project risk analysis

Risks in Project Financing

PROJECT RISK ANALYSIS†

CONTENTS

Introduction..............................................................................................1

Identification of Risk.................................................................................3

Currency related risk................................................................................4

Forward Contracts.................................................................................5

Swaps Contract.....................................................................................5

Futures contract....................................................................................6

Options contract....................................................................................6

Permit, Concession and License Risk.......................................................6

Change of law risk....................................................................................7

Expropriation Risk....................................................................................8

Demand Risks/ Revenue Risk/ Offtake Risk............................................10

Supply Risks...........................................................................................11

Operating Risks......................................................................................13

Delay Risk..............................................................................................14

Technological Risk..................................................................................14

Environmental Risk................................................................................15

Credit Risk/ Counterparty Risk...............................................................17

† Author: Astha Misra, S. Prathyusha, Shalini Wunnava, LL.M., National Law University, Jodhpur

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Force majeure Risk.................................................................................17

Cross-border Risks.................................................................................18

Mitigating Risks Through Investment Structure.....................................19

Bilateral Investment Treaties.................................................................20

Multilateral Investment Treaties (MITS).................................................22

ICSID......................................................................................................23

Conclusion..............................................................................................25

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INTRODUCTION

Project financing may be defined as the raising of funds on a limited-recourse or nonrecourse basis to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.‡ Project financings typically include the following basic features –

1. An agreement by financially responsible parties to complete the project and, toward that end, to make available to the project all funds necessary to achieve completion.

2. An agreement by financially responsible parties (typically taking the form of a contract for the purchase of project output) that, when project completion occurs and operations commence, the project will have available sufficient cash to enable it to meet all its operating expenses and debt service requirements, even if the project fails to perform on account of force majeure or for any other reason.

3. Assurances by financially responsible parties that, in the event a disruption in operation occurs and funds are required to restore the project to operating condition, the necessary funds will be made available through insurance recoveries, advances against future deliveries, or some other means.

A project financing requires careful financial engineering to allocate the risks and rewards among the involved parties in a manner that is mutually acceptable. The business of project financing is founded upon the identification, assessment, allocation, negotiation, and management of the risks associated with a particular project. Indeed, as project finance lenders look to the revenues generated by the operation of the financed project for the source of funds from which that financing will be repaid, ‡ JOHN D. FINNERTY, Project Financing: Asset-Based Financial Engineering, 1 (John Wiley & Sons, 2007).

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the whole basis for project financing revolves around an understanding of the future project revenues and the impact of various risks upon them. Risk is a crucial factor in project finance since it is responsible for unexpected changes in the ability of the project to repay costs, debt service, and dividends to shareholders. Risks must be identified in order to ascertain the impact they have on a project’s cash flows; risks must be allocated, instead, to create an efficient incentivizing tool for the parties involved. Cash flows can be affected by risk, and if the risk has not been anticipated and properly hedged it can generate a cash shortfall. If cash is not sufficient to pay creditors, the project is technically in default. If a project participant takes on a risk that may affect performance adversely in terms of revenues or financing, this player will work to prevent the risk from occurring. From this perspective, project finance can be seen as a system for distributing risk among the parties involved in a venture. In other words, effectively identifying and allocating risks lead to minimizing the volatility of cash inflows and outflows generated by the project. This is advantageous to all participants in the venture, who earn returns on their investments from the flows of the project company.

Most of the time allocated to designing the deal before it is financed is, in fact, dedicated to analysing (or mapping) all the possible risks the project could suffer from during its life. Above all, focus is on identifying all the solutions that can be used to limit the impact of each risk or to eliminate it. Risk allocation is also essential for another reason. This process is a vital prerequisite to the success of the initiative. In fact, the security package (contracts and guarantees, in the strict sense) is set up in order to obtain financing, and it is built to the exclusive benefit of original lenders. Therefore, it is impossible to imagine that additional guarantees could be given to new investors if this were to prove necessary once the project was under way. The process of risk management is crucial in project finance, for the success of any venture and is based on four closely related steps – 1) risk identification, 2) risk analysis, 3) risk transfer and allocation of risks to the actors best suited to ensure coverage against these risks, and 4) residual risk management.

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IDENTIFICATION OF RISK

Risks inherent to a project finance venture are specific to the initiative in question; therefore, there can be no exhaustive, generalized description of such risks. This is why it is preferable to work with broader risk categories, which are common to various initiatives. The criterion used to identify risk is chronological, an intuitive choice, seeing as this parameter is generic enough to be usable across different sectors of application. An essential aspect of the project finance lawyer’s role in helping the parties reach a ‘bankability’ assessment involves reviewing the project, and in particular it’s underlying documentation, in order to identify its potential and fundamental risks and to determine if, and how appropriately, those risks have been allocated among the parties.A project goes through at least two phases in its economic life–

1. The construction, or pre-completion, phase2. The operational, or post-completion, phase

These phases have very distinct risk profiles and impact the future outcome of the initiative question in different ways. In keeping with our chosen criterion, the risks to allocate and to cover are –

1. Pre-completion phase risks2. Post-completion phase risks3. Risks common to both phases

The various types of risk are –1. Permit, Concession and License Risks2. Currency-related risks3. Expropriation Risks4. Change of Law Risks5. Political Risks6. Country Risks7. Law and Legal Systems Risks8. Construction Risks9. Demand Risks/ Revenue Risk

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10. Supply Risks11. Operation Risks12. Cross-border Risks13. Environmental Risk14. Credit Risk or Counterparty Risk15. Force majeure Risk16. Delay Risk17. Technological Risk

The importance of risk to project finance has been stated several times. There are no complete definitions of risk, but it is often considered in relation to uncertainty and incomplete information. An uncertain or unknown future event can have a potential negative impact on some characteristic of value/the business and that is what is most often understood by risk. In relation to project finance it is as mentioned very important to identify, assess and allocate the risks. As the lenders place a large degree of reliance on the performance of the project, they will naturally be concerned with the feasibility of the project and its two possible events affecting it negatively. The aforesaid risks that have been enlisted dealt with separately in the following chapters.

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CURRENCY RELATED RISK

This sort of risk develops when some financial flows from the project are stated in a different currency than that of the SPV. It mostly occurs in international projects where cost and revenues are work out in different currencies. Even in the domestic project a similar situation may arise, when counterparty wants to bill the SPV in foreign currency. The best possible ways to cover tis kind risk is currency matching, means advisors of an SPV try to state as many flows as possible in the home currency, avoiding any use of foreign currency. If this is not possible (usually because counterparties have strong bargaining power), the following coverage instruments provided by financial intermediaries must be used§:

1. Forward agreements for buying or selling2. Futures on exchange rates3. Options on exchange rates

§ GATTI STEFANO, Project Finance in theory and practice Designing, Structuring, and Financing Privateand Public Project 37 (Academic Press, 2008).

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RISK

Strategic risk

Economic risk, Industry risk,

Strategic transactional

risk,Social risk,

technological risk,

Political risk,Organisational

risk

Operational risk

Environmental risks, Financial

RisksBusiness

Continuity Risks,Innovation risk,

Commercial Risk,Project risk,

Human resource risk,

Health and Safety risk,

Property Risk,Reputation Risk

Reporting risk

Information Risk,

Reporting Risk

Complaince risk

Legal and regulatory Risk,

Control Risk,Professional Risk


4. Currency swapsOne of the ways to manage the currency risk is Derivatives contracts. Covering financial risk in a project finance venture does not differ greatly from policies on corporate treasury management, though there is a major difference which is that the project life of such ventures is always longer than the time horizon for which these instruments are traded. In particular, this is the case regarding coverage instruments listed on stock exchanges and for some over-the-counter derivatives (such as futures on exchange rates). For this reason, structured finance transactions most often involve specific negotiated forms of coverage earmarked specifically for the project or use rollover strategies on standard contracts as they reach maturity**.

Forward Contracts This kind of contract involves an exchange with a delayed settlement in which the traders set down contract conditions (specifically the date of settlement and the price) upon signature of the contract, and the exchange is actually settled at a future, pre-agreed date. A forward contract might pertain to a currency exchange rate (on maturity, the traders sell each other one form of currency for another on the basis of an exchange rate set when the contract is drawn up), a financial asset, or an interest rate. In the cases where the price is fixed when the contract is made and remains unchanged until settlement, any potential fluctuations in the quotation on exchange rates, interest rates, or the financial asset in question do not affect the two parties, so both are covered. But where the listed prices rise above the negotiated price level of the forward contract, the buyer is at an advantage; the reverse will occur if the listing falls below the agreed-on price level. (Naturally, for the seller the opposite is true.)†† Forward contracts are used for the most part as coverage against exchange rate risks.

** Supra note 2, p. 37.†† Supra note 2, p. 38

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Swaps ContractThe contracts which are made between two counterparties that stipulate reciprocal disbursement of payment streams at pre-established future dates for a set period of time are known as Swaps. A swap is a combination of several forward transactions. In any case, the payment streams relate to interest calculated on given principal. When interest rates are stated in two different currencies, we refer to currency swaps, and the two streams can be either fixed rate or variable rate. When interest rates pertain to the same currency, obviously one of the flows is calculated at a fixed rate and the other at a variable rate. Contracts known as interest rate swaps, in their simplest form, are a periodic exchange of fixed-rate streams against variable-rate streams (usually indexed to LIBOR or Euribor) for a given time horizon.” Swaps are usually used to modify the conditions of a pre-existing loan. These are over-the-counter contracts which are handled by intermediaries on the basis of the specific needs of a trader, which make them contractual structures that are well suited to covering currency risk and interest rate risk in project finance deals.

Futures contractFuture contract is a forward agreement in which all contractual provisions are standardized (the underlying asset, date of maturity and date of delivery of the instrument in question, minimum contract lot). The future markets offers contracts written on the most widely exchanged currencies on an international level.

Options contract The contracts which are either listed on the stock markets or negotiated over the counter, that allow (but do not oblige) the buyer to purchase (call option) or sell ( put option) a commodity or a financial asset at a fixed price (strike price) at a future date in exchange for payment of a premium. Unlike all the contracts discussed previously, it let the buyer choose whether or not to settle the contract. And because of this the buyer pays premium to the seller as a cost of this choice. In project

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finance deals, options are used both for covering currency rate risk and protecting an SPV’s cash flows from interest rate risk.

This kind of currency risk can be managed by (1) borrowing an appropriate portion of project debt funds in U.S. dollars, (2) hedging using currency forwards or futures, or (3) arranging one or more currency swaps.

PERMIT, CONCESSION AND LICENSE RISK

There are many facets to regulatory risk mainly consist of permit, concession and license risk, the most common are the following:

1. The permits which are needed to start the project are usually delayed or cancelled by the regulatory authorities.

2. The basic concessions and permission for the project are unexpectedly renegotiated.

3. The core concession for the project is revoked.These kinds of delays or risks are usually caused by inefficiency in the public administration or the complexity of bureaucratic procedures. If in case these delays are the resultant of specific political intent to block the initiative, the situation would become more similar to political risk.

CHANGE OF LAW RISK

Political risk takes in various forms and change of law is one kind of that risk. Any change in the political situation can also bring the change in law and administration which may not share the same view as the previous one. The modification in law can result in hinder project operations. This kind of risks are more common to find in the countries which do not have a very well defined legal structure, mostly have political unstable government, and law can be easily be change according to the will of the government and political leaders in power. The primary focus of this risk is on project’s lenders, whose lawyers analyse and manage the risk. Their jobs is to ascertain in advance that any change in the commercial laws of

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the host country can bring any kind of problems during the construction or post completion phases.

It should be noted that contract enforceability does not depend exclusively on the degree of economic development in a country but also involves a series of other factors, such as a country’s judicial tradition and the institutional conditions and context characteristics and changes which come in them with the passage of time period.

There are two ways through which these risks can be covered –

1. To draw up an agreement with the government of the host country stating that the government will create a favourable environment for the sponsors and SPV in the case of change in law.

2. To provide an insurance market. Insurance policies are available offering total or partial coverage against these risks. These policies are offered by multilateral development banks and export credit agencies as well as by private insurance companies.

The magnitude this problem has reached has led various research organizations to compile indices that actually measure the degree of corruption and reliability of political and administrative institutions of a given country.

With change in law often led the project-sponsor to devote considerable time and effort to obtaining the appropriate legislative and regulatory approvals to allow a project to proceed. The existence of such hurdles can have a significant impact on the sponsors’ decision on where to build the project. Making the appropriate arrangements with the host country government can reduce substantially, or even eliminate, this problem.

EXPROPRIATION RISK

International investors and lenders face the risk of expropriation of their project investments. Projects in foreign jurisdictions and in particular those in politically unstable or developing countries must be structured to

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ensure that there is both contractual and treaty protection to safeguard such investments.

Historically, the lack of appropriate mechanisms open to foreign investors and lenders to protect projects and the associated risks caused a restriction in the flow of international investment into certain countries. In order to overcome this difficulty, to remedy the concerns of investors and lenders and to improve the flow of investment funds, there have been an increasing number of contractual protections that have become market standard for international projects and treaty protections for investors and lenders such as bilateral and multilateral investment treaties between states.

In recent years there has been a marked increase in the number of investors and lenders that have sought compensation from states perceived by investors and lenders to have expropriated their projects. This has been in part due to the internationalisation of projects and the ability of investors and lenders to seek recourse for such expropriation through investment treaties.

In a nutshell, expropriation is the taking of a project by the state, whether for public purposes or otherwise. As case law on expropriation has developed, so the understanding of what is and what is not expropriation has become clearer. At a basic level, expropriation can be divided into direct and indirect expropriation.

Direct expropriation is where the state exercises its sovereignty over a project either on an individual basis or as part of a wider scale nationalisation programme. Generally direct expropriation is a clear action by the state that transfers title of the project from the investors to the state and as such provides clear grounds for the deprived investors to seek compensation from the state; for example following Venezuela’s expropriation of oil projects in the Orinoco Belt in 2007. In other words the investors and lenders have a specific action and point in time from which they can measure the state’s liability.

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Indirect expropriation is less specific. As GC Christie surmised:

1. a state may expropriate property, where it interferes with it, even though the state expressly disclaims any such intention, and

2. even though a state may not purport to interfere with rights to property, it may, by its actions render those rights so useless that it will be deemed to have expropriated them.

Commentators have described indirect expropriation variously as disguised, creeping and consequential expropriation, for example the refusal to renew or the withdrawal of a licence (Tecmed v Mexico)‡‡, undermining contractual arrangements (CME v Czech Republic)§§ and termination of contracts for irrelevant reasons (Azinan v Mexico)***. For an investor and its lenders the main issue is that there is no clear single action by the state and as such the moment from which compensation should accrue may lack definition. The investor may therefore find itself in a position where it is unclear whether it should continue to operate the non-profitable project or abandon it and try to claim that expropriation has taken place due to the state’s indirect interference. It is worth noting that not all changes to legislation or regulation by a state which are to the detriment of a project can be classified as expropriation. Non-discriminatory measures that are lawfully taken by a state, including the introduction of quotas, changes to taxation, environmental protection, labour laws and other measures may not be deemed to be expropriation despite the loss suffered by the investor and lenders and as such little or no compensation would be available to the investor and lenders in such circumstances. Such non-discriminatory measures however must be in line with international law and must not have the effect of “eviscerating” the rights of the investor (Eureko v Poland)†††.

In short, the risk is that following a direct or indirect expropriation the investor is not compensated. Investors and lenders would argue that any expropriation by the state should result in sufficient compensation from ‡‡ ICSID Case No ARB (AF)/00/2§§ UNCITRAL, Partial Award 13 September 2001.*** ICSID Case No ARB (AF)/97/2 (Robert Azinian and Others v United Mexican States).††† RG 2006/1542/A Brussels CA

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the state to ensure that the investor is in no worse a position than if the expropriation by the state had not taken place. However, from case law the general trend is for the expropriating state either to seek to justify its expropriation of the asset or project and thereby not pay any compensation, or claim that no expropriation has taken place and therefore no compensation is due, such as in Metalclad v Mexico‡‡‡.

POLITICAL RISK

The form of risk most commonly considered in financial arrangements relates to political risks. Essentially, these are risks that arise from political and governmental circumstances and behaviour in the jurisdiction at issue. These include less severe circumstances such as change in government (which may occur at fixed intervals in many contexts but may be less predictable in other contexts), legal changes ( for example ,as a result of new legislation or treaties) and the classic consideration of nationalisation(i.e., government seizure or expropriation of assets). At the outset, the most effective management technique is simply to locate projects within stable political environments. Though it is not always suitable or desirable, as additional levels of risk should bring with them possibility of higher rates of return. Political risk is not completely ameliorated by a close relationship with the government of the time, as governments and political arrangements and political arrangements should carry on with the commitments of previous governments and regimes, this may not be politically acceptable in the actual circumstances. While direct involvement and commitment of the host government are genera;;y essential, at the same time , depending upon actual circumstances, this may not be sufficient to manage and mitigate political risk concerns.

Political risk component contains three risk factors. The first is investment risks, which relates to currency convertibility and transfer a component, which has to do with government restricting the outflow of money from

‡‡‡ ICSID Case No ARB (AF) /97/1.

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the country and converting the cash flows into other currencies. This is often necessary as the loan taken on the project is denominated in other currencies than the one of the host country. Developing markets often have poor financial markets that are not capable of providing the funds needed for the project, in which case the loan is denominated in foreign currency. Investment risk also includes the risk of expropriation of the investment by the government and war or internal and external conflicts, which makes the project unable to function properly or entirely. The second component of political risk component is “change of law” which include factors like: price controls, withdrawal of permits, licences or concessions, deregulation of the market introducing new competitors, increases in tax, tariffs, import duties or controls. All of which could create some of the input or revenue risks discussed previously. It also includes new rules and requirements on environmental issues, safety, health and employment. All of these can interfere with the operation of the project and the primary political risk is in government interference by changing the current setting in which the project operates. Under this is also creeping expropriation, which is found in the last political risk, component: Quasi-political risk. This also includes “sub-sovereign” risk, the risk that lower levels of officials interfering with the projects viability, and breach of contract which incorporates the risk of the host government not honouring their obligations or the legal system not being objective. This risk of the legal system not providing objective ruling is also mentioned earlier as the many contracts in a project finance deal depends on the legal system of the host country.

Issues which commonly arise in relation to such cover include –

1. The scope of political risk, including regulatory risk and administrative risk;

2. Whether or not political risk includes events in more than one country or different states of the host country;

3. The relationship between political risk and other normal project risk ( for example completion risk);

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4. The extent to which a shareholder( particularly a local shareholder) can influence events which compromise political risk; and

The consequences of a political risk event occurring and how it affect, for example, shareholder obligation to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic agencies or the basic liability of the borrower.

COUNTRY RISK

The risk that a foreign government will significantly alter its policies or other regulators so that it negatively impacts the business climate in that country or the returns on a particular industry, company or project. Macro country risk deals with policy changes that harm, say, exporters or foreign owned businesses in general ,while micro country risk implies that a government will deliberately target a particular company or way of making a living. For example, the political climate of a country in which defences contractors operate may turn against one particular company because of its perceived excesses or against contractors in general. This may cause the government revoke contracts for one or more defence contractors. Country risk varies from one country to next. Some countries have high enough risk to discourage much foreign investment. Country risks are basically assessed on the basis of a track record, and the maintenance of such a track record cannot be taken for granted. International Country Risk Guide bases its analysis on corruption risk, expropriation risk for private property and risk of contract repudiation. For each country, this guide complies statistics on the level of exposure with said risk. It is easy to see that in these cases, contracts are likely to be evaded if the institutional system does not adequately safeguard the rights of lenders. Narrowly defined, country risk is refers to cross currency and foreign exchange availability risks. More broadly defined, it can also include the political risk of doing business in a given country. Country risk is essentially a weighted average of the political or financial factors that are perceived to constitute country risk. Once a country risk is measured it can be incorporated into a capital budgeting analysis by adjustment of

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the discount rate. The adjustment is somewhat arbitrary, however and may lead to improper decision making.

LAW AND LEGAL SYSTEM RISKS

Additional risks are associates with foreign investment, leading regulatory and other laws, or the lack of them and different legal systems and cultures. The local laws of the jurisdiction where the project is located should be carefully examined by the project participants, particularly the project sponsor and lenders, early in the structuring and documentation process. The legal system of most emerging countries continue to be less developed and in industrialized countries. This results in a degree of uncertainty as to the legal environment the project must construct and operated in. It also provides uncertainty to the project lenders, if compelled to enforce their rights. Significantly considerations include access of foreign entities to judicial system, enforceability of foreign judgements, whether arbitration is permitted for dispute resolution, and enforceability of arbitration awards. An acute problem facing project financing investments is the state of the judicial systems of many Latin American countries. International project finance in these countries can proceed only so far without the host country’s institutional and legal support to help manage various risks. All too often, the element of legal risk as a result of the poor quality of judicial systems and other dispute resolution alternatives overcomes the projected profit margin and discourages potential foreign lenders and investors In these nations, legal risk can translate into many different obstacles for project financing should there be an impediment or conflict. Unfortunately, many Latin countries have slow, bureaucratic, inefficient and corrupt judicial systems when compared to similar institutions in the U.S. and Europe. To compound matters, the disputes that originate from international projects can be technically complex, and many of these countries’ courts do not have the requisite resources and technical comprehension to incorporate the findings of expert third-party participation. Differing legal cultures almost always require expensive international litigation procedures, each

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carrying cross-cultural challenges that require the support of lawyers, translators, experts and an ever-growing list of professionals. Along the way, there is another form of risk to be mindful of: legislative risk. Legislation may be enacted that changes the power relations among the parties and creates even more tension. As a consequence to these legal risks, when a dispute occurs, resorting to host countries’ judicial systems often means fewer profits; in some cases it may mean hindering the project’s progress to the point of compromising its success. In sum, due to poorly managed or anticipated legal risks, a conflict may slow down a project, increase its costs and reduce the return on the investment, if not put it on hold or even end it.

CONSTRUCTION RISK

In assessing risk, it is also often helpful to look at the various stages of the project separately since each may have a different risk profile and financing requirements. Most projects consist of three main phases: development, construction and start-up and operation. In development phase, risk is usually very high, and only equity capital from the main sponsors is generally used. During construction and start up, risk is high and large volumes of finance are required, typically in a mixture of equity, senior debt, subordinated debt and guarantees. In the operational phase, risk is generally lower (because the outlook is less uncertain), and it may be possible to refinance senior bank debt in the capital markets with cheaper, less restrictive bonds.

In the development phase, the prospective sponsor assesses the project’s scope, seeks any necessary regulatory and concession approvals from the government or municipal authorities, and attempts to attract financing. Risks sometimes arise because of unclear and arbitrary government processes, which cause long delay and may even lead sponsors. In the construction phase, the major risk is that construction will not be completed on time or will not meet the specifications set for the project. An incomplete project is unlikely to be able to generate cash flows to

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support the repayment of obligation to investors and creditors. Long delays in construction may raise the cost of a project significantly and erode its financial viability. A project may fail to reach completion for any of a number of reasons, ranging from technical design flaws to difficulties with sponsor management, financial problems, or changes in government regulation. Project companies hedge construction risk primarily by using fixed price, certain date construction contracts, with built-in provisions for liquidated damages if the contractor fails to perform, and bonuses for better than expected performance. The project company will probably also take out business start up and other kinds of standard insurance , include a construction contingency in the total cost of the project, and build in some excess capacity to allow for technical failures that may prevent the project from reaching the required capacity. Because lenders cannot control the construction process, they seldom assume completion risk, which is usually the responsibility of the project company, its sponsors, contractors, equipment suppliers, and insurers. Typically, creditors and investors are interested in both the physically and financially aspects of project completion.

Design engineering and construction risk are risks that are inherent during project design and construction phases. As construction moves forward, new risks arise and others subside. Design development and construction risks are primary risks to the project sponsors and the construction loan lenders, although each project participant is concerned with whether the project will be construction on time for the price upon which project financial projections are based. The classic construction risk is the necessity of a change in the work that is not contemplated in the construction price, such as a change necessitated by technical design refinements.

DEMAND RISKS/ REVENUE RISK/ OFFTAKE RISK

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The revenue that a project can generate will underpin its cashflows. The key risk to revenue generation is that, over the life of the project, the demand for its output will diminish or that the price it can achieve for its output will be reduced, whether by other, less costly suppliers entering the market or a particular off -taker deciding to reduce its purchases. For that reason, the off -take contract may be central to the finance ability of a project. A long-term sales contract with an entity that has an acceptable credit standing, extending for at least the term of a project’s loans, may offer a level of assurance to lenders in respect of these ‘market’ risks. Particularly where there is only one or perhaps a few off-takers, the credit strength of that party or parties will be a key consideration. If a government owns or controls an off -taker which itself lacks an acceptable credit standing, it may be necessary that the government itself guarantee or otherwise assure the off -taker’s performance under the contract. Off-take arrangements can range from availability or capacity-based revenue structures, which afford higher predictability of cashflows (i.e. projects in respect of which the market risk has been contracted), to arrangements where revenues are a function of volume and/or the price of the output, where cashflows will be less predictable (i.e. in respect of which the project is taking market risk).

Many projects operate in markets in which long-term sales contracts are not available at economic prices. Petrochemicals, natural resources, oil and gas, telecoms, and, in some cases, electric power, are often sold on spot or short-term markets. These markets may be mature and deep, providing assurance that the project’s output can be marketed. Project companies may seek flexibility to enter into a wide variety of short and medium term sales contracts to allow them to manage market conditions. Issues which need to be considered in this regard include the applicable regulatory environment, the reliability of access to the market, and the transparency of pricing.

SUPPLY RISKS

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A project’s inputs or supply requires just as much investigation as its off-take. The particular supply risks which will apply to a project will be determined by the nature of the project itself. For example, a toll road project will depend upon sufficient traffic; telecoms projects will require handsets; water projects will depend upon sufficient water supply; oil and gas and mining projects must have sufficient reserves; a processing plant must have sufficient raw materials and energy; and a power project must have sufficient fuel. Each project must have a guaranteed and steady supply of feedstock, fuel, or other necessary resources at a cost that does not significantly exceed the provision for those costs in the project’s financial forecasts.

To enable the project to access those materials, it is often necessary that new pipeline, rail, or road infrastructure be constructed, generally by parties other than the project company. The risk that the necessary infrastructure will not be completed in a timely manner must also be addressed. The choice of materials or fuel gives rise to various concerns in respect of supply and transportation. For example, if a power facility is gas-fired, adequate reserves of gas must be available and sufficient pipeline capacity must exist to satisfy transportation needs during the entire term of the financing. Many gas-fired power facilities have the capability to burn oil on a temporary basis, so that if gas becomes temporarily unavailable due to the occurrence of a force majeure or other event, the project will be able to continue operating until supply is restored. However, to the extent that the project relies on a single source of supply, as may be the case, for example, with plants fuelled by LNG sourced from abroad, the lenders will focus attention on the political or technical risk of the project’s LNG sources. For projects that are extracting and/or processing oil and gas or other natural resources, the lenders will focus particular attention on the sufficiency of the relevant reserves. The inquiry focuses both on the extent of the resource in the ground and also on whether it is economically recoverable. Volumes of resource are generally classified in accordance with the degree of uncertainty associated with their existence. The level of uncertainty is highest before

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the prospect is bored or drilled, and is reduced with the increase in data available as the resource area is mapped and assessed. A reserves audit report may provide a comprehensive tabulation of volumes at any stage of exploration or development, assigning appropriate risk classifications to the existence of those volumes.

The other variable, relevant to oil and gas reserves, is whether they can economically be recovered. When commodity prices are high, the project company can afford to extract higher cost resources. When prices are low, reserves that are physically available may nonetheless prove uneconomic to exploit. Lenders naturally prefer to finance oil and gas projects with sufficient proven, economically recoverable reserves. Although probable or possible reserves may be accorded value, these reserves are given less weight and lenders may require a significant margin of such reserves over the life of the project. In most cases, lenders will require a ‘reserve tail’, providing assurance that sufficient levels of resource will remain available to be exploited beyond the scheduled maturity of the debt. Lenders may require accelerated repayments (i.e. cash sweeps) if such probable or possible reserves are not converted to proven status at the rate anticipated in the exploitation plan or if reserves are no longer appropriately classified either due to technical or economic criteria. Lenders may also require accelerated repayments of the debt if the reserve is exploited by the project company at a faster or higher rate than was originally forecast in the financial model, so as to avoid debt remaining outstanding should the relevant reserves become depleted.

OPERATING RISKS

Operating risk includes the possibility that –

1. the cost of operating and maintaining the project will exceed budgeted forecasts;

2. the facility will be unable to perform consistently at a level sufficient to meet the required performance criteria; and/or

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3. the project’s operation will be interrupted by the acts or omissions of the operator.

The operator must have the financial and technical expertise to operate the project in accordance with the cost and production specifications that form the basis of the project’s original feasibility study. The necessary skills extend not only to routine operations, but also to undertaking or supervising major overhauls of complex equipment (which may be separately contracted to the relevant equipment supplier). The operator may be an independent company or an affiliate of one of the sponsors. The ability to operate the project efficiently and effectively is usually evidenced by past experience with the same type of project and technology, ideally in the same country and region, together with adequate resources, such as appropriately qualified staff. Although operators generally resist underwriting the full operating risk of a project, a well-structured operating agreement will provide sufficient incentives to ensure compliance with industry standards of performance. So, for example, contracts which appear under-priced may be regarded unfavourably by lenders as this might lead to delay or reduced expenditure on repairs and maintenance. To the extent that the operator does assume at least some material portion of the risk of operational cost overruns, the sponsors and the lenders will be able to place greater reliance on the certainty of the project’s financial projections. In addition to skilled operators, a good management team is crucial to the success of a project. The management personnel are required to make basic policy decisions, arrange financing, provide information to lenders and investors, and take responsibility for administrating the project company. The management must also control the ability of the project to maintain production levels and to comply with legal and regulatory requirements. Thus, the management team needs to be experienced, reliable and serve as a bridge among the sponsors, the operator, the government authorities, and the lenders.

DELAY RISK

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There are many factors that could delay the scheduled completion of a project, including the strength and experience of the contractors, the length of the projected construction period, the availability of building material and supplies, the terrain over which the project is being constructed, the risk of not receiving permits as and when required, the exposure to labour problems, the connection of required infrastructure, dispute resolution, and political risks. Many of these risk factors will also have cost implications for the project.

TECHNOLOGICAL RISK

Technology risk will contribute to the overall matrix of both completion and operating risks. Problems with the application of the proposed technology during construction may contribute to delays in completion and, during operation, may result in lower performance, leading to diminished operational cashflows. The completion risk for projects that employ proven technology is considered lower, particularly if proven in similar terrain, climate, and scale. A good example of relatively high technology risk can be found in the field of telecoms projects, which by their technical nature require very expensive sophisticated equipment and software that is often new to the market. The technology underpinning such projects is constantly evolving and, because such projects will involve the connecting of many points to fashion a network, they generally require a large amount of equipment often from several different sources which gives rise to compatibility risk.

In the growing off shore wind sector, where contractors have been reluctant to provide EPCM turnkey wraps, lenders have had to analyse carefully the new techniques used for piling and constructing the civil works which support the turbine towers and this has necessitated the structuring of appropriate completion support. For example, in the petrochemicals and refinery sectors, scale-ups of more than 25 per cent over and above existing and proven facilities may be the cause of concern to lenders, unless the technical evidence is very persuasive.

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Where technology risks exist, lenders are likely to place reliance on the opinions of an independent engineer, who will likely be required to confirm, prior to the lenders committing to finance, that the project can be completed to the required standards on the basis of a reasonable completion test.

ENVIRONMENTAL RISK

Environmental risk is present when the environmental effects of a project might cause a delay in the project’s development or necessitate a costly redesign. Most industrial facilities emit at least some waste and pollutants into the environment and require permits and other authorizations to construct and operate those facilities. Environmental concerns have become more prominent as a result of increased public and lender awareness, more stringent environmental, health and safety laws, and permitting requirements and heightened liability for the management, identification, and clean-up of hazardous materials and wastes. Regulations to moderate harmful emissions usually exist on a national level and sometimes also exist at international and local levels. These regulations often require studies of the impact of project construction and operation on the natural and social environment and restrictions on the project’s harmful emissions and impacts.

Multilateral and bilateral treaties and other agreements often regulate the manufacture, use, and release of certain hazardous chemicals and substances. In addition, increasing emphasis is being placed on the broader impacts of a project, including labour and working conditions for those employed by the project and the preservation of local biodiversity. These legal requirements give rise to fi ve primary risks to a project: (a) liability for the discharge of contaminants into the environment; (b) liability for noncompliance with environmental, health and safety laws, and permits; (c) uncertainty in environmental permitting; (d) changes in laws and enforcement priorities that tend to make environmental requirements more stringent over time; and (e) potential exposure to

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challenges brought against the project by affected populations or interested non-governmental organizations (NGOs) on their behalf.

Most countries regulate contamination under a ‘polluter pays’ regime. Contamination at a project site could give rise to liability and requirements that the polluter investigate and remediate the contamination. Non-compliance risk arises when a project fails to comply with the terms of issued permits or applicable environmental, health and safety laws and regulations. Non-compliance with these requirements can give rise to governmental action to rescind or terminate permits or authorizations or impose monetary fines and penalties or criminal sanctions. Permitting risk arises from concerns about whether a project will be able to obtain permits to construct and operate on terms that are not unduly burdensome or unfair. Permitting risk also arises under regimes that allow NGOs to challenge or appeal the issuance of permits to a project.

Change in law risk acknowledges that environmental laws tend to become more stringent over time, often requiring capital upgrades for additional pollution controls or the acquisition of pollution credits. Of particular concern is the regulation of greenhouse gases that are thought to give rise to global climate change, which has given rise to international treaties and host county laws that regulate emissions of greenhouse gases from industrial operations. Social and biological risk arises from actions taken by affected parties, or those acting on their behalf, to object to the project’s potential impacts. This risk can often be significant in developing counties where indigenous populations may be displaced by a project, biodiversity may be threatened by project construction and operation or local labour laws may not meet international guidelines and standards. To the extent environmental objections are voiced through the political process, they give rise to political risk.

CREDIT RISK/ COUNTERPARTY RISK

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This risk relates to the parties who enter into contracts with the SPV (Special Purpose Vehicle) for various intents and purposes. The creditworthiness of the contractor, the product buyer, the input supplier, and the plant operator is carefully assessed by lenders through an exhaustive due diligence process. The financial soundness of the counterparties (or respective guarantors if the counterparties are actually SPVs) is essential for financers. The significance of credit risk in project finance deals lies in the nature of the venture itself – 1) off-balance sheet financing with limited recourse to shareholders/sponsors and 2) a very high level of financial leverage. These features form the basis of a different approach for determining minimum capital requirements that banks must respect with regard to project finance initiatives. This approach was established by the Basel Committee, the international body that counts representatives of banking supervisory authorities from several countries among its member.

FORCE MAJEURE RISK

The expression ‘force majeur eclause’ is normally used to describe a contractual term by which one or both parties is excused from performance of the contact in whole or in part or is entitled to suspend performance or claim an extension of time for performance upon the happening of a specified event or events beyond its control. The effect of a force majeure clause will depend on how it is drafted, but for the most part, force majeure clauses are suspensory, that is, the affected obligations are not brought to an end, but are simply suspended while the force majeure event is continuing (unless the parties agree otherwise). Once the force majeure clause is triggered, the non-performing party’s liability for non-performance or delay in performance is removed, usually for as long as the force majeure event continues.§§§

This risk concerns with some discrete event that might impair, or prevent altogether, the operation of the project for a prolonged period of time §§§ G. H. TREITEL, Frustration and Force Majeure, ¶12.021 (2nd ed., Thomson/Sweet & Maxwell, London, 2004).

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after the project has been completed and placed in operation. A typical force majeure provision will describe the events which constitute force majeure for the purposes of the particular project agreement in some detail. Sometimes, force majeure may be described as falling within separate categories such as – acts of nature (sometimes called acts of God); acts of man (such as war, industrial action, etc.); acts of government (usually addressed in a project financing under political risk);**** and impersonal acts. Each type of disruption may be addressed separately with the consequences, associated solutions and remedies and cures differing markedly. Such an event might be specific to the project, such as a catastrophic technical failure, a strike, or a fire, earthquake, typhoon, cyclone or any other natural calamity. Alternatively, it might be an externally imposed interruption, such as an earthquake that damages the project’s facilities or an insurrection that hampers the project’s operation.

CROSS-BORDER RISKS

Any project fiancé issue is not bereft of a single risk, but a consortium of risks. In cases of cross-border or transnational projects the risk is of many folds. It includes – Currency-Related Risk, Political Risks, Inflation Risk, Expropriation Risks, Change of Law Risks, Country Risks, Law and Legal Systems Risks, Sovereign Risk, Permit, Concession and License Risk, etc. In a transnational project is subject to governmental jurisdiction and action exists. This can result in risks to the project that, if realized, affects the success of the project, cash flows and operating costs. There are limits on the control a project sponsor can have over the political stability surrounding a project. The degree of political risk’ the project faces is sometimes determined by the nature of the project. Projects of particular importance to a host government’s social welfare strategies might be less susceptible to many political risks described in this chapter. In contrast, projects significant to the country’s security or basic infrastructure might be more susceptible to certain political risks, such as expropriation. For **** Id.

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Example the Chad-Cameroon Pipeline project had great economic significance by political risk relating to the project had great repercussion to the lending agencies, for the successful completion and functioning of such a project.

MITIGATING RISKS THROUGH INVESTMENT STRUCTURE

The structure that investors and lenders adopt for a project is an important way in which investors and lenders can avoid any expropriation or interference in their project by the state. A state may be willing to provide lenders and investors with some form of sovereign or government guarantee to act as an incentive for an investment into their country. Such a sovereign guarantee may be given at the outset of a transaction, as seen in many infrastructure projects and will provide the investor and any lenders with comfort that the investment will be backed by the government and if an expropriation does take place the guarantee should ensure that the investor and lenders have direct recourse to the government for breach of contract. It is standard practice for such a guarantee to include a waiver of sovereign immunity. Sovereign guarantees are often provided in concession agreements, these typically take the form of payment guarantees; that is, if the contracting state entity does not pay the investors then the government will do so. If an expropriation by the state takes place the investors and any lenders to the investment will be able to seek compensation under such a guarantee from the government.

Sovereign guarantees will often go further when investors or lenders need further incentives to invest into the project. The host state will show its commitment and support of the project through covenants in the agreement between the investors, lenders and the state, for example undertaking to implement specific legislation, the grandfathering of key legislation if applicable, making available government resources and importantly committing not to undermine the investment through adverse regulation or similar. Investors and lenders may also seek an

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acknowledgement from the state of the investors’ equity contribution into the project and that they are due a return on their investment. In short the investors and lenders are seeking comfort from the host state that expropriation, whether direct or indirect, will not take place and there is the maintenance of minimum investment conditions.

Another way that lenders and investors can get comfortable with the project is to ensure that the accounts of the project company are kept offshore. Where there are currency restrictions in the host state, (often the case in developing countries) there will be a need to provide the project with special dispensation to allow revenues to be sent offshore. By having the accounts offshore in a “friendly” jurisdiction, the lenders and investors to the project can take comfort that they will be able to enforce their security over the offshore accounts if necessary.

It is increasingly common for lenders and investors to seek Export Credit Agency (ECA) support for their project. Typically an ECA will provide the lenders with a guarantee or insurance policy for 85 per cent of value of the export contract in the project. The ECA will charge a premium for providing such a guarantee or insurance policy, the cost of this premium is often dependent upon the risk, particularly political risk, associated with the host state. Another option is for the sponsors to seek a commercial insurance policy to cover any potential expropriation of the project.

BILATERAL INVESTMENT TREATIES

In addition to the above, the project lenders and investors can ensure from the outset that the project falls within the scope of a Bilateral Investment Treaty (BIT) or a Multilateral Investment Treaty such as the North American Free Trade Association (NAFTA) or the Energy Charter Treaty (ECT).

A BIT entered into between two states to protect “investments” made by a national of either of the states into the other. It also aims to provide a

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level of legal protection to the investor. Many BIT’s contain broadly similar protections.

To qualify for protection under a BIT, there must be an “investor” with an “investment” located in the host state. A dispute would qualify for protection under a BIT if it is between the investor and the host state. Each BIT contains the definition of an “investor” and an “investment”.

International arbitration is usually the neutral forum used to resolve disputes. However, a number of treaties provide for arbitration under the International Centre for the Settlement of Investment Disputes (ICSID). This is addressed in further detail below.

The protections commonly found in BIT’s are –

1. right to fair and equitable treatment;2. right to “national treatment”;††††

3. right to most favoured-nation-treatment;4. right to compensation for civil disturbance etc.;5. protection against expropriation and nationalisation;6. right to repatriate profits and property;7. protection against breach of contractual obligations/”umbrella

clauses”; and8. dispute resolution/enforcing rights/arbitration.

In any investment decision, the existence and status of a BIT is an important factor. The protection afforded by BIT’s is extra-contractual, and so will apply to an investment contract even if not expressly referred to. The host state’s signature of the BIT is sufficiently binding for it to apply to the investment contract.

The importance of BIT’s continues to grow. In fact, the total number of BIT’s rose to 2,676 by the end of 2008. Despite the intense BIT negotiating activity of some countries, over the last four years, there has

†††† This “national treatment” standard requires a host state to treat foreign investments no less favourably than the investments of its own nationals and companies (Asian Agricultural Products v Sri Lanka (1991) (ICSID Case number ARB/87/3).

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been no change in the ranking of the top ten signatory countries of BIT’s.‡‡‡‡

The growing number of BIT’s signed suggests that states value these treaties as having a tangible effect. However, some commentators submit that an issue may arise given the arguable inequality of bargaining power between developing countries that wish to promote foreign investment, and developed countries that wish to protect their investors§§§§. Either way, these are important protections for an investor who is looking to invest in a higher risk jurisdiction

MULTILATERAL INVESTMENT TREATIES (MITS)

MIT’s are similar to BIT’s. An example of a MIT is NAFTA. NAFTA covers many issues such as environment, mobility of persons, agriculture and importantly investment. Other MITs are less detailed and deal with a more general investment programme between states such as the ECT.

The objective of the ECT is, amongst other things, to protect and promote foreign investments in the energy sector in member countries. On the one hand the treaty is explicit in confirming national sovereignty over energy resources, ie each member country is free to decide how, and to what extent, its national and sovereign energy resources will be developed, and also the extent to which its energy sector will be opened to foreign investments. On the other hand, there is a requirement that rules on the exploration, development and acquisition of resources are publicly available, non-discriminatory and transparent*****.

Disputes under the ECT can either be settled by:

arbitration between parties to the ECT on the interpretation or application of the treaty;

‡‡‡‡ Recent Developments in International Investment Agreements (2008 – June 2009) – UNCTAD/WEB/DIAE/IA/2009/8.§§§§ The International Law on Foreign Investment M Sornarajah (2007).***** www.encharter.org

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dispute settlement mechanisms under art 26 which provides for various options for investors to take host governments to international arbitration;

a specialised conciliation procedure; a mechanism for settling trade disputes between member countries

(provided that at least one of them is not a World Trade Organization member); and

bilateral and multilateral non-binding consultation mechanisms for disputes arising out of competition or environmental issues†††††.

The ECT came into force in April 1998, and commentators have described its success since that date‡‡‡‡‡. It is difficult to assess the impact of the ECT since only 22 disputes have been brought under it to date. The issue of the recent dispute between Yukos and the Russian government has seen Russia move towards withdrawal from the ECT, which was never ratified by Russia but which has also seen the permanent Court of Arbitration in the Hague decide that Russia is bound by the treaty. It is pertinent to note that 15 out of the 22 reported ECT disputes are under the International Centre for the Settlement of Investment Disputes (ICSID)§§§§§.

ICSID

ICSID is an institution that administers and provides facilities for the conciliation and arbitration of international commercial disputes between states and nationals of other member states. It was created pursuant to the 1965 Washington Convention on Settlement of Investment Disputes between states and nationals of other states (ICSID Convention). It is available only in respect of disputes to which a state is a party to the convention. A list of states which has acceded to the convention can be found at the ICSID website******. It is important to note that the primary purpose of ICSID is to promote foreign investment by providing facilities for conciliation and arbitration of international investment disputes.††††† http://www.encharter.org/index.php?id=269&L=1%2F%2F%2F%5C%5C.‡‡‡‡‡ Clarisse Ribeiro “Investment Arbitration and the Energy Charter Treaty” (2006).§§§§§ http://www.encharter.org/index.php?id=213&L=1%2F%2F%2F%5C%5C.******http://icsid.worldbank.org/ICSID/FrontServlet?requestType=ICSIDDocRH&actionVal=Contractingstates&ReqFrom=Main.

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ICSID arbitration can arise in two ways either contractually (where the investor state contracts contain an express reference to ICSID for their dispute resolution) or outside the contract (where arbitrations arise from indirect consent to ICSID arbitration contained in either the host states national investment legislation or a bilateral or multilateral treaty). Interestingly, 75 per cent of ICSID arbitrations have been brought under the latter category.

The advantages of ICSID arbitration include the following –

1. arbitration proceedings are administered by the World Bank;2. it is a neutral and self-contained system;3. it is transparent; and4. it has clear and reasonable legal cost schedules.However, it is imperative for investors to remember to include a waiver from sovereign immunity clause in their contracts in order to bring a claim against a state entity - mere reference to ICSID arbitration will not be sufficient.

The essential criteria for ICSID arbitration is that –

1. parties must have consented to it in writing;2. the dispute must be between a contracting state and a national of

another contracting state; and3. the dispute must be a contractual legal dispute arising directly out of

an investment.Although recourse to ICSID is voluntary, once the parties have given their consent to it, they cannot unilaterally withdraw their consent.

In relation to the recognition and enforcement of ICSID awards, each contracting state to the ICSID Convention†††††† –

1. will automatically recognise the award as binding;2. will enforce the pecuniary obligations imposed by the award within its

territories as if it were a final judgment of a court in that state; and†††††† Non-pecuniary awards will have to be enforced by other means such as the New York Convention.

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3. may enforce an award though its federal courts, providing that such courts treat the award as if it were a final judgment.

A failure by a contracting state to enforce an ICSID award is a clear breach of its international treaty obligations. Similarly, and perhaps more crucially, a lack of enforcement may have implications for the state’s World Bank membership. This provides a valuable incentive for states to comply, and thereby offers a notable protection for investors. It is therefore easy to understand why the importance of ICSID has significantly increased in today’s world. This is evident from the fact that today ICSID has 156 signatories‡‡‡‡‡‡ and statistically there are already 167 ICSID cases which have concluded,§§§§§§ with 127 pending*******.

It is never too early for investors and lenders to a project to start to plan ways to protect a project from expropriation. Investors and lenders need to adopt an integrated structure that will take account of the protection available and afforded by international law, treaties and conventions. Wherever possible, investors and lenders should seek appropriate assurances from the state where the project will be located. In addition to this, the investors and lenders should factor into any investment model the threat of expropriation and structure their project accordingly.

CONCLUSION

A successful project financing initiative is based on a careful analysis of all the risks the project will bear during its economic life. Such risks can arise either during the construction phase, when the project is not yet able to generate cash, or during the operating phase. Risk management has become a relevant topic in corporate finance theory and in managerial practice. In recent years, corporate executives have progressively changed their focus from pure financial risk management to enterprise-

‡‡‡‡‡‡ It has been ratified by 144 , see http://icsid.worldbank.org/ICSID/FrontServlet?requestType=ICSIDDocRH&actionVal=Contractingstates&ReqFrom=Main.§§§§§§ It has been ratified by 144 , see http://icsid.worldbank.org/ICSID/FrontServlet?requestType=GenCaseDtlsRH&actionVal=ListConcluded.******* It has been ratified by 144 , see http://icsid.worldbank.org/ICSID/FrontServlet?requestType=GenCaseDtlsRH&actionVal=ListPending.

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wide risk management and have paid more attention to the links between enterprise risk, stock price performance, and corporate valuation. Intuitively, a lower volatility of cash flows, a reduced level of business risk, and a reasonable balance between debt and equity are all factors that enhance corporate value and, if the firm is listed, increase stock market prices.

Risk sharing is another manner of allocation of risk in project finance. A joint venture permits the sponsors to share a project’s risks. If a project’s capital cost is large in relation to the sponsor’s capitalization, a decision to undertake the project alone might jeopardize the sponsor’s future. Similarly, a project may be too large for the host country to finance prudently from its treasury. To reduce its own risk exposure, the sponsor or host country can enlist one or more joint-venture partners.

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project risk analysis

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