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RISK ANALYSIS AND ALLOCATION This web page examines
By the end, your understanding of the 16 risks should be sufficient to tackle any Project Finance or to determine the best sensitivities to test the robustness of a Project’s cashflow projections.
The first step toward risk definition must be to ascertain all of the risks to which a project or a company is exposed; otherwise one will remain ignorant of the possibility of a financially crippling loss until it occurs. However, simply stating what "risk" is can lead to debate. For example, risk could be:
For the project financier, the last definition is probably the closest . A better definition would be that the cashflow impact is different from that projected . From a Sponsor’s point of view the definition might well include the possibility of not achieving the expected financial return.
The 16 Risks As can be seen from the tables below, any risk category that cannot be clearly linked to a cashflow line is not of much use. General phrases such as economic, commercial, business, project, construction, development, financial, or competition should be disregarded as risk descriptions and too vague to link to cashflow. OPERATING RISK (This is also known as the Production or Performance risk) The operating risk has interrelated components: Technical, Management, and Costs. The ability to economically achieve the desired production rate depends on the engineering, experience, and quality of staff applied to the project. These make up the operating cost lines in a cashflow projection. As a general rule if: (a) Known and proven technology is used; (b) The facilities are projected to remain technologically competitive; and (c) Plant/project life is twice the funding life; then the financiers will take the Technical risk. If an untried technology is incorporated into a new project, most financiers may require a warranty. Project Financing is seldom applied to new technology. Even though the Technical Risk has been passed to the financiers, continuing covenants will be required to ensure that the borrower applies generally accepted practices and obeys the applicable laws including environmental regulations. (This is known as the "prudent operator" clause). The financiers will have scrutinised the technical feasibility study, back up reports, and assumptions, perhaps grilling the engineering staff or consultants directly. A number of risk allocation structures are available such as: Technology Guarantee Either the Sponsor itself or the technology developer will guarantee that the technology will work for a period of, say, six months to two years after startup. Twelve months is common in the power generation sector. If not, then financial penalties will apply although these are rarely sufficient to fully repay the loan. Many Technology companies are weak financially and may have little substance to back such a guarantee. Technology Management This may be seen where proprietary technology developments are to be provided to a project. Some industries favour this as a means of control and to obtain an extra return from their R & D and investment in the new venture. The management agreement reassures the financiers that new technological developments will continue to be made available to the project so that it can maintain its technological competitiveness. Technology Insurance In some cases, insurance cover may be raised from unconventional or conventional insurance markets. This can be expected to be difficult for brand-new technologies. Quality Assurance An equipment supplier of technology licenser may guarantee the resultant product’s specification which, to a large part, can cover the Technical component of Operating Risk. This is often seen in the industrial chemicals industry. Fleet Assurance An equipment supplier or lessor may guarantee to replace individual items found faulty from a fleet in the neighbourhood. This may be a little difficult for a dragline, in say, Thailand, although it may be easy for a toll-booth machine installed there. Alternative Sourcing If the technology does not work out, then the technology company undertakes to provide equipment from elsewhere (if the supplier) or arrange to use the technology elsewhere (if the plant) with no impact on cash-flows. This is rarely seen. Business Interruption Insurance This takes effect upon Project startup and can provide useful protection of the Assets or the Project Financing in the event of lost income arising from an accident. If a total loss, the banks will often want to be the loss payee under this type of insurance policy as well as the all-risks general insurance policy. This is indirect cover for the Technical Component of Operating Risk.
Cost risks apply to labour and materials inputs, productivity, and operating expenses ("opex"), including the effect of inflation. Most cashflows will show 7-10 key items of costs with the remaining cost categories usually amounting to only 5-10% of opex. This Cost Risk component is sometimes partly absorbed by the financiers by means of an economic test. However, the size of a Project Financing will depend on the scope of the economic test, if any. The selection of the stream of proceeds will also influence the size of a Production Loan. For example, if gross proceeds are dedicated to loan repayment - common in a US oil project financing - then the Sponsor is taking the Operating cost and the tax risk. Cost Curve One way to evaluate Cost risk in the absence of adequate sales contract coverage (Market risk) is to examine the position of the project on the "cost curve" relative to all the other producers of the given product or its direct competitors. (Cost curve analysis has not done too well in factoring in dramatic currency changes.) This is regularly done on a formal basis for operating and total costs for the resources and power sectors. As a general rule, a project in the lower half or lower third of the cost curve will be readily able to pass the Cost Risk to the financiers. Sales Contract Escalation provisions are the chief tool to cover the Cost component of Operating Risk and have many formulations in descending order of support: - Complete cost pass through (to the price/tariff) - Base price plus: actual escalation - Formula escalation - Floor price (escalation) - Fixed price with escalation built- in - Market prices linked to others - The cheapest alternative - A published index/price. Hopefully the producer can keep any productivity gain but this is sometimes caught in the formula. Additional bias in sales contract components to cover the risk in cost elements, (eg labour, energy) can help here. Cost Guarantee Sometimes suppliers to the industry will guarantee cost components of either consumables or the unit costs that may result from their plant and equipment. A guaranteed chemical consumption or low-cost hydropower costs are examples. Sometimes advantageous transfer pricing can provide a support here within a large company. Fixed treatment and refining charges or low processing/conversion penalties may provide such support. Cost Waivers A government will sometimes waive taxes or royalties for a period of time, often at least until a Project Financing has been retired or payback has been achieved, particularly if the project is a generator of export earnings. (This has, however, an element of political risk should a regime change or the law or decree be repealed.) The Sponsor itself may waive management charges, royalties, dividend rights, or interest charges for a specified period. The capital component of infrastructure charges may be held flat or waived until debt service is retired. The experience of the management in efficiently applying the given technology and controlling opex is crucial when considering the projected operating performance of a project. The availability of sufficient trained workforce may also need close examination in some locations. The financiers may seek an employment contract or "key-man" insurance to ensure the continued involvement of the Sponsor and of strategic individuals. Besides high skills and a proven track record, financiers may seek comfort from: Management Agreements, Management Agreements, whereby (a) the key staff are encouraged to stay with the development or (b) the Sponsor agrees to put whatever management talent it has or can find to the task of building and operating the Project. Bonuses or share options are the most usual incentives besides cash. This type of agreement is common where the company has either experience with the technology or regional conditions. Management Agreements, whereby (a) the key staff are encouraged to stay with the development or (b) the Sponsor agrees to put whatever management talent it has or can find to the task of building and operating the Project. Bonuses or share options are the most usual incentives besides cash. This type of agreement is common where the company has either experience with the technology or regional conditions. Management Agreements, whereby (a) the key staff are encouraged to stay with the development or (b) the Sponsor agrees to put whatever management talent it has or can find to the task of building and operating the Project. Bonuses or share options are the most usual incentives besides cash. This type of agreement is common where the company has either experience with the technology or regional conditions. Key-Man Insurance: Key-Man Insurance: This may literally insure the life of a few key people to a level equal to the debt outstanding should one or more of these individuals die. Key-Man Insurance: This may literally insure the life of a few key people to a level equal to the debt outstanding should one or more of these individuals die. Key-Man Insurance: This may literally insure the life of a few key people to a level equal to the debt outstanding should one or more of these individuals die. Labour Contracts Labour Contracts may be sufficiently firm and reliable to underpin this risk component. This can generally only occur in a mature industry. Labour Contracts may be sufficiently firm and reliable to underpin this risk component. This can generally only occur in a mature industry. Labour Contracts may be sufficiently firm and reliable to underpin this risk component. This can generally only occur in a mature industry. Training Agreements Training Agreements are often a part of technology supply agreement and provide useful support. There may even be a commitment to supply the executive staff for a period of years after startup. Some training agreements imposed by governments to enforce greater participation by their nationals in the industry may increase the management risk eventually, especially where group rivalries are hard to control. Training Agreements are often a part of technology supply agreement and provide useful support. There may even be a commitment to supply the executive staff for a period of years after startup. Some training agreements imposed by governments to enforce greater participation by their nationals in the industry may increase the management risk eventually, especially where group rivalries are hard to control. Training Agreements are often a part of technology supply agreement and provide useful support. There may even be a commitment to supply the executive staff for a period of years after startup. Some training agreements imposed by governments to enforce greater participation by their nationals in the industry may increase the management risk eventually, especially where group rivalries are hard to control. It is difficult to define the dividing line separating these three overlapping components of Operating Risk, but all are generally under the control of the Sponsors and are easier to absorb if the Sponsors have a successful history of building and operating similar projects.
PARTICIPANT RISK (This is also known as the Credit or Sponsor risk.) The stature of the other companies in the project may have an impact on the Project Financing especially if other Participants are weak financially or technically. If there is a weak or inexperienced Participant in a joint venture, the lenders may require cross guarantees. It is very important to study the Company’s charter or the joint venture agreement "JVA" since its structure may seriously inhibit Project Financing. In general, assignment of joint venturer's unencumbered interest should be possible without consent for the purposes of financing. The cancellation, abandonment, and force majeure clauses may be crucial to the Project Finance document. Close scrutiny of the JVA will concentrate on provisions for forfeiture, dilution of interest, and compulsory contribution by the other joint venturers. A financially strong Sponsor will choose to project finance less often since it can access other funding sources on a corporate basis and at a lower cost and with less hassle compared with documenting the complex risk-sharing mechanisms and supports in a project financing. Some large companies feel that they cannot "take a walk" from a project that is Project Financed since it has their name associated with it; some financiers and ratings agencies depend on these companies feeling that way; and consequently the credit basis is essentially the corporation and not just the project. The main risk allocation structures to handle Participant risk in a Project Financing are as follows: Joint Venture Agreement This document defines the joint venturers’ interrelationships among themselves which, if there is an imbalance in creditworthiness, can add to the overall credit support to the Project Financing. Conversely, sometimes provisions such as cross-charging or compulsory contributions/dilutions can interfere with the Project Financing. Recourse/Contingent Financial Support This can be provided to meet the Completion risk or may provide ongoing support to the financing such as working-capital-maintenance agreements, Cashflow/Debt Service Deficiency Agreements, or contingent equity underwriting agreements or guarantees from a strong parent. Financial Ratios The credit status of the Participant may be preserved at least until Completion through a set of financial ratios such as a current ratio of 1.2 to 1.0:liquidity of $X; debt to tangible net worth not greater than 2.0 to 1.0; minimum tangible net worth; or maximum amount of long-term debt. Certain subordination structures may be necessary to control inter-company loans, charges, dividends, and legal security. Off-Balance-Sheet The credit risk of some highly leveraged Participants may be further stage managed through the use of the off-balance-sheet structures which usually require corporate techniques to reduce ownership below 50% (rather than financing techniques). Accounting standards around the world are moving toward putting most financial obligations on the balance sheet and counting it as long-term debt. The capitalisation of lease obligations on balance sheet is a good example here for a financing tool that used to have this source of funds off-balance-sheet. Cross-collateralisation and cross-default Cross-collateralisation and cross-default clauses can gather in support from other project Participants or even non-project activities of the Sponsors. Cross-collateralisation and cross-default clauses can gather in support from other project Participants or even non-project activities of the Sponsors. Cross-collateralisation and cross-default clauses can gather in support from other project Participants or even non-project activities of the Sponsors.
COMPLETION RISK (Also called the Construction, Development, or Cost-Overrun risk). COMPLETION RISK (Also called the Construction, Development, or Cost-Overrun risk). Broadly speaking, a lender expects the loan proceeds to be spent on building a project which is on time, at budget, and is capable of producing sufficient cash flow after Completion of construction and commissioning to repay the loan comfortably. The Completion risk is usually not taken by financiers in project lending and other financial support is necessary prior to Completion. The usual format is to structure an objective Completion Test which, when satisfied, signals the pre-completion supports and undertakings are released and the project has commenced its limited-recourse status. This Project-Finance Completion Test is usually more extensive than the engineering/construction Completion used by the construction contractor in standard turnkey contracts. There are two main types of Completion Tests. One calls for the construction to be finished by a certain date and the loan is immediately due if completion has not occurred by that fixed date. A more common test is a performance Completion Test which might have all or some of the following types of components:
Completion Tests are becoming more complex as project financiers become more experienced in sizing up acceptable levels of risk and as Sponsors realise the possibilities of risk shedding while limiting the impact on their balance sheets. Additional Completion Test categories now seen include the following:
The implication of a Sponsor accepting the Completion risk is that cost overruns must be met by the Sponsor and, in the case of completion not being attained by a certain date, not achieving a Project Financing at all and the loan remains a corporate credit. In most Project Financing, this is certain to be the risk the financiers do not (or hate to) take. Numerous devices have been structured to package this risk more tolerably. There are at least nine major varieties of risk allocation for Completion. Completion Guarantee This requires the loan to be repaid by the Sponsor rather than the project’s cashflow either in full or on an agreed repayment schedule if the project is not completed by a certain date. It is seldom used in Project Financing today. Deficiency/Shortfall Agreement Even though the project is producing cashflows and has met a performance Completion Test, an agreed amount of Sponsor support is available to meet cashflow on Debt Service shortfalls for an agreed amount, for an agreed period post-Completion, or for an agreed obligation eg interest up to a limit. Completion Undertaking The Sponsors undertake to put in however much money it takes to make the Project meet the objective Completion Test. The Completion Test will, in all likelihood, pick up other risk categories as well. Therefore, the Completion Test is achieving support for other risk areas. In a disaster situation where the performance Completion Test can never be met, then there may be recourse to the Sponsors for the whole Project Financing. Overrun Undertaking In this case the Sponsors agree to provide only the overrun amounts above the pre-agreed debt and equity financing total. Stand-by Facility These may be contingent underwriting facilities, or indeed money in an escrowed bank account, provided to cover cost overruns perhaps from a strong parent or related companies. For example, interest may only be permitted to be capitalised to a given cumulative dollar ceiling beyond which the Sponsors must pay interest when due. Equity and Debt Subscription In the event of a cost overrun or a delay forcing capitalisation of interest, both the financiers and the company agree to contribute further funds, either pro-rata or in leap-frogging tranches, to meet the overrun with a ceiling on the bank’s exposure at some stage. Default Agreement This is a variation of Completion Guarantee except for a "stand-still" period after all base financing has been provided, say 90 days, within which talks proceed between the financiers and the Sponsors to hopefully (?) reach agreement on how to finance the increment to achieve project Completion. The commitment of both sides to proceed may be halted early if estimates show that the project will come in above the financed budget. Delay-In-Startup Insurance This can cover completion risk either through contract work policies or startup delay policies, which latter cover the capitalised interest bill caused by a delay. Turnkey Contract The turnkey construction contract may be formed in such a way as to provide the necessary financial support for the Completion aspect of Project Financing through healthy liquidated damages ("LDs"), Retentions, buydown payments, etc. However, most turnkey contracts incorporate project testing periods which may be acceptable at measuring physical Completion but are not long enough to cover the performance Completion Test in a Project Finance document. The various types of equipment or technical guarantees referred to under the Technical risks section above can also be integrated within this turnkey support.
SUPPLY RISK (This may also be known as the Reservoir or Reserve risk in resources financings and Traffic or Throughput risk for infrastructure projects.) SUPPLY RISK (This may also be known as the Reservoir or Reserve risk in resources financings and Traffic or Throughput risk for infrastructure projects.) The inputs to the project need to be capable of forecast and incorporation into the cashflow projections. For a BOO infrastructure project, this may be the traffic willing to pay the toll. Traffic studies are treacherous tools from which to build cashflows. The estimation of reserves has become a key element in banks’ evaluation of resources project financing. The usual rule of thumb for mining is that a proven reserve life needs to be more than twice the loan life and for petroleum 150% of the loan life. One of the difficulties here is the definition of what is "proven" and producible or of a lessor reserve category. An independent reserve report is usually required. The link of the supply to the production plan is especially important for processing. If supply is believed to be insufficient, the financiers may ask for a warranty. The following risk allocation techniques can be used: Traffic/Throughput Study Two or more independent studies will determine a safe level of throughput for a tollway, port, railway, or other land transportation project. The monopoly position and competing routes need careful assessment especially over the long period of Project Financing for these facilities. Supply Undertaking If periodically or at loan maturity, supply does not achieve a pre-agreed standard (often measured by NPV tests) then the financiers may have recourse to the Sponsor for all or a portion of the Project loan outstanding at the time via an undertaking document with the Sponsors. Supply Additions The company must assure supply eg convert reserves from a lower classification to a "proven" standard each year, before a certain date, or even startup. These usually must be certified by an independent consultant. If not, recourse to the Sponsor’s other cash flow and assets is required or further collateral has to be provided. Depletion Protection If supply is diminishing or expanded reserves are not proven up (or some is lost because of poor operating practices or an accident) then the debt repayment schedule will be faster. This support is widely used in oil and gas financing keyed to a net present value (NPV) of reserves according to the "decline curve:" of production and field depletion. To an extent, this NPV test also covers Operating as well as Market risk. A Production Loan also affords Depletion Protection if output is higher than forecast. Collateral Until supply reaches a "proven" standard, additional collateral is kept at the bank and is progressively released as the loan principal is reduced or output meets the standard. Such collateral could be access to other projects and their cash-flows, cash, shares, guarantees, or deficiency agreements. Reserve Weighting Banks hate to do it, but in serious resource financing, discounted probable, possible (inferred, indicated) reserves may be added to the proven figure to make up the loan life coverage required. Reserve Insurance This has been used in the oil and gas industry. The minerals industry, which usually has a quantum leap in better reserve definition than oil and gas reservoirs, should be able to obtain insurance coverage.
MARKET RISK (Sometimes called the Sales or Price risk) MARKET RISK (Sometimes called the Sales or Price risk) This is best defined as the gross revenue line in the cashflow. It is quantity times price. Market risk occurs, for example, when the sales price falls; market share drops (perhaps due to shift in freight rates or due to a new entry by a lower-cost competitor); demand for a Project ceases; or sales are lost due to deteriorating quality of the project's output. In certain circumstances, the risk arises when sales are cancellable after a period of below-par deliveries. This is one of the most critical areas of risk absorption by financiers. The best coverage of Market risk comes from long-term off-take contracts extending beyond the end of the loan life, although sales contracts are not often feasible or desirable for certain infrastructure or commodities. These contracts should be with a reliable consumer, adequately cover cost risk and escalation and, preferably have floor prices. As a rule, contracts with three-year price reopeners will only be regarded as three-year contracts even though the deal is for a "volume" or "evergreen" contract. Contracts will be evaluated with the minimum tonnage option and after discounting for other delivery conditions. Special techniques have been developed to handle shorter-term sales contracts, although it would be preferable for some output to be sold under a longer-term contract to minimally cover debt. The competitive position of a specific commodity to other product substitutes in the market is examined in detail and a technical link with a consumer is deemed highly desirable. The availability of alternate markets (eg the sale of coking coal as steam coal) is regarded as a positive contribution to minimising Market Risk. Sometimes a sales Completion Test will be required as well as the performance Completion Test (See Completion Risk above) before the financiers assume the Market risk. As a general rule of thumb, the financiers aim for the present value of the sales proceeds net of operating costs to be at least 1.5 times the amount of loan outstanding -- for a power project 1.3 to 1.4 is the general rule of thumb. Sales Completion is sometimes written as an ongoing obligation where the sales contracts are very short. This key risk in project financing is the most difficult to cover and usually has the weakest support overall within the project's collection of risks. Supports and risk allocations applicable here include: Sales Contracts Besides covering the Cost component of Operating Risk (see above), sales contracts provide support for Market risk. Many infrastructure financings are barely concealed monetisations of take-or-pay contracts. However, true "take-or-pay" contracts are now rare in any industry. The most common variety is "take-and-pay" although as markets world wide have become weaker in recessionary times, this has unfortunately shifted to "take-or-breach". The protection of equity or fairness clauses in Asian purchase contracts, while seeming to balance the commercial reality between supplier and buyer, are too frequently a cause for price re-openers. A sales contract should be longer than the loan life and should have protection for the supplier against contract cancellation and force majeure. Some contracts may provide short-term credit support through cash on presenting "clean" shipping documents, perhaps with such payment backed up by a bond. Merchant Financing If a trading company is providing money and an off-take contract (usually to secure an exclusivity on the sales agency for the project), then this support can be useful, provided that the trading company’s market position and credit standing is sound. This route often covers volume off-take but seldom offers long-term price protection. Consumer Financing If the consumers are providing debt or equity (or both) plus a contract, then this ties their support to the Project. It may, however, provide the consumer with too much insight into the operating costs and market strategies such that too high a percentage of this form of tied support can be hazardous. Buy-Back Clause If the service or product remains unsold, sometimes a buy-back arrangement may be structured at least to accommodate debt service repayments. This can also come in the form of market displacement guarantee whereby the producer agrees to reduce production at an existing plant in favour of the new producer to allow the shortfall to be placed within its existing customer base. Advanced Sales The money required for development can sometimes be entirely from an advance sale, provided that tax on such a large block of income can be properly handled. This has been popular in the uranium industry and to a much lesser extent in the aluminium industry. Deficiency Agreements If the predicted market price is not achieved or achievable, then a subsidy either on a per-unit basis or as a grant/buydown payment from the Sponsor or product purchaser may get the project financing back to the economics of its original structuring. Throughput Agreements These are fairly simple support tools that have developed more strongly in the oil and gas industries, particularly for common-user facilities such as pipelines. The user’s covenant to put sufficient material through the asset or entity involved to generate sufficient throughput revenue (through tolling charges or handling fees) to retire the debt for the asset/entity. Severe constraints on impossibility of performance and force majeure ensure that the cash flow eventuates more or less on a "hell-or-high-water" basis.
INFRASTRUCTURE RISK (Also called the Transportation risk) INFRASTRUCTURE RISK (Also called the Transportation risk) Infrastructure (other than that being developed in an infrastructure project itself) is a very important component of many projects and financiers will need to be assured that the chosen infrastructure will remain technologically and economically competitive especially in comparison with other existing or potential production centres. The materials handling costs required to deliver or export the production can sometimes equal or exceed the Project’s operating and capital costs. Moreover, port capacity may be the limiting factor in remote projects. If the sales price is on a f.o.b. basis, the ability to pass through transportation costs in any sales arrangements means that the buyer absorbs this risk. In some locations, the government builds and operates the rail and port, but one must be careful that the operator is not "taxed" through higher freight rates or user rates. In general, the financiers will wish to review closely the transportation studies and perhaps to inspect the existing facilities or the proposed sites. Independent certification will assist the financier's absorption of this risk component. The types of risk allocations here are: F.O.B. Sales Contracts F.O.B. Sales Contracts may put the risk of infrastructure upon the buyer if it is phrased as at the gate or well head. This can, however, have a sting in that the purchaser may choose not to arrange to collect the product eg as the Japanese have been doing by delaying or refusing to send coal carriers to various ports around the world. If the producer has no say in the infrastructure chain, it risks technical obsolescence, for example, if rail lines are not maintained or ports not deepened to keep up with the growth in bulk carrier size. F.O.B. Sales Contracts may put the risk of infrastructure upon the buyer if it is phrased as at the gate or well head. This can, however, have a sting in that the purchaser may choose not to arrange to collect the product eg as the Japanese have been doing by delaying or refusing to send coal carriers to various ports around the world. If the producer has no say in the infrastructure chain, it risks technical obsolescence, for example, if rail lines are not maintained or ports not deepened to keep up with the growth in bulk carrier size. F.O.B. Sales Contracts may put the risk of infrastructure upon the buyer if it is phrased as at the gate or well head. This can, however, have a sting in that the purchaser may choose not to arrange to collect the product eg as the Japanese have been doing by delaying or refusing to send coal carriers to various ports around the world. If the producer has no say in the infrastructure chain, it risks technical obsolescence, for example, if rail lines are not maintained or ports not deepened to keep up with the growth in bulk carrier size. Pooled Infrastructure Agreements are popular in some districts, particularly for water supply, power, telecommunications, the town site, and port. Often a new entrant has to rebate earlier Participants’ contributions; but in many cases a new company benefits from the cost of the existing infrastructure. Sponsors have a harder time getting together on overland transportation. Government Commitments. The government may commit to fund, develop, and maintain the requisite infrastructure. This should ensure their support for the success of the venture. However, it does present an easy way to levy indirect taxes through freight rates and handling charges. If matters are not progressing well on the project’s economic performance or government relations, it may be tempting for government to seek control or shareholding using the infrastructure card as the point of pressure.
This risk must be addressed for projects in all locations of the world. A Project Financing cannot proceed without favourable assurance of environmental compliance from the local regulatory bodies with which the Sponsors must deal. This risk category can also arise due to location of the project e.g. near towns or highway or in proximity to wilderness, heritage, native reserve, or scenic areas. This is not simply a sub-set of political risk but a distinct risk aspect of project financing today. Some Multilateral Agencies ("MLAs") will not even let a project finance application in the door until it gets an environmental tick first. Rehabilitation Guarantee This is a pool of funds or guarantee provided to the local authorities and is established at a level to rehabilitate the area should the plant have to shut down for any reason. International and state authorities are also increasingly demanding in this area, often calling for rehabilitation bonding. Pollution Control Bonds The risks of some environmental clean-up can sometimes be funded by public or institutional investors in jurisdictions, such as the USA, where tax-incentives attach to the bond. Environmental Management This may be provided voluntarily or by regulation whereby alternate operating strategies can be developed to bring operations into compliance in any one day or season. Environmental Insurance In North America, insurance firms are now specialising in assessing projects for environmental event, disaster, and clean-up policies. These skills are being transferred rapidly around the world. However, capacity is limited and deductibles tend to be high. Rehabilitation Waiver Some states waive the environmental requirements in areas where the operation is benign or where the area is beyond reprieve. Such a waiver may need to be additionally supported by letters of comfort or commitment from the ministries concerned or perhaps within the development act, decree, or agreement with government. Pollution Pool In order for a new source of pollution to proceed, an existing polluter must be closed down or cleaned up. This can apply to industrial parks or cities. Pollution control credits are starting to become tradeable. Environmental Warranty This transfers the risk to the Sponsor by giving the financiers recourse should environmental problems endanger cashflow and, in turn, Debt Service.
(Actually a mix of risk categories such as expropriation, currency inconvertibility, regulatory, and tax risks.) Each financier and rating agency has a continuing review process of country risk based on an evaluation of the political and economic outlook. Many funding sources are willing to take some degree of the political risk for certain countries. Loans to sovereign borrowers in the country establish the market "price" for the country itself. In the event financiers decide they cannot absorb Political risk, then some of the risks may be covered by government-Sponsored export credit agencies (ECAs); or through insurance from groups such as Lloyds of London or private insurance sources. Some surprisingly advantageous Political Risk insurance is now being written by large insurance groups. If the Project Financing parallels an MLA or ECA financing, then some (but not complete) comfort may be derived from the potential leverage from these government agencies. The risk of currency inconvertibility is usually due to arbitrary government action caused by serious balance-of-payment problems, which should have been identified in the country-risk analysis process. A mechanism will usually be set up to accrue the local currency in anticipation that remittance will be permitted at a future date. Debt:equity swaps can also remobilise this inconvertible pool of funds. The more difficult areas which must be judged on a case-by-case basis concern the following:
The development agreement with the government can be subject to direct change or cancellation, or to the exercise of other government powers. It is not uncommon for project lenders to seek a direct guarantee from the government not to subvert the development agreement. In the case of terrorism or war and insurrection, the financiers may, for example, share an individual risk component after a pre-agreed level of damage has been done. Guarantee mechanisms would otherwise be required in certain countries. A large project is a wide-open target for creeping expropriation through a noose of continually changing tax or royalty regimes. Financiers will try to anticipate the impact of tax changes on the ability of the project to stand on its own and may not accept more than a defined portion of this risk. The most difficult aspect of Political Risk assessment is the impact of non-government political activists. It is quite common to see additional repayment time made available to a project where strikes are expected. In fact, force majeure coverage may be very important in such an instance. This risk is one that the banks in their wisdom used to feel most equipped to handle, that is until the LDC debt mountain started to cast a shadow over bank loan portfolios everywhere. This is a prime motivation to invoke Project Financing since it brings a wider constituency to the forefront of a government's thinking on a project. Some of the main structures and risk allocation methods are listed below: Development Agreement This may be phrased in strong language with external arbitration provisions. It will never, however, control an intransigent sovereign power. The emergency provisions within a country, when invoked, can usually overwhelm the development agreement. Political Risk Insurance ("PRI") Some political risk agencies such as ECAs, Lloyds of London, and various private insurers will provide very effective insurance against currency inconvertibility, creeping expropriation, unfair calling of performance bonds, and the like. Usually a delay of six months is built in to the PRI defined events to ensure that the government action is not a temporary squeeze. War and Insurrection Residual In some tender political locations, banks have been willing to absorb some of this risk due to damage caused to the plant from such a reason. For example, the first $10 million in damage may be accepted by the banks. This is still a rarity. Tax Indemnification In almost all Project Financing, the banks bear the brunt of subsequent tax changes (short of creeping expropriation). However, should tax rates begin to jeopardise debt service, then there may be recourse for the increment of taxes. It may also trigger a more rapid amortisation of the loan. Imposition of additional interest withholding taxes is most commonly borne by the Sponsors. Offshore Proceeds Account One route to provide temporary support, especially against currency inconvertibility, is to ensure that all foreign exchange is kept offshore, possibly in a secured account, and Debt Service is paid from this account. Due to the debt rescheduling restraints so pervasive in LDC countries, this is an increasing popular route in export-oriented Project Financing. Currency Inconvertibility Agreements These usually provide for the accrual and local investment of blocked currency with a view to repatriation at a later date. This may also require the Sponsor to make good either through a currency swap or perhaps an asset swap or access to additional collateral such as a guarantee. The latter is a form of Foreign Exchange risk allocation. Co-financing The provision of a Project Financing in parallel with a national or supernatural body/MLA loan can be strong protection to the project leaders. The theory goes that the government will generally exempt such financing from freezes, embargoes, moratoria, or rescheduling since it cannot afford to lose the support of that national or supranational body in the greater scheme of its national debt and aid. It is not a foolproof method, but is a powerful support in Project Financing. Local National Participation An effort to include local nationals in a project as equity investors and local banks as lenders can forestall adverse government actions. This may involve the construction of different classes of shareholders and debt.
There are four types of force majeure risks:
Obviously Acts of Government overlaps with Political Risk. They should not be included in the force majeure definition where the government is a Participant to a project or a contract. Many force majeure events coincide with the other risk categories such as Technical risk (water inflow) or Political risk (government regulations), but lenders can accept some of the temporary Force Majeure Risk through Project Financing. The expectation of such risk will lead to a requirement for a flexible transaction. Business interruption insurance is becoming more prevalent and is another way, favourably viewed by the financiers in a Project Financing, to cover Force Majeure Risk. However, it is not yet available for amounts exceeding about $500 million. This is one of the risks which seems to affect almost every project at some stage of its development or operation. Supports can come from: Insurance Insurance can cover Acts of Nature but is less able to cope with Act of Man or Acts of Government. Business interruption insurance perhaps applies more readily here than under the Technical component of Operating risk since, if negligence or management causes can be proven, most insurance policies would not pay up. Deferral The provisions in the credit agreement can provide for automatic deferral of Principal due to poor or no cash-flows caused by force majeure. There may be a limit in the deferral amount or extension period; equally there may be a "claw-back" mechanism to prior cash distributions to the Sponsors should a shortfall occur; or there may be a balance provided with prior debt service paid as expected or ahead of time.
Besides currency inconvertibility (a Political risk), foreign exchange exposure can occur when project revenues differ from the currency of the Project Financing. Lenders usually avoid Foreign Exchange Risk in Project Financing. The best hedge is to match the loan currency to the (underlying) currency in which the price of the product/tariff/toll is set. A further step is to match equipment purchases to the sales revenue currency. However, if a large loan is required, the available loan currencies may be limited. Hedging Various techniques provide for relatively short-term foreign exchange hedging either with banks or with currency futures contracts. Swaps Longer term currency hedges can be arranged through swap transactions either on a back-to-back basis or through parallel loans. These are unusual within Project Financing structures. Barter Various elements of counter-trade can be utilised to exchange capital from different currencies for the hardware to build project and repayment for such plant and equipment. This is not always a perfect hedge since the accounts typically have to be established in one or another currency. Barter has an abysmal success rate.
ENGINEERING RISK (Also known as Design risk) ENGINEERING RISK (Also known as Design risk) This poorly understood risk is often counted as part of Completion Risk since engineering and design flaws become quickly noticeable as the project encounters difficulty in construction or startup. The risk here revolves around the poor quality of the engineer/ design work which can also have a crippling impact on the cash flow stream well after the (excess) capital has been spent pre-Completion to counter the hardware problem. This risk can arise from poor professional advice or selection of an inappropriate or inexperienced firm for the technology or location involved. Flaws in capital budgeting or poor design estimates are only coverable by outsiders under: Insurance A professional indemnity insurance may cover such items as error and omission but usually nowhere near the level of cover commensurate with the project finance loan size. Other conventional insurance policies can be obtained for design errors at a more realistic cover level. Independent Certification An independent authority (hopefully with a good credit standing) will warrant that it agrees with the project studies on the basis of its due diligence exercise.
SYNDICATION RISK (May be called the Financing or Underwriting risk) SYNDICATION RISK (May be called the Financing or Underwriting risk) Once the terms and conditions of the Project Financing have been negotiated and documented, the actual funding has some risks which should be understood. Of course, if the loan is only given by one financier then this risk category does not apply. However, by a virtue of the usually large amounts involved, most projects involve a layering of financing or a syndicate which has its own conventions. The arranger or lead managers (1-3 banks) carry the negotiating responsibility with the borrower and the participating banks. The agent bank (usually one of the lead managers) arranges the documentation and loan disbursements. The lead managers arrange a syndicate of banks, first choosing the managers (2-6 banks) and the co-managers (3-10 banks) whose ranking depends on the amounts of the loan; and finally the participating banks. The capital markets follow a similar syndication pattern. The types of bank syndicates vary from fully underwritten or club deals among the lead managers to best-efforts commitment to raise money over and above the amount committed by the lead managers. A fully underwritten financing requires a slightly higher interest margin than a best-efforts financing. If it is decided to arrange a Project Financing in a number of sequential borrowings, then the borrower takes the risk that the interest margin may increase. This risk arises when the banking syndicate is to be arranged. It is covered by: Underwriting Agreement This provides that the lead financier(s) will provide all of the Project Financing required whether or not others are willing to join the syndicate later and participate in the risk. An underwritten club deal usually does not proceed to syndication. Broad Syndication Addition of financiers who have:
can give support to a Project Financing. The second point is important as there is nothing worse than a panicking financier - banker or bondholder - trying to address a waiver down the line without that lender having a commercial and experiential background on the matter in question.
Most bank Project Financings are funded on a floating-rate basis due to the necessity for flexibility in drawdowns and repayment. If interest rates escalate uncontrollably, the available cash flow can be correspondingly reduced and may not be sufficient to repay principal when due. Financiers usually accept this risk indirectly in a Project Financing. The longer term fixed-rate capital markets have been aggressively chasing long-term infrastructure and power projects. Co-financing from government or quasi-government entities such as ECAs or the World Bank may help to introduce fixed-rate funding as well as longer maturities. This risk that interest rates will get out of hand is difficult to cover off through supports and guarantees, although some techniques can be applied. Interest Make-up Agreement The parent/Sponsor may agree to bear all interest expense in excess of, say 12% pa. Sometimes this excess may be recaptured from future cash-flows or the Sponsor may have built up a paper "credit" when interest rates are below this level. Interest Protection Agreement The banks may also agree to put a ceiling (cap) on interest rates if they float above the pre-agreed level. Again this could usually be recaptured when interest rates returned below the greed level. This is not popular with banks after some major money-centre banks got into trouble with big portfolios of this type of loan in the late 1970s and early 1990s. Hedging Some hedge mechanisms are available through forward interest-rate markets, and in some measure should longer term LIBOR funding periods be permitted (beyond the normal three and six month interest periods). These range in term from a few days to 18 months on the exchanges to possibly a few years for the London Interbank Offering Rate ("LIBOR" a common international US$ floating rate funding benchmark). Swaps Interest-rate swaps, floating-to-fixed, can be layered onto a Project Financing although it is unlikely to be on the full amount because of the unwinding penalties should a swap have to be broken. Swap length is usually 1-10 years. Commodity swaps are rapidly developing to underpin some Project Finance funding in the 1990s. Alternate Funding The option of lower-cost sources of funds can, of course, help reduce this risk. Gold funding and financial instruments such as commercial-paper provide flexible alternatives whereas export credits or leasing tend to have a rigid repayment terms viz one cannot readily stop leasing and then re-lease the equipment a few months later. These are accessed via letters of credit or guarantees; therefore, a bank/consortium credit or L/C is substituted for the project risk in the eyes of the other funding sources. Supplier Credits Sometimes suppliers have access to subsidised local funding which enables them to offer favourable financing terms to the project. Some suppliers may use their own lower-cost funding pool or may grant concessionary financing terms in order to clinch an order. Leasing Another party may elect to own the asset or development in return for the use of the attached tax benefits and thus provide or facilitate funding or indeed the asset itself at a lower interest rate. If the Lessor has to bear the risk on the asset (degradation, loss, maintenance), it is an operating lease. Otherwise the lease is called a finance lease.
The burden of legal documentation (which in the end apportions the risks among the lenders, insurers, governments, buyer, and sponsors) usually rests on the financier and its advisers. There is some risk that professional advisers will create risks in the document which can affect the tax position, tenure, security, enforcement, and other attributes so heavily negotiated in the risk-allocation process embodied in the Project Financing in the first place. Second opinions, judgement, and experienced staff and advisers are perhaps the only way to mitigate this final risk category. The risk of professional advisers creating unworkable, faulty or unenforceable documentary structures is difficult to mitigate overtly but some supports are available such as: Title Insurance This can sometimes be effective to cover deficiency in the title to tenure of the site. Title searches should be done professionally. Legal Opinion This element of the project finance documentation needs to be thoroughly scrutinised well before loan signing to ensure the lawyers have not embodied serious caveat to their opinions. A second opinion or jurisprudential statements, eg from a Queen’s Counsel, may be well worth the expense. International joint ventures can be tricky from a cross-border and language standpoint.
CONCLUSION A full understanding of who takes what risk and the general rules applied by Project Financiers can result in remarkably good Project Finance agreements without too much difficulty. An early dialogue with the financiers will serve to validate the Sponsor's expectations of risk sharing in a Project Financing. A firm understanding of these objectives should be established, perhaps with the assistance of a financial adviser. Matching these objectives to the structures in a Project Financing is heavily driven by the specific risk to be covered and the balance sheet and tax objectives of the Sponsor(s). The large number of supports described above should not become a checklist. Project Financing requires sophisticated judgements to arrive at the trade-off in these various supports to achieve both the lender's and the borrower's objectives and risk to match comfort levels. Yet the complexity of supports demonstrates the flexibility that has needed to be developed in order to make this source of funds attractive. Project Financings are live documents and one can expect changing conditions to have to be accommodated. The fewer loan documentary waivers or amendments required on an on-going basis is a good measure of skill in establishing the structure for which the documentation was stitched together.
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