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BY ANASTASIA SLIVKER APRIL 2011 Introduction While riding on a high-speed train through India, Europe, or Taiwan, a passenger may see massive wind turbines scattered throughout the countryside. Marveled by the landscape, the passenger may take a snapshot on her phone camera and send it to her family. Without realizing it, the passenger is likely to have benefitted from infrastructure projects that have been financed by a mechanism called ―project finance.‖ The high-speed rail, the wind turbine, and the telecommunication towers are all large and complex infrastructure undertakings. Sometimes such projects are made possible by traditional financial methods; increasingly, however, infrastructure projects are financed by a mechanism that engages a multitude of participants including multilateral organizations, governments, regional banks, and private entities. In project finance, participants negotiate amongst themselves to spread risks associated with an undertaking, thereby increasing the chances for success in developing vital infrastructure projects for that country and its population. Project finance is the preferred financing mechanism for large infrastructure projects that are essential for developing countries, emerging economies, and developed countries alike. This FAQ will define project finance and compare it to corporate finance, present project finance participants, and discuss the financing mechanism. It will also address the advantages and risks associated with project finance and provide insight into the future of project finance. I. What is Project Finance?
At its core, project finance is a method of financing where the lender accepts future revenues from a project as a guarantee on a loan. In contrast, traditional method of financing is where the borrower promises to transfer to the lender a physical or economic entity (collateral) in the case of default. In practice, most projects are financed by a combination of both traditional methods as well as by guarantee-backed loans. While the name suggests that project finance refers to raising capital by any means to pay for any project, the term refers to a narrow but increasingly more prevalent method of financing capital- and risk-intensive projects across a broad array of industries. The twentieth century was marked by a reliance on the public sector for developing infrastructure projects. Historically, governments initiated infrastructure projects to develop or build essential facilities so that citizens and businesses could conduct various operations and experience economic growth. In the last two decades, however, there has been a shift in the model of development from the public sector to greater private sector participation. These hybrid public-private partnerships (―PPP‖) have been instrumental in upgrading existing
Source: Thomson Routers
the risks involved (political risks. the repayment of debt is not based on the assets reflected on the sponsoring company’s balance sheet. In project finance.6 billion). Spain came in second with 67 loans (for a total of $174 billion) and Australia in third with 32 loans (worth $14. multilateral institution.‖ Today. etc. regional bank. That is. Project finance is an important tool for financing projects in developing and emerging economies. currency risks. the lender will be able to foreclose on the sponsor company’s assets. bilateral institution. The sponsoring company must consider several factors when determining whether to use a corporate or project finance structure. access to materials. transportation. telecommunications. 3 . mining. The chart above suggests that while project finance is most common in power and transportation projects. For example. in 2010 India had the most active project-finance market with over $52 billion worth of deals. various sectors employ project finance. II. yet developed countries employ the mechanisms as actively as less developed countries. The most common method of financing PPPs is ―project finance. oil and gas. petrochemicals. but on the revenues that the project will generate once it is completed. sell them. waste and recycling. leisure and property. etc. in the case of default.facilities and creating new infrastructure in various industries and in all parts of the world. Such considerations include the amount of capital needed. water and sewerage. environmental risks. stemming from 131 loans. As the graph below demonstrates. and agriculture and forestry. it extends to a broad range of industries. industry. What is the difference between project finance and traditional finance? In traditional or corporate financing. will be involved). and use the proceeds to recover its investment. the sponsoring company (the company building the project) typically procures capital by demonstrating to lenders that it has sufficient assets on its balance sheets. including power.) and the identity of the participants (whether a government.
is mostly on loans to the project company. project finance is most suitable for a project where there is a predictable revenue stream to support debt repayment. in the case of power projects. In fact. with project revenues as the source of the return on the investment to lenders. a sponsoring company can only use project finance where it can demonstrate that revenue streams from the completed project will be sufficient to repay the loan. Corporate Finance Model v. as compared to traditional corporate finance. because the lender relies only on the project revenue to repay the loan and cannot pursue the sponsoring company’s assets in the case of a default. lenders will often require that the sponsoring company demonstrate that it has agreements in place that will generate the required revenue (called ―off-take agreements‖). Therefore. Project Finance Model Corporate Finance: Project Finance: 4 . The focus in project finance. the sponsoring company often signs contracts with distributors where the distributors agree to purchase electricity generated by the project. Project finance greatly minimizes risk to the sponsoring company. however. For example. However.corporate finance most often involves private investors who provide financing in return for ownership (equity) in a project company.
A project sponsor can become involved in a project in one of two ways: (1) when the host government solicits bids (goes through a procurement process) and selects the best candidate among the bidders. the special purpose vehicle. In project finance that entity is called the Special Purpose Vehicle (SPV). contractors and builders. Every project must have a core entity responsible for organizing. Because of the complex structure of project finance. Since the goal of project finance is to build large infrastructure projects by allocating risks to the party most able to bear it. A Sponsor Company creates an SPV for the sole purpose of achieving the limited goals of construction and operation of a particular project. with or without soliciting 5 . a group of companies. Who are the participants in project finance and what are their roles? Project finance has many participants who participate at different stages of a project’s development and operation. financial institutions (multilateral. The Development Company. the host government. a joint venture. The Project Sponsor can be a company. or a subsidiary of another company that initiates a project.pdf III. and commercial banks). the following participants are usually involved in a project financed under a project finance model: the sponsor company. developing. and ensuring that the project is operational.org/sp/JohnSachs. not all projects follow the same structure and not all of the participants described below partake in all projects. and infrastructure operators and off-take purchasers.Source: http://www. regional development banks. (a) Sponsor Company. or (2) a company or group of companies may initiate a project on their own.syrianpppconference. bilateral.
For example. To ensure the success of the project. the sponsoring company will receive the profits generated by the project. However. The joint venture created the Arabian Power Company (APC). an SPV is the legal entity that contracts with other parties involved in the development process. most projects have government involvement and backing. Most importantly. the project sponsor has ownership of a project without some of the risks that it would face in traditional finance. While the project sponsor is the main equity owner of the SPV. which are linked to the type of financing that the SPV is likely to procure as well as the law of the host country. There are various ownership structures for an SPV. it is the company or group of companies that either solicits bids or receives tender from a host government to construct a site.host government involvement. the project sponsor does not carry liability in the case of default because. In return for a significant (and often majority) equity ownership stake in the SPV. in the United Arab Emirate’s Umm Al Nar Desalination Plan. as mentioned earlier. Therefore. the Sponsor Companies were a joint venture between a company that is wholly owned by Abu Dhabi Water and Electricity Authority (ADWEA). At the project’s completion. Tokyo Electric Power Company (TEPCO) and Mitsui. the joint venture companies provided the initial capital necessary to jump- 6 . (b) The Special Purpose Vehicle. which is the SPV. The project sponsor then creates a special purpose vehicle that will conduct all the business associated with the project on behalf of the project sponsor. A project sponsor creates a SPV for the purpose of constructing the project. A project sponsor has a limited but important role. future revenues of the project are the guarantee. the project sponsor invests a limited amount of its own money to win the procurement bid as well as to pay for early administrative costs.
but not to have an equity stake in the SPV. As addressed above in the discussion on the role of the project sponsor.start the project to the SPV. a government may procure a sponsor company to build the project on behalf of the government. a desalination plant or a power station. Large infrastructure projects often require government involvement. among others. sometimes at a set price. For example. the government may decide to build a project.1 billion dollar project. The host government can be a guarantor by providing risk mitigation in the form of sovereign guarantees which includes repayment of debt in the case of political unrest. Arabian Power Company. for example. It is also common for the government to be a guarantor. The investment was proportional to their share of ownership of the SPV. two private companies. in the Umm Al Nar Desalination project. the SPV. In the above Umm Al Nar Desalination Plant example. but will often lack the economic resources to construct the site. a government may not want to assume construction risks or face political risks if the project does not have strong political support. signed a purchase agreement with Abu Dhabi Water and Electricity Authority whereby the latter agreed to purchase all the desalinated water produced by the site for a 23-year period. to form a joint venture in order to secure all the additional funding. setting favorable tariffs. the 7 . A common sovereign guarantee is when the government agrees to purchase all or part of the output of the product. totaling 112 million British Pounds of the $2. The Host Government. While this is a common off-take arrangement. In order to mitigate construction risks and to draw together the necessary capital. given that many projects generate public consumer goods. and promises to pay back private debt in the case of default. Moreover. promises to make favorable legal reforms. Abu Dhabi Water and Electricity Authority is a government entity that solicited Tokyo Electric Power Company (TEPCO) and Mitsui.
S. regional development banks (for example. market interest-rate loans. provide guarantees and political risk insurance. and commercial bank financial assistance. To better understand the complexity and the ways in which financiers interact with each other. First. Financial Institutions. The form of support is as varied as the parties: low interest-rate loans. the government guaranteed to purchase all energy produced by the site. Most projects engage some combination of multilateral organizations (for example. In the case of the Pigbilao Project in India. equity ownership. guarantees. such as the World Bank or the European Bank for Reconstruction and Development. for example. some financial institutions. and technical and operational support. the International Finance Corporation). demand dropped during the Asian Financial Crisis and the government could not afford to continue to purchase all energy generated by the plant. bilateral organizations (for example. financial institutions provide loans with varying levels of interest rates depending on the economic situation in the host country and its creditworthiness. Second. political insurance (insurance against changes in authority or legislation). Ex-Im Bank). no interest-rate loans. the Islamic Development Bank). Generally. However. Finally. thereby providing assurance to other investors. consider the following example. financial intuitions may help provide guidance on how to manage the project or provide technical expertise. the Japan Bank for International 8 .guarantee can expose the host government to substantial liability. Furthermore. there is an even greater variety of capital support structures that a financial organization can provide for a project. the role of financial institutions is three-fold. There are numerous financial institutions that may be involved in building a site financed by project finance. the U. The CBK Power is a hydropower station in the Philippines that involved participation by multilateral organizations (―Senior Lenders‖ in the chart below) and a bilateral investment organization.
JBIC is not a lender to the SPV. JBIC provided guarantees to private financial institutions in case the sponsoring companies default on their loan to purchase ownership of the SPV. is limited to tariffs generated by the project. This demonstrates just one variation by which a sponsor company and the SPV can finance a project through project finance depending on the demands of a project. and in the case of a default.pdf Source: 9 . and repayment. to finance and guarantee the loan. as the chart below demonstrates. JBIC and the private financial institutions are mezzanine lenders. JBIC provided both financing and political risk coverage to the new sponsor companies. In this case. To enable the transaction.jp/english/publications/jbic_archive/others/pdf/project_finance. private financial institutions financed the equity acquisition. Source: http://www. Therefore. Note that JBIC did not lend directly to the SPV (―Project Company‖ in the chart) but to the company who wanted to purchase equity from the original sponsor company.Cooperation (JBIC).go. they are paid back after senior lenders. but a guarantor on a loan to purchase ownership of the SPV. in this case to J-Power and Sumitomo Corporation.jica. Because this project involved the continuation of an existing project with a shift in ownership.
Finances at rates based on its own costs and not international rates. As a result. Provides interest-free financing based on Islamic religious principles (Sharia law). Provides financing. Main function is to mitigate risk by providing political risk insurance (e. Provides both financing and loan guarantees. IDA charges a small fee rather than an interest rate. Provide short-term loans with floating interest rates based on good to excellent credit rating for the SVP and/or host country. Provide financing and political risk insurance. Charges market interest rates. providing long-term loans. and an equity investor. it does not. Can be an equity holder. technical cooperation. International Development Association (IDA) International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) Regional Development Banks* African Development Bank Asian Development Bank European Bank for Reconstruction and Development Islamic Development Bank Bilateral Organizations Commercial Banks * The list below is a sample. so the borrow must demonstrate that the project is feasible Reconstruction and and the borrower will be able to repay the loan. also finances leases. assists with drafting feasibility studies. Goals are to reduce poverty and increase development on a regional level.. and while it does have the capacity to provide guarantees. but has since shifted to provide lending to private companies. until recently. Focused on providing financing rather than guarantees. The IFC has two types of loans: "A loans"(financed by the IFC's own funds) and "B loans" (financed by external funds). B loans have high interest rates (higher than the World Bank) to attract more capital by offering capital investors a higher interest rate. Group Lender of last resort. Serves as a guarantor. IFC can be an equity shareholder. the ADB required the host government to provide a guarantee on lending available only to governments.g. rather than capital markets. MIGA backing can help attract funding. 10 . and other operations of the project. change of authority or change in legislation) as well as to mediate possible disputes. meaning that no other lender will provide International Bank of financing. Development (IBRD) Finances projects in the world's poorest countries (that do not qualify for market-based interest rates).OVERVIEW OF FINANCIERS AND THEIR ROLES SOURCE ROLE International Multilateral Organizations: World Bank Mitigate risks and provide risk enhancements as a senior lender. IDA receives funds from subscription members and the World Bank. in addition to a whole range of services including mobilizing additional funds. In fact.
or both.Contractors and Builders. When the sponsoring company. the contractor must deliver the completed project according to a strict timeline. the builder’s interest in extending the deadline conflicts with an SPV’s on-time delivery. The agreements must explicitly detail all phases of construction. offer the builder an on-time production bonus. Because the construction phase often involves significant risk of completion. those who lease equipment. the government is the off-take purchaser. Often. Depending on the structure of the agreement with the host government. since future revenues guarantee loans in project finance. The off-take purchaser has the most essential role at the outset of the project. the SPV can guarantee revenue for the project. In order to provide greater assurance for financial institutions. To avoid the conflict of interest. and other companies that are involved in constructing the project. attempts to secure financing. There is often tension between contractors and builders and the SPV because the contractor is required to finish the contract on a ―turn-key basis. Sometimes the off-take purchaser is the sponsoring company that wants to create the project to gain access 11 . There must be detailed arrangements with contractors.‖ That is. Operator and Off-take Purchaser. either the SPV or another company will take over the site and operate the facility. the SPV can insure against the construction risk. Because on-time completion is essential for the SPV to insure that it is able to pay back financial commitments. the operator may be the government (or its agent) or another company contracted by either the SPV or by the host government. an essential part of project finance is to be able to demonstrate that the project will be able to generate revenue. it is essential that risks be clearly allocated in documented agreements. Once the project is completed. In doing so. on behalf of the SPV. the sponsor company or the SPV will often seek out and sign an off-take agreement for the product or services the project will generate.
What are the financing mechanisms under project finance? Similar to the traditional finance model. ZincOx is acting as both a lender to the project and is a private off-take company purchasing zinc from Korea Zinc. Often host governments and debt lenders will require that the entity building the project obtain some equity funding in order to demonstrate project viability in the market and to 12 . Equity. Debt financing refers to funding a project with a loan. the SPV. the off-take purchaser may also be funding the project. where the SPV takes out a loan and no other investors are involved. In this case. a project finance model allows an entity to use equity or debt financing. ZincOx. Most entities in search of investment funds prefer debt financing to equity financing because they retain full control over the project and earn a greater return through the use of debt financing. IV. debt financing is attractive because project sponsors do not have to contribute extra capital to the project. In contrast. a South Korean zinc producer and recycler. equity financing requires the project sponsors of the SPV to either contribute cash needed for the project or sell ownership in the SPV to raise capital. For example. In addition to maintaining full control.to a needed resource. signed a letter of intent with Korea Zinc for a $50 million dollar loan as well as an off-take contract for Korea Zinc to purchase the zinc produced by the recycling plant. In other arrangements.
where the lender requires the borrower’s promise of repayment to be collateralized (backed by some asset). because there are other outstanding loans that have priority over the mezzanine loan in the case of a default. but is subordinate to other types of loans. A lender may stipulate that it is a senior debt lender. Recall the example above of the CBK hydropower station. There are a number of factors that influence the level of equity in the SPV that will be made available by the sponsoring companies via equity funding and how much of the construction costs the SPV will solicit in the form of loans. as the World Bank does for example. who the players are. and what legal requirements there may be in the host country. Typically. The mezzanine debt lenders were providing capital in order for one project sponsoring company to purchase the existing project company. Debt. (b) Senior Debt: As the name suggests. which has priority over equity.offset initial costs. Those factors include how the project is organized. pension funds. If the project fails. that lender will receive payment before other creditors of the project. senior debt has seniority in the event of default. This means that in the case of default. 13 . what the particular risks are in that country. equity comprises a smaller share compared to debt (although equity-to-debt ratios range from 5% to 50% in project finance). (a) Mezzanine Debt: Mezzanine Debt is a special type of debt. insurance companies. The important fact to bear in mind is that mezzanine debt refers to debt that is riskier. and other financial institutions). senior lenders who were lending to the SPV rather than to the new sponsor company will be paid off first. There are several types of debt available to sponsoring companies: Commercial financing (commercial banks. There are two main types of debt: Mezzanine and Senior Debt.
where the interest rate is below the market rate. The company leasing the equipment has a security interest in the equipment and can repossess the equipment in the case of a default. then the guarantor will make payments to the lender on behalf of the SPV. In return for the financing. Bond financing. Development institutions. this sort of financing can play an important role in enabling a project to proceed. but promises to pay for the equipment once the project begins to generate revenue. One other unique method of financing is lease financing where the SPV rents equipment relying on future revenue stream of the project to pay the lease. That is. 14 . governments. where those organizations provide a guarantee to the lender. the SPV does not make immediate payments on the leased equipment. Leasing. Subsidized loans. If the SPV cannot make payments on its debt. Because construction costs are significant. the SPV may be required to pay additional interest or pay a premium on the cost of renting the equipment. where the bondholder provides capital in return for a promise by the SPV to repay the initial amount with interest. and regional development banks (such as a loan from the African Development Bank) typically provide such subsidized loans. Credit enhancing arrangement from bilateral and multilateral organizations and regional banks.
set rates) based on market 15 . there are two main types of financial risks: interest rate risk and currency risk. Commercial Risks. Because project finance is a common financing mechanism for long-term. in their agreements with each other. What are the typical steps in project finance? VI. labor-intensive projects. What are the risks associated with project finance and how are they mitigated? One of the reasons that participants employ the project finance model as opposed to traditional finance is because infrastructure projects require large volumes of capital. In the larger scheme of commercial risks. With so many participants. This next section will discuss the main risks inherent in project finance and how the various parties.V. or both. Most projects are long-term so lenders charge floating rates (as opposed to predetermined. Like in traditional finance. attempt to mitigate them. changes to the interest rate may negatively affect the financier or the SPV. risks are abundant and may surface at any one of the many stages in the project cycle. risk can be allocated among the parties best able to bear it.
when interest rates rise. In project finance. Currency risk occurs when revenues are generated in one currency while debts must be repaid in a different currency. During the Asian Financial Crisis. but one that floats only within a fixed manageable range. and one that is not easily mitigated. the costs of the project will increase and the SPV may find itself unable to meet its financial obligations. many Asian countries’ currencies suffered significant depreciation. fluctuations in exchange rates may make repayment difficult if an SPV generates revenue in the Thai baht. This is called currency mismatch. it is best for the SPV to negotiate a either a fixed interest rate or a floating interest rate. The off-take purchaser (power purchaser in this case) bore the currency risk under the purchase agreement. Alternatively. and when the Indonesian rupiah fell 87% in 1996. Currency risk is also a serious financial risk to project finance. the power purchaser’s rates to customers skyrocketed because of its obligations to pay for the debt in 16 . because currency exchange rates fluctuate.. financing is typically received in the currency in which the lender operates and the lender expects to receive payment in the same currency—e. For example. If the baht drops in value with respect to the dollar. Therefore. Indonesia’s Java Bali Power Grid project demonstrates the extreme effect of currency mismatch. then the SPV will need to come up with more baht to pay back the loan because one baht now pays back less debt then before the devaluation. bank lends in dollars and expects to be repaid in dollars. like a private bank. but must pay back in dollars.S. an SPV may find itself unable to pay its lenders if the domestic currency suddenly and significantly drops in value. However. a U.g. the SPV may use interest-rate swaps to mitigate the risk that a floating rate will increase.conditions. The SPV may swap with another party. In order to mitigate this problem. the floating interest rate for a fixed interest rate on the principal amount the SPV borrowed. when possible.
as detailed below. demand for energy fell significantly. the Philippines National Power Company. which addresses the risk of a devaluation of the local currency. yet a regime change or a change in power of a ruling party can influence the success of both the construction and operation of a project. but when the Asian crisis hit in the 1990’s. A drop in demand was the reason the Pigbilao Project failed in the Philippines. The best method to mitigate demand risks is for the parties to do extensive pre-construction forecasting of future demand. As a result. which include changes in a government’s authority. Also. Additionally. the facility provides liquidity to cover the debt payments. legislation. in which case the essential element of project finance—the revenue stream to pay back loans—is reduced. and budget. resulting in a cash flow shortfall. In the event of a specified devaluation. was the off-take purchaser and bore the demand risk. Political risks take various forms. Closely related to the currency mismatch are demand risks. the power purchaser had to pay approximately 400% of the original price. the party bearing the demand risk may seek a guarantee from a third party like the World Bank. The project was well financed and completed on time. When demand fell and prices rose. Essentially.dollars. Political Risks. Given the close relationship of the SPV and the host country in project finance. demand for the project-finance generated goods or service may drop. allowing the SPV to convert debt into a more stable currency. Sponsoring companies often overlook the possibility of a change of authority. either through poor planning or because of some extraneous event like the Asian Financial Crisis. the SPV may mitigate risks stemming from currency exchangerate fluctuations by utilizing a currency swap. even the possibility of a change 17 . a real exchange-rate liquidity (REX) facility may be used. Similar to interest rate swamps. Napocor. Napocor feared political backlash and had to subsidize the price of energy.
forming the Dabhol Power Company (DPC). Private companies as well as multinational organizations (like MIGA. The sponsoring companies negotiated a rushed agreement with the Indian government.can be disruptive to the progress of a site. the Dabhol power project demonstrates the extent to which a change in power can bring a project to a standstill. While the project did not ultimately fail because of the political change (it failed because of miscalculation for demand). may lead to changes in the host country’s position on a vital element of an agreement. in addition to issuing performance bonds that guarantee completion. Government corruption can also seriously hinder a project. the new government created the Munde Committee. and that the agreement was too one-sided. which was anxious to have foreign investment in the region. the agreement with India was renegotiated. As a result. Political risks are mitigated by political risk insurance. either of a political system (like a change from autocracy to democracy) or a change of from one political party to another within a political system. The Congress Party lost control to a coalition party formed by Bharatiya Janata Party (BJP) and the ShivSena. Dabhol became a major campaign issue in the Maharashtra state election. Once in power. which has a special political insurance service) provide insurance in a traditional sense. the government ordered DPC to stop construction. Take for instance the Dabhol power project in India. The two parties won on a platform that advocated hostility to the sponsoring companies of the Dabhol Power Company. In 1995. A change in the political authority. which reviewed the Dabhol power project and determined that the Indian government rushed into an agreement with DPC. 18 . After lengthy negotiations.
such a political risk that may halt construction. changes in import and export tariffs can increase costs by preventing access to cheap raw materials or by forcing the SPV to use inferior domestic inputs. A technical risk may be access to a power grid for the distribution of power to customers. Specifically. Because storing power can be very challenging. Construction. Changes to the laws governing elements of agreement. In a power project. A host government may want to achieve certain shortterm economic or social goals by changing the tax code. status. and Technical Risks. immediate access in proportion to demand is essential for a successful power project. A thorough feasibility study should examine construction risks as well as how power 19 . Construction.Legal Risks. The main construction risk is that construction will be stopped or significantly delayed. which can have a catastrophic effect on the project. The rate at which host country taxes the SPV or other parties will significantly affect the financial benefits to participants. Operation. but it may also be intertwined with other risks. Legal risks are most often mitigated by guarantees (which are elaborated upon below) from one of the participants—most commonly the host government. the construction risk may be that the builders will have delay or problems having equipment shipped to the site. Finally. or change the laws governing ownership of companies or real estate. for example. which can purposefully or inadvertently affect the project structure. operation and technical risks are usually assessed during the first stages of the project in a ―feasibility study‖ that carefully examines risks associated with putting up the project as well as the technical and environmental regulations that may impact the project. Sometime construction is delayed because builders do not have access to materials. or operations of the project can significantly affect the costs of an operation. the host country can adopt laws that change the legal status of the SPV.
Another risk is that the host country could change technical requirements before the project is complete. If an international or national environmental agency detects non-compliance. To mitigate construction risks. and how the power generation site will connect to the grid. the laws on environmental protection may change or the national legislature may pass a new law that requires a higher density of steel for structures of a certain height. any one of the participants can provide a guarantee on any one of the associated risks. 20 . companies often conduct extensive environmental impact analyses. like the Asian Development Bank. one important method of mitigating commercial. political. provide guarantees for worthy projects. In order to mitigate some of the risks. parties can draft legal agreements that specify the terms under which the SPV has access to the grid. large multilateral organizations like the World Bank.will be interconnected to the main power grid. A feasibility study evaluates environmental regulations and the effect of building a site at a particular location. the SPV can negotiate for the builder rather than the SPV to bear that risk. For example. Such agreements are instrumental for the success of a project. or may face social and political backlash. fined. since access to the power grid is an essential component of generating revenue to repay loans. In order to comply with national and international environmental laws. affecting the project’s compliance with building regulations. Mitigating Risk with Guarantees As referenced above. and regional development banks. However. Most commonly. technology compatibility issues. legal and construction risks is for the SPV (the most common recipient) to acquire guarantees by the parties best able to bear the associated risk. a project may be shut down. and how revenue will be calculated.
some projects may never start. Often. contributed $250 million of guarantees to a $510 million gas pipeline that stretches 678 km approximately 15 miles off the coast of Nigeria to Ghana. Without guarantees.‖ where the guarantor promises to pay for any liability of the obligor (the project company). the roles of other participants. the International Development Bank (IDB). For example. guarantees can take various forms. Often. Depending on the organization of the projects. 21 . but the project company must pay back the guarantor. Typically. the sponsor company may be the guarantor. Along the way. the guarantors may purchase insurance in case they have to provide capital for a default under the guarantee agreement. smaller pipelines that lead to intake locations in Benin and Togo connect to the pipeline. multilateral and bilateral organizations mitigate financial and political risks by issuing guarantees. a subsidiary of Zurich Financial Services Group. and Steadfast Insurance Company (SIC). and the nature of the agreement with the sponsor company or SPV. Multilateral Investment Guarantee Agency (MIGA). in 2006. (that is in turn is insured by Oversees Private Insurance Corporation). In turn. third-party guarantors like a multilateral organization or a regional bank do not sign unconditional guarantees. these guarantees are in the form of ―put options. For example. Contractors usually guarantee project completion either by performance bonds or payment bonds (guarantees that subcontractors will be paid). but rather limited or indirect guarantees. during the early stages of construction.Guarantees are credit enhancement devices.
project finance offers several important advantages as a financing mechanism.Source: http://siteresources. It draws a greater volume of financing than under traditional schemes because risks are often spread among the various participants. As a relatively new method of financing dating back to the 1970’s. so private investors entering the region face significant political risks.worldbank. meaning that in the case of default by the sponsor company. the IDA would satisfy the SPV’s debt repayment obligations to its financiers. many essential and life-enhancing projects may have never been constructed. VII. By providing complementary guarantees (there was no interest rate attached to the guarantee) to the government of Ghana. What are the Advantages of Project Finance? Project finance allows countries to build the infrastructure necessary to increase growth and development. a borrower’s liability to 22 .org/INTGUARANTEES/Resources/WAGPNote. the International Development Association (IDA) guaranteed that if the Government of Ghana was unable to make payments on the gas under the off-take agreement. It is a non-recourse financing mechanism. the West African Gas Pipeline (WAGP) could not have been possible without the guarantees by multilateral and bilateral organizations. Nigeria. and development organizations mitigate risks by providing political and commercial guarantees. Benin and Togo are developing countries.pdf As one of the largest private investments in West Africa. Ghana. Without project finance.
Moreover. the financing is likely to be at a discounted interest rate. host governments maintain control over the site if necessary. This is called ―off-balance sheet‖ accounting. A massive hydropower generation site. multinational and regional organization. Moreover. for example. where all debts are assigned to the SPV rather than the sponsoring company and the sponsoring company does not have to account for the large debt in its accounting books. and develops needed infrastructure projects without exhausting host country reserves. are more willing to provide financing. Despite the lucrative gain. Given that power projects require high amounts of capital. given other demands on a nation’s resources. Given the participants and its organizational structure. the companies that own the project site do not have to fear that lenders will be able to go after the assets of the sponsor company if there is a default. project finance provides a safety net to private investors. depending on the financing arrangement. is a very expensive endeavor. the debt of the SPV is not reflected on the sponsor company’s balance sheet. Therefore. and because of the way projects are organized both financially and legally.the lender is limited to the assets of the special purpose vehicle rather than the company or companies that own the SPV. The guarantees provided by such organizations serve to attract more investors. Large infrastructure projects are essential for developing and emerging economies. many private companies shy away from such capital-intensive endeavors if there is no safety net. whose goals are often poverty prevention and developing economic prosperity. 23 . Therefore. like the World Bank or the African Development Bank. This allows the sponsoring company’s credit rating to remain unaffected. enables host governments to attract investment. and governments are also unable to make the necessary funding available.
In the six years prior to 2009. particularly by multilateral and regional banks like the African Development Bank or the Asian Development bank. and therefore can keep more of the profits once they are generated. What is the future of project finance? Project finance is an increasingly widespread financial mechanism. it is likely to continue to grow as the global economy recovers. VIII. favorable financing terms. and access to capital. Because project finance typically involves guarantees. Middle East and Africa (EMEA) benefiting most. Debt leveraging refers to financing by debt (as explained above) as opposed to equity. there was a relatively steady increase in the volume of capital financed under the project finance model. the SPV often attracts more investors and receives lower interest rates because the risk of default is reduced. which host governments and private investors are employing more frequently and in greater volumes as a method of financing infrastructure projects. with Asia Pacific and Europe.Other advantages of the project finance structure include debt leveraging. Project finance provides access to more capital than would be available to a private company or government on their own because governments would typically be limited to their internal financing and private companies usually cannot attract enough capital necessary for large infrastructure projects without additional guarantees. While not all areas of the world experienced the same growth in volumes of capital. total volumes nearly tripled from 2003 to 2008. This is an important advantage for the sponsor company because it does not have to reduce its ownership of the SPV. Furthermore. 24 . project finance remains a valuable financing approach that offers significant advantages to participants. While the most recent economic crisis has had a significant impact on the volume of capital available. The graphs below shows the growth trends for project finance.
In 2006. West-African nations were unable to take advantage of inexpensive regional reserves of natural gas. many governments are privatizing certain industries. despite the tightening of capital markets during that time. before the expansion of the West Africa Power Project. there were 541 project-financed projects for a total of $180 billion. technological improvements are reducing the risks associated with various projects that are best financed through the project finance model. In 2010. 25 . solar energy technology is becoming increasingly feasible and economically viable. developing and emerging economies are making significant strides to develop their economy. First. at the high point of global economic stability. For example. Third. while still in the process of economic recovery. given the speed with which the volume of capital is returning to pre-recession levels. Second. For example.Source: Thomson Reuters The graph suggests that capital in project finance will continue to increase. there were 587 project funded by $206 billion. so investors and developers are less wary to build such projects. Fourth. which often requires building infrastructure to effectively utilize available natural resources for domestic growth. especially when existing infrastructure needs repair or refurbishing. parties involved in project finance have over the last forty years developed the project finance mechanism in way that best mitigates risks. thereby insuring a greater likelihood of success. There are several possible explanations for the continued growth and success of the project finance model.
2006).In those cases. AND DEV. The primary reason is that governments are looking to build infrastructure that does not rely on oil. CENTER FOR INT’L FIN. but have a presence in developed countries. For these reasons. Power is just one industry where project finance is likely to have a growing impact in the future. project finance will ensure future global growth and development. DENTON WILDE SAPTE LLP. The area that seems to be growing most rapidly is power project financing for both power generation and transmission.com/2011/02/uruguay-to-expand-its-energy-options. http://uicifd. In many low-income countries like the ones in the West Africa Power Project. commentators believe that project finance drives economic development in low-income countries. many countries have other natural resources that can be converted into energy. There are several reasons that power projects dominate project finance.html. Uruguay to Expand Its Energy Options. Additionally. power projects financed by project finance are not limited to developing and emerging economies. the projects and the positive subsequent effects on regional and national economic developments would not have been possible without project finance. GRAHAM D. PUBLIC PRIVATE PARTNERSHIPS: BOT TECHNIQUES AND PROJECT FINANCE (2D ED. and power project finance allows nations to build new massive infrastructures costeffectively. Sources: Carrie Harrington.blogspot. particularly solar and turbine power generation in the United States and northern Europe. 2006) 26 . As developing and emerging economies work to create the necessary infrastructure to improve the lives of their citizens. (2011). governments are likely to turn to the project finance model in order to maintain involvement and control while reducing capital contributions. PROJECT FINANCE (3D ED. Finally. VINTER.
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