Gerard de Valence*
10.5 Project risks and financial security
The objective of a risk analysis is to determine the relative importance of potential risks at the project’s conceptual stage through an objective comparison and ranking of identified risks. Examples of some risk issues and risk management responses are examined below. Five risk responses identified by Baker et al. (1999) are:
䊉 total avoidance of the risk
䊉 significantly reducing the risk
䊉 mitigating the impact of the risk
䊉 allocating the risk to parties best able to manage it
䊉 accepting that the risk should remain with the client. In project finance the emphasis is on risk mitigation strategies.
Financial viability is the requirement that the project generate sufficient funds to repay loans and make a profit. There are many factors that can affect viability and the IFC identifies five major risk categories in project financing:
䊉 construction completion risk
䊉 market risk
䊉 economic risk
䊉 political risk
䊉 force majeure risk – these are dislocations to business caused by events such as strikes, damaged equipment or government decisions (James, 1986, p. 1008). Table 10.2 shows these risks and the risk mitigation strategies that can be used. Set against the risks are the agreements entered into by sponsors (the funds agreement or other financial support such as subordinated loans, the construction supply and operation contracts, and so on), the project assets and cash flow.
Specific financial risks relate to foreign exchange rates and interest rates. A foreign exchange exposure exists when a project’s profits are affected by changes in exchange rates or when a company has future foreign currency obligations or receipts. Interest rate risk arises as a result of exposure to future movements in interest rates. To manage foreign exchange-rate risk, two options are annual adjustments by sovereign guarantees (e.g., a commodity price adjustment formula or tariff rate change), and a currency insurance program (Gavieta, 2001). Another option that can be used is a forward foreign exchange contract that fixes a future exchange rate (Terry et al., 2000). For interest rates, a forward rate agreement provided by a wholesale bank allows borrowers and lenders to establish a forward interest rate for the period and amount of funding and limit risk resulting from changes in the rate of interest (Terry et al., 2000).
Escrow accounts are often used in project finance. These are established to receive project revenues and are managed by the creditors or their agent, subject to a distribution agreement that covers what payments are to be made from the account and their priority. These accounts can be onshore or offshore and can be used for both local and foreign currency. In a similar way an agreement on the assignment of receivables will specify the ranking of payments to be made from project cash flows. Both of these are important if the project does not meet the project’s anticipated level of output or revenue.
Table 10.2 Lender’s approach to managing major project risks (Ahmed and Xinghai, 1999)
Risk to lender Risk mitigation arrangement
Completion risk
Delays Turnkey contract; construction/equipment supply contracts. Specify performance obligations with penalty clauses. Project agreement to oversee construction on behalf of lenders and minority investors.
Cost overruns Include contingency and escalation amounts in original cost estimates. Sponsor support until physical and financial completion (project funds agreement). Site availability Land use agreement.
Project performance
Sponsor commitment Strong, experienced sponsors with significant equity; share retention agreement to tie sponsors to the project.
Technology assurance Prefer tried and tested technologies; new technologies can be used, provided the obligation to repay debt is supported by a guarantee of technological
performance from the participant that owns or licenses the technology. Equipment performance Performance bond/guarantee from equipment suppliers. Operation agreement
linking performance to compensation. Maintenance agreement.
Input activity Supply contracts specifying quantity, quality, and pricing. Match term of supply contract to term of offtake commitment.
Management and labour performance
Experienced management team. Performance incentives and penalties. Training provided by equipment suppliers and technical advisers.
Market risk
Demand potential Undertake independent market assessment. Offtake contract specifying minimum quantities and prices (take or pay arrangements). Conservative financing structure. Support low-cost producers.
Payment risk Sell output where possible to creditworthy buyers. If buyers not creditworthy, consider credit enhancements such as (1) government guarantees of contractual performance (if buyer is state-owned); (2) direct assignment of part of the buyer’s revenue stream; (3) escrow account covering several months’ debt service.
Economic risk
Funds availability Limit share of short-time financing to project; long-term finance to match project term; stand-by facility.
Interest rates Fixed-rate financing, interest rate swaps.
Exchange rates Match currency of project loans to project revenue, swaps and guarantees. Inflation Long-term supply contracts for energy and other important inputs; output prices
indexed to local inflation.
Force majeure Insurance policies and force majeure provisions.
Overall risk support
Debt service coverage Analysis based on pessimistic assumptions to set up-front debt/equity (D/E) ratio. Financial support until D/E ratio is reduced to safe level. Escrow accounts with debt service reserve.
Security Mortgage and negative pledge on project assets. Assignment of concession agreement and other relevant agreements. Share pledge. Disbursement conditions and loan covenants.
There are five principal methods used by lenders to manage financial security (Ahmed and Xinghai, 1999):
䊉 securing project assets – this involves a mortgage on the assets, where the realizable value of the assets exceeds the loan value. However, not all countries allow foreign investors to hold mortgages over domestic assets
䊉 a weak mortgage – used in countries that prevent lenders creating adequate mortgages; e.g., Indonesia, where land cannot be mortgaged to foreigners, or countries like China and Thailand, where mortgage law is untried or still being developed. In some cases there are restrictions on project security, e.g., in Sri Lanka recourse is only available to secured fixed assets
䊉 assignment of project receivables – determines how revenues are used for project agreements (such as concessions, supply and management agreements) and damages
䊉 an escrow account – project cash flow is collected, and spent as agreed
䊉 using the equity base held by the major investor to secure project loans through a pledge of shares. If a sponsor is a supplier of materials or services they can defer payments when necessary. On high-risk projects loans can be secured by insurance contracts and/or government guarantees.