Project Finance Session 02

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Slides from Session 2 of the Project Finance Class that I\'m currently teaching at ESADE.

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Project Finance Session 02

  1. 1. Project Finance<br />Session 2 – Project Risk Management<br />
  2. 2. Agenda<br />Revision – Session 1<br />Project Risk Management<br />Risk Management Processes<br />Identifying Project Risks<br />Risk Allocation with Contracts<br />Role of Advisors<br />Legal<br />Independent Engineer<br />Insurance<br />2009<br />Project Finance - Session 2<br />2<br />
  3. 3. Revision – Session 1<br />Characteristics of Project Finance<br />Debtor is a Project Company (SPV)<br />Legally Independent from Sponsors<br />Investing in a Capital Asset<br />Lenders have limited recourse to Sponsors Assets<br />Risk (more) Equitably Allocated <br />Finance Granted on the basis of future cash flows<br />2009<br />Project Finance - Session 2<br />3<br />
  4. 4. Revision – Session 1<br />Current Trends in Project Finance<br />Overall Project Finance market down 61% (3rd Qtr)<br />Shift in Market Dynamics<br />Developing Countries<br />Banks <br />Types of Projects<br />The Future of Global Infrastructure<br />$ Billions to Maintain current living standards<br />Power, Roads<br />2009<br />Project Finance - Session 2<br />4<br />
  5. 5. Session 2 – Risk Management<br />
  6. 6. Project Risk Management<br />From a Project Finance perspective … <br />Proper Risk Management helps to ensure consistent cash flows throughout the life of the Project, thereby reducing likelihood of default on debt servicing requirements. <br />From a Project Management perspective … <br />Risk Management helps to ensure that the probability & impact of Positive events are increased (negative events are decreased), thereby optimizing profitability of the venture.<br />2009<br />Project Finance - Session 2<br />6<br />
  7. 7. Risk Management Standards<br />Globally Recognised Standards include:<br />AS4360: Risk Management<br />COSO ERM Framework <br />IRM: Risk Management Standard<br />OGC: Management of Risk <br />PMI: Risk Management Standard<br />All documents have a similar methodology for the identification, analysis & treatment of Risks<br />2009<br />Project Finance - Session 2<br />7<br />
  8. 8. Risk Management Processes<br />2009<br />Project Finance - Session 2<br />8<br />
  9. 9. Identifying Project Risks<br />Pre-completion Phase<br />Activity Planning<br />Technology <br />Construction<br />Post-Completion Phase<br />Supply Risk<br />Operational Risk <br />Market Risk <br />2009<br />Project Finance - Session 2<br />9<br /><ul><li>Risk Breakdown Structure (RBS)</li></ul>Common Risks<br />Interest Rate Risk <br />Exchange Risk <br />Inflation Risk<br />Environmental Risk<br />Regulatory Risk <br />Legal Risk<br />Credit / Counterparty Risk<br />
  10. 10. Indentifying Project Risks<br />2009<br />Project Finance - Session 2<br />10<br />
  11. 11. Risk Measurement & Analysis<br />2009<br />Project Finance - Session 2<br />11<br />Forecast: Journey time to work<br />180<br />160<br />100<br />140<br />80<br />120<br />Cumulative (%)<br />100<br />Frequency%<br />60<br />80<br />40<br />60<br />40<br />20<br />20<br />0<br />0<br />47 minutes<br />25<br />40<br />60<br />Time (min)<br />
  12. 12. Risk Allocation with Contracts<br />The Project Company normally allocates risk through the config. of prelim. contracts before soliciting funds. <br />However, Bank Analysis may reveal further risks, in which case:<br />Financing is postponed<br />Additional covenants are included in the loan agreements<br />2009<br />Project Finance - Session 2<br />12<br />
  13. 13. Construction Risk <br />The price paid to the contractor is usually the largest capital expenditure incurred by the project company. <br />The contract is also the most likely source of significant cost overruns. <br />Turnkey / EPC Contract<br />Is usually fixed price, the contractor taking the risk of any fluctuations in the cost of labour or materials<br />FIDIC / NEC / Bespoke <br />2009<br />Project Finance - Session 2<br />13<br />
  14. 14. Turnkey / EPC Contract<br />Features:<br />(Fixed) Price<br />Completion Date <br />Handover, Testing & Commissioning (FAC) <br />Plant Performance (Minimum Standards)<br />Liquidate / Make Good <br />Guarantees & Warranties<br />Damages (Liquidated) <br />Force Majeure <br />2009<br />Project Finance - Session 2<br />14<br />
  15. 15. Supply Risk<br />Put-or-Pay Agreements<br />Supplier Sells @ Pre-agreed Prices <br />If supply is lacking, the Risk lies with the Supplier i.e.<br />Compensates the Project Company <br />2009<br />Project Finance - Session 2<br />15<br />Input Supplier<br />Project Company<br />Indexed Payments<br />The Input supplier bears the price risk on finding an alternative supplier – either directly or indirectly<br />Supply of raw materials from Alternative Source<br />Alternative Supplier<br />
  16. 16. Operational Risks<br />O&M Agreements<br />Fixed Price Contract: The Operator assumes risks relating to the fluctuations in operating costs<br />Pass-Through Contract: The Operator receives a fixed payment and performance bonuses<br />*Step-In Right: Lenders may request the right to remove the original operator and substitute with another. <br />2009<br />Project Finance - Session 2<br />16<br />
  17. 17. Market Risk<br />Offtake Agreements: <br />Long-term contracts where the Offtaker agrees to purchase nominated volumes/quantities of a good or services from the Project Company<br />Take-or-Pay: the offtaker is obligated to pay even if it does not actually take the good or service i.e. PPA<br />Shadow Toll System: payment is made by the Public Admin. on the basis of the volume of traffic & service level. Shadow refers to the fact that the end user does not actually pay the toll. <br />2009<br />Project Finance - Session 2<br />17<br />
  18. 18. The Role of Advisors<br />2009<br />Project Finance - Session 2<br />18<br />
  19. 19. The Role of Advisors<br />“Each project finance deal has a critical minimum-size threshold below which structuring costs become excessive in relation to its forecasted income and cash flows.”<br />Although efficiency is questionable, the role of advisors is essential to the closure of Project Finance Deals<br />Legal Advisors<br />Independent Engineers <br />Insurance Advisors<br />2009<br />Project Finance - Session 2<br />19<br />
  20. 20. Legal Advisors<br />Usually the first “Advisors” to be appointed by both Sponsors & Lenders<br />Address specifics of International Legal Systems i.e. Civil Vs Common<br />Activities involved in, include:<br />Incorporation of the Project Company (SL)<br />Due Diligence (AL)<br />Legal Opinions (AL)<br />Project Contracts (SL)<br />2009<br />Project Finance - Session 2<br />20<br />
  21. 21. Independent Engineer<br />Oversees & monitors the Project on behalf of the lending banks<br />There may be a number of “Independent Engineers” dependent upon the technical nature of the project. <br />Activities involved in, include:<br />Due Diligence Reporting<br />Certification / Issuing of Progress Reports <br />Oversight of Testing & Commissioning<br />Monitoring of Operations<br />2009<br />Project Finance - Session 2<br />21<br />
  22. 22. Insurance (General)<br />Insurance is an important risk mitigation tool that must be properly coordinated and linked to the project’s contractual structure. <br />Insurance should be used when the Project Company’s cost of risk mitigation using insurance policies is less than the premium for risk expressed in the interbank interest rates requested by banks if no coverage exists. <br />2009<br />Project Finance - Session 2<br />22<br />
  23. 23. Insurance Advisors<br />The scope of work for an insurance advisor includes:<br />Preliminary Insurance Report <br />Identifying analysis of contractual documentation & recommendations for risk coverage<br />Final Insurance Report (Construction)<br />Issued at the time of Financial Close – typically constitutes a condition precedent for disbursement (drawdown). <br />Conformity of Insurance Program <br />Finance Insurance Report (Operations) <br />Issued before start-up of Operations <br />2009<br />Project Finance - Session 2<br />23<br />
  24. 24. Typical PF Insurance Products<br />The most common forms of coverage used are: <br />Construction / Contractors – All-Risks <br />Transport Policy<br />Material & Damage – All Risks<br />Force Majeure <br />Key Man Insurance <br />2009<br />Project Finance - Session 2<br />24<br />
  25. 25. Summary<br />Project Risk Management is an extremely important tool in the identification, analysis and mitigation of Project Risks. <br />Advisors (Legal, Engineering & Insurance) play a crucial role in the mitigation of risks through: <br />Specialized Expertise <br />Due Diligence<br />Structure / Viability of the Project <br />Monitoring <br />2009<br />Project Finance - Session 2<br />25<br />

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