure
such as a BOT (build-operate-transfer). Under a BOT, developers set up and arrange loans to a special purpose vehicle (SPV) in the host country. Some 70-80% of the capital costs of construction will come from these loans, and the remainder will be provided by the developers through equity and / or other loans.
The SPV then enters into all the contracts needed for the project, including an engineering procurement construction (EPC) contract with the contractor. If the funding is from China, this EPC contract will almost always be with a Chinese contractor.
Conventional power projects are seen as particularly 'bankable' BOT projects, because the technology is usually tried and tested and there is a high likelihood that performance requirements will be met. These projects also do not generally require significant land acquisitions, or need extensive underground works, reducing the risk of delays and unforeseen problems. Many jurisdictions, in fact, now have standard form power purchase agreements and implementation agreements that offer to allocate project risks between the offtaker, the government and the developers in a split that is attractive to many lenders.
It has taken Chinese contractors some time to get used to EPC contracts under project financed structures, as these tend to be tough on the contractor. Rates of delay and performance liquidated damages, and the caps on these, are generally much higher, and the contractor's rights to additional time and cost are limited. Many of these rights have to match the power purchase agreement that the SPV has negotiated with the offtaker. However, the upside for the contractor is that the developers are often willing to pay a higher contract price in return for the contractor taking on these additional risks.
Where the finance for the project is coming from Chinese banks, the Chinese contractor may enjoy stronger bargaining power, although that is not always the case. There are plenty of Chinese contractors with the skills needed to build these power stations, and developers will often use the threat of switching negotiations to a competing contractor to get their way in negotiations.
Evolution to investment
Even before the launch of OBOR, the larger and more experienced Chinese contractors had begun the transition from a traditional contractor business model to a 'contractor plus investment' model. Now, the signs are that a significant proportion of OBOR projects will involve Chinese contractors making investments in the projects that they are engaged to construct, and conventional power projects have been among the first to use this structure.
The China Pakistan Economic Corridor (CPEC) has been among the first to see innovative project structures. The Thar Coal Block II project involves the development of an open pit coal mine and 660MW mine mouth power station through two SPVs set up by a consortium of Pakistani and Chinese investors, including a major Chinese contractor who will act as both EPC contractor and SPV equity participant. Project finance loans, including conventional RMB and Rupee Islamic tranches, are provided by syndicates of Pakistani and Chinese lenders including Habib Bank, United Bank, China Development Bank, Industrial and Commercial Bank of China and Construction Bank of China.
This sort of structure is likely to be replicated in other suitable OBOR countries. For example, in Zimbabwe a major Chinese contractor is now close to achieving financial close of a 660MW power station project in the country, involving the acquisition of a minority equity stake in the SPV as well as the EPC contract for the power station and transmission line. The US$1bn project finance loans will be provided by the China Export Import Bank.
Acting as an equity investor in the SPV as well as the EPC contractor brings several benefits, including locking in the EPC mandate, greater profits through return on equity and having a seat at the table during negotiation of contracts including the EPC contract and the all-important power purchase agreement with the offtaker.
Already, Chinese contractors are showing an appetite for larger investments in infrastructure projects, with conventional power projects in the lead over other asset classes. In the Port Qasim 1,320MW coal-fired power station in the CPEC Chinese contractor Sinohydro Resources Limited took a 51% equity stake in the SPV with the remainder held by a Qatar-based investment fund and China Exim Bank providing project finance loans. A Sinohydro sister company will undertake the EPC mandate.
In some cases, Chinese contractors are even stepping back and taking on the developer role themselves, and tendering for contractors, opening up the EPC and other mandates to a wider market. In addition to playing well with host governments who are keen to see local companies benefit from Chinese-funded projects, Chinese developers could benefit by developing relationships with local companies that can be leveraged in other markets.
To date, Chinese contractors have focused on China-friendly markets where there is lower competition. However, growing confidence and experience will see them look further afield, and there is plenty of choice amongst the over 65 nations that are officially on the OBOR routes. There will be challenges as they adapt to different and more regulated economic and legal environments, but these Chinese companies will bring experience, economic strength and a fresh approach to new markets that will give them a good chance of succeeding.
Many OBOR nations have strong domestic contractors and investors of their own, and others have a history of awarding projects to companies from countries other than China. It will be interesting to see the effect on local markets of OBOR and the Chinese companies that will deliver its vision. Some may choose to join forces with Chinese companies to win projects, while others may choose to compete, either alone or by combining resources with other companies. The answer is likely to be different from country to country, but what seems certain is that OBOR will shake things up and stimulate change.
For further information, please contact:
Greg Jones, Pinsent Masons