Rethinking procurement and financing

This article was originally published in Project Finance International on January 12th 2022.

“There is a global race to develop new green technology, kick start new industries and attract private investment. The countries that capture the benefits of this global green industrial revolution will enjoy unrivalled growth and prosperity for decades to come," said UK Business and Energy Secretary Kwasi Kwarteng in November 2021

The ability to attract and deploy capital rapidly and effectively into nascent technologies will be crucial if aspirational environmental and climate targets are to be achieved. There will need to be a step change in how capital projects, reliant on new technologies, are structured and delivered. With this will come a need to rethink how risk is managed from an investment perspective. We must remove the restraints of convention and conformity in order for opportunities to be realised and to move from words and gestures to project execution and realisation.

The proposals set out in this article recognise the fundamentals for investors from a credit risk perspective but, importantly, advocate a means of capital project delivery that will avoid mistakes of the past and that is best suited to secure successful project delivery.

Challenges to rapid deployment

Unprecedented levels of invention and innovation will be required to meet environmental and climate targets. The International Energy Agency (IEA) has forecast that 75% of the emissions reductions required to meet net zero carbon emissions are dependent on technologies that are yet to reach commercial maturity.

Investors in infrastructure rely on predictability of outcome, whether through an assessment of likely returns on their investment through project delivery and revenue generation and/ or rights of recourse against those delivering the project in the event of project failure. There will be no operational benchmark projects against which to assess the types of development required to meet the challenges of achieving climate and environmental targets. Furthermore, and perhaps more importantly, the appetite in the developer/contractor market for underwriting the delivery of relevant infrastructure works is likely to be near zero given the inherent technology risk.

The fundamental principles underpinning assessment as to bankability for investors funding on a limited or non recourse basis are absent in this context. We discuss below how the perceived bankability gap can be filled and the important role that governments and government agencies must play. Importantly however, in accepting that these fundamental principles are not going to be satisfied from the outset, we can shift away from the constraints of convention, which in our view undermine the ability to deliver projects with inherent technology risk.

Opportunity to rethink contracting

The standard approach to delivery of projects that are financed on a non recourse basis, and which involve any element of technology integration risk, is the use of a lump sum turnkey contract solution. This solution will typically provide for an experienced construction and engineering contractor with a healthy balance sheet offering a single point of responsibility for delivery of all aspects of design, construction and commissioning of the works, backed by a robust security package. For investors, this is perceived to remove interface risk and offer clear rights of recourse and recovery should there be any failure in delivery of the capital works.

Outside of the likely lack of market appetite for underwriting delivery of an infrastructure project employing nascent technologies that are truly novel and first in class, it is our view that the rigidity of a lump sum turnkey solution may not be appropriate in the context here. We say this as the lump sum turnkey solution will not be able to accommodate the level of design optimisation and innovation likely to be required to deliver these projects. In the context of projects we consider here, there will need to be flexibility in design development and implementation to allow for a reasonable degree of trial and error.

The lump sum turnkey model disincentivises such an approach, with its strict requirements with regard to price and programme certainty. We can justifiably question, for example, whether project failures seen in the deployment of new technologies in the waste to energy sector may have been avoided had the approach outlined in this article been adopted. We must learn from previous mistakes if we are to secure a successful project delivery pipeline at this critical time.

While what we are advocating will to some extent represent a shift away from the perceived time and cost certainty under a lump sum turnkey contracting solution, we certainly do not see this as an absolute trade off in order to achieve the scope for design optimisation and innovation. Management of time and cost should and will remain an absolute focus but the method by which it is managed will change.

• The EPCM model – To offer the best opportunity for success, a fully integrated design, procurement and construction management solution should be used for the entire project, led by a highly experienced professional engineering and project management contractor.

If properly employed and structured, the engineering, procurement and construction management (EPCM) contracting solution would be uniquely placed to facilitate the delivery of these early stage projects. Unlike the lump sum turnkey model, the EPCM solution is not a construction contract. It is instead a professional services contract under which the contractor will undertake design and procurement services and will assume responsibility for overall construction management and the achievement of agreed programme and budgetary targets.

The contract does not seek to transfer risk in overall project delivery, the contractor will instead manage project delivery under a regime where it will typically agree incentive payments and/or place an element of its profit or fees at risk against the achievement of key project targets. This is more than a construction management contract, it is a highly structured contracting solution used across complex major infrastructure projects in the resources, power and oil and gas industries.

• Ownership and optimisation of design – The EPCM model provides the opportunity for a single party experienced in delivering high value and technically challenging projects assuming full control of all aspects of design development. This ownership and control of design development outside of the constraints of the lump sum turnkey solution will provide an opportunity for design optimisation and innovation. There will be no incentive simply to carry on regardless when issues become apparent, taking chances and cutting corners due to restrictive programme and price constraints, as may be the case under the lump sum turnkey solution. This flexibility is of fundamental importance and while it will introduce increased risk for investors, we outline below how it may be managed.

The contractor will be engaged very early in the project development cycle and to a certain extent will be considered an extension of the client team in the early stages of the project. This early engagement will provide for continuity.

Early ownership of design development will allow this party to identify key risks and key interfaces, and to develop a robust strategy for management and mitigation of the same, including through the implementation of the procurement strategy outlined below.

• Control of procurement planning and execution – In addition to overseeing design development, the relevant contractor should oversee all aspects of procurement including for ancillary infrastructure under what is likely to be a multi package delivery solution. This will be important as the contractor will determine the allocation of works and supply into appropriate packages with a focus being on the management of interface risk through early design development and the identification of opportunities for innovation and collaboration through the supply chain.

A staggered approach to procurement will help to mitigate risk in overall costs exposure from time to time for the developer and investors, and importantly will also allow for early works and development activities to start prior to commencement of detailed design development. This can be contrasted with the lump sum turnkey solution, which relies on a certain level of design development before the terms of the contract can be settled and the procurement commenced. This will enable projects to get into the ground early, be shovel ready and in parallel with the proving of pilot projects. We have seen recently the benefits of commencing commercial development programmes while research and development is still being completed in the hugely successful Covid 19 vaccine rollout in the UK. There is no reason why a similar approach cannot be employed here to deliver this critical infrastructure.

• Management of construction – In controlling both design and procurement, the contractor will be ideally placed and should, in our view, be of the calibre and have the experience to oversee and manage all aspects of works execution and delivery against agreed budgetary and programme controls. These parties are known to the construction market. While there will not be a single lump sum turnkey contractor wrapping all aspects of the construction delivery risk, the contractor will instead provide a single point of responsibility for the management and coordination of the works delivery. The solution will be less about risk transfer and more about collaboration and reliance on the professional skill and competence of the relevant contractor pulling all aspects of the works delivery together.

Outside of purely structural issues, we also see the relevant contractor as being ideally placed to manage other aspects related to project development that will be of fundamental importance if there is to be a rollout of a pipeline of projects.

This party will also assume a central role in managing access to intellectual property both for the relevant project and other projects. A balance will need to be struck between incentivising innovation and opening up opportunities for repeat projects. It is of fundamental importance that successful projects and capital works delivery models are able to be replicated in the future. The structuring of the technology licence arrangements will be critical if opportunities are to be opened up in the future, and the contractor will be ideally placed to manage this in its procurement role.

In addition to the above, it is important that know how is transferred from one project to the next. This will include lessons learned from the design and procurement process and the use of template agreements and risk positions that can be quickly adopted on future projects. There are clearly advantages to keeping the same parties locked into this development pipeline in its initial phases outside of having to run a strict procurement regime for each project.

Aside from avoiding delay issues, this approach will help to maintain momentum and will encourage sustained investment in the process by key project parties. In the context of public procurement, it may be argued that this approach is already possible through the relaxation of public procurement procedures where there is only one economic operator able to deliver on the tender due to technical requirements or for reasons linked to intellectual property.2 It would be sensible, however, for this point to be revisited as part of the current consultation to public procurement being undertaken in the UK if it is to take the issue beyond doubt.

Central role of governments

The need for investment comes at a unique moment in time; the UK's balance sheet has been stretched by the Covid 19 pandemic in a manner that is unmatched since the 1940s. On the other hand, the government recognises that achieving net zero will require levels of investment that are also virtually unrivalled in recent memory.

Fortunately, looking across the current environment for infrastructure financing, the biggest challenge should not be the availability of funds, and the government should not need to bear the financial burden alone. There is a wall of private capital, both equity and debt, actively looking to invest in infrastructure, particularly if it has a sustainability focus.

The challenge lies in mobilising those funds and, to achieve this, the government and government agencies need to think creatively and create the right conditions to facilitate that investment.

So what are those conditions? Infrastructure investors are typically risk averse and their investment decisions are generally contingent on there being a clear, transparent and time certain model for likely return on that investment. This may come from an immediate exit or buyout of the investment at a premium or through economic factors and revenues generated by the project once it is operational. This focus on risk and certainty is particularly apparent for those providing debt financing to major capital projects, and the issues are only heightened if that debt is coming from pension funds or insurance companies.

Put another way, the typical investment model for those in the sector does not customarily absorb some of the technology and delivery risk that the next generation of projects will inevitably entail. In addition, the absence of a turnkey solution will mean that they do not have recourse to the sort of security package that has become commonplace and therefore there are inherent risks that the private sector will be reluctant to bear.

In the context of capital investment designed to achieve highly ambitious government targets, the natural person to bear some of that risk is the government. There is of course precedent for such an approach; government subsidies and support schemes have, historically, been instrumental in bolstering investor confidence and participation in renewable energy projects among other initiatives.

The contract for difference (CfD) regime has been successful in driving investment into the UK offshore wind sector primarily through (i) providing price certainty to developers and their investors for the duration of the CfD period and (ii) protecting electricity generators and their investors from future political interference in the Cfm price.

A similar framework may be considered in the context of these innovative projects both to foster investment and eventually reduce the cost of capital as a result of investor competition and stable, long term returns. With specific reference to carbon capture utilisation and storage (CCUS) projects, the government is already taking steps towards supporting the establishment of CCUS clusters and development of CCUS transport and storage networks; however, additional incentives will be required to encourage buy in from businesses that may not necessarily consider the net zero commitment when taking investment decisions.

Equally, the Green Investment Bank, (GIB) was an excellent example of the government looking to deploy public funds to encourage investment in sectors that may have otherwise proved challenging for the private sector. Applying this principle to nascent technologies, such as carbon capture and storage, would make sense. The aim for the government should be to crowd in investment, by absorbing risks which are either inherent in some of the emerging technologies required to achieve net zero and/or incompatible with the typical infrastructure investment model.

The government will need to provide innovative products to insulate investors from technology risk and also time and cost overrun risk. This could be achieved in a number of ways:

• Cost overrun facilities/guarantees – These are customary in the resources sector and could be deployed by the government as a “funder of last resort” in the event of a cost overrun during construction. Any funding could be provided on a subordinated or mezzanine basis, with a view to appropriately allocating risk. Alternatively, the overrun support could take the form of a guarantee, with the private sector providing the liquidity. A similar structure has been adopted on the Thames Tideway project and could serve as a useful reference point for future investment.
• Contingent equity – Similar to the rationale above, the government could provide additional equity in the event of a cost overrun. This would work well in the context of the government and the private sector seeking to form long term partnerships with a view to aligning their interests. Again, this approach can be seen on the Thames Tideway project, where if the cost overruns exceed 30%, the government could be forced to step in to provide additional equity to the sponsor consortium, or the investors will be allowed to discontinue the project and receive compensation.
• Overarching government guarantees – These could operate in any number of ways, but the fundamental principle would be for a government or government agency to backstop risk assumed by the private sector in connection with the delivery and performance of new technology. There are lots of examples of government or quasi government agencies performing this function. These include partial risk guarantees issued by the World Bank and its constituent parts, credit guarantee schemes offered by the European Investment Bank (EIB) to facilitate funding to SMEs, direct lending facilities offered by Treasury Infrastructure Finance Unit (TIFU) in the wake of the global financial crisis, or the recent credit guarantees issued by the government to support lending to companies affected by the Covid 19 pandemic. The support could be provided during construction, operation or both, and the common theme across these structures is the willingness of government to assume certain risks so as to encourage private sector investment at times of particular need or upheaval – it is time that we treated climate change in the same way.

It is clear that the UK government is ready to push the envelope and provide the means to pump prime new sectors and technologies through a range of different support mechanisms. The news this month of the deployment of the regulated asset base (RAB) funding model to new nuclear is testament to this approach.

There is limited detail at this stage regarding the role that the UK's Infrastructure Bank is envisaged to play. However, it is clear that it will have a significant balance sheet, and it could easily become the vehicle of choice to offer some of the credit support contemplated above. It could stand behind time and cost risk in delivery to plug the bankability gap to attract the wave of investment waiting in the wings.

In addition, if technology is being acquired from abroad, export credit agencies can be incorporated into the debt financing solution so as to further mitigate risks.

Any credit support or guarantee will need to be structured to properly incentivise the parties to deliver, and should only be available as a last resort. Furthermore, we do not envisage the government having to underwrite these risks indefinitely. Products can be structured in a way that they are “switched off” or released in whole or part as the projects become operational and risks are perceived to reduce. Equally, if a pipeline of similar projects can be created then credit support requirements should reduce over time as benchmarks for performance emerge and the private sector generally gains confidence with regard to delivery and performance risk.

The role of the government is not limited to credit support. From a regulatory perspective, it will be important for the government to ensure an enabling and supportive framework for these projects, particularly in the context of planning and environmental consents and approvals. Legal certainty regarding planning and environmental requirements as well as relative predictability regarding timeframes for processing and issuing approvals will be key from an investor perspective and should be facilitated by the relevant authorities.

In summary, there is a clear challenge; on the one hand we need investment from the private sector to deliver on net zero targets, and on the other hand their investment model has not been designed to absorb some of the technology risk that will be ever present in many of the projects that need to be delivered. It would be unrealistic to expect the government or the private sector to achieve these ambitious targets alone. Encouragingly, infrastructure investors have shown that they will deploy capital where the conditions for that investment are right and so the government now needs to work with the private sector to provide that foundation.

Closing remarks

The purpose of this article is to address general principles applicable to the delivery of critical infrastructure that is reliant on new technology. While it is recognised that the requirements in this regard will, to some extent, vary from one technology to the next, the principles around how key risks are managed should, in our view, apply across the board.