- 1. 1 WHAT IS PROJECT FINANCE AND HOW DOES IT WORK? BY ANASTASIA
SLIVKER APRIL 2011 Introduction While riding on a high-speed train
through India, Europe, or Taiwan, a passenger may see massive wind
turbines scattered throughout the countryside. Marveled by the
landscape, the passenger may take a snapshot on her phone camera
and send it to her family. Without realizing it, the passenger is
likely to have benefitted from infrastructure projects that have
been financed by a mechanism called project finance. The high-speed
rail, the wind turbine, and the telecommunication towers are all
large and complex infrastructure undertakings. Sometimes such
projects are made possible by traditional financial methods;
increasingly, however, infrastructure projects are financed by a
mechanism that engages a multitude of participants including
multilateral organizations, governments, regional banks, and
private entities. In project finance, participants negotiate
amongst themselves to spread risks associated with an undertaking,
thereby increasing the chances for success in developing vital
infrastructure projects for that country and its population.
Project finance is the preferred financing mechanism for large
infrastructure projects that are essential for developing
countries, emerging economies, and developed countries alike. This
FAQ will define project finance and compare it to corporate
finance, present project finance participants, and discuss the
financing mechanism. It will also address the advantages and risks
associated with project finance and provide insight into the future
of project finance. I. What is Project Finance?
2. 2 At its core, project finance is a method of financing where
the lender accepts future revenues from a project as a guarantee on
a loan. In contrast, traditional method of financing is where the
borrower promises to transfer to the lender a physical or economic
entity (collateral) in the case of default. In practice, most
projects are financed by a combination of both traditional methods
as well as by guarantee-backed loans. While the name suggests that
project finance refers to raising capital by any means to pay for
any project, the term refers to a narrow but increasingly more
prevalent method of financing capital- and risk-intensive projects
across a broad array of industries. The twentieth century was
marked by a reliance on the public sector for developing
infrastructure projects. Historically, governments initiated
infrastructure projects to develop or build essential facilities so
that citizens and businesses could conduct various operations and
experience economic growth. In the last two decades, however, there
has been a shift in the model of development from the public sector
to greater private sector participation. These hybrid
public-private partnerships (PPP) have been instrumental in
upgrading existing Source: Thomson Routers 3. 3 facilities and
creating new infrastructure in various industries and in all parts
of the world. The most common method of financing PPPs is project
finance. Today, various sectors employ project finance, including
power, transportation, oil and gas, leisure and property,
telecommunications, petrochemicals, mining, industry, water and
sewerage, waste and recycling, and agriculture and forestry. The
chart above suggests that while project finance is most common in
power and transportation projects, it extends to a broad range of
industries. Project finance is an important tool for financing
projects in developing and emerging economies, yet developed
countries employ the mechanisms as actively as less developed
countries. For example, in 2010 India had the most active
project-finance market with over $52 billion worth of deals,
stemming from 131 loans. Spain came in second with 67 loans (for a
total of $174 billion) and Australia in third with 32 loans (worth
$14.6 billion). II. What is the difference between project finance
and traditional finance? In traditional or corporate financing, the
sponsoring company (the company building the project) typically
procures capital by demonstrating to lenders that it has sufficient
assets on its balance sheets. That is, in the case of default, the
lender will be able to foreclose on the sponsor companys assets,
sell them, and use the proceeds to recover its investment. In
project finance, the repayment of debt is not based on the assets
reflected on the sponsoring companys balance sheet, but on the
revenues that the project will generate once it is completed. The
sponsoring company must consider several factors when determining
whether to use a corporate or project finance structure. Such
considerations include the amount of capital needed, the risks
involved (political risks, currency risks, access to materials,
environmental risks, etc.) and the identity of the participants
(whether a government, multilateral institution, regional bank,
bilateral institution, etc. will be involved). As the graph below
demonstrates, 4. 4 corporate finance most often involves private
investors who provide financing in return for ownership (equity) in
a project company. The focus in project finance, however, is mostly
on loans to the project company, with project revenues as the
source of the return on the investment to lenders. Project finance
greatly minimizes risk to the sponsoring company, as compared to
traditional corporate finance, because the lender relies only on
the project revenue to repay the loan and cannot pursue the
sponsoring companys assets in the case of a default. However, a
sponsoring company can only use project finance where it can
demonstrate that revenue streams from the completed project will be
sufficient to repay the loan. In fact, lenders will often require
that the sponsoring company demonstrate that it has agreements in
place that will generate the required revenue (called off-take
agreements). For example, in the case of power projects, the
sponsoring company often signs contracts with distributors where
the distributors agree to purchase electricity generated by the
project. Therefore, project finance is most suitable for a project
where there is a predictable revenue stream to support debt
repayment. Corporate Finance Model v. Project Finance Model
Corporate Finance: Project Finance: 5. 5 Source:
http://www.syrianpppconference.org/sp/JohnSachs.pdf III. Who are
the participants in project finance and what are their roles?
Project finance has many participants who participate at different
stages of a projects development and operation. Because of the
complex structure of project finance, not all projects follow the
same structure and not all of the participants described below
partake in all projects. Since the goal of project finance is to
build large infrastructure projects by allocating risks to the
party most able to bear it, the following participants are usually
involved in a project financed under a project finance model: the
sponsor company, the special purpose vehicle, the host government,
financial institutions (multilateral, regional development banks,
bilateral, and commercial banks), contractors and builders, and
infrastructure operators and off-take purchasers. The Development
Company. Every project must have a core entity responsible for
organizing, developing, and ensuring that the project is
operational. In project finance that entity is called the Special
Purpose Vehicle (SPV). A Sponsor Company creates an SPV for the
sole purpose of achieving the limited goals of construction and
operation of a particular project. (a) Sponsor Company. The Project
Sponsor can be a company, a group of companies, a joint venture, or
a subsidiary of another company that initiates a project. A project
sponsor can become involved in a project in one of two ways: (1)
when the host government solicits bids (goes through a procurement
process) and selects the best candidate among the bidders; or (2) a
company or group of companies may initiate a project on their own,
with or without soliciting 6. 6 host government involvement.
However, most projects have government involvement and backing. A
project sponsor has a limited but important role; it is the company
or group of companies that either solicits bids or receives tender
from a host government to construct a site. The project sponsor
then creates a special purpose vehicle that will conduct all the
business associated with the project on behalf of the project
sponsor. At the projects completion, the sponsoring company will
receive the profits generated by the project. While the project
sponsor is the main equity owner of the SPV, the project sponsor
does not carry liability in the case of default because, as
mentioned earlier, future revenues of the project are the
guarantee. Therefore, the project sponsor has ownership of a
project without some of the risks that it would face in traditional
finance. In return for a significant (and often majority) equity
ownership stake in the SPV, the project sponsor invests a limited
amount of its own money to win the procurement bid as well as to
pay for early administrative costs. (b) The Special Purpose
Vehicle. A project sponsor creates a SPV for the purpose of
constructing the project. There are various ownership structures
for an SPV, which are linked to the type of financing that the SPV
is likely to procure as well as the law of the host country. Most
importantly, an SPV is the legal entity that contracts with other
parties involved in the development process. For example, in the
United Arab Emirates Umm Al Nar Desalination Plan, the Sponsor
Companies were a joint venture between a company that is wholly
owned by Abu Dhabi Water and Electricity Authority (ADWEA), Tokyo
Electric Power Company (TEPCO) and Mitsui. The joint venture
created the Arabian Power Company (APC), which is the SPV. To
ensure the success of the project, the joint venture companies
provided the initial capital necessary to jump- 7. 7 start the
project to the SPV. The investment was proportional to their share
of ownership of the SPV, totaling 112 million British Pounds of the
$2.1 billion dollar project. The Host Government. Large
infrastructure projects often require government involvement. As
addressed above in the discussion on the role of the project
sponsor, the government may decide to build a project, for example,
a desalination plant or a power station, but will often lack the
economic resources to construct the site. Moreover, a government
may not want to assume construction risks or face political risks
if the project does not have strong political support. In order to
mitigate construction risks and to draw together the necessary
capital, a government may procure a sponsor company to build the
project on behalf of the government. In the above Umm Al Nar
Desalination Plant example, Abu Dhabi Water and Electricity
Authority is a government entity that solicited Tokyo Electric
Power Company (TEPCO) and Mitsui, two private companies, to form a
joint venture in order to secure all the additional funding. It is
also common for the government to be a guarantor, but not to have
an equity stake in the SPV. The host government can be a guarantor
by providing risk mitigation in the form of sovereign guarantees
which includes repayment of debt in the case of political unrest,
promises to make favorable legal reforms, setting favorable
tariffs, and promises to pay back private debt in the case of
default, among others. A common sovereign guarantee is when the
government agrees to purchase all or part of the output of the
product, sometimes at a set price. For example, in the Umm Al Nar
Desalination project, Arabian Power Company, the SPV, signed a
purchase agreement with Abu Dhabi Water and Electricity Authority
whereby the latter agreed to purchase all the desalinated water
produced by the site for a 23-year period. While this is a common
off-take arrangement, given that many projects generate public
consumer goods, the 8. 8 guarantee can expose the host government
to substantial liability. In the case of the Pigbilao Project in
India, for example, the government guaranteed to purchase all
energy produced by the site. However, demand dropped during the
Asian Financial Crisis and the government could not afford to
continue to purchase all energy generated by the plant. Financial
Institutions. There are numerous financial institutions that may be
involved in building a site financed by project finance.
Furthermore, there is an even greater variety of capital support
structures that a financial organization can provide for a project.
Most projects engage some combination of multilateral organizations
(for example, the International Finance Corporation), regional
development banks (for example, the Islamic Development Bank),
bilateral organizations (for example, the U.S. Ex-Im Bank), and
commercial bank financial assistance. The form of support is as
varied as the parties: low interest-rate loans, no interest-rate
loans, market interest-rate loans, guarantees, political insurance
(insurance against changes in authority or legislation), equity
ownership, and technical and operational support. Generally, the
role of financial institutions is three-fold. First, financial
institutions provide loans with varying levels of interest rates
depending on the economic situation in the host country and its
creditworthiness. Second, some financial institutions, such as the
World Bank or the European Bank for Reconstruction and Development,
provide guarantees and political risk insurance, thereby providing
assurance to other investors. Finally, financial intuitions may
help provide guidance on how to manage the project or provide
technical expertise. To better understand the complexity and the
ways in which financiers interact with each other, consider the
following example. The CBK Power is a hydropower station in the
Philippines that involved participation by multilateral
organizations (Senior Lenders in the chart below) and a bilateral
investment organization, the Japan Bank for International 9. 9
Cooperation (JBIC), to finance and guarantee the loan. Note that
JBIC did not lend directly to the SPV (Project Company in the
chart) but to the company who wanted to purchase equity from the
original sponsor company, in this case to J-Power and Sumitomo
Corporation. This demonstrates just one variation by which a
sponsor company and the SPV can finance a project through project
finance depending on the demands of a project. Because this project
involved the continuation of an existing project with a shift in
ownership, private financial institutions financed the equity
acquisition. To enable the transaction, JBIC provided guarantees to
private financial institutions in case the sponsoring companies
default on their loan to purchase ownership of the SPV. In this
case, JBIC is not a lender to the SPV, but a guarantor on a loan to
purchase ownership of the SPV. JBIC and the private financial
institutions are mezzanine lenders, and in the case of a default,
they are paid back after senior lenders. Therefore, JBIC provided
both financing and political risk coverage to the new sponsor
companies, and repayment, as the chart below demonstrates, is
limited to tariffs generated by the project. Source:
http://www.jica.go.jp/english/publications/jbic_archive/others/pdf/project_finance.pdf
Source: 10. 10 OVERVIEW OF FINANCIERS AND THEIR ROLES SOURCE ROLE
International Multilateral Organizations: World Bank Group Mitigate
risks and provide risk enhancements as a senior lender. Provides
both financing and loan guarantees. International Bank of
Reconstruction and Development (IBRD) Lender of last resort,
meaning that no other lender will provide financing, so the borrow
must demonstrate that the project is feasible and the borrower will
be able to repay the loan. International Development Association
(IDA) Finances projects in the world's poorest countries (that do
not qualify for market-based interest rates). IDA charges a small
fee rather than an interest rate. IDA receives funds from
subscription members and the World Bank, rather than capital
markets, providing long-term loans. International Finance
Corporation (IFC) Provides financing, and while it does have the
capacity to provide guarantees, it does not. The IFC has two types
of loans: "A loans"(financed by the IFC's own funds) and "B loans"
(financed by external funds). B loans have high interest rates
(higher than the World Bank) to attract more capital by offering
capital investors a higher interest rate. IFC can be an equity
shareholder. Multilateral Investment Guarantee Agency (MIGA) Main
function is to mitigate risk by providing political risk insurance
(e.g., change of authority or change in legislation) as well as to
mediate possible disputes. As a result, MIGA backing can help
attract funding. Regional Development Banks* Goals are to reduce
poverty and increase development on a regional level. African
Development Bank Finances at rates based on its own costs and not
international rates, assists with drafting feasibility studies,
technical cooperation, and other operations of the project. Asian
Development Bank Focused on providing financing rather than
guarantees. In fact, until recently, the ADB required the host
government to provide a guarantee on lending available only to
governments, but has since shifted to provide lending to private
companies. European Bank for Reconstruction and Development Charges
market interest rates, in addition to a whole range of services
including mobilizing additional funds. Serves as a guarantor, and
an equity investor. Islamic Development Bank Provides interest-free
financing based on Islamic religious principles (Sharia law), also
finances leases. Can be an equity holder. Bilateral Organizations
Provide financing and political risk insurance. Commercial Banks
Provide short-term loans with floating interest rates based on good
to excellent credit rating for the SVP and/or host country. * The
list below is a sample. 11. 11 Contractors and Builders. There must
be detailed arrangements with contractors, those who lease
equipment, and other companies that are involved in constructing
the project. The agreements must explicitly detail all phases of
construction. Because the construction phase often involves
significant risk of completion, it is essential that risks be
clearly allocated in documented agreements. There is often tension
between contractors and builders and the SPV because the contractor
is required to finish the contract on a turn-key basis. That is,
the contractor must deliver the completed project according to a
strict timeline. Because on-time completion is essential for the
SPV to insure that it is able to pay back financial commitments,
the builders interest in extending the deadline conflicts with an
SPVs on-time delivery. To avoid the conflict of interest, the SPV
can insure against the construction risk, offer the builder an
on-time production bonus, or both. Operator and Off-take Purchaser.
Once the project is completed, either the SPV or another company
will take over the site and operate the facility. Depending on the
structure of the agreement with the host government, the operator
may be the government (or its agent) or another company contracted
by either the SPV or by the host government. The off-take purchaser
has the most essential role at the outset of the project. When the
sponsoring company, on behalf of the SPV, attempts to secure
financing, an essential part of project finance is to be able to
demonstrate that the project will be able to generate revenue,
since future revenues guarantee loans in project finance. In order
to provide greater assurance for financial institutions, the
sponsor company or the SPV will often seek out and sign an off-take
agreement for the product or services the project will generate. In
doing so, the SPV can guarantee revenue for the project. Often, the
government is the off-take purchaser. Sometimes the off-take
purchaser is the sponsoring company that wants to create the
project to gain access 12. 12 to a needed resource. In other
arrangements, the off-take purchaser may also be funding the
project. For example, a South Korean zinc producer and recycler,
ZincOx, signed a letter of intent with Korea Zinc for a $50 million
dollar loan as well as an off-take contract for Korea Zinc to
purchase the zinc produced by the recycling plant. In this case,
ZincOx is acting as both a lender to the project and is a private
off-take company purchasing zinc from Korea Zinc, the SPV. IV. What
are the financing mechanisms under project finance? Similar to the
traditional finance model, a project finance model allows an entity
to use equity or debt financing. Most entities in search of
investment funds prefer debt financing to equity financing because
they retain full control over the project and earn a greater return
through the use of debt financing. Debt financing refers to funding
a project with a loan, where the SPV takes out a loan and no other
investors are involved. In contrast, equity financing requires the
project sponsors of the SPV to either contribute cash needed for
the project or sell ownership in the SPV to raise capital. In
addition to maintaining full control, debt financing is attractive
because project sponsors do not have to contribute extra capital to
the project. Equity. Often host governments and debt lenders will
require that the entity building the project obtain some equity
funding in order to demonstrate project viability in the market and
to 13. 13 offset initial costs. There are a number of factors that
influence the level of equity in the SPV that will be made
available by the sponsoring companies via equity funding and how
much of the construction costs the SPV will solicit in the form of
loans. Those factors include how the project is organized, who the
players are, what the particular risks are in that country, and
what legal requirements there may be in the host country.
Typically, equity comprises a smaller share compared to debt
(although equity-to-debt ratios range from 5% to 50% in project
finance). Debt. There are two main types of debt: Mezzanine and
Senior Debt. (a) Mezzanine Debt: Mezzanine Debt is a special type
of debt, which has priority over equity, but is subordinate to
other types of loans. Recall the example above of the CBK
hydropower station. The mezzanine debt lenders were providing
capital in order for one project sponsoring company to purchase the
existing project company. If the project fails, senior lenders who
were lending to the SPV rather than to the new sponsor company will
be paid off first. The important fact to bear in mind is that
mezzanine debt refers to debt that is riskier, because there are
other outstanding loans that have priority over the mezzanine loan
in the case of a default. (b) Senior Debt: As the name suggests,
senior debt has seniority in the event of default. A lender may
stipulate that it is a senior debt lender, as the World Bank does
for example. This means that in the case of default, that lender
will receive payment before other creditors of the project. There
are several types of debt available to sponsoring companies:
Commercial financing (commercial banks, pension funds, insurance
companies, and other financial institutions), where the lender
requires the borrowers promise of repayment to be collateralized
(backed by some asset). 14. 14 Subsidized loans, where the interest
rate is below the market rate. Development institutions,
governments, and regional development banks (such as a loan from
the African Development Bank) typically provide such subsidized
loans. Credit enhancing arrangement from bilateral and multilateral
organizations and regional banks, where those organizations provide
a guarantee to the lender. If the SPV cannot make payments on its
debt, then the guarantor will make payments to the lender on behalf
of the SPV. Bond financing, where the bondholder provides capital
in return for a promise by the SPV to repay the initial amount with
interest. Leasing. One other unique method of financing is lease
financing where the SPV rents equipment relying on future revenue
stream of the project to pay the lease. That is, the SPV does not
make immediate payments on the leased equipment, but promises to
pay for the equipment once the project begins to generate revenue.
Because construction costs are significant, this sort of financing
can play an important role in enabling a project to proceed. The
company leasing the equipment has a security interest in the
equipment and can repossess the equipment in the case of a default.
In return for the financing, the SPV may be required to pay
additional interest or pay a premium on the cost of renting the
equipment. 15. 15 V. What are the typical steps in project finance?
VI. What are the risks associated with project finance and how are
they mitigated? One of the reasons that participants employ the
project finance model as opposed to traditional finance is because
infrastructure projects require large volumes of capital. With so
many participants, risk can be allocated among the parties best
able to bear it. Because project finance is a common financing
mechanism for long-term, labor-intensive projects, risks are
abundant and may surface at any one of the many stages in the
project cycle. This next section will discuss the main risks
inherent in project finance and how the various parties, in their
agreements with each other, attempt to mitigate them. Commercial
Risks. In the larger scheme of commercial risks, there are two main
types of financial risks: interest rate risk and currency risk.
Like in traditional finance, changes to the interest rate may
negatively affect the financier or the SPV, or both. Most projects
are long-term so lenders charge floating rates (as opposed to
predetermined, set rates) based on market 16. 16 conditions.
Therefore, when interest rates rise, the costs of the project will
increase and the SPV may find itself unable to meet its financial
obligations. In order to mitigate this problem, when possible, it
is best for the SPV to negotiate a either a fixed interest rate or
a floating interest rate, but one that floats only within a fixed
manageable range. Alternatively, the SPV may use interest-rate
swaps to mitigate the risk that a floating rate will increase. The
SPV may swap with another party, like a private bank, the floating
interest rate for a fixed interest rate on the principal amount the
SPV borrowed. Currency risk is also a serious financial risk to
project finance, and one that is not easily mitigated. Currency
risk occurs when revenues are generated in one currency while debts
must be repaid in a different currency. This is called currency
mismatch. In project finance, financing is typically received in
the currency in which the lender operates and the lender expects to
receive payment in the same currencye.g., a U.S. bank lends in
dollars and expects to be repaid in dollars. However, because
currency exchange rates fluctuate, an SPV may find itself unable to
pay its lenders if the domestic currency suddenly and significantly
drops in value. For example, fluctuations in exchange rates may
make repayment difficult if an SPV generates revenue in the Thai
baht, but must pay back in dollars. If the baht drops in value with
respect to the dollar, then the SPV will need to come up with more
baht to pay back the loan because one baht now pays back less debt
then before the devaluation. During the Asian Financial Crisis,
many Asian countries currencies suffered significant depreciation;
Indonesias Java Bali Power Grid project demonstrates the extreme
effect of currency mismatch. The off-take purchaser (power
purchaser in this case) bore the currency risk under the purchase
agreement, and when the Indonesian rupiah fell 87% in 1996, the
power purchasers rates to customers skyrocketed because of its
obligations to pay for the debt in 17. 17 dollars. As a result, the
power purchaser had to pay approximately 400% of the original
price. Similar to interest rate swamps, the SPV may mitigate risks
stemming from currency exchange- rate fluctuations by utilizing a
currency swap, allowing the SPV to convert debt into a more stable
currency. Also, a real exchange-rate liquidity (REX) facility may
be used, which addresses the risk of a devaluation of the local
currency. In the event of a specified devaluation, resulting in a
cash flow shortfall, the facility provides liquidity to cover the
debt payments. Closely related to the currency mismatch are demand
risks. Essentially, either through poor planning or because of some
extraneous event like the Asian Financial Crisis, demand for the
project-finance generated goods or service may drop, in which case
the essential element of project financethe revenue stream to pay
back loansis reduced. A drop in demand was the reason the Pigbilao
Project failed in the Philippines. The project was well financed
and completed on time, but when the Asian crisis hit in the 1990s,
demand for energy fell significantly. Napocor, the Philippines
National Power Company, was the off-take purchaser and bore the
demand risk. When demand fell and prices rose, Napocor feared
political backlash and had to subsidize the price of energy. The
best method to mitigate demand risks is for the parties to do
extensive pre-construction forecasting of future demand.
Additionally, the party bearing the demand risk may seek a
guarantee from a third party like the World Bank, as detailed
below. Political Risks. Political risks take various forms, which
include changes in a governments authority, legislation, and
budget. Sponsoring companies often overlook the possibility of a
change of authority, yet a regime change or a change in power of a
ruling party can influence the success of both the construction and
operation of a project. Given the close relationship of the SPV and
the host country in project finance, even the possibility of a
change 18. 18 can be disruptive to the progress of a site.
Government corruption can also seriously hinder a project. A change
in the political authority, either of a political system (like a
change from autocracy to democracy) or a change of from one
political party to another within a political system, may lead to
changes in the host countrys position on a vital element of an
agreement. Take for instance the Dabhol power project in India. The
sponsoring companies negotiated a rushed agreement with the Indian
government, which was anxious to have foreign investment in the
region, forming the Dabhol Power Company (DPC). In 1995, Dabhol
became a major campaign issue in the Maharashtra state election.
The Congress Party lost control to a coalition party formed by
Bharatiya Janata Party (BJP) and the ShivSena. The two parties won
on a platform that advocated hostility to the sponsoring companies
of the Dabhol Power Company. Once in power, the new government
created the Munde Committee, which reviewed the Dabhol power
project and determined that the Indian government rushed into an
agreement with DPC, and that the agreement was too one-sided. As a
result, the government ordered DPC to stop construction. After
lengthy negotiations, the agreement with India was renegotiated.
While the project did not ultimately fail because of the political
change (it failed because of miscalculation for demand), the Dabhol
power project demonstrates the extent to which a change in power
can bring a project to a standstill. Political risks are mitigated
by political risk insurance. Private companies as well as
multinational organizations (like MIGA, which has a special
political insurance service) provide insurance in a traditional
sense, in addition to issuing performance bonds that guarantee
completion. 19. 19 Legal Risks. Changes to the laws governing
elements of agreement, status, or operations of the project can
significantly affect the costs of an operation. Specifically,
changes in import and export tariffs can increase costs by
preventing access to cheap raw materials or by forcing the SPV to
use inferior domestic inputs. A host government may want to achieve
certain short- term economic or social goals by changing the tax
code, which can purposefully or inadvertently affect the project
structure. The rate at which host country taxes the SPV or other
parties will significantly affect the financial benefits to
participants. Finally, the host country can adopt laws that change
the legal status of the SPV, or change the laws governing ownership
of companies or real estate, which can have a catastrophic effect
on the project. Legal risks are most often mitigated by guarantees
(which are elaborated upon below) from one of the participantsmost
commonly the host government. Construction, Operation, and
Technical Risks. Construction, operation and technical risks are
usually assessed during the first stages of the project in a
feasibility study that carefully examines risks associated with
putting up the project as well as the technical and environmental
regulations that may impact the project. The main construction risk
is that construction will be stopped or significantly delayed.
Sometime construction is delayed because builders do not have
access to materials, but it may also be intertwined with other
risks, such a political risk that may halt construction. In a power
project, for example, the construction risk may be that the
builders will have delay or problems having equipment shipped to
the site. A technical risk may be access to a power grid for the
distribution of power to customers. Because storing power can be
very challenging, immediate access in proportion to demand is
essential for a successful power project. A thorough feasibility
study should examine construction risks as well as how power 20. 20
will be interconnected to the main power grid, technology
compatibility issues, and how revenue will be calculated. In order
to mitigate some of the risks, parties can draft legal agreements
that specify the terms under which the SPV has access to the grid,
and how the power generation site will connect to the grid. To
mitigate construction risks, the SPV can negotiate for the builder
rather than the SPV to bear that risk. Such agreements are
instrumental for the success of a project, since access to the
power grid is an essential component of generating revenue to repay
loans. Another risk is that the host country could change technical
requirements before the project is complete. For example, the laws
on environmental protection may change or the national legislature
may pass a new law that requires a higher density of steel for
structures of a certain height, affecting the projects compliance
with building regulations. A feasibility study evaluates
environmental regulations and the effect of building a site at a
particular location. In order to comply with national and
international environmental laws, companies often conduct extensive
environmental impact analyses. If an international or national
environmental agency detects non-compliance, a project may be shut
down, fined, or may face social and political backlash. Mitigating
Risk with Guarantees As referenced above, one important method of
mitigating commercial, political, legal and construction risks is
for the SPV (the most common recipient) to acquire guarantees by
the parties best able to bear the associated risk. Most commonly,
large multilateral organizations like the World Bank, and regional
development banks, like the Asian Development Bank, provide
guarantees for worthy projects. However, any one of the
participants can provide a guarantee on any one of the associated
risks. 21. 21 Guarantees are credit enhancement devices. For
example, during the early stages of construction, the sponsor
company may be the guarantor. Contractors usually guarantee project
completion either by performance bonds or payment bonds (guarantees
that subcontractors will be paid). Often, multilateral and
bilateral organizations mitigate financial and political risks by
issuing guarantees. In turn, the guarantors may purchase insurance
in case they have to provide capital for a default under the
guarantee agreement. Depending on the organization of the projects,
the roles of other participants, and the nature of the agreement
with the sponsor company or SPV, guarantees can take various forms.
Typically, third-party guarantors like a multilateral organization
or a regional bank do not sign unconditional guarantees, but rather
limited or indirect guarantees. Often, these guarantees are in the
form of put options, where the guarantor promises to pay for any
liability of the obligor (the project company), but the project
company must pay back the guarantor. Without guarantees, some
projects may never start. For example, in 2006, the International
Development Bank (IDB), Multilateral Investment Guarantee Agency
(MIGA), and Steadfast Insurance Company (SIC), a subsidiary of
Zurich Financial Services Group, (that is in turn is insured by
Oversees Private Insurance Corporation), contributed $250 million
of guarantees to a $510 million gas pipeline that stretches 678 km
approximately 15 miles off the coast of Nigeria to Ghana. Along the
way, smaller pipelines that lead to intake locations in Benin and
Togo connect to the pipeline. 22. 22 Source:
http://siteresources.worldbank.org/INTGUARANTEES/Resources/WAGPNote.pdf
As one of the largest private investments in West Africa, the West
African Gas Pipeline (WAGP) could not have been possible without
the guarantees by multilateral and bilateral organizations.
Nigeria, Ghana, Benin and Togo are developing countries, so private
investors entering the region face significant political risks. By
providing complementary guarantees (there was no interest rate
attached to the guarantee) to the government of Ghana, the
International Development Association (IDA) guaranteed that if the
Government of Ghana was unable to make payments on the gas under
the off-take agreement, the IDA would satisfy the SPVs debt
repayment obligations to its financiers. VII. What are the
Advantages of Project Finance? Project finance allows countries to
build the infrastructure necessary to increase growth and
development. It draws a greater volume of financing than under
traditional schemes because risks are often spread among the
various participants, and development organizations mitigate risks
by providing political and commercial guarantees. Without project
finance, many essential and life-enhancing projects may have never
been constructed. As a relatively new method of financing dating
back to the 1970s, project finance offers several important
advantages as a financing mechanism. It is a non-recourse financing
mechanism, meaning that in the case of default by the sponsor
company, a borrowers liability to 23. 23 the lender is limited to
the assets of the special purpose vehicle rather than the company
or companies that own the SPV. Therefore, the companies that own
the project site do not have to fear that lenders will be able to
go after the assets of the sponsor company if there is a default.
Large infrastructure projects are essential for developing and
emerging economies. Therefore, multinational and regional
organization, like the World Bank or the African Development Bank,
whose goals are often poverty prevention and developing economic
prosperity, are more willing to provide financing. Moreover, the
financing is likely to be at a discounted interest rate. The
guarantees provided by such organizations serve to attract more
investors. A massive hydropower generation site, for example, is a
very expensive endeavor. Despite the lucrative gain, many private
companies shy away from such capital-intensive endeavors if there
is no safety net, and governments are also unable to make the
necessary funding available, given other demands on a nations
resources. Given the participants and its organizational structure,
project finance provides a safety net to private investors, enables
host governments to attract investment, and develops needed
infrastructure projects without exhausting host country reserves.
Moreover, depending on the financing arrangement, host governments
maintain control over the site if necessary. Given that power
projects require high amounts of capital, and because of the way
projects are organized both financially and legally, the debt of
the SPV is not reflected on the sponsor companys balance sheet.
This is called off-balance sheet accounting, where all debts are
assigned to the SPV rather than the sponsoring company and the
sponsoring company does not have to account for the large debt in
its accounting books. This allows the sponsoring companys credit
rating to remain unaffected. 24. 24 Other advantages of the project
finance structure include debt leveraging, favorable financing
terms, and access to capital. Debt leveraging refers to financing
by debt (as explained above) as opposed to equity. This is an
important advantage for the sponsor company because it does not
have to reduce its ownership of the SPV, and therefore can keep
more of the profits once they are generated. Because project
finance typically involves guarantees, particularly by multilateral
and regional banks like the African Development Bank or the Asian
Development bank, the SPV often attracts more investors and
receives lower interest rates because the risk of default is
reduced. Project finance provides access to more capital than would
be available to a private company or government on their own
because governments would typically be limited to their internal
financing and private companies usually cannot attract enough
capital necessary for large infrastructure projects without
additional guarantees. VIII. What is the future of project finance?
Project finance is an increasingly widespread financial mechanism,
which host governments and private investors are employing more
frequently and in greater volumes as a method of financing
infrastructure projects. While the most recent economic crisis has
had a significant impact on the volume of capital available,
project finance remains a valuable financing approach that offers
significant advantages to participants. Furthermore, it is likely
to continue to grow as the global economy recovers. The graphs
below shows the growth trends for project finance. In the six years
prior to 2009, there was a relatively steady increase in the volume
of capital financed under the project finance model. While not all
areas of the world experienced the same growth in volumes of
capital, with Asia Pacific and Europe, Middle East and Africa
(EMEA) benefiting most, total volumes nearly tripled from 2003 to
2008. 25. 25 Source: Thomson Reuters The graph suggests that
capital in project finance will continue to increase, given the
speed with which the volume of capital is returning to
pre-recession levels. In 2006, at the high point of global economic
stability, there were 541 project-financed projects for a total of
$180 billion. In 2010, while still in the process of economic
recovery, there were 587 project funded by $206 billion, despite
the tightening of capital markets during that time. There are
several possible explanations for the continued growth and success
of the project finance model. First, developing and emerging
economies are making significant strides to develop their economy,
which often requires building infrastructure to effectively utilize
available natural resources for domestic growth. For example,
before the expansion of the West Africa Power Project, West-African
nations were unable to take advantage of inexpensive regional
reserves of natural gas. Second, technological improvements are
reducing the risks associated with various projects that are best
financed through the project finance model. For example, solar
energy technology is becoming increasingly feasible and
economically viable, so investors and developers are less wary to
build such projects. Third, parties involved in project finance
have over the last forty years developed the project finance
mechanism in way that best mitigates risks, thereby insuring a
greater likelihood of success. Fourth, many governments are
privatizing certain industries, especially when existing
infrastructure needs repair or refurbishing. 26. 26 In those cases,
governments are likely to turn to the project finance model in
order to maintain involvement and control while reducing capital
contributions. Finally, commentators believe that project finance
drives economic development in low-income countries. In many
low-income countries like the ones in the West Africa Power
Project, the projects and the positive subsequent effects on
regional and national economic developments would not have been
possible without project finance. The area that seems to be growing
most rapidly is power project financing for both power generation
and transmission. There are several reasons that power projects
dominate project finance. The primary reason is that governments
are looking to build infrastructure that does not rely on oil.
Additionally, many countries have other natural resources that can
be converted into energy, and power project finance allows nations
to build new massive infrastructures cost- effectively. For these
reasons, power projects financed by project finance are not limited
to developing and emerging economies, but have a presence in
developed countries, particularly solar and turbine power
generation in the United States and northern Europe. Power is just
one industry where project finance is likely to have a growing
impact in the future. As developing and emerging economies work to
create the necessary infrastructure to improve the lives of their
citizens, project finance will ensure future global growth and
development. Sources: Carrie Harrington, Uruguay to Expand Its
Energy Options, CENTER FOR INTL FIN. AND DEV. (2011),
http://uicifd.blogspot.com/2011/02/uruguay-to-expand-its-energy-options.html.
DENTON WILDE SAPTE LLP, PUBLIC PRIVATE PARTNERSHIPS: BOT TECHNIQUES
AND PROJECT FINANCE (2D ED. 2006). GRAHAM D. VINTER, PROJECT
FINANCE (3D ED. 2006) 27. 27 HAL S. SCOTT, INTERNATIONAL FINANCE:
TRANSACTIONS, POLICY, AND REGULATION (16TH ED. 2009). HENRIK M.
INADOMI, INDEPENDENT POWER PROJECTS IN DEVELOPING COUNTRIES (2010).
J. Paul Forrester, Role of Commercial Banks in Project Finance
(1995),
http://www.mayerbrown.com/publications/article.asp?id=958&nid=6
JEFFREY DELMON, PRIVATE SECTOR INVESTMENT IN INFRASTRUCTURE (2D ED.
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its Causes and Understanding its Lessons, 41 VAN. J. TRANSNATL L.
907, 916918 (2008). RUMU SARKAT, TRANSNATIONAL BUSINESS LAW A
DEVELOPMENT LAW PERSPECTIVE (2003). SCOTT L. HOFFMAN, THE LAW AND
BUSINESS OF INTERNATIONAL PROJECT FINANCE (3D ED. 2008). Stefanie
Kleimeiera and Roald Versteeg, Project Finance as a Driver of
Economic Growth in Low Income Countries (2008),
http://69.175.2.130/~finman/Reno/Papers/projectfinanceasdriverofgrowth.pdf
THOMSON REUTERS, PROJECT FINANCE REVIEW: FULL YEAR 2010 (2010). Umm
Al Nar Desalination Plant, WATERTECHNOLOGY.NET (last visited April
14, 2011), http://www.water-technology.net/projects/umm/ World
Bank, Project Finance in Developing Countries, WORLDBANK.ORG (last
visited April 14, 2011),
http://rru.worldbank.org/documents/toolkits/highways/pdf/23.pdf.
World Bank, Project Finance and Guarantees, WORLDBANK.ORG (Jan.
2005) http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp409.pdf.