Project Finance of the Turkana Wind Power Project Finance Essay

Introduction

The project proposal was made in 2009 and is to be located in Kenya, at the southern end of Lake Turkana. The project has a concession area of about 150Km2 for 99 years renewable every 33 years and the project is expected to last 25-30 years. The aim of the project is to Finance Build Own and Operate (FBOO) a 300 MW wind farm beside Lake Turkana. The wind farm will have 353 wind turbines each with a capacity of 850 kW and it will produce an equivalent of 17% of Kenya's current power generation capacity, with the potential to power approximately 2 million Kenyan households. The project will also Finance Build Own Operate and Transfer (FBOOT) one (1) power transmission substation, one (1) terminal substation and a 428Km, 400kV transmission line from Lake Turkana to the grid at Suswa. Most of the equipment will be imported and the route for the transfer of equipment from the port to the project site is approximately 1,200 km hence the project will also include road constructions, upgrades and adjustments. Approximately 4,000 truck loads (to and fro) will be required and transportation will be done mostly at night. The project is expected to cost 780MUSD and it will be financed through equity and commercial loans. Kenya traditionally relies on hydropower which is much cheaper than wind generated power hence the tariff is expected to be higher. Electricity generated will be purchased by Kenya Power and Lighting Company (KPLC) and distributed to consumers in Kenya. KPLC buys all the electricity generated in Kenya and handles transmission and distribution. KPLC is a monopoly hence negotiations on tariff will be tough. The United Nations (UN) pays some monetary compensation to companies for reduction in emissions of CO2. The project expects to generate average emission reductions of 919,060 tonnes of CO2 per year which translates to about 12MEuro per year of carbon credit. The project is proposing to share some of the carbon credit revenue with KPLC as part of negotiations for a favorable tariff. The LTWP is being developed by a consortium of individuals, international and local companies. The table below shows members of the consortium. Company/Individual Background/Information Anset Africa Project Development and Management Company Globeleq UK based company focussed on providing reliable power in emerging markets (Africa, America, Asia ) KP&P B.V. Development & Operation of Wind Energy Projects Mr. Willem Dolleman Dutch Kenyan Resident Mr. Henk Hutting Dutch Mr. John Thiongo Mwangi Kenyan Mr. Kasper Paardekooper Dutch Mr. Ed Schieke Belgian Mr. Chris Stanbo Norwegian Mr. Carlo Van Wageningen Italian/Dutch Mr. Harry Wassenaar Dutch The project has the following partners: Partner Background/Information Anjarwall & Khanna Kenyan corporate law firm/legal advisers Carbon Africa Carbon project development company with headquarters in Kenya German Wind Energy Institute Wind measurement and consulting services KPMG Financial Management and Auditing Mammoet Europe B.V. Dutch company specialised in heavy lifting and extreme transport solutions Schick Consulting Belgian company providing research and consulting on energy systems and connection to existing networks Vestas Benalux B.V. Wind technology provider since 1979

Analysis

The project will be critically examined in the following areas: Benefits Finance Revenue Transportation Risks

Benefits

Profit for investors Reliable source of energy for economic development Being a pioneer project, its success will lead to proliferation of wind projects in Kenya and other developing regions Generation of employment for locals during the construction and operations phase Upgrade of the road system Increase in government revenue through the payment of tax Improvement in trade balance due to reduction in oil imports used for electricity generation Due to rising fuel prices and the non-sustainability of oil as a source of energy, the project has the potential to reduce the price of electricity in the long run As with most Public Private Partnerships, only the first benefit will accrue to the private sector, the rest goes to the public sector and the private sector cannot tap in them!

Finance

The project is expected to cost 780 MUSD. The project will be fully financed by the private sector using debt and equity. This means the cost of capital will be high compared to a government funded project. This will potentially make tariffs higher and the payback period longer. The major cost on the project will be wind turbines which will be procured from Europe. This introduces the risk of currency fluctuation and currency convertibility. To reduce this risk, estimates and contracts for wind turbines and should be made in the currency of the suppliers, in this case in Euro. Estimates for local labor, transportation and materials should be done in Kenyan currency. Finance should be scheduled to coincide with expenditure to reduce payments on interests. Inflation should be included in the estimate and provision should be made for changes in inflation rate.

Revenue

The project expects to get its revenue mainly through tariffs. Additional revenue of about 12 MEuro per annum of carbon credit is expected. Sales agreements should be made in such a way that both the public and private sector bears the usage risk. This can be by the public sector paying the private sector for availability there by managing the usage risk.

Transportation

Most of the major equipment will be imported through the sea ports and transported by road from the ports to the project site over a distance of about 1,200 Km. This will create marine cargo, transport and delay risks. These risks are insurable and should form part of the total project cost.

Risk

The risk of availability, reliability and maintainability can be shared with equipment suppliers by having them include the cost of personnel training and equipment maintenance in their proposals. This will form a long term contract that will cover the project life cycle. The contract should also share the risks of technology change with the suppliers. For this project, the supplier of the equipment has been listed as one of the partners; this might be a risk reduction strategy, depending on the details of the agreement. Concessions and licenses will be required from the government during the project. This has the potential to cause delays in the project. To reduce this risk, the project should assign an individual specifically dedicated to ensuring that all concessions and licenses are obtained on schedule. Since government is responsible for granting concessions and licenses, the agreement between the private sector partners and government should include a clause that ensures any additional cost or losses to the project as a result of delay approvals by government agencies will be borne by the government. Alternately, the contract can specify the maximum number of days between formal and proper submission of requests for concessions/licenses by the private sector partners and receipt of a response from government agencies. If the duration is exceeded without a response, it should be deemed approved. As with most emerging economies, there is poor infrastructure most especially in terms of governance. The 'horn of Africa' where the wind turbines will pass en-route Kenya has recently been a nest of pirates. Kenya also experienced some unrest during the last elections. These should be factored in before the final investment decision by making the hurdle rate of IRR high and including adequate contingency reserves in the project cost. In defining situations where either party can call for a force majeure, war, civil disturbance and any change in legislation that significantly affects project economics should be included. The project should include local (host) communities that will be affected by the project's activities in their Corporate Social Responsibility (CSR) program. It has been shown in many developing economies that if not properly consulted and informed, local (host) communities can cause delays, disruption and in extreme cases outright cancellation of infrastructure projects. Estimates of revenues should be conservative, inflation and risk should be factored in estimates of cost. Sensitivity analysis and parametric discounting should be done to identify parameters that have significant influence on project economics. These parameters should be analyzed to reduce probability / impact on project economics.

Reflections on Lessons Learned

During the 5 day workshop, the following were learnt: Importance of having individuals/organizations that will be responsible for making sure the project achieves the desired outcomes and goals. The cost of finance can be as high as 60% of the project cost! Hence sources of finance should be carefully evaluated to minimize cost of finance and care should be taken in calculating revenue, cost, cost of capital, working capital, fixed capital, operating costs, administrative costs and depreciation. Debts should be structured to coincide with the time when the finance will be needed to reduce cost of finance. Depreciation should be factored in the cost of infrastructure projects. Also, in order to ensure that the facility continues to serve its purpose, a sum of money equal to the amount of depreciation should be spent annually on maintenance. If an asset is to be replaced after a specific number of years, it should be depreciated annually in such a way that the total amount kept for depreciation will be able to replace it with a new one at the end of its service period. Project finance can be appraised using tools such as contribution, gross profit, operating profit, profit before tax, Accounting Rate of Return (ARR), Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Index (PI). It is necessary to be conservative in calculating inflows and to make outflow higher than expected in order to minimize risk. The concept of notional shares, notional value, book value and market capitalization of a company was learnt. 100% of project finance must be in place before a project can start. Various finance options are available and an increasingly popular source of finance is Islamic finance. The part on PPP's was very revealing and of great interest to me. My country, Nigeria is just venturing into this type of arrangement and the program has highlighted the risks, advantages and disadvantages as well as proposals for sharing risks between all stake holders. 'Risk should be transferred according to ability to manage them'- (R. Turner, 2010). My team's presentation is part of my learning curve in team work; it gets better with each assignment. The team studied the case together and agreed on responsibilities of each team member. However, as we progressed some members handled tasks outside their assigned tasks like preparing the final slides. Team members sought and got assistance from other team members during the case study. One of my learning experiences is that presentations should be simple and straight to the point. The right type and amount of graphics should be used. My team also identified and analyzed the risks but did not provide any good plans for avoiding, transferring, mitigating or accepting the risks. It is important to have a practical risk response strategy for a project. It is equally important to update the risk register as the project progresses. During the sensitivity analysis, my team only concentrated on the fuel price and Equity Risk Premium (ERP) instead of analyzing the project sensitivity to all the variables. Sensitivity analysis is a risk reduction strategy as such it should involve all the variables concerned. FBOO is a very difficult concept because although it is built, owned and operated by the private sector, the government always remains involved. In FBOOT arrangements, one disadvantage is risks are not shared based on capability to handle the risks. For example by bundling together construction, operation and maintenance, the companies that are good at construction might not be good at operations and maintenance hence these aspects of the project should not be lumped together. At what point should the asset be transferred to the government? This is usually determined by financial considerations, which is, when the private sector has recovered capital and made profits not according to when the public sector will be more capable of handling the risks. Hence FBOOT projects are not based on "the best possible arrangement", but on "the best political framework" or "the best way of shifting tax between levels of government".

Conclusion

This paper analyzed Lake Turkana Wind Power Project in terms of benefits, finance, revenue, transportation and risks. Apart from profits, all benefits will accrue to the government. The private sector is taking all the risks on this project. Usage risk should be taken by the government and equipment, maintenance and technology risk should be borne by the equipment suppliers. Government should also bare the risk of delays in approving concessions and licenses. Transportation, marine and delay risks should be insured. Considering the location of the project, there should be contingency reserves and the hurdle rate of IRR should be high. The project is supposed to start electricity generation by June 2011 and is to be completed in July 2012, if all project finance has been secured; government has consistently refused to be part of the funding and the global economic meltdown has reduced sources of credit for investors. This also means that the cost of capital may be high and payback period may be longer. The world is moving towards renewable energy and this project has huge potential to succeed if the factors mentioned in this paper are taken into consideration.

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