Alluminium Smelter-5 Model

8/8/2019 Alluminium Smelter-5 Model

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Green land Alum in ium

CRU STRATEGIES conf ident ia l

Chapt er 5Ow nersh ip m odels

SummaryIn this section we consider four potential ownership models that we believe are available to the

Greenland government. A brief introduction into the mechanics of each option is followed by a

comparison between them based on the risk factors involved and their potential implications for

the success of the project. This comparison will form the basis for our recommendation.

It is worth noting that although some benchmark examples are outlined in the introduction,

the nature of the Greenland project is such that only tentative links may be drawn between these

examples and the problem at hand, and therefore our final recommendation is based on risk

management considerations alone. The remote location of the power source makes it impossible

to consider the energy supply outside the context of the smelter. Equally, the proposed smelter

has been purposely located in Greenland for cheap power that it cannot source elsewhere. There

is therefore an even stronger mutual dependence than usual between the smelter and its

dedicated power source. Added to this are the logistical peculiarities of building a three-plant

network and preparing an adequate flat location for the positioning of the smelter in a harsh

environment.


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1-2 Greenland Alum inium ch a p te r 5

CRU STRAT EGIES conf ident ia l

Inextricably linked, or stranded individual assets

there is no alternativecustomer for the powergenerated by the plants

Greenland was chosen as

smelter location preciselyfor cheap energy


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Green land Alum in ium chap te r 5 1-3


1. The ow nership optionsThe following four options were identified on the basis of our perception of the Greenland

Governments aims, expectations and potential budget. The merits of each alternative will be

discussed from a risk management perspective in the next section.

1.1.Water r ight s Selling the water rights for the area to Alcoa would effectively mean no active involvement

in the project on behalf of the GHR. Alcoa would remain responsible for building the

infrastructure it requires, both for the smelter and for the power plants.

The GHR would incur no significant costs under this alternative. GHR can nevertheless generate both income and a market-related profit, through a

combination of the following:

A. A one-offup-front nominal fee: this would give Alcoa the right to operate within thestipulations of the contract;

B. A moderate fixed price per MWh, which would guarantee a meaningful income;C. An escalation fee proportional to the price of aluminium once it exceeds a defined

threshold, with a built-in accelerator if the individual projects return exceeds a defined

amount; to compensate for this premium, the GHR can offer long term ownership of the

energy resource;

D. A minor interest in the project in the form of shares.

Ownership options for GHR

GHR SmelterParticipation

GHR

Hydropowerparticipation

WATERRIGHTS

SOLE

POWERSUPPLIER

JV POWER

SUPPLIER

JV PARTNERIN

INTEGRATEDPROJECT

No active participation in project

X % participation in hydropower

100 % control of hydropower

Y % participation in smelter,Y % participation in hydropower

WATER RIGHTS

JV POWER SUPPLIER

SOLE POWER

SUPPLIER

JV PARTNER IN

INTEGRATED PROJECT


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Probably the best example of such a scheme being used are Alcans smelters in Canada, such

as Grande Baie, Beauharnois and Laterriere. All three are powered by self-generated

hydroelectric power from rivers in Quebec, where Alcan holds the water rights in perpetuity

(with the exception of Peribonka river, where the contract runs out in 2058). Alcan pay an

annual charge to the Quebec provincial government based on total energy generation in the

province, escalating at the same rate as the Consumer Price Index in Canada. The rights for

these rivers were contracted before 1970, hence the advantageous terms for Alcan. Already in

1984, when the contract for Peribonka river was negotiated, Alcan was tied to an annual

payment based on sales realisations of aluminium ingot, ensuring that the Quebec provincial

government participate in any upside generated by strong aluminium prices. The reason this

example is relevant is that at the time the initial contracts were signed, Quebec was more or less

in the same position as Greenland is now: the Canadian government in the 1940s wanted

economic activity in the sparse North-West, while Alcan wanted a location for smelters that had

both ocean access and, crucially, cheap energy. Nevertheless, the competitive nature of todays

global market, as well as the strong demand for aluminium should enable the GHR to push for a

more favourable agreement.

The North Atlantic:

cheap energy, small economic density

Alcan 1943-68

Quebec rivers

water rights inperpetuity

annual tax per

energy produced

escalator based

on CPI

1984, Peribonka

water rights till2058

annual tax persales of Al ingot

Alcoa, 2008

Greenland

? long-term waterrights (2038)

? up-front payment

? annual tax perenergy produced

? escalator basedon Al price

? potentialaccelerator once

the projects

returns exceed athreshold

? shares in project


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1.2.Jo in t Venture par tner in pow er supp ly Depending on the available financing, the GHR could opt to become a minority or majority

partner in a Joint Venture with Alcoa that only covers the energy side of the project.

The GHR would have to contribute to the cost of construction, but would incur smalloperating costs. Therefore the Greenland government would need initial access to cheap

capital, for instance infrastructure subsidies from the Danish government.

Alcoas smelter would not run on self-generated energy, but would in effect purchase theenergy from the Joint Venture company. Two basic types of tariff arrangement exist at

present:

A. Power price-relatedUnder this arrangement, the smelter would purchase power from the Joint Venture based on

a fixed base price to which an escalator is applied. The aim of the GHR would be to secure a

profit proportional to the global increase in energy prices, which can be achieved in twoways that are not necessarily mutually exclusive. Firstly, the escalator would have to be an

index reflecting price changes (similar to the Alcan example, where it was the Consumer

Price Index).

Secondly, the Greenland government, as owners of the power source, can attempt to

lock the position of the power provided to the Alcoa smelter on the global smelting power

price curve. With hydropower operating costs remaining low regardless of the global energy

context, such a measure introduced in the contract with Alcoa would guarantee that

whenever energy prices increase, the profit margin increases proportionally. Furthermore,

this is an attractive option for the smelter, as it guarantees that it remains competitive in

terms of power costs.

Locking in the profit: establishing a fixed position on

the tariff curve

tariff

production

2007 prices

2012 prices

2017 prices

2007 position onthe curve is fixed

minimum tariff

threshold


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1-6 Greenland Alum inium chap te r 5


B. Metal-relatedThis arrangement basically ties the power tariff to the price of Aluminium, so that the owner

of the power plant, in this case the Joint Venture, can take advantage of the profitable

commodities market. The formula for the calculation of the tariff can be proportional to the

aluminium price as traded on a major exchange such as the LME, or it can include

thresholds, where the proportion between power tariff and the price of aluminium is

variable according to certain aluminium price brackets stipulated in the contract. The

percentage of the aluminium price that will determine the power tariff can also be

renegotiated periodically. Below is an example:

1.3. Sole suppl ier o f e lect r ic i ty

This is the most expensive option available to the GHR, involving the building and fullcontrol of the hydropower plants. For this option to be feasible, a very sizeable capital fundwould have to be available to the GHR at relatively low interest.

The building of the power plants would have to begin between 15-30 months prior to thestart-up of construction for the smelter, as construction time is longer.

The Greenland government would set up a company independent of the smelter project tocommission the building of the dams and power plants.

The Alcoa smelter would then purchase the electricity from the GHR. The same types oftariff as above would apply.

This type of fully split ownership between the power source and the smelter is very common

throughout the world. The difference is that most often the smelter is the priority customer for

Venalum

State-owned Edelca increases the power tariff,but there are no thresholds

0%

5%

10%

15%

20%

1997 2001 2006

Power tariff

proportional to

LME aluminium

price

Example

If LME price = $1500/t

Power consumption = 14.8 MWh/t

Tariff = 16% = $16.2/MWh


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the power, but not the only available customer. The implications of this distinction will be

examined further in the next section.

Smelters that secured long-term energy contracts before 1980 generally still benefit from

simple, inflation-escalated contracts. By contrast, contracts concluded after 1990 are almost all

short- or medium term, metal-linked, and contain some provisions regarding escalation based on

the increase in the global or regional price of energy. These are more advantageous for the

hydropower owner and allow for more flexibility and renegotiation.

1.4. Jo in t Venture par tner in an in tegra ted projec t The GHR would commit to part of the investment in an integrated project that includes both

the hydropower stations and the smelter.

The share of participation would depend on the availability of viable capital. Alcoa would no longer purchase the energy, which would in effect be self-generated. The Greenland government would gain profits only from the difference between the price of

aluminium and that of alumina.

Given the strong interdependence between hydropower and smelter, this option appearslogical.

Joint Venture enterprises in primary aluminium production are a fairly recent trend, most

apparent in the projects set up in the Middle East and Asia. The giant EMAL smelter due to be

built in Abu Dhabi for a capacity of 1.4 mtpy will source power from a dedicated 2000 MW gas

power plant. The project is a 50-50 Joint Venture between Dubal and Mubadala and will

become the biggest single smelter in the world. A similar deal was struck between Qatar

Petroleum and Hydro for the building of Qatalum smelter and its dedicated 1350 MW gas-fired

Comparable smelters, vividly different deals

Mosjen, Norway (189,000 tpy), 100% hydropower

Power purchased mostly on the basis of 1950s and 1960s contracts.

Fixed long-term contracts.

Only escalation mechanism is local inflation.

Good deal for the smelter, BUT the contracts run out in 2007

THE FUTURE ?

Sundsval, Sweden (103,000 tpy), 100% hydropower

Power purchased on medium-term contracts (4-5 years).

Terms related to the aluminium price.

Escalation is based on prevailing forward power market prices,with a defined floor and a ceiling: HIGHER TARIFFS


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power plant. The Russian state has stated it is prepared to finance a third of the Boguchansky

smelter project, including a dedicated hydropower plant expected to cost $1.3 bn on its own.

Of the existing smelters, the most relevant is Asahan smelter in Indonesia, owned jointly by

the Indonesian state (41%) and Nippon Asahan Consortium (59%). The smelter is powered by a

dedicated hydroelectric plant on Lake Toba in Sumatra.

Major Joint Venture integrated smelters and projects

EMAL

(1.4 mtpy)

Dubal &

Mubadala

2000 MW (gas)

QATALUM

(585,000 tpy)

Qatar

Petroleum &Hydro

1350 MW (gas)

BOGUCHANSKY (600,000 tpy)

RusAl & Unified Energy Services

1500 MW (hydro)

ASAHAN

(255,000 tpy)

State & NipponAsahan

Consortium

447 MW (hydro)


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Green land Alum in ium ch a p te r 5 1-9


2. Econom ic Risk fac torsThe success of the Greenland smelter project from the perspective of the GHR depends on the

successful management of two key risk factors. The first is the potential cost of building the

hydropower network relative to the likely profits that ownership of all or part of that network

would bring. This is a risk that would primarily result in a heavy loss of invested capital,

although it does have some implications for profit opportunities. The second fundamental risk

relates to the parallel evolution of alumina and primary aluminium prices, which determines the

economic success of the smelter. This risk is more closely linked to profit lost or realised,although an abrupt change in the proportion between the two price structures could lead to real

loss of investment.

This section analyses each of the options outlined previously from the point of view of these

two main risk factors. For each option, the risks are identified and quantified according to

probability and likely impact, and potential management solutions are outlined.

Risk factors: possible scenarios

Power network building costs

Smelter project abandoned orsize reduced: stranded asset

Costs escalate beyond viabilitylimits during construction phase

Spread between alumina andaluminium prices

Alumina price increases at ahigher rate than aluminium price;if alumina supply is constrained,more value will be retained by the

alumina producers

LOSS of PROFIT

LOSS of INVESTMENT


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2.1. Water r ight sSince this option involves no upfront direct investment on behalf of the GHR, the risks only

relate to the loss of potential profit. The financial burden of constructing and running the

smelter and hydropower station would belong exclusively to Alcoa.

The limited risks associated with this option depend upon the system of payment. Ideally, the

water rights agreement would incorporate elements of all four types of tariff presented above: an

upfront payment, a yearly fixed charge, an adequate escalator that varies according to the

change in the price of aluminium, and a very small equity participation in the project. The best

ways to ensure that the GHR maximises its returns from the project are shown below.

RISK: Returns to GHR not maximised

Probability: Dependent on negotiations. However, we feel that the GHR would

be in a good position to negotiate a profitable tariff. Impact: Small. Some opportunities for profit may be lost in the negotiation, butthe GHR still stands to make substantial gains.

A fixed charge of $3/MWh for a usage of 600 MW would yield over$15,000,000 per year!

Small up-front fee: FIXED, one payment

Small equity participation: FIXED, shares

Charge per MWh: FIXED (annual tax) or VARIABLE(% of Al price with or without thresholds)

Accelerator based on project return: VARIABLE

NEGOTIATION TERMS: the tariff


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2.2. Jo in t Venture par tner in pow er supp lyAs mentioned above, this is a suitable option as long as the GHR has access to low-interest

capital, such as infrastructure subsidies or other forms of credit from the Danish government.

This would relieve some of the financing pressure off Alcoa. In return, Alcoa would have to

purchase the energy from the Joint Venture company, at a higher tariff than if they were paying

for water rights alone. An initial investment would therefore be compensated by higher later

returns.

Power purchase tariffs would necessarily be higherthan water rights tax

OPTION 1.1. WATER RIGHTS

GHR investment = 0

GHR revenue = water tariff

OPTION 1.2. JV partner

GHR investment = % CAPEX + % OPEX

GHR revenue = investment + profit margin

GHR PROFIT = WATER TARIFF

GHR PROFIT =

PROFIT MARGIN

POWER TARIFF > WATER TARIFF + INVESTMENT PAYBACK

Solutions for maximising the GHRs returns

Give them part of what they want: grant Alcoa long-term rights to the water (atleast 30 years)

Only charge what they can afford to pay: the escalator would only apply whenthe price of aluminium exceeds a threshold or when the project makes substantialreturns

Ask for shares in the project: this is less of a direct cost to Alcoa and means

some profit in the early phases of the project.

Prepare for negotiations Good understanding of capital andoperating cost structure of the futurepower network

Good knowledge of Alcoasalternative options

PLANTCAPEX

+OPEX

ALT.OPTIONTARIFF

GHR marginfor negotiation


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Whether the GHR holds a majority or minority stake in the Joint Venture company is

immaterial: Alcoa would have to purchase the energy regardless, and the hydropower network

owners, whoever they be, have no other option but to sell it to the smelter. The only real

variable is in the degree of exposure to risks, not in the nature of those risks.

The higher the participation of the GHR in the hydropower plant project, the greater the

exposure to this risk will become. There is no readily available solution, beyond leaving plenty

of contingency capital for the possibility that costs will escalate. This does not solve the

problem of losses suffered if capex grows to the extent that power costs are higher than the

tariff.

Furthermore, under this option, Alcoa has considerable degree of flexibility in how it can

react to an increase in construction costs. Given the lag time between the start of construction

for the power network and the start of construction for the smelter, Alcoa has up to two and a

half years to reconsider its position regarding the smelter and the size of its own investment in

the power plant network.

We do not believe this risk to be acceptable from the GHRs perspective. The only way to

manage it would be to negotiate a tariff that leaves room for potential cost increases by

increasing the profit margin. This is unlikely to be acceptable to Alcoa, as it would negate the

smelters competitive advantage on the cost curve.

RISK 1: Costs balloon during construction phase

Probability: Medium.

3 plants connected to smelter inunforgiving environment high quality

reinforced transmission lines required.

Tight construction market and global

financial uncertainty could run up the cost

considerably.

Impact: High.

If cost exceeds available budget, then

smelter project may need to be scaleddown or even abandoned strandedasset would have to be sold elsewhereat much reduced price.

Rising CAPEX can force losses ifpower cost becomes higher than thetariff agreed upon in the off-takecontract.

EXPECTED

CAPEX

PAYBACK

OPEX

PAYBACK

MARGIN

OPEX

PAYBACK

CONTRACTED

TARIFF

ACTUAL

CAPEXPAYBACK

ACTUAL

COST

LOSS


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This second risk is more easily manageable. While metal-related tariffs have recently

become the norm, it is still possible to ensure against price drops in aluminium. Over the short

and medium term this can be done through hedging, but a better long-term solution is locking

the tariffs position on the price curve as shown above, or providing for safe thresholds below

which the tariff remains constant. The former solution is more creative and provides more room

for profit made on the back of energy price surges, while at the same time reassuring Alcoa asthe consumer of energy that it faces no risk of tariffs rising abruptly with energy market

fluctuations. The latter solution is simpler and more frequently used in contracts worldwide. Its

appeal lies in the certainty of a fixed range of possible results, which is comforting both to the

supplier and the consumer of energy.

2.3. Sole suppl ier o f e lect r ic i t yAs mentioned above, the degree of commitment on behalf of the GHR does not change the

nature of the risks, only the level of risk. This option carries with it the same risks as above, but

the potential impact is much more devastating, particularly in the case of the risk 1.

If the hydropower network construction costs rise above initial estimates, the GHR is now

alone facing the consequences. Should the project be abandoned, the GHR is faced with

gigantic losses and a stranded asset with much less potential for revenue. This is of course the

worst of all potential outcomes, and its likelihood is low. Nevertheless, a substantial increase in

capex would lead to a shrinking of the profit margin on the contracted tariff, to the point where

the GHRs initial investment is no longer justified.

Given that the construction of the power network is likely to cost in excess of $1 billion,

which would have to be sourced entirely by the GHR, the risk degree is entirely unacceptable.Even if this amount were available at low interest, the particular mutual dependence between

the smelter and power network and the lag time between their respective construction times

RISK 2: Smelter profits hit by high alumina price andlow primary aluminium demand

Probability: Medium to low.

Strong demand growth forecast for primary aluminium and no imminentshortage of alumina.

Impact: Low.

Plant is likely to remain competitive in terms of power costs, although theGHR would lose profit from the metal-related segment of the tariff.

Solutions:

Long-term off-take contract that specifies the minimum energy to bebought by Alcoa from the power network: buy-or-pay agreement

Flexibly constructed tariff system: lock in the hydropower networksposition on the tariff curve as shown previously or fix thresholds in theformulae for calculating tariff on the basis of aluminium price


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makes separate ownership a risky proposition. Aluminium market fluctuations can be managed

for. However, this risk is about loss of sizeable hard capital, and under exclusive ownership,

there are no measures that can mitigate it. We therefore propose that this option be excluded

from further consideration.

2.4 Jo in t Venture par tner in an in tegra ted projec tAn integrated project would mean that the smelters power is self-generated. For the GHR, this

means that since power is no longer purchased, all revenue will be made on the back of the

strength of the aluminium market. From the projects point of view, this would reduce the

power costs to operating costs, with no tariffs to pay to the state. This arrangement essentially

means that the GHR and Alcoa share the exposure to the same two fundamental risks presented

above.

The risk of capex rising above expectations has the same probability as before, but a slightly

different impact on the GHR. The main problem in this case is not the imbalance between

construction costs and tariffs, but the change in the smelters position on the cost curve. This

shift upwards will most probably mean loss of potential profit. Given that no tariffs are paid and

operating costs are so low, it is unlikely that the total power costs could push the smelters costs

above the equilibrium price and lead to loss of investment.

RISK 1: Costs balloon during construction phase

ALCOA

GHR

ALCOA

GHRESTIMATED

CAPEX

ACTUALCAPEX

COST

QUANTITY

expected positionactual position

Impact: Medium

Fall of profits for GHR, if the smelter is still competitive relative to demand.

Loss of investment, if production costs exceed equilibrium price unlikely,given the low OPEX

DEMAND

equilibrium price


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As with separate ownership, this is a more easily manageable risk, for slightly different

reasons. The lack of a power tariff gives the smelter project a slight advantage in terms of its

position on the cost curve, meaning that the project is more likely to be able to afford temporary

drops in primary aluminium demand.

Participation in a Joint Venture integrated smelter project would therefore expose the GHR

to some degree of risk, but the potential impact of these risks is lower and they are easier to

mitigate. As long as there is readily available capital at low interest at the GHRs disposal, this

option is worth further consideration.

2.5 ConclusionsOf the two risks that we have considered the available options against, the construction-related

one appears to be decisive. The potential impact of the risk and the level of uncertainty that is

inevitably associated with a construction project of such complex nature in a punishing

environment leaves very little room for reliable, watertight solutions. We believe that the levelof risk is unacceptable, and therefore that any option involving split ownership of the

hydropower network and the smelter should be discarded from consideration.

Probability: Medium to low.

Strong demand growth for primary aluminium and no imminent shortage ofalumina

Project has a more advantageous position on the cost curve due to no powertariffs.

Impact: Medium to low.

Loss of profit more manageable, better position on the cost curve meansproject can afford lower premiums.

Solution:

Hedging for up to 5 years

RISK 2: Smelter profits hit by high alumina price andlow primary aluminium demand


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The option of participating in an integrated Joint Venture can be explored further, as the

risks in this case target the profit levels of the project rather than the investment itself. While the

GHR and Alcoa alike are exposed to the risk, the issue is likely to be how successful the project

is, not whether it will make any profit. This option also makes sense from the point of view of

the mutual dependence between the aluminium mill and the power source.

An investment of DKK 2.5 billion would secure a participation of up to 15-20% in an

integrated Joint Venture. If the GHR is confident that such a sizeable amount of capital can be

secured easily, it would be necessary to examine in detail the returns that participation in an

integrated Joint Venture would most likely yield, and compare them with the gains to be made

from selling the water rights.

At this point, given the respective risks associated with the two options, we believe that the

latter is the ownership solution that best suits the GHR. in view of the risk of spiralling capital

expenditure for the building of the power plant network. Water rights for the three rivers should

be sold to Alcoa for a minimum of 30 years, subject to the payment of an up-front fee, and then

an annual tax which is varied in accordance with inflation, the performance of the aluminium

market in general. Such an arrangement would not require any sizeable investment and would

provide a reliable annual income, which would enable the GHR to benefit from the projects

overall success freely, at no substantial risk. As long as the tariff is negotiated well, the GHR

will stand to gain substantial yearly revenue at virtually no cost.

The options and degrees of risk

PROBABILITY

IMPACT

WATERRIGHTS

JV POWER SUPPLIER

SOLE POWERSUPPLIER

JV PARTNER ININTEGRATED

PROJECT


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The options compared: water rights vs. Joint Venture

Returns

Market risk

Construction

risk

Investment

??

LOWVERY LOW

MEDIUMNONE


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3. Soc ial and Polit ica l Considerat ions

Having discarded the options based on separate ownership, we will now examine the non-

economic factors we believe the GHR needs to be aware of in determining whether to opt for

the concession of water rights or for junior participation in a Joint Venture integrated project.

One important note is that the social and political risks for any smelting project are only as

significant as the social and political problems in the area where the project will be located. For

instance, in a country or region of consensus government, where both the incumbent

government and the opposition are in agreement over industrial development and energy policy,

a smelting project can expect to meet with much fewer problems in the preliminary negotiation

phases than in areas where there are considerable differences of perspective. As an example

below shows, Alcoa has first-hand experience of the effect of political factors on the success of

its projects. Similarly, if a region has a serious unemployment problem, the aluminium company

can expect to be tied into more cumbersome negotiations regarding employment development

and knock-on effects on secondary and auxiliary industries that the state or region in question

expects the project to achieve.

In these respects, a project in Greenland is far less complicated both in political and in social

terms for Alcoa than an alternative in either more congested areas of the developed world (like

the US or Norway) or in socially struggling environments in the developing world (Trinidad,

Jamaica or Brazil, all potential Alcoa targets). For any aluminium company, it is important that

negotiations can proceed smoothly and as quickly as possible. Any deal will be made or broken

by the energy cost, but bureaucratic efficiency and the extent of likely social and economic

obligations that the smelter project will likely be burdened with are considerations that can

make one option safer and more attractive to the aluminium company than others.

GREENLAND

Population density:

negligible

GDP per capita:

$20,000/capita

Unemployment: 8.6%= 5,000 unemployed

Nearby smelterpower tariff: $21/MWh

(Nordural, Iceland)

JAMAICA

Population density:

250/sq. km

GDP per capita:

$4,000/capita

Unemployment: 11%

= 275,000 unemployed

Nearby smelterpower tariff: $25/MWh

(Venalum, Venezuela)

Different challenges, different deals, one goal for

ALCOA: Low energy costs


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An example of this is Alcoas negotiations with the Icelandic government in the run-up to

the opening of Fjardaal smelter in June 2007. Negotiations for the smelter began in 2003, with

the Icelandic government committed to securing a deal that created over 1,000 jobs for the

economically depressed Eastern coast. Environmental concerns were raised as the smelter

location overlapped with plans for a national park, but overall Alcoa was satisfied that the

government was open, forthcoming and committed to a swift resolution. There is no reason whythe same could not apply in Alcoas negotiations with the GHR.

A lesson learnt : Baie Com eau

In terms of deciding between ownership options, Alcoas planned modernisation and expansion

at Baie Comeau, Quebec offers a few useful insights into the political and social risks associated

with the negotiation process, as well as a useful comparison tool between these and Alcoas cost

considerations. The smelter is one of the largest in the Western Hemisphere, but its technology

is outdated and likely to be rendered obsolete within 10 years.

In 2002, Alcoa and the Quebec government, then ruled by the Parti Quebecois, signed a

Memorandum of Understanding for modernisation and expansion by 2010. Alcoa committed to

replacing its Soderberg technology with pre-bake utilities through investments worth C$ 1

billion. In return, the government agreed to renew the water rights for the McCormick dam for

25 years beginning in 2011 and to sell Alcoa 175 MW of the remaining necessary energy at

industrial rate. However, the Liberal government that replaced the Parti Quebecois in power in

2003 reneged on the non-binding terms of the MOU and called for a renegotiation of those

terms.

The new terms proposed by the government included the creation of 500 jobs in secondary

manufacturing in addition to the 1500 already pledged in the aluminium processing industry by

Alcoa. However, the most significant issue was over energy tariffs. The Quebecois government

(HQ) argued that the region was facing shortages before Hydro-Quebecs capacity expansion

was finalized, and that therefore the initial industrial rate was not satisfactory. Instead, it offered

to provide low-cost electricity for 50 years, with annual rate hikes no higher than inflation. The

deal tied the tariff to the energy price, which Alcoa stated as an unacceptable risk. Negotiations

fell apart and the project was called off in 2006, as Alcoa stated that it cannot commit over C$ 1

billion for a project where there is the risk that energy costs would escalate over the life of the

project.

The contrast between the Baie Comeau and the Fjardaal developments is evident and a small

part of the reason Alcoa chose Greenland as a site for future development could be an

association with the image of the latter. However, what is also apparent is that the social,

environmental and political factors exist, but are superseded by cost considerations. In the case

of Fjardaal, Alcoa committed to the creation of jobs and infrastructure for the local

communities, as well as providing substantial environmental assurances, in exchange for a

quick negotiation process and cheap energy provisions.

In terms of lessons to learn, one important implication of the Baie Comeau developments isthat Alcoa is adverse to energy-tied accelerators. It is much more likely to adhere to a cost

structure similar to the one presented above, which varies according to aluminium market


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factors and to the success of the project, or one where the tariff for the water rights is locked on

the global power cost curve. It should be much easier for Alcoa to feel that their investment is

safe in Greenland, as unlike Baie Comeau, where 66% of power was purchased, Alcoa would

generate all of their own power.

Another consequence of the failures in Quebec and, later on, in Brazil could be a preference

on behalf of Alcoa for the Joint Venture model. Political factors play a part here, as by joining

the project, a government effectively shows its commitment to the project and makes it

substantially more difficult for a different future government to back out of the venture, once

the initial investment has been made. These considerations were part of the reason for the

Asahan Joint Venture in Indonesia, where politics is considerably more volatile.

2. Financing optionsIf the GHR decides to participate in a Joint Venture integrated project, it will do so as a junior

partner to Alcoa. If the Joint Venture is incorporated, then Alcoa will take the primary

responsibility for sourcing the funding. Even if the partners do decide to each source their own

capital to avoid taking on excess risk, it is a common practice for the junior partner to follow in

the senior partners footsteps and approach the same financing institutions.

Most integrated smelter projects are financed through debt or through a mixture of debt and

equity. The proportion between the two varies, depending on the existence of sponsors for the

equity package, the availability of creditors at a competitive interest rate, and the degrees of risk

associated with the project. Sohar smelter in Oman, a recent integrated project, established a

60:40 split between debt and equity.

Debt gives the GHR full control of the returns once the loan and interest have been paid

back. While the issue of bonds would be logistically challenging, there are other commercial

options that can assist the GHR in finding creditors. One option is through the EKF, Denmarks

Export Credit Agency, which, by underwriting all or part of the financing, can give the project

more credibility and encourage investors. The Qatalum smelter project in Qatar recently secured

$600 million export credit loans, in addition to $2,000 million in a classic commercial tranche.


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Issuing shares is a way to attract up-front capital, but it means forfeiting a proportion of the

returns and possibly allowing a third party to be involved in corporate decision-making. The

GHR or the Danish Government could sponsor all or part of the stock.

In order to attract some financing from parties directly interested in the success of the

project, the equity could be divided between A shares and non-voting equity. A shares would

be destined for economic entities that have a vested interest in the price and quantity of

aluminium produced, such as off-take partners for the smelter or equipment providers for either

the smelter or the power plants. A shareholders would have a say in the floor price for the

primary aluminium produced and for negotiating interest rates with banks financing the project.

Non-voting shareholders would not be involved in such decisions, but they would get returns

proportional to their participation.

A more detailed evaluation of the mechanics of obtaining the financing can be performed

once a definite decision is taken by the GHR concerning the type of ownership it will opt forand the definite amount of capital it is looking to secure.

DEBT OPTIONS

BONDS cheaper and more secure for investors Logistics are difficult: Danish government would have to issue the bonds,

potential legal issues if Joint Venture is incorporated

COMMERCIAL CREDIT more expensive, but more likely to attract takers

Classic international syndicated loans, which would have to be

senior -> priority payback

secured, but limited recourse -> built assets as collateral

typical interest rates around 1% above London Interbank OfferedRate (LIBOR), lower during construction, higher during production

typical duration 15-25 years

Export credits facilitated through Denmarks Eksport Kredit Fonden (EKF)

Alluminium Smelter-5 Model

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