Now is the time to plan ahead
These are exciting times for the Middle East. The economic environment in the Middle East has seen a dramatic improvement this decade, notwithstanding the recent impact of the credit crunch and the fall of the price of oil. However, the development of infrastructure has often fallen behind and subsequently hindered economic growth and development.
Now is the ideal time for forward thinking and planning to ensure that the development of infrastructure matches the plans of governments and master developers. Fortunately, GCC governments have announced significant expenditure on infrastructure in 2009 to address this issue and to stimulate economic growth. Therefore, let's look at how, in the current economic climate, the provision of necessary infrastructure can continue to the benefit of end users while still providing financial stability for master developers and developers.
The options for provision of infrastructure are to provide them on either a concession basis (where, in its traditional form, a third-party designs, builds, operates, owns and finances the utility) or on a design, build and operate (DBO) basis (where, in its traditional form, a third-party designs, builds and operates the facility, but does not finance the facility or own it).
Concessions and DBOs have very similar risk profiles. In both cases, a special purpose vehicle (SPV) is formed by the party delivering the project, and that SPV is given the overall responsibility for designing, constructing and operating the facility. Both approaches give incentive for innovation and good design as the party building the facility is the party operating the facility. The fundamental difference in approach is that when a DBO is used, no private sector funding is necessary, as the DBO contractor is paid for the asset on completion, or as progress payments through construction, and is then paid an indexed service charge for the operation of the facility.
When utilities are financed at the SPV level through the use of a concession, financiers will not finance 100 per cent of the required capital, therefore, the SPV must provide the shortfall, in the form of equity, typically in the region of 20-30 per cent but in these times banks may require increased equity. This shortfall gives the SPV an equity stake in the utility, on which a concessionaire will expect a return. The presence of SPV equity, and finance, leads to a difference in how an SPV recovers its costs, and how it makes a profit.
In the case of a concession, the SPV is given the right to charge a tariff, and the tariff is the only compensation it receives. The tariff is calculated by reference to a financial model. The inputs into the financial model are the costs associated with constructing the utility, operating and maintaining the utility, and the required return on investment on the invested equity in the project. Use of a tariff, therefore, spreads the cost of the initial capital expenditure across the entire concession period – for example 20 years – meaning that the SPV needs to recover not only the capital costs, but also the finance charges associated with being indebted for a long period of time.
In the case of a DBO, the SPV is paid for its capital expenditure on completion of the asset, or as progress payments throughout construction, and then paid a service charge to operate and maintain the facility. As there is no debt involved, these amounts can be on a fixed-fee or a cost-plus basis. This results in a lower cost (however, in comparing costs between the two, the source of, and costs associated with, the finance used at the grantor level in the DBO scenario must be taken into account).
In the case of a combined approach, the developer maintains an equity stake in infrastructure through its ownership of the SPV. The SPV then passes on its obligations to the DBO contractor (with the financing in place). This results in a situation where the profile is similar to that of the DBO scenario outlined above.
There are a variety of ways in which a developer can participate in, and monetise for its own benefit, the revenue of the infrastructure that the developer is procuring. The most significant being: controlling the price to end-users of the infrastructure, and, if appropriate, profiting through the 'spread' between the service charge from the concession company or the DBO contractor and the end-user price; and selling the infrastructure (eg. to an infrastructure fund), with a long term operating agreement in place.
In the provision of certain infrastructure there are often synergies between different utilities that can result in lower costs and greater efficiencies if the utilities are combined. An example of this would be an integrated solution between sewerage treatment, potable water and district cooling. The utilities deal primarily with water, and the sewerage treatment facility can be used to produce polished water for use by the district cooling facilities.
Also, if utilities are combined, staffing costs, and other operating costs, can be shared between utilities resulting in lower overall costs. Integration of utilities also serves to lower the interface risk between utilities. Hopefully, food for thought and a way forward for governments, master developers and industry.
- Damian McNair is Head of Finance and Projects, at DLA Piper
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