UNIVERSITY OF PHOENIX COLLEGE OF EDUCATION AND EXTERNAL STUDIES SCHOOL OF CONTINUING AND DISTANCE EDUCATION DEPARTMENT OF EXTRA MURAL STUDIES MASTERS OF ARTS IN PROJECT PLANNING AND MANAGEMENT LDP 602: – PROJECT FINANCING CIRCUMSTANCES IN WHICH ENVIRONMENTAL, POLITICAL AND MACROECONOMIC RISKS ARE IMPORTANT FOR PROJECT FINANCIERS BEFORE ADVANCING LOAN TO A PROJECT COMPANY CESAR DELARIVIER L50/76492/2014 Term Paper Submitted in Partial Fulfilment of the Requirement for the Award of Master of Arts in Project Planning and Management in the Department of Extra-Mural Studies University of Phoenix. 1. Table of Content  page Explain the circumstances in which environmental, political and macroeconomic risks are important for project financiers before advancing loan to a project company (15marks). Introduction Project finance can be characterised in a variety of ways, while there is currently no universally adopted definition, different authors and practitioners articulate it through different definitions. Yescombe (2002 ) states that it is a method of raising long-term debt financing for major projects through “financial engineering,” based on lending against cash flow generated by the project alone: It depends on detailed evaluation of projects construction operating and revenue risks, and their allocation between investors, lenders and other parties through contractual and other agreements. Gatti (2007) defines it as “… the structured financing of a financial economic entity _the SPV, or special –purpose vehicle, also known as the project company- created by sponsors using equity or mezzanine debt and for which the lender considers cash flows as being the primary source of loan reimbursement…”. Gardner and Wright (2011) define it as the raising of finance on a limited recourse basis, for the purposes of developing a large capital intensive infrastructure[footnoteRef:1] project, where the borrower is a special purpose vehicle and repayment of the financing by the borrower will be dependent on the internally generated cash flows of the project” [1: In their text, for simplicity, the authors used the term ‘infrastructure’ generically to refer to any capital intensive asset or group of assets which provide essential goods or services (e.g. utilities, petrochemicals, transportation services, housing etc) and can be contractually structured to provide internally generated cashflows.] Though there are varied definitions a few factors resonate across the board: It is a form of secured lending characterised by intricate, but balanced, risk allocation arrangements (Fletcher and Pendleton 2014) and usually involves lenders extending credit sometimes to the tune of billions of shillings, to a project company whose core assets at the time of lending are likely to consist of little more than a collection of contracts, licences and ambitious plans. There are no guarantees to financiers from the project company (non-recourse finance ) or ...

1. UNIVERSITY OF PHOENIX
COLLEGE OF EDUCATION AND EXTERNAL STUDIES
SCHOOL OF CONTINUING AND DISTANCE EDUCATION
DEPARTMENT OF EXTRA MURAL STUDIES
MASTERS OF ARTS IN PROJECT PLANNING AND
MANAGEMENT
LDP 602: – PROJECT FINANCING
CIRCUMSTANCES IN WHICH ENVIRONMENTAL,
POLITICAL AND MACROECONOMIC RISKS ARE
IMPORTANT FOR PROJECT FINANCIERS BEFORE
ADVANCING LOAN TO A PROJECT COMPANY
CESAR DELARIVIER
L50/76492/2014
Term Paper Submitted in Partial Fulfilment of the Requirement
for the Award of Master of Arts in Project Planning and
Management in the Department of Extra-Mural Studies
University of Phoenix.
1. Table of Content page

2. Explain the circumstances in which environmental, political and
macroeconomic risks are important for project financiers before
advancing loan to a project company (15marks).
Introduction
Project finance can be characterised in a variety of ways, while
there is currently no universally adopted definition, different
authors and practitioners articulate it through different
definitions. Yescombe (2002 ) states that it is a method of
raising long-term debt financing for major projects through
“financial engineering,” based on lending against cash flow
generated by the project alone: It depends on detailed
evaluation of projects construction operating and revenue risks,
and their allocation between investors, lenders and other parties
through contractual and other agreements.
Gatti (2007) defines it as “… the structured financing of a
financial economic entity _the SPV, or special –purpose
vehicle, also known as the project company- created by
sponsors using equity or mezzanine debt and for which the
lender considers cash flows as being the primary source of loan
reimbursement…”.
Gardner and Wright (2011) define it as the raising of finance on
a limited recourse basis, for the purposes of developing a large
capital intensive infrastructure[footnoteRef:1] project, where
the borrower is a special purpose vehicle and repayment of the
financing by the borrower will be dependent on the internally
generated cash flows of the project” [1: In their text, for
simplicity, the authors used the term ‘infrastructure’
generically to refer to any capital intensive asset or group of
assets which provide essential goods or services (e.g. utilities,
petrochemicals, transportation services, housing etc) and can be
contractually structured to provide internally generated
cashflows.]

3. Though there are varied definitions a few factors resonate
across the board: It is a form of secured lending characterised
by intricate, but balanced, risk allocation arrangements
(Fletcher and Pendleton 2014) and usually involves lenders
extending credit sometimes to the tune of billions of shillings,
to a project company whose core assets at the time of lending
are likely to consist of little more than a collection of contracts,
licences and ambitious plans.
There are no guarantees to financiers from the project company
(non-recourse finance ) or very limited guarantees ( Limited-
recourse finance) and the main security can include things like
contracts, licences and ownership rights to natural resources as
physical assets in most cases are worth much less than the loan
advanced. In many cases the project company is generally a
legally-independent special purpose vehicle[footnoteRef:2]set
up by the project sponsor/s, who can each be a private or a
government owned entity, for the sole purpose of owning, and
borrowing the funds necessary for the project. [2: The investor
encyclopaedia defines an SPV, Also referred to as a
"bankruptcy-remote entity" as a project company whose
operations are limited to the acquisition and financing of
specific assets. The SPV is usually a subsidiary company with
an asset/liability structure and legal status that makes its
obligations secure even if the parent company goes bankrupt. A
corporation can use such a vehicle to finance a large project
without putting the entire firm at risk.
http://www.investopedia.com/terms/s/spv.asp
]
Getting a financier willing to advance a large sum of money to a
project company or SPV on the basis that the cash flows from
the project will be sufficient to offset the money loaned is key,
which makes the focus on identification, analysis and mitigation
of risks important for the parties involved since the benefits to
the financiers are only realised should the project come to

4. fruition. This calls for prudent risk analysis and allocation at
the onset of the discussions to ensure the project is worth the
investment which therefore calls for proper risk management.
RISK MANAGEMENT
Risk management is defined as the process of identification,
assessment, mitigation, and allocation of risks to reduce cost of
risk and improve incentives (Aydemir_2006). Risks are As
alluded to by the definition of risk management above,
financiers would prefer to advance loans to project companies
that can mitigate against risks and ensure returns. Projects with
low risks and high returns would be preferred and provide an
incentive for a financier to consider financing a project.
Unfortunately most projects that require a big enough
investment to approach a financier for funding are high risk
projects. This therefore means that measures have to be taken to
mitigate against possible risks.
It is important to identify the potential sources of risk for a
particular project before hand. The potential sources of risk
vary from one project to another; factors that determine the
project risk include nature of the project, location of the project
and parties involved in the project. These can be either internal
e.g. relations between the different parties in the agreement, or
external e.g. government policy and natural disasters. These
varied factors suggest that certain risks will affect the
implementation of certain projects more adversely than others
based on their impact to the project. The impact of risks to
projects can lead to the project coming to a complete halt or not
operating in its full capacity. The risks may also manifest
themselves in the project overrunning the time frame or budget
of the project and /or not generating enough cash flow (which is
key for repayment of the financier’s investment).
Several steps can be taken to ensure that these potential risks
are identified and analysed and that mitigation measures and
contingency plans are put in place.

5. The first step is to ensure that a feasibility study is carried out
to identify the possible risk of the project, this is fundamental
to assessing the bankability of a project. The non-recourse basis
of loans in project finance, as well as the limited recovery that
can be expected from the liquidation of project assets, puts high
premium on the reliability of the feasibility study. Moreover,
unlike established business enterprises which tend to have a
certain track record and a certain degree of diversification, the
risks associated with a project loan tend to be highly project
specific; the lender does not have the benefit of risk-spreading
that comes from diversification of a business enterprise’s
undertakings (Loke,1998). At this point it is key for the
financier to find out whether the cash flow to be realized by the
project can repay the money advanced which will determine
whether financing the project is a worthwhile endeavor.
However, care should be taken to ensure that the interests of all
parties involved are considered. It is therefore advisable to have
an independent party carry out the feasibility study to avoid
bias of the findings in favor of the financier or the sponsor. At
the end of the feasibility study the potential risks to the project
are presented.
After the potential risks have been established all the players
need to get on the table and discuss how the risk can be spread
amongst them; a process that requires a lot of negotiation,
objectivity and good will. Project finance packages risks
associated with the project into discrete “bundles”. The
segregated risks can then be parceled out to diverse willing
parties. It thus allows for parties best able to control or insure
against the risks to assume them – it enables efficient risk
allocation.[footnoteRef:3] Splitting up the assumption of project
risks in this manner has – in addition to risk spreading – the
effect of reducing the associated risks. As a consequence, a
project which is unacceptably risky to one party becomes
feasible through first, risk spreading and second, risk reduction

6. ( Loke 1998). Who bears what risk should be determined based
on each stakeholder’s capacity to manage, control or insure
against risks operationally, at the project level and financially
and the agreements have to be bound by contracts. Ayedemir (
2006) describes how costs of risk can be reduced with the
following: Some risks can be reduced by spreading the burden
across many participants; some other risks cannot be spread, but
can be shifted or reallocated. Different stakeholders in a project
may have different preferences, and hence different willingness
and capacity to bear risks. Cost of risk is lower to those with
greater capacity and willingness to bear risk. Risk-return trade-
offs may enable integrative (not necessarily competitive)
negotiations among different stakeholders and may create value
in a project setting, and the gains in economic efficiency can be
achieved if overall cost of risk declines through risk shifting
and reallocating; the same risk will have a lower cost if born by
parties better capable and willing to do so. [3: This underpins
the The Abrahamson Principles formulated in the context of
construction contracts: A party to a contract should bear a risk
where: 1. The risk is within the party’s control 2. The party can
transfer the risk (eg, by insurance), and it is most economically
beneficial to deal with the risk in this fashion 3. The
preponderant economic benefit of controlling the risk lies with
the party in question 4. To place the risk upon the party in
question is in the interests of efficiency including planning,
incentive and innovation efficiency 5. If the risk eventuates, the
loss falls on that party in the first instance and it is not
practicable, or there is no reason under the above principles, to
cause expense and uncertainty by attempting to transfer the loss
to another. “No Dispute – Strategies for Improvement in the
Australian Building and Construction Industry” May 1990. A
Report by NPWC/NBCC Joint Working Party p 6 cited in Peter
Megens, “Construction Risk and Project Finance – Risk
Allocation as Viewed by Contractors and Financiers” (1997) 14
ICLR 5 at 8.
]

7. After the risks are identified and apportioned rightfully it is up
to the different stakeholder to handle the risks that they have
contractually agreed to. This is the next step in risk
management, ensuring that all identified risks are mitigated
against or handled appropriately should they occur. Risks fall
under several categories and based on the nature of the project
these may occur at different phases, at different intensities and
have different impacts. Risks are vast and cannot be exhausted
when the nature and all the factors affecting a project are
unknown. Three risks that are likely to affect in projects include
environmental, political and macroeconomic risks. Due to their
different effects to the projects all can be handled differently.
Macro-economic risks (also known as financial risks) relate to
external economic effects not directly related to the project
(i.e., inflation, interest rates, and currency exchange rates);
Yescombe (2002 )
Political risks (also known as country risks) relate to the effects
of government action or political force majeure events such as
war and civil disturbance (especially, but not exclusively, where
the project involves cross-border financing or investment);
Yescombe (2002 )
Political risk
Some of the main risks a project located in a lesseconomically
developed country faces are political
risks (also known as country risks), which includes war
or civil disturbance, expropriation, exchange controls or other
types of currency transfer limitations
Environmental risks Nowadays, economic grouth and the
development of new technologies and products, has brought
environmental risks. Environmental risks are assessed before
the development of a new project aiming to determine, among
others, the way it should be mitigate or manage them properly.
This is called “risk management”. Hence the development of
any activity or project that caused impact directly or indirectly

8. to the environment, it is subject to analysis by financial
institutions before granting a loan.
For some years, it has been identified that environmental
problems or environmental impacts caused by large scale
projects can be mitigated or controlled if financial institutions
or investors review and assessed environmental risks from the
beginning. Hence, the International Finance Corporation in
1998 adopted a Social and Environmental Policy applied since
2006 in projects in which it invests. The aim is to assess the
environmental risks and thereby, avoid, as much as possible, the
negative impacts to the environment or communities where the
project is developed. Thus, in 2003 the Equator Principles were
created by a group of international banks and the International
Finance Corporation itself. These principles are the framework
for financial institutions to assess and manage environmental
and social risks in their project finance transactions worldwide
for any economic sector, including real estate developments.
· Site acquisition and access, permits
· A government support agreement
· Market risk: Uncertainty regarding the future price and
demand for the output
· Volume risk: cannot sell entire output
· Price: cannot sell output at profit
· Long term off-take contract with creditworthy buyers:
· take and pay, take or pay, take if delivered contracts:
· Price floors
· A fixed price growth path
· An undertaking to pay a long-run average price
· Specific price escalator clauses that would maintain the
competitiveness of the product, such as indexing price to the
price of a close substitute or cost of major input
· Hedging contracts
· Force majeure risk: Likelihood of occurrence of events like
wars, labor strikes, terrorism, or nonpolitical events such as
earthquakes, etc.

9. · Insurance for natural disasters
Risk
Solution
· Exchange rate changes: Uncertainty regarding the changes in
the exchange rate throughout the life of the project
· Implications of a sudden major local currency devaluation in
cases where the project revenue is in local currency and debt in
foreign currency
· Revenues, costs, and debt in same currency (indexing if they
are not in the same currency)
· Market-based hedging of currency risks (though not widely
used)
· For protection from a sudden major devaluation, a revolving
liquidity facility can be utilized to cover the time lapse between
the devaluation and the subsequent increase in inflation that
should compensate the project company for debt payments
· Currency convertibility / transferability risk: As it is often not
possible to raise funding in local currency in developing
countries, revenues earned in local currencies need to be
converted into foreign currency amounts needed by offshore
investors/lenders, and then need to be transferred outside the

10. country to pay for them. Additionally, foreign currency may be
needed to import materials, equipment, etc.
· Government Support Agreement: Government guarantee of
foreign exchange availability: However, if the host country gets
into financial difficulty and runs out of foreign currency
reserves, then the government may forbid either the conversion
of local currency amounts to foreign currency, or the
transmission of these amounts abroad The support agreement
may become invalid
· Enclave projects: If the project revenues are paid from a
source outside the host country, the project can be insulated
from foreign exchange and transfer risks (Example: sales of oil,
gas across borders)
· Offshore debt service reserve accounts
Risk