Market Risk in Project Finance

Overview of Market Risk in Project Finance

Market Risk in Project Finance is a significant project finance risk to which the project is exposed for the entire project lifecycle. Until turned over to operations and begins generating revenue the Project Company will not be able to repay or even service project loans.

The success or failure of the project depends entirely on the sponsor to assess, allocate, and mitigate project finance market risk to maintain the quality and performance standards specified in the contract documents, revenue, and margin.

Product Risk

Product risk is a project finance market risk but, by no means is it the most significant project finance risk. The principal project finance market risk in any project financing is competitor risk.

Customer Risk

Every Project Company wants construction to come in under budget. Unfortunately, that’s not very common, while construction cost overruns are. Construction cost overruns also pose a very real threat to the success and even viability of the project. Construction cost risk stems from a number of different factors that must be accounted for because factors that cause construction cost overruns can sink the project. Some of the most common causes of construction cost risks are:

1. Poorly designed or drafted building plans can cause budgeting errors.
2. Inflation can cause increasing commodity and building material costs.
3. An inadequate supply of labor can cause construction labor costs to increase.
4. An unqualified contractor or a contractor that bids too low can cause extensive change orders.

Competitor Risk

Competitor risk is, essentially, a form of the broader industry risk, and is subject to many of the same forces. However, competitor risk, whether local, national, or international, focuses more directly on a specific competitor’s ability to out-compete the project.

Competitor risk does not refer to or contemplate a competitor’s skills or business acumen. Or competitors who just do a better job. Rather, competitor risk contemplates and prepares for what are, essentially, unfair competitive advantages that specific competitors could potentially exploit.

Broadly speaking competitor risks are too numerous to enumerate but include things such as competitors who are closely related to a powerful government official, or a competitor with the resources to circumvent structural barriers to entry.

Exclusive agreements, offtake agreements, and supply arrangements all contribute to defending a long-term competitive advantage.

Industry Risk

Competitor Risk is, essentially, a form of the broader industry risk, and is subject to many of the same forces. However, competitor risk, whether local, national or international, focuses more directly on a specific competitor’s ability to out-compete the project.

Competitor risk does not refer to or contemplate a competitor’s skills or business acumen, or just doing a better job. Rather, competitor risk contemplates what are, essentially, unfair competitive advantages that specific competitors could potentially exploit. Broadly speaking they are too numerous to enumerate, but include things such as a government official who is related to a competitor, or competitors with the resources to circumvent competitive barriers. Exclusive agreements, offtake agreements and supply arrangements all contribute to defending a long-term competitive advantage.

Allocating Project Finance Market Risk

Just as important as identifying and assessing project finance market 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 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 project financing 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.

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