51432284 project-finance

INTRODUCTION TO PROJECT FINANCE

OUTLINE

1. What is Project Finance?

2. How does project finance create value?

3. Project valuation

4. Case analyses

5. Recap

What Is Project Finance?

• Definition

• Major characteristics

• Schematic example of a project structure

• Major project contracts

Definition:

“Project Finance involves one or more corporate sponsors

investing in and owning a single purpose, industrial asset

through a legally independent project company

financed with limited or non-recourse debt.”

A relevant question to investigate:

SPONSOR + PROJECT?

Finance separately with non-recourse debt? (Project Finance)

Finance jointly with corporate funds? (Corporate Finance)

Major characteristics:

• Economically and legally independent project company– Founded extensively on a series of legal contracts that unite

parties from input suppliers to output purchaser – Project assets/liabilities, cash flows, and contracts are separated

from those of the sponsors, conditional on what accounting rules permit

– Investors and creditors have a clear claim on project assets and cash flows, independent from sponsors’ financial condition

– Debt is either limited (via completion guarantees) or non-recourse to the sponsors


• Highly leveraged project company with concentrated equity ownership– Partly due to firms’ need for flexibility and excess debt capacity

to invest in attractive opportunities whenever they arise– Syndicate of banks and/or financial institutions provide debt– Typical D/V ratio as high as 70% and above– Debt has higher spreads than corporate debt– One to three equity sponsors– Sponsors provide capital in the form of equity or quasi-equity

(subordinated debt)– Governing Board comprises of mainly affiliated directors from

sponsors

• Historically formed to finance large-scale projects

– Industrial projects: mines, pipelines, oil fields – Infrastructure projects: toll roads, power plants,

telecommunications systems– Significant financial, developmental, and social returns

• Examples of project-financed investments– $4bn Chad-Cameroon pipeline project– $6bn Iridium global satellite project– $1.4bn aluminum smelter in Mozambique– €900m A2 Road project in Poland


• Statistics as of year 2002

– $135bn of capital expenditure globally using project finance– $19bn of capital expenditure in the US– Smaller than the $612bn corporate bonds market, $397bn asset

backed securities market and $205bn leasing market; approximately same size with the $27bn IPO and $26bn venture capital market


A simplified project structure example:

A “nexus of contracts” that aids the sharing of risks, returns, and control

Source: Esty, B., “An Overview of Project Finance – 2002 Update: Typical project structure for an independent power producer”

Major project contracts:• The Offtake Contract:

– A framework under which Project Company obtains revenues

– Provides the “offtaker” (purchaser) with a secure supply of project output, and the Project Company with the ability to sell the output on a pre-agreed basis

– Can take various forms, such as “Take or Pay” Contract:

• “Power Purchase Agreement” (PPA)

• Input Supply Contract:

– The Offtake Contract for the input supplier

– Provides the Project Company the security of input supplies on a pre-agreed pricing basis

– The terms of the Input Supply Contract are usually crafted to match those of the Offtake Contract (such as input volume, length of contract, force majeure, etc.)

Major project contracts:• Construction Contract:

– A contract defining the “turnkey” responsibility to deliver a complete project ready for operation (a.k.a. Engineering, Procurement, Construction (EPC) Contract)

• Operation and Maintenance Contracts:– Ensures that the operating

and maintenance costs stay within budget, and project operates as planned.

• Permits:– Contracts that ensure permits

and other rights for construction and operation of the project, as well as for investing in and financing of the Project Company

– May be provided by central governments and/or local authorities

• Government Support Agreements:– Provisions may include

guarantees on usage of public utilities, compensation for expropriation, tax exemptions, and litigation of disputes in an agreed jurisdiction

OUTLINE




4. Case analyses

5. Recap

How Does It Create Value?

• Drawbacks of using Project Finance• Value creation by Project Finance

– Organizational structure• Agency costs, debt overhang, risk contamination, risk

mitigation

– Contractual structure• Structuring the project contracts to allocate risk, return,

and control

– Governance structure• Benefits of debt-based governance

• Case examples to value creation

Drawbacks of Using Project Finance Structure:

• Takes longer to structure and execute than equivalent size corporate finance

• Higher transaction costs due to creation of an independent entity and complex contractual structure

• Non-recourse project debt is more expensive due to greater risk and high leverage

• High leverage and extensive contracting restricts managerial flexibility

• Project finance requires greater disclosure of proprietary information to lenders

Still, the combination of organizational, financial, and contractual features may offer an opportunity to reduce net cost of financing and improve performance

Structure matters, contrary to MM Proposition!

Structural decisions may affect the existence and magnitude of costs due to market perfections:

* Agency conflicts* Financial distress* Structuring and executing transactions* Asymmetric information between parties

involved* Taxes

Value Creation

Organizational Structure

Contractual Structure

Governance Structure

Why does structure matter?




mitigation


and control



Value creation by organizational structure: Agency Costs

• Agency conflicts between sponsors (owners) and management (control)

• High levels of free cash flow leading to overinvestment in negative NPV projects

• Risk shifting/debt shifting by managers to invest in high risk, negative NPV projects to recoup past losses

• Refusal to make

additional investment

• Concentrated equity ownership and single cash flow stream provides critical monitoring

• Strong debt covenants allow both sponsors and creditors to better monitor management

• High debt service reduces the free cash flow exposed to discretion

• Extensive contracting reduces managerial discretion

• “Cash Flow Waterfall” mechanism facilitates the management and allocation of cash flows, reducing managerial discretion. Covers capex, debt service, reserve accounts, and distribution of residual income to shareholders

• Given the projects are defined within narrow boundaries with limited investment opportunities, moral hazard (risk shifting, debt shifting, reluctance to invest) is minimized

Problems Structural Solutions:


• Agency conflicts between sponsors and creditors:

– Distribution of cash flows, re-investment, and restructuring during distress

– Moral hazard (such as risk shifting and debt shifting) encouraged by full recourse nature of debt to sponsor

• “Cash Flow Waterfall” mechanism reduces potential conflicts in distribution and re-investment of project revenues

• Legally/economically separate project company eliminates potential for risk shifting and debt shifting

• Concentrated debt ownership is preferred (i.e. bank loans vs. bonds) to facilitate the restructuring and speedy resolutions

• Usually subordinated debt (quasi equity) is provided by sponsors

• Strong debt covenants allow better monitoring

• Single cash flow stream and separate ownership provides easier monitoring



• Conflicts between sponsors and other parties (purchasers, suppliers, etc.)

• Vertical integration is effective in precluding opportunistic behavior but not at sharing risk. Also, opportunities for vertical integration may be absent.

• Long term contracts such as supply and off take contracts: these are more effective mechanisms than spot market transactions and long term relationships.

• Joint ownership with related parties to share asset control and cash flow rights. This way counterparty incentives are aligned.



• Conflicts between sponsors and government: Expropriation through either asset seizure, diversion, or creeping

• Since project is large scale and the company is stand alone, acts of expropriation are highly visible in the international arena which detracts future investors

• High leverage leaves less on the table to be expropriated

• Multilateral lenders’ involvement detracts governments from expropriation since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects.

• High leverage also reduces accounting profits thereby reducing the potential of local opposition to the company.


Value creation by organizational structure: Debt Overhang

• Sponsor’s under-investment in positive NPV projects when sponsor has:

– limited corporate debt capacity

– agency or tax reasons that exclude equity as a valid option

– pre-existing debt covenants that limit possibility of new debt

• Non-recourse debt in an independent entity allocates returns to capital providers without any claim on the sponsor’s balance sheet. Preserves corporate debt capacity.

• The fact that non-recourse debt is backed by project assets/cash flows and not by the sponsor’s balance sheet increases the chances of an already highly leveraged sponsor to separately finance a viable project


Value creation by organizational structure: Risk Contamination

• A high risk project may potentially drag a healthy sponsor into distress, by increasing cash flow volatility and reducing firm value.

• Conversely, a failing sponsor can drag a healthy project along with itself.

• Very large projects can potentially destroy the sponsor’s balance sheet and lead to managerial risk aversion

• Benefit from portfolio diversification is negative (risk is higher) when sponsor and project cash flows are strongly positively correlated.

• Project financed investment exposes the sponsor to losses only to the extent of its equity commitment, thereby reducing its distress costs

• Through project financing, sponsors can share project risk with other sponsors:

– Pooling of capital reduces each provider’s distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced.

• Separate incorporation eliminates potential increase in risk when financing a project strongly correlated to sponsor’s existing asset portfolio.


Value creation by organizational structure: Other motivations

• Joint venture projects with heterogeneous partners: Financially weaker partner cannot finance its share of investment through corporate borrowings, and needs project finance to participate

• Location: Large projects in emerging markets usually cannot be financed by local equity due to supply constraints. Investment specific equity from foreign investors is either hard to get or expensive.

• The stronger partner is better equipped to negotiate terms with banks than the weaker partner and hence participates in project finance even if it can finance its share via corporate financing

• Debt may be the only option and project finance the optimal structure.

• Besides, host government may grant the project “tax holiday”, which provides sponsors exemptions from taxation





mitigation

– Contractual structure• Structuring the project contracts to allocate risk, return, and

control



Value creation by contractual structure:

• An introduction to risk management

– Risk management defined– Sources of risks– Who bears risk?– Mechanisms for reducing cost of risk

• Contractual structure in Project Finance to reduce cost of risk and create value

Value creation by contractual structure:An Introduction to Risk Management

Risk Management:

The process of identification, assessment, mitigation, and allocation of risks to reduce cost of risk and improve incentives

Sources of risk:

– External: • Markets: Availability and quality of products, inputs, and services used• Financial markets• Government policy• Natural resource availability and quality• Natural disasters, politics

– Internal:• Incentive problems during construction and operation stages• Relationships between management, sponsors, lenders, workers,

suppliers, government (some addressed in the previous slides under “value creation by organizational structure”)

Who bears risk?

• Sponsors bear the residual gains and losses, and make key investment decisions.In simple terms,

Return to equity = Revenues – Material / service costs – Labor costs - Depreciation – Interest expenses – Taxes

Variability in RHS variables lead to changes in return to equity

• Other earners of net income (or net value added) from investment can also share risk:

Net Value added = Return to equity + Interest expenses + Taxes + Labor costs

= Revenues – Material / service costs – Depreciation

Profit sharing mechanisms or tax incentives may change how variability in income is shared among sponsors, lenders, government, and labor

• Output purchasers and input suppliers can also share the risks as they experience variability in their markets


How are costs of risk reduced?

• Some risks can be reduced by spreading the burden across many participants; some other risks cannot be spread, but can be shifted or reallocated

• Different stakeholders in a project may have different preferences, and hence different willingness and capacity to bear risks

– Cost of risk is lower to those with greater capacity and willingness to bear risk– Risk-return trade-offs may enable integrative (not necessarily competitive)

negotiations among different stakeholders and may create value in a project setting

• Gains in economic efficiency can be achieved if overall cost of risk declines through risk shifting and reallocating:

– The same risk will have a lower cost if born by parties better capable and willing to do so


Mechanisms to reduce cost of risk:

• Capital, financial, and futures markets:– Mix of debt and equity (capital structure) and probability of default– Risk spreading / pooling– Risk diversification – Insurance markets (for residual risks)– Derivative financial instruments (not available for asymmetric risks)– Futures markets

• Real options: Design flexibility into project to allow for responses of new information or market changes

• Project design itself for risk mitigation (elements of production process, technology used, etc.)

• Project Finance mechanism: complex contractual arrangements involving all mechanisms of contractual risk allocation and reduction to deal with risk in large scale investments


• Generally well developed capital, financial, and futures markets may not always be available

• Special contractual arrangements are often required to manage risk to make projects viable

• The aim of extensive contracting is to reduce cash flow volatility, increase firm value and debt capacity in a cost-effective way

• Guarantees and insurance for those risks that cannot be handled through contracting

Elements of contracting:• General form:

– Exchange risk (x) for return (y)• Additional considerations:

– Participation or partial transfer of ownership– Timing of x and y– Contingency of x and y (under what circumstances)– Penalties on non-performance– Bonus on performance

Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk

Contracting criteria:• Contract with lowest cost not necessarily best contract• Effective contracts may provide:

– Better risk shifting: better distributions of cost– Better incentives: higher project returns or lower total project risk as a result of

incentives• Change the incentive structure to change the probabilities of different outcomes

stakeholders have incentives to increase probability of success and reduce probability of failure in project

• “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives– Cost focus is implicitly a zero sum perspective: one stakeholder gains and the

other stakeholder loses– Integrative focus is explicitly a positive sum perspective: By crafting the right

contract, one stakeholder can gain without necessarily costing to the other one (due to differences between perceived values, preferences, and risk bearing capacity) contracts that create increased value through risk sharing and /or improved incentives


Sources of contracting benefits:• Stakeholders’ differing risk preferences• Differing capability to diversify• Differing capability to manage risks• Differing information or predictions regarding future• Differing ability to influence project outcomes

Risks manageable via contractual structure or other mechanisms inProject Finance:

• Pre-completion risks: Resource, technological, timing, and completion risks• Post-completion risks: Market risk, supply risk, operating cost risk, and force

majeure• Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk,

expropriation• Financial risks: Default risk


Value creation by contractual structure:Pre-completion risks:

Risk Solution

•Site acquisition and access, permits •A government support agreement

•Risks related to contractor:–Is it competent to do the work?

•Reputation, references for similar projects and technology being used•Experience with the country, good relationships with local subcontractors •Similar references for the subcontractors

–Is it also one of project’s sponsors? (Conflict of interest)

•Contract supervision by the project company’s other personnel not directly related to the contractor

–The contractor’s credit standing? If the contractor’s wider business gets into difficulty, the project is likely to suffer

•Careful review of contractor’s credit standing•Careful review of the project scale in relation to the size of contractor’s overall business•If project too big for the contractor to handle alone, a joint venture approach with a larger contractor•Guarantees of obligations by the contractor's parent company


Risk Solution

•Construction cost overruns: reduce equity returns, and DSCR

•Pre-agreed overrun funding (contingency finding)•Fixed (real) price contract, as the EPC contract is normally the largest cost item in budget (60-70%)•Contractor takes junior debt and/or equity stake in operations (BOT or BOO)

•Delay in completion: failure to meet the milestones increase costs, reduce equity returns, and reduce DSCR

–Financing costs, especially as debt will be outstanding longer–Revenues from operating the project will be lost or deferred (significant risk also especially if part of financing depends on early revenues)–Penalties may be payable under contract to input suppliers or off-taker

•Completion guarantees, date-certain EPC contract•Performance bonds•Completion bonuses/penalties•Reputable contractor•Close monitoring / testing of project execution (operational, financial, etc.) for early detection of problems•Careful definition of “completion” in all the contracts (EPC contract, input supplier contracts, off-taker contract, etc) so that it is acceptable and manageable by all parties involved

•Process failures •Process / Equipment warranties•Tested technology


Risk Solution

•Nonperformance on completion: due to poor design, inadequate technology

•Debt recourse to sponsors (from lenders’ perspective)•Performance LDs (liquidated damages): Pre-agreed level of loss to be born by the contractor. Covers the NPV of loss due to nonperformance over the life of the project• The Project Company should be aware of the uncertainty regarding the LDs and should allow a margin when negotiating the calculations with the contractor

•Natural resource risk •Independent reserve certification


Risk Solution

•Third party risks: –The contractor may be dependent on third parties such as suppliers of utilities to complete the project

–The project may be dependent on completion of another project – worst type of third party risk especially when the project financing is dependent on it.

•If the third party is not otherwise involved in the project, incentive mechanisms to keep the timetable•If the third party is involved with a project contract, the contract should include terms such that the third party should be held responsible for the delay losses•Contractor’s good relationships and experience with the third parties may be a plus

•Financing the projects as one package may be examined as a potential solution, as long as the sponsors’ interests on both sides can be aligned

•Sponsor-related risks (Lenders’ perspective):–Sponsor commitment to the project–Financially weak sponsor

•Require lower D/E ratio•Starting with equity: eliminate risk shifting, debt overhang and probability of distress (lenders’ requirement). •Add insider debt (Quasi equity) before debt: reduces cost of information asymmetry.•Attain third party credit support for weak sponsor (letter of credit)•Cross default to other sponsors

Value creation by contractual structure:Post-completion risks:

Risk Solution

•Market risk: Uncertainty regarding the future price and demand for the output

–Volume risk: cannot sell entire output–Price: cannot sell output at profit

•Long term off-take contract with creditworthy buyers:–take and pay, take or pay, take if delivered contracts:

•Price floors•A fixed price growth path•An undertaking to pay a long-run average price•Specific price escalator clauses that would maintain the competitiveness of the product, such as indexing price to the price of a close substitute or cost of major input

•Hedging contracts

•Operating cost risk: Uncertainty regarding the changes in the operating cost throughout the life of the project

•Risk sharing contracts to increase correlation between revenue and some cost items:

–If there is an off-take contract, linking input supply price to it:

•Basing the product price under the off-take contract on the cost of the input supplies (more likely if input supply is a widely traded commodity like oil)•Basing the input supply price to product price under the off-take contract: (more likely if the input is a specialized commodity, or if there is no off-take contract and risk is passed to the input supplier)

–Price ceilings–Profit sharing contract with labor–Output or cost target related pay

Value creation by contractual structure:Post-completion risks:

Risk Solution

•Input supply risk: Uncertainty regarding the availability of the input supplies throughout the life of the project

•If there is an off-take contract, linking the terms of the output contract with input supply contracts such as the length of contract, volume, or force majeure•If there is no off-take contract, making the input supply contract run for at least the term of debt•An input supply contract is off-take contract for the supplier

•Organizational risks: Incentive problems relating to management or workers

•Profit sharing / stock options•Output or cost target related pay for workers

•Operating risk: operating difficulties due to technology (being degraded or obsolescent), processes used, or incapacity of operator team leads to inefficiencies and insufficient cash flow

•Performance warranties on equipment•Expert evaluation and retention accounts•Proven technology•Experienced operator/management team•Operating/maintenance contracts to ensure operational efficiency•Allowances for service / upgrade built into equipment supply contracts •Insurance to guarantee minimum operating cash

•Force majeure risk: Likelihood of occurrence of events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc.

•Insurance for natural disasters

Value creation by contractual structure:Sovereign risks:

Risk Solution

•Exchange rate changes: Uncertainty regarding the changes in the exchange rate throughout the life of the project•Implications of a sudden major local currency devaluation in cases where the project revenue is in local currency and debt in foreign currency

•Revenues, costs, and debt in same currency (indexing if they are not in the same currency)•Market-based hedging of currency risks (though not widely used)•For protection from a sudden major devaluation, a revolving liquidity facility can be utilized to cover the time lapse between the devaluation and the subsequent increase in inflation that should compensate the project company for debt payments

•Currency convertibility / transferability risk: As it is often not possible to raise funding in local currency in developing countries, revenues earned in local currencies need to be converted into foreign currency amounts needed by offshore investors/lenders, and then need to be transferred outside the country to pay for them. Additionally, foreign currency may be needed to import materials, equipment, etc.

•Government Support Agreement: Government guarantee of foreign exchange availability: However, if the host country gets into financial difficulty and runs out of foreign currency reserves, then the government may forbid either the conversion of local currency amounts to foreign currency, or the transmission of these amounts abroad The support agreement may become invalid•Enclave projects: If the project revenues are paid from a source outside the host country, the project can be insulated from foreign exchange and transfer risks (Example: sales of oil, gas across borders)•Offshore debt service reserve accounts


Risk Solution

•Hyperinflation risk: Relative changes in the price of inputs and output may adversely affect the project

•Indexing the output price (in the long term sales contract) against the CPI and or industry price indices in the host country where the relevant costs are incurred (Indexing means increasing over time against agreed, published economic indices)

•Expropriation: Direct, diversion, creeping•Government’s breach of contract and court decisions

•Government guarantees or regulatory undertakings to cover taxes, royalites, prices, monopolies, etc.•Involvement of multilateral/bilateral agencies•Offshore accounts for proceeds•Government’s equity ownership•Using external law or jurisdiction

•Legal system: –Unclear and/or inconsistent legal/regulatory framework for project’s operations–Insufficient protection of private investment and private ownership/control of project–Bureaucratic hurdles–Changes in law, such as imposition of new environmental/health/safety requirements, price controls, import duties/controls, increase in taxes, royalties, deregulation, amendment or withdrawal of project’s permits, changing the control of company

•Government support agreement •Using external law or jurisdiction•Involvement of multilateral/bilateral agencies•A general principle is that the party who is paying for the output under a project contract should pay for the losses incurred due to changes in law specific to the industry, because such change is reflected in the entire industry and any extra costs will normally be passed on to end users; therefore an offtaker who does not bear this risk would earn extra profits at the expense of the project company


Risk Solution

•Political risks: Likelihood of occurrence of political events like wars, labor strikes, terrorism, etc.

•Political risk insurance•Involvement of multilateral agencies (WB/IFC) (structuring legal/financial documents, mediation in negotiations, sovereign deterrence, “halo effect”)•Bilateral agencies: Export credits from ECAs (who provide PRI)•The private insurance market•Contractual sharing of political risks between sponsors and lenders

Value creation by contractual structure:Financial risks:

Risk Solution

•Default risk: •Ensure sufficient debt service coverage•Decrease debt/equity ratio•Match term of loan to productive life of assets•Match repayment schedule to expected cash flows•Bonds with interest rates indexed to product sales price•Match currency of loans to currency of revenues

•Interest rate risk: •Interest rate swaps and hedging•Interest rate caps




mitigation


and control



Value creation by governance structure:

• Benefits of debt-based governance

– Tighter covenants limit managerial discretion and enforces greater discipline via better monitoring

– High leverage reduces free cash flow exposed to discretion– High leverage reduces expropriation risk– High leverage also reduces accounting profits thereby

reducing the potential of local opposition to the company– Tax shields

2. How Does It Create Value?



mitigation


and control

– Governance structure• Costs and benefits of debt-based governance


Background:

The project included a 12,500 km submarine telecommunications system between Australia and Japan via Guam at a cost of $ 520M. The project would use Telstra’s two landing stations at Australia. In Japan, it needed to either obtain permit from the government for building new stations, or contract or partner with other companies to obtain access to the existing ones. Japanese Government seemed not likely to approve building of a new landing station. Most significant risks were market and completion risks.

The lead sponsor, Telstra, has to structure the project company, selecting an ownership, financial, and governance structure.

Case examples to value creationAustralia-Japan Cable – Structuring a Project Company:

Issues:

1. Selection of strategic sponsors who would bring the most value to the project

2. Mitigation of market risk: Growing demand and capacity shortfall that triggers competition, rapid improvements in cable technology and resulting price decline necessitates moving very quickly

3. Completion risk: Potential delays due to environmental approvals and other permits

4. Management of possible agency conflicts between:1. sponsors and management2. sponsors and other parties (capacity buyers (purchasers), suppliers,

etc.)3. sponsors and creditors - decision of how many and which banks to

invite to participate

Case examples to value creation

1. Telstra partnered with Japan Telecom (who would bring its landing station in Japan and was interested in buying capacity) and Teleglobe (a major carrier who would bring significant volume) as sponsors (reducing cash flow variability)

2. Other equity investors to be selected would be high rated sponsors who were also capacity buyers. They would be made to sign presale capacity agreements ( reducing variability).

3. Capacity agreements with high rated sponsors would also be instrumental in raising debt with favorable conditions

How project structure may help:


4. Contemplated on concentrated equity ownership to maintain more effective management and monitoring

5. As for an interim management team, sponsors would also be made equal partners in control, regardless of individual ownership shares

6. A permanent management team was discussed, that would work exclusively for the project:

• Management compensation package was easier to craft, since it was a single purpose company with limited and well-defined growth opportunities

• Single cash flow easier to monitor



7. Decided on high leverage and project finance structure to help:• limit the amount of equity they needed to invest to an acceptable size• share the project risk with debt holders• enforce management discipline by reduced free cash flow and

contractual agreements

8. Bank debt with a small banking group was preferred rather than project bonds to have flexibility

• The initial tranche of bank debt would be secured and repaid in 5 years with presale commitments

• The second tranche would also be repaid in 5 years, but from future sales, acting as “trip wires” for the management team



Background:

Calpine, a small power generator with high leverage (~80%), sub-investment grade rating, and little debt capacity, has to decide how to finance its aggressive growth strategy, facing increasing pressure for speed, efficiency, and flexibility in a soon-to-be competitive commodity market.

The growth strategy includes building and operating a “power system” consisting of multiple power plants. Project financing and corporate financing alternatives are considered.

Calpine Corporation


Issues:

1. Speed was very important to gain first mover advantage

2. Necessity to be a low-cost producer in a commodity market

3. Operating a system of power plants to gain scale economies and also the flexibility to switch between the plants to offer uninterrupted service


Issues:

4. Using corporate finance as the financing method:

• Benefits:– Issuing high yield bonds would not require collateral and reduce

legal fees– Bonds would leave Calpine free to switch between plants in the

power system

• Costs:– The high-yield market was thinner and more volatile compared to

investment grade market, creating pricing and availability risk– As a firm with high leverage and sub-investment grade rating, the

high cost of corporate financing might lead Calpine to miss the opportunity to invest in a positive NPV growth project (Debt Overhang)

– A large debt issue might further jeopardize Calpine’s debt rating


Issues:

5. Using project finance as the financing method:

• Benefits:– Opportunity to finance the growth strategy even if Calpine had low

investment ratings and limited debt capacity

• Costs:– Time consuming and expensive to set-up and execute individual

deals– Limited size and absorption capacity of the project finance market – Possible restrictions to flexibly switch between the plants in the

power system if each plant would be collateralized separately


A hybrid structure was crafted that combined elements of both project and corporate finance:

1. Project Finance: i. Calpine project financed a portfolio of plants rather than a single

plant. This reduced legal and other fees, transaction costs, and saved time.

ii. Project finance allowed raising a large amount of debt on a non-recourse basis, which was impossible at the parent level

2. Corporate Finance:i. The structure gave Calpine flexibility to build the plants using equity,

and manage them flexibly as part of a power system (which would be impossible with separately project financing the individual plants)



Background:

A large and well-capitalized company, BP Amoco tries to decide on the best way to finance its share in the $8 billion development project of Caspian oil fields, undertaken by a consortium of 11 companies.

Each of the partners had a choice in how to finance its share of the total investment. Of these companies, 5 formed a Mutual Interest Group (MIG) to obtain project loan with assistance of IFC and EBRD. The alternatives BP Amoco considered for its share were corporate financing, project financing, or a hybrid structure.

BP Amoco


Issues:

1. Project Risks: The project had considerable political, financial, industrial (price and reserve volatility), and transportation related risks largely due to the unique region it was located.

2. Risk management: Protection of BP Amoco’s balance sheet from risk contamination or distress costs from investing in a risky asset

3. Involvement of multilateral organizations: Increased capacity to raise capital


Using corporate finance as the financing method:

• Benefits:– Financially strong enough to support a corporate funding strategy with

favorable terms– Easier to set up and less costly

• Costs:– Project might create additional risks in BP Amoco’s current asset portfolio

Risk contamination – BP Amoco’s absence in the IFC/EBRD finance deal for the MIG would

make it harder for the weaker partners to negotiate good terms, reducing flexibility in operations and management

– BP Amoco’s using corporate funding while at least some of the other partners’ using the IF/EBRD deal might potentially create disagreements

– Other partners might accuse BP Amoco as free rider, since BP Amoco would benefit at no cost from the political risk protection IFC/EBRD deal would have provided

– How they funded the initial phase would change possibilities of financing for the coming stages



Using project finance as the financing method:

• Benefits:– Reducing project’s potential negative impact on the balance sheet:

The project was very large and posed too many risks which BP Amoco could not bear alone, meaning a potentially huge negative impact on the balance sheet if financed solely by internal funding

– More protection from the many project risks due to risk sharing– Accommodating the financially weaker partners in the consortium to

negotiate better deals with creditors for the sake of future managerial and operational flexibility

– Benefiting from IFC/EBRD’s existence to shield from possible conflicts with the host governments

• Costs:– Harder, costlier, and more time consuming to set up– Less flexibility compared to corporate finance alternative



OUTLINE




4. Case analyses

5. Recap

Project Valuation

• Background• Approaches to calculating the Cost of

Capital in Emerging Markets• Country Risk Rating Model (Erb, Harvey and

Viskanta)

Background• Projects are characterized by:

– unique risks– high and rapidly changing leverage– imbedded flexibility to respond to changing conditions (real options)– changing tax rates – early, certain and large negative cash flows followed by uncertain positive cash flows

• Traditional DCF method is inaccurate:– Single discount rate does not account for changing leverage– Ignores imbedded options– Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor

• Traditional CAPM method is inaccurate:– Many mega projects are in emerging markets– Many of these markets do not have mature equity markets. It is very difficult to estimate Beta with the World

portfolio.– The Beta with the World portfolio is not indicative of the sovereign risk of the country (asymmetric downside

risks). E.g. Pakistan has a beta of 0.– Most assumptions of CAPM fail in this environment

• More appropriate approaches to project valuation may include:– Usage of non CAPM based discount rates especially for emerging markets investments– Changing discount rate to account for changing leverage– Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate– Valuation of real options– Usage of Monte Carlo simulation

Approaches to calculating the Cost of Capital in Emerging Markets

• World CAPM or Multifactor Model (Sharpe-Ross)• Segmented/Integrated (Bekaert-Harvey)• Bayesian (Ibbotson Associates)• CAPM with Skewness (Harvey-Siddique)• Goldman-integrated sovereign yield spread model• Goldman-segmented• Goldman-EHV hybrid• CSFB volatility ratio model• CSFB-EHV hybrid• Damodaran

Approaches to calculating the Cost of Capital in Emerging Markets

Many of these methods suffer problems because:

– Method does not incorporate all risks in the project– Assume that the only risk is variance, and fails to capture

asymmetric downside risks– Assume markets are integrated and efficient– Arbitrary adjustments which either over or underestimate risk– Confusing bond and equity risk premia.

The Country Risk Rating Model

• Erb, Harvey and Viskanta (1995)• Country credit rating a good ex ante measure of future

risk: – Some of the factors that influence a country credit rating are:

• political and other expropriation risk,

• inflation, exchange‑rate volatility and controls,

• the nation's industrial portfolio, its economic viability, and its sensitivity to global economic shocks

– The credit rating may proxy for many of these fundamental risks as it is survey based

• Impressive fit to data• Explains developed and emerging markets

The Country Risk Rating Model

Returns and Institutional Investor Country Credit Ratings from 1990

R2 = 0.2976

-0.1

0

0.1

0.2

0.3

0.4

0.5

0 20 40 60 80 100

Rating

Ave

rage

ret

urns

The Country Risk Rating Model• Cost of Capital = risk free + intercept – (slope x Log(IICCR))

– Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating – Gives the cost of capital of an average project in the country in $).

• If cash flows are in local currency, convert into $US:– Calculate the difference between the multiyear forecasts of inflation in the host country and

those in US– Use the difference to map out the expected exchange rates– Use calculated expected exchange rates to convert cash flows into $

• Adjust for industry risk:– Calculate the country risk premium from ICCRC:

Country risk premium = Country cost of equity capital – US cost of equity capital

– Calculate US industry cost of capital by using industry beta– Add the country risk premium to US industry cost of capital

• Adjust for project specific risks that deviate the project from the average level of risk in the host country

– Risks incorporated in cash flows or industry adjustment:• Pre-completion: technology, resource, completion. • Post-completion: market, supply/input, throughput.

– Risks incorporated in discount rate:• Sovereign risk: macroeconomic, legal, political, force majeure.• Financial risk.



3. Project Valuation

4. Case analyses

5. Recap

OUTLINE

• Chad-Cameroon Petroleum Development and Pipeline Project

• Petrozuata and Oil Field Development Project

• Financing the Mozal Project

Case analyses

Chad-Cameroon Petroleum Development and Pipeline Project

• Background• Corporate finance vs. project finance

– Why is there a difference between financing of field and export systems?

• The role of World Bank• Assessment of project risks and returns• Real options• Project update

Background

• ExxonMobil, Chevron, and Petronas undertake a $4 Billion petroleum development and pipeline project in Chad, which presented a unique opportunity to stimulate Chad’s economic development, and yet entailed environmental and social risks.

• Corporate finance for the development of the field system and project finance for the pipelines

• Debate on unstable political structure and how Chad would use its share of project revenues

• WB’s introduction of “Revenue Management Plan” to target Chad Government’s returns from the project for developmental purposes, and debate on the likelihood of effectiveness of such a plan

Corporate financing for the field system:

– The lead sponsor, ExxonMobil had AAA debt rating, very strong balance sheet ($145M assets) and $16M cash flow Could afford the field investment in a less costly way relative to project financing

– ExxonMobil was actually a huge portfolio of upstream businesses (exploration, development, production of crude oil and natural gas), downstream businesses (transportation, marketing, and sales), as well as chemical byproducts and operations in mining. With less than perfect correlation among its assets, ExxonMobil might actually have been able to eliminate the idiosyncratic risks via adding a field development project to its portfolio. Corporate financing as opposed to project financing helped ExxonMobil keep the project as part of its portfolio and reduce the risks.

– Besides, the vertically integrated business model made it a naturally cost-efficient choice for ExxonMobil to hold the assets collectively with corporate financing rather than individually with project financing

– Corporate financing probably also enabled managerial flexibility and discretion over the use of oil wells, drilling equipment, etc. that constitute the field system

Corporate financing for the field system:

– Field development was the less risky part of the entire project for the sponsors, because upstream operations including field development and production was one of the core business areas where they were very strong at. This reduced the cost of bearing these risks themselves since they were better equipped than anyone else.

– Project financing for a field development project would also not be a viable financing option, as the lenders generally would be reluctant to finance until after all reserves are proven and capable of production.

– The crude oil prices for the last 18 months ranged from $9 to $42, averaging $20 per barrel, which, even after discounted for the lower grade, was considerably higher than the project’s $5.20 exploration and development costs. With a total proven plus probable reserves of 917M barrels, downside exposure to price and resource risk was already mostly eliminated No serious need to protect from the downside risk (via risk sharing )with project finance and incurring higher interest rates and loan fees.

– Corporate financing probably also helped save both the costly delays at the development stage of the project and the structuring costs, which would be incurred in project financing

Project financing for the export system:

– Export system was the riskiest part of the project. Project financing for the export system mainly enabled the sponsors to spread the political risks as much as possible via the presence of outside lenders such as WB, IFC, ECAs.

– The expectation was that the Chad and Cameroon Gov’ts would be less likely to take or tolerate adverse actions against the project in fear of jeopardizing future funding from the WB and other international financing institutions who were lenders of last resort

– Additionally, it facilitated alignment of Gov’ts interests with the project through equity ownership, which would not have been possible otherwise as Gov’ts could not afford on their own

– Project financing also created the opportunity for the pipeline companies (JV between Gov’ts and the sponsors) to issue limited-recourse debt, guaranteed by the sponsors through completion

– Project financing enabled external monitoring from the lenders– ExxonMobil also reduced total investment commitment to the project

under the corporate/project finance structure, compared to that under a complete corporate finance structure

The role of World Bank:

– WB involvement assured sponsors the much needed protection against the political risk

– Besides direct investment through A loans, it mobilized other funding sources like ECA and other banks through a syndicated B loan

– WB’s extensive lending and policy experience with Chad offered the leverage that sponsors did not have

– The project with potentially high returns and developmental impact for Chad was also aligned with WB’s policy objectives

– WB facilitated extensive consultation process including supporters and opponents: The process helped sponsors’ restructuring the project to minimize the social and environmental impact (such as increasing the benefits to indigenous people and changing the pipeline route to protect the natural habitat)

– WB also initiated a “Revenue Management Plan” to help prevent probable misuse of Chad’s revenues by the Gov’t, and target them for developmental purposes to increase welfare

– Insisted on an open and transparent project planning process – Established capacity building programs to develop the infrastructure for a well-

functioning petroleum industry and investment climate in both Chad and Cameroon

The role of World Bank:

– WB involvement also ensured that sponsors did not abandon the project due to huge political risks and looked instead for safer opportunities in other countries, leading to a missed opportunity for Chad

– Without the WB, the Gov’t might turn to neighboring countries such as Sudan and Libya for partnering in oil export. This potentially would have adverse consequences in case the project revenues were utilized to finance non-developmental purposes such as war.

• Such an alternative would mean longer and hence more expensive pipelines

• The project’s exposure to social risks would increase, as the pipelines would inevitably cross the northern part of the country with social unrest and upheavals.

Subjects of opposition:

– The environmental and social impacts were claimed to be irreversible– The revenue management plan was claimed to be flawed and to lack

effective oversight• Gov’t claimed to “have little intention of allowing the plan to affect local

practice” • Criticism on oversight committee’s composition and power• The RMP was a concept untested

– According to Harvard Law School, “Oil will not lead to development in Chad without real participation, real transparency, and real oversight, none of which currently exists”

– The revenue management plan also regarded as “infringement of sovereign rights”

• The sovereign rights controlled by undemocratic rulers versus people– The beneficiaries of the project were claimed more to be the corporate

sponsors and commercial banks, as opposed to people of Chad– Valuable funds could have been used in alternative causes, rather than

potentially strengthening a corrupt Gov’t

Assessment of Project Risks and Returns:Chad

– Benefits: • Project provides an important opportunity for Chad to reduce poverty, though

contingent on Gov’t commitment– Receive up to $125M per year from the project, increasing Gov’t revenues by more than 50%– Chad has few other alternatives if any for development

• RMP provisions and future linking of developmental funds to Gov’t compliance may deter potential misuse of project revenues by the Gov’t

• Project helps leveraging WB and other financial resources which Gov’t could not have mobilized by itself

• Leveraging technical expertise of the reputable sponsors significantly reduces Chad’s exposure to operational risks

• Potential employment opportunities created for local people in operations• Environmental/social concerns seem to be well addressed in contingency plans with

extensive public consultation• Another positive externality may be WB’s capacity building efforts to establish the

sufficient infrastructure for a well-functioning petroleum industry and investment climate in Chad

• Greatest protection from downside risk (i.e. price or volume risk) compared to corporate sponsors, probably because bulk of the revenues (royalties) independent from price or reserve levels.


– Risks: • The realization of the opportunity for economic development strictly

dependent on Government’s commitment in implementation of RMP– RMP is claimed to lack credible oversight and enforcement

mechanisms, which would work against the people of Chad due to undemocratic and oppressive Gov’t in power

– RMP was a concept yet to be tested with the project; even WB admitted the project to be an “experiment”, which increases people’s exposure to risk

• Chad has to put its only natural resource into the project under project finance structure and RMP, which considerably eliminates sovereign discretion and flexibility

– Impositions on the allocation of revenues may turn out to be constraining for a future democratic government who wants to implement other projects to the benefit of people of Chad

– Government’s compliance to RMP is a requirement for future WB loans, which extends the potential influence of the project-specific impositions and commitments to non-project specific areas, increasing Chad’s exposure to risks


– Risks: • Even if the project generates promised revenues for Chad, Chad might not gain

on an incremental basis, as it will no longer be eligible to certain types of developmental funding due to increased revenues

– Current aid is around $188M (Exhibits 7 and 8), which exceeds the expected cash flow. Chad might not gain on an incremental basis due to displacement of existing aid, and yet lose control on its single natural resource

• Environmental and social risks mostly remain with Chad – Some adverse impacts are either irreversible or extremely hard to fix– Despite contingency plans, there may be leakages in the pipeline that

would go unnoticed for long time, due to limitations of even the most advanced technologies

• Less share of the gains in the upside (though balanced with the highest protection from downside risks)

• Although expected to be a highest priority issue from Chad’s perspective, the timing of cash flows were not negotiated to the advantage of Chad

– Considering the urgent need for funds, the allocation of cash flows should have favored Chad more in the initial years

– Compared to the timing of cash allocations for other sponsors, the late allocation might be perceived as unfair and might increase the chances of expropriation

Assessment of Project Risks and Returns: Sponsors (Exxon Mobil)

– Benefits: • The presence of WB/ECA/IFC along with participation on

governments in equity financing significantly reduced political risk exposure

• Project might have helped portfolio diversification• Low construction risks (sponsors’ expertise and reputation in the

industry)• Low operating risks (positive NPV under most scenarios in Exhibit 5

with different price and reserve levels) • Low financial risks, considering the DSCR (as high as 2:1) and low

breakeven finding and development costs compared to price• The presence of WB/ECA/IFC in the deal, alignment of Gov’t

interests via equity ownership through project finance structure, the linking of installment of future development funds to Government’s compliance to the RMP significantly reduced political risk exposure. However,

Assessment of Project Risks and Returns: Sponsors (Exxon Mobil)

– Risks: • Back-loaded cash flows to Gov’t may be perceived as unfair

and may result in expropriation – Still chances are low, as Gov’t would not probably want to

jeopardize future capital inflows by risking its relations with WB and the rest of the financial community

– The Gov’t would not want to forego serious amount of revenues in the form of dividends, taxes, royalties.

• Any social or political instability in either Chad or Cameroon would adversely effect the export of oil through the pipelines across the two countries

– However, the construction of pipelines underground may have helped reduce the negative consequences of being exposed to such risk

Real options

• Shadow costs: In case WB is not involved in the project, it is likely that the Gov’t will go with Libya

• Temporary stop option if oil price drops

Project Update

• After WB approved the deal, President Deby used part of the proceeds to buy weapons

• Huge criticism by social activists/interest groups against WB and sponsors• WB responded by requiring that the proceeds should be repaid out of

general revenues, suspended new loan programs, and also set up a new oversight body headed by external people

• After these reforms, WB and IMF permitted debt relief to Chad

• In December 2005, the National Assembly of Chad amended the country’s Petroleum Revenue Management Law in the following ways*:

• “broadening the definition of priority sectors to include, among other areas, territorial administration and security; and by allowing that further changes in the definition of priority sectors can be made by decree”;

• “eliminating the Future Generations Fund, thus allowing the transfer of more than US$36 million already accumulated there to the general budget “

• “increasing from 13.5 % to 30% the share of royalties and dividends that can be allocated to non-priority sectors that are not subject to oversight and control”

* Chad-Cameroon Pipeline Project, World Bank Web Site

Project Update

• WB considered these changes a breach of contract, and on January, 2006, it suspended new loans and grants to Chad, as well as disbursements under eight ongoing IDA operations in the country.

• The suspension automatically freezed the flow of part of Chad’s oil revenues within the offshore escrow account

• WB states in its web site that it “remains in dialogue with the Chadian authorities, and is determined to safeguard the oil revenues intended for poverty reduction programs included in its original agreement with Chad, while recognizing the fiscal strains currently experienced by the government of Chad”.

Petrozuata and Oil Field Development Project

• Background• Why use project finance? • Risk management

– Pre-completion risks– Post-completion risks– Sovereign risks– Financial risks

• Real options• Cost of capital calculation• Project update

Background

• Petrozuata is a $2.4B integrated oil field development project in Venezuela. The project is planned to be financed under project financing structure. The project sponsors Conoco and Maraven are subsidiaries of Du Pont and PDVSA, a Venezuelan state owned enterprise. The sponsors decide on 60% debt financing, and seek for alternative ways to raise the required funds. The alternatives considered are project bonds, securing of which are contingent on securing investment-grade rating for the project; or bank loans, which may need to be covered by PRI provided by multilateral agencies.

The priority and challenge for the sponsors is to craft the project’s operational and financial details so as for the project to achieve an investment grade rating.

Why use Project Finance?

• Strategic reasons in the long run: $2.4B Petrozuata will be the first in a series of projects planned which total as high as $65 B.

– PDVSA needs to preserve debt capacity for future funding needs. – Success in this project will be a proof of concept for the rest. – Project finance structure provides PDVSA a wider capital access

• Debt financing for PDVSA more expensive under corporate finance structure:

– PDVSA has low credit rating (long-term senior unsecured debt rating B from S&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b)

– Under project financing, if the project can secure BBB investment grade rating, lower cost of debt ~ 7.70%

– A gain of 2.47%– However, huge transaction and contracting costs as well as the longer time

needed to structure a project financed deal should be weighed against the potentially lower cost of debt to see if there is a net gain in terms of costs


• Positive-sum as opposed to a zero-sum deal for PDVSA and Venezuela:

– Cost focus would be a zero sum perspective for both PDVSA and Conoco (one party gains and the other loses)

– Involvement of experienced Conoco and Du Pont in the deal may help increase the aggregate net cash flows to the project, due to efficiency gains as well as risk sharing/allocation benefits (positive-sum perspective)

• Massive tax benefits

– Under project finance, the project is subject to significantly lower income tax rates (34% as opposed to 67.7%) and royalties.

• Avoidance of possible risk contamination

– But losing the benefit of co-insurance which would come with corporate financing


• Resolving possible agency conflicts

– High leverage and dedicated cash flows via the “cash waterfall” structure helps prevent opportunities for risk shifting, underinvestment, or cross-subsidization of negative NPV projects

• From lenders’ perspective, separated cash flows also allow easier monitoring and possibly lower monitoring costs

• Project finance allows better allocation or sharing of risks via contractual relationships, thereby reducing the cost of risk

Risk management

• Identification and mitigation of:

• Pre-completion risks: Resource, technological, timing, and completion risks

• Post-completion risks: Market risk, supply risk, throughput risk, and force majeure

• Sovereign risks: Inflation risk, exchange rate volatility convertibility risk, expropriation

• Financial risks: Leverage risk under the constraint of investment grade rating

Pre-completion risks and mitigation

• Resource Risk: Quantity and quality of the crude oil

+ Petrozuata being a development and not an exploration project: • An independent evaluation found that the field contain 21.5

barrels of oil. Assuming production level of 120,000 BPCD and 35 years project life, 7% of these reserves is sufficient to sustain the project

+ Variability in the available crude oil’s quality was not deemed to be significant to reduce the efficiency of upgraders

+ Additional value creation for Conoco from corporate perspective: • In addition to being an equity holder in the project, Conoco

would also benefit from low-cost reserves and long-run supply of crude oil the project would provide (with off-take contracts) for its refinery business


• Technological risk: How proven is the technology used? How experienced are the contractors to handle technological risks? The ability to handle such risks are important to prevent likely cost overruns or construction delays

+ Conoco had sufficient project experience and technological knowhow with its proven production and refining technology

+ Maraven also had significant production technology and experience- The pipelines would run 125 miles between the oil fields and the coast,

increasing risk exposure+ The terrain between the oil fields and the coast was relatively flat

and sparsely populated, which would ease pipeline construction+ Most of the pipelines would be laid underground

+ The well drilling technology to be used had been an established one, used in both the Oronoco belt and all around the world

+ EPC contracts for the downstream facilities and pipelines were planned to put out to bid to a consortia of leading international contractors

+ Contracts for upstream constructions were planned for experienced and authorized Venezuelan companies


• Timing and completion risk: Failure to meet the intermediate milestones in a complex project may jeopardize the timely completion of the entire project as well as increasing costs

– The project is a complex one consisting of multiple components including field

facilities, pipeline system, and the upgrader facilities– Sponsors dependent on proceeds from selling the early production oil to fund

part of the construction – Failure to meet completion criteria would make all non-recourse debt due and

payable+ Both Conoco and Maraven had significant project experience to handle the

execution complexities+ An independent evaluator assessed their execution plan and concluded that the

milestones are aggressive but within reach, and that the plan complies with local and international regulations and standards (a factor that would help mitigate likely regulative delays)

+ Both sponsors made commitments (such as contingency funding for unexpected cost overruns) guaranteed by parent companies to ensure successful completion of the project

Post-completion risks and mitigation

• Market risk: Uncertainty regarding the future price and demand for the output

– The price of oil is volatile+ The off-take agreement with Conoco secures a significant portion of

the output to be purchased for 35 years at a price pegged to market price of Maya crude

+ Petrozuata being a low cost producer with breakeven price well below industry average could still operate even if prices fell dramatically

– Currently there is no broader market developed for syncrude + However, in expectation of the development of such a market in the

near future, Petrozueta retained the option to sell the syncrude to third parties if they demand at a higher price than Maya crude.

+ According to an independently conducted assessment, the development of a third party market was expected in 3-5 years, and that the syncrude output would sell at a $1/barrel premium.


• Supply risk: Uncertainty regarding the availability of the input supplies throughout the life of the project

+ The project will be self sufficient in terms of electricity, gas, and water after completion.

+ During construction, the supplies such as water, electricity, hydrogen supply and diluent supply will all be contracted to firms owned by the Venezuelan Gov’t


• Operating cost risk: Uncertainty regarding the changes in the operating cost throughout the life of the project

+ An independent consultant assessed the project and concluded that the cost estimates are reasonable considering industry standards

Sovereign risks and mitigation

• Exchange rate risk: Uncertainty regarding the changes in the exchange rate throughout the life of the project

– Free floating of the Bolivar against $ may result in appreciation of the currency, leading to increased local costs and tax liabilities

+ Conversely, a likely depreciation of the Bolivar would increase the revenues (in $) against the local operating expenses (in Bolivar) in relative terms.

+ No strong signal inferred from the case as to either of the directions

+ No significant risk as both revenues and debt service were denominated in $


• Inflation risk: Relative changes in the price of inputs and output may adversely affect the project- Serious inflation levels that reached 100% in 1996

Sovereign risks and mitigation• Expropriation risk: Sovereign risk in the form of government’s direct seizing of

project assets, project cash flows (diversion), or changing tax policy (creeping)

- Risk of Government’s changing the currently preferential tax and royalty treatment

- Possible negative influence of Gov’t on the effective functioning of offshore proceeds account

- History of nationalization in the 1970s+ Gov’t cannot afford to risk the future funding opportunities for the planned series

of upcoming projects by getting involved in any form of expropriation+ The Gov’t owns a serious portion of the assets anyway (PDVSA and Maraven as

sponsors)+ Any expropriation attempt may face a retaliation from US where PDVSA has

assets (CITGO) + Gov’t interests aligned with the project’s success, as Gov’t receives tax and

royalty payments, as well as benefits of employment opportunities created and access to the refining technology

+ Project output syncrude has a narrow market limiting Government’s motivation for a diversion attempt


• Force Majeure risk: Likelihood of occurrence of political events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc.

– Venezuela’s historic political and economic instability– Oil facilities are generally targets of terrorism due to their

significance in economy– Project’s agreements were defined to be invalid in case of force

majeure events + The pipelines will be constructed underground, and in a sparsely

populated area

Financial risks and mitigation

• Leverage risk: Balancing the incentive to maximize the equity returns (via leverage) against the likelihood of default and failure to get an investment grade rating+ The target leverage of 60% turns out to be just right to allow for

a minimum DSCR of about 2.08X (in year 2008), which exceeds the minimum acceptable ratio of 1.80X allowed for an investment grade rating

+ More equity commitment actually signals that sponsors perceive the project as right

Real Options – value of flexibility

• Option to delay the project• Option to increase the production• Option to sell the excess capacity to future projects in

the area• Option to abandon the project, since the project consists

of several stages

Cost of capital calculation* Project Risk Mitigation (-10 to 10; where 10=risk completely eliminated, 0=average for country)

Weights Score

Impact on Country Premium

Sovereign0.40 9.00 -6.64 Currency (convertibility)0.12 -5.00 1.11 Expropriation (direct, diversion, creeping)0.04 9.00 -0.66 Commercial International partners0.03 3.00 -0.17 Involvement of Multilateral Agencies0.04 -3.00 0.22 Sensitivity of Project to wars, strikes, terrorism0.04 0.00 0.00 Sensitivity of Project to natural disasters

Operating0.05 0.00 0.00 Resource risk0.03 0.00 0.00 Technology risk

Financial0.03 3.00 -0.17 Probability of Default0.03 2.00 -0.09 Political Risk Insurance

Real Options (some handled through cash flows)0.05 8.00 -0.74 Project impacts other projects0.05 5.00 -0.46 Option to delay the project0.05 8.00 -0.74 Option to increase/decrease production0.05 5.00 -0.46 Option to abandon the stages of the project

1.00 Sum of weights (make sure = 1.00)

*C. Harvey’s International Cost of Capital Calculator

Cost of capital calculation*

*C. Harvey’s International Cost of Capital Calculator

Cost of Capital Worksheet

Risk Premium CalculationInputs Output Category

5.60 U.S. risk free in %7.00 U.S. risk premium in %

90.70 Current U.S. Credit Rating32.00 Institutional Investor country credit rating (0-100)

31.04 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

18.44 Country Risk Premium

Industry Adjustment0.60 Beta (Industry)

-2.80 Sector adjustment

Project Cost of Capital 19.44

TN

Exhibit 9

Exhibit 11

What happened?

• The project received ratings that exceeded the sovereign ratings by five notches

• Completed a $1B bond issue, which was five times oversubscribed, and a total of $450M bank financing (with 14 years maturity at 7.98%, 12 years maturity at 7.86%)

• The project considered by analysts as “one of the best structured and best executed project finance deals ever done”, 1997

• PDVSA continued to structure deals for the Orinoco Basin• Venezuelan economy was hit hard by the decline in crude oil prices• S&P revised its outlook for Petrozuata to negative, as a result of the cost

overruns, lower than expected early production revenues, falling prices, and political uncertainty

• As economic situation worsened, Gov’t demanded and received extraordinarily high dividends from PDVSA reaching up to 134% of projected income in 1999

• Hugo Chavez won the 1998 elections and announced not to interfere with foreign oil investments

Financing the Mozal Project

• Background

• Risk management– Completion risks– Operation risks– Sovereign risks (Major risk group in this project and the reason

for project financing)– Financial risks– Real options

• The role of IFC

• Project update

Background

Mozal is a $1.4 B aluminum smelter project in Mozambique. The sponsors are Alusaf, a subsidiary of a South African natural resource company, and IDC, a government-owned South African development bank with long-standing relationship with Alusaf.

The sponsors are interested in structuring a limited-recourse financing deal with IFC involvement.

IFC’s concerns are the size of the project, as well as the political risks of doing business in Mozambique.

Risk Management

• Identification and mitigation of:

• Pre-completion risks: Technological, timing, and completion risks• Post-completion risks: Market risk, supply risk, and force

majeure• Sovereign risks: Inflation risk, exchange rate volatility,

convertibility risk, expropriation• Financial risks: Leverage risk


• Timing and completion risk:– Mozambique has complex bureaucratic processes that may delay

getting the necessary permits to proceed with the construction– The conditions of the basic infrastructure (like the insufficiency of

connecting roads, or dependability of electricity supply) may slow down the construction efforts

– Sponsors dependent on cash generated during start-up for funding $34M of the project

+ Sponsors had a proven track record with the Hillside project where they were able to complete the project four months ahead of schedule and 21% under budget

+ The same contractors and construction team used in the completion of the Hillside smelter would be called for the project.

+ Sponsors planned a $75M contingency budget for the construction period


• Technological risk: How proven is the technology used? How experienced are the contractors to handle technological risks? The ability to handle such risks are important to prevent likely cost overruns or construction delays+ Mozal would use proven, state-of-the art smelting technology (Pechiney

technology from France) that was used in the Hillside smelter+ Both sponsors have significant experience in the smelting industry with

Hillside being their most recent undertaking+ Alusaf was the subsidiary of the South Aftrican Gencor group, which

was the world’s fourth largest aluminum producer

• Market risk: Price of the output– The sponsors planned to purchase all of the output subject to long-term

purchase agreements, but at market prices– The market prices had been declining for the last couple of years, and

the trend was expected to continue due to the developing scrap market + Mozal would be a low cost producer in the industry (lowest 5% in terms

of cost) , having higher margins than other players to absorb potential market price declines


Supply risk and operating costs: Availability, quality, and price of the alumina, electricity, and labor

• Alumina accounted for 33% of production costs+ The sponsors planned to link the price for alumina to LME aluminum

market prices+ Alumina would be imported from a supplier of Alusaf’s affiliated

company Billiton under a 25 year supply contract• Electricity accounted for 25% of production costs

+ The electricity price would also be a function of aluminum prices + Eskom and Mozambican Electric company would provide

inexpensive electricity under a 25 year contract whereby the price will be fixed in the early years and then tied to aluminum prices

+ The majority of unskilled labor would come from Mozambique, decreasing labor costs compared to industry averages

+ Other inputs would be supplied from the same contractors who supplied the Hillside smelter under similar long-term contracts

Sovereign risks

Expropriation risks:- Outright seizure of assets – very unlikely:

- The scale of the project relative to the size of the poor economy (9% of GDP), combined with short-term survival concerns may be tempting for a shortsighted Gov’t to expropriate

+ Gov’t wouldn't want to curb the investments, because they are interested in development

+ Gov’t cannot afford an outright seizure, due to potential reactions from WB/IFC, as this would jeopardize the much needed future development funds

+ Following a direct seizure, international suppliers may not be willing to work with the Gov’t, and Mozambique does not have local suppliers of the raw materials to go on with the business alone

Sovereign risks

Expropriation risks:- Seizure of cash flows (diversion) – low risk:

- Gov’t may divert the aluminum and sell it to others+ However, the spot market for aluminum is very thin for Gov’t to divert

and easily sell the output+ Potential reactions from WB/IFC

- Changing of taxation – creeping – moderate risk:- Gov’t may remove the privileges that the smelter would be exempt from

customs duties and income taxes- It is highly likely that the Gov’t may change the 1% sales tax, which is

more critical than the income tax

Sovereign risks

Political events:– Political instability – Risk of war: not completely eliminated – Legal instability– Bureaucratic hurdles– Underdeveloped infrastructure– Unskilled / untrained labor

Macroeconomic risks:– Currency exposure:

+ Not a major risk as the major inputs and all the output would be denominated in $.

– Convertibility risk:+ Not a major risk since the proceeds will be kept at an overseas

trustee

Sovereign risks mitigation

Sovereign risk was the most important reason that Gencor/Alusaf chose to finance the project via project financing, as opposed to corporate financing, in order to minimize their risk exposure and be able to raise capital. Project was structured in the following way to ensure that an expropriation would have international consequences, and also lenders would be comfortable enough to participate in the project:

• Existence of international commercial partners:+ International suppliers: Power from Eskom of South Africa, alumina from

an Australian supplier, technology from France, most of the other inputs (coke, petroleum, etc.) would be imported as well

+ Any expororpiation would jeopardize as well the trade relationships with these countries as they were at the same time Mozambique’s important trade partners

• Involvement of multilateral/bilateral agencies:+ IFC: Almost totally reduces the risk of expropriation and default+ French and South African ECAs+ Any expropriation would have impact on future flow of development funds

• Foreign trustee to keep the sales proceeds


• Government and local commitment+ The Gov’t and Mozambique would benefit from the developmental impact of

a successful project+ Increasing GDP by 9%, exports by $430M, spurring local business,

upgrading and expanding local infrastructure (i.e. power, roads), technology transfer, creating permanent employment opportunities (873 jobs) and 5000 construction jobs as well as human capacity building

+ Diligent environmental and social impact analysis by IFC+ Social programs planned for Mozambican people

+ Gov’t established a special committee to ease the bureaucratic / administrative hurdles for the Mozal project

+ Gov’t signed an Investment Protection Agreement with South African Gov’t for cross-border projects

+ Government committed to economic and legal reforms– In addition to the positive externalities outlined above, Gov’t might have

also been given an equity share to better ensure it has a vested interest in the project’s success to minimize risk of expropriation (See Chad-Cameroon Case)


• Using high leverage: + Ensures cash flows are kept low so that temptation for seizure is low

+ Besides, the project structure was designed in such a way to allow for higher interest payments when sales increase, minimizing the cash balances

+ High leverage also ensures that as long as the sponsors provide on-going benefits, it is to the Government’s benefit not to expropriate

+ Even in case of expropriation, governments generally feel obliged to pay for the project’s foreign debt because of undesirable repercussions in the international community for not doing so.

Financial risks and mitigation

• Political risk insurance:

– As much as IFC involvement was the critical issue, securing political risk insurance was important as well to provide comfort to potential lenders:

+ Political risk insurance is an instrument to help shift (not mitigate) the political risks (like expropriation, war, breach of contract, or currency inconvertibility) to parties that are best able to bear it

+ PRI providers generally have a more diversified portfolio than banks to absorb these risks

+ PRI providers are more competent in analyzing sovereign risks, whereas commercial banks in analyzing commercial risks

+ A French ECA supporting the use of the French technology was expected to provide 85% insurance for loans from French banks, and IDC was in advance discussions with the South African ECA for insurance for $400 M senior debt

+ The French ECA may be more willing to bear the political risk than banks do because it attaches a higher value to the project in order to be able to export the technology

+ Similarly, the South African ECA may be more willing to bear the political risk than banks do because it attaches a higher value to the project in order to be able to promote the south African exports

Real options

• Option to expand+ Mozal would be constructed with all the infrastructure to double the capacity

when needed.

The role of IFC

• Appraising the project+ Helps uncover the information about the project, as well as sponsors

and governments involved, which may not be readily available to lenders

+ Acts as a mediator between the governments and sponsors to ensure all issues are addressed and handled properly

+ Better qualified to do sovereign risk analysis given its development experience and relationships with governments

– Significant difference between ex-ante and ex-post economic and financial return calculations

• Structuring the legal/financial documents+ Has a reputation for being an “honest broker”+ Significant experience in mediating large and diverse groups and

resolving complex legal issues+ Instrumental in harmonizing the legal structures of Mozambique and

South Africa to create an agreed-upon basis for dispute resolutions+ Instrumental in facilitating creation of common legal terms for critical

issues like completion guarantees, which all parties agree to abide by.

The role of IFC

• Providing long-term capital+ Willing to lend senior debt and subordinated debt, and also equity+ Longer maturities compared to bank loans: 7-12 years on senior debt

and 8-15 years on quasi-equity+ Compared to commercial banks, willingness to bear higher risks for the

same return because of the developmental aims it attaches to projects + It provides a catalytic effect on other lenders once it agrees to

participate in a project+ Empirical evidence suggests IFC involvement increases the country

credit ratings, encouraging future investment in high-risk countries • Deterring sovereign interference

+ IFC pays attention to structure “fair” deals that would benefit the governments and then monitor them to preclude short-term opportunistic behavior

+ “Halo effect”: IFC, with virtue of being a WB affiliate, receives preferential treatment from the governments in terms of debt obligations, and hence provides indirect protection for the lenders

What happened?

• IFC approved the $120M investment in 1997, its largest investment by then

• In 1998, Project Finance International declared Mozal as the “Industrial Deal of the Year”

• Construction temporarily stopped in 1998 when workers went on strike to protest low wages and poor working conditions

• Workers on strike held management hostage in 1999

• Despite the ongoing strike, the project proceeded as planned, and was in fact on time and below budget

• Critics argued that the sovereign risk had been too high, showing the strike as evidence

• Critics also defended that sponsors were treated too generously in the deal compared to Mozambique

• Despite the criticisms, the Mozal project appeared to set the stage for an inflow of additional private investments in Mozambique in the final analysis



3. Project Valuation

4. Case analyses

5. Recap

OUTLINE

Recap - Type of assets/projects and appropriate method of financing:

– When the asset is less than perfectly correlated to the rest of company’s asset portfolio, corporate financing may help eliminate idiosyncratic risks via diversification

– When the sponsor has strong balance sheet to secure debt in favorable terms, and a vertically integrated business model (which minimizes variability)

– When the sponsor is better equipped than anyone else in assessing and bearing risks

– Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance).

– When the benefits of above told co-insurance outweighs cost of risk contamination

Corporate Finance:


– Discrete, non-core assets that can be separated from the rest of the business) Example: power plants

– Large, highly risky projects with cash flows highly correlated with those of sponsor (no benefits from diversification under one portfolio)

– Projects appropriate for high leverage (those with predictable cash flows, low distress costs, and minimal ongoing investment requirements)

– Projects that are more transparent and easier to monitor during construction, development, and ongoing operations (transparency can lower cost of capital by facilitating credit decisions)

– Projects with a structure that minimizes overall costs associated with market imperfections

– When it is possible and cost effective to allocate the project risks contractually

– Projects whose cash inflows and outflows can be set by long-term contracts (to reduce variability)

Project Finance:


– For oil industry, production projects, rather than exploration or development: Banks generally reluctant to lend on project basis until the underlying stock/flow is proven and capable of production ( reducing variability and risk)

– High risk projects such as first-time investments in new industries, markets, technologies: project finance may bring added discipline and access to experienced partners

– Projects exposed to high degree of sovereign/political risk may benefit from the existence of outside lenders in project finance structure: host governments cannot risk project due to potential reaction from international finance community

– Project financing may help accommodating critical partners (such as governmental agencies) who cannot finance their shares via corporate borrowing (Joint venture projects)

– Project finance is preferred when it results in higher combined variance when added to corporate portfolio

– When firm value decreases due to cost of financial distress which increases with combined variance.

– Project finance is preferred when cost of risk contamination exceeds the benefits of co-insurance.

– When creation of an independent entity allows project to obtain tax benefits not available to sponsors

Project Finance:

Acknowledgements

The content of this presentation has been derived from:

– Emerging Markets Corporate Finance Course materials taught by Campbell Harvey at Duke University

– Project Finance lecture slides by Campbell Harvey, Aditya Agarwal, Sandeep Kaul at Duke University

– Modern Project Finance: A Casebook, Benjamin Esty, John Wiley & Sons, 2004 – Principles of Project Finance, E.R. Yescombe, Academic Press, 2002– Petrozuata, A Case Study of the Effective Use of Project Finance, Benjamin Esty,

Journal of Applied Corporate Finance– Contracting and Project Finance Lecture Notes, Program on Project Appraisal and

Risk Management, May 16-June 10 2005, Duke Center for International Development

– Risk Management Lecture Notes, Evaluating Projects in the Public Sector Course, Program in International Development Policy, Duke University

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