A. OVERVIEW OF OPERATING AGREEMENTS
The main operating documents are the Supply Contract, the Operation and Maintenance (O & M) Contract and the Offtake/User Contract; and, depending on the nature of the project, other operating agreements like a Technology Licensing Agreement may also be relevant. These agreements become operational when construction is completed; and each is of critical importance to the success of the project as the SPV must be assured of a continuous supply of essential inputs under the supply agreement in order to produce the output under the O & M agreement to be sold under the offtake/user agreement to generate the project’s revenue stream.
Supply and offtake/user contracts raise similar issues as both are purchase and sale agreements. The SPV is the seller under a project’s offtake/user contract and the buyer under the supply agreement; and a take-or-pay offtake/user contract and a supply-or-pay contract are similar in nature. While they are not mirror images of each other, they do have many similar terms; and the issues they raise with respect to type of contract, definition of force
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majeure, nature of purchaser and seller obligations, price adjustment and termination are also similar.
In the case of the O & M contract, many of the concepts discussed in connection with construction contracts are also applicable as the provider of O & M services has a role somewhat similar to that of a the contractor. Issues with respect to the type of contract used, risk allocation, performance standards, and incentives and penalties arise in both types of contracts. With respect to risk allocation, the SPV will want to transfer as much performance risk as possible to the operator and have a fixed price contract, a narrowly defined force majeure clause and penalties for poor performance. The operator will, like the contractor, generally prefer some type of cost plus contract, try to minimize the amount of performance risk it assumes, and seek broadly defined relief events, loosely defined performance standards and limits on its liability.
The relative importance of the various operating agreements will vary with the type of project and the nature of the market in which the project operates. Each contract deals with a mixture of technical, financial and legal issues so an interdisciplinary, team effort involving engineers, financial experts and lawyers is required to negotiate, draft and
implement the supply, O & M, and offtake/user agreements. The purpose of this chapter and the next is to outline the key legal and financial provisions of these agreements from a lender’s perspective. The focus will be on (1) risks
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and other areas of special interest to lenders in evaluating the bankability of a project and (2) how these risks and interests are mitigated and dealt with in the three main operating agreements.
B. GENERAL LENDER INTERESTS IN OPERATING AGREEMENTS
The lenders’ main concern is that the operating agreements are structured to ensure that they work together to generate sufficient cash flow on a sustainable basis to meet debt service obligations for as long as their debt is outstanding. In their more detailed focus on the adequacy of the expected revenue stream, lenders consider a number of more specific operating phase risks which are summarized below.
1. SUPPLY AND PERFORMANCE RISKS
There are a number of factors which can affect the quality and quantity of a project’s performance, including:
• lack of critical inputs (e.g. fuel for a power station) caused by market conditions, political disturbances, or transportation problems which means that the project cannot produced the expected level of output:;
• low quality of critical inputs (e.g. inferior quality coal for a power plant) which leads to reduced performance and output;
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• price of inputs increases which, if not passed on to ultimate consumers, could reduce the net revenue stream of the project;
• delay in delivery of inputs which delays output and which may require the SPV to pay LD’s to the offtaker/user;
• an accident or other force majeure event interrupts production or service from the project and results in diminution of revenue;
• the project ceases to operate causing a complete cessation of the revenue stream;
and
• the project works but at reduced levels of capacity causing a reduction in the revenue stream.
2. MARKET AND DEMAND RISKS
One of lenders’ main concerns is the risk of a reduction in demand for the project’s output or service which leads to a reduction in the revenue stream available for debt service. The decrease in demand can result from a number of factors, including:
• a general decrease in overall economic activity which, in turn, decreases demand for the project’s output;
• competitive factors which divert demand away from the project (e.g. when a newer more efficient power plant starts selling in a merchant power market);
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• inaccurate demand forecasts which lead to the creation of an overly optimistic financial model. The problem of overly optimistic demand projections has been especially widespread in the traffic estimates for toll road projects;
• currency mismatches that occur when a borrower borrowers in one currency (e.g.
the US dollar, Euro, or Yen) but earns its revenue in a local currency. In cases where the local currency devalues relative to the foreign currency of the borrowing, this may result in substantial increases in the local currency prices for a project’s output and a consequent reduction in demand by local consumers;
• price fluctuations resulting from a variety of factors including competitive factors in merchant or retail markets, weather considerations resulting in reduced (or increased) demand for power, and pass-through of changes in fuel costs; and
• price escalation under an offtake/user contract caused by inflation, fuel cost increases, or exchange rate devaluations which, when passed on to consumers, may have a negative impact on demand.
3. RISK MITIGATION
One of the major tasks of a project finance lawyer is to work with the project’s technical and financial
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advisors to mitigate these risks to levels that lenders find acceptable and enable them to conclude that a project is bankable. The tools available to do this include: the way that the terms and conditions of the main operating agreements are drafted; various forms of government and third-party credit support; or most likely, a combination of the two. The remainder of this chapter and Chapter 11 consider how the supply, O & M and offtake/user contracts can work together to deal with some of these risks. Chapters 13, 14 and 15 consider other methods of providing credit support.
C. SUPPLY CONTRACT
The supply contract provides the products and other inputs essential to the operation of the contract—e.g. fuel for power stations; raw water for water projects; ore for refining and smelting facilities; and oil and gas for pipelines, refineries, petrochemical and other processing facilities. Without the essential inputs, projects would not operate and there would be no revenue stream to service the lenders’ loans.
While supply agreements are obviously a critical element of projects like power generation, water treatment and processing plants which depend on a continuous supply of critical inputs, they are far less important for road projects and social infrastructure projects involving construction of government buildings, schools or hospitals where ongoing supply considerations are not as important.
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1. LENDER INTERESTS
Issues that are typically dealt with by engineers, financial officers and/or lawyers in supply contracts include: the quantity to be supplied; the method and timing of delivery;
the quality and other specifications of the product; the price (or method of determining price) and any formula for adjusting price over the life of the project (e.g. through escalation clauses); transport and storage issues; and liquidated damage and termination provisions related to delays in deliveries or complete failure to deliver. The issues of particular interest to lenders are: how can the availability of essential inputs be assured?
how can unwanted changes in future input prices be prevented or mitigated? how can input of the needed quality be assured? and how should these risks be allocated between the supplier and the SPV to minimize the negative impact on the revenue stream?
2. RISK MITIGATION
With respect to input availability and quality, the best way to insure sustained availability is to select known, reliable suppliers from stable parts of the world because no contract provision can ensure the delivery of a product when it is simply not available.
However, contract provisions can help the SPV mitigate the consequences of lack of delivery and/or sub-standard input quality. For example, under a “supply-or-pay” contract, if the supplier is not able to supply the product on time and/or in the specified quantity or quality, the contract would require the
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supplier to pay the SPV the cost of obtaining the needed input from an alternative source. In addition, liquidated damage clauses can be used to compensate the SPV for any claims brought against it by the offtaker or user for damages resulting from any delay
in delivery or diminished quantity or quality of inputs.
With respect to supply price, some inputs can be obtained using long term fixed price supply contracts with price set at an initially agreed level and often with a formula for escalation due to various factors like inflation and exchange rate changes. In cases where long term fixed price supply arrangements are not possible, SPV and lenders may have to accept the risk that input prices will fluctuate with market conditions. However, the consequences of such price movements can sometimes be minimized using derivative markets (e.g. the forward and/or futures markets or floating to fixed commodity price swaps.)