Risk analysis and mitigation are crucial for project finance success. Most time is spent analyzing and mapping all possible risks during the project life. There are three strategies to mitigate risks: retain the risk, transfer it to counterparties through contracts, or purchase insurance. Construction poses industrial and planning risks if delays occur. Operational risks include reduced performance, supply issues, or lower-than-expected demand. Throughout the project, interest rate, currency, inflation, environmental, regulatory, political, legal, and credit risks must also be considered and addressed.

2.  Risk is a crucial factor in project finance since it is responsible
for unexpected changes in the ability of the project to repay
costs, debt service, and dividends to shareholders.
 Most of the time allocated to designing the deal before it is
financed is, in fact, dedicated to analyzing (or mapping) all
the possible risks the project could suffer during its life.
 There are three basic strategies the SPV can put in place to
mitigate the impact of a risk:
› 1. Retain the risk.
› 2. Transfer the risk by allocating it to one of the key
counterparties.
› 3. Transfer the risk to professional agents whose core
business is risk management (insurers).
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4.  The phase leading up to the start of operations involves
building the project facilities.
 This stage is characterized by a concentration of industrial
risks, for the most part.
 These risks should be very carefully assessed because they
emerge at the outset of the project, before the initiative
actually begins to generate positive cash flows.
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5.  Delays in completing one activity can have major
repercussions on subsequent activities.
 The risk is, in fact, that the structure on which the SPV
depends to generate cash flows during the operations phase
may not be available. This is known as planning risk.
 Additional effects of bad planning are possible repercussions
on the SPV’s other key contracts.
› Penalties paid to product purchaser
› Cancellation of contracts
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6.  In some sectors where project finance is applied,
construction works can require the use of technologies that
are innovative or not fully understood.
 In many cases, contractor opts the technology which is
made upstream by other sponsors.
 Technological risk arise in projects involving innovative
technologies that have not been adequately consolidated in
the past.
 It is very hard to imagine that a project finance venture
would be structured on the basis of completely unknown,
untested technology.
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7.  This risk arises when the project is not completed or delay in
construction.
 Forms of construction risk that may happen:
› Non completion or delayed completion due to force majeure
› Completion with cost overruns
› Delayed completion
› Completion with performance deficiency
 In a project finance transaction, construction risk is rarely
allotted to the SPV or its lenders.
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8.  The major risks in the post completion phase involve:
› Supply Risk
› Operational Risk or Performance Risk
› Market Risk
 These risks are as important as those faced by the project
during its pre completion phase since their occurrence can
cause a reduction of cash flows generated by the project
during its economic life.
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9.  Supply risk arises when the SPV is not able to obtain the
needed production input for operations or when input is
supplied in suboptimal quantity or quality as that needed for
the efficient utilization of the structure.
 It also arises when SPV finds input but at a higher price than
expected.
 The effects of supply risk are that the plant functions below
capacity, margins shrink and supplemental costs accrue due
to the need to tap additional sources for input.
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10.  The operating risk (or performance risk) arises when the plant
functions but technically underperforms in post completion
testing.
 The effect of performance risk is lower efficiency and, in the
end, unwelcome cost overruns.
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11.  Demand risk (or market risk) is the risk that revenue generated
by the SPV is less than anticipated.
 This difference can be due to unanticipated strategies put in
place by competitors, particularly if the product can be
easily substituted.
 The case of the strong competition following the construction
of the Eurotunnel by air carriers and ferry operators is a good
example of market risk due to cross elasticity between
alternative sources of the same transportation service.
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12.  Risks found in both the construction and operational phases
are those that might systematically arise during the life of the
project.
 Risks found in both the phases include:
› Interest rate risk
› Exchange rate risk
› Inflation risk
› Environmental risk
› Regulatory risk
› Political risk
› Legal risk
› Credit risk
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13.  In project finance ventures, there is always the risk of
fluctuations in interest rates.
 Sponsors and their advisors have to decide whether or not to
cover against this risk, a decision that is not exactly identical
throughout the life of the project.
 During the construction phase, the project does not generate
revenues. However, draw downs begin to produce interest
payable, the amount of which depends on the level of
interest rates during the years in which the project is under
construction.
 The risk the SPV runs is that unexpected peaks in the
benchmark rate to which the cost of financing is indexed can
cause an increase in the value of the investments such as to
drain project funds entirely.
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14.  The most difficult problem for the SPV’s sponsors is to select
the best strategy for covering floating-interest-rate loans
during the post completion phase of the venture.
 The key concept advisors focus on is self-protection of cash
flows, i.e., valuing whether cash flows from operations are
sustainable in the face of negative variations in the value of
the debt service.
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15.  This risk emerges when some financial flows from the project
are stated in a different currency than that of the SPV.
 This often occurs in international projects where costs and
revenues are computed in different currencies.
 The best risk coverage strategy is currency matching.
 Advisors of an SPV try to state as many flows as possible in the
home currency, avoiding any use of foreign currency.
 If this is not possible (usually because counterparties have
strong bargaining power), the following coverage instruments
provided by financial intermediaries must be used:
› Forward agreements for buying or selling
› Futures on exchange rates
› Options on exchange rates
› Currency swaps
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16.  Inflation risk arises when the cost dynamic is subject to a
sudden acceleration that cannot be transferred to a
corresponding increase in revenues.
 Both industrial and financial costs and revenues are
impacted by inflation risk.
 Inflation risk is even more difficult to deal with in the
framework of ventures in which the buyer is a public entity or
a service is offered for public use, such as with public
transportation.
 Fee readjustments that take the inflation dynamic into
account must be approved by means of administrative
measures.
 Delays in this process can create the conditions for
diseconomies in operations for periods of time that are not
always predictable.
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17.  To cover against this risk, a swap contract is drawn up
between a hedging bank and the SPV. This Consumer Price
Index swap (CPI swap) serves to mitigate the effect that a
drop in inflation would have on the capacity of nominal cash
flows to service the debt, in any given period.
 When a hedging contract is signed, the benchmark inflation
rate is quoted by the hedging bank for the entire tenor of the
loan (henceforth Fixed Swapped Index, or FSI).
 At every loan repayment date, the SPV can face three
alternative scenarios:
› CPIt < FSI: When this occurs, the inflation rate at t is less than the rate fixed when the
hedging contract was signed. The drop in the nominal value of cash flows and the
resulting emergence of inflation risk is counterbalanced by a corresponding
amount paid by the hedging bank to the SPV.
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18.  CPIt > FSI: Here the inflation rate at t is higher than the rate
fixed when the hedging contract was signed. The increase in
the nominal value of cash flows is counterbalanced by a
corresponding amount paid by the SPV to the hedging bank.
 CPIt = FSI: In this circumstance, the real and fixed rates of
inflation are exactly the same.
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19.  This risk has to do with any potential negative impact the
building project could have on the surrounding environment.
 Some of the factors which causes this risk are:
› Building or operating the plant can damage the surrounding
environment.
› Change in law can result in building variants and an increase in
investment costs.
› Public opposition to projects with major environmental impact
could lead the host government to reconsider government
support agreements with the SPV and may create difficult
operating conditions for the project.
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20.  There are various facets to regulatory risk; the most common
are the following.
› The permits needed to start the project are delayed or
cancelled.
› The basic concessions for the project are unexpectedly
renegotiated.
› The core concession for the project is revoked.
 Delays are usually caused by inefficiency in the public
administration or the complexity of bureaucratic procedures.
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21.  Political risk takes various forms, for instance, a lack of
government stability, which for some projects may be critical.
 Classification of Political risk:
› Investment risk
› Change-in- law risk
› Quasi – Political risk
 Investment risks relate to limitations on the convertibility or
transfer of currency abroad.
 Change – in –law risks include any modification in legislation
that can hinder project operations.
 Quasi – political risks includes all disputes and interpretations
regarding contracts already in place (breach of contracts)
that emerge from a political, regulatory, or commercial
background.
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22.  Political risks are especially important for lenders in project
finance ventures located in developing countries.
 These nations, in fact, have legal structures that are not well
defined, most have politically unstable governments, and
there is little experience of private capital investments in
strategic sectors.
 There are two ways to cover against these risks. The first is to
draw up an agreement with the government of the host
country stating that the government will create a favourable
(or at least non discriminatory) environment for the sponsors
and the SPV, which is called Government support
agreement.
 The second way to cover against political risks is through the
insurance market. Insurance policies are available offering
total or partial coverage against political risks.
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23.  Legal risk centers primarily on the project’s lenders, whose
lawyers analyze and manage this risk.
 Their job is to ascertain whether the commercial law of the
host country offers contract enforceability.
 Contract enforceability depends on:
› Degree of economic development of a country
› Country’s judicial tradition
› Institutional conditions
 In countries where the rule of law is grounded in civil law,
lenders find less protection than in nations where common
law is in force.
 Institutional conditions complicate matters, because they are
linked to factors such as corruption and the tendency toward
illicit behaviour, which can often turn a decision against
lenders.
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24.  This risk relates to the parties who enter into contracts with the
SPV for various intents and purposes.
 The creditworthiness of the contractor, the product buyer, the
input supplier, and the plant operator is carefully assessed by
lenders through an exhaustive due diligence process.
 The financial soundness of the counterparties (or respective
guarantors if the counterparties are actually SPVs) is essential
for financers.
 The significance of credit risk in project finance deals lies in
the nature of the venture itself: off-balance-sheet financing
with limited recourse to shareholders/sponsors and a very
high level of financial leverage. 24

25.  All risks are appropriately allocated to various players, lenders take
a comprehensive look at the network of contracts with the SPV.
 Complex situation arises when the project analyses run by the
banks reveal risks that were not initially addressed in the contracts.
1. Closing on the financing is postponed until the problems
in question are solved.
2. Problem solving is postponed until financial closing, as long as the credit
agreement includes provisions that oblige the parties to implement an
acceptable solution by a specified date.
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26.  The contractor guarantees the SPV the following:
1. The completion date
2. The cost of the works
3. Plant performance
 In addition to these guarantees, there may be coverage against
technological risk.
1. To ask independent technical advisors their opinion on the effectiveness of
the technology
2. To oblige the technology supplier to pay penalties either in one lump sum
or proportional to the patent value of the technology
3. To oblige the contractor to provide performance guarantees on the
technology that are incorporated in the construction contract (wrapping
or wraparound responsibility).
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27.  As far as guarantees on completion dates, when the pre-established
construction time is up, one of two possible situations can occur:
1. The plant meets minimum performance standards.
2. The plant does not meet minimum performance standards.
 If the plant meets the MPS but does not function at a 100%
performance level as defined in the contract, the contractor is
usually given two options:
1. To liquidate( Buydown Damage -difference in actual revenue as compared
to 100% yield).
2. To make good
 The contractor is not in breach of contract if plant completion is
delayed due to force majeure events.
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28. Contractor Guarantees on Project Completion Date and
Performance: How They Work
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29.  In addition, contractors always attempt to negotiate the following in
the construction contract:
1. Bonuses in their favor if the plant is completed ahead of schedule or if it
functions more efficiently than specified in the contract (for example, with
a lower level of input consumption)
2. Clauses that limit their responsibility for paying damages, up to a
maximum percentage of the turnkey price (guaranteed by a performance
bond that contractors post in deposit until construction is complete)
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30.  In these accords, the supplier sells the SPV preset volumes of input
at preagreed prices (again, adjusted according to predicted trends of
a given price index).
 If supply is lacking, normally the supplier is required to
compensate for the higher cost incurred by finding another source
of input.
 In this way, sales revenues and supply costs are synchronized.
 In cases where the input is not physically near the plant or the
structure in question, the sponsors also negotiate contracts for
transporting input from its production site to where it will actually
be utilized.
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31. How a Put-or-Pay Contract Works
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32.  Operating risk can be mitigated by the experience and the
reputation of the project operator. As far as O&M contracts are
concerned, two solutions are possible:
1. Fixed-price contract
2. Pass-through contract
 Lenders also request a step-in right, which is the option to remove
the original operator and substitute that company with another of
the lender’s choosing. This is one of the many direct agreements
made between banks and the different counterparties of the SPV
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