This case study describes the challenges that arose and solutions developed during the project financing of the Kwale sugar plantation, refinery and power plant in Kenya. By Martin Kavanagh, partner, Herbert Smith Freehills.
To see the digital version of this report, please click here.
To purchase printed copies or a PDF of this report, please email gloria.balbastro@thomsonreuters.com.
The financing of the US$200m Kwale sugar plantation, refinery and power plant reached financial close in July 2013. Kwale International Sugar Company Ltd (Kiscol) is the sponsor of the project – the first of its kind in Kenya. The purchaser of the power is Kenya Power & Lighting Company (KPLC), a quasi-government offtaker that runs the Kenyan grid, but there is no guaranteed offtake agreement in place due to the limited capacity of power being sold. A consortium of banks led by Standard Bank’s CfC Stanbic agreed project financing of US$120m.
The project is notable because it is a rare example in the region of commercial banks lending into a renewable energy project that uses new technology for a particular market, and without having the security of a guaranteed offtake agreement or political risk insurance cover – a groundbreaking achievement that bodes well for the project finance market in East Africa.
Project background and structure
The Kwale sugar plantation, refinery and power plant is situated 80km to the south of Mombasa. It is being built from the ground up incorporating 5,500 hectares of cultivated sugar cane, a 3,000 tonnes-crushed-per-day sugar mill, an 18MW power plant run on bagasse (a by-product of sugar cane refining and the production of sugar for sale) and a sophisticated irrigation and water management system. On completion about 10MW of the power will be used by the sugar refinery, with the remainder sold to the Kenyan grid. The project is one of the largest greenfield projects of its type in Africa and is expected to be fully operational by mid-2014.
Kiscol is a joint partnership between the locally-based sugar trading Pabari family and leading Mauritian sugar producer Omnicane. Omnicane owns and operates a similar facility on the island of Mauritius, which provides a substantial amount of power to the Mauritian power grid. Management of the company is shared at a ratio of 75% and 25% for the Pabari family and Omnicane respectively. As the power plant will contribute additional energy to the grid in order to ease Kenya’s demand for power, Kiscol was able to instigate the project itself and present it to the government without a formal bidding process taking place – as has been the case with a number of recent independent power projects in the region.
As reported in PFI on July 17 2013, a consortium of banks led by Standard Bank’s CfC Stanbic – a subsidiary based in Nairobi, agreed financing of US$120m split into US$100m over a nine-year tenor and the remaining US$20m over a 12-year tenor. The pricing was Libor plus 700bp on the nine-year loan and Libor plus 600bp on the 12-year loan, with a floor of 10%. Stanbic arranged the floating to fixed interest rate hedging. The debt to equity split was 60/40.
Standard Bank Mauritius provided US$15m, CfC Stanbic provided US$22.5m, and local development bank PTA (the East and Southern African Trade and Development Bank) provided US$20m. The balance was split by a combination of Kenyan and Mauritian banks. The main finance documents were executed under English law, as is typical for project finance transactions in Kenya and more generally in Sub-Saharan Africa.
A good story for Kenya and Africa
Kenya’s demand for power has historically exceeded the supply available and this trend is only likely to continue with continuing industrialisation and growth of the middle classes, so the ability to use bagasse as a raw material for electricity generation will provide a welcome contribution of additional energy to the grid. A further benefit is that the project will enable Kenya to diversify its power portfolio away from wind, which tends to be located in the north, and geothermal resources in the centre and west – as well as other more traditional resources.
The project will use new technology that essentially separates the sugar from the cane and treats the remaining bagasse so that it can be fired, with the resulting steam creating power. Previously exploited by Omnicane in Mauritius, it will be the first time that this technology has been used on the East African mainland. As a result, Kenya will be able to generate some power in the populous coastal locations where sugar cane grows, thereby avoiding the transmission losses that would otherwise occur when distributing electricity over longer distances from other areas of the country.
Bagasse-based power production is green in that it uses the by-product of food production, and there are limited, if any, transportation costs from the source of the fuel to the power generation facility. The expertise of Omnicane in building and operating a similar plant has proved invaluable. Although the risk analysis of the interface between the different elements of the project is a complex one, the actual task of designing and building a bagasse-fired power station is not especially complex, and the construction period is relatively short compared with other sources of power.
In addition, because the power generation facility is usually based on the same land owned for the production of sugar, the issues associated with securing land access and ownership that arise in the case of wind and geothermal power developments do not exist. From an environmental perspective, the existing sugar treatment and milling involves some industrial activity, noise and steam output, so the addition of power generation on the same site is a relatively small increment in additional environmental impact as compared with building a power generation facility on a totally greenfield site.
The plant will also contribute to the creation of a viable domestic sugar industry. The 5,500 hectares of cultivated sugar cane for the sugar processing facility will see 3,000 tonnes of cane crushed per day at the sugar mill, processed and then introduced to the Kenyan, regional and international market. As Kenya has traditionally acquired refined sugar through importation, the project will therefore provide an alternative source for local companies, including higher-value refined white sugar producers.
All of this amounts to a good story for Kenya: there are relatively few places in the world that have the right climate and soil to build a bagasse plant because sugar cane grows best in tropical areas that get a requisite amount of rain and have warm temperatures all year round.
The involvement of Kenyan banks alongside an international lending group is also significant, as is the fact that the commercial banks were comfortable enough to not require political risk cover, all of which contributes to the perception of Kenya being a market where international businesses can get things done.
With the ability to build viable plants at US$200m project cost levels, we are therefore likely to see more of these projects in the coastal regions of East and West Africa that don’t have access to other renewable sources such as wind and solar. Wind resources are typically limited in the equatorial regions of the world, and solar can also be problematic due to increased tropical cloud and haze, which reduces solar efficiency.
An innovative contract structure
The interface between the three separate project components – sugar farm, refinery and power plant – posed a number of intellectual challenges to the project for project finance lenders. As water availability is a crucial element to sugar production, various dams we required either to be improved or built, along with night storage facilities, in order to provide water irrigation for the estate.
The complicated nature of this integrated project meant that it was not possible to put in place a single engineering, procurement and construction (EPC) contract because all of the different aspects required specialist areas of expertise, encompassing everything from the sugar plantation, the mill processing plant for the sugar cane, the power station and all of the transmission that comes out of it, and the dams. While the developers and contractors do not see this work as especially technically challenging, the analysis of a contractual risk matrix for project finance purposes dictates that risks are allocated and as few interfaces as possible exist.
Because a civil works contractor that builds a dam at a sugar refining plant is not likely to be the same contractor that provides turbines for a power generation plant, it was therefore necessary to put in place a multiple contract structure with various different construction contractors.
This meant that the lender group had to become comfortable with the multi-contract structure (as opposed to a single point of responsibility lump-sum turnkey construction contract), as well as come to terms with the contractual caps on liability offered under the various smaller construction contracts, even though delay or default under any of those contracts would prevent completion of the integrated project.
This was a major issue for the lenders. Having one large construction contract is preferable to things being sliced and diced into six different sub-caps where each has to be pursued separately for relatively small sums of money.
The whole project financing took nearly 18 months, which in a market such as Kenya is not an inordinate length of time, especially with Omnicane coming in as a new equity investor part way through the deal, which meant that it had to perform its own due diligence on the project. Omnicane’s involvement was crucial, however, as lenders were able to take a view to some degree on the experience of Omnicane as a builder and operator of these complex projects. In hindsight, it would have been very difficult for lenders to achieve that level of comfort without its involvement.
Complicated financial modelling
The financial modelling around the amount of power that can be sold to the grid and the price of that power was a particularly complicated issue for the lenders. As there isn’t a single power purchase agreement (PPA) with KPLC, the lenders are effectively relying on a market price for power sales. This which involves a host of varying factors, such as how much sugar the plant can grow; the potential for an extreme weather event such as a hurricane, cyclone or flood that damages the sugar cane crop; whether it will be a dry year to grow sugar cane and if supplies run out whether sugar cane can be purchased elsewhere; and the risk of fire, flood or of the plant itself not working.
This risk was mitigated to some degree by introducing a process whereby the lenders won’t automatically default the loans if the project has a bad year, but at the same time the sponsors won’t be able to take dividends because instead the money will be put aside through a “cash sweep” mechanism that comes into place once market prices and cover ratios reach a certain level.
Based on the boom-bust nature of sugar prices, the cash sweep works when sugar prices rise as well as fall. The mechanism essentially flattens out the commodity cycle and offers protection to the lenders and the borrower from the first day of operation. The mechanism approximates a long-term hedge in that it takes the highs and lows out of the cycle.
Hence, the project has a very conservative modelling and financial prudence structure put in place that is reflective of the risk of not having a guaranteed offtake agreement as well as the various other individual risks inherent in the region. The cash sweep ensures that Kiscol is kept as financially solvent as possible and in the best possible position to weather any unfortunate elements of nature that arise.
The participation of commercial banks
Aside from PTA, which had a relatively small involvement in the deal, the vast majority of the lenders were international and regional commercial banks, and the fact that they were able to lend into a green energy project without relying overly on development bank funding, using new technology without a guaranteed offtake and without political risk insurance, is a major achievement.
Confidence in Kenya
The closing of this project financing is another step in the rapid rise of Kenya as a market in which lenders have confidence, and where the power sector is seen as a stable and well-managed sector upon which to base a project financing. Although it remains true that in all Sub-Saharan jurisdictions there are challenges in closing non-recourse or limited-recourse financings, Kenya has taken steps to distance itself from the pack of other countries. The geothermal power sector is managed in a structured way and attracts international investors, and it is likely that in the not too distant future two large wind-power project financings for projects at Kinangop and Lake Turnkana will reach financial close.