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SUBJECT:

Project Finance

STUDENT NO.

246202

DUE DATE:

11 March, 2010

Declaration:
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INTRODUCTION

So You Want to be a Mining Magnate Project Finance for Mineral Development Projects

Author: Jamie Morien

Submitted in partial fulfilment of the requirements for the degree of Master of Construction Law (MConLaw)

The University of Melbourne 2010

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TABLE OF CONTENTS
I INTRODUCTION
A B Purpose Mineral Development Projects 1 The Mining Cycle 2 Risks 3 Financing Mining a Corporate Financing b Project Financing

4
4 4 4 5 6 6 7

II

MINING PROJECT DEVELOPMENT

A B Exploration and Deposit Discovery Economic Evaluation 1 Scoping Study 2 Pre-Feasibility Study 3 Feasibility Study a Project Finance Submission b Risk Aspects of Project Financing i Completion Risk ii iii iv 4 Resource Risk Operating Risk Market Risk

10
10 11 14 15 15 16 17 18 20 22 22 23 25 25 26 26 26 27 30 31

The Commercial Aspects of Project Financing a The Sponsor b Offtake Contracts and Long Term Purchase Contracts c Contractors and Suppliers i Licenses and Permits ii iii iv v Host Government EPC/ EPCM Contractors Insurers Operations Contracts

III CONCLUSION

32

TABLE OF FIGURES
Figure 1 Risk Reward Diagram Figure 2 Recommended Phases of a Mining Project Figure 3 United Nations Classification of Resources Figure 4 Debt-to-Total Capitalisation Ratios: Project Companies vs. Corporations Figure 5 The structure of project finance 11 12 21 24 24

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INTRODUCTION

Purpose

Taking a mining project from a prospect to a fully operational mine facility producing a saleable product is an enormous task consuming significant human and financial resources. This paper describes a process by which a sponsor develops such a mineral extraction (mining) project. Financing the mining enterprise requires sources in addition to the banks, as the banking sector is unwilling to take equity risk in such ventures. Mining itself is a highly risky venture and ranks near the top of what constitutes risky projects. Entering into the industry is an unlikely prospect given the significant financial requirements and the high likelihood of failure. Staying in the industry requires the mining companies to diversify their risks and leverage their investments. The use of project finance provides both a mechanism to offload risk, and where the loan is non-recourse to the companys balance sheet, it allows the miner to leverage in to the project with as little as 30% of the post-feasibility study costs. Project finance is not available prior to the completion of the feasibility study (which is also known commonly as a bankable feasibility study) and as such start-up costs for exploration and the economic evaluation of the prospect is necessary. This paper describes the concept of project finance and when and how it is available. It also examines the key risks of the mining enterprise that impact on project financing deals and evaluates the types of commercial arrangements that exist in such an enterprise.

B 1 The Mining Cycle

Mineral Development Projects

Mineral development projects belong to a category of project called extraction projects.1 According to the worlds largest gold miner:
theres more to mining than extracting gold from rock. First, you must find (or acquire) a promising mineral deposit. If the project survives the hurdles of the exploration pipeline, you move it into development. If it survives those new hurdles, you commission a mine which you then operate, and finally close. Its a long cycle, requiring large, sustained investments of skill, commitment, human resources and money.2

1 2

Paul Gellert, Barbara Lynch, Mega-projects as Displacements (2003) 175 International Social Science Journal 15, 17. Basics of Mining Barrick Gold Corporation http://intranet.barrick.com/C12/C8/About%20Mining/default.aspx (9 January 2010)

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The entire process is called the mining cycle and extends through six distinct stages:3
1. Exploration and deposit discovery; 2. Economic evaluation of the viability of exploiting the discovery; 3. Construction of facilities to process the ore; 4. Extraction (mining) of the ore from the ground; 5. Ore processing and refining; 6. Final rehabilitation of the mine site. The scope of this paper is to evaluate the risks, commercial issues and financing strategies up to the point of the full authorization of project funds which occurs subsequent to the economic evaluation (stage 2) and prior to execution (stage 3).

Risks

Typically as a project progresses throughout the various stages of the mining cycle the level of risk reduces as the level of certainty increases. The greatest uncertainty is in the early stages of a project so the decisions of greatest impact can be made during pre-feasibility and feasibility stages of a project.4 In fact moving through to execution of a project without properly completing the early studies is a recipe for disaster as discussed in section IIB of this paper. Regardless of which stage the project is in, mining is a risky endeavor. In fact mining and resource development projects, with the possible exception of shuttle and defence projects are the highest cost, most complex and risky ventures undertaken in todays world.5 One risk expert posits that mining can probably claim the greatest familiarity with risk.6 Resource bodies are generally becoming more marginal and as such mining companies have been forced to increase the scale of developments to benefit from economies of scale and access resource bodies in more difficult locations.7 This venturing out includes moving into more geographically difficult areas as well as more politically risky regions of the world. As the size and complexity of projects increase so do the number and magnitude of risks. Very large projects are characterised by long temporal horizons and require large, irreversible

Gavin M Mudd, The Sustainability of Mining in Australia: Key Production Trends and Their Environmental Implications for the Future (2007) Department of Civil Engineering, Monash University and Mineral Policy Institute, 6. Available online: <http://www.mpi.org.au/attachment/d016df19778a7c563cd1c99afe29c43a/f2065acefd9648fc79d94181e9032269/ 1_SustMining-Aust-aReport-Master.pdf> on 5 November 2008. P A Thompson, J G Perry, Engineering Construction Risks. A Guide to Project Risk Analysis and Assessment Implications for Project Clients and Project Managers (1992) SERC Project Report. Neil Cusworth, Robert Maskell, Lifting Management to the Next Needed Level (2000) December Mining Finance Yearbook 55. Stephen Grey, Risk Management and Mining Developments and Trends 2, 6 The Mining Chronicle July (2007). Stephen Grey, Dale Cooper, Risk Management for Resource Companies 6, 2 The Mining Chronicle February (2001).

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commitments with large potential downside loss but limited upside gain.8 This makes the financing of the larger projects more difficult as the outside tenor (i.e. loan life) for mining project loans is around 12 years and in recent years has been reduced to as little as six to eight years.9

Financing Mining

Mining was hard hit by the global economic crisis. With the exception of precious metals such as gold (which is considered a hedge against economic uncertainty) [t]he plummet in commodities pricing has left some of the majors struggling with debt repayments and many juniors are either having to mothball projects or go out of business simply because they cannot raise cash.10 There are numerous options available to mining companies for raising funds to meet capital requirements. These options include bank financing, debt financing, share issues and notes issues in both domestic and overseas capital markets. Different costs and risks are involved in these different methods of raising funds, for both the mining company and its lenders. Different terms and conditions, such as borrower reporting obligations and covenants, are also involved.11 In any event many options dry up in times of economic crisis except for the truly excellent project opportunities.

a Corporate Financing
A mining company may seek funds for development of a prospect using its balance sheet as security for the loan. Such financing which is on credit or full recourse to the sponsor, whether it is directly borrowed or guaranteed by that sponsor, is a corporate financing. 12 The financial model which the lender will use to base the credit assessment on will contain forecast production levels, profit and loss statements, forecast cash flows and balance sheets.13 Often lenders will rely on an assessment of the mining companies historical results rather than an assessment of the project or a detailed assessment of the future activities and prospects.14 The balance sheet and the income statement of the borrowers will be studied extensively by the lenders in a corporate financing. The balance sheet provides a picture (snapshot) of the financial posture of the firm at a particular data (e.g. 31 Dec 2005).15 The

Serghei Floricel, Roger Miller, Strategizing for Anticipated Risks and Turbulence in Large-Scale Engineering Projects (2001) 19 International Journal of Project Management 445, 446. Halupka, above n 9, 372. Is Mining in a Financing Crisis? Project Finance, May 2009 Martin Kudnig, Financing for Mining Companies: The Miners Perspective AMPLA Yearbook, 211, 212. Kyle Wightman, Project Finance Does it Exist in the Mining Industry: CRAs Experience 568, 568. Kudnig, above n 11, 213. Wightman, above n 12, 568. Willie Tan, Principles of Project and Infrastructure Finance, 2007, 42.

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balance sheet has three key elements: assets; liabilities; and net worth (assets minus liabilities) also called shareholders equity, which is positive if assets exceed liabilities and negative otherwise.16

b Project Financing
For a multitude of reasons discussed within this paper, sponsors pursue off-balance sheet loans to finance their mining project. The larger a project, the riskier it generally is for a single firm to finance it on its own balance sheet.17 As such competitors can collaborate to bring projects to fruition or they can seek other ways of taking a project off the companies balance sheet. Banks however are not equity risk-takers. Lenders want to feel secure that they are going to be repaid either by the project, the sponsor or an interested third party.18 Therein lies the rub. The key to a successful project financing is structuring the financing of a project with as little recourse as possible to the sponsor, while at the same time providing sufficient credit support through guarantees or undertakings of the sponsor or third party, so that lenders will be satisfied with the credit risk.19 Financing which does rely upon the economics of a prospect are project finance deals. Project finance is defined as [a] financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan20 Project financing does not rely upon the soundness and creditworthiness of the parties proposing the business idea to launch the project. Approval does not even depend on the value of the assets sponsors are willing to make available to financiers as collateral. Instead, it is basically a function of the projects ability to repay the debt contracted and remunerate capital invested at a rate consistent with the degree of risk inherent in the venture concerned.21 This form of finance can be attractive for the banks in that interest margins can be three to four times higher than for corporate borrowing, but attendant with their reward is the assumption by the banks of considerable risk.22 The value of project finance investment has grown from less than $10 billion per year in the late 1980s to almost $220 billion in 2001.23 This is due to the various benefits of the approach. Additional benefits of structuring a project finance deal include:

16 17 18 19 20 21 22

Ibid. John D. Finnerty, Project Financing (2nd Ed.,2007), 31. Nevitt, P.K., F.J. Fabozzi, Project Financing, 7(2000, 7th ed.) 3. Ibid. Ibid. Stefano Gatti, Project Finance in Theory and Practice (2008), 2. J. OLeary, Mining Project Finance and the Assessment of Ore Reserves, Geological Society, London, Special Publications, 1994, v. 79, 129, 129. Benjamin C. Esty, An Overview of Project Finance2001 Update (2002) Harvard Business School Case #202-105.

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Gearing - Project financing can sometimes be used to improve the return on the capital invested in a project by leveraging the investment to a greater extent than would be possible in a straight commercial financing of the project;24

Risk diversity - The use of debt facilitates risk diversity allowing the companies to undertake multiple projects thereby minimizing harm in the event of project failure;25

Protection of company assets - For example BP typically uses project finance whenever a proposed investment exceeds approximately 5% of the companies total assets;26

Preserves or maximises the value of the mining companies common shares by not requiring the company to issue additional shares which would dilute the value of the common shares;27

Preservation of sponsors borrowing capacity because the borrower has not had to rely on using any of the companies assets as collateral;28

A source of finance: Project lending is attractive to banks seeking higher returns than may be available from corporate lending. Therefore the universe of potential lenders for a project finance deal may include financial institutions that are not interested in participating in a conventional corporate loan facility;29

The sponsor retains control of the project: Within the constraints imposed under a typical project finance deal, the project sponsor retains control of the project. In many instances the only other source of funding would be an equity issue (leading to share dilution) or the sale of an interest in the project to another party;30

Risk reduction:31 o o o o o o Project financing reduces risk for the project sponsor; Lender recourse limited; Repayment deferrals; Strong negotiating position if difficulties arise; Limits cross default; Reduced political risk;

24 25 26 27 28 29 30 31

Nevitt, above n 18, 4. See C Richard Tinsley, Project Finance Supports and Structuring, Finance for the Minerals Industry (1985) 549, 551 Benjamin C. Esty, The Economic Motivations for Using Project Finance (2001) Harvard Business School, 27. Herbert D Drechsler, Mining Finance, Finance for the Minerals Industry (1985) Society of Mining Engineers, 530. Wightman, above n 12, 568. Halupka, above n 9, 373. Ibid. Wightman, above n 12, 568.

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o o o

Third party audit; Extends bank lending limits; and Longer term maturities.

For some other credit impact objective:32 o o To avoid being shown on the face of the balance sheet; To avoid being shown as debt on the face of the balance sheet so as not to impact financial ratios; o To avoid being within the scope of restrictive covenants in an indenture or loan agreement which precludes direct debt financing or leases for the project; o o To avoid an open-end first mortgage; To avoid being considered as a cash obligation which would dilute interest coverage ratios, and affect the sponsors credit standing with the rating services; o To limit direct liability to the construction period and start up and avoid a liability for the remaining life of the project; and o To keep the project off-balance sheet during construction and/ or until the project generates revenues.

For any one of these side benefits:33 o Credit sources may be available to the project which would not be available to the sponsor; o Guarantees may be available to the project which would not be available to the sponsor; o A project financing may enjoy better credit terms and interest costs in situations in which a sponsors credit is weak; o o Higher leverage of debt to equity may be achieved; Legal requirements applicable to certain investing institutions may be met by the project but not by the sponsor; o o Regulatory problems affecting the sponsor may be avoided; For regulatory purposes, costs may be clearly segregated as a result of a project financing; o The project may enable a public utility sponsor to achieve certain objectives regarding its rate base;

32 33

Nevitt, above n 18, 4 5. Nevitt, above n 18, 6 7

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Investment protection in foreign projects may be improved by joining as joint venturers with international parties, thus lessening the sovereign risk;

A more favourable labour contract or climate may be possible by separating the operation from other activities of the sponsor; and/ or

Construction financing costs may not be reflected in the sponsors financial statements until such time as the project begins producing revenue.

The disadvantages of project financing include:34 Complexity Additional time and effort to implement and administer Additional lending margins and fees applying to this incremental financing The provision of security over project assets to lenders Additional legal expenses and possibly financial advisory fees A reduction in the level of confidentiality applying to the proposed project

II

MINING PROJECT DEVELOPMENT

Exploration and Deposit Discovery

The discovery of a mineable deposit follows a program of mapping, surveying, drilling and core sampling whereby the deposit is classified into mineral resources (inferred, indicated and measured) and mineral reserves (probable or proved).35 Mineral resources should be audited, defined and reported according to the relevant code of practice before each relevant phase of the project.36 The uncertainty in this early phase is the greatest and therefore so is the level of risk. Mineral resource/reserve problems are the most likely technical problem to account for failure of mining projects.37 The final viability of the enterprise turns entirely on this analysis, as the commercial

34 35

Halupka, above n 9, 374. The South African Code for the Reporting of Exploration Results, Mineral Resources and Mineral Reserves (The SAMREC Code), 2007 Edition, The South African Mineral Resource Committee (SAMREC) Working Group Under the Joint Auspices of the Southern African Institute of Mining and Metallurgy and the Geological Society of South Africa. David Noort, C. Adams, Effective Mining Project Management Systems, paper presented to the International Mine Management Conference, Melbourne, October 2006. Shillabeer, J, and Gypton, C, Highlighting Project Risk Following Completion of the Feasibility Study, in Proceedings Mining Risk Management (2003) 101-109 (The Australasian Institute of Mining and Metallurgy: Melbourne).

36

37

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outcome is more sensitive to head grade variations than to capital costs, operating costs or metallurgical recoveries, within their respective ranges of variation.38 Exploration and development are very risky and highly speculative undertakings. Very few exploration companies actually find commercial deposits. Also, exploration and development companies generate no cash to fund operations or service debt. They are almost entirely dependent on risk equity which is very hard to find in the current environment.39 Project finance is not an option in the early stages of the mining cycle but the potential for massive windfalls are what attract junior equity who occupy the high end of the risk-reward curve40 as illustrated in Figure 1 below. Project financing deals in general wont be available until the viability of the enterprise has been proven within specified limits of accuracy following completion of the second stage of the mining cycle. In the early exploration and reserve development phases, prior to the feasibility, mining projects are as a rule to risky for lenders, and funding is restricted to equity sources.41

Figure 1 Risk Reward Diagram

42

Economic Evaluation

For a large project requiring significant financing, an independent study certified by a recognized engineering firm will be mandatory for the study to be regarded as bankable (emphasis in original).43 The economic evaluation is itself a multi-staged process that eventuates in a study document widely known as a bankable feasibility study. A bankable study must be of sufficient technical and financial accuracy to meet bank requirements for assessment of the project for financing

38

Peter L McCarthy, Managing Technical Risk for Mine Feasibility Studies Mining Risk Management Conference, Sydney NSW 9-12 September 2003. Janne Duncan The Global Economic Crisis Worldwide Impact on Mining Companies <http://www.mineafrica.com/documents/Macleod%20Dixon%20article.pdf> Halupka, above n 9, 371. Halupka, above n 9, 376. Ibid, 371. John Scott, Brian Johnston, Guidelines to Feasibility Studies in A. Mular, D. Halbe, D. Barratt (eds), Mineral Processing Plant Design, Practice, and Control (2002) 306.

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40 41 42 43

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purposes.44 The validity of the term itself is disputed and may tend the uninitiated to falsely believe that the study itself will have some kind of bankable value. The use of the term bankable in replacement of definitive feasibility study is ambiguous and best not used as it implies that there is a underlying attractiveness to the investment which does not necessarily reflect the accuracy of the study.45 Some writers recommends sponsors and engineers avoid using the term bankable at all.46 Additionally the term is founded on obtaining non-recourse project financing but is used broadly in the mineral development industry for all feasibility studies, and as such can be confusing and essentially misleading.47

Economic evaluation accompanies all phases of the mining cycle and provides the basis and justification for continued investment of money for the proposed development.48 Detailed evaluation is most intense however during the second phase of the mining cycle where a series of studies are conducted culminating in the final definitive feasibility study. Figure 2 below illustrates the phases of economic evaluation and shows how each study will go through multiple iterations until a single selected go-forward strategy is agreed.

Figure 2 Recommended Phases of a Mining Project

49

44 45 46 47

McCarthy, above n 38, 7. Noort and Adams, above n 36. See Daley A. Is it Bankable? Ore Reserve Estimates. The Impact on Miners and Financiers (1990) AusIMM. R. Craig Johnson, Michael R McCarthy, Essential Elements and Risks in Bankable Feasibility Studies for Mining Transactions (2001) Parsons Behle & Latimer 6. Scott and Johnston, above n 43, 281. Noort and Adams, above n 36, 5.

48 49

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Typically three formal studies are conducted with different objectives and successively more accurate outcomes. It is important to move through the process and not skip any steps. Skipping the prefeasibility or scoping study phase can lead to costly delays in the definitive feasibility study.50 Strictly following the process of successively more detailed studies focused on more specific options ensures that due consideration has been made on whether the project should be investigated further, that all of the alternatives are investigated before a particular direction is taken, that project viability has been investigated in detail and confirmed prior to carrying out additional design and estimating and committing significant funds, and that due processes are followed in determining and fine-tuning the project scope, timeframes and cost estimates. The type and quality of cost estimates have also been standardized in the industry with the level of contingency (margin for error) reducing from one study to the next in line with the increasing level of technical and economic knowledge. It should be stated that the industry accepted standard below by the AACE International identifies engineering to be up to 70% complete by the time that the feasibility study is complete is probably highly optimistic in mining projects. Evaluations by the author of some 25 recent mining megaprojects (valued at >USD1B) demonstrated that less than 30% was the highest level of engineering achieved prior to authorization and many of those projects were BHP Billitons who follow the AACEI standard. The level of engineering complete, which fundamentally reflects the level of scope detail drives the level of certainty in the final costs and schedule. The discussion around the use of EPC lump sum turnkey contractors in a later section of this paper points out how claims are the key outcome if scope is not adequately defined at authorization. For this reason financiers should be careful to establish, through the use of their engineer, the true status of engineering, which can be measured in various ways before selecting an implementation approach.
Table 1: Percentage Engineering and Estimate Classification
Investment Process Phase Identification Study Phase (Concept) Selection Study Phase (Pre-feasibility) Front-end Loading Conceptual Class 4 Equipment Factor 1% to 5% Preliminary Class 3 Semi-Detailed 10% to 30% Basic Class 2 Detailed 30% to 70% Definition Study Phase (Feasibility) Execution Phase (Implementation) EPC Detailed Class 1 Definitive 70% to 100%

Project Phase Engineering Estimate Classification Estimate Type BHP Billiton51

50 51

Ibid. BHP Billiton Estimating Guideline PMG-PC-110.

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Identification Study Phase (Concept) 5%

53

Selection Study Phase (Pre-feasibility) 10 % to 15% 10% to 40% 10% to 15% 5% to 15% 5% to 10%

Definition Study Phase (Feasibility) 30% to 40% 30% to 70% 10% to 25% 20% to 35% 15% to 30%

Execution Phase (Implementation) 80% 50% to 100% 40% to 60% 95% to 100% > 65%

Anglo America52 AACE International Cusworth (2005) Huxley (2002)55 Hickson (2002)
56 54

1% to 15% 1% to 2% 1% to 5% 0% to 2%

Scoping Study

A primary concern of this study is an evaluation of the resource body. The resource is defined as [a] concentration of naturally occurring solid, liquid, or gaseous material in or on the Earth's crust in such form and amount that economic extraction of a commodity from the concentration is currently or potentially feasible."57 The Society of Mining Engineers qualifies this language saying, [l]ocation, grade, quality, and quantity are known or estimated from specific geological evidence. To reflect varying degrees of geological certainty, resources can be subdivided into measured, indicated, and inferred.58 The type of estimate used for this phase of the cycle is known as a Class 4 equipment factored estimate.59 The factorial method of cost estimation for process plants is attributed to Lang (1948). 60 The Lang Factor is a formula that posits that the fixed capital cost of the project is given as a function of the total purchase cost of equipment by the following equation: 3.10 for solid process plant Delivered equipment cost X 3.60 for solid-fluid plants 4.70 for fluid process plants = Total estimated plant costs

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Anglo America, ATDP_ES_000098 Estimate Classes <http://www.anglotechnical.co.za/ATDP_ES_000098.DOC> on 23 July 2008. AACE International Recommended Practice No. 17R-97 Cost Estimate Classification System TCM Framework. Neil Cusworth, Capital Investment Systems: Making the Right Investment Decisions (Paper presented at the Project Management Australia Conference, Brisbane Australia, 2 September 2005), <http://www.enthalpy.com.au/PS1639.pdf> at 9 June 2008. Anthony L Huxley, Estimate Classes: An Explanation (2002) June, Construction Economist, 12. Robin J Hickson, Success Strategies for Building New Mining Projects in A. Mular, D. Halbe, D. Barratt (eds), Mineral Processing Plant Design, Practice, and Control (2002) 2250, 2255. United States Bureau of Mines & United States Geological Survey, Principles of a Resource/Reserve Classification for Minerals, Geological Survey Circular, 831 (1980). Society of Mining Engineers, Working Party #79 Report: A Guide For Reporting Exploration Information, Resources and Reserves, 379 (1991). AACE International above n 53. R. K. Sinnott, Chemical Engineering Design, John Metcalfe Coulson, John Francis Richardson

53 54

55 56

57

58

59 60

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Pre-Feasibility Study

The South African code for the reporting of exploration results, mineral resources and mineral reserves (SAMREC) defines two types of studies: pre-feasibility and feasibility. SAMREC provides the following definition of a pre-feasibility study:
A comprehensive study of the viability of a range of options for a mineral project that has advanced to a stage at which the preferred mining method in the case of underground mining or the pit configuration in the case of an open- pit has been established and an effective method of mineral processing has been determined. It includes a financial analysis based on realistic assumptions of technical, engineering, operating, economic factors and the evaluation of other relevant factors that are sufficient for a Competent Person, acting reasonably, to determine if all or part of the Mineral Resource may be classified as a Mineral Reserve. The overall confidence of the study should be stated, A Prefeasibility Study is at a lower confidence level than a Feasibility Study.61

A pre-feasibility study is an intermediate study and is considered essential for three reasons:62 1. Justify a major ongoing exploration program following a successful initial exploration effort. 2. Provide the basis for proceeding to a final feasibility study. 3. To attract a joint venture investor or a buyer for the entire project, or to provide the basis for raising additional risk capital by way of a major underwriting.

Feasibility Study

If the pre-feasibility study establishes the viability of the project within specified limits of accuracy (confidence levels) then a feasibility study will be pursued. The primary objective of the feasibility study is to optimise the single selected go-forward investment alternative. SAMREC provides the following definition of a feasibility study:
A comprehensive design and costing study of the selected option for the development of a mineral project in which appropriate assessments have been made of realistically assumed geological, mining, metallurgical, economic, marketing, legal, environmental, social, governmental, engineering, operational and all other modifying factors, which are considered in sufficient detail to demonstrate at the time of reporting that extraction is reasonably justified (economically mineable) and the factors reasonably serve as the basis for a final decision by a proponent or financial institution to proceed with, or finance, the development of the project.63

61 62 63

The South African Code for the Reporting of Exploration Results, above n 35. Scott and Johnston, above n 43, 308. The South African Code for the Reporting of Exploration Results, above n 35.

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During the feasibility study the selected alternative for the investment opportunity is rigorously evaluated in order to optimise the total life cycle costing and net present value (NPV) for the investment, to finalise the scope, cost and schedule and other KPIs, to establish the risk profile and the uncertainties associated with this risk profile, and to clearly define the project execution plan.64 Key parts of the feasibility study are:65 Economic appraisal: This process identifies options and assesses their benefits and costs, both qualitatively and quantitatively, to determine the options with the highest net present values or the highest benefit-cost ratios. The appraisal process also involves sensitivity testing, which may use elements of risk analysis in its conduct and interpretation. Risk analysis: This process identifies major areas of uncertainty and risk, highlights key sensitivities and considers allocation of risk amongst the stakeholders. It also involves consideration of responses to risk, thus generating recommendations for risk management and control strategies. Quantitative risk analysis may be conducted as a key part of the economic appraisal, or as part of the financial feasibility analysis. Financial feasibility: This process examines the financing of the project and its cash flows, to determine whether it is financially feasible. (This contrasts with economic appraisal, where non-monetary factors are important; here the focus is on cash movements.) Outputs from a financial feasibility study may include recommended financing structures and debt to equity ratios. Environmental appraisal: This process examines the potential environmental impacts of the project and identifies measures for mitigating adverse effects.

a Project Finance Submission

Once the decision has been made to pursue a mineral development project following a so-called positive feasibility study, a separate decision will be made to determine the manner in which the project will be financed.66 The project finance submission will be made following completion of the feasibility study once it is determined that the project is viable and prior to committing to the execution phase. The feasibility study document itself is submitted containing all the technical/ economic information and auditing necessary for a banker (and the bankers independent engineer) to

64 65

Standard for a Definition Phase Study (Feasibility) Version 2.2 March (2007) BHP Billiton, 4. Dale Cooper, Stephen Grey, Geoffrey Raymond, Phil Walker, Managing Risk in Large Projects and Complex Procurements 312. Johnson, McCarthy, above n 47, 11.

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determine that the project risks are acceptable and that the project is indeed viable on a stand-alone (emphasis in original) project financing basis.67 The actual project finance submission will typically contain the following breakdown68 Cover/Title Sheet Index/Table of Contents Sheet Model Administration Sheet Inputs and Outputs Summary Sheet Financial Modeling Assumptions Sheet (Inputs Sheet) Income (Profit & Loss) Statement Balance Sheet Cash Flow Sheet Expenditure Sheet Operations & Maintenance Costs (O & M) Sheet Funding Drawdown (Debt & Equity Drawdown) Sheet Working Capital Sheet Project Output Sheet (Power and/or Steam output generated etc) Revenue Sheet (Power and/or Steam Revenue Sales etc) Tax Sheet Depreciation Sheet Ratios Sheet Sensitivity Calculations Sheet Benefits Calculation Sheets (where relevant)

b Risk Aspects of Project Financing

The various risks inherent in each of the stages of the mining cycle are of primary concern to lenders. Whereas equity partners seek to leverage their investment and are willing to take significant (calculated) risks with the intention of making significant returns on their investment, lenders take a much more conservative approach. Project financing can sometimes be used to improve the return on the capital invested in a project by leveraging the investment to a greater extent than would be possible in a straight commercial financing of the project.69 When banks lend capital on a long-term basis they do so in return for a relatively modest and fixed returns; consequently, lenders willingly accept
67 68

Scott and Johnston, above n 43, 306. The Dynamics of Relative AttractivenessA Case Study in Mineral Exploration and Development, Financial Planning and Analysis Techniques of Mining Firms: A Note on Canadian Practice Nevitt, above n 18, 5.

69

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borrowers risk, but avoid taking what they perceive as equity risk.70 Even so project loans do contain some level of equity risk in the sense that they rely on the project for their pay-out and not on the general credit of the borrower.71 The technique of project financing evolved around the concept of risk and particularly the idea of shifting it.72 The assessment of the various elements of risk in a project and the sharing of that risk between sponsors and lenders is the most critical feature (of project financing)73 A detailed discussion of four of the key types of risk and how they are assessed and allocated is of great relevance to the topic of mineral development project finance and is provided herewith.

Completion Risk

Obviously the most critical risk on a project is that the project itself will not be completed on time, to budget or within the performance requirements established in the project charter. In assessing the development risks of a particular project, the primary objective is to assess the risk that the mine will not be completed on time and within budget.74 Of course the worst-case scenario is that the project will not be completed at all and this then is the key risk of concern to the lenders. Completion risk is generally allocated to the project sponsors (or project company) in the project financing of resource and infrastructure projects.75,76 Banks dont accept completion risk.77 Completion risk is often defined in broad terms that equate to definitions of risk itself78 such as exposure to possible economic loss or gain arising from involvement in the construction process. 79 Completion for the lender may also be defined in a different way that it is by other project participants. A lender will consider a project to be incomplete if it is not performing to the required throughput levels for production and as such revenues are not at the level anticipated.80 A completion test will be required by the lenders who will specify particular criteria to be met. The lenders Independent Engineer (IE) will always play a role in the monitoring of the completion test and the singing off of
70 71 72 73 74 75

Halupka, above n 9, 371. Philip Wood, Law and Practice of International Finance (1980), 14-2. Nora Scheinkestel, Project Finance The Lenders Perspective, 52, 52. Wightman, above n 12, 568. Kudnig, above n 11, 213. Paul Tobin, The Allocation of Construction Risks on a Mega-BOT: The Taiwan High Speed Rail Project (2008) The International Construction law Journal 484, 485. See Tinsley, above n 25, 551; and Richard Ladbury, Financing Resources Projects (1988) 62 Australian Law Journal 937 Scott and Johnston, above n 43, 308. See Scott McConnel, Project Financing in the Energy Industry and its Impact on Completion Risk (2001) 20, 2 Australian Mining and Petroleum Law Journal, 148, 152. Robert J. Smith, Risk Identification and Allocation: Saving Money by Improving Contracts and Contracting Practices (1995) 40 International Construction Law Review, 42. Karen Brown, Standardised Risk Allocation For PPPs: Will it Impact on Transition Costs and Efficiency? (2006) 17(2) Journal of Banking and Finance Law and Practice 92, 96.

76 77 78

79

80

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test components.81 The breadth of attitudes towards what is completion requires clear definition of the term for each particular project, as per Ladbury:
The tests for completion are often contentious and the subject of protracted negotiation. There are differing stages of completion. First, the documentation should cover as a minimum requirement, physical completion of the mine, treatment plant and infrastructure. Second, documentation should address performance completion which may require, for example, that the project is capable of or actually has produced a specified level of production for a specified period at a specified cost. There may also be sales tests or cover ratio tests to be satisfied.82

The completion test will include such items as the following:83 Minimum current reserve estimate Achievement of operating stability Achievement of design production Achievement of design capacity Achievement of design recovery Specified operating cost Specified product quality Cash flow coverage of debt service Debt ceiling (debt/ equity ratio)

Lenders may also require some kind of completion and recompletion covenants and a breach of such a covenant may give rise to an action for damages. Where recourse for the lender is fully limited to the project this of course has limited value.84 A successful completion test will result in two key outcomes; firstly the transfer of risk as the sponsors covenant will fall away, and secondly the debt obligations transfer from the sponsor to the project on a stand-alone basis.85 Following construction completion it is also likely that the lender will require a covenant around ownership and project management responsibilities (ensuring that the sponsor remains the contracted party), however this requirement is not usually essential.86 It is fully expected that there will be deviations from the assumptions of the feasibility study that are realised during construction. Typically these will be marginal to the successful outcome of the project
81 82 83 84 85 86

Halupka, above n 9, 378. Ladbury, above n 76, 938. Scott and Johnston, above n 43, 308. Ladbury, above n 76, 938. Halupka, above n 9, 378. Scheinkestel, above n 72, 68.

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and will be provided for from a contingency fund. There are projects however that experience such exorbitant increases so as to make the entire enterprise uneconomic. Sometimes companies persist with the project to their own peril. BHP Billiton for example, the worlds largest diversified mining company has too many such examples in its historical pipeline. Their Ravensthorpe Nickel Project was approved in March 2004 for a $1.1 Billion investment only to be completed over a year late and for a reported $2.2 Billion.87 Last year a Forbes article provocatively entitled BHP's $3.7 Billion Investment Not Worth A Nickel reports how BHP Billiton persisted through commissioning and into operations burning another $1.5 Billion.88 The fallout of the BHP Billiton loss was some major writedowns, mass redundancies and a plummeting share price. In 2007 the Galore Creek project in Canada suffered a cost blow-out during construction from $2.2 billion to $5 billion. Shareholders filed a class action against the company.89

ii

Resource Risk

Resource risk is the risk that the minerals and other resources will not meet the quantity, quality or mineralogy specified in the earlier studies.90 Project financiers recognize that ore reserves hold potentially the greatest risk for project finance lenders where there is no recourse to the parent entity beyond the project91 In fact Mineral resource/reserve problems are the most likely technical problem to account for failure of mining projects.92 The sensitivity due to ore grade can be two to three times that of the sensitivity due to capital costs.93 Studies have shown that resource risk has had significant outcomes on projects for decades. For example a study of 35 Australian gold mines in the 1980s found that 68% failed to deliver the planned head grade,94 and in the 1990s a study demonstrated that of nine Australian underground base metal mines only 50% achieved design throughput by Year 3 and 25% never achieved it at all.95 A more recent study found that 17% of a sample of 105 projects failed to meet geology, resource and

87

Peter Klinger, $1b Over Budget and a Year Late, Nickel Mine Finally Open, The West Australian (Perth) <http://www.thewest.com.au/default.aspx?MenuID=32&ContentID=74725> at 8 June 2008. Tina Wang, BHP's $3.7 Billion Investment Not Worth A Nickel, Forbes.com <http://www.forbes.com/2009/01/21/bhplosses-mining-markets-comm-cx_twdd_0121markets02.html> at January Steve Fiscor, Mining Project Standards Must Rise to a New, Consistent Level Engineering and Mining Journal, December 2008, 116, 116. Wood, above n 71, 14-2.1. Amos Q. and Breaden P., The JORC Code A Bankers View, AIG Journal Paper 2001-7, August 2001. Shillabeer and Gypton, above n 37, 4. OLeary, above n 22, 134. Burmeister B.B., From Resource to Reality: A Critical Review of the Achievements of New Australian Gold Mining Projects During the Period January 1983 to September 1987, Macquarie University, 1988. D. J. Ward, P.L. McCarthy, Start-up Performance of New Base Metal Projects in Adding Value to the Carpentaria Mineral Province, Conference Mt Isa, Qld, Australian Journal of Mining, April 1999.

88

89

90 91 92 93 94

95

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reserve estimations.96 The best response is to adhere to the specifics of the standards described earlier in this paper, which offer a set of guidelines for mining studies. The United Nations Classification of Resources is illustrated as follows:

Figure 3 United Nations Classification of Resources

97

A roundtable by one of the larger mining consultancies agreed overwhelmingly that levels of accuracy for feasibility studies overall should not be defined in terms of estimate accuracy but rather in terms of detailed lists of prescribed investigations with the estimate accuracy implied by completing the specified studies.98 The issue that faces the financiers is that the classification systems can differ significantly in terminology and interpretation. For example a North American gold producer that defines proved ore as a block estimated on the basis of at least one sample no more than 75m from the block centre, whereas a South American copper producer defines a block confidence 25% at the 95% confidence level on an individual clock basis to qualify in the same category.99 One issue is widely agreed and that is that [m]ineral resources should be audited, defined and reported according to the relevant code of practise (sic) before (emphasis in the original) each relevant phase of the project. Modifying the resource base because of geological reinterpretation or information obtained during the course of a study phase is often the cause of rework and delays.100 In general project financiers have been willing to accept resource risk where they have had the opportunity to call in independent experts to assess the relevant data forming the basis for the

96 97

McCarthy, above n 38, 7. J. J. Schanz, The United Nations Endeavour to Standardise Mineral Resource Classification (1980) 4 Natural Resources Forum 307, 313. Fiscor, above n 89, 116. OLeary, above n 22 133. Noort and Adams, above n 36, 7.

98 99

100

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estimates[the] degree of risk may be reflected in the security taken and the relevant margins.101 As another form of risk mitigation lenders will typically require a reserve tail which is an amount of economically recoverable ore reserves which remain unexploited at the scheduled maturity date. 102 A standard rule of thumb in project lending is to restrict the loan life to a maximum two-thirds of the project life on the basis of proven and provable ore reserves, thereby leaving a 50% reserve tail as a cushion against deviations from the plan.103

iii

Operating Risk

Operating risk includes new technology risk, management and labor issues, and environmental and governmental interference issues.104 Operating risk also includes the availability of raw materials for the project, the availability of a competent labour force, vulnerability of the project to breakdown, the expertise of the operator and the exposure of the project to a hostile physical environment.105 Generally the lenders are willing to accept operating risk, within reason, post-construction.106 Where the producers, advisers and consultants have a good track record, lenders usually accept technology risk107

iv

Market Risk

Market risk is the risk of whether there will be a market for the product, or at least that there wont be unacceptable risks of volatility in that market.108 The best treatment for this type of risk is to establish offtake agreements which are a form of hedging.
Off take agreements govern the sale of the product of the project. For process plant projects these agreements are crucial to the development proceeding. Financiers will not lend the funds and boards will not approve the project if there are no customers locked in to take the product. The impact of the offtake agreement is on practical completion. If there are take or pay agreements it is vital that the project is ready to delivery product from inception date of the off-take agreement or it will face

101 102 103 104

Ladbury, above n 76, 937. Scheinkestel, above n 72, 55. Halupka, above n 9, 377. James Bremen, Adrian Lawrence, Taking it to the Bank Making Your Mining Project Bankable (2005) September Engineering and Mining Journal 80, 83. Wood, above n 71, 14-2.1. Bremen and Lawrence, above n 104, 83. Ladbury, above n 76, 938. Wood, above n 71, 14-2.1.

105 106 107 108

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penalties. It may even have to buy product on the open market to meet its obligations. This can be a costly exercise if those markets are thinly traded or demand for these products is high.109 In mining projects the product produced is often not in its finished form. For example a mine in Australia might produce copper concentrate with dilutions of gold, silver and zinc. The smelting and refining process can be resource intense so it is more cost effective to export the concentrate to an existing smelter and refinery in Indonesia rather than construct a similar facility in Australia. The market for the product is thus tied to the limited market of refiners who have a facility of the proper configuration to treat the concentrate. Project financing deals typically require that at least 80% of production during the loan life be secured under long term purchase and sale conracts with approved smelting/ refining companies.110 Lenders may prefer sales contracts to be established based on a take-or-pay form of contract whereby there is an unconditional obligation to pay for the product irrespective of whether the product is actually delivered.111 In my own experience such a take-or-pay arrangement was put in place for the sale of acid which was produced as a by-product of a mineral processing process. When the global financial crisis caused the purchaser to put their facilities on care and maintenance they chose to pay rather than take physical delivery of the acid. A risk that wasnt properly identified prior to establishing the take-or-pay contract was what to do in the event of such a scenario where the wider market for acid faltered. The entire process plant had to be shut down as there was nowhere for the acid to be stored as it was produced during the process.

The Commercial Aspects of Project Financing

A number of contractual arrangements exist in a project financing arrangement that define the commercial and financial relationships between the various parties to the project. In fact the quantum of paperwork involved is tremendous as exemplified by the CSR Limiteds Delhi transaction in 1982 which according to the lenders involved more paperwork than the rescheduling of the entire Polish sovereign debt outstanding at the time.112 The legal considerations of a project financing deal revolve around two groups of concepts: 1. The project company and its economic/ legal function; and 2. The network of contracts (first and foremost, the credit agreement) that regulate the relationship between the different players in the project.113

109

Damian McNair, Stephen Webb, Nicholas Tsirogiannis, EPC Contracts Process Plants (2005) Review, at http://www.mallesons.com/publications/update-combine.cfm?id=481 at 25 November 2008. Halupka, above n 9, 375. Ladbury, above n 76, 939. Scheinkestel, above n 72, 53. Gatti, above n 21, 233.

110 111 112 113

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A key characteristic of a project financing is that the project company is established as a separate business and legal entity, or Special Purpose Vehicle (SPV), relying heavily on debt leverage (typically 50% or more) for its capital needs.114 Compared to typical public companies this highly leveraged element is significant. Figure 4 demonstrates the significant difference in the debt to total capitalisation between a sample of project companies and corporations in the United States. How the project company is structured is determined by the financial, legal, accounting and taxation constraints and objectives of each of the sponsors.115

Figure 4 Debt-to-Total Capitalisation Ratios: Project Companies vs. Corporations

116

Figure 5 below demonstrates a typical structuring for a project finance deal. The structuring differs from one project to the next. For example there may not be an issue of bonds and the sponsors may be the only equity investors and are typically the operator of the facility.

Figure 5 The structure of project finance

117

114 115 116

Halupka, above n 9, 371. John Martin, Project Finance in Bruce et al Handbook of Australian Corporate Finance (1997) 302. Esty, above n 23, 37.

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a The Sponsor
Given the sheer size of many mining projects it is often essential to involve multiple parties in the project company. An unincorporated joint venture is the most common ownership structure for projects in Australia.118 The joint venturers may procure lending together (joint financing) or severally (several financing). In joint financing, each of the joint venturers procures its finance from the same lenders. Each joint venturer commonly gives a charge over its individual interest in the project and any product, sales contracts and proceeds in favour of the lenders, and also gives a guarantee of the other joint venturers debt in favour of the lenders and a charge in furtherance of that guarantee.119 In several financing, each of the joint venturers arranges its own finance. Where several finance is obtained on the security of the project the borrowing venturer will almost invariably be asked to charge its individual interest and its interest in production, any sales contracts and the proceeds thereof. It is in this sort of financing that conflicts can arise between the lenders and the nonborrowing joint venturers in relation to the joint venture agreement.120 A key benefit to creating an SPV is that it provides an opportunity to create a new, asset-specific governance system to address the conflicts between ownership and control.121 This extends to deterring expropriation by host governments of projects.122

b Offtake Contracts and Long Term Purchase Contracts

The offtake contract or long terms purchase contracts are important as they assure a market exists for the projects output as per the discussion above.123 Challenges arise however when the fundamentals underpinning the original deal change significantly. One commentator identifies numerous examples of project sponsors having to renegotiate with purchasers as diverse as Japanese steel mills and Australian government owned utilities discover that estimates of requirements or long-term pricing may have been flawed.124 Therefore it is also important that the length of offtake agreements (and certain other agreements) is adequate:
The relative lengths of the key project contracts are important for project financing. As a general rule, the lenders to a project who are depending on the offtake, raw materials, operating, and other key agreements as an important source of the credit strength of the project will not agree to a debt contract whose maturity

117 118 119 120 121 122 123 124

Tan, above n 15, 124. Martin, above n 115, 303. Ladbury, above n 76, 943. Ibid, 944. Esty, above n 23, 3. Ibid. Finnerty, above n 17, 36. Scheinkestel, above n 72, 58.

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MINING PROJECT DEVELOPMENT exceeds the length of any one of these key agreements. As the project company will usually have to repay the debt by the maturity of the debt agreement, the length of these key project agreements constrains the maturity of project debt. Bank loans and bonds will be scheduled to mature before the concession agreements and the offtake contracts are scheduled to expire. 125

c Contractors and Suppliers

The contractors and suppliers in the project financing structure provide materials, equipment and services for the design and construction of the mine, process plant and infrastructure. The contracts define the terms and conditions by which the facilities will be built. The main contracting parties involved in the design and construction of the mine process plant include the process supplier who provides the high tech process engineering design, the Engineering, Procurement and Construction (EPC) turnkey contractors or Engineering, Procurement and Construction Management (EPCM) contractors who provide the balance of the engineering design, procurement and construction management , thirdly the construction (sub)contractors who are engaged by the EPC and EPCM firms and fourthly the insurers.126 Contracts can be used to allocate risk,127 and proper risk identification should lead to the form of contract most suitable for the project.128

Licenses and Permits

The lenders will require the process technology licenses to be in place for at least the duration of the project loan.129 Other key licenses and permits encompass native title, licenses essential to construct and operate the plant such as water supply licenses, property and right to mine licenses.130 In less mature legal jurisdictions the process can be highly uncertain and as such lenders will require that at least in principle agreements be in place prior to the finance submission.131

ii

Host Government

Host governments pose a special set of political risks especially in the developing world in regard to expropriation, discriminatory legislative or regulatory changes covering tax regimes and environmental laws; concession; political force majeure such as riots, strikes, civil unrest, wars,

125 126

Finnerty, above n 17, 37. Andrew Stephenson, Risk Allocation in Process Engineering Projects (2003) 22 Australian Resources and Energy Law Journal 49, 61. Peter Megens, Construction Risk and Project Finance Risk Allocation as Viewed by Contractors and Financiers (1997) 1 The International Construction Law Review 9. P Jeff Gard, The Risks and Rewards Associated with Different Contractual Approaches in A. Mular, D. Halbe, D. Barratt (eds), Mineral Processing Plant Design, Practice, and Control (2002) 2245, 2256. Halupka, above n 9, 379. Bremen and Lawrence, above n 104, 83; Halupka, above n 9, 379. Ibid, 84.

127

128

129 130 131

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invasions, terrorism, and religious turmoil need to be considered.132 Insurance may be an option for treating host government risks. In practice lenders seek to avoid political risk by:133 Externalising the security (e.g. guarantees are kept in external trust accounts); Externalising the governing law of and forum for the loan documents; Formal undertakings from the host government as to its policy on taxes, royalties, foreign management, currency availability, government participation or nationalisation, and the continued availability of the concession; Encouraging the involvement of international agencies as co-lenders on account of their greater diplomatic bargaining power in the event of default; and Taking out political risk insurance.

iii

EPC/ EPCM Contractors

The implementation strategy for the development of the mine, process plant and infrastructure is of key interest to the lenders. The contracting strategy, which defines in a major way the overall implementation strategy, should be developed through a detailed process of risk allocation. Contracts can be used to allocate risk,134 and the proper risk identification should lead to the form of contract most suitable for the project.135 However for the bulk of investments (by number and probably value) in the resource sector, the implementation strategy is typically set to first deliver completion guarantee support to debt providers.136 For this reason contracts guaranteeing completion and performance such as Engineering, Procurement and Construction (EPC) contracts, which include liquidated damages for late or under-performing plants, are generally preferred by lenders.137 A construction contract is after all an exchange of promises to produce a project for a price within a period.138 And EPC contracts probably provide the most advantageous risk structure for certainty of price, schedule and performance. The problem that may arise here is that the sponsor may be unable to apply innovative risk management and transfer strategies or alternative contracting strategies because of the involvement of the project financier who
132

Ali Jaafari, Management of Risks, Uncertainties and Opportunities on Projects: Time for a Fundamental Shift 19 (2001) International Journal of Project Management 89, 92. Wood, above n 71, 14-17 14-18 Megens, above n 127, 9. P J Gard, above n 128. Cusworth, above n 54 Damian McNair, Stephen Webb, Nicholas Tsirogiannis, EPC Contracts Process Plants, Review, September 2005, <http://www.mallesons.com/publications/update-combine.cfm?id=481> at 25 November 2008. John Dorter, 1999, Performance, BCL Vol. 15, pp. 361

133 134 135 136 137

138

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will see completion risk as one of the key drivers.139 Also the lenders may seek to allocate maximum risk to the contractor for the good of cash flow insisting on an allocation of risk even more narrow than that which might otherwise have been negotiated between industry participants.140 At the same time a project financier may be unhappy to proceed if it feels significant risks are being borne by a project participant who may not have the wherewithal nor ability to control that risk. 141 The result is that projects may be implemented differently where there is project finance involved than if a sponsor with full equity had ultimate control of the strategy. Project participants who are involved in selffunded projects with some of the majors, for example, should be aware of this and not simply follow the precedent of other similar projects which may have been influenced by the lenders in this way. The Lump-sum EPC acts as a quasi-insurer.142 The use of EPC contracts for mineral development projects however is much less common than EPCM contracts.143 This is often because the scope of mineral development projects is less defined moving from the feasibility study into the detailed engineering that kicks off the execution phase once full project authorization has been received. Such a scenario implies increased cost and schedule risk.144 But one must be careful in selecting an EPC contract when an EPCM may have been more suitable because if limits are not precisely defined, all one gets from a lump sum, are change orders to the contractors benefit.145 The key risks that are assigned to the EPC contractor are:146 Defects in design and failure of the process engineering; Defects in construction; Delay in reaching mechanical completion; Delay in commissioning and ramp-up; and Inadequacy of insurance.

The key difference between the EPCM and the EPC forms of contract is that in the EPC form the contractor is a principal in relation to procurement and construction, whereas in an EPCM is merely an agent.147 The EPCM contractor will merely carry out the balance of the engineering design (typically
139 140 141 142

Patrick Mead, Who Goes First? (2006) October 13, Lawyers Weekly, 2. Patrick Mead, Conducting an Effective and Accurate Assessment of Project Risk 5. Ibid. S Ward, C Chapman, On the Allocation of Risk in Construction Projects 9, 3 (1991) International Journal of Project Management, 140, 142. Andrew Chew, An Overview of Delivery Structures used in Major and Complex Infrastructure, Process Plant, Mining and Public-Private Partnership (PPP) Projects (2004) May/ June Australian Construction Law Newsletter, 6. Von Branconi, above n 273, 120. Hickson, above n 56, 2261 Dominick Soldano, Reducing Development Time & Cost Through Effective Project Management (1995) Northcon 95. I EEE Technical Applications Conference and Workshops Northcon95, 10-12, 370, 372. Stephenson, above n 248, 61.

143

144 145 146

147

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excluding the process technology) and manage the procurement and construction of the project.148 Typically the EPCM contractor has limited liability in respect to time, cost and performance of design, manufacture and construction.149 The owner must take a much more significant role with an EPCM contract and drive the project, investing more resources and assuming all risks. The contractor has little incentive to be efficient.150 Important consequences may flow from the inefficient allocation of risks:151 The bankability of the project (i.e. a project financier may be unhappy to proceed if it feels significant risks are being borne by a project participant who may not have the wherewithal nor ability to control that risk); The principal paying an inflated price for the project as a result of loading unnecessarily (from the principals point of view) built into the tender prices as a result of the tenderers being asked to price a contingency over which they have no control; The ability of that party to procure the requisite and appropriate insurance or even to determine whether insurance is required with respect to a particular risk or whether that risk is better managed via that partys internal risk management processes. The inability to determine which risks should be shared: risks that are outside of the control of both contractual parties may be ones best shared for example the risk of inclement weather may be one agreed to be borne by the principle in a time sense but in a cost sense will be the contractors risk. Shared risks outside of the control of each party with financially significant consequences may also be ones transferred to a third party, such as an insurer, in order to provide balance sheet protection. The selection of the appropriate contracting strategy is far from an exact science there is no formula into which each projects peculiarities and owners requirements can be plugged in to produce the most suitable delivery structure.152 That being said, the Construction Industry Institute (CII), a think tank in Austin Texas produces numerous tools for assisting project developers including the Owners Tool for Project Delivery and Contract Strategy Selection.153 CII points out that risk allocation should be done in a compromising and educated manner, recognizing the unique circumstances of

148 149 150

Chew, above n 143, 8. Doug Jones, Where Are the Standard Forms Going? 47 Australian Construction Law Newsletter 15, 21. Christof von Branconi, Chistoph H Loch, Contracting for Major Projects: Eight Business Levers for Top Management (2004) International Journal of Project Management 22, 119, 120. Mead, above n 54, 49. Chew, above n 143, 6. Construction Industry Institute, Owners Tool for Project Delivery and Contract Strategy Selection (2003, 2 nd ed) Project Delivery and Contract Strategy Research Team, Implementation Resource 165-2, 1.

151 152 153

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each specific project.154 The CII tool involves six steps whereby the project team evaluates the project objectives and then selects six factors that are imperative to the delivery of the project. The factors are ranked in order of significance and the outcome is a chart demonstrating the most appropriate contracting strategy and a ranked tabulation of the project delivery and contract strategy options with default compensation approaches recommended.155 Chew (2004) points out that the following factors need to be considered in the development of the contracting strategy:156 Degree of complexity of the engineering; The size and complexity of the project; Level of control the owner wants over the project phases of design development, construction and commissioning; Schedule constraints; Project planning and controls capability of the contractors (cost, time and quality); Safety record of the contractors; Capability of the principal (technological, construction, project controls etc.).

iv

Insurers

An important consideration is the insurers. In situations where the EPCM contractor is not responsible for the process design, the EPCM provides no warranty for the process itself working. Insurance may be the only risk allocation solution for the sponsor.157 It is typically difficult for finaciers to obtain insurance cover specifically protecting their exposure during the construction phase, but one option is to take out loss of profits insurance against the risk of late delivery of the project or other delay in cashflow.158 Conventional project insurances do however allow the financiers interests to be recognised in the project cover.159 Numerous unconventional insurances may also be available to the financier and are worth exploring that cover risks including design risk, political risk, performance risk, shortfall of mineral deposits and force majeure.160

154 155 156 157

Awad S. Hanna, Justin Swanson Contracting to Appropriately Allocate Risk CII Research Report 210-11, August 2007 Construction Industry Institute, above n 153 1. Chew, above n 143, 6. Peter Doyle, Tony Holland, John Naughton, Project and Infrastructure Financing in Mellesons Stephen Jaques Australian Finance Law (2003, 5th ed) 277. John Baartz, Construction and Infrastructure Projects Risk Management through Insurance, Allens Arthur Robinson, 2003 Charles Berry, Conventional and Nonconventional Risks Insurance for Mining Projects (1995) Forty-first Annual Rocky Mountain Mineral Law Institute 472, 473. Ibid, 474 - 475.

158

159

160

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Operations Contracts

Lenders are much less concerned with the risks during operations of a plant. They may like to see raw material contracts to ensure adequate sources of supply for the key raw materials without which production cannot take place and possibly some advancement on operating agreements that govern the day-to-day operation of the project company.161

161

Finnerty, above n 17, 37.

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CONCLUSION

III

CONCLUSION

This paper has examined many of the issues that arise in a project financing undertaking for mining projects. Mining is risky business and the typically conservative financiers seek to protect their investment and not take an equity risk on the project. The need then for the miner and financier alike is to assess, control and treat risks to ensure that uncertainty is reduced and quantified. The miners have to take the initial lead in this process and understand what the requirements are of financiers and address them early in the investigation and study process. The significant up-front costs in initiating a mining project still rely on conventional funding sources including bond and share issues and investments of equity. Once an opportunity is proven however within specified tolerances the use of project finance becomes an option. The use of project finance has many benefits to the sponsor organisation that extend from the key defining element of this type of finance which is that it is offbalance sheet with limited or no recourse to the sponsor. Project finance will likely continue to be the predominant form of financing for mining projects as it allows mining companies who have diminishing reserves to maintain a pipeline of new projects. Project finance allows them to leverage their resources and pursue more or larger projects than otherwise possible.

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