Tackling risk in district cooling
Joanne Emerson Taqi and Hugh Murray* explore some of the principal issues affecting the district cooling sector in the Middle East and examine how such issues have been addressed in Singapore.
01 July 2011
THE centralised production and distribution of chilled water to residential, commercial and industrial facilities for the purpose of air-conditioning, known as district cooling, remains a relatively new industry in the Middle East.
District cooling derives economic advantage from the scale of production compared with traditional in-building chiller or window units. The benefit of such economies of scale can, however, come at the cost of limited flexibility for subscribing consumers as well as a lack of control over quality and pricing. Service providers also face significant ongoing risks involving demand, billing and collection, tariff setting, and succession and assignment issues.
Many providers also remain concerned about the lack of regulation or legislative framework for the industry. To date, no comprehensive measures have been taken to address these issues in the Middle East.
In a pioneering district cooling market such as Singapore, the situation is markedly different. The Singaporean authorities established the Energy Market Authority (EMA) in 2001 as the sector’s regulating authority and, shortly afterwards, passed the District Cooling Act (2001) (the Act), which granted the EMA wide-ranging powers to administer and enforce the distribution and consumption of district cooling in Singapore.
Demand risk
In the Middle East, demand risk is typically either borne by the provider or shared with the master developer (for example, through direct revenue guarantees up to an agreed demand level). However, even if it is shared with the master developer, demand risk can have a significant impact on the economics and bankability of a district cooling project.
Unlike the wastewater and potable water utility sectors, the district cooling sector is particularly vulnerable to demand risk due to the fact that traditional in-building chiller units or window units are readily available and easily installed.
In the Middle East, demand risk is usually dealt with through contractual mechanisms, including positive covenants on developers requiring them to ensure that end-users enter into end-user utility agreements, which include obligations to use district cooling. Regional district cooling providers also use phased construction programmes to further mitigate demand risk.
In Singapore, demand risk is expressly addressed by provisions in the Act, which require “the occupier of every premises within a service requiring air-conditioning that they must use the district cooling services provided by a licensee if such services are available”. Additionally, each consumer is obliged not only to use the district cooling provided to it, but also not to install any “independent chilled water production facilities, unless agreed in writing”.
Collection risk
For the majority of private utilities (for example, wastewater and potable and irrigation water), collection risk represents a key issue. The ability to collect fees and generate revenue is similarly critical to the ongoing success and operation of a district cooling facility.
In the Middle East, a district cooling provider will typically be unwilling to accept collection risk, particularly on high-rise buildings with multiple occupants. In such buildings, a provider will usually agree to deliver a chilled water energy transfer station (ETS) located in the basement of the building (and not to the individual units). Consequently, the district cooling provider has no practical means of enforcing payment (that is, by terminating delivery of chilled water to an individual unit).
If a provider is unable to bargain out of accepting such risk, then it is possible to mitigate it by, for example, passing the collection risk to a facilities manager (thereby mitigating multi-user collection risk, although facilities managers would only be likely to agree to accept the risk in exchange for a portion of the monies collected) or to sub-developers and owners corporations (if applicable).
In Singapore, the very existence of the EMA as a third party, with statutory authority to regulate the industry, provides a mechanism through which collection risk has been addressed. The 2009 Code of Practice issued by the EMA (the Code), pursuant to and enforceable under the Act, provides that a district cooling provider can mitigate collection risk by requiring ‘reasonable security’ for the payment to it of all money that may become due. Such security may include cash deposits and/or a bankers’ guarantee, but is limited to a maximum of two times the estimated monthly fees payable by the consumer. In the event of a default by the consumer, the provider may retain such security and then, if no payment is received after 16 days, discontinue the supply of district cooling.
Tariffs
The tariff system is typically the most difficult and potentially troublesome aspect of a district cooling arrangement. Whilst there are commonly adopted tariff schemes, more often than not each provider’s scheme is different.
In the Middle East, 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 may require adjustments to the tariff, to cover among other aspects 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.
Although used in the Middle East to control tariff adjustments, benchmarking can be difficult due to the lack of comparable district cooling projects. Moreover, in the absence of an independent authority to regulate tariffs, tariff adjustments can appear arbitrary and outside the control of end-user consumers.
In Singapore, tariffs must be set at a level no higher than the equivalent costs of chilled water production in conventional building plants employing similar technology. Initial tariffs are proposed in the first instance by the licensee provider, submitted for approval to the EMA and then reviewed at half-yearly intervals.
The finalised tariffs are published by the EMA and included in each consumer’s monthly invoice. Failure by the provider to comply with its obligations of fair pricing and transparency of tariffs may result in the EMA imposing one of a wide range of punishments authorised under the Act, including the ability to cancel a licence and impose a fine of up to 10 per cent of the provider’s annual turnover.
Succession & assignment
The passing of the connection, payment, and off-take obligations of any district cooling service to subsequent purchasers is difficult in the Middle East because, with no third-party regulator, successful recourse relies on the existence of a specific legal mechanism (such as a positive covenant) which runs with the land or a matrix of contractual obligations.
Typically, the district cooling provider will seek to obtain an undertaking from the master developer that the latter will require each initial consumer 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, however, the district cooling provider will be required either to sue for breach of contract or call on an indemnity if these undertakings are breached.
This can prove difficult, particularly if the end-user cannot be located or has relocated outside the jurisdiction. Whilst district cooling providers often seek a master developer indemnity to mitigate this risk, these types of indemnity provisions are often strongly opposed.
The legislative and regulatory framework in Singapore largely serves to eliminate succession risk. As highlighted above, the regime in Singapore obliges the occupier of every premises within an area designated a district cooling area to use the service provided by the licensee. This serves to bind successors in title automatically to consume district cooling services and so prevents the Middle East scenario from occurring, where a missed provision or incomplete contractual chain can create a time-consuming and sometimes irresolvable problem for the provider.
Conclusion
The regime in Singapore provides an invaluable example of a legal framework for district cooling, with obligations on both licensed providers and end-users largely eliminating the significant risks of non-consumption and non-payment and establishing a permanent and independent third-party regulator. Whether the Singapore model can provide a model regulatory solution for district cooling in the Middle East, however, remains to be seen.
* Joanne Emerson Taqi is a partner and Hugh Murray is an associate at Norton Rose (Middle East) and are based in Bahrain. 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 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 the Abu Dhabi, Bahrain and Dubai 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.
