FINANCING INFRASTRUCTURE PROJECTS
Main Financing Mechanism for Infrastructure Projects
A number of financing mechanisms are available for infrastructure projects, and for public-private partnership (PPP) projects in particular.
Government Funding
The Government may choose to fund some or all of the capital investment in a project and look to the private sector to bring in expertise and efficiency. This is generally the case in a so-called Design-Build-Operate project where the operator is paid a lump sum for completed stages of construction and will then receive an operating fee to cover operation and maintenance of the project. Another example would be where the Government chooses to source out the civil works for the project through traditional procurement and then brings in a private operator to operate and maintain the facilities or provide the service.
Even where Governments prefer that financing is raised by the private sector, increasingly Governments are recognizing that there are some aspects of the project or some risks in a project that may be easier or more sensible for the Government to take.
Corporate or On-Balance Sheet Finance
The private operator may accept to finance some of the capital investment for the project and decide to fund the project through corporate financing – which would involve getting finance for the project based on the balance sheet of the private operator rather than the project itself. This is typically the mechanism used in lower value projects where the cost of the financing is not significant enough to warrant a project financing mechanism or where the operator is so large that it chooses to fund the project from its own balance sheet.
The benefit of corporate finance is that the cost of funding will be the cost of funding of the private operator itself and so it is typically lower than the cost of funding of project finance. It is also less complicated than project finance. However, there is an opportunity cost attached to corporate financing because the company will only be able to raise a limited level of finance against its equity (debt to equity ratio) and the more it invests in one project the less it will be available to fund or invest in other projects.
Project Finance
One of the most common, and often most efficient financing arrangements for PPP projects is “project financing”, also known as “limited recourse” or “non-recourse” financing. Project financing normally takes the form of limited recourse lending to a specially created project vehicle (special purpose vehicle or “SPV”) which has the right to carry out the construction and operation of the project. It is typically used in a new build or extensive refurbishment situation and so the SPV has no existing business. The SPV will be dependent on revenue streams from the contractual arrangements and/or from tariffs from end users which will only commence once construction has been completed and the project is in operation. It is therefore a risky enterprise and before they agree to provide financing to the project the lenders will want to carry out an extensive due diligence on the potential viability of the project and a detailed review of whether the project risk allocation protects the project company sufficiently. This is known commonly as verifying the project’s bankability.
Risk Allocation, Bankability and Mitigation in Project Financed Transactions
A number of key risks that need to be allocated and managed to ensure the successful financing of the project are:
- Tenor and Refinancing Risk
These risks will need to be allocated with the party that is best placed to manage them in a cost effective way (this will not necessarily always be the private sector).
Construction and Completion Risk
Cost of Construction - Clearly, the cost of completion will be fundamental to the financial viability of the project as the financial assumptions and ratios are all dependent on the assumed cost of construction of the project. The lenders will need some mechanism to manage the risk if the project company’s cost of completion increases as compared with that anticipated at financial close. The project company will also seek to lock in certain costs such as costs of commodities, as early as possible in the project, so as to limit price escalation.
Delay - Completion represents the end of the construction phase of the project. The construction contractor will be liable for liquidated damages for late completion, therefore the definition of "completion" will have a large impact on the construction contractor's risk.
Performance - The lenders will want to ensure that completion requires the works to be in a condition sufficient to merit release of the construction contractor from delay liquidated damages liability. The works will therefore be subject to certain technical tests and demonstration of performance capacity before completion is achieved.
The project company will want to ensure that the criteria placed on completion can be measured objectively as set out in the construction contract, and that the lenders do not have the right to refuse completion owing to their own subjective evaluation of the works. This may involve technical testing effectuated by independent experts, or by standard measures or tests with clearly ascertainable results, not unreasonably subject to dispute.
Operating Risks
As noted under Certainty of Revenue Stream, the financial model and assumptions to viability of the project are dependent on the projected costs of operations. If there is something in the cost of the operation that increases, lenders will want to be protected to the extent that it will impact the revenue stream. For instance, one of the key costs of operation in a power generation project will be the cost of the fuel and in the case of a water treatment plant, the cost of power. The cost can be locked in, to some extent, through hedging and futures contract and through input agreements but there are likely to be some costs that are not hedged and the lenders will want to be sure that these are limited (for instance, the increased cost is reflected in the tariff calculation for the power or treated water). Another key cost in operations will be the cost of workers and an assumption for wage inflation is usually built into the agreement by reference to an index such as the retail price index. It is important to ensure that the index covers increases in the sorts of costs incurred by the project.
The other key risk in operations is performance. The lenders and other investors are likely to have chosen an experienced operator to operate the project but there will be risks associated with operations such as key pieces of plant breaking down when they are out of construction warranty and also in the project company failing to meet the performance requirements and facing penalties and even the risk of termination for default. The lenders will seek to mitigate these risks through warranties and step-in rights.
Demand Risk
As noted above, the project is unlikely to generate revenue until the operations period and so it is going to be key to lenders and other investors that the revenue stream is certain and that forecasts of revenues are accurate. Future forecasts of demand, cost and regulation of the sector in any relevant site country will be important to private sector investors considering the revenue prospects of the project. For example, they may wish to:
- review the demand profile for project offtake, in the context of the extent to which the project company will bear project risk and will be able to influence demand;
- examine demand projections and information on the historical willingness of consumers to pay tariffs and to pay such tariffs on time (where the offtake is directly to consumers, for instance in the case of a toll road);
- look at prospects for growth, demographic movements, current tariffs and projections of consumer attitudes towards paying increased tariffs;
- where tariffs are based on indices, look at projections of the future movement of such indices and their relation to actual costs, including operating costs, finance costs, capital expenditure requirements and other such costs;
- review public, residential, commercial and industrial consumption and usage, actual and forecast, within the service area; and
- consider the impact of technical changes on the revenue stream, for example the installation of meters may cause a reduction in use and therefore project revenues.
The project participants must ensure that the project has received all necessary approvals from the host government and any local authorities, and that the government will not change its regulation of the project's operation in such a way as to inhibit the project development and production plans, or the revenue stream. This risk is often difficult to manage in particular in countries with developing or highly volatile legal and regulatory structures.
The project company will want to review the reasonableness of sanctions for failure to operate to the standards required, the payment structure for financial penalties, and any further sanctions for project company breach. The project structure should be reasonable and flexible, especially where the project in question is to continue over a long period, as the incentive mechanisms may need to change to ensure efficiency as the project evolves over time.
Force Majeure and Change in Law
It is important to note that the financing agreements will not include force majeure or change in law provisions. The obligation to repay the loans will continue in the event of force majeure or change in law. The lenders will want to review the force majeure and change in law provisions in the project documents and ensure that they are back to back (as far as possible) with the concession agreement.[1]
Political and Regulatory Risk and Expropriation or Nationalization Risk
As the market for project finance transactions has expanded into developing countries, concerns about political risk have grown. Key risks that arise are the decision by a government to cancel a project or to change the terms of the contract or not to fulfil its obligations, political or regulatory risk in failing to implement the tariff increases agreed upon in the contract, the risk of expropriation or nationalization of project assets by a government. Some of this will be managed in the project agreements with the government taking some of the risk in terms of compensation to be paid in the case of unilateral termination or expropriation, but not all political risks are likely to be borne by the government.
Commercial lenders may be prepared to take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral agencies or export credit agencies to shoulder some or all of this burden, as described in
Issues which commonly arise in relation to such cover include:
- the scope of "political risk", including regulatory risk and administrative risk;
- whether or not political risk includes events in more than one country or different states of the host country;
- the relationship between political risk and other "normal" project risks (for example completion risk);
- the extent to which a shareholder (particularly a local shareholder) can influence events which comprise political risk; and
- the consequences of a political risk event occurring and how it affects, for example, shareholder obligations to achieve completion, liability of shareholders under indemnities provided to export credit agencies or the basic liability of the borrower.
Environmental Risk
Environmental and social laws and regulations will impose liabilities and constraints on a project. The cost of compliance can be significant, and will need to be allocated between the project company and the grantor.
Equally, in order to attract international lenders, in particular IFIs, the project must meet minimum environmental and social requirements that may exceed those set out in applicable laws and regulations. For more on requirements of IFIs, go to Environment. This process is made easier where local law supports similar levels of compliance.
The Equator Principles constitute a voluntary code of conduct originally developed by the IFC and a core group of commercial banks, but now recognized by most of the international commercial banks active in project finance.
These banks have agreed not to lend to projects that do not comply with the Equator Principles . They follow generally the IFC system of categorizing projects, identifying those that are more sensitive to environmental or social impact, and requiring specialist assessment where appropriate. During project implementation, the borrower must prepare and comply with an environmental management plan.
Environmental due diligence in respect of such projects and in respect of the legal regime within which they are being constructed, and an appreciation of the environmental requirements of public agencies which will be involved with the project, are crucial if the project company and lenders are to make a proper assessment of the risks involved.
Social Risk
Infrastructure projects generally have an important impact on local communities and quality of life, in particularly delivery of essential services like water and electricity or land intensive projects like toll roads. Project impact of society, consumers and civil society generally, can result in resistance from local interest groups that can delay project implementation, increase the cost of implementation and undermine project viability.[3] This social risk should be high on a lenders due diligence agenda, though it often is not. The lenders and project company often look to the grantor to manage this risk. The grantor in turn may underestimate its importance, since the social risk paradigm for public utilities is very different, the grantor may not have experience of its implications for private investors.
Currency Exchange Risk
Project finance debt is often sourced from foreign lenders, in foreign currencies, yet project revenues are generally denominated in local currency. Where the exchange rate between the currency of revenue and the currency of debt diverge, the cost of debt can increase, often dramatically. Though under the theory of purchasing power parity, inflation pressures on the devalued currency will eventually bring the foreign exchange rate back to parity, project finance lenders are generally not prepared to wait quite so long (with average periods of about 10 years).
Where revenues are to be earned in some currency other than that in which the debt is denominated, the lenders will want to see the revenue stream is adjusted to compensate for any relevant change in exchange rate or devaluation. If this is not available, the lenders will want to see appropriately robust hedging arrangements or some other mechanism to manage currency exchange risk.[4]
Interest Rate Risk
Interest may be charged at a fixed rate, at variable rates (usually based on the banks lending rate or an inter-bank borrowing rate plus a margin) or a floating rate (calculated by reference to cost of short-term deposits). The spread or margin is expressed in "basis points”. One basis point is one-hundredth of 1%. Inter-bank borrowing rates include LIBOR (London inter-bank borrowing rate), EURIBOR (in the EU) and NIBOR (in New York).
Project finance debt tends to be fixed rate. This helps provide a foreseeable, or at least somewhat stable, repayment profile over time to reduce fluctuations in the cost of infrastructure services. If lenders are unable to provide fixed rate debt and no project participant is willing to bear the risk, hedging or some other arrangements may need to be implemented to manage the risk that interest rates increase to a point that debt service becomes unaffordable to the project. The tension between local and foreign currency debt is often a question of balancing fixed rate debt with foreign exchange rate risk or local currency debt subject to interest rate risk.
Lender Protection in financed transaction
In a project financed transaction the lenders will want to ensure that the revenue stream is protected and that the project performs as it is supposed to perform so that the lenders recover their loan and the project company does not default on its loan. Lenders will therefore require that there are a number practical control mechanisms of the company, such as limitations on what the project company can do without lender approval and the ability to step into management of the project company in the event the project is not performing, and that they take security over project assets.
Any warranties and representations used by the lenders is not so much as a basis for claiming damages but rather as potential events of default which permit the lenders to suspend drawdown, terminate, demand repayment and enforce security. The lenders will want the project company to repeat certain warranties and representations with each drawdown and periodically throughout the life of the loan, to ensure continued compliance.
The key mechanisms to secure the lending include:
- share pledge or retention in the project company;
- seccurity over all of the project assets and project agreements;
- security over insurance proceeds, bonds, guarantees and liquidated damages obligations of the project participants;
- collateral agreements and direct undertakings between the lenders and the parties to the more significant sub-contracts such as the construction agreement;
- standby equity or debt;
- legal rights and receivables (in particular the revenue stream) of the project company;
- sponsor support undertakings;
- guarantees from parent companies for their subsidiaries;
- government guarantees;
- default, cross-default and step-in rights so as to give the lenders maximum control over the possible termination, and cure, of any default related to any of the project documents; and
- comprehensive insurance cover either as co insureds or assignable to the lenders.
THE KEY TO PROJECT FINANCING
The key is tailoring of financing choice to project needs: The debt component of infrastructure projects may be financed in a variety of ways, including by way of the bank loan market, the debt private placement market and the public institutional investor capital markets. As each market has different inherent features, they may be more or less suitable for any particular infrastructure project. However, no one particular market is necessarily optimal for financing infrastructure projects while fulfilling all the project’s requirements, so consideration of the relative merits, and priority weighting, should be given to a variety of influential factors. These include the flexibility to accommodate changes to circumstances over the life of the project, the degree to which the tenors and interest rate structures offered by each type of financing best suit the requirements of the project’s revenues and debt profile, the nature of the transaction risk and the risk appetite of the target investors, confidentiality, all- in cost effectiveness and economics of the method chosen and consequent value-for-money, all of which need to be further explored.
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