The Municipal Division operates waste treatment facilities for UK and Canadian city and county councils under long-term contracts, typically 25 years. Such contracts are established primarily to divert waste from landfill in a cost effective and sustainable way.
In the UK, the capital cost of the associated infrastructure is financed with non-recourse bank debt and in the case of PFI, is supported by central government funding. Both PFI and PPP contracts benefit from guaranteed revenues and tonnages from the associated council. The business model is shown in the graphic below.
In a typical PFI or PPP solution, a special purpose vehicle (SPV) is created to finance the construction of the treatment assets and Shanks arranges for a club of banks to provide funding. Securing this funding is called ‘Financial Close’, at which point all the long-term contracts are signed between Shanks, the councils, the suppliers and the banks. This signals the start of the build phase, in which Shanks may or may not be the main contractor. On completion and commissioning of the assets, Shanks will generally inject up to 20% of the invested capital of the SPV in the form of subordinated debt, which should earn a return of around 12% pre-tax.
Once operational, there are two potential income streams from the PFI or PPP contract. The first is the income for treatment of the waste under the operating contract, which is signed with Shanks Waste Management Limited as the supplier. Success relies not only on excellent management of the contract and the meeting of strict diversion targets, but also on working closely with the customer to identify improved ways of managing the waste, to a shared benefit. It is this latter focus on continuously improving how we do things that has driven a sustained increase in the Group margin and, importantly, a significant saving for the councils. The operating contract offers the Group protection from waste volumes and similar items that have caused challenges within our Commercial Waste Division.
The second cash stream is the interest from the subordinated debt and ultimately a dividend stream from the SPV. Shanks has historically sold the majority of its interest in its SPVs, following commissioning, to a third party; so this is currently a minor part of our income. However, we maintain an open stance on our ownership of current and future SPV stakes.
In Canada, the facilities are generally funded from our own balance sheet, supported by long-term contracts. On occasion, the customer may provide some funding support.
The bidding process for major PFI/PPP opportunities in the UK is largely complete, with only our Derby project still under construction. Some councils are still seeking a solution to their waste diversion needs, quite possibly through contracting spare capacity in existing assets. The Canadian market is still in a growth phase, with many municipalities yet to invest in the infrastructure required to divert waste, especially organic waste, from landfill. Shanks has a good overview of the pipeline of potential opportunities in Canada and into parts of the US and expects to bid selectively if it believes that the project opportunity meets strict criteria for the deployment of capital.
The Municipal Division, having secured its input waste under long-term contract, then competes in a number of downstream markets, in particular with regard to the provision of solid recovered fuels (SRF) to cement manufacturers and refuse derived fuels (RDF) to energy from waste companies. A proportion of these disposal routes are secured under long-term agreements.
Products and technologies
The overall goal of all municipal contracts is to maximise recycling and diversion from landfill. Each contract will involve a bespoke solution to meet the needs and preferences of the customer. This may include the operation of household waste recycling centres (HWRCs) and materials recycling facilities (MRFs) to sort incoming waste streams into recyclates. Shanks has an exclusive contract with A2A (formerly Ecodeco), a leading European waste engineering company, to operate mechanical biological treatment (MBT) facilities in the UK. These treat the residual waste, shredding and drying it to produce SRF, a high calorific fuel which can be burned as a fossil fuel substitute in cement kilns, or RDF which can be incinerated to produce electricity. Organic waste can be composted to secure further diversion from landfill or can be processed by anaerobic digestion (AD) to produce electricity.
The core strategy of the Municipal Division is to:
- Deliver sustained operational excellence under our current contracts;
- Ramp up operational performance in the BDR and Wakefield facilities following full service commencement;
- Successfully commission the Surrey and Derby facilities;
- Remain alert to opportunities to assist other potential customers without a current solution to their waste diversion requirements.
Municipal revenues grew by 21% at constant currency to £189.7m but trading profit fell by 15% at constant currency to £9.6m. The revenue growth was boosted by the inclusion of £13m construction costs at a minimal margin relating to the Surrey project in which we are the EPC contractor and principal. Excluding these construction costs, underlying revenue increased by 12%.
UK revenues increased by 13% as a result of full service commencement at BDR and Wakefield. Trading profit fell by 20% to £7.8m due to a worsening market conditions including increasing fuel offtake costs, lower recyclate and energy income, and increases in the cost of insurance. These had a combined impact of £3m on profitability in 2015/16 and will have a further full year impact on 2016/17. These headwinds, while disappointing, are expected to ease or reverse over time, allowing the full profit and cash potential of our facilities to be delivered.
Canadian revenues increased by 118% to £26.2m including the Surrey build costs, although this represented an underlying reduction of 7% at the two existing plants primarily due to lower throughput from one municipal customer. Trading profit grew by 14% as a sharp reduction in bid costs offset profit pressures at the Ottawa and London sites. Both sites were impacted by increased offtake costs and also by the impact of changing customer demand.
The UK performed strongly at an operational level, with the roll out of continuous improvement alongside other initiatives offsetting much of the adverse impact of the worsening external environment.
At ELWA, a continuous improvement project identified £1m of cost savings and created new capacity improvements of over 25% on certain operating lines. Both ELWA and Derby delivered another year of record diversion from landfill, ELWA achieving an all-time peak of 98.8% in March 2016. ELWA also made good progress with the reconstruction of its refinement hall at the flagship Frog Island facility, which was destroyed by fire in August 2014. The new refinement lines will be commissioned in the first quarter of 2016/17.
As reported above, the offtake market worsened significantly during the year as a combination of reducing available demand for SRF and increasing RDF prices as a function of supply/demand and also the weakening of sterling. We responded by creating a Group offtake initiative to work across the Group to ensure the best possible offtake options. This has resulted in improved supply arrangements into two incinerators in the Netherlands and improved recyclate pricing for paper. However, these initiatives were not sufficient to offset the market conditions.
As a consequence of these changes in the UK offtake market, our Cumbria PPP contract has become loss-making in the second half and is forecast to remain so subject to resolution of offtake challenges. As a result, we have accounted for the contract as an onerous contract, recognising a £5m charge as an exceptional item.
The division has made good progress in sharing best practice across its contracts. The new Evergreen IT solution provided a new platform for tracking and sharing operational performance of assets across the division. Our new compliance IT solution is being piloted at one site and is intended to help contract teams ensure perfect adherence to customer requirements.
The commissioning of BDR and Wakefield were central to the operational performance during the year. BDR is our largest MBT facility, capable of processing up to 265,000 tonnes of residual waste per annum, extracting recyclates and creating a high quality fuel for SSE’s new multi-fuel facility at Ferrybridge. The facility commissioned on time and on budget in July 2015 and has been processing steadily increasing volumes. The completion of our £100m facility at Wakefield was briefly delayed by the insolvency late in the construction process of a major contractor for the AD facility on site. However, a determined response by our engineering teams ensured that the facility entered full service just four months late and in line with our revised opening schedule. The Wakefield facility provides a wide range of waste treatment technologies to process the full waste streams from Wakefield Council. The operation of this contract for the long-term is not affected by the sale of financial assets relating to the SPV for the project (see Group Finance Director’s review for further details).
Construction on our flagship Derby gasification project has made good progress and is on time. The site is due to commission at the end of 2016/17. Interserve Group plc is the EPC contractor and joint venture partner on this project.
The Canadian business experienced a mixed year operationally. [New compost regulations came into force that are not helpful for companies operating higher technology tunnel composting lines as they require longer maturation times and a moister compost. These regulations have impacted site capacity and costs. In addition, we have seen lower volumes from the City of Toronto to our London facility. Nevertheless, the business worked hard to increase efficiency and reduce cost, including staff costs, overtime and overhead.
Construction has proceeded well on the Surrey bio-fuel project near Vancouver. This state-of-the-art facility will take organic waste from the City of Surrey for treatment to produce bio-gas that will be used to fuel the City’s fleet of waste collection vehicles in an innovative circular solution. Commissioning is due in the fourth quarter of 2016/17.