Operating Risk In Project Finance

Overview of Operating Risk In Project Finance

Operating risk in project finance is a significant project finance risk to which the project is exposed from the completion of construction, performance testing, and turnover to operations through the sale and disposition of the project. The Project Company is exposed to Operating Risk in project finance for a longer duration than any other project finance risk.

The success or failure of the project depends entirely on operating the project pursuant to the performance standards specified in the contract documents.

Operatring risk is not a single broad risk, but a number of separate dependent and independent project finance risks that must each be identified, assessed, allocated, and managed.

Operating Risks

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.

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 are operating risks that 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 with supplier risk in project finance 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.

Allocating Operating Risk in Project Finance

Just as important as identifying and assessing project finance risk is allocating those risks to the project participants or stakeholders 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.