Investment in Italian power falls short

Author: | Published: 24 May 2005
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The suspension of electricity supply on June 26 2003 and the blackout on September 28 2003 drew Italy's attention to the weaknesses in its national electricity system, which for some time has been at the centre of political debate (the so-called Marzano draft bill of law for the reorganization of the energy sector, presented by the Ministry of Production in October 2002, is still awaiting approval by the Italian parliament).

The preliminary inquiry concluded at the end of 2003 by the Energy and Gas Authority revealed that the main structural cause of the blackout was that the country's generating capacity is not enough to cope with peaks in demand, and that, as a consequence, Italy depends heavily on imported energy.

These problems have been recognized for some time but, despite constant growth in demand for power, a growing availability of natural gas and new power plants already being authorized for about 13.787 MW as of April 7 2004, with an additional 80 power plant permit applications for about 44.107 MW, there has been a continuing shortage in investment in new power projects.

A series of impediments have made it difficult to get the necessary financial resources for the development and construction of power projects.

First, there is opposition from local communities. The nimby (not in my back yard) syndrome has pervaded entire provinces, resulting in protests and causing delays in construction.

The solution to this is not simple: on one hand, some think that incentives should be introduced for municipalities that accept the building of power plants, and, on the other hand, some propose the introduction of higher taxes for electricity consumers in regions with fewer power plants. A solution must be identified quickly, whatever it might be.

Secondly, there are increasingly frequent hindrances and delays resulting from proceedings brought by local citizens and authorities opposing the construction of new power plants. Law 55 of April 9 2002 (the so-called Fast-track Decree) was meant to expedite the permit procedure by introducing a single authorization that includes environmental aspects; however, this decree has proven unfit to resolve this problem.

In Italy, a private citizen, local entity or association is entitled to challenge an authorization or permit within 60 days of its publication before an administrative court on the basis that the provision in question may damage its interests. In addition, the challenging party may demand the suspension (sospensiva) by the court of the administrative provision, an urgent remedy aimed at preventing any action taken to carry out the administrative provision.

Because the sole authorization to develop a power plant is an administrative provision, it can be challenged on such terms. Recent experience has shown that administrative courts usually reject any proceedings opposing the construction of power plants. But even ungrounded proceedings cause concern and uncertainty with respect to the project until a definitive decision is granted. Indeed, the issuance of the definitive decision can take more than one year from the date on which the proceedings were filed. Furthermore, if the administrative court admits the request of suspension of the sole authorization, construction works relating to the power plant can be interrupted even at an advanced stage.

From this standpoint, to guarantee greater certainty among investors, a path to be explored could be a set of rules that reduces the terms necessary to get to the definitive decision and lays down stricter requirements for granting a suspension remedy, as happened in the past in accordance with Legislative Decree 190 of August 20 2002 with regard to the construction of infrastructure having pre-eminent national interest.

Thirdly, much uncertainty has been generated through the lack of published reliable indices, which would allow financiers to have a reliable price per kilowatt/hour when estimating the investment risk.

From this viewpoint, concerns stem from the possible fall in power prices after the opening of the Power Exchange (Mercato Elettrico) on April 1 2004. Those who have already invested large sums in the construction or re-powering of power plants, as well as potential investors, could see their levels of profitability fall as a result of price reductions.

However, certain optimism has emerged among foreign investors regarding the development of generation plants in Italy. One of the reasons is that prices are not likely to suffer excessive reduction because the range of power plants belongs to just a few subjects. A further upside for potential investors is the high degree of efficiency and flexibility in the dispatching of new generation plants, markedly, the new 800 MW CCGT plants which, in the initial phases, are likely to be dispatched base load. Moreover, even if it cannot yet be considered a representative record, in the first days of operating the Power Exchange, power prices have risen.

Fourthly, there is a continuous uncertainty of the regulatory framework. Regulations are constantly evolving (the Energy and Gas Authority has already issued 54 resolutions since the beginning of 2004 and often provides for temporary rules). For instance, the recent Legislative Decree 379 of December 19 2003, which was issued to boost the development of new generating capacity through the provision of a capacity payment scheme aimed at remunerating power plants during peak periods, does not set out a final framework.

Some of the main unresolved regulatory issues relate to the liquidity of the Power Exchange, the rules and regulations governing zone prices, the absence of tested derivative financial instruments to hedge price volatility, the impact of the new dispatching regulations on power generation, the role played by the single buyer and the effectiveness of the system set up to control possible market manipulations by the incumbents. From this point of view, the solution is clearly to lay down precise rules and avoid the protracted issuance of temporary regulations.

One question arises: how is it possible to get out of this static situation?

From a financing point of view, because few operators in the Italian market are able to finance projects on a corporate basis, it is necessary to find a way to overcome obstacles to financing new generation plants on a non-recourse basis.

As to the traditional scheme based on long-term, off-take contracts, the lack of flexibility afforded by PPAs is not conducive to their use in a situation of price volatility, which, in all probability, will be the case at the outset of the Power Exchange. In any event, their use is prevented by resolutions 78/99 and 123/03 of the Energy and Gas Authority, providing for a mandatory clause that allows the off-taker to withdraw from the PPA upon notice (this provision can be derogated if the off-taker is a wholesale customer but not if the off-taker is a final customer).

Alternative solutions are merchant structures and tolling structures.

In the initial phase of the Power Exchange, which is characterized by uncertainties, investors still do not favour so-called pure merchant plants because they are considered to be excessively risky.

Yet, it has been pointed out that investment on a merchant basis in the short term should not be markedly worrying due to the constant growth in demand and delays in the creation of new generation capacity. In the long term, however, these structures may, more than any others suffer the effects of competition.

Financiers consider tolling structures preferable to merchant structures. In particular, to spread the risks, the tolling scheme preferred by financiers seems to be the multi-toller scheme, possibly providing for automatic step-up of the remaining toller in the event of default. This structure seems to satisfy bankers' requirement to spread the project risks among several operators, thereby reducing the equity contribution made by the sponsors, while also bringing greater clarity and predictability.

So far in Italy, there are two examples of power projects funded on the basis of tolling structures. The first is the multi-party tolling agreement for the 6,300 MW portfolio of thermal power plants of Edipower (formerly Eurogen), the second largest Italian generator controlled by Edison, AEM Milano, AEM Torino and Atel. In this deal, the tolling structure was not only functional to financing the acquisition and repowering works, but was also underpinned by a wider industrial project.

The second example is the 100 MW Novel (a joint venture between Swiss Atel and Italian group Radici) co-generation power plant in Novara. In this project, tollers assumed fuel and off-take price risk by paying the producer a tolling fee structured by an availability fee and an off-take fee. Radici will use the power generated by the plant for internal purposes, while Atel will trade it on the Italian market.

As the risks in tolling structures lie largely with the toller, it is essential that the toller shows enough technical capacity to handle and supply the fuel and to trade the power, and, more importantly, that he can maintain an adequate credit standing through the tenor of the financing. In Italy, with few exceptions, not many potential tollers are able to maintain a credit standing considered adequate.

In addition to the above structures, other hybrid versions exist that have been tested in other European markets and are capable of mitigating pure merchant risks and, therefore, constitute an acceptable risk for recourse financing. In Europe merchant plants have been financed on a non-recourse basis where access-to-market risks (that is, volume, pricing and trading risks) have been mitigated through the use of several commercial agreements.

These schemes require banks to become aware of trading issues. In any case, whatever schemes the parties decide to follow, past experience has shown that there is no optimum type of structure and that even the strongest contractual scheme can amount to nothing if the fundamental requirements are lacking. In this sense, clear economic indicators exist with respect to the constant growth in demand for electricity and on the holding of price levels in Italy, at least in the short term. As a consequence, the choice of the most suitable scheme should not be dogmatic and rigid but it must be tailored to the specific circumstances and to the particular interests of the parties involved.