Germany: Project finance develops with energy

October 01, 2008

Project finance plays a fundamental role in today's rapidly expanding German energy market and will continue to do so in the future, say Tobias Schulten and Björn Neinlein of Clifford Chance

The financing of energy projects, in particular power plants on a project finance basis, has been successfully undertaken worldwide for more than 15 years now. This phenomenon has enjoyed great popularity, initially in the US and Asia before spreading to Europe (especially Hungary, Spain, Italy and the UK). Project finance often features as the leading topic in many well-known magazines dealing with energy projects and is generally considered by sponsors and energy providers to be a profitable and attractive financing alternative.

What is most interesting, however, is that the project financing of power plants and other energy projects has only recently made an appearance in the German market. Today, plans for power plants based on project financings worth tens of billions are being developed in Germany and other project finance structures are being frequently used for other energy projects such as gas storage facilities. Accordingly, it is interesting to consider why it has taken so long for large-scale German energy projects to be funded through traditional project financing structures.

Rationale

The key reason for the absence of project finance in the German energy market in the past becomes clear when taking a look at the situation and historical background of the German electricity market.

In terms of the country's geological situation, only minor sources of gas and oil are found in Germany. Coalmining, as well as oil and gas exploration and production, are of minimal importance in Germany, primarily because Germany's coal sources have been depleted or its production is economically not feasible. Therefore, there was no need for the financing of oil or gas production. Previously, there has been almost no interest shown in investing in liquefied natural gas (LNG) and no large national pipeline projects have been completed. In a nutshell, with respect to gas, oil and coal, debt based financing was simply unnecessary and unwanted.

More or less the same position applies to the German electricity market. The market, in particular pertaining to power generation, was (and still is) dominated by the so-called Big 4, comprising E.ON, RWE, EnBW and Vattenfall. Nearly 80% of the installed generation capacities are owned by these four utility companies, with E.ON and RWE providing more than 60% of such capacities. These private utility companies supply their own financing needs, including the expensive investments of power plants, usually through their own internal financial resources, consisting of: (i) the original cash flow of the company; (ii) the financing sources provided by financial institutions based on the creditworthiness of the private utility companies; and (iii) corporate bonds. As a result, there was no real need for a separate external financing strategy from the Big 4.
With regard to the historical background, the focus of investments in Germany has been on the repairing and reconditioning of existing plants rather than the building of new ones. Not a single significant new power plant has been constructed in Germany during the last decade.

Changed circumstances

Germany has now arrived at a crossroads when it comes to sourcing power. Due to the recent liberalisation of the German (and European) electricity market, the proliferation of the concept of IPP and the development of electricity as a stock market commodity, project finance has finally found a place in the German energy market.

The aforementioned facts have caused new market participants to enter the electricity generating and gas storage markets with immense vigour. Smaller or regional German utilities (Stadtwerke, for example) have tried to expand their own capacity to include power trading, with the result that these regional German utilities developed from being electricity customers to being power generating competitors. Within the electricity value creation chain of the municipal utilities, the emphasis has shifted from transportation to generation.

Another reason for new participants joining the electricity generation market relates to the growing gap between generation and demand. Germany is facing a significant shortage with respect to generation capacities for two main reasons. First, the limited generation capacity is partly based on Germany's political decision to phase out nuclear power generation. At the moment, the installed capacity of nuclear energy amounts to 20 GW, which will, according to the German law concerning the nuclear phase-out, fall away completely by 2020. Secondly, another capacity decrease of 20 to 30 GW will take place due to the obsolescence of the plants. These circumstances will occur at the same time as Germany is faced with an increase in the demand for electricity. As a result, the Federation of German Industry, the BDI, has warned that Germany, as Europe's biggest electricity market, is heading for a huge power supply shortfall if Germany does not act quickly to replace its power stations.

Experts concur that it will take more that the Big 4 to close the gap between generation and demand when re¬powering existing plants or constructing new ones. More and more foreign electricity suppliers, such as Statkraft, Electrabel and Dong, have become new participants in the market to address the balance and have already built or are planning to build power plants in Germany. In creating opportunities for these smaller suppliers, which often lack the internal financing resources or cannot justify the huge, individual costs entailed in constructing a large-scale power plant, cooperation between many public utilities has been vital. Therefore, for many foreign electricity suppliers, project financing serves as the ideal financing tool in the German electricity generating market.

Actual projects

During the last four to five years, project financing of energy projects in Germany, especially power plant projects, has become popular for various reasons. We have outlined three notable types of project that illustrate such popularity.

Trianel projects

The first project financed power plant project in Germany was the 800 MW CCGT of Trianel (Trianel Power Kraftwerk Hamm-Uentrop GmbH & Co. KG) in Hamm-Uentrop, commissioned in 2007. The core of this project was Trianel European Energy Trading GmbH, a horizontal cooperation of about 30 independent municipal utilities from Germany, Austria and Switzerland. By using such a structure, the sponsors of this project (municipal companies) were aiming to achieve greater independence from their suppliers.

After successfully commissioning the project in Hamm-Uentrop, Trianel also set up a 750 MW hard coal-fired power plant project in Lünen and a project on the chemical site of Bayer in Krefeld to diversify its generation portfolio. The latter project is characterised by the fact that a party outside of the Trianel group receives a large share of the capacity.

In addition, Trianel is also planning to implement an offshore wind park project whereby 40 municipal companies under Trianel's lead management have gathered to develop the offshore wind park Borkum-West II in the North Sea. All of Trianel's projects use project finance.

Mark-E/Statkraft Markets

Almost parallel to the Trianel project in Hamm-Uentrop, the regional utility of Mark-E and Statkraft Markets GmbH, the German subsidiary of the Norwegian state-owned utility Statkraft, founded a joint venture in 2007 to set up a 400 MW CCGT in Witten-Herdecke. This was the second power plant project of Statkraft Markets GmbH in Germany at that time, after having bought the 800 MW CCGT in Hürth-Knapsack from InterGen.

The Herdecke project was thus the first project of sponsors with completely different backgrounds: on the one hand the regional supply company of Mark-E and on the other the trading company of Statkraft Markets GmbH.

Gekko

Although not project financed, the so-called Gekko project is worth mentioning. Gekko is a co-operation of about 25 German municipal companies that founded a joint venture with RWE Power AG to develop and operate a 1,800 MW hard coal-fired power plant. RWE Power AG was neither in need of nor interested in project financing the deal. The financing of the participation of the municipal companies in Gekko was provided through a debt-structured finance.

Future projects

As previously stated, there are several further power plant projects in the planning phase that will be financed by way of project finance.
The most publicised project finance (or potentially project financed) transactions at the moment include the following.

• The 1,800 MW hard coal-fired power plant projects of SüdWestStrom Kraftwerk GmbH & Co. KG in Brunsbüttel. Similarly to Trianel, SüdWestStrom arose from a cooperation of numerous municipal companies that originally bundled their interests with respect to the procurement of commodities and portfolio management.
• The 800 MW hard coal-fired power plant project of Kraftwerke Mainz-Wiesbaden AG (KMW) in Mainz must be mentioned. KMW, a joint venture of the two municipal companies of Stadtwerke Mainz and Stadtwerke Wiesbaden, already operates power plants.
• The joint venture project involving EnBW, Germany's third largest utility, and Dow Chemical's German affiliate to construct a 200 MW cogen plant and an 800 MW hard coal-fired power plant. Both of them will be realised using project financing.
• The so-called NorGer project, a 1,400 MW submarine cable project between Norway and Germany, run by a consortium of one Swiss and two Norwegian companies.

Usual transaction structure

In principle, power plants are quite suitable for off-balance sheet financing and the majority of new projects underway are, or will be, financed on a non-recourse basis.

Similar to international projects, a typical project finance deal in Germany is characterised by three elements. First, a project finance deal will focus on the prospective cash flow, as opposed to a historical financial statement and P&L analysis. Second, it is typically viewed from the sponsors perspective as a non (or limited) recourse financing. Third, a main characteristic is the ring fencing: that is, the strict separation of the rights and obligations and the assets of the debtor on the one hand and the other persons concerned on the other hand. Project finance deals usually provide for a special purpose vehicle (SPV): that is, a company that has no objective other than to develop and operate the asset to be financed. With respect to the establishment of the SPV, the corporate structure of choice in Germany is usually either a limited liability company (GmbH) or a limited partnership with a limited liability company as general partner (GmbH & Co. KG). Similar to a stock corporation, both types of entities provide for limited recourse to the sponsors but, in contrast, only require the relatively low sum of €25,000 ($35,000) as initial capital.

In a usual transaction, the SPV will enter into various project agreements, for instance an O&M agreement, a grid agreement and works and service agreements (among the latter the most important is the EPC agreement). The agreement of choice regarding securing the property, in case it cannot or should not be acquired, is a heritable building right, according to which the beneficiary is entitled to construct, operate and maintain an asset on foreign premises. The same result could be achieved with a land lease agreement but with significant disadvantages, the most obvious being that an asset, according to German law, would form an integral part of the premises it is built on and would thus be the property of the landowner. Also, the heritable building right can be encumbered with a land charge in favour of financing banks and, therefore, constitutes a security interest of considerable importance. The repayment of the loans is secured by long-term agreements: in power plant projects security is achieved through long¬term power purchase agreements.

On the downside, the structuring of project finance deals is complicated by the spiralling prices of construction materials for EPC contracts. The critical pressure and temperatures used in the new generation of coal-fired power plants require high alloy steel, which is becoming increasingly popular as cleaner standards are introduced around the world. This means that EPC contractors face an inflation risk when ordering materials for construction before being paid and are less and less keen to take that risk. In fact, also due to the high demand for new power plants and the limited number of EPC contractors available in the market, EPC contractors such as Siemens are now more reluctant to provide turnkey contracts and tend to focus on selling the equipment. If the sponsors have sufficient engineering capabilities, banks have previously accepted that construction is not done under a single lump sum turnkey contract but is split into several smaller contracts.

Current trends

Besides the traditional project finance scheme, equity to the project company by way of shareholder loans rather than debt is the preferred choice of financing structure in Germany for power plant projects.

By way of example, in the Gekko project (see above) RWE used a structure for its 1,600 MW hard coal project in Hamm where 23 municipal utilities have taken a 350 MW stake by way of a corporate investment structure. The financing provided by KfW IPEX-Bank and IKB Deutsche Industriebank was granted by way of loans to an SPV, which was a shareholder in the project company and in which all municipal utilities requiring financing were shareholders. However, the unique feature of this German power plant financing model was that no collateral was granted in favour of the financing banks other than assignments over rights and claims arising out of the power purchase agreements and shareholder agreements. The view taken by some market participants has been that this model might be regarded as a blueprint for future financing structures involving German municipal companies. In essence, the RWE model offers the benefit of the expertise of a big utility and the financing allows such municipal companies to participate in such power projects without the Bank scrutiny that project finance would entail.

Looking at current and planned projects, it is evident that there is a real focus from sponsors and project companies on coal-fired power stations in Germany. Coal is regarded as being a cheap energy Option as gas is proving to be expensive, renewables are reaching their limits and nuclear power is being phased out. However, to put this in its political and national context, the government support for coal projects is dwindling and, some argue, is turning into resistance. The government plans to stop supporting the heavily subsidised coalmining industry and the country's power industry depends on imported hard coal and domestic brown coal. As cheap as coal may be at the moment, it also produces more greenhouse gases per MW than oil or gas, reducing national support. Therefore, even if Chancellor Merkel drove a €30 billion programme through the German legislature for the construction of new power stations, on a local and national level the support has become increasingly lukewarm.

The overall outcome is that success has been mixed and unpredictable for sponsors seeking to obtain approval for coal projects. While Südweststrom and Iberdrola received approval from the city of Brunsbüttel for their 1,800 MW hard coal project, allowing them to launch a formal application, RWE last year had to shelve its planned Ensdorf coal plant in the state of Saarland after the local vote threw it out. The message is therefore that one needs to closely monitor how far the German government will support the upcoming coal-fired power stations and whether there will be more resistance from local and federal public authorities against such projects. Accordingly, it will be necessary to consider other energy sources such as renewables and even nuclear energy.