District cooling faces key issues
Joanne Emerson* elaborates on the risks that need to be weighed up when drawing up a concession agreement for district cooling between a master developer and a district cooling provider.
01 April 2010
DISTRICT cooling is still a relatively new industry in the Middle East and many stakeholders and their advisers have yet to come to grips with the unique set of issues presented by this sector.
While some of the demand and collection risks are similar to other types of water infrastructure projects, there are some key differences, which stakeholders and their advisers should be aware of when negotiating a district cooling concession agreement.
For the purpose of this article, let us address the issues involving a concession agreement between a master developer and a district cooling provider.
Demand risk
A master developer will typically seek to pass demand risk onto the district cooling provider and exit the project (generally five to seven years into the concession) without providing any guarantee to the provider that the demand for district cooling services (during an initial defined period or at all) will be as predicted or – even if as initially predicted – will continue for the duration of the concession period.
If the district cooling provider agrees to accept demand risk, the following risks need to be considered:
• The development may not be sold-out or occupied in accordance with the master-developer’s predictions;
• The development may not be constructed in accordance with the original masterplan (that is, the masterplan may be amended so that the development is low density, rather than high density, resulting in fewer end-users for the district cooling service); and
• It can be cheaper for end-users to purchase a stand-alone air-conditioning unit than to pay for district cooling, which may result in end-users refusing to enter into district cooling purchase agreements or deliberately defaulting on their service payments. This risk is unique to district cooling projects.
If the district cooling provider agrees to accept demand risk in the absence of a master-developer guarantee, these risks can be mitigated by:
• Obtaining an undertaking from the master-developer that it will assume some of the demand risk for the district cooling services (that is, by payment of the capacity charge during the early phases of the development during which the parties could expect low occupancy levels);
• 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 (or end-user) agreements have been entered into;
• 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 (including the tariff) in the event of a change in the masterplan (there is generally a pre-agreed allowance for some level of change), including in relation to building design, gross floor area and indicated usage, resulting in lower than expected demand for district cooling services.
Lenders to district cooling projects are generally very sensitive to the demand risks issues associated with district cooling projects, particularly developments where the master-developer/concession grantor looks for an early exit from the project. There are regional district cooling schemes that have been debt financed in the absence of master-developer/concession grantor covenants over the life of the concession or other significant protections against some of the risk factors highlighted in this note. However, given the current economic climate, lenders are now actively seeking robust guarantees from master-developers over the concession term in order to address the numerous demand risk issues faced by district cooling providers.
Collection risk
Collection risk can be a critical issue in a district cooling project. A district cooling provider will typically be unwilling to accept end-user collection risk in relation to high-rise buildings. In high-rise buildings, chilled water will be delivered to the energy transfer station (ETS) located in the basement of the building (and not to individual units). Therefore, the district cooling provider will be unable to terminate delivery of chilled water to an individual unit (that is, reducing its ability, as a practical measure, to “persuade” an individual unit holder to pay the service charges and reduce its exposure to further income losses).
If a district cooling provider agrees to accept collection risk, however, these risks can be mitigated by:
• Appointing a facilities manager to take the 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 master-developer’s agreement to assist the district cooling provider to secure payment by agreeing to terminate essential services (provided that this is permitted under local law) until district cooling services payments are made; and
• Not entering into any end-user agreements with individual unit owners (only sub-developers and owners corporations, if applicable).
Reputation risk
If the master-developer is neither contributing to the capital cost of the district cooling plant, involved in the operation of the plant, nor an end-user, its main risk then, as the concession grantor, is the reputational risk associated with a poorly performing district cooling scheme.
This risk can be mitigated by the selection of a recognised district cooling provider with a good reputation and strong balance sheet and resources, implementation of a “benchmarking” mechanism requiring the district cooling provider to demonstrate best value in relation to fees and charges levied to end-users, performance reviews against established key performance indicator (KPI) criteria and termination rights for persistent or material breaches.
In the absence of an independent sector regulation that includes licensing of district cooling operators, benchmarking can provide the master-developer with the best available tool to ensure that a district cooling provider delivers best value in relation to fees and charges levied 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 (this comparison is, in practice, often very difficult due to the lack of directly comparable projects in the region).
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 master-developer may be entitled to terminate the concession. District cooling providers are typically very sensitive to benchmarking mechanisms, particularly where the benchmarking exercise may lead to termination of the concession agreement.
Tariffs
The tariff is usually the most difficult part of any district cooling concession agreement due to a general lack of understanding about tariff structures in the sector. While there are some typical tariff schemes, which most district cooling providers adopt, our experience shows that each provider’s scheme is different.
Tariffs typically comprise a connection charge (to cover the capital costs of the ETS), contract capacity charges (effectively an availability charge) and a consumption charge. 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 plant.
Over the course of a long concession (anywhere between 25 and 50 years), the district cooling provider will require adjustments to the initial tariffs, including those that reflect inflation, foreign exchange fluctuations, change in law as well as increases in the cost of basic inputs into the district cooling plant, such as energy, labour and water.
In some regional schemes, district cooling providers have agreed to pay a royalty to the master developer in consideration of the concession rights granted over a particular development. Some stakeholders consider these types of payments to become feasible only if the master developer is prepared to take demand risk (such payments constituting the demand risk return to the master developer).
*Joanne Emerson is a senior associate in the Bahrain office of Norton Rose (Middle East) LLP. Legal queries related to the construction sector can be addressed to Norton Rose (Middle East) LLP through Gulf Construction magazine at editor@gulfconstructionworldwide.com.
Norton Rose Group has had a presence in the Middle East for more than 30 years and has advised developers, lenders, and contractors in relation to the legal aspects of a wide variety of construction and infrastructure projects in the region.
With a combined team located in both the Bahrain, Dubai and Abu Dhabi offices, Norton Rose (Middle East) LLP is able to provide both contentious and non-contentious support to financiers, developers, contractors and specialist contractors in the region.
