Pipeline financing

Publication | March 2014

Introduction

Pipeline projects present challenges that other energy projects do not present. Pipelines can run long distances. They can cross borders. They can even run under the sea. Few other assets share these characteristics. Commercial and legal risks therefore may require greater scrutiny. We have advised on over 70 oil and gas pipelines globally, as well as over 40 cable and interconnector projects. We are familiar with the issues that apply in all contexts, including financings, corporate, regulatory, construction and disputes. The ten things below are more focussed on pipeline financings.

01 | Project financing or financing a project?

Sponsors of a pipeline may fund the construction of a pipeline purely through equity contributions or other shareholder funds to the project company, but may also wish to obtain debt funding from commercial banks, export credit agencies and/or multilateral financial institutions.

Where the project company is borrowing from third party lenders in order to fund construction costs, the lenders will need to be comfortable that the gas/oil transportation agreement related to the pipeline is bankable, not least because the lenders will typically only have recourse to the revenue stream generated by the pipeline owner from transporting the gas/oil, and will typically have no recourse to any assets not related to the project. Transportation agreements will also typically be structured on an availability/send-or-pay basis, such that the project company is being paid a capacity fee if the pipeline is operational. The capacity fee would be sufficient to cover interest and principal on the project finance loan and other fixed costs. It would also be paid a separate variable fee to cover variable costs. That said, this is a traditional way of project financing a pipeline. There are also examples of lenders having recourse to additional revenue streams of the sponsors relating to the supply agreements.

Where different parts of the overall supply chain (for example, the upstream facilities, the pipeline, and the downstream facilities) are owned by different sponsors and being project-financed by different syndicates, the construction of a pipeline in that chain may be further complicated by the different syndicates’ competing interests.

02 | Corporate structure – IJV vs. UJV

A pipeline will often be developed by multiple parties which have an interest in either selling or buying the oil or gas. These parties may own the project by either an incorporated joint venture (“IJV”) or an unincorporated joint venture (“UJV”). The IJV structure is the more traditional form of corporate vehicle selected for pipeline and other project financings. Where a UJV is used, it gives rise to questions of how the pipeline and other assets are owned by the developing sponsors (eg, tenants in common), how are those ownership interests evidenced and what are the rights and obligations which attach to those ownership interests (eg, what are the funding obligations). Where one of the sponsors is seeking to project finance its share of the costs, then that raises additional questions that require its lenders to conduct extensive due diligence on the underlying UJV structure. Cross border pipelines may present additional corporate challenges if different segments are owned by different companies.

03 | Cross-border aspects

Pipelines which cross borders will inevitably operate under different legal and regulatory regimes. Consequently, it will be important on any pipeline financing to consider the implications of the lack of a single overarching legal regime. Often, the states through which a pipeline crosses will enter into a treaty or an inter-governmental agreement (“IGA”) setting out the rights and privileges which will be necessary for the construction and operation of the pipeline. It is also possible that an IGA will provide assurance to the lenders that the states involved will not interfere in their interest in the pipeline. Also important is any Host Government Agreement (“HGA”) that the pipeline company will sign with each host country. While the IGA reflects the political will to facilitate the pipeline project among the countries that the pipeline will cross, the HGA may set out the more commercial aspects of how each country will facilitate the pipeline project on its soil (eg, tax treatment, favourable conditions, import of materials and equipment). The Energy Charter Secretariat has produced model agreements for both the IGA and HGA.

04 | Sub-sea aspects

Where a pipeline contains an offshore section, the United Nations Convention on the Law of the Sea (“UNCLOS”) may apply. UNCLOS sets out the rights and obligations of the signatory states in their use of the sea and contains guidelines for businesses and the environment. Furthermore, it establishes the Exclusive Economic Zones (“EEZs”) of the signatory states. Broadly speaking, a state’s EEZ is the area from the shoreline to the point 230 miles out to sea. Where a pipeline passes through a state’s EEZ, it will be subject to that state’s legal regime. Generally, within a signatory state’s EEZ, entities incorporated in other signatory states may lay submarine pipelines, subject to compliance with any applicable local laws and regulations.

While most of the world’s states have signed and ratified UNCLOS, there are a few notable exceptions, such as the United States of America and Turkey.

05 | EPC structures

There are two common approaches to the contractual framework for the engineering, procurement and construction of a pipeline. The project company can contract all the required services through the EPC contractor alone. The EPC contractor will then be obliged, under the terms of the contract with the project company, to procure all necessary services, by itself contracting with, for example, the pipe supplier and the vessel charter company.

Alternatively, the project company can contract separately with each contractor. In this scenario, the project company would have separate contracts with a pipe supplier to supply the pipes and a contractor to build the pipeline; where there is a sub-sea element, it would also have a contract for chartering the vessels to lay the pipes. This gives rise to enhanced interface risk, although this would not necessarily make it impossible to obtain project financing as there are established mitigants to interface risk. That said, where the sponsors are seeking to obtain project financing, then this contractual structure becomes subject to additional scrutiny as lenders will wish to ensure that the contract(s) required to build the pipeline are as time and cost certain as possible.

06 | Regulatory and competition (antitrust) issues, such as third party access

Regulatory and competition (antitrust) law issues will need to be considered in relation to the construction and operation of a pipeline and merger filings to relevant competition (antitrust) authorities may be needed in relation to the establishment of the project company.

The regulatory and competition (antitrust) rules may require the operator of a pipeline to operate the pipeline in a way which is less than optimal with regards to its interests, and by extension, those of the lenders. For example, in the European Union, refusing third parties access to spare capacity in the pipeline could fall foul of the EU regulatory regime and/or infringe the competition law prohibition on the abuse of a dominant position within the market, since as a general rule EU law requires third parties to be granted access to a pipeline where capacity is available (subject to limited exceptions) on the basis of non-discriminatory and cost-reflective tariffs. Depending on the relevant jurisdiction through which the pipeline passes, the charge which the third party then pays the project company may be set either by the project company (and the project company may be obliged to publish such rates on, for example, an annual basis) or by that jurisdiction’s government.

It is, however, possible for major new infrastructure (including pipelines) to be granted an exemption from the regulatory third party access requirements for a certain period of time, since the European Commission and national energy regulators in the individual EU Member States recognise that investments in such infrastructure – whether cross-border or not – may be risky. An exemption may be granted if a number of conditions are satisfied. For example, it needs to be shown that the investment will enhance competition in the supply of gas in the EU; charges will need to be levied on any users of the infrastructure, and the level of risk attached to the investment should be such that the investment would not take place unless an exemption was granted.

The regulatory regime in the EU also requires the ownership and operation of a pipeline to be separated (“unbundled”) from any gas production, electricity generation and gas or electricity supply operations, which means that in many of the EU Member States the ownership of the pipeline and its operation must be fully separated from any production or supply operations.

07 | The importance of the transportation agreement

The transportation agreement is a vital component of a pipeline financing, as it will usually represent the sole (or at the very least, the main) source of revenue for the project to service its debt. The transportation agreement is typically an availability-based contract, where the basis of the shipper’s obligation to pay is (generally speaking) independent of whether or not it ships gas or oil through the pipeline. This is known as a ship-or-pay basis.

It is important that the ship-or-pay obligation of the shipper is sufficiently tight in order to ensure certainty of payment. Key considerations include whether the obligation survives the occurrence of an event of force majeure to the pipeline, whether the shipper has a right of set-off against any amounts owed to it by the project company, and whether local law impacts on the enforceability of such an unconditional obligation.

08 | Supply risk

A key risk to a pipeline financing is that there are either insufficient supplies to take up the pipeline’s capacity, or inadequate infrastructure to bring the gas or oil to the pipeline’s entry point. To a certain extent, the ship-or-pay obligations in the transportation agreement may mitigate these risks from the lenders’ perspective, but the project company’s ability to make full use of the pipeline will nonetheless be reduced if, for example, there is no shipper able to take up any unused capacity which is not subject to the initial gas transportation agreement.

09 | Connections on the other side

Similarly, a lack of adequate infrastructure or demand for the gas or oil on the other side of the pipeline can impact on the viability of a pipeline financing. Therefore, it will be important to ensure that a sufficiently robust set of gas or oil supply agreements and adequate interconnectors and other onward infrastructure are or will be in place by completion of the pipeline. Where project financing is part of the sources of funding, then lenders will wish to review the connection agreements entered into by the project company as part of their due diligence. Where the pipeline is cross border and the connection agreements are being entered in to with a state-owned operator of a pipeline system, their terms may be regulated by law and not necessarily subject to extensive negotiation nor may direct agreements/consents and acknowledgements always be available for lenders.

10 | Lenders’ security over the pipeline/contents of the pipeline

Lenders will take security over the proceeds of the gas transportation (and possibly supply) agreements, along with any other security which local law will permit, such as a pledge of other assets and the project bank accounts. In addition, lenders may require sponsor support from the sellers in the form of, for example, a completion guarantee or an undertaking to contribute further equity upon certain events occurring. Such support will generally fall away upon completion of the pipeline, and the lenders will only be able to rely upon their security over the project from that point onwards. Lenders may seek to take security over the pipeline itself, and/or over the gas/oil travelling through it, although this is not always possible where a cross-border pipeline is being project financed.


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