Project Finance has become an increasingly attractive technique for financing infrastructure projects in developing countries over the last twenty years. Furthermore, the use of project financing raises difficult legal issues with respect to the ability of developing countries’ governments to control the provision of public sets that are intimately connected to these infrastructure projects. Project finance has several advantages, such as the opportunity for investors to participate directly in an otherwise far away and lucrative-albeit risky-market and the ability to participate in high-risk investments without diminishing creditworthiness. Lenders for projects are chiefly large international commercial edges, such as ABN Amro and Citibank, or multilateral lending agencies, such as the International Finance Corporation (IFC) and the European Bank for Reconstruction and Development (EBRD). They will in no doubt, consequently, seek to put in some issues in a term sheet.
The first step in setting up a project financing usually involves the sponsors or developers forming a project company known as a special purpose means or entity, which is designed to construct, own, and function the project facility. consequently project finance benefits sectors or industries in which projects can chiefly be structured as a separate entity from their sponsors or developers.
consequently it is the project company, which is the entity that is borrowing funds for the project. The lenders loan money to the project company with the assets and cash flow of the project acting as the security interest for the project loans.
Definitions and Meanings
European Investment Bank defines project finance as “a loan made chiefly against cash flows generated by the project, instead of relying on a corporate balance sheet, the security value of the physical assets or other forms of security”.
A project developer is the sponsor or the borrower for the project.
A strength buy agreement (PPA) is an agreement which serves as one of the pre-requisites for the lender to borrow funds for a project. It is a contract that “there will be ready market for the project on completion”.
A term sheet is an outline of the principal terms and conditions hypothesizedv for the project and investment. It is not in itself a legal document but a sort of draft proposals subject for approval by all parties involved.
Types of Risks
In project transactions, there are typically numerous parties from different jurisdictions involved, and consequently, the laws of many different jurisdictions are potentially applicable to any given transaction. consequently the uncertainties or fears expressed by each party translate to a risk of a sort. It becomes important that the terms sheet or the PPA or the PSA be analysed consequently and where necessary, find the appropriate legal regulations or instruments to mitigate any risks.
Risks are different for each project – they are often country-specific, and differ depending on the kind of project one wishes to attempt.
There are, generally different kinds of risks with the extent being different from one project to another project. Some of the permissible forms of risks that should be considered at all costs are as follows:
– Sponsor risks
– Pre-completion risks
– Inflation and foreign exchange risk
– Operating risks
– Technological risks
– Completion risk
– Input risk
– Approvals, regulatory and environmental risk
– Offtake and sales risk
– Political risks
Believe it or not, when all the risks-financial, construction & completion risks, technology & performance risks, foreign exchange & availability risks- are critically analysed, it could be deduced that they are to a greater extent connected to government’s policies; in other words, political activities or ideologies. Linking political risk to regulatory risk in most of his study, Louis T. Wells, Jr described Political and regulatory risks as a meaningful impediment to private investment in the infrastructure sectors of developing and change economies; and are defined as” threats to the profitability of a project that origin from some sort of governmental action or inaction instead of from changes in economic conditions in the marketplace: in each case, action or inaction by political authorities or their agents, instead of changes in supply and need of goods and sets, must be the proximate cause of the change in profitability”(Moran H Theodore ,1999). Planning and political risk occurs due to the long gestation periods of infrastructure projects. During these long periods, projects are unprotected to changes in policy (Vickerman, 2002).
Despite the popularity of project finance, the extensive amount of political risk associated with it is very high. For this report, political risk is going to be mentioned and analysed most as the main risk to the project developer.
Generally, the main known political risks are the following:
The act of taking something from its owner for public use. There are many instances in the former eastern Europe and especially in Africa, where governments decide at the break of the day to take something from a private individual for the use and assistance of the public in the name of what they term as “people’s strength” ,” dramatical change” and so on. This is very upsetting and makes project development a high risk to a project developer.
move of business from private to state ownership. This is not usually experienced in the west as in South America and Africa. Political ideologies in most part of these continents are influenced by one-party state cronies who believe in nationalism than in capitalism. There is the saying that “once bitten, twice shy”; most of these governments are in the developing countries and have the fear that as the west colonised them in the past it could happen again.
-Change of law:
The great number government can change the laws overnight and this can affect a project. Sometimes for economic and political reasons, tax laws are enacted which might not be to the advantage of the project developer in terms of the cost increase to certain elements which could increase the buy price of the product on completion and can jeopardise the PPA.For example an increase in the fuel tax can affect the supply of fuel to the project. Environmental-related issues are also to be blamed for reasons in change of law to please environmentalist pressure group and sometimes for political reasons. Any or all of these could one way or the other affect the project developer in an on-going project or hypothesizedv project.
Furthermore, there could be a breach of contract for political reasons.
consequently consequently, Theodore, (1999) divided the political and regulatory risks that private infrastructure investments and for that matter the project developer are exposed to, into three sharing characteristics categories:
a) Parastatal performance risks: risks of non-compliance with supplier agreements or buy agreements by the government or government entities leading to political risk. This is to say that government agents or authorities will fail to honour their part of the obligation thereby politicizing the issue.
b) Traditional political risks: risks relating to political uncertainty, without of Government sustain, delay in clearances (which chiefly have to be taken from government authorities), money convertibility and transferability, expropriation and breach of investment agreement. This could take any form from delaying permits to failing to sign licenses on time because someone is not happy because no gifts might have “passed under the bridge”. There is consequently, the inclination that the project developer will confront this exposure, which lenders would not be happy with.
c) Regulatory risks: risks arising from the application and enforcement of regulatory rules, both at the economy-wide and the industry- or project-specific level. They overlap because they affect one or the other politically. Within emerging economies and under developing countries, regulatory bodies are being set up as independent bodies to minimise the political risk faced by the investors. However, in many instances, these so called independent bodies may come under tremendous pressures from their governments and tend to get influenced. for example, a regulator, for political reasons, may make decisions relating to tariffs that render a project unattractive to investors, sometimes with the view to move the deal to a family friend or a political crony. This is a very shared practice in Ghana.
Furthermore, infrastructure projects are unprotected to continuous interface with various other regulatory authorities that expose them to possible regulatory actions consequently affecting their profitability. It is conceivable that explicit tariff formulae ensuring remunerative pricing at the start of the project can be negated afterward by regulatory authorities on the grounds that tariff was too high. This issue is also very shared in Ghana where the term “big elephant” has become synonymous with projects that have been abandoned over the years due to the above political reasons.
Nonetheless, the following risks can be argued to have their roots in one political activity or the other.
Following change of law in political risk discussed above, possible legal risks to a project developer include inadequate legal, legislative, and regulatory framework on sales tax, export & import restrictions, pensions, health and safety rules and penalties for non-compliance. Sometimes the case and administrative laws in the country concerned are not developed. These issues are of great concern to lenders and for that matter the project developer will have to deal with this risk.
Construction & completion risk
Another meaningful risk is construction and completion risk. In the event when construction of the project is delayed for any reason whatsoever, the completion date might be affected.Levnders, consequently, focus upon cost & schedule overruns and time-delay risks of the project in great detail.
This risk deals with n two meaningful issues which edges are so much concern with. They are equity commitment and corporate substance (i.e. corporate strengths and experience).On corporate substance; edges consider that sponsor risk has something to do with completion date and for that matter completion risk. For this reason, whether or not the sponsor or project developer has sought pre-completion guarantees, the edges looks further by working with corporate sponsors with substantial technical skill and financial thoroughness. because of the belief that “one puts his money where his heart belongs”, regarding equity, lenders will typically require a contribution between 15% to 50% of the project cost to ensure the sponsor is committed to complete the project on schedule.
Financial risks usually cover interest rates, foreign exchange rate & availability risk, money and inflation. Inflation really affects the project developer in a PPA for reasons like raising the cost of the project which can delay its completion due to without of funds. Some governments are also skeptical about foreign investment in their country and sometimes prevent the repatriation of funds by foreigners outside. Devaluation and interest rate just like inflation can also affect the projects negatively especially when provision has not been made in the PPA for that. International funds are often cheaper than local ones, but given the fact that the energy generated is sold locally, and paid in local money, using foreign loans creates exposure to the risk of money depreciation.
Global warming is becoming ‘national information’ if not a household information. consequently environmental risk is of great concern to both the government and a project developer because of the aftermath of certain projects like land degradation, pollution of rivers, and air. Lenders are concerned about their liability to meet great claims arising out of pollution caused by borrowers and so need high in a PPA.In a PPA, for example, the sponsor or the project developer is responsible to provide “reasonable and customary measures within its control required to ensure the protection and security of the site”. This goes to say that the project developer is responsible to obtain regulatory and other approvals like licences and other local permits needed for the project. The significance of this is that until recently, project developers leave land unattended after exploratory activities and corporate social responsibility was not known to corporate bodies but now it is gaining roots. To please the locals, corporate bodies have to take additional responsibilities because of the aftermath of certain projects. This could already serve as guarantee for borrowers.
Offtake and sales risk
The uncertainty that the project will fail to take off and bring in adequate income to offset the cost of the project is known as Offtake and sales risk. When a project fails to generate the required income, lenders cannot be repaid. Sometimes the selling of the output to the market is also uncertain. edges in effect have high interest in anything that might affect this risk and so will look for assurances in the business plan of the project developer. The onus of this risk is that the project developer had to make extensive market examination to get to know the market need for the product or output. It could be energy alright but if the macroeconomic situation of the country concerned is not sound, the income generated could not meet the investment. Ghana had a similar experience in the late 90s when the government in strength decided to extend electricity grid to the rural areas where .It became a big issue as the villagers could not provide the payment of the tariff , the government could not pay either and the electricity corporation had to run a huge debt.
Technology & operation risk:
Technology risk is usually when the technology being applied or hypothesizedv for the project is “very new” and not really known by the lenders. Lenders are particularly concerned about such projects and will do anything to minimise such risk. Operation risk deals with the aftermath of the project and it running.i.e the risk that forecasted cash flows arising from the failure of operations of the project. edges are not only concerned with the competency and financial capability of the contractor but also those who are going to run the project must apply the applicable technology for its day to day activities in order to generate the required cashflow.
– Others like local knowledge, customs of the local people, for example if it has to deal with hydro-related project, some river deities have to be pacified and the project could be delayed for the insignificant reason that some chiefs or local leaders might politicised the whole customary rites to the extent that the project cost might expand or already be called off.
already though we are not analysing the responsibilities of the seller and buyer in a PPA, suffice it to say that both parties’ responsibilities are considered vital hence the need to have proper enabling ecosystem especially politically in order to execute the project successfully. This will have to come about with the help of the Government in strength.
truly, developers have built up experience in negotiating PPAs and factor in time for negotiations which are necessary to get a satisfactory deal. Wind energy schemes are generally seen as a low risk technology, compared to other replaceable energy technologies.
Nevertheless some developers have noted that PPAs are generally not long enough and that it takes time to find a appropriate solution which can rule to delays. Most comments in relation to PPAs focused on the need to continue certainty in the replaceable Obligation in order to avoid destabilising the market. One smaller developer noted that ‘political change is a big worry…we wouldn’t be able to finance projects if the RO changed’.
The minimum investment criteria for replaceable energy projects varied from respondent to respondent, but typically investors do not want to commit to projects until financial close or beyond, when all project risks have been satisfactorily mitigated in terms of planning, technology, performance and long-term revenue security (PPA). Some investors will look for a minimum project size, in terms of installed capacity or output per annum, whilst others will look for a minimum amount of debt to be provided at an internally permissible rate of return.
Mitigating the Risks
In the World Report 2006 by UNCTAD,some meaningful causes of delay were discussed.
Although of the perceived risks, no single component was unanimously highlighted from the responses as the most meaningful cause for delay. It was reported that, beyond planning approval, mitigating risks to permit finance and insurance to be secured is the next most meaningful obstacle highlighted by all of the developers. The ability for a developer to raise finance is greatly affected by the perceived risks of the project and or the developer himself. Financial investors or lenders will typically require all risks associated with fuel supply, planning conditions, construction & completion, and wayleave rights, strength buy agreements, technology and the EPC contract mitigated prior to their participation, which would typically not be before project financial close has been reached. This will also inevitably be a concern to a project developer.
Nonetheless, the following approaches have been suggested as ways and method to reduce or eliminate the risks mentioned above. Among them are:
Track record of country:
With regard to political risk, the solution lies in having a stable political air in the country in which the project developer is investing. And because of the way some political leaders influence the populace with their ideologies, it id expedient that there is a sound legal framework like rule of law in place to combat the way issues are politicised.Sometimes it is clear that personal ideologies are made to take precedence over what will assistance the whole nation. Another mitigating approach is to have proper laid down investment and other financial regulations in place which can help out project developers reduce or eliminate political risk in a PPA.Local knowledge is also very important. A recent issue reported in the News and the Financial Times about locals in Ethiopia killing 9 Chinese workers among 74 people working in an exploration site in Ethiopia because of what the locals described as “not having their permission to mine in their territory”. This kind of issue could have been avoided should the Chinese knew about the local perception about their presence with regard to the project and adhered to. In most instances, sound macro-economic indicators i.e. sovereign credit rating, for reserves, trade balance, future government obligations are very important to lenders and provide guarantee to the project risks being minimised.
Insurance by World bank or credit export agencies:
The risks of a Government changing its position in terms of law could be covered on the political risk insurance market. sometimes, export credit agencies enabled equipment suppliers to sell on credit by covering most of the buyers’ credit risk. The market for political risk insurance in developing countries is nevertheless small. This is because; first, meaningful South-South FDI is a recent occurrence, and as a consequence, demands for political risk insurance from developing-country. Traditionally focusing on trade, export credit agencies (ECAs) in developing countries have not in addition fully developed political risk insurance sets for investors and their capacity to underwrite is limited. There are, however, indications that concerns about political risk and awareness of risk mitigators are growing as investors from developing countries seek out business opportunities in other developing countries.
sometimes, export credit agencies enabled equipment suppliers to sell on credit by covering most of the buyers’ credit risk. But in recent years, several new risk mitigation instruments have become obtainable.
The complete package of risk mitigants used in typical project finance can carry a high cost, too high for smaller projects. But some of the concepts of project finance can be used already in rather small projects in order to reduce risks. For example, the “limited recourse” aspect of project finance has been used in a lease-buy scheme for small hydropower plants in Cambodia. It works like this; local entrepreneurs prepare the project, showing that the hypothesizedv plant is economically and financially viable. On the basis of this feasibility study, they can then negotiate a strength buy agreement with the national utility, Electricité de Cambodge (EdC), and they would also sign a lease-buy agreement for the hydropower plant; both will come into operation only once the plant has truly been constructed. On the basis of these two agreements, the entrepreneur can then acquire short-term construction loans from local edges and equipment suppliers – in other words, until the plant is constructed, the entrepreneur takes all the risks.
However, once the plant is operational, the lease-buy agreement becomes operational: EdC buys the plant from the entrepreneur for the total of his construction loans, which can then be reimbursed. EdC leases back the plant to the entrepreneur, and deducts the payments due for the lease from the electricity payments it makes under the PPA. After a fixed lease period, the entrepreneur can buy the plant from EdC for a symbolic US$ 1. This scheme considerably reduces financing risks and, consequently, costs, and makes this form of replaceable energy competitive with traditional energy supplies. This scheme in my opinion will work not for small projects but also many projects in general considering the fact that the lease-buy scheme becomes operational after the project has been completed.
The crux of the receivables-based financing structure lies in leveraging contractual obligations within the value chain. Receivables from the strength purchaser or receivables from other partners in the chain can be used either as security or for directly meeting the financial obligations related to the replaceable energy project.
Structured finance techniques:
Structured finance can help conquer some of these barriers and manage many of the risks, though not all (policy-and regulation-related issues need to be dealt with by Governments; limited local managerial capacity or poor understanding of replaceable energy projects in local edges can be tackled by donor-funded capacity-building programs, etc.). Financial risks can be mitigated by the incorporation of certain elements into the financing structure (e.g. escrow accounts), while others can be shifted to third parties. The possibilities for shifting risk are improving. For example, the possibilities to shift risk to the capital market, by securitization, have much improved.
Structured finance techniques, which are widely used by financiers in the commodity sector to mitigate a series of risks, can help to reduce the “funding gap” for replaceable energy projects, and can help Governments and aid agencies to enhance the leverage that they unprotected to with their financial sustain. Several case studies illustrate how this can rule to successful projects. replaceable energy is a sector in complete expansion -already though it is nevertheless far from replacing hydrocarbons as the major source of energy. replaceable energy offers great opportunities for developing countries, in particular for areas that are not closest nearby to existing electricity grids. However, private sector financiers are often cautious of funding replaceable energy projects – a sector with which they are often not very familiar and which carries certain risks. Governments and aid donors sustain the expansion of the sector, but often have difficulty finding sustainable models.
UNCTAD has done important work on the use of structured finance techniques in developing countries, particularly for the commodity sector. Use of such techniques reduces the risks taken by the financier, including by shifting risk from the borrower to other parties who are more creditworthy, leaving the financier with performance risks instead of credit risks on the borrower. The general principles of structured finance and its possible uses for developing countries are discussed in several UNCTAD reports, as are some particular applications (e.g. warehouse receipt finance).
Turnkey construction contract:
With regard to construction & completion risks, a strong Turnkey construction contract is recommended with performance LDs to conquer cost and schedule overruns which could affect the project construction & completion. Lenders can also minimise this risk by analysing whether or not the various contractors’ area financially capable and that their obligations are covered by performance bonds or other third party sureties. In another report , another suggestion of fixed price EPC contract with delay LDs was provided to combat cost and schedule overruns. It further indicated that, a World Bank Study of 80 hydro projects studied, 76 projects surpassed their final budgets, with half of those exceeding the cost by at the minimum a quarter. With a strong turnkey construction contract, this risk could be avoided. Another solution is putting in place a sponsor completion sustain in form of contingency facility, stand-by equity or credit by a credit agency.
There should be long-term guaranteed strength buy agreement or contracts for projects to serve as a meaningful component that can eliminate the price and quantity risks from energy projects for example. Contracts could also be drawn such that edges are offered an noticeable Offtake agreement if the other party’s (purchaser) financial standing is not certain and the generator has the ability to set output pricing for the whole time of the contract. Finally on Offtake and sales risks, it is recommended that sponsors consider the fact that lenders will wish to take security to guarantee strength and heat sale contract. Lenders could also be assured that should the quantity and price risk surface again, the sponsor will be prepared to consider paying a portion of the debt.
On sponsor risks, the effect of reducing this risk is that an invitation could be extended to a more credit worthy sponsor for partnership in the project. Furthermore, smaller sponsors can have their governments guarantee some projects or approach a bank for structured finance after asking for a credit rating form a recognised agency and move the risk to a third party.
With regard to technology & operations risk, the project developer must try to reduce these risks and so must show that the technology is not new and has a high success rating. It should also be demonstrated that the contractor responsible for the building of the project is competent and conversant with the mtechnology.Operations and Maintenance of the project on completion must also be assured ion addition to the fact that warranties and guarantees have been thoroughly negotiated. This could be achieved by engaging the sets of a recognised contractor with the applicable skills and competency. This is known to be highly permissible by edges as reduced operation and technology risk.
Ghana has recently famous its golden jubilee of becoming an independent state dealing with its own affairs so to speak; however, politics has not changed much because politics is the ideologies of individuals. For that reason, so many people within one political party or government can bring different ideas to bear on the politics of a nation affecting project finance one way or the other. It is the inability of the synchronization or blending of these ideas that is really a matter of concern for political risk in project financing. If these could be suppressed or deleted, then political risk and all the related risks can be mitigated. The list for project risk could be endless considering the fact that people in addition as governments’ fear and anticipation are very uncertain.However; the risks could be slightly minimised or deleted.
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