Time For Desalination Plants?

Time For Desalination Plants?

July 09, 2015

California is in year four of a record drought. The governor has ordered a 25% cutback in water usage. Is it time to roll out plans for $1+ billion desalination plants? Large combined water and power projects are commonplace in the Middle East. Carlos Riva, CEO of Poseidon Water, and Sandra Kerl, deputy general manager of the San Diego Water Authority, talked about the economics of desalination projects at the Chadbourne global energy & finance conference in June. The moderator is Keith Martin with Chadbourne in Washington.

MR. MARTIN: Carlos Riva, you are working on a large desalination plant in Carlsbad, California between San Diego and Los Angeles, about 60 miles south of here. Let’s get some metrics. How much is the project expected to cost?

MR. RIVA: It is a $1 billion project. The financing of it was $930 million and then, in addition, the water authorities spent something like $80 million making improvements to their systems to be able to accommodate the water. The water is 50 million gallons a day, 365 days a year.

MR. MARTIN: How many households will that supply?

MR. RIVA: That is about 8% of the water supply for San Diego County.

MR. MARTIN: Is that the water supply of just the county or the city of San Diego, as well?

MR. RIVA: We will sell all of our water under a 30-year contract to the San Diego Water Authority, which is the wholesale agency, and they will resell the water to their members, who are the local water districts.

MR. MARTIN: How many districts can there possibly be in and around San Diego?

MS. KERL: We have 24 member agencies.

MR. MARTIN: I didn’t realize California had such an intricate government. Why do you need more than one water agency for San Diego?

MS. KERL: That’s a really long topic. [Laughter.]

MR. MARTIN: Carlos Riva, how long is it taking to build the Carlsbad project?

MR. RIVA: The construction is fairly straight forward. We have a contract that guarantees no longer than a 35-month construction period. We are trending a little ahead of that, so we expect to be commercial, knock on wood, by the end of September or early October 2015, which will be two months ahead of schedule.

MR. MARTIN: Do you expect a shakedown period before the project is fully operational?

MR. RIVA: That includes the shakedown period. We are in commissioning now. The plant is more than 95% complete and so we are wet commissioning it now and then there will be a 30-day acceptance period at the end of which the plant will be commercial and sales will commence under our water contract.

Economics

MR. MARTIN: In the Middle East, these projects include a power plant and a desalination facility. Yours produces only water. Where are you getting the electricity from to run it?

MR. RIVA: Our plant is different than many of the desalination projects in the Middle East that use a distillation process. Ours uses a reverse osmosis process, which uses high pressure to drive water through special filters that purify the water, and that is driven by electricity rather than thermal processes. We get our electricity from the grid, from San Diego Gas & Electric.

MR. MARTIN: You are paying a retail rate?

MS. KERL: In the water purchase agreement, the risk for energy usage per unit volume of water is on Poseidon and for the price is on the water authority. The water authority has the ability to supply power to the project at any time. We are looking at all of our options, including the possibility of building a hydropower pumped storage project with the city of San Diego.

MR. RIVA: We have the ongoing incentive to try to find ways to reduce the energy consumption for each unit of water produced. There is a lot that can be done as new technologies for membranes and the like start to be developed over the life of the plant.

One thing again that I found very interesting about this technology is, unlike those of us that have been used to large power projects, where when you buy your turbine, for instance, you have that turbine for life and the turbine represents a major single point failure potential and also a major expense.

Here, out of a $1 billion project, the cost of the membranes is something like $10 million. There are 14,000 of them. They last maybe five to seven years, so you are constantly in a position of monitoring and swapping them.

A lot of people may have heard some of the new innovations in membranes with new materials, graphene and the like. We have the ability to introduce those technological changes into our plant as part of the normal process of maintenance, and that is where we see a lot of future benefit in reducing energy.

MR. MARTIN: A lot of benefit, but also continuing high capital costs to replace these membranes?

MR. RIVA: No. No. Absolutely not. The cost is already factored into the O&M budgets for the units going forward.

MR. MARTIN: Let’s talk about financing. You used $734 million in tax-exempt debt. You said it was $930 million in total financing. How was the balance covered?

MR. RIVA: The balance came from an infrastructure fund, Stonepeak Infrastructure Partners, and they are the source of the permanent equity for the project.

MR. MARTIN: So the balance up to $930 million was equity. The water authority provided $80 million. In what form did the water authority provide that?

MS. KERL: In addition to the plant, there is a 10-mile conveyance pipeline to get the water into the water authority system, and then the water has to be pumped up quite a distance. We put in a pump station as well as made improvements to our water treatment facility to accept the water.

We will be moving the water in our aqueduct in the opposite direction than it moves today. We had to strengthen that aqueduct pipeline to withstand the pressure, and that accounts for the $80 million.

MR. MARTIN: So about 73% of the capital cost was debt, the balance equity. What sort of returns were the equity investors promised?

MR. RIVA: It was actually 18% equity and 82% debt. The extra $80 million dollars that Sandy spoke about was not part of the financing. That was done by them.

I think that the returns that the equity investors were looking at were consistent with the kind of returns that large infrastructure projects that have 30-year take-or-pay offtake contracts would expect.

MR. MARTIN: So high teens?

MR. RIVA: I wish, but no.

MR. MARTIN: The Carlsbad project was 12 years in the making, right? You had to work through the regulatory maze. I think you spent six years getting permits. Do you have other projects that are equally far along?

MR. RIVA: Our next project is just up the coast in Huntington Beach. It is a similarly-sized project. We think we are about a year away from starting construction, so that will be another 30-some months of construction.

That project has most of its permits, although It is missing one critical one from the California Coastal Commission. We have signed a term sheet with the Orange County Water District to sell the full output of the unit for, in this case, 50 years.

Offtake Contract

MR. MARTIN: Sandy Kerl, you signed a contract to buy the output from Carlsbad for the entire output from the plant. But there is a minimum take requirement. You have the option to take above that.

MS. KERL: Yes, our minimum take is 48,000 acre feet a year. The plant can produce up to 56,000 acre feet a year. If we take that additional increment, it is only at the variable cost, so there is an incentive for the water authority to take it.

We wanted to ensure that we were only committing to take the amount of water that we believe we can use. However, given where we are in California, in the fourth year of a drought, I suspect that we will probably be heading upwards of the top limit of the plant. Nevertheless, we wanted to ensure that we were not taking water and storing it from the plant.

MR. MARTIN: What happens if the water authority does not take more than 48,000 acre feet per year? You simply produce at the lower number? There is no one to buy the extra output?

MR. RIVA: We don’t produce it, but we will recover all of our costs at that level of output.

MR. MARTIN: Sandy Kerl, is your payment solely the equivalent of an energy payment –- it is just for water taken –- or is there also a capacity payment?

MS. KERL: We are purchasing water. We take the amount that we have committed to. If for some reason we can’t take it under certain conditions, we still pay for the water, but we do not pay for anything unless Poseidon delivers the water at the quality and consistency that we require.

All the risk for operating is on the project, and the obligation to the water authority is to make that minimum 48,000 acre feet purchase a year.

MR. MARTIN: In terms of cost, I think you buy your water currently from various sources, correct?

MS. KERL: We have several sources. We get about 48% of our water from the Metropolitan Water District, which takes water from the Colorado River as well as the Bay Delta project. We also have something called the Quantification Settlement Agreement, where we have done a deal with the Imperial Irrigation District to get water that has been saved through farming conservation.

That is our water that comes directly to us. Then the desalination project is a next increment to make sure that we have a diversified portfolio of water. It will represent up to 10% of the total water needed in San Diego County.

MR. MARTIN: How does the amount you pay Poseidon compare to what you pay others for water?

MS. KERL: There are two markers to look at on that. Today, it is about double the cost of what we pay to Metropolitan for water, but over time those lines will cross. Because we have a contract and specific provisions for how costs increase, we have some level of control.

We do not have similar control over the Metropolitan water. We believe the cost lines will cross in about the 2020s. If we try to develop other new sources of supply – for example, potable reuse projects and water that is conserved from the lining of earthen canals, the All-American and Coachella canals — the cost of that water will be what we are paying for desalination. The next new increment is double what we are paying today. There is no cheap water available.

MR. MARTIN: This is a concept with which we are familiar in the power industry with front-loaded power contracts, where the utility pays more up front to allow the project to get financed in exchange for paying less later.

In a way, this is an insurance policy. You have a 30-year water contract. You are buying insurance for 8% of your supply, yet you are down more than 8% currently in the state due to the drought. Would it make sense to buy more such insurance?

MS. KERL: It is a balance of risk and cost, and right now I think our board feels that we have the right balance, but over time, we will be continuing to look for opportunities for sources of supply.

We are doing some pilot testing of a desalination plant out on Camp Pendleton. That project, if it moves forward, is probably an early 2030 project that could be the size of Carlsbad or even three times the size of the Carlsbad project.

MR. MARTIN: And that would be one you own?

MS. KERL: Potentially.

MR. MARTIN: Just to put things into perspective, the Carlsbad project is the largest in the Americas, correct?

MR. RIVA: That is correct.

MR. MARTIN: And there is a large number of desalination plants already in the US, but they are small.

MR. RIVA: That is correct. The second largest, in Florida, is about half the size of Carlsbad, and then there are many that are a tenth the size or smaller.

Fickle Climates

MR. MARTIN: Sandy Kerl, there was a long article in the New York Times, and there was a similar one in the Los Angeles Times recently, that suggested we will not see any more desalination plants in California because, by the time they are built, the rains will return and they will be shut down.

MS. KERL: Don’t we wish.

MR. MARTIN: What do you think the appetite is among water agencies in California for more of these plants?

MS. KERL: I think all eyes are on the Carlsbad project right now, and after four years of drought, we do not know what will happen in 2016 and beyond. We will continue to be in more drought years than wet years, so looking to a new source of water supply for the west should be something in which many communities in California are interested.

MR. MARTIN: Carlos, those two newspaper articles also mention that Santa Barbara built a desalination plant, at a cost of $34 million, in the late 1980s. The plant was completed in 1992, by which time the rains had returned.

It was put through start-up testing, and then immediately mothballed. Australia spent something like $12 billion on six desalination plants in 2006. By 2012, four of them had been shut down. What do you think when you see such statistics? Is this a good business to be in?

MR. RIVA: It is a fair question. I think Santa Barbara is a bit of a different case because the technology has moved on so much since the 1980s, and they are putting another one in. It will use more modern technology and will be maybe four times more efficient from an electrical standpoint.

I think Australia is a different case, too, and it is not a uniform case. In western Australia, the plants are operating, and they are an essential part of the supply. Eastern Australia went through a prolonged drought. They were built as an insurance policy.

When the rains returned, they did not need the coverage, but by the same token, you cannot look back at life insurance and complain because you didn’t die.

Southern California is very different as well because these projects were not built to address a drought. They were begun well before this epic drought. Part of the motivation was drought that occurred back in the 1980s and early 1990s, but nevertheless, they were built to secure a local supply of water because San Diego County has enough water for only about 10% of its needs.

The balance back then was all imported, as Sandy said, so they really wanted a local supply because it was drought-proof and because the water coming from long distances was subject to all sorts of other hazards, including seismic risk and the like.

Over time, this is a lower cost option than continuing to buy imported water from other sources, so there are a lot of compelling drivers for that. Those are not going to change when the rains finally come back.

MR. MARTIN: Why not?

MR. RIVA: Because I think those same drivers will be there; people want to have a local supply. Water is too critical to them to leave it to chance of either drought, politics or earthquakes, and they want to be able to control it in ways that they can’t with imported water.

MR. MARTIN: Sandy Kerl, you negotiated the contract with Poseidon Water. What was the one biggest impediment to reaching a deal? The toughest issue.

MS. KERL: I think the biggest challenge was for us to come to an understanding about the difference between the public sector and the private sector. Everything we do in the public sector has to be completely transparent, so every cost component and every aspect of the deal we struck was subject to public review and comment.

I can’t speak from the private sector because I have not been in the private sector, but for Carlos it was like, “What do you mean we have to share this with everyone?” We have to be fully up front with where the costs are coming from and what the rate of return is.

That was challenging, but once we got over that hump and came to a mutual understanding, I think we had a very powerful working relationship. Once we got the water purchase agreement done, we went on the road and met with investors together.

It was really a public-private partnership. It is a BBB minus rated project and the fact that the water authority, which is a AA plus credit, was the sole offtaker of the water helped in terms of the overall financing package. I think it is the transparency.

MR. MARTIN: Carlos, what did you take away as a lesson from the experience at Carlsbad that you will apply to the next project?

MR. RIVA: I think Sandy hit on it. It is the fact that doing deals with municipal agencies is very different than doing them with corporates, especially when you look at Sandy’s board, for instance, with thirty-some members.

MS. KERL: Thirty six.

MR. RIVA: A number of those are elected officials, which means that you are actually doing a deal with the electorate, with the public, and they have demands for transparency. They want to know how you got to the outcome.

It is not like going into a room with closed doors and negotiating, coming out and saying, “This is our deal, isn’t it great?” They want to know every step along the way.

That was a revelation for us because we had not really experienced it in the power sector. Sandy touched on it: even though this is a bilateral contract where we produce water and sell it to them, we had to get over the mental construct of that to understand that this is really a partnership. It was never going to happen until the water authority was comfortable that everything was done according to standards that would meet its requirements for transparency.

Also, Sandy at one point said to me, “This may well be fine; that’s a contract, but you have to understand that if you guys screw up and something happens to the contract, it is still 10% of our water supply, so we need to own that.”

Once that got through our thick skulls, we made a lot of progress. That lesson is something that we will bring to the next negotiation.

MR. MARTIN: It sounds like the good relationship the two of you developed during negotiations was central to pulling off the project. It also sounds like the best time to do a deal like this is right after an election, rather than becoming tied up in the election, with 36 board members having to comment, many of whom are elected officials.