Risk is a crucial factor in project finance since it is responsible

for unexpected changes in the ability of the project to repay

costs, debt service, and dividends to shareholders.

Most of the time allocated to designing the deal before it is financed is, in fact, dedicated to analyzing (or mapping) all

the possible risks the project could suffer during its life.

There are three basic strategies the SPV can put in place to

mitigate the impact of a risk:

› 1. Retain the risk.

› 2. Transfer the risk by allocating it to one of the key

counterparties.

› 3. Transfer the risk to professional agents whose core

business is risk management (insurers).

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The phase leading up to the start of operations involves

building the project facilities.

This stage is characterized by a concentration of industrial risks, for the most part.

These risks should be very carefully assessed because they

emerge at the outset of the project, before the initiative actually begins to generate positive cash flows.

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Delays in completing one activity can have major

repercussions on subsequent activities.

The risk is, in fact, that the structure on which the SPV depends to generate cash flows during the operations phase

may not be available. This is known as planning risk.

Additional effects of bad planning are possible repercussions on the SPV’s other key contracts.› Penalties paid to product purchaser

› Cancellation of contracts

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In some sectors where project finance is applied, construction works can require the use of technologies that are innovative or not fully understood.

In many cases, contractor opts the technology which is made upstream by other sponsors.

Technological risk arise in projects involving innovative technologies that have not been adequately consolidated in the past.

It is very hard to imagine that a project finance venture would be structured on the basis of completely unknown, untested technology.

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This risk arises when the project is not completed or delay in

construction.

Forms of construction risk that may happen:

› Non completion or delayed completion due to force majeure

› Completion with cost overruns

› Delayed completion

› Completion with performance deficiency

In a project finance transaction, construction risk is rarely

allotted to the SPV or its lenders.

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The major risks in the post completion phase involve:› Supply Risk

› Operational Risk or Performance Risk

› Market Risk

These risks are as important as those faced by the project

during its pre completion phase since their occurrence can

cause a reduction of cash flows generated by the project

during its economic life.

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Supply risk arises when the SPV is not able to obtain the

needed production input for operations or when input is

supplied in suboptimal quantity or quality as that needed for

the efficient utilization of the structure.

It also arises when SPV finds input but at a higher price than

expected.

The effects of supply risk are that the plant functions below

capacity, margins shrink and supplemental costs accrue due

to the need to tap additional sources for input.

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The operating risk (or performance risk) arises when the plant

functions but technically underperforms in post completion

testing.

The effect of performance risk is lower efficiency and, in the

end, unwelcome cost overruns.

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Demand risk (or market risk) is the risk that revenue generated

by the SPV is less than anticipated.

This difference can be due to unanticipated strategies put in place by competitors, particularly if the product can be

easily substituted.

The case of the strong competition following the construction of the Eurotunnel by air carriers and ferry operators is a good

example of market risk due to cross elasticity between

alternative sources of the same transportation service.

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Risks found in both the construction and operational phases

are those that might systematically arise during the life of the

project.

Risks found in both the phases include:› Interest rate risk

› Exchange rate risk

› Inflation risk

› Environmental risk

› Regulatory risk

› Political risk

› Legal risk

› Credit risk

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In project finance ventures, there is always the risk of

fluctuations in interest rates. Sponsors and their advisors have to decide whether or not to

cover against this risk, a decision that is not exactly identical throughout the life of the project.

During the construction phase, the project does not generate revenues. However, draw downs begin to produce interest payable, the amount of which depends on the level of interest rates during the years in which the project is under construction.

The risk the SPV runs is that unexpected peaks in the benchmark rate to which the cost of financing is indexed can cause an increase in the value of the investments such as to drain project funds entirely.

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The most difficult problem for the SPV’s sponsors is to select

the best strategy for covering floating-interest-rate loans

during the post completion phase of the venture.

The key concept advisors focus on is self-protection of cash

flows, i.e., valuing whether cash flows from operations are

sustainable in the face of negative variations in the value of the debt service.

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This risk emerges when some financial flows from the project

are stated in a different currency than that of the SPV.

This often occurs in international projects where costs and

revenues are computed in different currencies.

The best risk coverage strategy is currency matching.

Advisors of an SPV try to state as many flows as possible in the

home currency, avoiding any use of foreign currency.

If this is not possible (usually because counterparties have strong bargaining power), the following coverage instruments

provided by financial intermediaries must be used:› Forward agreements for buying or selling

› Futures on exchange rates

› Options on exchange rates

› Currency swaps

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Inflation risk arises when the cost dynamic is subject to a sudden acceleration that cannot be transferred to a corresponding increase in revenues.

Both industrial and financial costs and revenues are impacted by inflation risk.

Inflation risk is even more difficult to deal with in the framework of ventures in which the buyer is a public entity or a service is offered for public use, such as with public transportation.

Fee readjustments that take the inflation dynamic into account must be approved by means of administrative measures.

Delays in this process can create the conditions for diseconomies in operations for periods of time that are not always predictable.

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To cover against this risk, a swap contract is drawn up

between a hedging bank and the SPV. This Consumer Price

Index swap (CPI swap) serves to mitigate the effect that a

drop in inflation would have on the capacity of nominal cash flows to service the debt, in any given period.

When a hedging contract is signed, the benchmark inflation

rate is quoted by the hedging bank for the entire tenor of the

loan (henceforth Fixed Swapped Index, or FSI).

At every loan repayment date, the SPV can face three alternative scenarios:› CPIt < FSI: When this occurs, the inflation rate at t is less than the rate fixed when the

hedging contract was signed. The drop in the nominal value of cash flows and the resulting emergence of inflation risk is counterbalanced by a corresponding amount paid by the hedging bank to the SPV.

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CPIt > FSI: Here the inflation rate at t is higher than the rate

fixed when the hedging contract was signed. The increase in

the nominal value of cash flows is counterbalanced by a

corresponding amount paid by the SPV to the hedging bank.

CPIt = FSI: In this circumstance, the real and fixed rates of

inflation are exactly the same.

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This risk has to do with any potential negative impact the

building project could have on the surrounding environment.

Some of the factors which causes this risk are:

› Building or operating the plant can damage the surrounding

environment.

› Change in law can result in building variants and an increase in

investment costs.

› Public opposition to projects with major environmental impact

could lead the host government to reconsider government

support agreements with the SPV and may create difficult

operating conditions for the project.

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There are various facets to regulatory risk; the most common

are the following.

› The permits needed to start the project are delayed or

cancelled.

› The basic concessions for the project are unexpectedly

renegotiated.

› The core concession for the project is revoked.

Delays are usually caused by inefficiency in the public

administration or the complexity of bureaucratic procedures.

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Political risk takes various forms, for instance, a lack of

government stability, which for some projects may be critical.

Classification of Political risk:› Investment risk

› Change-in- law risk

› Quasi – Political risk

Investment risks relate to limitations on the convertibility or

transfer of currency abroad.

Change – in –law risks include any modification in legislation that can hinder project operations.

Quasi – political risks includes all disputes and interpretations

regarding contracts already in place (breach of contracts)

that emerge from a political, regulatory, or commercial background.

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Political risks are especially important for lenders in project finance ventures located in developing countries.

These nations, in fact, have legal structures that are not well defined, most have politically unstable governments, and there is little experience of private capital investments in strategic sectors.

There are two ways to cover against these risks. The first is to draw up an agreement with the government of the host country stating that the government will create a favourable (or at least non discriminatory) environment for the sponsors and the SPV, which is called Government support agreement.

The second way to cover against political risks is through the insurance market. Insurance policies are available offering total or partial coverage against political risks.

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Legal risk centers primarily on the project’s lenders, whose lawyers analyze and manage this risk.

Their job is to ascertain whether the commercial law of the host country offers contract enforceability.

Contract enforceability depends on:› Degree of economic development of a country

› Country’s judicial tradition

› Institutional conditions

In countries where the rule of law is grounded in civil law, lenders find less protection than in nations where common law is in force.

Institutional conditions complicate matters, because they are linked to factors such as corruption and the tendency toward illicit behaviour, which can often turn a decision against lenders.

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This risk relates to the parties who enter into contracts with the

SPV for various intents and purposes.

The creditworthiness of the contractor, the product buyer, the input supplier, and the plant operator is carefully assessed by

lenders through an exhaustive due diligence process.

The financial soundness of the counterparties (or respective guarantors if the counterparties are actually SPVs) is essential

for financers.

The significance of credit risk in project finance deals lies in

the nature of the venture itself: off-balance-sheet financing with limited recourse to shareholders/sponsors and a very

high level of financial leverage. 24

All risks are appropriately allocated to various players, lenders take

a comprehensive look at the network of contracts with the SPV.

Complex situation arises when the project analyses run by the

banks reveal risks that were not initially addressed in the contracts.

1. Closing on the financing is postponed until the problems

in question are solved.

2. Problem solving is postponed until financial closing, as long as the credit

agreement includes provisions that oblige the parties to implement an

acceptable solution by a specified date.

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The contractor guarantees the SPV the following:

1. The completion date

2. The cost of the works

3. Plant performance

In addition to these guarantees, there may be coverage against

technological risk.

1. To ask independent technical advisors their opinion on the effectiveness of

the technology

2. To oblige the technology supplier to pay penalties either in one lump sum

or proportional to the patent value of the technology

3. To oblige the contractor to provide performance guarantees on the

technology that are incorporated in the construction contract (wrapping

or wraparound responsibility).

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As far as guarantees on completion dates, when the pre-established

construction time is up, one of two possible situations can occur:

1. The plant meets minimum performance standards.

2. The plant does not meet minimum performance standards.

If the plant meets the MPS but does not function at a 100%

performance level as defined in the contract, the contractor is

usually given two options:

1. To liquidate( Buydown Damage -difference in actual revenue as compared

to 100% yield).

2. To make good

The contractor is not in breach of contract if plant completion is

delayed due to force majeure events.

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Contractor Guarantees on Project Completion Date and

Performance: How They Work

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In addition, contractors always attempt to negotiate the following in

the construction contract:

1. Bonuses in their favor if the plant is completed ahead of schedule or if it

functions more efficiently than specified in the contract (for example, with

a lower level of input consumption)

2. Clauses that limit their responsibility for paying damages, up to a

maximum percentage of the turnkey price (guaranteed by a performance

bond that contractors post in deposit until construction is complete)

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In these accords, the supplier sells the SPV preset volumes of input

at preagreed prices (again, adjusted according to predicted trends of

a given price index).

If supply is lacking, normally the supplier is required to

compensate for the higher cost incurred by finding another source

of input.

In this way, sales revenues and supply costs are synchronized.

In cases where the input is not physically near the plant or the

structure in question, the sponsors also negotiate contracts for

transporting input from its production site to where it will actually

be utilized.

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How a Put-or-Pay Contract Works

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Operating risk can be mitigated by the experience and the

reputation of the project operator. As far as O&M contracts are

concerned, two solutions are possible:

1. Fixed-price contract

2. Pass-through contract

Lenders also request a step-in right, which is the option to remove

the original operator and substitute that company with another of

the lender’s choosing. This is one of the many direct agreements

made between banks and the different counterparties of the SPV

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