It is well known that funding even low risk projects can be difficult. But what about projects that do contain risk? Risk is not something lenders run to embrace, not then and certainly not now. Take the waste sector for example.

Thanks to a piece of European legislation (the European Landfill Directive) a slew of new waste treatment plants are currently being procured and built in the UK. The driver for this is restrictions on the amount of biodegradable municipal waste that can be sent to landfill. Failure to meet these targets under the “LATS” regime could have led to local authorities being fined up to £200 (US$318) per tonne. Whilst the current year will see the end to the penalty regime for England and Scotland, Welsh Authorities still face potential fines and the UK as a whole may be fined if its current projected compliance with the directive is not met. That said, focus has now turned to landfill tax as being the policy instrument of choice - encouraging everyone away from landfill and reducing the associated environmental impact. This tax was only £24 per tonne 5 years ago and will rise to £80 per tonne in 2014. Factors such as these have been powerful incentives for the development of new waste infrastructure.

Merchant Opportunities

Whilst local authorities appear to have built enough capacity to avoid landfill fines and mitigate the effect of the rising landfill tax, the same cannot be said of the Commercial & Industrial (“C&I”) sector. Development of capacity to treat this waste has lagged substantially behind. At first sight this might seem slightly odd; whilst it’s true the EU Landfill directive does not apply to C&I waste, landfill tax certainly does. A c.300 per cent increase in the costs of disposal is a significant driver to think about alternative methods. And where there is demand, then surely money will be found to finance a suitable solution?

Not quite so easy

Here is where things start to get difficult. On the one hand we have expected demand for C&I waste treatment; on the other not an insignificant number of waste companies wanting to meet this demand. Surely this is a match made in heaven? The market should be able to facilitate the provision of new waste infrastructure. The trouble is waste infrastructure is not like most standard accommodation-style infrastructure.

There is often a considerable amount of risk in projects. For infrastructure serving the C&I market this is more so. You have construction risk, operating risk, risk on the treatment technology, risk on performance, risk on the input waste composition, risk on the availability of the waste, risk on the price you can charge for treating the waste and risk on the price you get for any power / residual offtakes you generate.

And we all know bankers love risk.

Those risk shy bankers

Whilst funders have got comfortable with the risk involved in a PPP/PFI authority-backed waste project, the same cannot be said of a fully merchant waste plant (i.e. one that’s not underpinned by a local authority contract) or a substantially merchant waste plant. Or that was the case until very recently.

The issue funders have struggled to get comfortable with is third party income risk - risk that revenues from C&I waste or from the sale of power produced would arise in sufficient quantities to service the debt. There is a significant gap between what banks will lend money against and what sponsors believe will be achieved by the projects. In short, banks will lend money against robust contracts that are in place at financial close. However, for sponsors it makes little sense to enter into C&I/ power off-take contracts some 3 or 4 years before a facility becomes operational or even has planning. And nor in practice would this be possible.

These constraints effectively limit the contractual agreements that can be put in place at financial close to those with a sponsoring local authority or similar body. Everything else is off the table. Even if other contracts could be entered into counterparty risk means lending money against these incomes over any appreciable period of time is problematic.

It’s not that the banks think this other C&I and power income won’t arise, in their heart of hearts they think some or most of it probably will. The trouble is ‘probably’. Bank lending is not priced off ‘probably’. With margins on most projects only marginally above the banks own cost of funding you can see their point.

Until recently sponsors wanting to include significant quantities of third party income risk had only one option, to build and finance on balance sheet. Whilst for some this is clearly attractive, it’s not an option available to all. Indeed those companies who can do this may still reach limits in this market and this option might not available or attractive forever.

A bridge over troubled waters

So what could be done differently? In Norfolk Waste, a deal recently closed in the market, KPMG developed an innovative financing structure for a semi-merchant waste plant. Despite less than half of the project revenues coming from or being underwritten by a local authority contract, the project achieved financial close on standard long term debt terms and with a gearing of approximately 80:20.

To achieve this, in addition to the standard equity, subordinated debt and senior debt slices a third tranche of debt was introduced. This facility carried a credit support package provided by sponsors and allowed cash to be lent by senior funders (on senior debt terms) but provided certain protection to them in the event things didn’t work out as sponsors expected. Working this through the contract structure and credit agreement required some work, but then again doing things differently is always going to require a higher level of thought and diligence.

The resultant structure allowed sponsors to invest considerably less equity than would otherwise be required, but also allowed them to retain their view of the financing economics. Should the project succeed then the credit support package can be varied, or even removed altogether. Whilst it’s easy to see the incentive for sponsors, funders are also incentivised through the thoughtful and intelligent structuring of the financing arrangements. All parties are therefore motivated for the continuing success of the project.

Such a non-standard financing structure required detailed and sometimes complex negotiations with both Norfolk Country Council and WIDP/HMT. However, both ultimately recognised the enormous benefits the structure brought to the project and to the economics of the bid. Indeed as a delivery tool for waste infrastructure involving merchant exposure it was recognised by WIDP/HMT as having the potential to be the way forward.

Sponsors were able to fund the majority of the project from senior funders at PPP/PFI market terms, but provided protections to these funders insulating them from the downside risks that have traditionally kept them out of this market. A win for all parties, and one that facilitated the success of the project.

A brave new world?

Funding projects with revenue risk has never been easy, but it is possible. By understanding the funding market, sponsor appetite and project dynamics it can work. Of course this applies not just to the waste sector. Many sectors face revenue risk in some way shape or form and an alternative to the standard financing structure which allows more than a token amount of revenue risk is surely welcome. A brave new world? Perhaps!

Ivan Hollins is associate director at KPMG, and Mike Harlow is a partner