Risk management in context of project financing of infrastructure project

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Risk Management in Context of

Project Financing

of Infrastructure Project

Prof GLENN P JENKINS

DEPARTMENT OF ECONOMICS

EASTERN MEDITERRANEAN UNIVERSITY

NORTH CYPRUS

What is Project Finance?

• No universally accepted definition of the term “Project Financing”

different people use it in different senses.

• Project financing refers to a financing in which lenders to a project

look primarily to the cash flow and assets of that project as the

source of payment of their loans.

PROJECT FINANCE

Origins and Development of

Project Finance

• Project financing had its origins in the energy industry in

industrialized countries (oil & gas production loans)

• Later extended to infrastructure, transportation, mining,

utilities and large industrial projects

• Scope further expanded to include all kinds of

infrastructure projects

• Today even medium-scale projects (US $5 million) can use

project finance

Development of Project Finance

1994 1996 1997

• Number of Project

Finance Transactions 50 400 380

in emerging markets

• 41% of emerging markets project finance flows between

1994 and 1998 went to Asia

• About 75% of project finance flows worldwide went to

infrastructure and energy in 1999

Source (IFC 1999), Capital Data Project Finance Ware (2000)

Why Project Financing?

• Project Owners’ Perspective

– Size and cost of projects

– Risk minimization

– Preservation of borrowing capacity

and credit rating

– May be only way that enough funds

can be raised

Private Public Partnerships in

Infrastructure

• A major new user of project financing techniques

• Infrastructure traditionally financed and managed by

governments

• Demand for infrastructure has been growing faster than

available government funding particularly in emerging

economies

• Recent trend has been to involve the private sector in the

supply and provision of these services

• There has to be a clear benefit for both the public and the

private partners

Main Characteristics of Suitable Investments for Projects Financing

• The ideal candidates for project financing are capital

investment projects that

• are capable of functioning as independent

economic units,

• can be completed without undue uncertainty, and

• When completed, will be worth demonstrably more

than they cost to complete.

Main Characteristics of Project Finance (Summary)

– Project is a distinct legal entity.

– Project assets, project-related contracts, and project cash flows are separated to

a large degree from the sponsors.

– Sponsors provide limited or no recourse to cash flow from other assets.

– Lenders may have recourse to their funds through other stakeholders through

various types of security arrangements.

– Two-phase financing is common.

The Basic Elements of a Project Financing

Loan funds

Debt repayment

Equity funds

Returns to investors

Cash deficiency agreement and

Equity

Lenders

Raw

materials

Supply

contract(s)

Purchase contract(s)

Output Assets comprising the

project

Prerequisites for Project

Financing

• Financial Analysis

• Economic Analysis

• Risk Analysis

It’s All About Risk!

The key to project financing is

the reallocation of any risk away

from the lenders to the project.

Definition of Project Completion

• Principle Categories of Risk: Pre-Completion and

Post-Completion

• Physical Completion

– Project is physically complete according to technical

design criteria.

• Mechanical Completion

– Project can sustain production at a specified capacity for

a certain period of time.

• Financial Completion (financial sustainability)

– Project can produce under a certain unit cost for a certain

period of time & meets certain financial ratios (current

ratio, Debt/Equity, Debt Service Capacity ratios)

Management and Alleviation of Risks

Principle Categories of Risk: Pre-Completion and Post-Completion

A:Pre-Completion Risks:

Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution

•Participant Risks

-Sponsor commitment to project - Reduce Magnitude of investment?

-Require Lower Debt/Equity ratio

-Finance investment through equity then by debt

– Financially weak sponsor - Attain Third party credit support for

weak sponsor (e.g.,Letter of Credit)

- Cross default to other sponsors

•Construction/Design defects

Management and Alleviation of Risks

A:Pre-Completion Risks (cont’d):

Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution

•Process failure - Process / Equipment warranties

•Completion Risks

– Cost overruns - Pre-Agreed overrun funding

- Fixed (real) Price Contract – Project not completed - Completion Guarantee

- Tests: Mechanical/Financial for completion

– Project does not attain - Assumption of Debt by Sponsors if

mechanical efficiency not completed satisfactorily

B Post-Completion Risks

Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution

• Natural Resource/Raw Material

– Availability of raw materials - Independent reserve certification

- Example: Mining Projects: reserves twice planned mining volume

- Firm supply contracts

- Ready spot market

• Production/Operating Risks

– Operating difficulty leads to - Proven technology

insufficient cash flow - Experienced Operator/ Management Team

- Performance warranties on equipments

- Insurance to guarantee minimum cash

Some Examples of

Ways to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Market Risk

–Volume -cannot sell entire output - Long term contract with creditworthy

buyers :take-or-pay; take-if-delivered; take-and-pay

–Price - cannot sell output at profit - Minimum volume/floor price provisions

- Price escalation provisions

• Force Majeure Risks

–Strikes, floods, earthquakes, etc - Insurance

- Debt service reserve fund

B Post-Completion Risks

Some Examples of

Ways to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Political Risk

–Covers range of issues from - Host govt political risk assurances

nationalization/expropriation, - Assumption of debt

changes in tax and other laws, - Official insurance: OPIC, COFACE, EXIM

currency inconvertibility, etc - Private insurance: AIG, LLOYDS

- Offshore Escrow Accounts - Multilateral or Bilateral involvement

• Abandonment Risk

–Sponsors walk away from project - Abandonment test in agreement for

banks to run project closure based on historical and

projected costs and revenues

• Other Risks: Not really project risks but may include:

–Syndication risk - Secure strong lead financial institution

–Currency risk - Currency swaps / hedges

–Interest rate exposure - Interest rate swaps

–Rigid debt service - Built-in flexibility in debt service

The Need for Contracts

• Project financing arrangements invariably involve strong

contractual relationships among multiple parties

• Project financing can only work for those projects that can

establish such relationships and maintain them at an acceptable cost

• To arrange a project financing, there must be a genuine

“community of interest” among the parties involved in the

project

• In must be in each party’s best interest for the project financing

to succeed

• Only then will all parties do everything they can to make sure

that it does succeed