A few years ago, I was approached with the opportunity to launch an initial offering of a Project Finance course at the University of Calgary - this was my first foray into the challenge of teaching. Thankfully, I was able to draw on my experiences and involvement on dozens of energy infrastructure projects around the world to structure the course around what I refer to as the “6+1” approach to project development. This structure is, I feel, quite helpful for the LNG industry as it appears that capabilities around project execution will only become more important over the next 5-10 years.
This is highlighted in the data in Figure 1 showing global awarded LNG liquefaction (permitted) projects as well as those projects which have become newly active (operational) in the 2011-2018 period.
In light of the number of announced and awarded projects (many of which will have, at least, 5 years of development and construction ahead of them), it is important to take a few moments to consider a model that might be utilized to increase the chances of successfully executing what are inherently highly complex, expensive and difficult projects.
The “6+1” approach to Project Development is summarized as follows:
a. EPC: Engineering, Procurement & Construction
Within the EPC axis, companies need to optimize construction contracts to reduce the risk of financing by considering key aspects such as the design scope, performance considerations & warranties, construction timing, price, payments, and variations. Additional considerations around Owner’s risks, relief events, how Liquidated Damages are defined and managed, security and dispute resolution mechanisms need to be contemplated. A consideration needs to be made as well in terms of whether an “LSTK” (Lump Sum Turn Key” approach makes sense. The critical point with EPC considerations is the experience and credit-worthiness of the constructing firm. From a financing perspective, this tends to matter more than engaging with the cheapest or lowest cost Contractor. Ultimately, we often counsel our clients to take the initiative and perform benchmarking analyses and market sounding of their contract(s) so that they are best informed with what is a fundamental and crucial relationship.
b. O&M: Operations & Maintenance
Within the O&M, project proponents need to evidence that they’ve given serious consideration around planning for who will operate and maintain the asset. We advise proponents to, again, consider this from a financing perspective and a risk allocation view. What one wants to assess is the Contractor (or in-house team’s) experience in running what are invariably highly complex assets. Financiers want to see a credible plan that includes the O&M provider involved with the planning and design of the asset. If contracting to a third party, clear execution and mobilization plans coupled with a strong set of performance and operating guarantees are desirable.
Insurance is a too-often overlooked component notwithstanding the fact that a solid insurance strategy can often be the difference between achieving and not achieving “bankability”. It is in this axis that any deficiencies in risk distribution can be remedied. Examples include effective (and competitively priced) policies covering Construction and Erection All Risk (CLEAR), Pollution Liability, Liquidated Damages top-ups, Transport and Shipping (especially when building modules offsite and shipping to project site). To the extent that offtake or feedstock contracts (see below) require credit enhancement or price support(s); bespoke insurance products can be crafted to further de-risk those elements of the project.
The Financing axis is where proponents are encouraged to approach the project in a holistic fashion, carefully considering the interplay across the other axes. Considerations need to be made around how (and when) to raise the required funding for the project as well as the optimal capital structure – in particular, given risk allocations across the other axes. For example, the stronger the EPC contract or the offtake contract , the more favourable the pricing of the financing. It is imperative that a well-structured, dynamic financial model is being executed, which allows for sensitivities and dynamic analysis to be carried out covering all key inputs as well as stress-testing capital structuring alternatives. Finally, an advisor with experience, global reach and familiarity with the nuances of attracting investor interest is indispensable.
e. Feedstock / Inputs
In the feedstock / inputs axis, proponents need to establish supply contracts that might optimize the project. It is important to periodically conduct benchmarking analyses whilst negotiating the underlying contracts. Albeit the critical success factor in structuring one’s feedstock contracts is to achieve long-term volumetric (at least) and price (ideally with some level of price ceiling) certainty from solid credit rated suppliers. Ultimately, as with the other axes, proponents are encouraged to pursue these contracts with a firm focus on overall project bankability.
The offtake axis is a critical component that proponents need to carefully consider. One could debatably argue that it is, in fact, the most important axis. It is also the axis allowing for a great deal of creativity in terms of working to make projects bankable. Key contract features include the tenor (length) of the contract, pricing characteristics and mechanisms including utilized benchmarks, credit-worthiness of the counterparty and any credit-enhancing features of the contract, hedging strategies, contract incoterms, and any direct participation in the project by the offtaker. The days of projects being executed with a simple volumetric contract are coming to an end; increasingly, contracts are being structured where the offtaker is effectively a true partner to the project sponsors. Not only does this type of engagement assist project proponents with achieving bankability and actually executing projects, it also positions offtaker(s) much more closely to the project developer and allows for a strategic interface that ultimately benefits the offtaker in constructing multiple sources of supply.
g. The “+1”: Regulatory, Stakeholder engagement
When assisting proponents developing LNG projects, the “+1” consideration can be structured into three buckets: Permitting, Environmental, Political, or “PEP” for short. Again, the focus is on bankability and encouraging proponents to develop a cohesive approach in order to alleviate investor and financier concerns. Within the Permitting bucket, project sponsors must be able to show that they’ve abided by applicable Development Agreements and have a comprehensive handle on all required permits (Right of Ways, Water, Zoning, etc.) and are monitoring all requisite concession terms. With respect to Environmental (ESG ) matters, proponents must be able to demonstrate a coherent approach that not only abides by applicable local jurisdictions, but also meets global expectations - in particular, with respect to Equator Principles (currently moving towards what is referred to as “EP4” environment). Although Equator Principles abidance is voluntary, our experience shows that project proponents who are proactive on this front and able to demonstrate a path to compliance will greatly benefit from a more efficient capital raise process. In terms of Political considerations, in this bucket proponents are encouraged to proactively engage with political and local stakeholders in an ethical and transparent fashion. Legislative awareness is critical, and proponents cannot afford to be caught off guard by a lack of visibility on political evolutions. Energy infrastructure projects are often developed in an understated manner, typically gaining media attention only when adversarial stakeholder situations develop. The case for the project needs to be clearly articulated to all parties and positive messaging maintained throughout the life of the project: in this regard, LNG Canada stands as an example of how to execute such a strategy. This is particularly important for projects such as large liquefaction assets that ultimately have development tenors spanning decade-plus lifecycles.
In presenting the “6+1” model for project development, we hope that project sponsors are introduced to a model for developing large-scale energy infrastructure projects - liquefaction assets for instance - that brings a simultaneously holistic and focused approach. In this vein, we encourage proponents to look at their EPC and Offtake strategies, in particular, in a different, more strategic lens. In future, successful projects will require project sponsors to drive real collaboration across these axes in order to achieve bankability. Project sponsors that continue to attempt to deliver large energy infrastructure projects in a siloed manner will be left behind and, all things being equal, ultimately face higher risk, higher cost and likely non-bankable projects.
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