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• khalid alsad

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Risk Analysis and Risk Allocation Week 3

Index 1

Project Finance as a Bulk of Risks: The Need of Risk Management

2

How to Map Risks in a Project Finance Deal: Risk Taxonomy

3

Pre-Completion Risks: Technology and Construction

4

Post-Completion Risks: Supply Risk, Operational and Performance Risk, &

Demand Risk 5

Risks Common to Both Phases

6

Wrap Up: The Risk Matrix

LEGEND:

Additional content

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CLIP 1 PROJECT FINANCE AS A BULK OF RISKS: THE NEED OF RISK MANAGEMENT

Project Finance as a Bulk of Risks Analyzing risk and understanding sources of risk is crucial. Unexpected risks can jeopardize cash flow stability.

Effective risk management involves: 1. The identification of sources of risk; 2. The allocation of risk to the parties in the best condition to control them and manage them; ... so that the SPV becomes a Remote Bankruptcy Vehicle.

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CLIP 2 HOW TO MAP RISKS IN A PROJECT FINANCE DEAL: RISK TAXONOMY

How to Map Risks in a Project Finance Deal Tip #1

Mapping of project risks following project life-cycle: 1. Pre-completion phase risks 2. Post-completion phase risks 3. Risks common to both phases

Project absorbs cash: the project is not able to generate any cash flow and all the money is committed to building the infrastructure.

The project first recovers the deficit of cash and then generates a cash surplus. 3

CLIP 3 PRE-COMPLETION RISK: TECHNOLOGY AND CONSTRUCTION

Pre-Completion Risks Types Planning • The design of the project is not correct or the advancement of the work is not properly scheduled. Technology • The technology for the project does not perform as originally expected. Construction • The contractor delivers the infrastructure with a delay. • The project is delivered but it performs below the agreed upon standards. • The final cost of construction far exceeds the original budget. 4

Pre-Completion Risks Responsibilities & Solutions The contractor takes on most of the responsibilities that arise in the construction phase by entering a turnkey construction contract (TKCC) which includes specific penalties.

Responsibility

The key elements for the TKCC to be bankable are: 1. The provision for a maximum cap which excludes extra cost for the SPV; 2. The provision for the refund by the contractor of damages to the SPV for delay in construction (determined on a daily basis and proportional to the damages to the SPV); 3. And the provision for the payment of damages if performance is not in line with a originally agreed minimum standard (tested by an independent technical engineer at completion). • •

The TKCC is generally backed by a bank guarantee (bonding). To cover all the risks that do not fall under the control of the contractor the SPV typically enters insurance policies (among others: ALOP, Advance Loss Of Profits).

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CLIP 4 POST-COMPLETION RISK: SUPPLY, OPERATIONAL AND PERFORMANCE RISK, & DEMAND RISK

Post-Completion Risk Supply risk: Definition • Particularly for plant, a shortage of raw material can hamper normal plant operations • Higher prices of raw material than forecast Put or Pay Agreements The SPV enters a contract with one or a small number of suppliers to which they commit to provide a certain quantity of raw materials: • At certain specific dates; • at a certain level of quality; • And at a predetermined price. If the supplier does not provide raw materials it is required to find alternative sources of supply, and to bear the extra cost if the alternative source is more expensive than the original one. 6

Post-Completion Risk Operational/Performance risk: Definition • Malfunctioning • Bad procedures • Not careful maintenance of plants and equipments O&M Agreement The SPV enters a contract with one O&M agent by which it commits to refund damages to the SPV for the losses incurred due to any performance below the pre-specified service level agreement (SLA).

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Post-Completion Risk Demand risk: Definition The budgeted amount of revenues is higher than actual revenues due to a fall in demand, drop of prices of SPV’s product, service, or both. Take or Pay Agreement The SPV enters a long term contract with one or more buyers of the products/services it will generate whereby it commits to provide supplies to the off-taker who is unconditionally required to pay the predetermined price (even if it is not able to withdraw the production). Demand risk cannot be completely covered if production is sold on the retail market.

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Post-Completion Risk Counterparty risk: Definition One or more of the parties involved in the project are not able to keep up with their obligations. Sponsors and creditors require counterparties to be stable and financially sound.

Creditors require that all the counterparties of the vehicle can be substituted if they are unable to perform as expected (Direct Agreements).

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CLIP 5 RISKS COMMON TO BOTH PHASES

Risks Common to Both Phases Risks that are common to both the pre-completion and post-completion phases and cannot be allocated to any specific counterparty by means of a contractual obligation are as follows: • Natural disasters (or Acts of God, Force Majeure) • Political risk: change in law, investment risk • Environmental risk: public opposition, contamination risk For the most part these are covered by insurance policies (in the case of investment risk these are provided by Export Credit Agencies). To safeguard the value of cash flows lenders typically require to hedge against all fluctuations of macro variables (condition precedent) • Interest rate risk • Exchange rate risk • Inflation risk (only for base risk: revenues and costs linked to different inflation rates) 10

CLIP 6 WRAP UP: THE RISK MATRIX

Wrap Up: The Risk Matrix TYPE OF RISKS PRE-COMPLETION PHASE RISKS Technological, Planning or Design Risk

WHO

SPV

Sponsors' guarantees to lenders

Contractor

Included in the construction agreement

Technology Supplier

Penalties to be paid

Construction Risk

Fixed price turnkey agreement

Operator Buyers Suppliers Export Credit Agency (ECAs) Banks Insurance Companies Independent Engineering Firms

Insurance policies Assessments on technological validity

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Wrap Up: The Risk Matrix TYPE OF RISKS POST-COMPLETION PHASE RISKS Operational Risk

WHO

Suplly Risk

Demand/Market Risk

SPV Contractor

Turnkey Agreement (first test)

Technology Supplier Operator

Penalty payments and removal of operator (later tests)

Buyers

Take or Pay Pur or Pay Agreement or through Pur Agreements

Suppliers Export Credit Agency (ECAs)

Endorsement credit to back supplier's loans

Banks Insurance Companies

Endorsement credito to back buyer's loans

Insurance policies

Independent Certification of later testing Engineering Firms

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Wrap up: The Risk Matrix TYPE OF RISKS RISK FOUND IN BOTH THE PRE- AND POST-COMPLETION PHASES Exchange Rate Interst Rate Risk Risk

WHO

SPV

Inflation Risk

Environmental Risk

Regulatory Risk

Political Risk

Country Risk

Credit insurance programs

Credit insurance programs

Current matching by advisors Limited to obtaining building permits

Contractor

Technology Supplier Operator Establishing preagreed inflation adjustments Establishing preagreed inflation adjustments

Buyers Suppliers Export Credit Agency (ECAs) Banks Insurance Companies Independent Engineering Firms

Derivative products and coverage instruments

Derivative products

Insurance policies

Insurance policies

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Wrap Up: The Risk Matrix RISK FOUND IN BOTH THE PRE- AND POST-COMPLETION PHASES Exchange Rate Risk Interst Rate Risk

SPV

Inflation Risk

Environmental Risk

Regulatory Risk

Political Risk

PRE-COMPLETION PHASE RISKS Country Risk

Current matching by advisors

Technological, Planning or Design Risk

Construction Risk

Operational Risk

Fixed price turnkey agreement

Turnkey Agreement (first test)

Limited to obtaining building permits

Included in the construction agreement

Technology Supplier

Penalty payments and removal of operator (later tests) Establishing preagreed inflation adjustments

Buyers

Take or Pay Pur or Pay Agreement or through Pur Agreements

Establishing preagreed inflation adjustments

Suppliers

Credit insurance programs

Export Credit Agency (ECAs)

Independent Engineering Firms

Demand/Market Risk

Penalties to be paid

Operator

Insurance Companies

Suplly Risk

Sponsors' guarantees to lenders

Contractor

Banks

POST-COMPLETION PHASE RISKS

Derivative products and coverage instruments

credit insurance programs Endorsement credit to back supplier's loans

Derivative products

Insurance policies

Insurance policies

Insurance policies Assessments on technological validity

Endorsement credito to back buyer's loans

Insurance policies Certification of later testing

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