1 Risk Management in Context of Project Financing of Infrastructure Project Prof. GLENN P. JENKINS DEPARTMENT OF ECONOMICS EASTERN MEDITERRANEAN UNIVERSITY NORTH CYPRUS

2 What is Project Finance? No universally accepted definition of the term “Project Financing” -- different people use it in different senses. Project financing refers to a financing in which lenders to a project look primarily to the cash flow and assets of that project as the source of payment of their loans. PROJECT FINANCE

3 Origins and Development of Project Finance Project financing had its origins in the energy industry in industrialized countries (oil & gas production loans). Later extended to infrastructure, transportation, mining, utilities and large industrial projects. Scope further expanded to include all kinds of infrastructure projects. Today even medium-scale projects (US $5 million) can use project finance

4 Development of Project Finance Number of Project Finance Transactions in emerging markets 41% of emerging markets project finance flows between 1994 and 1998 went to Asia. About 75% of project finance flows worldwide went to infrastructure and energy in Source (IFC 1999), Capital Data Project Finance Ware (2000)

5 Why Project Financing? Project Owners’ Perspective –Size and cost of projects –Risk minimization –Preservation of borrowing capacity and credit rating –May be only way that enough funds can be raised

6 Private Public Partnerships in Infrastructure A major new user of project financing techniques Infrastructure traditionally financed and managed by governments Demand for infrastructure has been growing faster than available government funding particularly in emerging economies. Recent trend has been to involve the private sector in the supply and provision of these services There has to be a clear benefit for both the public and the private partners

7 Main Characteristics of Suitable Investments for Projects Financing  The ideal candidates for project financing are capital investment projects that  are capable of functioning as independent economic units,  can be completed without undue uncertainty, and  When completed, will be worth demonstrably more than they cost to complete.

8 Main Characteristics of Project Finance (Summary) –Project is a distinct legal entity. –Project assets, project-related contracts, and project cash flows are separated to a large degree from the sponsors. –Sponsors provide limited or no recourse to cash flow from other assets. –Lenders may have recourse to their funds through other stakeholders through various types of security arrangements. –Two-phase financing is common.

9 The Basic Elements of a Project Financing Loan funds Debt repayment Equity funds Returns to investors Cash deficiency agreement and other forms of credit support Equity investors Lenders SuppliersPurchasers Raw materials Supply contract(s) Purchase contract(s) Output Assets comprising the project

10 Prerequisites for Project Financing Financial Analysis Economic Analysis Risk Analysis

11 It’s All About Risk! The key to project financing is the reallocation of any risk away from the lenders to the project.

12 Definition of Project Completion Principle Categories of Risk: Pre-Completion and Post- Completion Physical Completion –Project is physically complete according to technical design criteria. Mechanical Completion –Project can sustain production at a specified capacity for a certain period of time. Financial Completion (financial sustainability) –Project can produce under a certain unit cost for a certain period of time & meets certain financial ratios (current ratio, Debt/Equity, Debt Service Capacity ratios)

13 Management and Alleviation of Risks Principle Categories of Risk: Pre-Completion and Post-Completion A:Pre-Completion Risks: Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution Participant Risks -Sponsor commitment to project - Reduce Magnitude of investment? -Require Lower Debt/Equity ratio -Finance investment through equity then by debt –Financially weak sponsor- Attain Third party credit support for weak sponsor (e.g.,Letter of Credit) - Cross default to other sponsors Construction/Design defects - Experienced Contractor - Turn key construction contract

14 Management and Alleviation of Risks A:Pre-Completion Risks (cont’d): Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution Process failure - Process / Equipment warranties Completion Risks –Cost overruns - Pre-Agreed overrun funding - Fixed (real) Price Contract –Project not completed- Completion Guarantee - Tests: Mechanical/Financial for completion –Project does not attain - Assumption of Debt by Sponsors if mechanical efficiency not completed satisfactorily

15 B. Post-Completion Risks Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution Natural Resource/Raw Material –Availability of raw materials- Independent reserve certification - Example: Mining Projects: reserves twice planned mining volume - Firm supply contracts - Ready spot market Production/Operating Risks –Operating difficulty leads to - Proven technology insufficient cash flow - Experienced Operator/ Management Team - Performance warranties on equipments - Insurance to guarantee minimum cash

16 Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution Market Risk –Volume -cannot sell entire output - Long term contract with creditworthy buyers :take-or-pay; take-if-delivered; take-and-pay –Price - cannot sell output at profit - Minimum volume/floor price provisions - Price escalation provisions Force Majeure Risks –Strikes, floods, earthquakes, etc.- Insurance - Debt service reserve fund B. Post-Completion Risks

17 Some Examples of Ways to Reduce or Shift Risk Types of Risks Away from Financial Institution Political Risk –Covers range of issues from- Host govt. political risk assurances nationalization/expropriation, - Assumption of debt changes in tax and other laws,- Official insurance: OPIC, COFACE, EXIM currency inconvertibility, etc. - Private insurance: AIG, LLOYDS - Offshore Escrow Accounts - Multilateral or Bilateral involvement Abandonment Risk –Sponsors walk away from project - Abandonment test in agreement for banks to run project closure based on historical and projected costs and revenues Other Risks: Not really project risks but may include: –Syndication risk- Secure strong lead financial institution –Currency risk - Currency swaps / hedges –Interest rate exposure - Interest rate swaps –Rigid debt service- Built-in flexibility in debt service obligations –Hair trigger defaults

18 The Need for Contracts  Project financing arrangements invariably involve strong contractual relationships among multiple parties.  Project financing can only work for those projects that can establish such relationships and maintain them at an acceptable cost.  To arrange a project financing, there must be a genuine “community of interest” among the parties involved in the project.  In must be in each party’s best interest for the project financing to succeed.  Only then will all parties do everything they can to make sure that it does succeed.