Creating markets for North American LNG: Emerging market power projects

This article was originally published in Gastech in September 2017.

With the significant growth of North America as an LNG exporter, investors in the North American LNG industry need to find buyers for LNG – at the same time, power demand continues to grow in emerging markets and, post-COP21, gas-fired power generation is perceived as a relatively low-carbon option for providing flexible generation.

LNG exporters that are able to effectively develop independent power projects (IPPs) in emerging markets can therefore capitalise on this as a strong source of demand for US LNG. However emerging market IPPs have complex risk profiles and multiple interfaces with the host country that differentiate them even from oil & gas investments in the same jurisdictions.

Many investors in the US LNG market have either been out of the power project development business for a considerable period or have limited exposure to market practice in emerging markets, so need to quickly understand the market characteristics and drivers underpinning emerging market IPPs; and the impact on their LNG business of selling LNG to integrated IPPs.

Over the course of part 1 and part 2 of this article, we will examine five key issues which emerging market investors will need to consider before making a decision.

1. Market structure: Power sectors in many emerging markets are partially or fully unbundled (generation, transmission, distribution and supply have been separated) and the sector is regulated by an independent body that supervises performance by sector participants through a licensing regime. The separation of the power sector functions from the state drives domestic utilities to avoid assuming what might typically be classified as ‘government’ risk (e.g. war, embargo, grid risk, etc). Many utilities struggle to achieve cost reflective electricity tariffs, resulting in a lack of creditworthiness. IPP developers and their lenders typically need some form of agreement with the host government to address this deficiency in the risk allocation (including to facilitate the availability of political risk insurance).

In markets where gas is not already available, generators typically procure liquid fuel from a relatively limited pool of suppliers or from a government owned monopoly supplier. The more capital intensive LNG infrastructure places a significant burden on the cost base of a IPP. Where the liquid fuel supply market tends to be flexible and offer multiple routes to market, dedicated LNG infrastructure drives the need for take or pay obligations that must be passed through the IPP to the electricity utility. In most successful projects of this kind, the take or pay risk is borne by the utility and/or host government, rather than the IPP.

2. Lack of direct recourse: The LNG supplier will not have direct recourse to the electricity utility or government (where there is a government support agreement) so must consider ways of mitigating this risk. Equity interests in the IPP can often provide sufficient comfort to an LNG supplier, but this exposes the LNG supplier to technology and other risks that it is not accustomed to. Collection account mechanisms can, in some instances, be used to provide some level of cash flow certainty to the LNG supplier.

This article is part 1 of a 2 part series. Read about the integration with indigenous gas reserves, equity exposure and interface issues in part 2.