California Drought Adds Sense of Urgency to Desalination Project

October 24, 2014

LOS ANGELES — California's drought has added a sense of urgency to a proposal for a $900 million seawater desalination project in Huntington Beach, Calif. Orange County Water District board President Shawn Dewane said nearly every time he speaks publicly he gets asked why the desalination project isn't already finished.

The Huntington Beach plant would be built by Boston-based desalination developer Poseidon Water. Every major state water planning document includes desalination and California Gov. Jerry Brown's water plan calls for the production of 400,000-acre feet of desalinated water by 2030, Dewane said.

"In Orange County and Los Angeles, we are living on decisions made by bold decision makers 80 years ago," Dewane said. "They built projects like the Colorado (River) Aqueduct in recessionary times that were extremely expensive. People like me need to not look ahead to next year, but ahead 80 years and think about the people who will have to live with the decisions we are making today."

Voters will decide on Nov. 4 whether the state can sell $7.1 billion in additional general obligation bonds for water. Roughly $750 million of that would be split among regional water districts to create locally sourced water projects, like OCWD's proposed desalination plant. In coming months, the water district board will weigh funding mechanisms for the proposed desalination plant. Among the alternatives the OCWD asked consulting firm Clean Energy Capital to evaluate are those that would have the water district taking on more risk than the San Diego County Water Authority did for the very similar Poseidon Carlsbad desalination plant under construction 60 miles south. The risk would come if the triple-A rated OCWD issued the bonds itself rather than in a structure similar to SDCWA, where Poseidon and bondholders took on the lion's share of the risk.

The San Diego County authority did not irrevocably commit to pay for the plant; it committed to pay for water at an established price if water was produced, said David Moore, co-founder, chief executive officer and managing director of Clean Energy Capital. The tradeoff for OCWD taking more risk is that its triple-A credit would bring a lower cost of capital, resulting in cheaper water rates for consumers.
Poseidon proposed a plan of finance in Huntington Beach similar to that used for the Carlsbad plant, which is expected to come online in fall 2016 and produce 56,000-acre-feet of water annually.

In Huntington Beach, under Poseidon's proposal, two sets of bonds totaling $732 million would be issued through a conduit issuer such as the California Pollution Control Financing Authority. There would be $123 million in tax-exempt governmental bonds issued on behalf of the water district to finance construction of the pipeline from the plant, and $608 million in private-activity bonds for Poseidon to finance construction of the plant, which would be subject to the alternative minimum tax. The third piece would come from $160 million in private equity from an unnamed source. If Poseidon fails to provide the amount and quality of water agreed to or doesn't open on time, it would be responsible for debt service on the bonds. In Poseidon's Huntington Beach proposal, as in Carlsbad, the risk of constructing the project on schedule, on budget, and producing water meeting the water district's specifications would be transferred to Poseidon. All of those conditions would have to be met in order for Poseidon to get paid and, in turn, make the bond payments. The bond structure passes that risk on to the bondholders and private equity, resulting in a low-investment grade rating and higher cost of capital.

After bonds for the Carlsbad project were issued at triple-B ratings, the assumption is that the bonds for the Huntington Beach project would be rated the same if structured similarly. The savings for OCWD in the alternative proposal comes through issuing the bonds itself under the triple-A rating, Moore said. "So the bondholders would not be asked to take the credit risk, they would look to the OCWD's triple-A rating and say: 'I don't care if the project works or not, it's not our risk,'" Moore said.

Since the Huntington Beach plant will be the second such plant, not the first, that in itself makes Orange County's plant less risky for OCWD, Moore said. The analysis that Moore's company produced for the water district also looked at the cost if the private equity portion were replaced with municipal bonds. The savings if OCWD issued the bonds itself would be $120 per acre foot. If it also replaced the equity with municipal bonds, it would save an additional $220 per acre foot for a total savings of $340 per acre foot with the alternative financing plan.

If it issues the bonds itself, and incorporates a $340-per-acre-foot subsidy from the Metropolitan Water District of Southern California, the cost per acre-foot down would come down to $1242 per acre foot, according to Moore's report. That figure is still higher than the $970 per acre foot that MWD, a water wholesaler, charges member agencies like OCWD.
"The project even with subsidies and taking the risk transfers is still more expensive than MWD water, but it is a new water supply," Moore said. "It has different reliability characteristics." In order for the water district to be able to issue the bonds, Poseidon also would have to agree to allow the water district to share ownership, something Moore characterized as an unknown. Poseidon's business model has been to be a private owner entering a long-term P3 water purchasing contract with the water district, not to have a water district own the project, he said.

Poseidon's development strategy is similar for the two projects. Poseidon acquired sites co-located with power plants a decade ago, so the desalination plant does not have to break new ground in terms of the water in-flow and out-flow. Moore presented his preliminary report to the board at its meeting the first week of October. The board has another meeting planned in mid-November to further discuss the plan. Moore's company will then have until December to produce a final report incorporating comments and questions.

"There are many, many ways this agreement could be negotiated," said board president Dewane, owner of Newport Beach-based Dewane Investment Strategies, a Raymond James affiliate. "The risk characteristics could be transferred to the district, or held by Poseidon."

In addition to the 10 OCWD board members, the district also has 19 member agencies that will participate in the decision. While the water district considers the financial side, Poseidon is waiting on a third-party study the California Coastal Commission requested in November before it can move forward in the permitting process. The study is looking at whether it is feasible to use a subsurface intake system to draw seawater into the desalination system.

"We jointly convened an independent panel of scientists and they have been meeting for six months," said Scott Maloni, Poseidon's vice president of development and project manager for the Huntington Beach project. The scientists came up with two methods for drawing water into the system, one beneath the sea floor and one originally proposed by Poseidon where the pipes run directly into the ocean. He anticipates being able to return to the coastal commission in spring 2015.

"The project is fundamentally about reliability and creating a drought-proof reliable resource; and there is a premium for creating that reliability," Moore said. "The decision will be based on whether the constituency looks at the cost difference between $1200 and $900 as a good value for a drought-resistant locally controlled water supply."

Efforts to increase local water resources are a key part of MWD's long-term plan, said Deven Upadhyay, the water wholesaler's water resources manager. When the board found that costs to develop and maintain local water resources were preventing water districts from taking advantage of its subsidy program it made a decision Oct. 14 to increase the subsidies to $340 per acre from $250 per acre, Upadhyay said, and allow the subsidies to be used for desalination in addition to recycled water and recovered groundwater.

MWD wasn't meeting its long-term goals of increasing local water sources, he said. "We recognize that more can be done to expand available local supplies for the region and become more drought-ready," said Debra Man, MWD's chief operating officer and assistant general manager. "Since 2011, we have been working with our member public agencies to identify what actions can be taken to stimulate additional local resource projects and increase future reliability."

About Clean Energy Capital
Clean Energy Capital provides investment banking and financial advisory services to participants in the energy and infrastructure sectors.  Our core focus is project financing of energy and infrastructure assets, and support of companies engaged in project finance.