eBusiness Weekly
Jacob Mutevedzi
Risk is a critical element in project finance because it gives rise to unforeseen changes in the ability of the project to repay costs, debt service, and dividends to shareholders.
In instances where the risk has not been forecasted and hedged, it can significantly impact cash flows and occasion a cash shortfall.
Where cash is not adequate to pay creditors, the project is technically in default. The bulk of the time invested in crafting the deal before it is financed is, in fact, dedicated to mapping all the conceivable risks that can befall the project in its lifetime.
Cardinally, focus lies on identifying all the solutions that can be used to limit the impact of each risk or to eliminate it.
The risks innate to a project finance venture are specific to the initiative in question; therefore, there can be no definitive description of such risks.
This article focusses on broader categories of risk which are germane to various initiatives.
Completion Risk
Completion risk includes construction and design risk and invariably results in time and cost overruns leading to a significant increase in capital and interest expenses during construction.
This risk can emanate from weather, industrial action or late delivery of equipment and supplies. The party rendering the engineering and construction service is usually required to post a performance bond.
Only rarely is construction risk allocated to the Special Purpose Vehicle (SPV) or its lenders. Usually, it is the contractor or even the sponsors themselves who must assume this risk.
Whether or not the banks are keen to accept construction risk also depends on the nature of the technology and the reputation of the contractor.
Political Risk
A stable political climate and legal system in a country will invariably generate more investor interest in a project. Moreover, the lower the political risk, the lower the required rate of return.
Most investors tend to review the history and current political conditions of the host country to assess the likelihood of expropriation, nationalisation, war and restrictions on the repatriation of funds, or exchange controls.
Further, investors will also focus their attention on the prospect of other changes within the legal system, in particular with respect to tax, employment and environmental issues.
Risk of this nature is also known as legislative or policy risk. Besides, force majeure risk, political or country risk is probably the most difficult risk to manage.
Consequently, investors keep a constant eye on the political conditions of the host country and make risk-limiting decisions on an ongoing basis. For example, they can limit or freeze any additional capital investment or take steps to repatriate funds.
Exchange Rate Risk
This risk often manifests when some financial flows from the project are stated in a different currency than that of the SPV.
This usually happens in international projects where costs and revenues are computed in different currencies.
In domestic projects a similar situation may arise when a counterparty wants to bill the SPV in foreign currency. When possible, the best risk coverage strategy is currency matching.
Force Majeure Risk
This risk relates to the occurrence of unexpected and uncontrollable natural and/or man-made conditions like earthquakes, tsunamis, volcanoes or war, which may negatively impact the construction or operations of a project.
Invariably, such risks are assumed by the project promoters and investors for at least a limited time or amount of investment. Investors will definitely consider the likelihood of such occurrences when valuing the project and determining the required rate of return.
Regulatory Risk
Regulatory risk comes in a multiplicity of forms. There are various facets to regulatory risk but the most common are the following:
the permits required to commence the project are delayed or cancelled;
the basic concessions for the project are unexpectedly renegotiated; and
the core concession for the project is revoked.
Frequently, delays occur as a result of inefficiency in the public administration or the complexity of bureaucratic procedures. If delay emanates from political intent to block the initiative, such a situation would be more akin to political risk.
Inflation Risk
This risk represents the likelihood that the actual inflation rate will exceed the risk projected during the feasibility study.
It may be mitigated by including an actual index, based on inflation, in the contract’s pricing formula, or by entering into long-term supply contracts with predetermined prices.
To the extent that the risk cannot be controlled by the private sector, the public sector may decide to retain the risk, reducing the cost of the project.
Environmental Risk
This risk relates to any potential adverse impact the project could have on the surrounding environment.
Such risk can emanate from an assortment of factors. For example:
constructing or operating the plant can damage the surrounding environment;
legislative developments can result in building variants and an increase in investment costs; and
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.
Environmental issues affect all sorts of projects.
The world over, there is no tolerance for industrial sins like air pollution or construction on wetlands.
Further, in recent years stringent legislation has been enacted to protect the environment.
In Anglo-Saxon countries, for instance, lenders are not willing to ask for guarantees in the form of the plant itself because the liability for possible environmental damage derives from the ownership or actual control of the project.
Operating Risk
Operating risk applies to the numerous resources that are central to the operations of the project.
This risk may be directly controlled by management, for instance, employment issues or arise from external conditions, for example, exchange rates on imported resources.
They may also include inadequate maintenance, or design, engineering or construction faults which negatively affect the project’s eventual operations. These problems may inhibit the project from achieving the agreed quantity and/or quality of services.
Usually, investors rely on the operating experience of the promoters of the project to mitigate this risk.
Ways of ameliorating operating risk include adopting employee-friendly labour policies, for example, training, personal advancement and share ownership schemes, long-term fixed price supply contracts which support the projected profit margins, proper insurance, and adherence to all environmental laws and regulations.
Conclusion
The nub of any project financing is the identification of all key risks associated with the project and the distribution of those risks among the various players participating in the project.
Absent a detailed analysis of these project risks at the beginning, the parties are bereft of a proper comprehension of the liabilities they may be undertaking assuming in connection with the project and therefore they are not in a position to consider appropriate risk-mitigation exercises at the relevant time.
In the event that problems arise when the project is under way, this can result in protracted delays, huge expenses and contention as to who is responsible.
As a rule, a particular risk should be assumed by the party best able to manage and control that risk.
Jacob Mutevedzi is a commercial lawyer and commercial arbitration practitioner contactable on [email protected], on Twitter @jmutevedzi_ADR and on +263775987784. He writes in his personal capacity.
