Middle East Economic Survey

VOL. L

No 46

12-November-2007

REGIONAL/GCC

Power Generation In The Middle East:  Can The Boom Continue?

By Hisham Khatib

The following paper, was presented by Dr Khatib to a recent conference in Bahrain. The author is Chairman of the Jordan Electricity Regulatory Commission and Honorary Vice Chairman, World Energy Council.

Growth Of Electricity Demand In The Middle East

In spite of economic considerations, the Arab region, in contrast to the rest of the world, always witnessed very high growth in electricity demand. Whereas electricity demand in the world is now growing at an average rate of 2.6% annually and in developing countries at twice this rate, the Arab region witnessed an average growth rate of 6-8% annually over recent years. In spite of the fact that electricity and energy demand worldwide are being gradually rationalized, that in the Arab region is still growing and increasing at high rates.

This is not only caused by oil income and economic factors but also by the existence of subsidies. Existence of subsidies renders economic models, which relate power consumption to economic growth, irrelevant. In the Gulf, and due to subsidies, electricity use continued to grow at a very fast rate, even when economic growth was not healthy and per capita incomes were declining. Correspondingly, economic models cannot be applied to most countries in the Arab region because prices do not reflect cost, and the value of the electricity bill is only a small proportion of household incomes. Of course, the harsh summer weather in the Gulf countries dictates intensive electricity use, particularly for air-conditioning and water production, and is increasingly laying a heavy burden on electricity networks and facilities. During the 1990s, regional economic growth averaged 3.2%, while electricity consumption was almost double this at 6.1% annually. Table 1 demonstrates the fast growth in electricity demand in the Arab region during recent years.

Table 1

Arab / World Comparison

e = estimated

It must also be realized that due to climatic conditions, high demand in summer and low winter demand, average utilization of facilities in the Arab region is quite low adding to economic cost.

Generating facilities and the network could not always keep pace with this increasing demand. Reserve margins dangerously decreased or became non-existent. Power shortages are not uncommon in the Gulf States and are quite common in some other Arab countries. Besides the economic cost of such shortages they also cause serious disruptions to normal life and availability of water (during summer). All this necessitated accelerated power projects and huge investments which are straining governmental resources and thus calling on new financing arrangements, other than the traditional governmental financing. The capabilities of international power suppliers and contractors are also being tested, leading to higher prices, project bottlenecks and delays. (Arab generation statistics and fuels used in electricity generation are detailed in Annex 1 and 2.)

Investment Requirements

Recently the Arab Petroleum Investment Corporation (APICORP) carried out a detailed study into investment requirements in the power sector in the Middle East and North Africa (MENA) region over the five-year period (2007-11). It estimated that the Arab countries are expected to build 48gw of new capacity over that period, thus raising the power generation capacity from 138gw in 2006 to 186gw in 2011, ie by 35% in five years, an average of 6.2% annually. This is the same high rate that has persisted on average over the last two decades with capacity and output doubling every 10-12 years (these were the rates that existed in Europe prior to the 1973 oil price adjustment).

Total generation investment requirements, at an average of $1,000 per KW, add up to $48bn over this five-year period and average almost $10bn per year. When the transmission, distribution and control requirements are added, these investments add up to $80bn (at a ratio of 60% generation, 40% network), ie $16bn per year. Such figures exclude the huge investments in the water part of the combined water and power producing facilities. Most of these investments are likely to be in Saudi Arabia where average electricity investments (including water desalination) are expected to average $5bn every year for the next five years ( see Table 2)

Table 2

Capacity Increments and Investments

In October 2007, APICORP revised its estimates. It estimated power generation facilities to grow by 70mw over the 2008–12 period and increased power generation investments in the Arab region to $70bn, an average of $14bn per year over the coming five years. It also predicted that IPPs/IWPPs would account for 40% of these facilities. The rest will be government owned and financed. Of the IPPs investment, equity will represent only 25% of capital requirements, debt the remaining 75%. In a few cases and due to the limited risk in power generation a 85:15 debt:equity ratio is not unusual. It can be estimated that total power sector investments including networks, will be around $120bn (2008-12).

To demonstrate the significance of the Arab figures they have to be contrasted with the global ones. The International Energy Agency (IEA) estimates that the average growth in power generation facilities globally averaged 3.1% annually over the last 10 years, dropping to 2.6% over the period 2004-30. The Arab growth figures are more than twice these figures demonstrating the huge power boom in the Arab region (see Table 3).

Table 3

Future Electricity Demand (GW)

The Gross Domestic Product (GDP) in the Arab world, in 2006, was around $ 1,150bn with a gross capital formation of around 20%, ie $230bn. Over the period 2008-12, we can assume that this figure will grow by almost 30%, in current figures, ie will average around $300bn on average per year. This means that around 8% of Arab investments will go into the power business over the next few years. This may be a slightly exaggerated conclusion because of the increasing IPP investment. However, it can be safely said that around 6% of Arab generated investment will go into the electricity sector during the next few years.

Power Generation Contracting Procedures

Traditionally in the Arab region all power projects were government financed and government owned. In recent years, huge financing requirements necessitated implementation of reforms to moderate governmental involvements in the power sector, with increasingly governments leaving investments in the power sector to private investors (local as well as foreign). Increasingly power/desalination projects are involving independent power/water producers (IPP /IWPP). These are limited-liability partnerships that allow for long-term power (or power–water projects) that sell their products to the incumbent utilities (usually a single buyer model). Payment obligations are generally guaranteed by governments but increasingly semi-sovereign or no guarantees are becoming not unusual. Project ownership can be in the form of build-own-operate (BOO) or a build-own–operate-transfer (BOOT) arrangements. These are expected to meet 40% of the Arab region capacity increments over the next five years.

IPP/IWPP investments are generally undertaken on a project finance basis. Project finance is based on a non-recourse or limited–recourse structure where equity and debt are paid back from the revenues generated by the project company and the project assets are generally pledged as collateral. As indicated earlier, the overall capital structure of the power sector is likely to be 75% debt and 25% equity on average for the whole region. However given the tendency of private investors to seek higher returns, recent IPP/IWPP have exhibited a much higher leverage of 85:15. Furthermore, to compensate for the risks associated with longer maturity (up to 22 years) lenders have tended to set loan margins higher than for the other downstream projects such as refining, petrochemical, LNG or GTL plants.

Most electricity projects in the Arab region are still being executed by engineering, procurement and construction (EPC) services. As EPC services continue to outstrip supply and costs ratchet higher, project sponsors and financiers are not the only ones facing challenges. Contractors constructing the growing list of new projects are also subject to procurement pressures as prices and lead time for raw materials and basic engineering items escalate. Consequently electricity project costs are rising rapidly much higher than global or local inflation. It is a case of local demand outstripping, or at least heavily straining, global supply. Also IPP and IWPP projects costs are inflating rapidly. All this is not only straining local resources but will also cause a significant increase in costs of electricity production necessitating future tariff reviews.

Jumbo Projects

The size of electricity contracts are becoming huge. This restricts competition because only few firms/consort-iums can manage the risks, finances and manpower involved. All this is leading to uncertainty, project risks, delays and cost escalation. In jumbo projects (some Arab power projects can be so identified), increased lead times and prices are fundamentally changing the EPC business. As a result, the lump sum turnkey contract (LSTK), which has been the mainstay of much project development, can no longer be typical. Most recent regional jumbo contracts (outside the power sector) are open book conversion, where EPC contractors agree with a sponsor in advance on a margin or fee for their services. EPC contractors then conduct procurement on an open book basis allowing the client to view costs. The books are closed (the contract is wrapped) at a late stage (with around 85% of the engineering completed) and then converted to LSTK, and only at client request. Amid rising materials costs, project sponsors find that open book conversion contracts are a more cost-effective option. If EPC contractors are asked to price on an LSTK basis, they will assume a worst-case scenario on procurement costs. Rising material costs are to be blamed for almost one quarter of project cost increases, shortage of contractors and skilled manpower causing the remainder. Such contracting arrangements are not unlikely to be introduced into the power business.

The Saudi Electricity Company (SEC) expects to spend SR190bn ($50.7bn) over the next 10 years to meet the projected increase in demand for electricity and desalination. By 2024 the kingdom's population may exceed 50mn (up from 25mn now) and will require 70gw of electric power.

In its new procurement, SEC noted that developers were not bound by detailed specifics on the engineering, procurement and construction (EPC) contracts and could, instead, respond to general requirements. Thus, the developer has latitude to adopt technologies improvements as long as specified performance is met. SEC is taking the IPP route to enable it to fund the extra facilities needed as a result of climbing residential and industrial demand, and to attract private sector investment, both domestic and foreign, in the power industry. It plans to expand ownership through future initial public offering (IPOs). The IPP model will help the company to avoid the mismatch between the long life of a power plant and the short-to–medium financing terms that are typical on corporate loans. The ownership in the plants is anticipated as 10% for SEC, 60% for developers and another 30% for third parties (or additional developers or SEC take if no other parties are present). Projects will be implemented on a BOO basis. SEC's funding needs will be met in part through the launch of Sukuk (Islamic leasing bonds) and a road show to promote the issuance took place last summer.

Can The Power Boom Continue?

The quick answer is yes. The boom is driven by few fundamental factors:

• Unfortunate existence of subsidies which do not encourage rationalization, or efficiency in use. This is likely to continue.
   

• Abundant availability of cheap resources – particularly in feed gas and fuels.
   

• Rapid economic growth in the whole Middle East region, mainly driven by high oil resources and prices. Sustainable high oil prices have become part of future global scenarios.
   

• High population growth: the population of Saudi Arabia is speculated to grow at an average of 4.2% annually for a few years to come. The same applies to almost all Gulf States, while a more moderate, but still high growth figures apply to other countries in the region.
   

• The continuing and growing need for desalinated water, mainly in the Gulf region, but also increasingly likely in other countries.

Of course there are other factors that are likely to moderate this growth, most important being the growing financing requirements, the need for restructuring, the increasing numbers of IPPs/IWPPs, the growing cost of EPC contracts and difficulty in concluding them, the size of generation/desalination projects and the shortage of appropriate suppliers/contractors, the shortage of natural gas, etc.

Interconnection of the Gulf countries’ networks will also reduce the combined peak and need for new generating facilities to meet it. But all this is marginal. The fact is that the fundamentals explained above have not changed and are not likely to change markedly over the next few years. APICORP also estimated that demand would grow around 6-6.5% annually over the coming five years. Correspondingly in the medium term, ie until 2012, power growth is going to continue to be rampant around 6-7% annually; the longer term, beyond 2012, is not likely to be much different.

References

This article benefited from the following sources:

Economics Commentary – APICORP Research, January – October 2007.

Arab Union of Producers Transporters and Distributors of Electricity (AUPTDE) Annual Statistical Bulletins.

International Energy Agency (IEA), World Energy Outlook 2006.

UN – ESCWA, Energy Statistical Review – West Asia.

Arab Fund/Arab Monetary Fund, Annual Arab Economic Report 2006.

Middle East Economic Survey (MEES): Various Issues in 2007.

Annex 1

Arab Electricity Generation 2006 and Power Fuels

Neg: Negligible.

Source: different country sources. Sum differs from that of Annex 2, which is the AUPTDE figure.

Annex 2

Arab Generation Growth

Figures 2000-02 estimated.

Figures for year 2003 onwards – AUPTDE Annual Statistical Bulletins.