UNIVERSITY OF PHOENIX
COLLEGE OF EDUCATION AND EXTERNAL STUDIES
SCHOOL OF CONTINUING AND DISTANCE EDUCATION
DEPARTMENT OF EXTRA MURAL STUDIES
MASTERS OF ARTS IN PROJECT PLANNING AND MANAGEMENT
LDP 602: – PROJECT FINANCING
CIRCUMSTANCES IN WHICH ENVIRONMENTAL, POLITICAL AND MACROECONOMIC RISKS ARE IMPORTANT FOR PROJECT FINANCIERS BEFORE ADVANCING LOAN TO A PROJECT COMPANY
CESAR DELARIVIER
L50/76492/2014
Term Paper Submitted in Partial Fulfilment of the Requirement for the Award of Master of Arts in Project Planning and Management in the Department of Extra-Mural Studies University of Phoenix.
1. Table of Content page
Explain the circumstances in which environmental, political and macroeconomic risks are important for project financiers before advancing loan to a project company (15marks).
Introduction
Project finance can be characterised in a variety of ways, while there is currently no universally adopted definition, different authors and practitioners articulate it through different definitions. Yescombe (2002 ) states that it is a method of raising long-term debt financing for major projects through “financial engineering,” based on lending against cash flow generated by the project alone: It depends on detailed evaluation of projects construction operating and revenue risks, and their allocation between investors, lenders and other parties through contractual and other agreements.
Gatti (2007) defines it as “… the structured financing of a financial economic entity _the SPV, or special –purpose vehicle, also known as the project company- created by sponsors using equity or mezzanine debt and for which the lender considers cash flows as being the primary source of loan reimbursement…”.
Gardner and Wright (2011) define it as the raising of finance on a limited recourse basis, for the purposes of developing a large capital intensive infrastructure[footnoteRef:1] project, where the borrower is a special purpose vehicle and repayment of the financing by the borrower will be dependent on the internally generated cash flows of the project” [1: In their text, for simplicity, the authors used the term ‘infrastructure’ generically to refer to any capital intensive asset or group of assets which provide essential goods or services (e.g. utilities, petrochemicals, transportation services, housing etc) and can be contractually structured to provide internally generated cashflows.]
Though there are varied definitions a few factors resonate across the board: It is a form of secured lending characterised by intricate, but balanced, risk allocation arrangements (Fletcher and Pendleton 2014) and usually involves lenders extending credit sometimes to the tune of billions of shillings, to a project company whose core assets at the time of lending are likely to consist of little more than a collection of contracts, licences and ambitious plans.
There are no guarantees to financiers from the project company (non-recourse finance ) or very limited guarantees ( Limited-recourse finance) and the main security can include things like contracts, licences and ownership rights to natural resources as physical assets in most cases are worth much less than the loan advanced. In many cases the project company is generally a legally-independent special purpose vehicle[footnoteRef:2] set up by the project sponsor/s, who can each be a private or a government owned entity, for the sole purpose of owning, and borrowing the funds necessary for the project. [2: The investor encyclopaedia defines an SPV, Also referred to as a “bankruptcy-remote entity” as a project company whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. http://www.investopedia.com/terms/s/spv.asp ]
Getting a financier willing to advance a large sum of money to a project company or SPV on the basis that the cash flows from the project will be sufficient to offset the money loaned is key, which makes the focus on identification, analysis and mitigation of risks important for the parties involved since the benefits to the financiers are only realised should the project come to fruition. This calls for prudent risk analysis and allocation at the onset of the discussions to ensure the project is worth the investment which therefore calls for proper risk management.
RISK MANAGEMENT
Risk management is defined as the process of identification, assessment, mitigation, and allocation of risks to reduce cost of risk and improve incentives (Aydemir_2006). Risks are As alluded to by the definition of risk management above, financiers would prefer to advance loans to project companies that can mitigate against risks and ensure returns. Projects with low risks and high returns would be preferred and provide an incentive for a financier to consider financing a project. Unfortunately most projects that require a big enough investment to approach a financier for funding are high risk projects. This therefore means that measures have to be taken to mitigate against possible risks.
It is important to identify the potential sources of risk for a particular project before hand. The potential sources of risk vary from one project to another; factors that determine the project risk include nature of the project, location of the project and parties involved in the project. These can be either internal e.g. relations between the different parties in the agreement, or external e.g. government policy and natural disasters. These varied factors suggest that certain risks will affect the implementation of certain projects more adversely than others based on their impact to the project. The impact of risks to projects can lead to the project coming to a complete halt or not operating in its full capacity. The risks may also manifest themselves in the project overrunning the time frame or budget of the project and /or not generating enough cash flow (which is key for repayment of the financier’s investment).
Several steps can be taken to ensure that these potential risks are identified and analysed and that mitigation measures and contingency plans are put in place.
The first step is to ensure that a feasibility study is carried out to identify the possible risk of the project, this is fundamental to assessing the bankability of a project. The non-recourse basis of loans in project finance, as well as the limited recovery that can be expected from the liquidation of project assets, puts high premium on the reliability of the feasibility study. Moreover, unlike established business enterprises which tend to have a certain track record and a certain degree of diversification, the risks associated with a project loan tend to be highly project specific; the lender does not have the benefit of risk-spreading that comes from diversification of a business enterprise’s undertakings (Loke,1998). At this point it is key for the financier to find out whether the cash flow to be realized by the project can repay the money advanced which will determine whether financing the project is a worthwhile endeavor. However, care should be taken to ensure that the interests of all parties involved are considered. It is therefore advisable to have an independent party carry out the feasibility study to avoid bias of the findings in favor of the financier or the sponsor. At the end of the feasibility study the potential risks to the project are presented.
After the potential risks have been established all the players need to get on the table and discuss how the risk can be spread amongst them; a process that requires a lot of negotiation, objectivity and good will. Project finance packages risks associated with the project into discrete “bundles”. The segregated risks can then be parceled out to diverse willing parties. It thus allows for parties best able to control or insure against the risks to assume them – it enables efficient risk allocation.[footnoteRef:3] Splitting up the assumption of project risks in this manner has – in addition to risk spreading – the effect of reducing the associated risks. As a consequence, a project which is unacceptably risky to one party becomes feasible through first, risk spreading and second, risk reduction ( Loke 1998). Who bears what risk should be determined based on each stakeholder’s capacity to manage, control or insure against risks operationally, at the project level and financially and the agreements have to be bound by contracts. Ayedemir ( 2006) describes how costs of risk can be reduced with the following: 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, and the 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. [3: This underpins the The Abrahamson Principles formulated in the context of construction contracts: A party to a contract should bear a risk where: 1. The risk is within the party’s control 2. The party can transfer the risk (eg, by insurance), and it is most economically beneficial to deal with the risk in this fashion 3. The preponderant economic benefit of controlling the risk lies with the party in question 4. To place the risk upon the party in question is in the interests of efficiency including planning, incentive and innovation efficiency 5. If the risk eventuates, the loss falls on that party in the first instance and it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another. “No Dispute – Strategies for Improvement in the Australian Building and Construction Industry” May 1990. A Report by NPWC/NBCC Joint Working Party p 6 cited in Peter Megens, “Construction Risk and Project Finance – Risk Allocation as Viewed by Contractors and Financiers” (1997) 14 ICLR 5 at 8. ]
After the risks are identified and apportioned rightfully it is up to the different stakeholder to handle the risks that they have contractually agreed to. This is the next step in risk management, ensuring that all identified risks are mitigated against or handled appropriately should they occur. Risks fall under several categories and based on the nature of the project these may occur at different phases, at different intensities and have different impacts. Risks are vast and cannot be exhausted when the nature and all the factors affecting a project are unknown. Three risks that are likely to affect in projects include environmental, political and macroeconomic risks. Due to their different effects to the projects all can be handled differently.
Macro-economic risks (also known as financial risks) relate to external economic effects not directly related to the project (i.e., inflation, interest rates, and currency exchange rates); Yescombe (2002 )
Political risks (also known as country risks) relate to the effects of government action or political force majeure events such as war and civil disturbance (especially, but not exclusively, where the project involves cross-border financing or investment); Yescombe (2002 )
Political risk
Some of the main risks a project located in a lesseconomically developed country faces are political
risks (also known as country risks), which includes war
or civil disturbance, expropriation, exchange controls or other types of currency transfer limitations
Environmental risks Nowadays, economic grouth and the development of new technologies and products, has brought environmental risks. Environmental risks are assessed before the development of a new project aiming to determine, among others, the way it should be mitigate or manage them properly. This is called “risk management”. Hence the development of any activity or project that caused impact directly or indirectly to the environment, it is subject to analysis by financial institutions before granting a loan.
For some years, it has been identified that environmental problems or environmental impacts caused by large scale projects can be mitigated or controlled if financial institutions or investors review and assessed environmental risks from the beginning. Hence, the International Finance Corporation in 1998 adopted a Social and Environmental Policy applied since 2006 in projects in which it invests. The aim is to assess the environmental risks and thereby, avoid, as much as possible, the negative impacts to the environment or communities where the project is developed. Thus, in 2003 the Equator Principles were created by a group of international banks and the International Finance Corporation itself. These principles are the framework for financial institutions to assess and manage environmental and social risks in their project finance transactions worldwide for any economic sector, including real estate developments.
· Site acquisition and access, permits
· A government support agreement
· 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
· Force majeure risk: Likelihood of occurrence of events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc.
· Insurance for natural disasters
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
· 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
1. Conclusion.
2. References.
Presented in the alphabetical order of the surnames of the authors. For books, one should give the surname of the author, year when the work was published, title of work, town where the work was published and name of publisher.
Use American Psychological Association style or the Harvard Business School style.
Aydemir, C. (2006). Introduction to Project Finance.
Fletcher, P., & Pendleton, A. (2014). Identifying and managing project finance risks: Overview. Practical Law. Retrieved from uk.practicallaw.com/5-564-5045
Gardner, D., & Wright, J. (n.d.). Project Finance. Retrieved April 7, 2014, from https://www.hsbcnet.com/gbm/attachments/products-services/financing/project-finance.pdf
Gatti, S. (2007). Project Finance in Theory and Practice: Designing, Structuring, and Financing Private and Public Projects. Academic Press.
Loke, A. (1998). Risk Management And Credit Support In Project Finance. Singapore Journal of International and Comparative Law, 2(0219-0508), 37-75. Retrieved from http://law.nus.edu.sg/sybil/downloads/articles/SJICL-1998-1/SJICL-1998-37.pdf
Yescombe, E. (2002). Principles of project finance. Amsterdam: Academic Press.