“Иқтисодиёт ва инновацион технологиялар” илмий электрон журнали. № 6, ноябрь-декабрь, 2014 йил
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D. Umarov,
senior teacher, TSUE
PROJECT RISKS: IDENTIFICATION AND MINIMIZATION
Мақолада лойиҳавий молиялаштиришда мавжуд бўлган рискларни
аниқлаш
ва
камайтиришнинг
муҳимлиги
ёритилган.
Лойиҳавий
молиялаштиришда кредиторлар дуч келадиган асосий муаммолар кўрсатиб
ўтилган. Мақолада ноаниқлик, риск, лойиҳанинг фазалари бўйича лойиҳавий
рискларнинг туркумланиши кўриб чиқилган ва рискларни камайтириш йўллари
ёритилган. Тадқиқот натижалари асосида таклиф ва хулосалар келтирилган.
В статье рассматривается важность определение и минимизирование
рисков связанное с проектной финансирование. В нем рассматриваются
ключевые проблемы, что кредиторы сталкиваются в проектной
финансирование. В статье рассматриваются неопределенности, риски,
классификация рисков проекта в соответствии с фазами проекта и
обсуждается пути минимизации рисков. Приводятся соответствующие
рекомендаций и заключение в зависимости от результатов исследования.
Key words:
Project financing, risks, types of risks, assessment, risk
identification, risk minimization.
In project financing where debts and loans are provided with non-recourse or
limited recourse bases there are more risks than other method of financing. As a
feature of project financing, debts and loans are only repaid when the project is
operating accordingly. If the project by any chance fails to operate, the lenders are
likely to lose a substantial amount of money. Assets of the project are usually
specialised to the project and they may have less value as collateral outside the
project. Because of high possibility of risks, lenders always give effort to reduce or
eliminate the project risks. It is time consuming to provide financing and the cost of
project financing is higher as a result of high risks.
In project financing sponsors and lenders face following key challenges:
Management of multiple parties with individual interests, including
construction companies, suppliers, governments, off-takers, sponsors, and guarantors
Long standing horizon of projects makes estimating revenues and cash flows
from the financed asset difficult
Dependence on a cash-flow stream from a single project
Intensely changing risk profile through the project lifecycle, from
construction to start-up to operation
Distinctive default characteristics and minimal historical data due to great
variety of project types and few defaults
Fairly high risk of construction delays, cost overruns, and start-up problems
Several, and potentially conflicting, regulatory requirements
Unsatisfactory information and markets
“Иқтисодиёт ва инновацион технологиялар” илмий электрон журнали. № 6, ноябрь-декабрь, 2014 йил
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Complex or weak structural aspects of transactions (1).
Sponsors are concerned with minimising the dangers of any events which
could have a negative impact on the financial performance of the project, in
particular, events which could result in:
The project not being completed on time, on budget, or at all;
The project not operating at its full capacity;
The project failing to generate sufficient revenue to service the debt;
The project prematurely ending (2).
Economists, scholars, risk theorists and statisticians have given various
concepts of risk. However, risk traditionally has been defined in terms of uncertainty.
Various types of risks are involved during the project life cycle. Every undertaken
project is different and it is not possible to rank the project risks in order of priority.
A major risk for one project may not be important for another project. Some risks
may occur during the construction phase of the project, some during the operation
phase and some other risks in both construction and operation phases. It is useful to
divide the project financing risks according to the phases of the project because the
nature and the allocation of risks usually change between the construction phase and
the operation phase as shown in Diagram-1.
Diagram-1
Types of Project Financing Risks
Source: Developed by researcher depending on other sources
.
Construction phase risk/Completion risk
The risk is related to the problems with completion of the project. This phase
carries the greatest risk for the sponsors and lenders. While the lender(s) already
released funds for the land acquisition and initial start-up of construction but the
Project financing risks
Project financing risks
Construction phase risks
Construction phase risks
Operation phase risk
Operation phase risk
Construction/operation phases
risks
operational phases
Construction/operation phases
risks
operational phases
Completion risk
Completion risk
Technical Risk
Technical Risk
Resource / reserve risk
Resource / reserve risk
Operating risk
Operating risk
Participant / credit risk
Participant / credit risk
Currency risk
Currency risk
Market / off-take risk
Market / off-take risk
Regulatory / approvals risk
Regulatory / approvals risk
Political / Sovereign Risk
Political / Sovereign Risk
Environmental Risk
Environmental Risk
Force major risk
Force major risk
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borrower / project developer does not initiate construction then the lender may have
to foreclose on raw or only partially improved land that does not have sufficient value
to cover the initial release of funding. If a certain amount of funding is released and
the project developer becomes insolvent or there is some type of problem that halts
the project then the lender may have to foreclose on assets / infrastructure that is
incomplete and not of sufficient value to recover all or a partial amount of funding
from the borrower. The assets may be very highly specialised and possibly located in
a remote area. Because the assets are project specific they may have not have any
value (other than scrap) outside of the project itself. The lenders may have to hire a
new company to come in and complete the project and provide additional funding to
that new developer, and may have to re-negotiate off-take contracts due to perceived
problems connected to the project. Construction phase risk reflects all risks and
factors: difficulties with suppliers during construction, natural conditions and
weather, political and force major, environmental regulation, labour and technical /
construction issues (3).
Following mechanisms were identified for minimising completion risk before
lending takes place include:
(a) Gaining completion guarantees requiring the sponsors to pay all debts and
liquidated damages if completion does not occur by the required date;
(b) Guaranteeing that sponsors have a significant financial interest in the
success of the project so that they remain committed to it by insisting that sponsors
inject equity into the project;
(c) Demanding the project to be developed under fixed-price, fixed-time
turnkey contracts by reputable and financially sound contractors whose performance
is secured by performance bonds or guaranteed by third parties;
(d) Gaining independent experts' reports on the design and construction of the
project.
This kind of risk is managed throughout the loan period by methods such as
making pre-completion phase drawdowns of additional funds conditional on
certificates being issued by independent experts to confirm that the construction is
progressing as planned.
Operation phase risk - Resource / reserve risk
Resource/reserve risk is for a mining, rail, power station and toll road projects.
There may be scarce inputs that can be processed or serviced to generate sufficient
return. This risk may occur when there are insufficient reserves for a mine, fuel for a
power station or outsourcing delays. These kinds of resource/reserve risks can be
minimised by:
(a) Experts' reports as to the existence of the inputs (e.g. detailed reservoir and
engineering reports which classify and quantify the reserves for a mining project) or
estimates of public users of the project based on surveys and other empirical evidence
(e.g. the number of passengers who will use a railway);
(b) Demanding long term supply contracts for inputs to be entered into as
protection against shortages or price fluctuations (e.g. fuel supply agreements for a
power station);
(c) Gaining guarantees that there will be a minimum level of inputs (e.g. from a
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government that a certain number of vehicles will use a toll road);
Operating risk
Operating risks may occur when operating costs increase or when project does
not operate qualitatively and quantitatively according to planned output which affect
the cash flows generated from the project. These risks include scarcity of skills of the
operators, insufficient level of skilled labour force. The most acceptable way for
minimising operating risks before lending takes place is to require the project to be
operated by a reputable and financially sound operator whose performance is secured
by performance bonds and to minimise and manage operating risks during the loan
period lender(s) should require the provision of detailed reports on the operations of
the project and control cash-flows by requiring the proceeds of the sale of product to
be paid into a tightly regulated proceeds account to ensure that funds are used for
approved operating costs only.
Market / off-take risk
Loan can be repaid if the project’s products/services can generate cash and
actual cash flow of the project can be affected by interest rates, exchange rates,
inflation, labour costs and prices of resources, machinery and outputs of the project
which lead to market risk as project would be unable to repay the debt or loans. The
cost of inputs may have increased which increases the price of the output and there
may not by customers who can buy or use products/services of the project when
offered at the market. The most acceptable way of minimising market risk before
lending takes place is signing forward sales contracts with financially stable
purchasers and allocate market/ off-take risks to the purchasers.
Risks common for construction and operational phases-Participant / credit risk
Participant/credit risks are associated with both sides: sponsors and the
borrowers themselves. The issue is whether borrowers have sufficient resources to
construct, operate and manage the project and resolve problems that may occur. To
minimise and manage participant/credit risks, the lenders have to make sure that the
participants of the project have gained enough experience from previous projects of
the same nature, have sufficient experienced human resources, and do not have
financial problems.
Technical risk
Technical risks occur when there are technical difficulties and defects in the
plant, machinery and equipment in both construction and operational phases of the
project which lead technology to function at lower capacity or cannot provide
demandable products/services or abuse environmental regulations. To minimise
technical risk sponsors preferably try to use tested technologies rather than unproven
new technologies; use experts advices and reports on suggested technology. Sponsors
can manage technical risks by signing maintenance contracts with maintenance
companies by allocating risks to the maintenance company and reserve a certain
amount of cash to cover maintenance expenditure.
Currency risk
Currency risks occur when construction items bought from different country in
foreign currencies and the change of exchange rate may increase the cost of
construction or obtained loan may be in foreign currency and the change of exchange
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rate of revenue currency may lead to cash flow problems. Sponsors can use following
mechanisms to minimise currency risks:
- Corresponding the currencies of the sales contracts with the currencies of
supply contracts as far as possible;
- Denominating the loan in the most relevant foreign currency;
- Demanding suitable foreign currency hedging contracts.
Regulatory / approvals risk
Regulatory/ approval risks occur when required government approvals or
licences are really difficult to get issued by host country to construct and operate the
projects or strict requirements to supply and distribute locally, extra taxation and
payments. To reduce these kinds of risks sponsors need to get legal advice from
reputable law firms about relevant laws.
Political / Sovereign Risk
Political risk may occur during both the construction and operation phases of
the project, particularly in unstable developing countries and emerging markets as a
host country. These kinds of risks may be caused by followings:
Expropriation by the host nation
Currency convertibility and transferability
Political violence / terrorism
Unforeseen changes in regulations or the failure by the government to
implement tariff adjustments (critical to power projects) because of political
considerations
Government licenses and approvals required to construct or operate the
project are not issued
Project operation is subject to state-owned suppliers or customers
Taxation and royalty payments are individually augmented.
Common mechanisms for sponsors to minimise political risks include: (a)
demanding host country agreements and assurances that project will not be interfered
with; (b) gaining legal opinions as to the applicable laws and the enforceability of
contracts with government entities; (c) demanding political risk insurance to be
obtained from bodies which provide such insurance (traditionally government
agencies); (d) including lenders from a number of different countries, national expert
credit agencies and multilateral lending institutions such as a development bank; and
(e) creating accounts in stable countries for the receipt of sale proceeds from
purchasers.
Environmental Risk
Environmental risk may occur during the project life cycle. Because of the
defect technology or inappropriate usage during the construction or operation period
of the project some kind of dangerous material may spill and contaminate the
ecosystem around the project’s location or the operation of the plant may abuse the
environmental regulations like CO
2
emissions limits. In order to minimise
environmental risks participants have to allocate these risks to right parties by signing
contracts and transferring responsibilities.
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Force major risk
Force major risk may cause the construction or operation of the project to stop
completely (fire, earthquake, volcanic eruption) or temporarily (strike, minor fire or
minor floods). To minimise these kinds of risks, sponsors may share out such risks to
other parties accordingly; demand sufficient insurances that show lenders interests
appropriately.
Taking into account limited recourse financing as a main lending, in order to
minimise project risks, participants have to reallocate these risks to those participants
who best able to bear them as shown in Table-1.
Table-1
Project risks, hedging tools and sources of coverage
Risk
Hedging tool
Source
Construction and completion risks
Supply and availability of raw
material and building
materials
Supply or pay contract
Supplier
Adequate communication
Project’s network
Sponsors
Contractor’s performance
Feasibility study
Sponsors
Force major
Insurance
Insurance agency
Cost overruns
Completion guarantee
Standby credit
Contractor
Lenders
Delays
Completion guarantee
Contractor
Operational risks
Energy supply
Long-term supply contract
Energy supplier
Output
Take and pay contracts
Purchaser of output
Transportation
Long-term transportation
contract
Project’s transportation
infrastructure
Sponsors
Sponsors
Operator performance
Feasibility study
Compensation agreements
Sponsors
New technology
Licensing agreement
Licenser/Sponsor
Conflicts of interest among
sponsors
Inter-sponsor contracts
Sponsors
Resources
Feasibility study
Sponsors
Force major
Insurance
Financial risks
Exchange rates
Options, futures, swaps, and
so on
Financial Institutions
Inflation
Long-term supply and output
contracts
Suppliers and
purchasers
Interest rate
Fixed-rate loan, interest
ceilings, interest rate
derivatives
Financial institutions,
lenders
Political risks
Availability of licences and
Good working relationship
Sponsors
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permits
with government
Expropriation
Participation of local
sponsors, international
agencies, lenders
Sponsors
Country risk
Feasibility study
Insurance
Sponsors
Insurance agency
Sovereign risk
Feasibility study
Sponsors
Source: Developed by researcher depending on other sources.
In conclusion we can say that lenders will generally not give funds to a project if
their loans would be exposed to business or economic risks. Lenders are typically willing
to bear some financial risk but they will insist on being compensated for bearing such risk.
A critical aspect of financial engineering for a large project involves identifying all
significant project risks and then crafting contractual arrangements to allocate those risks
(among the parties who are willing to bear them) at the lowest ultimate cost to the project.
But there are risks which can not be identified and analysed at early stages of the project
life cycle. If those risks occur at any stage of the project management in order to minimise
the possibility of risk occurrence and its consequences, take the risks and manage them.
Of course, greater the risk lender bear, the more they know about the risk and they control
the project broadly. Lenders monitor the project closely to bear the risks and be ready if
the borrower defaults. Financial or commodity derivatives and instruments are used in
modern project risk management to manage efficiently the risks even though by accepting
to incur extra costs. These instruments allow diversifying risks according to assets,
regions, sectors, markets and timing scale and hedge the risks through the whole period of
assets. Various types of swaps, options and forwards are used broadly to hedge and
manage efficiently project finance risks by lenders.
References
1.
Moody’s Analytics Risk Management Services (2008) “Project &
Infrastructure
Finance
Risk
Assessment”
available
from
http://v3.moodys.com/sites/products/ProductAttachments/Project_Infrastructure%20
Finance.pdf
2.
EagleTraders.com (2009) “What is project finance?” Pretoria, South Africa,
available from
http://www.eagletraders.com/loans/loans_what_is_project_finance.
3.
Credit & Finance Risk Analysis (2009) “Project Finance Underwriting &
http://www.credfinrisk.com/projfin.html
4.
Buljevich E.C, Park Y. (2006) “Project Financing and the International
Financial Markets” USA, Springer US, 2
nd
ed.
5.
Finnerty J.D. (2007) “Project financing: asset-based financial engineering”
New-Jersey, John Wiley &Sons Inc, 2
nd
ed.
6.
Hoffman S (2007) “The Law & Business of International Project Finance”
UK, Cambridge Univ. Press. pp 4.
7.
Pollio G (1999) “International Project Financing & Analysis” London,
Macmillan Press Ltd, 3
rd
ed.
