It’s All About Risk! The key to project financing is the reallocation of any risk away from the lenders to the project.
Definition of Project Completion Principle Categories of Risk: Pre-Completionand 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)
Management and Alleviation of RisksPrinciple Categories of Risk: Pre-Completionand 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 thenby 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
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
Regulatory Risks Regulatory is the risk of not obtaining all approvals required to build (e.g. export licences) and operate (e.g. orbital slots assignment and frequency coordination, landing rights) the system.
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
B. Post-Completion Risks 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
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 debtchanges 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
Currency risk Currency risks include the risks that: (a) a depreciation in loan currencies may increase the costs of construction where significant construction items are sourced offshore; or (b) a depreciation in the revenue currencies may cause a cash-flow problem in the operating phase.
Project Financing and Political Risk MitigationThe Singular Case of the Chad-Cameroon Pipeline
Chad-Cameroon Pipelines: Project Background Oil first discovered in southern Chad by Conoco early in 1970’s Initial consortium: Conoco, Exxon, Shell, Chevron Additional discoveries brought reserves to ~1 billion barrels Chad’s unique risk profile Landlocked country: oil must be pipelined to Atlantic coast for export Best route: through Cameroon – ranked 148/177 on poverty, 99/99 on corruption – potential for pipeline to be held “hostage” Chad: 30 year civil war after independence; ruled by Gen. Indris Deby since 1990; unstable borders; $300 per capita income; 173/177 poverty Oil companies declined to develop Chad’s reserves Conoco withdrew in favor of Exxon; Chevron sold to Elf-Acquitaine
Key to Unlocking Chad’s Reserves – Risk MitigationProject Finance one of few Available Tools Project Finance can mitigate location/political risk in 3 ways: Stake Reduction: limiting project sponsor’s capital at risk Requires financing to be “non-recourse” to sponsor Also strengthens sponsor’s ability to resist host government pressure Deterrence: disrupting financing involves consequences that deter host government disruptive actions Financing to include lenders which host governments don’t want to offend 3. Terms Clarification: project finance process forces host government to clarify/document commitments Ties commitments to NY/UK law and/or offshore arbitration Private firms want deterrence to avoid unilateral contract revision
First Test: Esso Production Malaysia(EPMI)1978 Concept: Cash flow allocated for debt service could be impacted by government changes in tax rates Bank loan repayment at risk if government raises rates Consortium: Top three international PF banks in lead Citibank, JP Morgan, Chase Followed by top 3 Malaysian commercial banks Result: Inconclusive Malaysia raised rates, banks responded with mild protests Exxon repaid loans; Malaysia did not raise rates again Result left Exxon disinclined to use PF for upstream risk mitigation
Special Risks in Chad-Cameroon led Oil Company Consortium to reconsider using PF Chad’s acute revenue needs for poverty/security; lack of rule of law Cameroon’s potential to hold pipeline hostage once built, demanding higher transit fees, equity participations Nothing about EPMI suggested PF by itself would deter such events Consortium’s new concept: combine PF & World Bank deterrence WB’s status: “concessionary” lender, ties to IMF as ‘lender of last resort’ Track record where few if any countries failed to repay WB loans Plan to combine WB participation with strategic ECA/MLA lenders US Ex-Im, CoFACE, European Investment Bank (EIB)