Overview of Country Risk In Project Finance
Country risk is a category of risk to project financings that stem from the country in which the project is located. Broadly, country risk is economic and political in nature and includes risks such as civil unrest, terrorism, project sabotage, work stoppages, currency exchange, monetary policy, inflation, and the like. Country risk is significant and is very often the overarching factor in rating a project financing. Many credit rating agencies and consultants will not issue a credit rating for a project that exceeds the sovereign credit rating of the host country.
Despite the gravity of country risk, it can be mitigated and it is incumbent upon the project finance provider to do so. Country risk is part of our initial assessment of a request for project financing, and we are quick to advise project sponsors and stakeholders when the country risk exceeds reasonably expected risk tolerances.
Specific risk mitigants employed by Global Trade Funding focus heavily on using innovative project structures and documents. Some of our additional country risk mitigation tools include political risk insurance to protect against civil unrest, terrorism, and force majeure events, special allocations of risk to experienced local partners, and a network of well-connected project professionals to provide project sponsors leverage with local governments.
Assessing Project Finance Risk
Project finance providers and lenders expend significant resources and utilize sophisticated computer programs to analyze, assess and, ultimately manage project finance risk. Most project finance lenders rely on a credit risk department whose job it is to assess the project, and extend credit (or not) accordingly. Most sophisticated lenders use proprietary software to analyze, reduce and transfer project finance risk. Almost all project finance lenders also use third party provided intelligence, subscribing to services like Standard & Poor’s and Moody’s to provide information, many of whom rate the risk of project financings.
For large companies with liquidly traded corporate bonds or credit default swaps, bond yield spreads and credit default swap spreads indicate the credit risk assessment of market participants and may be used as a reference point to price loans or trigger collateral calls. Most project finance lenders employ proprietary models to score the credit risk of project financings in order to rank potential and existing customers according to risk, and then apply appropriate risk mitigation strategies.
Credit scoring models are also part of the framework used by project finance lenders to grant credit to clients. For project financings, these models generally perform qualitative and quantitative analysis that outline various aspects of the project finance risk including, but not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively.
Types of Project Finance Risk
Sponsor Risk
The project sponsor is typically an entrepreneur or consortium of entrepreneurs who provide the motivating force behind the project. Often, the project sponsor is an entrepreneur without sufficient capital to carry out the project. In other cases, the sponsor might have the necessary capital but is unwilling to bet the parent corporation’s balance sheet on a high-risk venture.
The primary risks with sponsors revolve around the sponsor’s experience, management ability, its connections both international and with the local agencies, and the sponsor’s ability to contribute equity. Investors and lenders can mitigate these risks by carefully evaluating the project sponsor’s track record with similar transactions.
As noted under Certainty of Revenue Stream, the financial model and assumptions to viability of the project are dependent on the projected costs of operations. If there is something in the cost of the operation that increases, lenders will want to be protected to the extent that it will impact the revenue stream. For instance, one of the key costs of operation in a power generation project will be the cost of the fuel and in the case of a water treatment plant, the cost of power. The cost can be locked in, to some extent, through hedging and futures contract and through input agreements but there are likely to be some costs that are not hedged and the lenders will want to be sure that these are limited (for instance, the increased cost is reflected in the tariff calculation for the power or treated water). Another key cost in operations will be the cost of workers and an assumption for wage inflation is usually built into the agreement by reference to an index such as the retail price index. It is important to ensure that the index covers increases in the sorts of costs incurred by the project.
The other key risk in operations is performance. The lenders and other investors are likely to have chosen an experienced operator to operate the project but there will be risks associated with operations such as key pieces of plant breaking down when they are out of construction warranty and also in the project company failing to meet the performance requirements and facing penalties and even the risk of termination for default. The lenders will seek to mitigate these risks through warranties and step-in rights.
Demand Risk
Operating Risk
The operator is the company or entity charged with the responsibility of maintaining the quality of the assets that generate the project’s cash flow. Of course, lenders and investors want to make sure that the assets remain productive throughout the life of the project, or more importantly from their perspective, the life of the loan or investment. Hence, operating risks center around the efficient, continuous operation of the project, whether it is a mining operation, toll road, power plant or pipeline. Contracted incentive schemes are one way to allocate this risk to the operator.
Product Risk
Product risks might include product liability, design problems, etc. The underlying risk here is unperceived risks with the product, e.g., unforeseen environmental damages. For instance, an electrical transmission project running through a populated area might carry the risk of affected the population through the detrimental health effects of the electro-magnetic radiation. Using older, tested designs and technologies reduces the risk of unforeseen liabilities. For instance, the Asian infrastructure developer Gordon Wu built his reputation by recycling one straightforward power plant design in his many projects instead of re-designing each individual project. Through using a tested design, Wu was able to not only reduce product and construction risks, but also to reduce design costs through economies of scale.
Competitor Risk
This risk is related to industry risk, however it focused more directly on resources with which the competitor might be able to circumvent competitive barriers. Exclusive agreements, offtake agreements and supply arrangements all contribute to defending a long-term competitive advantage.
Industry Risk
Competitive forces within the industry represent significant risks to the project. It is necessary for project sponsors to analyzes the potential risks that their particular project faces vis-à-vis global and local industries. The prices of substitute products, inputs and outputs are critical factors in determining the economics of the project. Other competing projects within the country or in the neighboring region have competitive implications for the project. Standard and Poor’s checklist for competitive forces for pipelines provides an example of the types of industry risks that creditors emphasize:
· the influence of other existing or planned pipelines in the area; · cost of transportation – the economics of the pipeline to the end users;
· substitutes – other sources of energy that could compete with the fuel being transported;
· the potential for other uses and/or users of the feedstock being transported by the pipeline, which could render the pipeline obsolete;
· present and prospective commodity price and supply situation;
· potential for supply disruptions and exposure to price fluctuations.30
The primary mitigant against industry or competitive risk is thorough industry analysis and insight into the industry’s underlying dynamics.
Customer Risk
The risk with customers is that demand for the product or throughput declines or widely fluctuates. Given the high fixed costs of infrastructure projects, it is difficult, if not impossible, for these projects to reduce costs to match lower demand. Thus, the chief mitigant against this type of risk is an offtake agreement, i.e., a contract which guarantees purchase of the throughput. Essentially, a project company agrees to sell a large share of its output (minerals, electricity, transportation services through a pipeline, etc.) to a customer or group of customers for an extended period of time. The price per unit of output can be fixed, floating or adjusted for inflation or other factors. The customer benefits from this arrangement by securing a long-term, guaranteed source of supply for the output, but generally forfeits a certain amount of flexibility in sourcing. The project company benefits by eliminating or substantially reducing its marketing risk.
Supplier Risk
The general issue here is with securing supplies for the project – electricity, water, etc. – and, again, long-term agreements that guarantee that the project will have access to critical inputs for the duration of the project’s life are the chief instruments used to mitigate the risk. The three critical dimensions of supply are quality, quantity and availability. Does the input meet the necessary quality requirements of the project? Can the project get enough of the input? Is the supply reliable or are interruptions likely? For pipeline projects, rights-of-way might also be considered critical inputs because without them the project company would not be able to build the pipeline.
Country Risk
Country risk is a category of risk to project financings that stem from the country in which the project is located. Broadly, country risk is economic and political risk that includes risks such as civil unrest, terrorism, project sabotage, work stoppages, currency exchange, monetary policy, inflation and the like. Country risk is significant and is very often the overarching factor in rating a project financing. Many credit rating agencies and consultants will not rate a project higher than the sovereign credit rating of the host country.
Despite the gravity of country risk, it can be mitigated and it is incumbent upon the project finance provider to do so. Country risk is part of our initial assessment of a request for project financing, and we are quick to advise project sponsors and stakeholders when country risk exceeds reasonably expected risk tolerances.
Specific risk mitigants employed by Global Trade Funding focus heavily on using innovative project structures and documents. Some of our additional country risk mitigation tools include political risk insurance to protect against civil unrest, terrorism and force majeure events, special allocations of risk to experienced local partners, and a network of well-connected project professionals to provide project sponsors leverage with local governments.
Sovereign Risk
Sovereign credit risk is the risk of a government being unwilling or unable to meet its loan obligations, or reneging on loans it guarantees. Many countries have faced sovereign risk in the late-2000s global recession. The existence of such risk means that creditors should take a two-stage decision process when deciding to lend to a firm based in a foreign country. Firstly one should consider the sovereign risk quality of the country and then consider the firm’s credit quality.
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:
• Debt service ratio
• Import ratio
• Investment ratio
• Variance of export revenue
• Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of export revenue and domestic money supply growth.[17] The likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling likelihood can increase if the investment ratio rises as the foreign country could become less dependent on its external creditors and so be less concerned about receiving credit from these countries/investors.
Expropriation & Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Mitigating Country Risk
Issues which commonly arise in relation to such cover include:
the scope of “political risk”, including regulatory risk and administrative risk;
whether or not political risk includes events in more than one country or different states of the host country;
the relationship between political risk and other “normal” project risks (for example completion risk);
the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Political Risk
Political risk describes the exposure which stems from changes or events in the political landscape of the host country. Specific exposures include changes of government administrations and national policies, laws and regulatory frameworks. Although elevated in emerging markets, political risk is not confined to only unstable regimes in the developing world and political risk is frequently misjudged because it is too often thought of only in terms of expropriation or other drastic political events.
While expropriation was of major concern historically, it now occurs very infrequently. Political risk to project financings now look more like price regulations, currency manipulation and inconvertibility, inaccessible or delayed permits, work permit restrictions for foreign workers and managers, renegotiation of contracts, and the like. Political risk in project finance can be almost entirely mitigated with political risk insurance.
However it is wrong to only look for these risks in the developing world. State, county and municipal governments in Europe and the United States, especially those with a progressive bent, are often more absurd than governments in developing countries. The State of California routinely delays multi-billion dollar development projects for years at a time to protect endangered insects. In general, we advise against projects which are subject to leftist governments.
Global Trade Funding thoroughly assesses the political risk to a project as part of our project finance services and, when necessary, we advocate for and provide political risk insurance as part of the project financing we provide.
Currency Risk
Currency risk in project finance, which are primarily exchange rate fluctuation and currency control or manipulation. For instance, sovereign governments can limit the project company’s access to foreign exchange or can curtail its ability to make foreign currency payments outside of the country. When providing project financing, Global Trade Funding thoroughly assesses the currency risk exposures the project faces and recommends bespoke mitigants along with Political Risk Insurance with currency risk provisions.
Project financings are usually sourced from foreign lenders, in foreign currencies, yet project revenues are generally denominated in local currency. Where the exchange rate between the currency of revenue and the currency of debt diverge, the cost of debt can increase, often dramatically. Though under the theory of purchasing power parity, inflation pressures on the devalued currency will eventually bring the foreign exchange rate back to parity, project finance lenders are generally not that patient.
When revenue will be earned in a currency which is different than the denominated financing, lenders typically require that the project revenue is adjusted for changes in exchange rates or devaluation. If not practicable, lenders typically require robust hedging arrangements or mechanism to manage currency exchange risk.
Expropriation & Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Risk Mitigation Products
Issues which commonly arise in relation to such cover include:
the scope of “political risk”, including regulatory risk and administrative risk;
whether or not political risk includes events in more than one country or different states of the host country;
the relationship between political risk and other “normal” project risks (for example completion risk);
the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Currency Risk
Currency risk in project finance, which are primarily exchange rate fluctuation and currency control or manipulation. For instance, sovereign governments can limit the project company’s access to foreign exchange or can curtail its ability to make foreign currency payments outside of the country. When providing project financing, Global Trade Funding thoroughly assesses the currency risk exposures the project faces and recommends bespoke mitigants along with Political Risk Insurance with currency risk provisions.
Project financings are usually sourced from foreign lenders, in foreign currencies, yet project revenues are generally denominated in local currency. Where the exchange rate between the currency of revenue and the currency of debt diverge, the cost of debt can increase, often dramatically. Though under the theory of purchasing power parity, inflation pressures on the devalued currency will eventually bring the foreign exchange rate back to parity, project finance lenders are generally not that patient.
When revenue will be earned in a currency which is different than the denominated financing, lenders typically require that the project revenue is adjusted for changes in exchange rates or devaluation. If not practicable, lenders typically require robust hedging arrangements or mechanism to manage currency exchange risk.
Expropriation & Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Risk Mitigation Products
Issues which commonly arise in relation to such cover include:
the scope of “political risk”, including regulatory risk and administrative risk;
whether or not political risk includes events in more than one country or different states of the host country;
the relationship between political risk and other “normal” project risks (for example completion risk);
the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Political Risk
Political risk describes the exposure which stems from changes or events in the political landscape of the host country. Specific exposures include changes of government administrations and national policies, laws and regulatory frameworks. Although elevated in emerging markets, political risk is not confined to only unstable regimes in the developing world and political risk is frequently misjudged because it is too often thought of only in terms of expropriation or other drastic political events.
While expropriation was of major concern historically, it now occurs very infrequently. Political risk to project financings now look more like price regulations, currency manipulation and inconvertibility, inaccessible or delayed permits, work permit restrictions for foreign workers and managers, renegotiation of contracts, and the like. Political risk in project finance can be almost entirely mitigated with political risk insurance.
However it is wrong to only look for these risks in the developing world. State, county and municipal governments in Europe and the United States, especially those with a progressive bent, are often more absurd than governments in developing countries. The State of California routinely delays multi-billion dollar development projects for years at a time to protect endangered insects. In general, we advise against projects which are subject to leftist governments.
Global Trade Funding thoroughly assesses the political risk to a project as part of our project finance services and, when necessary, we advocate for and provide political risk insurance as part of the project financing we provide.
Currency Risk
Currency risk in project finance, which are primarily exchange rate fluctuation and currency control or manipulation. For instance, sovereign governments can limit the project company’s access to foreign exchange or can curtail its ability to make foreign currency payments outside of the country. When providing project financing, Global Trade Funding thoroughly assesses the currency risk exposures the project faces and recommends bespoke mitigants along with Political Risk Insurance with currency risk provisions.
Project financings are usually sourced from foreign lenders, in foreign currencies, yet project revenues are generally denominated in local currency. Where the exchange rate between the currency of revenue and the currency of debt diverge, the cost of debt can increase, often dramatically. Though under the theory of purchasing power parity, inflation pressures on the devalued currency will eventually bring the foreign exchange rate back to parity, project finance lenders are generally not that patient.
When revenue will be earned in a currency which is different than the denominated financing, lenders typically require that the project revenue is adjusted for changes in exchange rates or devaluation. If not practicable, lenders typically require robust hedging arrangements or mechanism to manage currency exchange risk.
Expropriation & Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Risk Mitigation Products
Issues which commonly arise in relation to such cover include:
the scope of “political risk”, including regulatory risk and administrative risk;
whether or not political risk includes events in more than one country or different states of the host country;
the relationship between political risk and other “normal” project risks (for example completion risk);
the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Currency Risk
Currency risk in project finance, which are primarily exchange rate fluctuation and currency control or manipulation. For instance, sovereign governments can limit the project company’s access to foreign exchange or can curtail its ability to make foreign currency payments outside of the country. When providing project financing, Global Trade Funding thoroughly assesses the currency risk exposures the project faces and recommends bespoke mitigants along with Political Risk Insurance with currency risk provisions.
Project financings are usually sourced from foreign lenders, in foreign currencies, yet project revenues are generally denominated in local currency. Where the exchange rate between the currency of revenue and the currency of debt diverge, the cost of debt can increase, often dramatically. Though under the theory of purchasing power parity, inflation pressures on the devalued currency will eventually bring the foreign exchange rate back to parity, project finance lenders are generally not that patient.
When revenue will be earned in a currency which is different than the denominated financing, lenders typically require that the project revenue is adjusted for changes in exchange rates or devaluation. If not practicable, lenders typically require robust hedging arrangements or mechanism to manage currency exchange risk.
Expropriation & Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Risk Mitigation Products
Issues which commonly arise in relation to such cover include:
the scope of “political risk”, including regulatory risk and administrative risk;
whether or not political risk includes events in more than one country or different states of the host country;
the relationship between political risk and other “normal” project risks (for example completion risk);
the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Funding Risk
The funding risk is that the capital necessary for the project is not available. For example, equity participants might fail to contribute their determined amount. Or, the underwriters might not be able to raise the target amount in the market. Another funding risk is re-financing which occurs if the duration of the initial funding does not match the duration of the project. Funding risks can also relate to the division between local and foreign currency funding. As funding is often the linchpin of project financings, it is difficult to reduce the risk of not finding the funding. The choice of an experienced financial advisor as well as seeking capital from a broad range of sources represent two ways to mitigate this risk. Also, it is sometimes possible to restructure transactions to delay drawdown dates or to change the amounts of foreign versus local currency.
Interest Rate Risk
Interest may be charged at a fixed rate, at variable rates (usually based on the banks lending rate or an inter-bank borrowing rate plus a margin) or a floating rate (calculated by reference to cost of short-term deposits). The spread or margin is expressed in “basis points”. One basis point is one-hundredth of 1%. Inter-bank borrowing rates include LIBOR (London inter-bank borrowing rate), EURIBOR (in the EU) and NIBOR (in New York).
Project finance debt tends to be fixed rate. This helps provide a foreseeable, or at least somewhat stable, repayment profile over time to reduce fluctuations in the cost of infrastructure services. If lenders are unable to provide fixed rate debt and no project participant is willing to bear the risk, hedging or some other arrangements may need to be implemented to manage the risk that interest rates increase to a point that debt service becomes unaffordable to the project. The tension between local and foreign currency debt is often a question of balancing fixed rate debt with foreign exchange rate risk or local currency debt subject to interest rate risk.
Interest rate fluctuations represent a significant risk for highly-leveraged project financings. Arranging for long-term financing at fixed rates mitigates the risk inherent in floating rates. Furthermore, projects can enter into interest rate swaps to hedge against interest rate fluctuations.
Interest Rate Risk
Interest may be charged at a fixed rate, at variable rates (usually based on the banks lending rate or an inter-bank borrowing rate plus a margin) or a floating rate (calculated by reference to cost of short-term deposits). The spread or margin is expressed in “basis points”. One basis point is one-hundredth of 1%. Inter-bank borrowing rates include LIBOR (London inter-bank borrowing rate), EURIBOR (in the EU) and NIBOR (in New York).
Project finance debt tends to be fixed rate. This helps provide a foreseeable, or at least somewhat stable, repayment profile over time to reduce fluctuations in the cost of infrastructure services. If lenders are unable to provide fixed rate debt and no project participant is willing to bear the risk, hedging or some other arrangements may need to be implemented to manage the risk that interest rates increase to a point that debt service becomes unaffordable to the project. The tension between local and foreign currency debt is often a question of balancing fixed rate debt with foreign exchange rate risk or local currency debt subject to interest rate risk.
Infrastructure projects generally have an important impact on local communities and quality of life, in particularly delivery of essential services like water and electricity or land intensive projects like toll roads. Project impact of society, consumers and civil society generally, can result in resistance from local interest groups that can delay project implementation, increase the cost of implementation and undermine project viability.[3] This social risk should be high on a lenders due diligence agenda, though it often is not. The lenders and project company often look to the grantor to manage this risk. The grantor in turn may underestimate its importance, since the social risk paradigm for public utilities is very different, the grantor may not have experience of its implications for private investors.
Environmental Risk
Environmental and social laws and regulations will impose liabilities and constraints on a project. The cost of compliance can be significant, and will need to be allocated between the project company and the grantor.
Equally, in order to attract international lenders, in particular IFIs, the project must meet minimum environmental and social requirements that may exceed those set out in applicable laws and regulations. This process is made easier where local law supports similar levels of compliance.
The Equator Principles [2] constitute a voluntary code of conduct originally developed by the IFC and a core group of commercial banks, but now recognized by most of the international commercial banks active in project finance.
These banks have agreed not to lend to projects that do not comply with the Equator Principles . They follow generally the IFC system of categorizing projects, identifying those that are more sensitive to environmental or social impact, and requiring specialist assessment where appropriate. During project implementation, the borrower must prepare and comply with an environmental management plan.
Environmental due diligence in respect of such projects and in respect of the legal regime within which they are being constructed, and an appreciation of the environmental requirements of public agencies which will be involved with the project, are crucial if the project company and lenders are to make a proper assessment of the risks involved.
Force Majeure in Operation & Maintenance Agreements
In cases where the project company’s obligations are largely limited to paying the operator, force majeure provisions should be included in Operation & Maintenance Agreements and should be common to all project finance documents. To the extent such provisions are not aligned, and there are significant gaps in liability which are retained by the project company, it is customary for the project lenders to require some form of sponsor support or guarantee to cover the exposure. The parties to an O & M Agreement should be aware that consequences for a force majeure event during project construction can be severe but are usually manageable because a force majeure event will simply increase construction costs and delay completion.
This risk is minimal and can be allocated among project participants prior to the commencement of the project. Conversely, force majeure events during the operations phase could lead to an insolvent operator. In this event, the operator may not be capable of performing its obligations according to the performance standards in the Agreement. The Agreement should impose an obligation on the party affected by the force majeure event to take all possible steps to overcome the event, including the reasonable expenditure of funds. The failure to perform contractual obligations because of the event, however, will typically prevent such a party from being in default.
Allocating Project Finance Risk
Just as important as identifying and assessing project finance risk is allocating those risks to the project participants or stakeholders who are best suited to manage the risks. Thus, allocating project finance risk is one of the most effective and cost effective forms of risk mitigation.
If stakeholders are responsible for project risks they are not suited to manage, the entire project finance structure is at risk. Therefore, the crux of every project financing is the proper allocation of risk. It is also often the most difficult part of a project financing. The most significant characteristic of project finance is the art of minimizing and apportioning risk among the various participants and stakeholders.
How are the risks in a project financings allocated? The principal instruments for allocating the risks and rewards of a project financing are the voluminous project finance documents, specifically the contracts that are created between the project company and other stakeholders. While often the most time consuming and expensive documents to create, efficient risk allocation is essential for making projects financeable and critical for maximizing performance.
Mitigating Project Finance Risk
Risk Mitigation
Lenders mitigate credit risk in a number of ways, including:
• Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
• Covenants – Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as:
o Periodically report its financial condition,
o Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company’s financial position, and
o Repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt-to-equity ratio or interest coverage ratio.
• Credit insurance and credit derivatives – Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
• Tightening – Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
• Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
• Deposit insurance – Governments may establish deposit insurance to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash.
Cost of Construction – Clearly, the cost of completion will be fundamental to the financial viability of the project as the financial assumptions and ratios are all dependent on the assumed cost of construction of the project. The lenders will need some mechanism to manage the risk if the project company’s cost of completion increases as compared with that anticipated at financial close. The project company will also seek to lock in certain costs such as costs of commodities, as early as possible in the project, so as to limit price escalation.
Delay – Completion represents the end of the construction phase of the project. The construction contractor will be liable for liquidated damages for late completion, therefore the definition of “completion” will have a large impact on the construction contractor’s risk.
Performance – The lenders will want to ensure that completion requires the works to be in a condition sufficient to merit release of the construction contractor from delay liquidated damages liability. The works will therefore be subject to certain technical tests and demonstration of performance capacity before completion is achieved.
The project company will want to ensure that the criteria placed on completion can be measured objectively as set out in the construction contract, and that the lenders do not have the right to refuse completion owing to their own subjective evaluation of the works. This may involve technical testing effectuated by independent experts, or by standard measures or tests with clearly ascertainable results, not unreasonably subject to dispute.
Force Majeure and Change in Law
It is important to note that the financing agreements will not include force majeure or change in law provisions. The obligation to repay the loans will continue in the event of force majeure or change in law. The lenders will want to review the force majeure and change in law provisions in the project documents and ensure that they are back‑to‑back (as far as possible) with the concession agreement.[1]
Political and Regulatory Risk and Expropriation or Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Issues which commonly arise in relation to such cover include:
- the scope of “political risk”, including regulatory risk and administrative risk;
- whether or not political risk includes events in more than one country or different states of the host country;
- the relationship between political risk and other “normal” project risks (for example completion risk);
- the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
- the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
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