District Cooling: Lessons from the Gulf

Introduction

Analysts estimate that the global market for the district cooling sector will hit $39.9 billion by 2026, growing from $21.9 billion in 2018, at a CAGR of 7.77 per cent.¹ The Middle East has rapidly adopted district cooling technology and currently accounts for between 15% and 25% of the world’s installed cooling capacity.

District cooling has some obvious advantages. As well as increasing property values and reducing cooling costs for end users, studies indicate that district cooling has other environmental benefits, including reduced energy consumption (by up to 5,000 terawatts-hours) and reduced emissions.

District cooling is a sector, however, with its own unique set of issues. While some of the demand and collection risks are similar to other types of water infrastructure, there are some key differences. This article provides insight into some key considerations that arise on district cooling transactions.

Project structure

Contracting models

There are a number of different contracting models used on district cooling projects in the Middle East, including:

• a single-offtaker concession model, where a single offtaker enters into a cooling services agreement with a district cooling provider and purchases the entire capacity of the district cooling plant on an availability model basis (we have seen this type of structure applied at airports in the Middle East); and
• a typical concession arrangement, where a developer engages a district cooling provider to finance, construct and operate the plant, and permits the provider to offer district cooling services to end-users (either sub-developers, body corporates or individuals) at the development site. In this arrangement, the developer will be required to ensure that end-users purchase district cooling from the appointed provider and providers will often take full demand and collection risk, subject to some protections set out in the concession agreement with the developer, including exclusivity. Click here to view an illustration of this model.

Tariffs

The tariff system is usually the most challenging aspect of a district cooling arrangement. While there are some typical tariff schemes which most district cooling providers adopt in the Middle East, in our experience each providers’ scheme is different.

Tariffs typically comprise of a connection charge (to cover capital cost of the energy transfer station (ETS)), contract capacity charges (effectively an availability charge covering capex and fixed O&M costs) and a consumption charge (covering variable O&M costs including chemicals, electricity and water (potable/TSE)). Some district cooling providers also levy an efficiency charge, which penalises users who fail to utilise the thermal energy in the delivered chilled water resulting in lower efficiency and higher production costs at the central chiller plant.

Over the course of a long concession (anywhere between 25 and 50 years), the district cooling provider will usually require adjustments to the initial tariffs in certain circumstances, including to reflect inflation, foreign exchange fluctuations, and changes in law. Basic utilities such as water and power are usually paid for by the offtaker as pass-through costs and are pegged to the rates for such utilities charged by the relevant utility supplier. Efficiency targets for such utilities are often included.

In some schemes in the Middle East, district cooling providers have also agreed to pay a royalty to the developer/building owner in consideration of the concession rights granted in relation to a particular project. From our experience, these types of payments only become feasible if the developer/building owner is prepared to take demand risk (such payments constituting the demand risk return to the developer/building owner).

The offtaker would typically expect to continue to pay 100% of the contract capacity charge even in the event of an (either planned or unplanned) interruption of service, provided that the relevant cooling services are being delivered through temporary cooling facilities (although we have seen a drop down in payments (to 50% of the contract capacity charge) in the event of prolonged interruptions (between 7 and 30 days) caused by the provider or which occur as a result of an emergency or a natural force majeure event).

Key issues explored

Demand risk

In a concession model, the developer/building owner will typically expect to pass all demand risk onto the district cooling provider and exit the project (typically 5 to 7 years into the concession) without providing any guarantee to the district cooling provider that demand for district cooling services (during an initial defined period, or at all) will be as predicted or, even if as predicted, continue for the term of the concession. Unlike other types of water concessions, the district cooling provider also faces an uneven demand profile with high consumption during the summer months and lower or non-existent consumption during the winter months.

If the district cooling provider is considering accepting the demand risk, the following risk scenarios need to be considered:

• the development may not be sold-out or occupied in accordance with the developer’s/building owner’s predictions;
• the development may not be constructed in accordance with the original Master Plan (e.g. the Master Plan could be amended so that the development is low density, rather than high density, resulting in fewer end-users for the district cooling service);
• end-users may refuse to enter into district cooling purchase agreements or deliberately default on their service payments (this risk is unique to district cooling projects) or elect not to take all of their allocated capacity.

If the district cooling provider agrees to accept demand risk, these risks can be mitigated as follows:

• obtaining an undertaking from the developer/building owner that it will assume some of the demand risk for the district cooling services (e.g. by paying the capacity charge during any ramp-period);
• ensuring that the district cooling provider has no obligation to commence construction of the district cooling plant until a minimum number of district cooling purchase agreements have been entered into by end-users (with guaranteed capacity offtake);
• ensuring that each end-user agreement contains rigorous succession obligations requiring the end-user to ensure that any subsequent purchaser enters into an agreement with the district cooling provider for the provision of district cooling services; and
• seeking to renegotiate the terms of the concession agreement with the developer (including the tariff) in the event that the Master Plan is amended resulting in lower than expected demand for district cooling services.

Collection risk

Collection risk can be a critical issue in a district cooling project. A district cooling provider will typically be unwilling to accept multi-end user collection risk (e.g. individual apartments in a residential apartment block). Chilled water is delivered to the ETS (Energy Transfer Station) unit located in the basement of the building (and not to individual units) and transmission of the chilled water to individual apartments is usually the responsibility of the body corporate or building owner. As a result, the district cooling provider often has no practical means of enforcing payment (i.e. by terminating delivery of chilled water to an individual unit).

If, however, a district cooling provider agrees to accept multi-end user collection risk, this risk can be mitigated as follows:

• appointing a facilities manager to assume collection risk (on a pass-through plus uplift basis);
• ensuring that each end-user agreement contains rigorous succession obligations requiring the end-user to ensure that any subsequent purchaser enters into an agreement with the district cooling provider for payment of district cooling services;
• seeking the body corporate/building owner/developer’s agreement to assist the district cooling provider to secure payment by agreeing to cut-off cooling services to individual apartment owners (to the extent that this course of action is permitted under local law) until district cooling payments are made.

Risks for developers/building owners

If the developer/building owner is not contributing to the capital cost of the district cooling plant and is not a single source offtaker, the risk for developers/building owners in any district cooling project primarily arises from two issues:

• poor performance and default by the district cooling provider; and
• in the absence of government regulation of this sector, high cooling costs impacting on the ‘saleability’ of the individual units or sub-developments to end-users/sub-developers.

These risks can be largely mitigated by the selection of a recognised district cooling provider with a strong balance sheet and resources, implementation of a "benchmarking" mechanism in the concession agreement to ensure best value, performance reviews against established KPIs and termination rights for persistent or material breaches.

Benchmarking can provide the developer/building owner with a powerful tool to ensure that a district cooling provider delivers best value to end-users. On some schemes, the district cooling provider's fees and charges are compared against prices paid for similar utilities on comparable developments in a similar location (although this would only likely be acceptable to a district cooling provider if such utilities actually exist). If the benchmarking exercise demonstrates that the district cooling provider is not competitive, then the district cooling provider may be required to adjust its fee structure and/or the developer/building owner may be entitled to terminate the concession. District cooling providers are typically very sensitive to benchmarking mechanisms, particularly where the possible consequences of the benchmarking exercise is termination of the concession agreement.

Developers/building owners will also often require external auditing of the district cooling provider’s performance. This is typically an external audit by an independent district energy organisation which takes place every 3 or 5 years during the term of the concession agreement. These audits are measured against agreed key performance indicators and a "reliability score" (which relates to the number of hours during the year when chilled water has not been supplied).

Reticulation Network

In a master development, the master developer will often procure the installation of the district cooling reticulation network as part of an early works infrastructure package and prior to the appointment of the district cooling provider and then require the district cooling provider to adopt the network upon appointment. This strategy creates risks for both the developer/building owner and the district cooling provider including:

• a district cooling provider may not be willing to accept the risk associated with a reticulation network that it has not designed or constructed;
• the district cooling provider may consider that it could have built the reticulation network at a lower cost (i.e. the pipe sizes used in the reticulation network provided by the master developer may be unnecessarily large);
• the district cooling provider will be exposed to warranty/liability issues associated with a network that it has not built;
• it can be more difficult (if not impossible) for a district cooling provider to obtain insurance for such networks given that the pipelines are likely to have already been laid and covered.

Related interoperability issues also arise in the context of existing networks (and also brownfield plants) which can create interface risks for providers, particularly in the context of expansion projects.

Temporary facilities

Liquidated damages or deductions are not typically levied for delayed completion or service outages in district cooling projects. If the district cooling provider cannot achieve commercial operation by the service commencement date, or fails to provide cooling services at any time, then the provider will typically be obliged to deliver chilled water through temporary facilities. If the provider fails to provide the temporary facilities, then the developer/building owner would be entitled to do so at the district cooling provider’s cost.

Temporary facilities are generally prohibitively expensive and there will, therefore, be cost consequences for the developer/building owner if temporary facilities are required to be installed due to the developer’s/building owner’s default. If, however, such temporary facilities are installed due to the provider’s default, the provider may also seek the right to terminate the concession agreement if it is required to provide temporary facilities for a prolonged period of time.

As noted above, the developer/building owner would typically expect to continue to pay 100% of the contract capacity charge even in the event of a service outage provided that the relevant cooling services are being delivered through temporary cooling facilities.

Succession and assignment

In the absence of a positive covenant that runs with the land, the district cooling provider will typically seek to obtain an undertaking from the developer/building owner that the developer/building owner will require each initial end-user to enter into a district cooling services agreement with the district cooling provider. Each subsequent purchaser will also be required to enter into a further district cooling services agreement. Without legislative support, these mechanisms provide the district cooling provider with a mere entitlement to sue for breach of contract in the event that an end-user fails to ensure that a subsequent purchaser enters into the district cooling services agreement. While district cooling providers often seek a developer/building owner indemnity to mitigate this risk, these types of indemnity provisions are often strongly resisted.

Typically, the district cooling provider will only have a leasehold/contractual right to use the land on which the plant is located. The district cooling provider will require a contractual obligation on the developer/building owner in the concession agreement to assign/novate the rights and obligations of the owner under the concession agreement to any successor developer (i.e. if the developer/building owner sells the development or building) or a body corporate and to indemnify the district cooling provider for any loss it suffers because of the developer/building owner’s failure to comply with such contractual obligation.

Conclusion

District cooling is a sector with its own unique set of issues. As such, familiarity with regulated utilities sectors such as power and water does not necessarily squarely translate to the district cooling sector. As the oldest and largest district cooling market, the Middle East offers a unique perspective on the types of risk allocation issues that arise in this sector and the types of mitigants that have been developed to address these risks.

It is inevitable that Australia and other countries in this region will continue look to district cooling as a viable cooling option for the right developments and that Asia Pacific will become attractive to providers active from other markets, including the Middle East. While Australia is currently an emerging market for district energy projects, there are some key issues to consider in the context of such projects in Australia. In the next article in this series, we will be looking at risk allocation issues in domestic district cooling and district energy projects in Australia.

Joanne Emerson Taqi (Partner) led our firm’s district energy practice in the Middle East for 10 years and has recently relocated to our Sydney office. This article has been prepared based on our extensive international experience working on district energy projects for pre-eminent utilities operators, providers, lenders and developers. We have advised on and/or reviewed most of the key forms of district cooling concession agreements and worked closely with financial analysts on financing and payment structures for district cooling projects. Joanne also facilitated the Masterclass Workshop on Key Contracting Strategies in the District Cooling Sector at the MEED District Cooling Conference in Dubai for a number of years.