Martin Preston, Gulf Construction - Financial risk part of every project
20 September 2010
This article first appeared in Gulf Construction
In any project finance transaction, be it a public-private partnership (PPP), an independent (water and) power project (I(W)PP) or a process plant, there are a number of key risks that will need to be addressed in order for the project to be bankable.
These, then, are the key issues that the lenders will look at in determining the viability of a project. They can be categorised as: completion risk, input supply risk, commercial risk, financial risk, force majeure risk, and political risk.
The construction phase is when the project is most at risk. Funds are being advanced to the project company to make payments under the construction contract prior to the project generating any revenue. Completion may be delayed, delaying the receipt of revenue to meet debt service and/or the project may not fully meet the completion requirements.
This risk can be mitigated by having in place a robust construction contract that entitles the project company to receive liquidated damages for delay and, on power and process plants, liquidated damages for performance shortfalls if the project meets the minimum, but not the guaranteed, performance standards. The effectiveness of these remedies will depend on the creditworthiness of the contractor and/or the contractual arrangements in place to ensure that these funds are available to the project regardless of the contractor’s ability to pay them itself.
Such mechanisms usually include payment by reference to the achievement of milestones and a requirement that milestones must be satisfied in chronological order, so that payment is not made to the contractor until the work that relates to that payment has been completed. To ensure that the project company does not put itself in a position where it is seeking to recover liquidated damages from sums already paid to an insolvent contractor, this mechanism can be allied to a right to set-off liquidated damages and other sums owing from the contractor from amounts that would otherwise be due to the contractor.
Other security for the performance of the contractor’s obligations is usually provided by way of retention (or a retention bond), which is typically 10 per cent of each payment due to the contractor and is retained to cover the cost of any defects until the end of the defects liability period, a performance bond of 10 to 20 per cent of the contract price and, if applicable, a parent company guarantee. If the lenders are not satisfied that these protections are adequate (if, for example, unproven technology is being used), they may additionally require a completion guarantee from the project sponsors.
Input supply risk applies to projects dependent on receiving fuel or feedstock from third parties, so this is an issue for IPPs/IWPPs and process plants, but not usually an issue with PPP projects.
An IPP/IWPP, for example, will require fuel in order to generate electricity (and, if applicable, produce desalinated water). If fuel is not available, the plant will not be able to operate and no revenue will be generated. Contractually, this risk can be mitigated by the feedstock or fuel supply agreement containing robust provisions, which deal with the obligation to supply and the remedies available if supply is not made in accordance with the agreement. Whether this risk can be mitigated in full will depend on the identity and bargaining power of the counterparty providing the feedstock or fuel.
Further contractual mitigation may be possible by ensuring that the feedstock or fuel supply agreement is back to back with the offtake agreement – which phrase, for the purposes of this article, includes power (and water) purchase agreements (P(W)PA) – so that the project company is not penalised for a failure to supply as a result of fuel or feedstock not being available. However, although this will (if accepted by the offtaker) mean that the project company is not liable for a failure to supply in these circumstances, it will not replace the revenue lost as a result of fuel or feedstock not being available.
Other measures that may be available to the project company to mitigate this risk include insurance (depending on the reason for the unavailability), stockpiling and storage of feedstock (if possible) or looking to any alternative sources of supply.
On most of the regional power projects, the project company has been paid a capacity charge on an availability basis so that its fixed costs (including debt service) are met irrespective of whether or not the plant is despatched. Similarly, the Mafraq-Ghweifat Road PPP project is to be let on an availability basis, such that the project company’s payments will depend on the road being available and the project company will not be required to take a risk on the volume of traffic using the road.
Where payments to the project company are not based on availability but on demand for the services required or the product produced, such as a toll road or a process plant selling to the market, the lenders will need to satisfy themselves that the project is commercially viable over the term of the debt (termed here as commercial risk).
A key issue here will be exclusivity. If a project company is to construct a toll road and repay its debt through the tolls received, it will want to ensure that no competing infrastructure will be constructed that will reduce demand for the toll road.
In satisfying themselves at the outset that the project is feasible, the lenders will rely on traffic projections if the project is taking the demand risk in relation to a road. They will want to ensure that any assumptions remain unaffected by the actions of the government – or that suitable compensation is paid if competing infrastructure is constructed.
With a process plant, the project company’s protection with regard to exclusivity will typically be with the feedstock supplier and/or the licensor of the process technology. Conversely, a merchant power plant – which is one that does not have a long-term power purchase agreement (PPA) but which sells into a wholesale power market at the prevailing market rate – is fully exposed to commercial risk but the project may be able to mitigate this by putting in place a contract for differences.
Financial risk is the risk where increases in interest rates, and/or currency fluctuations may adversely impact the economics of the project. It is possible that this may be addressed in the concession agreement or offtake agreement on an availability payment-based model and this may offer the grantor or offtaker the best value for money method of addressing this risk. However, it is more usual for such risks to be addressed by financial instruments such as swaps or hedging.
Force majeure risk encompasses both natural and political force majeure. Natural force majeure events are generally insurable events and, to the extent that a force majeure event can be covered by insurance, this is usually how such risks are addressed. Insurance would usually cover not only damage to the project – through contractor’s all risk (CAR) insurance during the construction phase and material damage insurance during the operation phase – but also loss of revenue if this loss results from the damage covered by the CAR or material damage policy under the delay in start-up and business interruption policies in the construction and operation phases, respectively.
A number of issues arise in relation to insurance, which are outside the scope of this article but, broadly, they are: who is responsible for paying any deductibles; who is entitled to the insurance proceeds, and at what stage can the lenders apply the insurance proceeds towards repayment of the debt (the so-called “head for the hills” provision); who bears the risk if insurance ceases to be available; and are suitable non-vitiation and waiver of subrogation provisions in place?
Political risk covers not only political force majeure (acts of war, civil commotion, etc) but also change of law and nationalisation or expropriation of the project. Political force majeure and change of law would usually entitle the project company to relief under a concession agreement or offtake agreement, although the treatment of changes of law may depend on whether the change in law is categorised as general, specific or discriminatory.
Expropriation or nationalisation will typically be an event of default, entitling the project company to terminate the concession agreement or offtake agreement. Compensation from the host government following expropriation or nationalisation may not be sufficient to repay the debt, or may be paid late or in instalments or not at all. If the lenders are concerned about political risk, political risk insurance may be available from export credit agencies or multilateral entities such as the Multilateral Investment Guarantee Agency, an affiliate of the World Bank.