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9. Identification and Mitigation of Project-related Risks

© New York University/Stern School of Business, CC BY 4.0 http://dx.doi.org/10.11647/OBP.0106.09

Risk identification, calibration, and mitigation are central to project and infrastructure finance. As noted, for the government or corporate sponsor involved, the main objective is to move a project’s construction, operating, and financial risks off the balance sheet whilst maintaining control and capturing the economic upside — financial and, in the case of government, economic and social. For the creditors involved, because there is often no financial recourse to the project’s sponsors, the primary goal is to ensure a stable source of cash flow to service the outstanding debt whilst safeguarding their standing in the cash-flow “waterfall” and collateral rights within the project’s overall capital structure.

Given the multiple parties and myriad risks involved, most project and infrastructure financings are highly structured transactions. The nature of the risks in a large-scale capital project changes as the project moves from its construction phase (typically 1 to 5 years) to its longer-term operating phase (generally 25 to 30 years or longer).1

During construction, the main risks are that the project might be completed behind schedule, incur cost overruns, or fail to achieve commercial acceptance for technical reasons.

Once a project begins operations, the key risk is that projected cash flows might fall short of expectations because of weak demand, price pressures, or higher-than-anticipated operating and maintenance capital costs.

In the long term, potential risks include production issues (i.e., unplanned outages) and force majeure such as earthquakes, hurricanes, or terrorist attacks. All projects are exposed to sovereign or political risk during their entire life cycle, regardless of the nature of government involvement in their financing.

As discussed earlier in this study, infrastructure projects are intended to be significant direct and derivative contributors to national or local economic performance and stable generators of cash flow in the long term. Therefore, from the perspective of debt or equity capital providers, infrastructure projects are potential stationary targets for the host government — not only at a national level but in many cases state and local. Such political risk — generally termed “sovereign risk” at the national level — can range from increased taxation and other fiscal or regulatory regime changes to pressure to renegotiate contract terms (particularly if a government agency is a project counterparty) to outright expropriation.

Political risk tends to increase once a project starts operations and begins to generate cash. This risk is of special concern for projects in lower-rated emerging market countries with shaky lender and investor protections unless it can be mitigated by alternative governing law or external guarantees.

Political risk in infrastructure financing can be addressed in a variety of ways, including purchase of political risk insurance covering the capital structure, as well as participation of influential banks from several different countries (particularly major trading partners or creditors of the host country), regional development banks, or the World Bank. Sometimes a country’s continued need for balance of payments financing, including rollovers of maturing debt, may give lenders and investors sufficient implied leverage to constrain adverse political moves.

At the project level, sources of risk to lenders and investors in infrastructure financing sometimes relate only to completion of a project. Alternatively, these risk sources may be longer term and could affect the project’s operation for many years.

Evaluating and reducing both completion and operating risk requires expertise and ingenuity. Financial management of these risks generally relies on various guarantees. These may be direct (full and unqualified commitment on the part of the guarantor); limited in terms of amount or duration; or contingent, involving relatively unlikely events that lenders want mitigated in order to secure their participation. Guarantees may be either implied as an obligation of the guarantor or indirect via performance of some related activities that will, in effect, make the lender whole in the event of problems.

Lenders and investors also face completion risks, which are the focus of the sponsor’s own evaluation of the technical challenges involved in successfully bringing a project on-line. These risks are assessed in-house and by engineering consultants or other outside experts. The sponsors, operators’ and EPC contractors’ track records of successfully undertaking comparable projects elsewhere are important in such assessments.2 Projects involving new technologies or particularly adverse conditions (e.g., climatic or topological) tend to multiply completion risks.

Lenders may require completion guarantees from project sponsors to unconditionally warrant that performance will be as specified (in terms of quantity, quality, timing, and minimum period of operation) and that the sponsors will cover any and all cost overruns. Sponsors may be asked in advance to agree to specific tests of physical and economic completion, with lender recourse lapsing only after these tests have been satisfactorily met. Cost-sharing arrangements may oblige sponsors to carry a specific pro rata share of all project outlays, including debt service payments.

Sponsors may also provide “comfort letters”, sometimes called “letters of moral intent” or “keepwells”. Without issuing a formal guarantee, these letters promise that the sponsor will supervise and maintain an active interest in the vehicle company throughout the project’s pre-completion and operating phases. Such documents, however, even when tightly worded, cannot be viewed as guarantees.

Following project completion, market risk (notably the risk of revenue shortfalls) in infrastructure financings can be met by “take-or-pay” contracts, whereby the ultimate purchasers unconditionally commit themselves to make specific payments for a given period, whether or not they actually take delivery of the project’s products or services. One problem with take-or-pay contracts is that, in effect, the sponsor sacrifices a certain degree of control over the facility. Because the guarantor may be a third party, this approach can involve somewhat higher financing costs.

Infrastructure financing providers can sometimes also obtain “deficiency guarantees” covering an entire venture, either from the sponsors or from the government of the country where the project is located, or perhaps from the sponsors’ home-country governments. Some guarantees cover losses of principal and interest suffered by lenders after any collateral has been liquidated in the event of default. In the case of a government’s sovereign guarantee, country risk assessment will determine the guarantee’s true value.

Collateral itself can take many forms, such as a lender’s mortgage over the borrower’s license or project facilities, assignment of interests in various agreements and contracts, assignment of insurance proceeds, assignment and liens on revenues generated or inventories and accounts receivable, contingent claims on financial accounts, or pledges of borrowers’ equity shares.

In addition, sponsors may be committed to maintaining their financial interest in a venture at or above a specified level. Sellers of equipment to the project and/or their export credit agencies may also be willing to provide certain guarantees. The existence of a complex of guarantees provides support for infrastructure financing only to the extent that the guarantors are able and willing to meet their obligations. Each guarantor must therefore be subject to careful due diligence with respect to both “ability” and “willingness”.

In essence, lenders and investors in project and infrastructure financings have to decide which of these risks are “bankable” and which must be covered by contractual arrangements with either project sponsors or third parties such as suppliers, customers, governments, or international organizations. In general, the rule is, “Manage the risks you know, and sell the rest”.

To that end, contractual agreements are the main instrument for mitigating risk throughout the life of a project. During the construction phase, sponsor completion guarantees and fixed-price, turnkey EPC contracts (with contingency cushions) are often used to ensure projects are completed on time and on budget. During the operating phase, take-or-pay off-take and supply agreements related to infrastructure services are typically used to minimize project cash flow volatility and margin pressures, whereas insurance contracts are used to mitigate the risk of business interruption and total casualty loss.

To ameliorate sovereign risk, multilateral development banks and sovereign lenders are often deliberately included in the capital structure, along with political risk insurance policies and offshore cash lockboxes. The choice of governing law and arbitration forum for settling legal disputes is also a key risk mitigation technique.

In summary, a central function in infrastructure financing is to identify and quantify the various risks and then structure the deal to allocate those risks acceptably among the various participants. As financial institutions and investors enhance their understanding of the risks in particular types of projects, they may become increasingly prepared to accept a larger share of total project risks, which could mean less onerous covenants and guarantees for project sponsors. A reputable sponsor with a good record should be able to negotiate over a broad range of risks.

The fundamental challenge facing financial advisors on major projects is how to assemble a financing package that aligns all parties’ interests, given the available financing sources, the risks, and the options for reducing and shifting those risks. In the end, the infrastructure project’s underlying viability tends to be the determining factor.


1 For a detailed discussion, see Smith, Walter and De Long (2012).

2 EPC contractors refer to firms responsible for project engineering, procurement and construction.