51432284 project-finance

INTRODUCTION TO
PROJECT FINANCE

OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap

What Is Project Finance?

• Definition
• Major characteristics
• Schematic example of a project
structure
• Major project contracts

Definition:
“Project Finance involves one or more corporate sponsors
investing in and owning a single purpose, industrial asset
through a legally independent project company
financed with limited or non-recourse debt.”

A relevant question to investigate:

Finance separately with non-recourse
debt? (Project Finance)
SPONSOR + PROJECT?
Finance jointly with corporate funds?
(Corporate Finance)

Major characteristics:
• Economically and legally independent project company
– Founded extensively on a series of legal contracts that unite
parties from input suppliers to output purchaser
– Project assets/liabilities, cash flows, and contracts are separated
from those of the sponsors, conditional on what accounting rules
permit
– Investors and creditors have a clear claim on project assets and
cash flows, independent from sponsors’ financial condition
– Debt is either limited (via completion guarantees) or non-
recourse to the sponsors

• Highly leveraged project company with concentrated equity
ownership
– Partly due to firms’ need for flexibility and excess debt capacity
to invest in attractive opportunities whenever they arise
– Syndicate of banks and/or financial institutions provide debt
– Typical D/V ratio as high as 70% and above
– Debt has higher spreads than corporate debt
– One to three equity sponsors
– Sponsors provide capital in the form of equity or quasi-equity
(subordinated debt)
– Governing Board comprises of mainly affiliated directors from
sponsors

• Historically formed to finance large-scale projects

– Industrial projects: mines, pipelines, oil fields
– Infrastructure projects: toll roads, power plants,
telecommunications systems
– Significant financial, developmental, and social returns

• Examples of project-financed investments
– $4bn Chad-Cameroon pipeline project
– $6bn Iridium global satellite project
– $1.4bn aluminum smelter in Mozambique
– €900m A2 Road project in Poland

• Statistics as of year 2002

– $135bn of capital expenditure globally using project finance
– $19bn of capital expenditure in the US
– Smaller than the $612bn corporate bonds market, $397bn asset
backed securities market and $205bn leasing market;
approximately same size with the $27bn IPO and $26bn venture
capital market

A simplified project structure example:

A “nexus
of
contracts”
that aids
the sharing
of risks,
returns,
and
control

Source: Esty, B., “An Overview of Project Finance – 2002 Update: Typical project structure for an independent power producer”

Major project contracts:
• The Offtake Contract: • Input Supply Contract:

– A framework under which
Project Company obtains – The Offtake Contract for the
revenues input supplier
– Provides the “offtaker” – Provides the Project Company
(purchaser) with a secure
supply of project output, and the security of input supplies
the Project Company with the on a pre-agreed pricing basis
ability to sell the output on a – The terms of the Input Supply
pre-agreed basis
Contract are usually crafted to
– Can take various forms, such
as “Take or Pay” Contract: match those of the Offtake
• “Power Purchase Contract (such as input
Agreement” (PPA) volume, length of contract,
force majeure, etc.)

Major project contracts:
• Construction Contract: • Permits:
– A contract defining the – Contracts that ensure permits
“turnkey” responsibility to and other rights for
deliver a complete project construction and operation of
ready for operation (a.k.a. the project, as well as for
Engineering, Procurement, investing in and financing of
Construction (EPC) Contract) the Project Company
• Operation and Maintenance – May be provided by central
Contracts: governments and/or local
– Ensures that the operating authorities
and maintenance costs stay • Government Support
within budget, and project Agreements:
operates as planned. – Provisions may include
guarantees on usage of public
utilities, compensation for
expropriation, tax exemptions,
and litigation of disputes in an
agreed jurisdiction

How Does It Create Value?
• Drawbacks of using Project Finance
• Value creation by Project Finance
– Organizational structure
• Agency costs, debt overhang, risk contamination, risk
mitigation
– Contractual structure
• Structuring the project contracts to allocate risk, return,
and control
– Governance structure
• Benefits of debt-based governance
• Case examples to value creation

Drawbacks of Using Project Finance Structure:

• Takes longer to structure and
execute than equivalent size
corporate finance
Still, the combination
of organizational,
• Higher transaction costs due to
creation of an independent entity financial, and
and complex contractual structure contractual features
may offer an
• Non-recourse project debt is opportunity to reduce
more expensive due to greater net cost of financing
risk and high leverage and improve
performance
• High leverage and extensive
contracting restricts managerial
flexibility

• Project finance requires greater Structure matters, contrary to
disclosure of proprietary
information to lenders MM Proposition!

Why does structure matter?

Structural decisions may affect the existence and magnitude of costs
due to market perfections:
* Agency conflicts
* Financial distress
* Structuring and executing transactions
* Asymmetric information between parties involved
* Taxes

Value Creation

Organizational Structure Governance Structure

Contractual Structure

Value creation by organizational structure:
Agency Costs
Problems Structural Solutions:
• • Concentrated equity ownership and
Agency conflicts between single cash flow stream provides critical
sponsors (owners) and monitoring
management (control) • Strong debt covenants allow both
sponsors and creditors to better monitor
• High levels of free cash management
flow leading to • High debt service reduces the free cash
overinvestment in flow exposed to discretion
negative NPV projects • Extensive contracting reduces
managerial discretion
• Risk shifting/debt • “Cash Flow Waterfall” mechanism
shifting by managers to facilitates the management and allocation
invest in high risk, of cash flows, reducing managerial
negative NPV projects discretion. Covers capex, debt service,
to recoup past losses reserve accounts, and distribution of
residual income to shareholders
• Refusal to make • Given the projects are defined within
additional investment narrow boundaries with limited
investment opportunities, moral hazard
(risk shifting, debt shifting, reluctance to
invest) is minimized

Agency Costs
• Agency conflicts between • “Cash Flow Waterfall” mechanism
sponsors and creditors: reduces potential conflicts in distribution
and re-investment of project revenues
– Distribution of cash flows, re-
investment, and restructuring • Legally/economically separate project
during distress company eliminates potential for risk
shifting and debt shifting
– Moral hazard (such as risk
shifting and debt shifting)
encouraged by full recourse • Concentrated debt ownership is preferred
nature of debt to sponsor (i.e. bank loans vs. bonds) to facilitate the
restructuring and speedy resolutions

• Usually subordinated debt (quasi equity)
is provided by sponsors

• Strong debt covenants allow better
monitoring

• Single cash flow stream and separate
ownership provides easier monitoring

Agency Costs
• Conflicts between sponsors and • Vertical integration is effective in
other parties (purchasers, precluding opportunistic behavior but
suppliers, etc.) not at sharing risk. Also,
opportunities for vertical integration
may be absent.

• Long term contracts such as supply
and off take contracts: these are
more effective mechanisms than
spot market transactions and long
term relationships.

• Joint ownership with related parties
to share asset control and cash flow
rights. This way counterparty
incentives are aligned.

Agency Costs
• Conflicts between sponsors and • Since project is large scale and the
government: Expropriation company is stand alone, acts of
through either asset seizure, expropriation are highly visible in the
diversion, or creeping international arena which detracts
future investors
• High leverage leaves less on the
table to be expropriated
• Multilateral lenders’ involvement
detracts governments from
expropriation since these agencies
are development lenders and
lenders of last resort. However these
agencies only lend to stand alone
projects.
• High leverage also reduces
accounting profits thereby reducing
the potential of local opposition to
the company.

Debt Overhang
• Sponsor’s under-investment in • Non-recourse debt in an
positive NPV projects when independent entity allocates returns
sponsor has: to capital providers without any claim
on the sponsor’s balance sheet.
– limited corporate debt capacity Preserves corporate debt capacity.
– agency or tax reasons that
exclude equity as a valid option • The fact that non-recourse debt is
backed by project assets/cash flows
– pre-existing debt covenants and not by the sponsor’s balance
that limit possibility of new debt sheet increases the chances of an
already highly leveraged sponsor to
separately finance a viable project

Risk Contamination
• A high risk project may • Project financed investment exposes
potentially drag a healthy the sponsor to losses only to the
sponsor into distress, by extent of its equity commitment,
increasing cash flow volatility thereby reducing its distress costs
and reducing firm value.
• Through project financing, sponsors
• Conversely, a failing sponsor can share project risk with other
can drag a healthy project along sponsors:
with itself. – Pooling of capital reduces each
provider’s distress cost due to the
• Very large projects can relatively smaller size of the
potentially destroy the investment and therefore the overall
sponsor’s balance sheet and distress costs are reduced.
lead to managerial risk aversion
• Separate incorporation eliminates
• Benefit from portfolio potential increase in risk when
diversification is negative (risk financing a project strongly
is higher) when sponsor and correlated to sponsor’s existing
project cash flows are strongly asset portfolio.
positively correlated.

Other motivations
• Joint venture projects with • The stronger partner is better
heterogeneous partners: equipped to negotiate terms with
Financially weaker partner banks than the weaker partner and
cannot finance its share of hence participates in project finance
investment through corporate even if it can finance its share via
borrowings, and needs project corporate financing
finance to participate

• Location: Large projects in
emerging markets usually • Debt may be the only option and
cannot be financed by local project finance the optimal structure.
equity due to supply
constraints. Investment specific • Besides, host government may grant
equity from foreign investors is the project “tax holiday”, which
either hard to get or expensive. provides sponsors exemptions from
taxation

How Does It Create Value?
mitigation
• Structuring the project contracts to allocate risk, return, and
control

Value creation by contractual structure:

• An introduction to risk management

– Risk management defined
– Sources of risks
– Who bears risk?
– Mechanisms for reducing cost of risk

• Contractual structure in Project Finance to reduce cost of risk and
create value

An Introduction to Risk Management

Risk Management:

The process of identification, assessment, mitigation, and allocation of risks
to reduce cost of risk and improve incentives
Sources of risk:
– External:
• Markets: Availability and quality of products, inputs, and services
used
• Financial markets
• Government policy
• Natural resource availability and quality
• Natural disasters, politics
– Internal:
• Incentive problems during construction and operation stages
• Relationships between management, sponsors, lenders, workers,
suppliers, government
(some addressed in the previous slides under “value creation by
organizational structure”)


Who bears risk?

• Sponsors bear the residual gains and losses, and make key investment decisions.
In simple terms,
Return to equity = Revenues – Material / service costs – Labor costs -
Depreciation – Interest expenses – Taxes

Variability in RHS variables lead to changes in return to equity

• Other earners of net income (or net value added) from investment can also share
risk:
Net Value added =
Return to equity + Interest expenses + Taxes + Labor costs
= Revenues – Material / service costs – Depreciation

Profit sharing mechanisms or tax incentives may change how variability in income
is shared among sponsors, lenders, government, and labor

• Output purchasers and input suppliers can also share the risks as they experience
variability in their markets


How are costs of risk reduced?

• 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

• 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


Mechanisms to reduce cost of risk:

• Capital, financial, and futures markets:
– Mix of debt and equity (capital structure) and probability of default
– Risk spreading / pooling
– Risk diversification
– Insurance markets (for residual risks)
– Derivative financial instruments (not available for asymmetric risks)
– Futures markets
• Real options: Design flexibility into project to allow for responses of new
information or market changes
• Project design itself for risk mitigation (elements of production process,
technology used, etc.)
• Project Finance mechanism: complex contractual arrangements involving all
mechanisms of contractual risk allocation and reduction to deal with risk in
large scale investments

Contracting and Project Finance to reduce cost of risk

• Generally well developed capital, financial, and futures markets may not always be
available
• Special contractual arrangements are often required to manage risk to make projects
viable
• The aim of extensive contracting is to reduce cash flow volatility, increase firm value
and debt capacity in a cost-effective way
• Guarantees and insurance for those risks that cannot be handled through contracting

Elements of contracting:
• General form:
– Exchange risk (x) for return (y)
• Additional considerations:
– Participation or partial transfer of ownership
– Timing of x and y
– Contingency of x and y (under what circumstances)
– Penalties on non-performance
– Bonus on performance


Contracting criteria:
• Contract with lowest cost not necessarily best contract
• Effective contracts may provide:
– Better risk shifting: better distributions of cost
– Better incentives: higher project returns or lower total project risk as a result of
incentives
• Change the incentive structure to change the probabilities of different outcomes 
stakeholders have incentives to increase probability of success and reduce probability
of failure in project
• “Zero Sum” (Competitive) versus “Positive Sum” (Integrative) perspectives
– Cost focus is implicitly a zero sum perspective: one stakeholder gains and the
other stakeholder loses
– Integrative focus is explicitly a positive sum perspective: By crafting the right
contract, one stakeholder can gain without necessarily costing to the other one
(due to differences between perceived values, preferences, and risk bearing
capacity)  contracts that create increased value through risk sharing and /or
improved incentives


Sources of contracting benefits:
• Stakeholders’ differing risk preferences
• Differing capability to diversify
• Differing capability to manage risks
• Differing information or predictions regarding future
• Differing ability to influence project outcomes

Risks manageable via contractual structure or other mechanisms in
Project Finance:

• Pre-completion risks: Resource, technological, timing, and completion risks
• Post-completion risks: Market risk, supply risk, operating cost risk, and force
majeure
• Sovereign risks: Inflation risk, exchange rate volatility, convertibility risk,
expropriation
• Financial risks: Default risk

Pre-completion risks:
Risk Solution
•Site acquisition and access, permits •A government support agreement

•Risks related to contractor: •Reputation, references for similar projects and
–Is it competent to do the work? technology being used
•Experience with the country, good relationships with
local subcontractors
•Similar references for the subcontractors

–Is it also one of project’s sponsors? •Contract supervision by the project company’s other
(Conflict of interest) personnel not directly related to the contractor
–The contractor’s credit standing? If the •Careful review of contractor’s credit standing
contractor’s wider business gets into •Careful review of the project scale in relation to the
difficulty, the project is likely to suffer size of contractor’s overall business
•If project too big for the contractor to handle alone, a
joint venture approach with a larger contractor
•Guarantees of obligations by the contractor's parent
company

Risk Solution

•Construction cost overruns: reduce equity •Pre-agreed overrun funding (contingency finding)
returns, and DSCR •Fixed (real) price contract, as the EPC contract is
normally the largest cost item in budget (60-70%)
•Contractor takes junior debt and/or equity stake in
operations (BOT or BOO)

•Delay in completion: failure to meet the •Completion guarantees, date-certain EPC contract
milestones increase costs, reduce equity returns, •Performance bonds
and reduce DSCR •Completion bonuses/penalties
–Financing costs, especially as debt will be •Reputable contractor
outstanding longer
•Close monitoring / testing of project execution
–Revenues from operating the project will (operational, financial, etc.) for early detection of
be lost or deferred (significant risk also problems
especially if part of financing depends on
early revenues) •Careful definition of “completion” in all the contracts
(EPC contract, input supplier contracts, off-taker
–Penalties may be payable under contract contract, etc) so that it is acceptable and manageable
to input suppliers or off-taker by all parties involved

•Process failures •Process / Equipment warranties
•Tested technology

Risk Solution
•Nonperformance on completion: due to poor •Debt recourse to sponsors (from lenders’
design, inadequate technology perspective)
•Performance LDs (liquidated damages): Pre-agreed
level of loss to be born by the contractor. Covers the
NPV of loss due to nonperformance over the life of
the project
• The Project Company should be aware of the
uncertainty regarding the LDs and should allow a
margin when negotiating the calculations with the
contractor

•Natural resource risk •Independent reserve certification

Risk Solution

•Third party risks: •If the third party is not otherwise involved in the
–The contractor may be dependent on third project, incentive mechanisms to keep the timetable
parties such as suppliers of utilities to •If the third party is involved with a project contract,
complete the project the contract should include terms such that the third
party should be held responsible for the delay losses
•Contractor’s good relationships and experience with
the third parties may be a plus
–The project may be dependent on
completion of another project – worst type •Financing the projects as one package may be
of third party risk especially when the examined as a potential solution, as long as the
project financing is dependent on it. sponsors’ interests on both sides can be aligned

•Sponsor-related risks (Lenders’ perspective): •Require lower D/E ratio
–Sponsor commitment to the project •Starting with equity: eliminate risk shifting, debt
–Financially weak sponsor overhang and probability of distress (lenders’
requirement).
•Add insider debt (Quasi equity) before debt: reduces
cost of information asymmetry.
•Attain third party credit support for weak sponsor
(letter of credit)
•Cross default to other sponsors

Post-completion risks:
Risk Solution

•Market risk: Uncertainty regarding the future •Long term off-take contract with creditworthy buyers:
price and demand for the output –take and pay, take or pay, take if delivered contracts:
–Volume risk: cannot sell entire output •Price floors
•A fixed price growth path
–Price: cannot sell output at profit •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

•Operating cost risk: Uncertainty regarding the •Risk sharing contracts to increase correlation
changes in the operating cost throughout the life between revenue and some cost items:
of the project –If there is an off-take contract, linking input supply price
to it:
•Basing the product price under the off-take contract on the
cost of the input supplies (more likely if input supply is a
widely traded commodity like oil)
•Basing the input supply price to product price under the off-
take contract: (more likely if the input is a specialized
commodity, or if there is no off-take contract and risk is
passed to the input supplier)
–Price ceilings
–Profit sharing contract with labor
–Output or cost target related pay

Post-completion risks:
Risk Solution

•Input supply risk: Uncertainty regarding the •If there is an off-take contract, linking the terms of the
availability of the input supplies throughout the life output contract with input supply contracts such as
of the project the length of contract, volume, or force majeure
•If there is no off-take contract, making the input
supply contract run for at least the term of debt
•An input supply contract is off-take contract for the
supplier

•Organizational risks: Incentive problems relating •Profit sharing / stock options
to management or workers •Output or cost target related pay for workers
•Operating risk: operating difficulties due to •Performance warranties on equipment
technology (being degraded or obsolescent), •Expert evaluation and retention accounts
processes used, or incapacity of operator team •Proven technology
leads to inefficiencies and insufficient cash flow
•Experienced operator/management team
•Operating/maintenance contracts to ensure
operational efficiency
•Allowances for service / upgrade built into equipment
supply contracts
•Insurance to guarantee minimum operating cash

•Force majeure risk: Likelihood of occurrence of •Insurance for natural disasters
events like wars, labor strikes, terrorism, or
nonpolitical events such as earthquakes, etc.

Sovereign risks:
Risk Solution

•Exchange rate changes: Uncertainty regarding •Revenues, costs, and debt in same currency
the changes in the exchange rate throughout the (indexing if they are not in the same currency)
life of the project •Market-based hedging of currency risks (though not
•Implications of a sudden major local currency widely used)
devaluation in cases where the project revenue is •For protection from a sudden major devaluation, a
in local currency and debt in foreign currency 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 •Government Support Agreement: Government
is often not possible to raise funding in local guarantee of foreign exchange availability: However, if
currency in developing countries, revenues the host country gets into financial difficulty and runs
earned in local currencies need to be converted out of foreign currency reserves, then the government
into foreign currency amounts needed by offshore may forbid either the conversion of local currency
investors/lenders, and then need to be transferred amounts to foreign currency, or the transmission of
outside the country to pay for them. Additionally, these amounts abroad  The support agreement
foreign currency may be needed to import may become invalid
materials, equipment, etc. •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

Sovereign risks:
Risk Solution

•Hyperinflation risk: Relative changes in the price •Indexing the output price (in the long term sales
of inputs and output may adversely affect the contract) against the CPI and or industry price indices
project in the host country where the relevant costs are
incurred (Indexing means increasing over time against
agreed, published economic indices)

•Expropriation: Direct, diversion, creeping •Government guarantees or regulatory undertakings
•Government’s breach of contract and court to cover taxes, royalites, prices, monopolies, etc.
decisions •Involvement of multilateral/bilateral agencies
•Offshore accounts for proceeds
•Government’s equity ownership
•Using external law or jurisdiction

•Legal system: •Government support agreement
–Unclear and/or inconsistent legal/regulatory •Using external law or jurisdiction
framework for project’s operations
•Involvement of multilateral/bilateral agencies
–Insufficient protection of private investment and
private ownership/control of project •A general principle is that the party who is paying for
–Bureaucratic hurdles the output under a project contract should pay for the
–Changes in law, such as imposition of new losses incurred due to changes in law specific to the
environmental/health/safety requirements, price industry, because such change is reflected in the
controls, import duties/controls, increase in taxes, entire industry and any extra costs will normally be
royalties, deregulation, amendment or withdrawal of passed on to end users; therefore an offtaker who
project’s permits, changing the control of company does not bear this risk would earn extra profits at the
expense of the project company

Sovereign risks:
Risk Solution

•Political risks: Likelihood of occurrence of •Political risk insurance
political events like wars, labor strikes, terrorism, •Involvement of multilateral agencies (WB/IFC)
etc. (structuring legal/financial documents, mediation in
negotiations, sovereign deterrence, “halo effect”)
•Bilateral agencies: Export credits from ECAs (who
provide PRI)
•The private insurance market
•Contractual sharing of political risks between
sponsors and lenders

Financial risks:
Risk Solution

•Default risk: •Ensure sufficient debt service coverage
•Decrease debt/equity ratio
•Match term of loan to productive life of assets
•Match repayment schedule to expected cash flows
•Bonds with interest rates indexed to product sales
price
•Match currency of loans to currency of revenues

•Interest rate risk: •Interest rate swaps and hedging
•Interest rate caps

Value creation by governance structure:

– Tighter covenants limit managerial discretion and enforces
greater discipline via better monitoring
– High leverage reduces free cash flow exposed to discretion
– High leverage reduces expropriation risk
– High leverage also reduces accounting profits thereby
reducing the potential of local opposition to the company
– Tax shields

2. How Does It Create Value?
mitigation
• Structuring the project contracts to allocate risk, return,
and control
• Costs and benefits of debt-based governance

Case examples to value creation
Australia-Japan Cable – Structuring a Project Company:
Background:
The project included a 12,500 km submarine telecommunications system
between Australia and Japan via Guam at a cost of $ 520M. The project
would use Telstra’s two landing stations at Australia. In Japan, it needed to
either obtain permit from the government for building new stations, or
contract or partner with other companies to obtain access to the existing
ones. Japanese Government seemed not likely to approve building of a new
landing station. Most significant risks were market and completion risks.

The lead sponsor, Telstra, has to structure the project company, selecting
an ownership, financial, and governance structure.


Issues:

1. Selection of strategic sponsors who would bring the most value to the
project
2. Mitigation of market risk: Growing demand and capacity shortfall that
triggers competition, rapid improvements in cable technology and resulting
price decline necessitates moving very quickly
3. Completion risk: Potential delays due to environmental approvals and
other permits
4. Management of possible agency conflicts between:
1. sponsors and management
2. sponsors and other parties (capacity buyers (purchasers), suppliers,
etc.)
3. sponsors and creditors - decision of how many and which banks to
invite to participate

How project structure may help:
1. Telstra partnered with Japan Telecom (who would bring its landing station
in Japan and was interested in buying capacity) and Teleglobe (a major
carrier who would bring significant volume) as sponsors (reducing cash
flow variability)

2. Other equity investors to be selected would be high rated sponsors who
were also capacity buyers. They would be made to sign presale capacity
agreements ( reducing variability).

3. Capacity agreements with high rated sponsors would also be
instrumental in raising debt with favorable conditions

4. Contemplated on concentrated equity ownership to maintain more
effective management and monitoring

5. As for an interim management team, sponsors would also be made equal
partners in control, regardless of individual ownership shares

6. A permanent management team was discussed, that would work
exclusively for the project:
• Management compensation package was easier to craft, since it was
a single purpose company with limited and well-defined growth
opportunities
• Single cash flow easier to monitor

7. Decided on high leverage and project finance structure to help:
• limit the amount of equity they needed to invest to an acceptable size
• share the project risk with debt holders
• enforce management discipline by reduced free cash flow and
contractual agreements

8. Bank debt with a small banking group was preferred rather than project
bonds to have flexibility
• The initial tranche of bank debt would be secured and repaid in 5
years with presale commitments
• The second tranche would also be repaid in 5 years, but from future
sales, acting as “trip wires” for the management team

Calpine Corporation
Background:
Calpine, a small power generator with high leverage (~80%), sub-
investment grade rating, and little debt capacity, has to decide how to
finance its aggressive growth strategy, facing increasing pressure for
speed, efficiency, and flexibility in a soon-to-be competitive commodity
market.
The growth strategy includes building and operating a “power system”
consisting of multiple power plants. Project financing and corporate
financing alternatives are considered.


Issues:

1. Speed was very important to gain first mover advantage

2. Necessity to be a low-cost producer in a commodity market

3. Operating a system of power plants to gain scale economies and also
the flexibility to switch between the plants to offer uninterrupted
service

Issues:
4. Using corporate finance as the financing method:
• Benefits:
– Issuing high yield bonds would not require collateral and reduce
legal fees
– Bonds would leave Calpine free to switch between plants in the
power system
• Costs:
– The high-yield market was thinner and more volatile compared to
investment grade market, creating pricing and availability risk
– As a firm with high leverage and sub-investment grade rating, the
high cost of corporate financing might lead Calpine to miss the
opportunity to invest in a positive NPV growth project (Debt
Overhang)
– A large debt issue might further jeopardize Calpine’s debt rating

Issues:

5. Using project finance as the financing method:

• Benefits:
– Opportunity to finance the growth strategy even if Calpine had low
investment ratings and limited debt capacity

• Costs:
– Time consuming and expensive to set-up and execute individual
deals
– Limited size and absorption capacity of the project finance market
– Possible restrictions to flexibly switch between the plants in the
power system if each plant would be collateralized separately


A hybrid structure was crafted that combined elements of both project
and corporate finance:
1. Project Finance:
i. Calpine project financed a portfolio of plants rather than a single
plant. This reduced legal and other fees, transaction costs, and
saved time.
ii. Project finance allowed raising a large amount of debt on a non-
recourse basis, which was impossible at the parent level

1. Corporate Finance:
i. The structure gave Calpine flexibility to build the plants using equity,
and manage them flexibly as part of a power system (which would
be impossible with separately project financing the individual plants)

BP Amoco
Background:
A large and well-capitalized company, BP Amoco tries to decide on the
best way to finance its share in the $8 billion development project of
Caspian oil fields, undertaken by a consortium of 11 companies.
Each of the partners had a choice in how to finance its share of the total
investment. Of these companies, 5 formed a Mutual Interest Group
(MIG) to obtain project loan with assistance of IFC and EBRD. The
alternatives BP Amoco considered for its share were corporate
financing, project financing, or a hybrid structure.


Issues:

1. Project Risks: The project had considerable political, financial, industrial
(price and reserve volatility), and transportation related risks largely due
to the unique region it was located.

2. Risk management: Protection of BP Amoco’s balance sheet from risk
contamination or distress costs from investing in a risky asset

3. Involvement of multilateral organizations: Increased capacity to raise
capital


Using corporate finance as the financing method:
• Benefits:
– Financially strong enough to support a corporate funding strategy
with favorable terms
– Easier to set up and less costly
• Costs:
– Project might create additional risks in BP Amoco’s current asset
portfolio  Risk contamination
– BP Amoco’s absence in the IFC/EBRD finance deal for the MIG
would make it harder for the weaker partners to negotiate good
terms, reducing flexibility in operations and management
– BP Amoco’s using corporate funding while at least some of the other
partners’ using the IF/EBRD deal might potentially create
disagreements
– Other partners might accuse BP Amoco as free rider, since BP
Amoco would benefit at no cost from the political risk protection
IFC/EBRD deal would have provided
– How they funded the initial phase would change possibilities of
financing for the coming stages


Using project finance as the financing method:
• Benefits:
– Reducing project’s potential negative impact on the balance sheet:
The project was very large and posed too many risks which BP
Amoco could not bear alone, meaning a potentially huge negative
impact on the balance sheet if financed solely by internal funding
– More protection from the many project risks due to risk sharing
– Accommodating the financially weaker partners in the consortium to
negotiate better deals with creditors for the sake of future managerial
and operational flexibility
– Benefiting from IFC/EBRD’s existence to shield from possible
conflicts with the host governments
• Costs:
– Harder, costlier, and more time consuming to set up
– Less flexibility compared to corporate finance alternative

Project Valuation

• Background
• Approaches to calculating the Cost of
Capital in Emerging Markets
• Country Risk Rating Model (Erb, Harvey and
Viskanta)

Background
• Projects are characterized by:
– unique risks
– high and rapidly changing leverage
– imbedded flexibility to respond to changing conditions (real options)
– changing tax rates
– early, certain and large negative cash flows followed by uncertain positive cash flows

• Traditional DCF method is inaccurate:
– Single discount rate does not account for changing leverage
– Ignores imbedded options
– Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor

• Traditional CAPM method is inaccurate:
– Many mega projects are in emerging markets
– Many of these markets do not have mature equity markets. It is very difficult to estimate
Beta with the World portfolio.
– The Beta with the World portfolio is not indicative of the sovereign risk of the country
(asymmetric downside risks). E.g. Pakistan has a beta of 0.
– Most assumptions of CAPM fail in this environment

• More appropriate approaches to project valuation may include:
– Usage of non CAPM based discount rates especially for emerging markets investments
– Changing discount rate to account for changing leverage
– Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate
– Valuation of real options
– Usage of Monte Carlo simulation

Approaches to calculating the Cost of Capital
in Emerging Markets

• World CAPM or Multifactor Model (Sharpe-Ross)
• Segmented/Integrated (Bekaert-Harvey)
• Bayesian (Ibbotson Associates)
• CAPM with Skewness (Harvey-Siddique)
• Goldman-integrated sovereign yield spread model
• Goldman-segmented
• Goldman-EHV hybrid
• CSFB volatility ratio model
• CSFB-EHV hybrid
• Damodaran

Approaches to calculating the Cost of Capital
in Emerging Markets
Many of these methods suffer problems because:

– Method does not incorporate all risks in the project
– Assume that the only risk is variance, and fails to capture
asymmetric downside risks
– Assume markets are integrated and efficient
– Arbitrary adjustments which either over or underestimate risk
– Confusing bond and equity risk premia.

The Country Risk Rating Model

• Erb, Harvey and Viskanta (1995)
• Country credit rating a good ex ante measure of future
risk:
– Some of the factors that influence a country credit rating are:
• political and other expropriation risk,
• inflation, exchange‑rate volatility and controls,
• the nation's industrial portfolio, its economic viability, and its
sensitivity to global economic shocks
– The credit rating may proxy for many of these fundamental
risks as it is survey based
• Impressive fit to data
• Explains developed and emerging markets


Returns and Institutional Investor Country Credit
Ratings from 1990
0.5
0.4
Average returns

2
0.3 R = 0.2976
0.2
0.1
0
-0.1 0 20 40 60 80 100

Rating

• Cost of Capital = risk free + intercept – (slope x Log(IICCR))
– Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating
– Gives the cost of capital of an average project in the country in $).
• If cash flows are in local currency, convert into $US:
– Calculate the difference between the multiyear forecasts of inflation in the host country and
those in US
– Use the difference to map out the expected exchange rates
– Use calculated expected exchange rates to convert cash flows into $
• Adjust for industry risk:
– Calculate the country risk premium from ICCRC:
Country risk premium =
Country cost of equity capital – US cost of equity capital
– Calculate US industry cost of capital by using industry beta
– Add the country risk premium to US industry cost of capital
• Adjust for project specific risks that deviate the project from the average level of risk in the
host country
– Risks incorporated in cash flows or industry adjustment:
• Pre-completion: technology, resource, completion.
• Post-completion: market, supply/input, throughput.
– Risks incorporated in discount rate:
• Sovereign risk: macroeconomic, legal, political, force majeure.
• Financial risk.

OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project Valuation
4. Case analyses
5. Recap

Case analyses
• Chad-Cameroon Petroleum Development
and Pipeline Project

• Petrozuata and Oil Field Development
Project

• Financing the Mozal Project

Chad-Cameroon Petroleum
Development and Pipeline Project

• Background
• Corporate finance vs. project finance
– Why is there a difference between financing of field and export
systems?
• The role of World Bank
• Assessment of project risks and returns
• Real options
• Project update

Background

• ExxonMobil, Chevron, and Petronas undertake a $4 Billion
petroleum development and pipeline project in Chad, which
presented a unique opportunity to stimulate Chad’s economic
development, and yet entailed environmental and social risks.
• Corporate finance for the development of the field system and
project finance for the pipelines
• Debate on unstable political structure and how Chad would use its
share of project revenues
• WB’s introduction of “Revenue Management Plan” to target Chad
Government’s returns from the project for developmental purposes,
and debate on the likelihood of effectiveness of such a plan

Corporate financing for the field system:
– The lead sponsor, ExxonMobil had AAA debt rating, very strong balance
sheet ($145M assets) and $16M cash flow  Could afford the field
investment in a less costly way relative to project financing
– ExxonMobil was actually a huge portfolio of upstream businesses
(exploration, development, production of crude oil and natural gas),
downstream businesses (transportation, marketing, and sales), as well
as chemical byproducts and operations in mining. With less than perfect
correlation among its assets, ExxonMobil might actually have been able
to eliminate the idiosyncratic risks via adding a field development project
to its portfolio. Corporate financing as opposed to project financing
helped ExxonMobil keep the project as part of its portfolio and reduce
the risks.
– Besides, the vertically integrated business model made it a naturally
cost-efficient choice for ExxonMobil to hold the assets collectively with
corporate financing rather than individually with project financing
– Corporate financing probably also enabled managerial flexibility and
discretion over the use of oil wells, drilling equipment, etc. that constitute
the field system

Corporate financing for the field system:
– Field development was the less risky part of the entire project for the
sponsors, because upstream operations including field development
and production was one of the core business areas where they were
very strong at. This reduced the cost of bearing these risks themselves
since they were better equipped than anyone else.
– Project financing for a field development project would also not be a
viable financing option, as the lenders generally would be reluctant to
finance until after all reserves are proven and capable of production.
– The crude oil prices for the last 18 months ranged from $9 to $42,
averaging $20 per barrel, which, even after discounted for the lower
grade, was considerably higher than the project’s $5.20 exploration and
development costs. With a total proven plus probable reserves of 917M
barrels, downside exposure to price and resource risk was already
mostly eliminated  No serious need to protect from the downside risk
(via risk sharing )with project finance and incurring higher interest rates
and loan fees.
– Corporate financing probably also helped save both the costly delays at
the development stage of the project and the structuring costs, which
would be incurred in project financing

Project financing for the export system:
– Export system was the riskiest part of the project. Project financing for
the export system mainly enabled the sponsors to spread the political
risks as much as possible via the presence of outside lenders such as
WB, IFC, ECAs.
– The expectation was that the Chad and Cameroon Gov’ts would be less
likely to take or tolerate adverse actions against the project in fear of
jeopardizing future funding from the WB and other international
financing institutions who were lenders of last resort
– Additionally, it facilitated alignment of Gov’ts interests with the project
through equity ownership, which would not have been possible
otherwise as Gov’ts could not afford on their own
– Project financing also created the opportunity for the pipeline companies
(JV between Gov’ts and the sponsors) to issue limited-recourse debt,
guaranteed by the sponsors through completion
– Project financing enabled external monitoring from the lenders
– ExxonMobil also reduced total investment commitment to the project
under the corporate/project finance structure, compared to that under a
complete corporate finance structure

The role of World Bank:
– WB involvement assured sponsors the much needed protection against the
political risk
– Besides direct investment through A loans, it mobilized other funding sources like
ECA and other banks through a syndicated B loan
– WB’s extensive lending and policy experience with Chad offered the leverage
that sponsors did not have
– The project with potentially high returns and developmental impact for Chad was
also aligned with WB’s policy objectives
– WB facilitated extensive consultation process including supporters and
opponents: The process helped sponsors’ restructuring the project to minimize
the social and environmental impact (such as increasing the benefits to
indigenous people and changing the pipeline route to protect the natural habitat)
– WB also initiated a “Revenue Management Plan” to help prevent probable
misuse of Chad’s revenues by the Gov’t, and target them for developmental
purposes to increase welfare
– Insisted on an open and transparent project planning process
– Established capacity building programs to develop the infrastructure for a well-
functioning petroleum industry and investment climate in both Chad and
Cameroon

The role of World Bank:
– WB involvement also ensured that sponsors did not abandon the
project due to huge political risks and looked instead for safer
opportunities in other countries, leading to a missed opportunity
for Chad
– Without the WB, the Gov’t might turn to neighboring countries
such as Sudan and Libya for partnering in oil export. This
potentially would have adverse consequences in case the
project revenues were utilized to finance non-developmental
purposes such as war.
• Such an alternative would mean longer and hence more expensive
pipelines
• The project’s exposure to social risks would increase, as the
pipelines would inevitably cross the northern part of the country with
social unrest and upheavals.

Subjects of opposition:
– The environmental and social impacts were claimed to be irreversible
– The revenue management plan was claimed to be flawed and to lack
effective oversight
• Gov’t claimed to “have little intention of allowing the plan to affect
local practice”
• Criticism on oversight committee’s composition and power
• The RMP was a concept untested
– According to Harvard Law School, “Oil will not lead to development in
Chad without real participation, real transparency, and real oversight,
none of which currently exists”
– The revenue management plan also regarded as “infringement of
sovereign rights”
• The sovereign rights controlled by undemocratic rulers versus
people
– The beneficiaries of the project were claimed more to be the corporate
sponsors and commercial banks, as opposed to people of Chad
– Valuable funds could have been used in alternative causes, rather than
potentially strengthening a corrupt Gov’t

Assessment of Project Risks and Returns:
Chad
– Benefits:
• Project provides an important opportunity for Chad to reduce poverty, though
contingent on Gov’t commitment
– Receive up to $125M per year from the project, increasing Gov’t revenues by more than 50%
– Chad has few other alternatives if any for development
• RMP provisions and future linking of developmental funds to Gov’t compliance may
deter potential misuse of project revenues by the Gov’t
• Project helps leveraging WB and other financial resources which Gov’t could not have
mobilized by itself
• Leveraging technical expertise of the reputable sponsors significantly reduces Chad’s
exposure to operational risks
• Potential employment opportunities created for local people in operations
• Environmental/social concerns seem to be well addressed in contingency plans with
extensive public consultation
• Another positive externality may be WB’s capacity building efforts to establish the
sufficient infrastructure for a well-functioning petroleum industry and investment climate
in Chad
• Greatest protection from downside risk (i.e. price or volume risk) compared to
corporate sponsors, probably because bulk of the revenues (royalties) independent
from price or reserve levels.

Chad
– Risks:
• The realization of the opportunity for economic development strictly
dependent on Government’s commitment in implementation of RMP
– RMP is claimed to lack credible oversight and enforcement
mechanisms, which would work against the people of Chad due to
undemocratic and oppressive Gov’t in power
– RMP was a concept yet to be tested with the project; even WB admitted
the project to be an “experiment”, which increases people’s exposure to
risk
• Chad has to put its only natural resource into the project under project
finance structure and RMP, which considerably eliminates sovereign
discretion and flexibility
– Impositions on the allocation of revenues may turn out to be
constraining for a future democratic government who wants to
implement other projects to the benefit of people of Chad
– Government’s compliance to RMP is a requirement for future WB loans,
which extends the potential influence of the project-specific impositions
and commitments to non-project specific areas, increasing Chad’s
exposure to risks

Chad
– Risks:
• Even if the project generates promised revenues for Chad, Chad might not
gain on an incremental basis, as it will no longer be eligible to certain types
of developmental funding due to increased revenues
– Current aid is around $188M (Exhibits 7 and 8), which exceeds the
expected cash flow. Chad might not gain on an incremental basis due
to displacement of existing aid, and yet lose control on its single natural
resource
• Environmental and social risks mostly remain with Chad
– Some adverse impacts are either irreversible or extremely hard to fix
– Despite contingency plans, there may be leakages in the pipeline that
would go unnoticed for long time, due to limitations of even the most
advanced technologies
• Less share of the gains in the upside (though balanced with the highest
protection from downside risks)
• Although expected to be a highest priority issue from Chad’s perspective,
the timing of cash flows were not negotiated to the advantage of Chad
– Considering the urgent need for funds, the allocation of cash flows
should have favored Chad more in the initial years
– Compared to the timing of cash allocations for other sponsors, the late
allocation might be perceived as unfair and might increase the chances
of expropriation

Sponsors (Exxon Mobil)
– Benefits:
• The presence of WB/ECA/IFC along with participation on
governments in equity financing significantly reduced political risk
exposure
• Project might have helped portfolio diversification
• Low construction risks (sponsors’ expertise and reputation in the
industry)
• Low operating risks (positive NPV under most scenarios in Exhibit 5
with different price and reserve levels)
• Low financial risks, considering the DSCR (as high as 2:1) and low
breakeven finding and development costs compared to price
• The presence of WB/ECA/IFC in the deal, alignment of Gov’t
interests via equity ownership through project finance structure, the
linking of installment of future development funds to Government’s
compliance to the RMP significantly reduced political risk exposure.
However, 

Sponsors (Exxon Mobil)
– Risks:
• Back-loaded cash flows to Gov’t may be perceived as unfair
and may result in expropriation
– Still chances are low, as Gov’t would not probably want to
jeopardize future capital inflows by risking its relations with WB
and the rest of the financial community
– The Gov’t would not want to forego serious amount of revenues
in the form of dividends, taxes, royalties.
• Any social or political instability in either Chad or Cameroon
would adversely effect the export of oil through the pipelines
across the two countries
– However, the construction of pipelines underground may have
helped reduce the negative consequences of being exposed to
such risk

Real options

• Shadow costs: In case WB is not involved in the
project, it is likely that the Gov’t will go with Libya
• Temporary stop option if oil price drops

Project Update
• After WB approved the deal, President Deby used part of the proceeds to
buy weapons
• Huge criticism by social activists/interest groups against WB and sponsors
• WB responded by requiring that the proceeds should be repaid out of
general revenues, suspended new loan programs, and also set up a new
oversight body headed by external people
• After these reforms, WB and IMF permitted debt relief to Chad

• In December 2005, the National Assembly of Chad amended the country’s
Petroleum Revenue Management Law in the following ways*:
• “broadening the definition of priority sectors to include, among other areas,
territorial administration and security; and by allowing that further changes in
the definition of priority sectors can be made by decree”;
• “eliminating the Future Generations Fund, thus allowing the transfer of more
than US$36 million already accumulated there to the general budget “
• “increasing from 13.5 % to 30% the share of royalties and dividends that can
be allocated to non-priority sectors that are not subject to oversight and
control”

* Chad-Cameroon Pipeline Project, World Bank Web Site

Project Update
• WB considered these changes a breach of contract, and on January, 2006,
it suspended new loans and grants to Chad, as well as disbursements under
eight ongoing IDA operations in the country.

• The suspension automatically freezed the flow of part of Chad’s oil revenues
within the offshore escrow account

• WB states in its web site that it “remains in dialogue with the Chadian
authorities, and is determined to safeguard the oil revenues intended for
poverty reduction programs included in its original agreement with Chad,
while recognizing the fiscal strains currently experienced by the government
of Chad”.

Petrozuata and Oil Field Development Project

• Background
• Why use project finance?
• Risk management
– Pre-completion risks
– Post-completion risks
– Sovereign risks
– Financial risks
• Real options
• Cost of capital calculation
• Project update

Background

• Petrozuata is a $2.4B integrated oil field development project in Venezuela.
The project is planned to be financed under project financing structure. The
project sponsors Conoco and Maraven are subsidiaries of Du Pont and
PDVSA, a Venezuelan state owned enterprise. The sponsors decide on
60% debt financing, and seek for alternative ways to raise the required
funds. The alternatives considered are project bonds, securing of which are
contingent on securing investment-grade rating for the project; or bank
loans, which may need to be covered by PRI provided by multilateral
agencies.

The priority and challenge for the sponsors is to craft the project’s
operational and financial details so as for the project to achieve an
investment grade rating.

Why use Project Finance?

• Strategic reasons in the long run: $2.4B Petrozuata will be the first in a
series of projects planned which total as high as $65 B.

– PDVSA needs to preserve debt capacity for future funding needs.
– Success in this project will be a proof of concept for the rest.
– Project finance structure provides PDVSA a wider capital access

• Debt financing for PDVSA more expensive under corporate finance
structure:

– PDVSA has low credit rating (long-term senior unsecured debt rating B from
S&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b)
– Under project financing, if the project can secure BBB investment grade rating,
lower cost of debt ~ 7.70%
– A gain of 2.47%
– However, huge transaction and contracting costs as well as the longer time
needed to structure a project financed deal should be weighed against the
potentially lower cost of debt to see if there is a net gain in terms of costs


• Positive-sum as opposed to a zero-sum deal for PDVSA and Venezuela:

– Cost focus would be a zero sum perspective for both PDVSA and Conoco (one
party gains and the other loses)
– Involvement of experienced Conoco and Du Pont in the deal may help increase
the aggregate net cash flows to the project, due to efficiency gains as well as risk
sharing/allocation benefits (positive-sum perspective)

• Massive tax benefits

– Under project finance, the project is subject to significantly lower income tax rates (34% as
opposed to 67.7%) and royalties.

• Avoidance of possible risk contamination

– But losing the benefit of co-insurance which would come with corporate financing


• Resolving possible agency conflicts

– High leverage and dedicated cash flows via the “cash waterfall” structure helps
prevent opportunities for risk shifting, underinvestment, or cross-subsidization of
negative NPV projects

• From lenders’ perspective, separated cash flows also allow easier
monitoring and possibly lower monitoring costs

• Project finance allows better allocation or sharing of risks via contractual
relationships, thereby reducing the cost of risk

Risk management

• Identification and mitigation of:

• Pre-completion risks: Resource, technological, timing, and
completion risks
• Post-completion risks: Market risk, supply risk, throughput risk,
and force majeure
• Sovereign risks: Inflation risk, exchange rate volatility
convertibility risk, expropriation
• Financial risks: Leverage risk under the constraint of investment
grade rating

Pre-completion risks and mitigation
• Resource Risk: Quantity and quality of the crude oil

+ Petrozuata being a development and not an exploration project:
• An independent evaluation found that the field contain 21.5
barrels of oil. Assuming production level of 120,000 BPCD
and 35 years project life, 7% of these reserves is sufficient to
sustain the project
+ Variability in the available crude oil’s quality was not deemed to
be significant to reduce the efficiency of upgraders
+ Additional value creation for Conoco from corporate perspective:
• In addition to being an equity holder in the project, Conoco
would also benefit from low-cost reserves and long-run
supply of crude oil the project would provide (with off-take
contracts) for its refinery business

• Technological risk: How proven is the technology used? How experienced
are the contractors to handle technological risks? The ability to handle such
risks are important to prevent likely cost overruns or construction delays

+ Conoco had sufficient project experience and technological knowhow
with its proven production and refining technology
+ Maraven also had significant production technology and experience
- The pipelines would run 125 miles between the oil fields and the coast,
increasing risk exposure
+ The terrain between the oil fields and the coast was relatively flat
and sparsely populated, which would ease pipeline construction
+ Most of the pipelines would be laid underground
+ The well drilling technology to be used had been an established one,
used in both the Oronoco belt and all around the world
+ EPC contracts for the downstream facilities and pipelines were planned
to put out to bid to a consortia of leading international contractors
+ Contracts for upstream constructions were planned for experienced and
authorized Venezuelan companies

• Timing and completion risk: Failure to meet the intermediate milestones
in a complex project may jeopardize the timely completion of the entire
project as well as increasing costs

– The project is a complex one consisting of multiple components including field
facilities, pipeline system, and the upgrader facilities
– Sponsors dependent on proceeds from selling the early production oil to fund
part of the construction
– Failure to meet completion criteria would make all non-recourse debt due and
payable
+ Both Conoco and Maraven had significant project experience to handle the
execution complexities
+ An independent evaluator assessed their execution plan and concluded that the
milestones are aggressive but within reach, and that the plan complies with local
and international regulations and standards (a factor that would help mitigate
likely regulative delays)
+ Both sponsors made commitments (such as contingency funding for unexpected
cost overruns) guaranteed by parent companies to ensure successful completion
of the project

Post-completion risks and mitigation
• Market risk: Uncertainty regarding the future price and demand for the
output

– The price of oil is volatile
+ The off-take agreement with Conoco secures a significant portion of
the output to be purchased for 35 years at a price pegged to market
price of Maya crude
+ Petrozuata being a low cost producer with breakeven price well
below industry average could still operate even if prices fell
dramatically
– Currently there is no broader market developed for syncrude
+ However, in expectation of the development of such a market in the
near future, Petrozueta retained the option to sell the syncrude to
third parties if they demand at a higher price than Maya crude.
+ According to an independently conducted assessment, the
development of a third party market was expected in 3-5 years, and
that the syncrude output would sell at a $1/barrel premium.

• Supply risk: Uncertainty regarding the availability of the input
supplies throughout the life of the project

+ The project will be self sufficient in terms of electricity, gas,
and water after completion.
+ During construction, the supplies such as water, electricity,
hydrogen supply and diluent supply will all be contracted to
firms owned by the Venezuelan Gov’t

• Operating cost risk: Uncertainty regarding the changes in the
operating cost throughout the life of the project

+ An independent consultant assessed the project and
concluded that the cost estimates are reasonable
considering industry standards

Sovereign risks and mitigation
• Exchange rate risk: Uncertainty regarding the changes in the
exchange rate throughout the life of the project

– Free floating of the Bolivar against $ may result in appreciation
of the currency, leading to increased local costs and tax liabilities
+ Conversely, a likely depreciation of the Bolivar would increase
the revenues (in $) against the local operating expenses (in
Bolivar) in relative terms.
+ No strong signal inferred from the case as to either of the
directions
+ No significant risk as both revenues and debt service were
denominated in $

• Inflation risk: Relative changes in the price of inputs and output
may adversely affect the project
- Serious inflation levels that reached 100% in 1996

• Expropriation risk: Sovereign risk in the form of government’s direct seizing of
project assets, project cash flows (diversion), or changing tax policy (creeping)

- Risk of Government’s changing the currently preferential tax and royalty
treatment
- Possible negative influence of Gov’t on the effective functioning of offshore
proceeds account
- History of nationalization in the 1970s
+ Gov’t cannot afford to risk the future funding opportunities for the planned series
of upcoming projects by getting involved in any form of expropriation
+ The Gov’t owns a serious portion of the assets anyway (PDVSA and Maraven as
sponsors)
+ Any expropriation attempt may face a retaliation from US where PDVSA has
assets (CITGO)
+ Gov’t interests aligned with the project’s success, as Gov’t receives tax and
royalty payments, as well as benefits of employment opportunities created and
access to the refining technology
+ Project output syncrude has a narrow market limiting Government’s motivation
for a diversion attempt

• Force Majeure risk: Likelihood of occurrence of political events like
wars, labor strikes, terrorism, or nonpolitical events such as
earthquakes, etc.

– Venezuela’s historic political and economic instability
– Oil facilities are generally targets of terrorism due to their
significance in economy
– Project’s agreements were defined to be invalid in case of force
majeure events
+ The pipelines will be constructed underground, and in a sparsely
populated area

Financial risks and mitigation
• Leverage risk: Balancing the incentive to maximize the equity
returns (via leverage) against the likelihood of default and failure to
get an investment grade rating
+ The target leverage of 60% turns out to be just right to allow for
a minimum DSCR of about 2.08X (in year 2008), which exceeds
the minimum acceptable ratio of 1.80X allowed for an investment
grade rating
+ More equity commitment actually signals that sponsors perceive
the project as right

Real Options – value of flexibility

• Option to delay the project
• Option to increase the production
• Option to sell the excess capacity to future projects in
the area
• Option to abandon the project, since the project consists
of several stages

Cost of capital calculation*
Project Risk Mitigation
(-10 to 10; where 10=risk completely eliminated, 0=average for country)
Impact on
Country
Weights Score Premium
Sovereign
0.40 9.00 -6.64 Currency (convertibility)
0.12 -5.00 1.11 Expropriation (direct, diversion, creeping)
0.04 9.00 -0.66 Commercial International partners
0.03 3.00 -0.17 Involvement of Multilateral Agencies
0.04 -3.00 0.22 Sensitivity of Project to wars, strikes, terrorism
0.04 0.00 0.00 Sensitivity of Project to natural disasters

Operating
0.05 0.00 0.00 Resource risk
0.03 0.00 0.00 Technology risk

Financial
0.03 3.00 -0.17 Probability of Default
0.03 2.00 -0.09 Political Risk Insurance

Real Options (some handled through cash flows)
0.05 8.00 -0.74 Project impacts other projects
0.05 5.00 -0.46 Option to delay the project
0.05 8.00 -0.74 Option to increase/decrease production
0.05 5.00 -0.46 Option to abandon the stages of the project

1.00 Sum of weights (make sure = 1.00)

*C. Harvey’s International Cost of Capital Calculator

Cost of capital calculation*

Cost of Capital Worksheet
Exhibit 11

Risk Premium Calculation
Inputs Output Category
5.60 U.S. risk free in %
Exhibit 9
7.00 U.S. risk premium in %
90.70 Current U.S. Credit Rating
32.00 Institutional Investor country credit rating (0-100)
31.04 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

18.44 Country Risk Premium
TN
Industry Adjustment
0.60 Beta (Industry)
-2.80 Sector adjustment

Project Cost of Capital 19.44

*C. Harvey’s International Cost of Capital Calculator

What happened?

• The project received ratings that exceeded the sovereign ratings by five
notches
• Completed a $1B bond issue, which was five times oversubscribed, and a
total of $450M bank financing (with 14 years maturity at 7.98%, 12 years
maturity at 7.86%)
• The project considered by analysts as “one of the best structured and best
executed project finance deals ever done”, 1997
• PDVSA continued to structure deals for the Orinoco Basin
• Venezuelan economy was hit hard by the decline in crude oil prices
• S&P revised its outlook for Petrozuata to negative, as a result of the cost
overruns, lower than expected early production revenues, falling prices, and
political uncertainty
• As economic situation worsened, Gov’t demanded and received
extraordinarily high dividends from PDVSA reaching up to 134% of
projected income in 1999
• Hugo Chavez won the 1998 elections and announced not to interfere with
foreign oil investments

Financing the Mozal Project

• Background
• Risk management
– Completion risks
– Operation risks
– Sovereign risks (Major risk group in this project and the reason
for project financing)
– Financial risks
– Real options
• The role of IFC
• Project update

Background

Mozal is a $1.4 B aluminum smelter project in Mozambique. The
sponsors are Alusaf, a subsidiary of a South African natural
resource company, and IDC, a government-owned South African
development bank with long-standing relationship with Alusaf.

The sponsors are interested in structuring a limited-recourse
financing deal with IFC involvement.

IFC’s concerns are the size of the project, as well as the political
risks of doing business in Mozambique.

Risk Management

• Identification and mitigation of:

• Pre-completion risks: Technological, timing, and completion risks
• Post-completion risks: Market risk, supply risk, and force
majeure
• Sovereign risks: Inflation risk, exchange rate volatility,
convertibility risk, expropriation
• Financial risks: Leverage risk


• Timing and completion risk:
– Mozambique has complex bureaucratic processes that may delay
getting the necessary permits to proceed with the construction
– The conditions of the basic infrastructure (like the insufficiency of
connecting roads, or dependability of electricity supply) may slow down
the construction efforts
– Sponsors dependent on cash generated during start-up for funding
$34M of the project
+ Sponsors had a proven track record with the Hillside project where they
were able to complete the project four months ahead of schedule and
21% under budget
+ The same contractors and construction team used in the completion of
the Hillside smelter would be called for the project.
+ Sponsors planned a $75M contingency budget for the construction
period


• Technological risk: How proven is the technology used? How experienced
are the contractors to handle technological risks? The ability to handle such
risks are important to prevent likely cost overruns or construction delays
+ Mozal would use proven, state-of-the art smelting technology (Pechiney
technology from France) that was used in the Hillside smelter
+ Both sponsors have significant experience in the smelting industry with
Hillside being their most recent undertaking
+ Alusaf was the subsidiary of the South Aftrican Gencor group, which
was the world’s fourth largest aluminum producer

• Market risk: Price of the output
– The sponsors planned to purchase all of the output subject to long-term
purchase agreements, but at market prices
– The market prices had been declining for the last couple of years, and
the trend was expected to continue due to the developing scrap market
+ Mozal would be a low cost producer in the industry (lowest 5% in terms
of cost) , having higher margins than other players to absorb potential
market price declines


Supply risk and operating costs: Availability, quality, and price of the
alumina, electricity, and labor
• Alumina accounted for 33% of production costs
+ The sponsors planned to link the price for alumina to LME aluminum
market prices
+ Alumina would be imported from a supplier of Alusaf’s affiliated
company Billiton under a 25 year supply contract
• Electricity accounted for 25% of production costs
+ The electricity price would also be a function of aluminum prices
+ Eskom and Mozambican Electric company would provide
inexpensive electricity under a 25 year contract whereby the price
will be fixed in the early years and then tied to aluminum prices
+ The majority of unskilled labor would come from Mozambique, decreasing
labor costs compared to industry averages
+ Other inputs would be supplied from the same contractors who supplied the
Hillside smelter under similar long-term contracts

Sovereign risks

Expropriation risks:
- Outright seizure of assets – very unlikely:
- The scale of the project relative to the size of the poor economy (9% of
GDP), combined with short-term survival concerns may be tempting for
a shortsighted Gov’t to expropriate
+ Gov’t wouldn't want to curb the investments, because they are
interested in development
+ Gov’t cannot afford an outright seizure, due to potential reactions from
WB/IFC, as this would jeopardize the much needed future development
funds
+ Following a direct seizure, international suppliers may not be willing to
work with the Gov’t, and Mozambique does not have local suppliers of
the raw materials to go on with the business alone

51432284 project-finance

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