In this article, we will be looking at the risks in project finance transactions.

As in any business venture, the project company in project finance faces 4 types of risks, these are project-specific risks, macroeconomic risks, political risks, and natural disaster risks.

And, it is an efficient and structured allocation of these risks to the parties that are most capable of managing them which makes the project finance possible.

Project Life Cycle

Let’s start with the project life cycle to better understand the project specific risks.

Risks in Project Finance

The first stage is project development when the project sponsors have to carry out technical and economic evaluations, obtain all the necessary permits, and acquire the land where the project will be built. This development stage takes anywhere from 3 to 10 years dependent on the country, industry, and project.

Next, is the stage when financing is closed and construction starts. At the construction stage, an EPC contractor designs the project, procures the necessary equipment and materials, and builds the project according to the specifications set by the project sponsors. This stage lasts anywhere from 1 to 5 years, dependent on how complex the project is.

Once the construction has been completed, and all the necessary tests have been carried out, the project enters the operations stage. At this stage, the O&M contractor takes over and is responsible for running the operations of the project.

And finally, once the project’s life is over, the project enters the decommissioning stage.

Based on the project life cycle, project-specific risks can be divided into risks that fall under the project’s pre-completion stage, and, post-completion risks.

Pre-Completion Risks

Pre-completion risks in project finance

We have already mentioned that at the development stage sponsors have to carry out numerous tasks to understand whether the project makes sense, to obtain the necessary permits from the government, and acquire the land. These tasks are costly as multiple consultants will be employed by the sponsors to carry out these tasks, and, at this stage, the sponsors do not yet know if the project will be able to raise necessary financing. So, the risk is entirely on project sponsors and it is their industry expertise and project finance transaction experience, which can really mitigate the risks at the development stage.

Next, when the project enters the construction stage, there are three major risks to the project – first is the delay risk – will the project be built on time?

If the project is delayed, the lenders will not be paid according to the agreed debt repayment schedule, the buyers will not be given the project’s output as per the agreed schedule, the suppliers to the project will not sell their product as per the agreed schedule, and, the list of problems will go on.

construction risk in project finance

Project finance is a highly structured transaction where each step or misstep may generate a multi-million dollar liability as per the project agreements. So, delay risk is an important risk that needs management and mitigation. This risk is dealt with in EPC contract, where EPC contractor will have to pay penalties to the project company for each day the project completion is delayed. These penalties are usually equivalent to the costs that the project company incurs including the cost of lost opportunities.Essentially, the losses that third parties such as lenders or suppliers make because of the project completion delay, are passed through to the EPC contractor.

Another important risk that a project faces at construction is completion risk – will the project be built on time? Again, this is dealt with in EPC contract whereby the EPC contractor provides a completion guarantee and this guarantee is typically backed by an independent bank.

Finally, the performance of the project once the construction is complete is a risk that EPC is responsible for. The project has to perform at least as good as specified in the EPC contract or better. In case the project’s performance is worse than the specifications set in the contract, the project will not be able to produce planned output and generate planned cash flows, which will negatively affect its ability to repay the debt and pay the dividends. Therefore, it is customary to have performance guarantees in the EPC contract. Any shortfalls in the performance will be penalized.

So, essentially, at the construction stage EPC contractor takes the risk under a turn-key EPC contract.

Post-Completion Risks

When construction is completed and the project enters operations, there are a number of operational risks.

post-completion risks in project finance

First is the revenue – is there a market for the project’s output? Will the market purchase the project’s output at the planned price? And, there are several ways to deal with the revenue risk. If the project has a few or only one buyer, the project typically enters into a take-or-pay contract with buyers, which means that the buyers must purchase a specified quantity of the project’s output and at the specified price in the contract. The buyer must purchase the output when it is delivered. This type of contract generates stable cash flows to the project company as there is no way the buyer can back out of such contracts.

If there are multiple buyers of the project’s output, for example in the case of toll road projects, the revenue risk can be mitigated through either government support whereby the government provides some minimum payments to the project to cover the project’s fixed costs and debt repayments in case revenue falls short of planned amount,or the revenue risk can be mitigated by in-depth and detailed market studies.

So, essentially, it is either government or sponsors and lenders that take the revenue risk, and, in the later case, the project may not be financeable. Such revenue uncertainty affects the project’s debt capacity and the cost of financing.

Next, is the risk of supply – that necessary amount of raw material will be supplied to the project at a specified price in the supply contract. This risk is managed through the “put-or-pay contracts” under which a party agrees to supply raw material for a certain price during a stated period, and agrees to pay for an alternative supply if it cannot perform. So, the suppliers take this risk.

And finally, it is operations – the O&M contractor responsible for the performance and maintenance of the facility, receives variable and fixed payments for its services which is agreed in the O&M contract. However, if the performance of the project is worse than that specified in the contract, penalties will be applied to the O&M contractors.

Macroeconomic and Political Risks

Now, let's review the macroeconomic and political risks. Macroeconomic risks such as inflation is generally a pass-through to the project off-taker. It is typical to include price escalation in the offtake and supply contracts, so the supply costs increase is according to the escalation formula and it is fully offset by price increases according to the price escalation formula in the off-take agreement.

macroeconomic and political risks in project finance

The exchange rate risk arises from the fact that financing costs are almost always in some kind of hard currency such as United States dollars but revenue is in local currency. If the local currency depreciates against the financing currency, the project company will not be able to repay the debt and equity returns. So, this risk needs to be managed.

Exchange rate risk can sometimes be hedged if the project is built in developed countries. However, if the hedging is not available, it is possible to quote the price of the product or service in a hard currency such as the United States dollar and thus avoid the exchange rate risk. Off-course, in the end, the off-taker takes the risk of the exchange rate.

Often, the exchange rate risk is taken by the government, which compensates the project company for any losses coming from the adverse exchange rate movements.

The political risks such as the risk of change of law or project expropriation risk are often taken by the host government and insurance may also be available from Export-Import Agencies, such as US EXIM Bank.

Risk Matrix

We have outlined the major risks in project finance and typical risk allocation. We can put everything together, and, analyze these risks using a risk matrix, which shows which party is taking the risk. A risk matrix is a convenient way to see that the risk is allocated to the party, which is most capable of managing it.

risk matrix in project finance

So, on top of our matrix, you can see the type of risk, for example, the construction risk or revenue risk, and on the left side of our matrix is the party to whom this risk has been allocated. You can see, for example, that construction risk is mostly taken by the EPC contractor, revenue risk is mostly taken by the off-taker, and so on.

In a perfect world, we would allocate each risk in the project to the party, which is most capable of handling it. This would allow a significant reduction of the financing cost of the project, which would eventually translate into a benefit for end-users of the product or service. However, in the real world, there are many shortcomings in risk analysis and risk allocation, which sometimes result in project failures.

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