MITIGATION AND RISK ALLOCATION
In the process of risk management, risk is identified and at the same time allocated to the parties involved in the transaction whenever possible. To make sure that all risks are appropriately allocated to various players, lenders take a comprehensive look at the network of contracts with the SPV. Normally, when lenders are solicited for funds, the SPV has already configured risk allocation by means of a series of preliminary contracts and has covered the residual portion of risk with insurance policies. Depending on the method used for covering risk, lenders might ask to reconsider certain terms or renegotiate some contracts. The following reviews the most important risk allocation mechanisms and contracts in use in project finance.
Construction and completion risks
Construction/completion risks can be allocated or mitigated in the following ways :
- Turnkey contract. A turnkey, also known as EPC (engineering, procurement, and construction), agreement is a construction contract by which the SPV transfers construction risk of the structure to the contractor in exchange for a set fee. Turnkey arrangements are popular with lenders since the contractor assumes responsibility for the design element of the works, thus simplifying negotiations with only one party for all aspects of the construction works during the construction period.
- Fixed price lump sum contract. These reduce the likelihood of cost overruns being the responsibility of the project company. If there are to be any changes to the contract price, this will enable the lenders to protect their position, especially if there are any changes to project specifications by the project company.
- Completion guarantee. Pre-completion risks can be covered via the use of a completion guarantee. This is basically a guarantee from one or more of the project sponsors that the loan will be repaid if completion (as defined by certain performance tests) is not achieved by a certain date.
- Completion test. Once the project has been completed, the sponsors will wish to be released from whatever undertakings they have made to the lenders. The exact moment at which this happens is determined by the ‘completion test’. The terms of the completion test usually involve considerable negotiation between lenders and sponsors.
- Liquidated damages in construction contracts. If construction of a project is at a stage where commercial operations cannot be undertaken or the project does not operate after completion at guaranteed levels, the project company will still need to service debt and other obligations. This can occur via ‘liquidated damage payments’ – these constitute an estimate by the contractor and project sponsor of the shortfall arising from late or deficient performance. The advantage of the liquidated damage clause is to avoid calculation of damages following a dispute. Enforceability of a liquidated damage clause, however, must be carefully considered, particularly in the international context.
Operational risks
Operational risks can be mitigated by the following :
- Long-term supply contracts. In many projects, long-term requirements contracts are developed to provide the necessary raw material supply at a predictable price to reduce this risk. In such cases, the lender must ensure that the credit of the supplier be sufficient to ensure performance of the contract.
- Take-or-pay contracts. Project financiers can minimize cash flow risk by entering into ‘take-or-pay’ contracts. This is a contract entered into between the project company and a third party whereby the third party agrees to purchase a specified amount of the project’s production over a specified period whether or not it actually takes delivery of them. The advantage to the project entity of course is that it locks in a portion of the production over time at a fixed price – which may be below prevailing market prices but which are stable and locked in over time, thereby facilitating financial planning. The incentive for the off-taker to enter such contracts is the desire to obtain certainty of supply in circumstances and at a price which otherwise might be unavailable to it. The bank’s position is considerably strengthened by a take-or-pay contract, as it can ensure that the proceeds of such con- tracts be paid into the lending bank’s account, an additional cash flow monitoring mechanism. Note that the off-take purchaser must be credit- worthy if such arrangements are to provide the requisite comfort to the bankers.
- Take-and-pay contract. A take-and-pay contract is similar to the take- or-pay contract except that the buyer is only obligated to pay if the product or service is actually delivered. Thus, a take-and-pay contract does not contain an unconditional obligation.
- Put-or-pay and throughput contracts. The coverage method for limiting or eliminating supply risk consists in drafting contracts for unconditional supply (put-or-pay agreements or throughput agreements). In these accords, the supplier sells the SPV preset volumes of input at pre-agreed prices. If supply is lacking, normally the supplier is required to compensate for the higher cost incurred by finding another source of input. In this way, sales revenues and supply costs are synchronized.
Financial risks
Financial risk can be reduced or mitigated through the use of derivative instruments. The risks that can be controlled are those associated with funding costs (interests), currency fluctuations when cash flows are not in the home currency and commodity price fluctuations. Examples of derivative instruments include :
- Futures contracts. In a project financing, interest rate futures can be used to protect against funding costs and currency future to protect against foreign exchange rate fluctuations.
- Forward contracts. Forward contract on foreign exchange are used for hedging existing or anticipated currency exposures. Long-term foreign exchange agreements can be used by project companies manage the currency risk arising from multi currency transactions.
- Options. A call option gives the buyer a maximum price (the strike price) and a put option gives the buyer a minimum price (the strike price) at which the underlying product can be sold. Project companies can therefore use calls and puts to control input and output prices.
- Swaps. Swaps can mitigate financial risks. There are currency swaps, interest rate swaps and commodity swaps. An interest rate swap can create a source of lower cost debt or higher yielding assets, and provide access to an otherwise unavailable source of funds. A commodity swap can be used to manage the price risk of the outputs or inputs for a project.
Political risks
It is impossible to mitigate all risks pertaining to a specific project. One way to avoid entering into potentially high risk lending situations, reducing political risk, is to lend through, or in conjunction with, multilateral agencies such as the World Bank, the EDRD and other regional development banks such as the ADB.
The rationale behind this is that when one or more of these agencies is involved in a project, the risk of an uncooperative or unhelpful attitude from the host country is reduced since the host government is unlikely to want to offend any of these agencies for fear of cutting off a valuable source of credit in the future. The default track record of Mexico and Brazil in the 1980s supports this view.
Other ways of protecting against political risk include :
- Private market insurance, although this can be expensive and subject to exclusions rendering the policy’s effectiveness next to useless. Moreover, the term that such insurance is available for will rarely be long enough.
- Political insurance from national export agencies (usually be given in connection with the export of goods and/or services by a supplier to the project). Lending in conjunction with national export credit agencies tends to probably enjoy a similar ‘protected’ status as loans in conjunction with development banks since there is a government element in addition to purely commercial element. Here, ‘government involvement’, not surprisingly, is seen as a reassuring accomplice rather than the realization of the ‘government as the source of all evil and an infringement on capitalist freedom’ arguments espoused by ideological zealots.
- Obtaining assurances from the relevant government departments in the host country, especially as regards the availability of consents and permits.
- The central bank may guarantee the availability of hard currency for export in connection with the project provided appropriate individuals are lobbied assiduously.
- Thorough review of the legal and regulatory regime in the country where the project is to be located is essential so as to ensure that all laws and regulations are complied with and all procedures are followed correctly, therefore reducing the scope for challenge at a future date. In countries with primitive legal systems and ‘commission hungry’ government officials, such ambiguities should be clearly identified in order to enable an accurate risk assessment and loan pricing mechanism to be set in place.
Let's take a closer look now at the possible possible financing mechanisms under project finance.
Follow this link : Financing mechanisms.
Follow this link to Summary.
Follow this link : Financing mechanisms.
Follow this link to Summary.
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