Estaban Buljevitch

7
What is Project Financing?
Overview of Project Financing
Project financing can be traced back to the medieval times ~ when in the 12 'h cen-
tury the British Crown negotiated with Frescobaldi (an Italian merchant bank of
that time) a loan for the development of the Devon silver mines on the basis of a
production payment loan structure. 2 In the 19'h century, many infrastructure projects
were financed using project financing techniques, such as railways in Argentina
(1860) and India (1880) and the Suez Canal (1850). However, project financing as
a sophisticated modern financing technique started to be actively used in early
1970s, as a result of the international banking crisis of 1974 that caused a dramatic
change in the international financial markets and in the ways of financing infra-
structure and other types of projects. 3 In fact, the modern version of limited-re-
course project financing was first pioneered in the early 1970s for developing the
North Sea oil fields. Since then, project financing has been increasingly used as a
tool for financing large, capital-intensive projects.
Project financing has made it possible to finance a myriad of revenue-generat-
ing projects that could not have been undertaken otherwise. Infrastructure, oil and
gas, telecommunications, petrochemicals and other types of large projects are more
and more often being developed by private, non-governmental entities. Projects
can no longer be financed solely on the basis of the credit standing of their spon-
sors nor can they be primarily supported by broad sovereign or sovereign-backed
lending techniques. Project developers and host country governments sometimes
do not have the necessary creditworthiness to support the required levels of in-
debtedness for a project or, albeit creditworthy enough to do so, are not prepared
88 Project Financing and the International Financial Markets
to devote the necessary financial resources for, or to assume the contingent liabili-
ties comprising a guarantee support for, such projects. In general, project develop-
ers are not prepared to assume directly the highly-leveraged debt financing necessary
for capital-intensive projects nor are they ready to bear the various risks associated
with such projects, because those circumstances could lead to a downgrade of
their credit rating and, consequently, to an increase in the financing cost for all
their existing operations.
Project finance structures have allowed private project sponsors to undertake
new ventures without granting to the lenders full recourse to their assets and with-
out securing strong financial support from host country governments. Addition-
ally, project developers have been able to exclude such debt financing from their
financial statements (off-balance sheet treatment) and have successfully avoided
restrictive covenants under their financial arrangements.
In summary, project financing has developed as an innovative and dynamic tech-
nique for financing large, capital-intensive projects, and the international financial
community is increasingly using it to solve the still growing need for infrastruc-
ture and other types of projects of both the developed and the developing world.
T h e Project F i n a n c e T e c h n i q u e
Project financing is a financing technique by which lenders agree to look initially

to the projected revenues of a project and to the assets given in collateral as the
basis of their credit analysis and as the main source of repayment of their loans,
independently of the credit standing of the developers of such project. 4 The term
project financing is generally used to refer to different kinds of financial struc-
tures, in which the debt financing is not based on the support of the sponsors or the
value of the physical assets of a project but primarily on the success of a project
itself?
Project financing comprises any financing (or refinancing) of the acquisition,
construction or development of a project if the creditor providing such financing
expressly agrees to rely on the properties of, and the revenues to be generated by
the operation of, such project as the main source of repayment of monies advanced.
Project financing differs from more traditional corporate lending practices, in
which creditors provide financing to a creditworthy company, make their credit
analysis based on the borrower's historic financial statements and their projec-
tions, and are satisfied to have full recourse against all of the assets of such credit-
worthy borrowing company. On the contrary, project financing implies lending on
the assumption that the project revenues and the assets given in collateral will
What is Project Financing ? 89
provide enough resources to repay the debt financing. And the lenders, at least
initially, will not expect the developers of a project to contribute to debt service
payments with their own funds or to grant a guarantee for the repayment of the
debt financing. In a true project financing, the project, its assets, its cash flows and
the project contracts are segregated from the developers in such a way to permit
the lenders to make their credit analysis of such project on an isolated basis. 6 Such
credit analysis will determine if a project can be considered economically, finan-
cially, technically and legally sound enough to generate adequate cash flow to
support the highly leveraged, non-recourse or limited-recourse, debt financing
necessary for its implementation.
The word "initially" is of great importance for the purpose of fully understand-
ing the concept of project financing. While lenders initially, but only initially, may
accept to make a segregated credit analysis of a project, that analysis does not
necessarily mean that they will be prepared to assume all the risks involved in such
project. More often than not, most of those project risks need be distributed and
assumed by various creditworthy parties. 7
Project financing does not imply p e r se that lenders assume all project risks
without any kind of credit enhancement from creditworthy parties. Actually, only
in very exceptional circumstances project financing is structured without any sort
of credit enhancement or guarantee from third parties, and, even less, without any
kind of credit support from the sponsors. In general, different credit support mecha-
nisms are necessary to make a project bankable on a project finance basis.
The decision of lenders to accept a non-recourse or limited-recourse structure
for a debt financing must be knowingly taken based on the understanding that any
risk that has not been distributed or neutralized would be assumed by them. An
adequate balance in this respect is perhaps the hardest challenge in any project
finance transaction. This is why an observer has mentioned that project financing
is not a science, but an art. 8
Project financing implies the designing of the financing of a project with the
least degree of recourse to the developers as is possible, while at the same time
securing enough credit enhancement from such sponsors or any other interested
third party, in a way that the lenders would not assume a significant exposure to
project risks. 9
The magic of project financing consists of distributing the different risks associ-
ated with a project to the various participants who have a particular interest in the
success of that project, in such a way that each participant assumes a portion of
project risks but none bears all the risks. Ideally, a well-implemented risk distribu-
tion structure should provide lenders with the s a m e - - o r substantially the s a m e - -
credit risk that they would have assumed had they made a full-recourse loan to the
sponsors of a project while at the same time affording the sponsors an off-balance
sheet treatment for the debt financing of such project, l°
Lenders are usually prepared to assume certain residual risks relating to the
construction, start-up and operation of a project because they can retain technical
experts who will make a correct evaluation and quantification of such risks. Cer-
tain other risks, such as casualty force majeure and political risks, may be neutral-
ized with various types of insurance coverage. And the remaining risks in the puzzle
may be distributed through derivative instruments (e.g., swaps, futures, forwards,
options, etc.), by means of long-term arrangements with various third-party par-
ticipants or by virtue of any other kind of credit enhancement granted by the de-
velopers or any of the other participants in the project. No precise formula or
procedure exists to identify, evaluate, distribute and neutralize project risks. The
art and the essence of project financing lies in the fact that all risks must be iden-
tified, evaluated and, if necessary, distributed. No other possible solution exists.
Since lenders typically do not have full recourse to project sponsors, any risk that
has not been identified and properly managed will inevitably end up being a lend-
ers risk. That is why project financing is a risky business, and many times, a dan-
gerous one. ~1
Consequently, the various risks affecting the success of a project must be prop-
erly identified and evaluated at the outset of the project to permit the implementa-
tion of the most appropriate risk management plan. In this respect, a project financier
must observe the following steps: first, risks must be identified and understood at
an early stage; second, risks must be quantified and assessed to determine their
magnitude; third, to the extent possible, risks must be reduced;fourth, risks must
be distributed among the parties best capable of assuming and managing them;
and fifth, if possible, risks must be further allocated by means of insurance and
derivative instruments.
Notes
1. Reinhard Zimmermann, "Non-Recourse--"The Most Condemnableof Loan Transactions,"

Project FinanceInternational, Issue 100 (July 3, 1996) at 62/3 describes the "Fenus Nauticum" as
another precedent of project financingback in the Greek and Roman times. Accordingto Reinhard
Zimmermann"... In antiguity,there was one situationin whichcapital was supposed to be at the risk
of the lender, pecuniatraiecticia(moneyto be sent overseas) or, to use the more accurate post-classi-
cal term, fenus nauticum (sea loan). This was a loan of money given to a merchant involved in
overseas trade who lacked the capital to buy the merchandiseand ship it at his own risk. Sea voyages
on the Mediterraneanwere dangerousin Greek and Roman times because of the storms and pirates.
The average merchant therefore looked for some kind of marine insurance.This was the function
served by fenus nauticum:the moneyhad to be repaid only if the ship arrived safely in port with the
cargo on board..."
W h a t is P r o j e c t F i n a n c i n g ? 91
2. See John D. Finnerty, Project Financing: Asset-Based Financial Engineering, John Wiley &
Sons Inc. (1996), at 4.
3. For a more detailed description of the origins of project financing, see Stewart E. Rauner,
"Project Finance: A Risk Spreading Approach to the Commercial Financing of Economic Develop-
ment," Harvard International Law Journal, Vol. 24 (Summer, 1983) at 146/56.
4. See Peter K. Nevitt, Project Financing, Fifth Edition, Euromoney Publications, (1989), at 3.
5. See Clifford Chance, Project Finance, IFR Publishing (1991), at I. According to Scott L.
Hoffman, "A Practical Guide to Transnational Project Finance: Basic Concepts, Risk Identification,
and Contractual Considerations," The Business Lawyer, Vol. 45 (November, 1989), at 181, " . . . the
term "project finance," or "segregated finance" as it is sometimes called, is generally used to refer to
the arrangement of debt, equity, and credit enhancement for the construction or refinancing of a
particular facility in a capital-intensive industry, in which lenders base credit appraisal on the pro-
jected revenues from the operations of the facility, rather than on the general assets or the corporate
credit of the promoter of the facility, and in which they rely on the assets of the facility, including the
revenue-producing contracts and cash-flow, as collateral for the d e b t . . . " Stephen W. Stein and Yves
Miedzianogora, "International Project Finance--New Frontiers," Project & Trade Finance (Decem-
ber, 1993), at 39 indicate that " . . . the more relevant definition of project f i n a n c e . . , refers to the
financing or the establishment of a stand alone grass roots project in which the lenders of the debt
finance for the project will look solely or primarily to the revenue stream created by the project for
repayment of the financing, at least once operations have commenced, and to the assets of the project
as collateral for the l o a n . . . "
6. See Peter K. Nevitt, supra, at 1.
8. See Arturo Olvera Vega, "Risk Allocation in Infrastructure Financing," The Journal of Project
Finance, Volume 3, Number 2 (Summer 1997), at 40.
10. See Peter K. Nevitt, supra, at 4 and 257.
11. See Skadden, Arps, Slate, Meagher & Flom, Project Finance: Selected Issues in Choice of Law,
Euromoney Books (1996), at 4.
8
Description of a Project
Finance Transaction
s an introduction to international project financing, a description of a typical

A cross-border infrastructure build, own, and operate (BOO) project financing
transaction is presented below.1 Additionally, certain relevant terms that are appli-
cable to most project financings are defined below and are used accordingly through-
out this book.
This step-by-step approach is presented for instructional purposes only and is
not purported to apply rigidly to each project financing. In reality, many of the
steps mentioned occur either concurrently with one another or in a different order
or otherwise are not present. Obviously, project finance structures vary from trans-
action to transaction and may or may not include all the elements described in this
description of a project finance transaction. However, those elements are gener-
ally to a greater or a lesser extent applicable to most types of project financing.
S t e p 1. Project
A stand-alone revenue-generating project of any kind that is technically, finan-
cially and economically sound (the "project") is proposed for construction, main-
tenance and operation in a certain host country (the "host country").
The project is awarded to the offering partners (the "bidders") who have ten-
dered the best offer in a bidding process called by the government of the host
country (the "government").
Step 2. Concession a n d P r o j e c t C o m p a n y
A concession or license (the "concession") for the construction, maintenance and

operation of the project is typically granted by the government to the bidders or to
a special-purpose legal entity incorporated or created for purposes of the develop-
ment of the project (the "project company").
The determination of the best type of legal entity to undertake a project (e.g.,
corporation, limited-liability company, partnership, unincorporated joint venture,
trust, etc.) is usually dependent upon certain significant factors, such as proportion
of debt and equity investments, tax considerations, accounting rules, credit im-
pact, transferability of equity interest in the project, indenture limitations and regu-
latory issues. A special-purpose corporation or limited-liability company especially
established in the jurisdiction of, and pursuant to the laws of, the host country to
act as project company generally is chosen by the sponsors in order to, among
other things, limit their responsibility in relation to such project. However, de-
pending on the laws and jurisdiction applicable to each particular case, the spon-
sors may still face responsibility for the project company's obligations in the event
of fraud or inaccuracy of representations and warranties made to the lenders in
relation to the project or if the "piercing of the corporate veil" doctrine applies.
The requirements for the application of the "piercing of the corporate veil" doc-
trine vary from jurisdiction to jurisdiction and, therefore, must be checked on a
case-by-case basis. Generally speaking, to prevent the application of the "piercing
of the corporate veil doctrine" to a project financing structure, it is advisable to
adopt, among other things, the following: (i) the business and operations of the
project company must be carried out by its own officers and employees; (ii) the
respective business and operations of the sponsors and the project company must
be carried out in different physical locations; (iii) the financial statements, corpo-
rate books, records and information systems as well as the cash management of
the sponsors and the project company must be clearly distinguished; (iv) the project
company must be adequately capitalized; (v) the distributions of dividends or free
cash-flows from the project company to the sponsors shall be reasonable depend-
ing on the circumstances and (vi) the transactions between the sponsors and the
project company must be conducted on an arms-length basis.
Step 3. Sponsors
The stakeholders of the project company may be the parent companies of each of
the developers of the project (the "sponsors" or the "developers") or special-pur-
Description of a Project Finance Transaction 95
pose corporate subsidiaries of each of them (the "holding companies"), z consti-

tuted (either in the jurisdiction of the host country or off-shore) solely for the
purposes of acting as a corporate link between the respective sponsor and the project
company. In some cases, the sponsors may jointly establish (either in the jurisdic-
tion of the host country or off-shore) a special-purpose corporation designated to
hold all---or at least the majority-- of the voting share capital of the project com-
pany for purposes of coordinating the sponsors' relationship in respect of the project
and for achieving more flexibility in bringing in new equity investors in the project?
The sponsors generally consist of one or more corporations with certain spe-
cific interests in the development of a project based upon their respective areas of
specialization or business strategy. Sponsors of project finance ventures may con-
sist of (i) a company interested in the construction and procurement of the project
facilities; (ii) a company eager to operate the project; (iii) a company with the
intention of providing certain supplies to the project or acquiring the project out-
puts; (iv) passive institutional investors willing to make a minority capital invest-
ment offering a high yield; and (v) banks and other financial institutions interested
in being appointed as financial advisors for the project and in structuring its debt
financing.
The presence of local partners may be advisable for purposes of easing the
relations with the local government and other participants in the domestic market
and providing some local management input and also as a way to reducing certain
political risks. In certain strategic areas (e.g., natural resources, energy and public
services) the presence of, or control of a project company by, local partners may
be imposed by local law.
Step 4. Project Studies
The developers or the project company usually prepare at the outset of the project
a technical, economic and financial feasibility study for the project (the "feasibil-
ity study")? The basic purpose of a feasibility study is to determine, in a prelimi-
nary manner, if a project is technically, economically and financially feasible and,
consequently, if there are sufficient grounds to further continue with the project
analysis and development.
Moreover, if a project has any potentially significant environmental and social
issues, the developers or the project company may also prepare an environmental
and social impact study (the "environmental impact study"), which typically con-
sists of information regarding inter alia applicable environmental statutory re-
quirements, required environmental permits and authorizations, applicable
environmental and social elements affected by the project and any potential envi-
ronmental hazard.
Step 5. Project Advisors
The project company generally retains one or more financial advisors with recog-
nized expertise in the industry (the "financial advisors") that will actively assist it
in the different stages of project development. Commercial banks, investment banks,
financial companies, boutiques specializing in project financing and independent
consultants well-known in the industry are usually appointed as financial advisors
for project finance transactions. Generally speaking, financial advisors assist the
project company in determining project feasibility, in choosing the best project
structure and in syndicating the debt financing.
The project company usually retains legal advisors for structuring the transaction
(the "company's transaction counsel") as well as local counsel for all legal matters
relating to the laws of the host country (the "company's local counsel" and, together
with the company's transaction counsel, the "company's legal advisors"). On the
other hand, the lenders also retain legal advisors for structuring the debt financing
(the "lenders' transaction counsel") and local counsel for all local law matters, in-
cluding the creation and perfection of security (the "lenders' local counsel" and,
together with the lenders' transaction counsel, the "lenders' legal advisors").
In most transnational project finance transactions, transaction counsel for the
lenders and the project company typically are reputable international law firms
with expertise in the industry. On the other hand, an experienced and internation-
ally oriented local counsel is of utmost importance for the success of a cross-
border project. In fact, in countries where there are a limited number of business
lawyers, it is often important to choose one of the better firms at an early stage
before all major firms are retained by the other participants in the project. ~
The project company usually appoints an engineering firm who will assist it in
all technical matters related to the design, engineering, construction, start-up and
operation of the project (the "company's engineering advisor"). Another engineer-
ing firm is often retained by the lenders in order to act as their independent con-
sultant in all above-mentioned technical matters (the "independent consultant").
Finally, the project company generally retains an insurance broker or risk man-
agement consultant (the "project company's insurance advisor") who will design,
place and administer the project's insurance program, which program shall be
typically reviewed and approved by the lenders' insurance advisor (the "indepen-
dent insurance advisor").
Step 6. I n f o r m a t i o n M e m o r a n d u m
The project company, with the assistance of its financial and legal advisors, usu-
ally prepares an information memorandum in connection with the project for the
syndication of the debt financing (the "information memorandum"). The informa-
tion memorandum generally is prepared on the basis of information contained in
feasibility and environmental impact studies. The information memorandum typi-
cally includes all relevant aspects related to a project, such as: (i) description of the
project; (ii) project operating and financial plan; (iii) project cost breakdown, in-
cluding construction and start-up costs, operating costs, financial costs, and appli-
cable taxes; (iv) information regarding the project company and its capitalization;
(v) project company's ownership structure, including information about the spon-
sors; (vi) description of the management team; (vii) description of the project out-
put and its markets, marketing strategies and analysis of competitors; (viii)
description of technology and analysis of production processes; (ix) description of
availability and prices of the different critical supplies; (x) description of all rel-
evant project contracts and applicable legal framework; (xi) description of insur-
ance program; (xii) environmental considerations; (xiii) analysis of all material
commercial and political risks associated with the project; and (xiv) financial in-
formation together with financial projections and sensitivity or scenario analysis.
Step 7. Project Site
The project company determines the best site upon which the project facility will
be installed (the "site") and proceeds to buy or lease such land as well as to secure
adequate access to the site.
It is always preferable that the project company purchases and has title over the
site and all related permits and authorizations. However, the project company may
choose to lease the site, in which case the lenders should ensure, among other
things, that the term of lease is at least equal to the useful life of the project, that
rental charges are fixed (although a certain quantitable escalator may be included),
that there are no termination events and that the lease and related permits and
authorizations are assignable to the lenders.
Step 8. Permits a n d A u t h o r i z a t i o n s
Once the site is determined, the project company starts the process of obtaining all
governmental (national, regional and local) and private permits, authorizations,
licenses, easements, rights-of-way, consents, approvals, rulings, tariff rates and

exemptions necessary for the construction, start-up and operation of the project
(the "permits and authorizations"). 6
Permits and authorizations may include inter alia rights to use private or public
roads that gain access to the site; rights to use ports, warehouses or storage facili-
ties; rights to build pipelines and transmission lines to the project site; rights to use
water from rivers, lakes or wells; rights to dispose of water, including waste water;
rights to store, use and dispose hazardous materials, etc.
To the extent possible, permits and authorizations must be permanent and non-
revocable; if a permit or authorization is not permanent, is renewable, is revocable
or is subject to certain discretionary requirement or condition, such circumstance
may make the structuring of a project financing more difficult and, in some cases,
may require credit support from the sponsors or another interested party.
S t e p 9. P r o j e c t C o n t r a c t s
The project company enters with various project contractors into different project
contracts for the purposes of the development of the project, such as an off-take
agreement, a construction contract, a supply agreement and an operating and main-
tenance agreement.
Project contracts are the foundation for the success of a project financing and
most of the issues relating to the structuring of a project finance transaction are
usually addressed by project contracts. For example, project contracts are critical
for determining whether a certain risk is being assumed or shared by the sponsors,
the lenders, or a third party with a special interest in the project. Project contracts
are also important for establishing whether a project will generate sufficient cash
flow to support the debt financing.
Project contracts must be consistent and must work together as a whole. Lend-
ers must assess the various and complex interrelations among project contracts to
clearly understand who is assuming what risk. If there are gaps in project contract
documentation, lenders may request some credit support, such as for example: (i)
a completion guarantee, if the constructor's turnkey obligations do not give suffi-
cient comfort to the lenders; (ii) a back-up supply facility, if the supply agreement
is not sufficiently firm; (iii) a large operating and maintenance reserve amount or
a cash deficiency guarantee, if the operating and maintenance costs are unpredict-
able or are not "passed through" to the operator or the off-taker or (iv) a large debt
service reserve amount or a cash deficiency agreement, if the cash flow stream is
unpredictable or could be interrupted in certain events, such as force majeure.
S t e p 10. O f f - t a k e A g r e e m e n t
In most capital-intensive projects, the project company usually enters with a gov-
ernment agency or private-sector company (the "off-taker") into a long-term sale
and purchase contract in respect of the project outputs (the "off-take agreement"
or the "revenue agreement"). By virtue of an off-take agreement, the off-taker
agrees to buy from the project company a certain quantity and quality of project
output, for a certain period of time and at certain pre-established prices. Conse-
quently, an off-take agreement provides certainty that a project will generate suf-
ficient cash flow to cover debt service and operating costs, and provide a reasonable
return on investment.
An off-take agreement may consist of provisions relating to matters such as: (i)
quantity and quality of the output to be delivered, purchase price and delivery
timetable; (ii) escalation or adjustment formulas for the purchase price in accor-
dance with certain appropriate indices for local and foreign costs, such as ex-
change rate and inflation; (iii) in some cases, pass-through purchase price adjustment
formulas intended to compensate the project company for certain increased costs,
including taxes, costs of complying with changes in law, and interest rate fluctua-
tions; (iv) incentive payments and low performance penalties in order to encour-
age a project to operate efficiently; (v) a term of at least equal to, and preferably
two to three years longer than, the term of the debt financing; 7 (vi) a definition of
force majeure, including sometimes certain political risk events, consistent with
the applicable provisions under the concession contract, the construction contract,
the supply agreements and the O&M agreement; (vii) in some cases, the obliga-
tion of the off-taker to continue making certain minimum payments, even under
certain force majeure events; (viii) conditions of effectiveness establishing that the
obligation of the project company to deliver the output shall commence at a date
certain, which date must be consistent with the completion date established in the
construction contract with a reasonable cushion time for contingencies; (ix) lim-
ited events of default and termination provisions, such as bankruptcy of the project
company or the off-taker, payment default and other material defaults after a cer-
tain grace period; (x) a well-established mechanism for notice of a contract breach
and a reasonable cure period; (xi) in some cases, credit enhancement provisions
relating to the off-taker payment obligations, such as governmental guarantees,
stand-by letters of credit, corporate guarantees and pledge of the off-taker rev-
enues; 8 (xii) scheduled outages and overhauls of the plant; (xiii) liquidated dam-
ages provisions; and (xiv) dispute resolution mechanisms.
Certain infrastructure public-service projects, such as toll roads, toll bridges,
telecommunication networks, etc., generally are undertaken without an off-take
agreement and there is usually no certainty of an adequate project-revenue stream

because the success or failure of the project is dependent upon the use of that
particular service by the public. For example, in the case of toll road projects,
although concession contracts and ancillary documentation usually govern the terms
and conditions of the service and its applicable tariff, governments generally do
not guarantee any minimum utilization of the service by the public. 9
Finally, in the event that the project output is a commodity, such as oil, gold or
copper, and a well-developed and efficient market exists for such commodity, the
project may be structured without any kind of off-take agreement, based upon the
off-take assurance provided by such market. However, when cash flows of a project
are exclusively dependent upon the prices of a commodity market, the project
company must consider entering into a hedging facility, such as a long-term com-
modity swap, for purposes of reducing the risk of commodity price fluctuations
and in order to give some certainty to the revenue stream of the project.
S t e p 11. S u p p l y A g r e e m e n t s
The project company enters with one or more suppliers (the "suppliers") into one
or more long-term supply agreements (the "supply agreements") for the provision
of the critical supplies necessary for the start-up and operation of the project i.e.,
raw materials, gas, coal, feed stocks, fuel, etc. (the "supplies"). Supply agreements
provide certainty in respect of the availability and the price of the key supplies
needed to produce and deliver the project outputs in accordance with the terms
and conditions of the off-take agreement.
The terms and conditions of supply agreements inevitably vary depending upon
the type of supply needed for the operation of a project (e.g., fuel, gas, coal, etc.)
but generally a supply agreement, with a term of at least as long as the tenor of the
debt financing, is executed prior to financial closing.
Supply agreements usually consist of provisions relating to inter alia: (i) the
firm, quasi-firm or interruptible commitment of the supplier to timely deliver at
the plant a sufficient quantity of the applicable supply to permit continuous opera-
tion of the project and enable the project to comply with its obligations under the
off-take agreement; 1° (ii) the obligation of the supplier to ensure a quality of sup-
ply compatible with the project's design and specifications and the requirements
of the off-take agreement; (iii) pricing provisions (usually subject to escalators)
providing for an "all-in" delivered cost of supplies in terms compatible with the
underlying project's economics and, to the extent possible, matching the provi-
sions of the off-take agreement to allow the project company to "pass through" in
full any adjustments in the supply prices to the off-taker; l~ (iv) transportation pro-
visions allowing the project company to purchase supplies on a "delivered" basis,
thereby avoiding any problem of arranging for separate supply transportation; lz
(v) provisions establishing a delivery point at which supplies must be delivered
from the supplier to the project company and at which title to the supplies trans-
fers; (vi) provisions establishing the scheduling and nomination of supply deliver-
ies and providing the project company certain flexibility to schedule deliveries as
necessary to meet its supply requirements taking into account its on-site storage
capacity; 13(vii) provisions establishing the measurement procedures to be used to
calculate deliveries and payments; (viii) conditions of effectiveness establishing
that the obligation of the supplier to provide the supplies and of the project com-
pany to purchase them shall only commence if and when the project facility has
been completed and the project company requires the initial supplies for testing;
(ix) provisions requiring the supplier to pay liquidated damages in the event that it
does not comply with its delivery obligations; ~4(x) corporate or commercial per-
formance guarantees covering supplier's payment and performance obligations
and, sometimes, corporate or commercial payment guarantees covering the project
company's payment obligations; (xi) limited events of default and termination pro-
visions, such as bankruptcy of the project company or the supplier, payment de-
fault, non-delivery, and other material defaults after a certain grace period; (xii) a
well-established mechanism for notice of a contract breach and a reasonable cure
period; (xiii) force majeure provisions excusing the supplier from complying with
its obligations consistent with those in the off-take agreement, the O&M agree-
ment and the concession contract; (xiv) force majeure provisions allowing the
project company not to take the supply deliveries in the same instances when the
project company is permitted to be excused from performance due to a force ma-
jeure event under the off-take agreement, the O&M agreement and the concession
contract; and (xv) dispute resolution mechanisms.
Step 12. C o n s t r u c t i o n C o n t r a c t
The design, engineering, construction, erection, procurement, installation and com-

missioning of the project facilities (the "construction phase") are usually contracted
by the project company with one or more construction companies and/or equip-
ment suppliers (the "constructor") pursuant to the terms of an engineering, pro-
curement and construction turnkey contract (the "EPC contract" or the "construction
contract"). An EPC contract generally provides for the obligation of the construc-
tor to build and deliver the project facilities on a turnkey basis, i.e., to complete the
project facilities at a certain pre-determined fixed price, by a certain date, in accor-

dance with certain specifications and good industry practices, 1~ and with certain
performance warranties.
The term "turnkey contract" comes from the fact that, at least in theory, when
the plant is delivered by a turnkey constructor, the project company is required to
do nothing more than turn a key in order to start the project's operation. Conse-
quently, a turnkey construction contract typically provides all-inclusive engineer-
ing, procurement and construction services necessary to complete a project facility.
A turnkey EPC contract usually consists of provisions relating to inter alia (i)
an all-inclusive description of the services to be performed by the constructor,
such as design and engineering services, procurement of all materials, equipment,
machinery, tools and utilities; administration and construction management ser-
vices; construction activities; provision of qualified personnel; import and trans-
portation of materials, equipment and machinery; production of documentation
and manuals for start-up, maintenance and operation; quality control; safety pro-
cedures and personnel training; procurement of all relevant permits and authoriza-
tions relating to the construction of the project and clean up activities; (ii) a fixed-sum
price (usually subject to escalators), payable in installments upon achievement of
certain specified construction milestones; (iii) in some cases, a bonus incentive
payable to the constructor for early completion; (iv) an undertaking by the con-
structor guaranteeing that the project facility will be completed by a date certain,
with certain liquidated damages payable by the constructor for each day of delay
sufficient to compensate the project company for all costs associated with such
delay, such as interest on debt and other fixed costs; (v) a performance undertak-
ing by the constructor guaranteeing that the project facility will perform in accor-
dance with certain specifications, with liquidated damages payable by the
constructor in case of noncompliance; 16 (vi) warranties for design, materials and
workmanship for a period of approximately one or two years after project physical
completion; (vii) a performance bond, an advance payment bond, a retention money
guarantee (generally in lieu of a retainer or withholding construction payment
clause) and a maintenance bond to back constructor's performance under the ECP
contract, all of them granted by creditworthy commercial guarantors for the ben-
efit of the project company (and the lenders) and for the account of the construc-
tor; (viii) a "change order" provision establishing the ability of the constructor and
the project company to require a change or amendment of the construction con-
tract specifications;aT (ix) limitation of liability clauses in favor of the constructor,
which generally are equal to one-hundred percent of the turnkey price; (x) limited
termination and events of default provisions, such as bankruptcy of the project
company or the constructor, payment default and other material defaults after a
certain grace period; (xi) insurance provisions requiring the constructor to con-
tract a comprehensive insurance package covering all insurable risks relating to
the construction phase of the project prior to completion; (xii) tight force majeure
provisions to excuse construction delays or cost over-runs caused by events be-
yond the control of the constructor; TM (xiii) customary provisions relating to the
passage of title of the facility and equipment from the constructor to the project
company, the responsibility of constructor for liens over the equipment and the
responsibility of constructor for payment of subcontractors; and (xiv) dispute reso-
lution mechanisms.
Step 13. O p e r a t i n g a n d M a i n t e n a n c e A g r e e m e n t
Many times, the project company delegates the operation, maintenance and man-
agement of the project (the "operating phase") to a reputable operator with expertise
in the industry (the "operator") under the terms of an operating and maintenance
agreement (the "O&M agreement") in order to ensure that the project will be operated,
managed and maintained according to prudent operating industry practices.
Under an O&M agreement, the operator is given exclusive authority to manage,
operate and maintain a project facility and the operator agrees to perform for a fee
all operation, management, maintenance and repair services for a project in accor-
dance with prudent operating industry practices and in a manner consistent with
the off-take agreement requirements. The operator usually assumes residual project
operating risks other than casualty force majeure, political force majeure, techni-
cal risks, market risk and unavailability and prices of supplies.
An O&M agreement generally has a term of at least equal to the length of the
debt financing and usually includes among others the following provisions: (i)
description of the general services to be provided by the operator, including inter
alia performing day-to-day operation, management and maintenance activities;
dealing with the various project contractors; maintaining a stock of spare parts and
supplies; procuring the necessary equipment; selecting, training and managing
employees for operation and observing all applicable laws and regulations; (ii)
preparation of an annual budget and, once approved by the project company, sub-
mission to that annual budget for the operation and maintenance of the project;
(iii) administration of project contracts, including, but not limited to, the coordina-
tion of supply deliveries under the supply agreements and the compliance with
output deliveries pursuant to the off-take agreement; (iv) an initial fixing (subject
to escalation) of all costs within the operator's control, such as labor and general
and administrative expenses, and pass-through provisions regarding all operating
expenses outside the operator's control, such as procurement of supplies, spare
parts, etc.; (v) operating fee provisions intended to compensate or penalize the
operator depending upon the operating performance of the project; ~9 (vi) limita-
tion of liability clauses in favor of the operator; (vii) insurance provisions requir-
ing the operator to secure comprehensive insurance package covering the operating
phase; (viii) force majeure provisions that must not be broader than the ones estab-
lished under the off-take agreement, the concession contract and the supply agree-
ments; (ix) corporate or commercial performance guarantees covering operator's
performance obligations; (x) limited termination and events of default provisions,
such as bankruptcy of the project company or the operator, payment default by the
project company, performance defaults by the operator, and other material de-
faults after a certain grace period; (xi) scheduled outages and overhauls of the
plant; and (xii) dispute resolution mechanisms.
In other cases, the project company may carry out by itself the operation and
maintenance of the project, and may eventually arrange for the technical assis-
tance of an experienced company (the "technical assistant") by virtue of a techni-
cal assistance agreement (the "technical assistance agreement").
S t e p 14. L e g a l F r a m e w o r k
The sponsors as well as the banks, financial institutions, institutional investors,

bilateral, regional and multilateral agencies, export credit agencies (ECAs), capi-
tal market investors and any other investors (collectively the "lenders") who pro-
vide debt financing for the project (the "debt", the "loan" or the "debt financing," as
the context so requires) must ensure that certain legal matters relating to the equity
and debt investment in a project (the "legal framework"), such as taxes, foreign
investment laws and foreign exchange regulations, are satisfactory to all of them.
Local law matters can be addressed by host country governments in different ways,
such as (i) by applicable foreign investment laws and regulations; (ii) by conces-
sion contracts or other kind of government support agreements; (iii) by laws or
regulations specially enacted by the host country government for the purposes of a
project and/or (iv) by means of assurances expressly granted by the host govern-
ment to the sponsors or lenders in connection with a project and its financing.
S t e p 15. E q u i t y F i n a n c i n g
The lenders generally require that the sponsors commit certain minimum equity
contributions to a project company (the "equity"). The amount and timing of such
contributions inevitably vary from transaction to transaction depending on the

particularities of each project and its financial plan.
In that sense, the appropriate debt-to-equity ratio for a project finance transac-
tion is a matter of negotiation between the lenders and the sponsors and is basi-
cally dependent upon a myriad of factors, such as customary industry practices,
market conditions, project characteristics and credit enhancement structure. Ac-
ceptable debt-to-equity ratios in project financing are typically higher than those
usually required for corporate loans. Project finance structures usually accept debt-
to-equity ratios of approximately between 70/30 and 80/20, and, in exceptional
cases, may even accept higher ratios. However, the amount of equity contributed
by the sponsors to a project is of utmost importance to the lenders and the lenders
generally require additional credit enhancement from creditworthy parties if eq-
uity contributions fall below certain minimum levels. Higher equity contributions
decrease the burden placed on the project to make debt service payments and also
give lenders comfort in terms of the financial commitment of the sponsors in re-
spect of a project. At least in theory, the more equity contributed by the sponsors to
a project, the more the sponsors are bound to such project, the less the likelihood
of an early abandonment, and the greater the chances that the project will be a
success.
The equity capital requirements of a project can be secured by different spon-

sors' arrangements, such as (i) a subscription agreement, which governs the sub-
scription of shares of the project company by the various sponsors (the "subscription
agreement"); (ii) a shareholders' agreement, which governs shareholders' matters
with respect to the project (the "shareholders agreement") or (iii) any other agree-
ment by which the sponsors may assume the obligation to periodically contribute
equity to a project. The sponsors usually contribute capital funds to the project
company by means of either capital contributions (the "cash contribution") or share-
holders' loans to the project company, which loans are generally subordinated in
liquidation and current payment to the senior debt financing provided by the lend-
ers (the "shareholders' subordinated loans"). 2°
Depending upon the circumstances, lenders may require either that all the eq-
uity must be contributed up front prior to any debt disbursement or that the equity
and the debt must be injected into a project on a paripassu basis. Occasionally, the
equity may be contributed after the full disbursement of the debt, especially when
a creditworthy sponsor has provided a direct, unconditional, and full completion
guarantee. The timing of equity injections into a project is a fundamental question
for all projects. While the interest burden during the construction phase is mini-
mized if equity is contributed prior to debt financing, sponsors typically prefer to
postpone equity contributions to maximize the sponsors' return on equity.
Step 16. P r o j e c t C o m p l e t i o n
Completion of the construction phase of a project is a matter of utmost importance

for lenders. It is critical to the success of a project that the project facilities are
completed (i) in due time, within the projected construction schedule, and without
any significant construction delays; (ii) at the price agreed to by the parties to the
construction contract, with no significant cost over-runs, and (iii) according to the
original technical specifications. The completion of the construction phase in due
time and in accordance with specifications allows the project company to start
the operation phase that will generate the necessary cash flow for the repayment
of debt.
To ensure a successful project completion, sponsors are often required to enter
into a cash contribution agreement with the project company whereby the spon-
sors assume the obligation to contribute from time to time to the project company
additional funds necessary to support cost over-runs or cash shortfalls not contem-
plated in the financial plan (the "cash contribution agreement").
A cash contribution agreement (also often called "capital contribution agree-
ment," "project funds agreement" or "financial support agreement") is usually
entered into among the project company, the sponsors and the lenders, and pro-
vides for a firm, absolute, unconditional, and irrevocable commitment of each
sponsor to the project company to make available by means of cash contributions
or shareholders' subordinated loans such funds as may be necessary to enable the
project company to pay completion costs to the extent such completion costs may
be in excess of funds already available to the project company.
A cash contribution agreement usually establishes that if there is reasonable
cause to believe that sufficient funds are not or will not be available to achieve the
completion date, then the sponsors shall be obliged, on a joint and several or sev-
eral but not joint basis, as the case may be, to provide such additional funds to the
project company as necessary to reach the completion date. Additionally, a cash
contribution agreement may sometimes provide that if for any reason whatsoever
the project is not completed, the sponsors must make available sufficient funds to
pay back the debt financing in full. In general, lenders want to have a direct right
of enforcement of such sponsors' obligations under a cash contribution agree-
ment. Thus, the rights of the project company under a cash contribution agreement
are usually collaterally assigned to the lenders as a part of the security package for
the debt financing.
Other times, the sponsors grant the lenders an irrevocable, unconditional and
absolute completion guarantee (the "completion guarantee") that shifts all comple-
tion risk from the lenders to the sponsors.
As opposed to a cash contribution agreement, which establishes a contractual

obligation of each of the sponsors to the project company, a completion guarantee
usually provides for a direct, absolute, unconditional, continuing and irrevocable
obligation of the sponsors to the lenders to guarantee the payment in full of all of
the project company's payment obligations to the lenders under the financial ar-
rangements until the completion of the project. By a completion guarantee, the
guarantors agree to pay upon demand by the lenders in immediately available
funds, in the same currency and in the same manner required pursuant to the finan-
cial arrangements all guaranteed payment obligations, upon the occurrence of any
payment default under the financial arrangements or otherwise if the completion
date does not occur on or before a date certain. A completion guarantees may also
consist of a performance guarantee where sponsors undertake to cause the project
to be completed by a date certain and to provide additional funds to cover all cost
over-runs, including in most of the cases financial increased costs.
Sponsors are typically released from their obligations under a cash contribution
agreement or a completion guarantee, as the case may be, upon the occurrence of
project completion. The mechanics for determining the occurrence of project
completion are generally subject to lengthy negotiations among lenders and spon-
sors. Generally, the completion date is deemed to have occurred only if and when
both project physical completion and project financial completion have occurred
in a manner satisfactory to the lenders.
Financial completion date is sometimes defined as the last day of the calendar
month in which all of the following requirements have been fully satisfied: (i) the
project company has delivered to the lenders a notice, together with the relevant
supporting documentation, all in form and substance satisfactory to the lenders,
certifying that (A) no event of default or potential event of default has occurred
and is continuing under the respective financial arrangements and (B) during a
reasonable "test period" occurring after the physical completion date, the project
company has consistently maintained certain minimum or maximum, as the case
may be, pre-determined financial ratios, such as current ratio, debt to equity ratio
and debt service coverage ratio, calculated based upon the audited financial state-
ments of the project company (such notice is usually accompanied by an auditor's
certificate certifying the compliance with financial ratios) and (ii) the lenders have
notified the project company that such notice is acceptable to them and therefore
that the financial completion and the completion of the project have occurred.
On the other hand, project physical completion date is sometimes defined as the
last day of the calendar month in which the following requirements have been
fully satisfied: (i) the project facilities have been duly and properly constructed,
erected, installed, commissioned and completed in accordance with design speci-
fications and have satisfactorily passed all applicable performance tests; (ii) the
project has satisfactorily demonstrated during a reasonable "test period" effective
operating capacity as established in the construction contract; (iii) all permits and
authorizations required for the normal operation of the project have been obtained
and remain in full force and effect; (iv) all physical facilities of the project have
been constructed, erected, installed, commissioned and completed and are operat-
ing in accordance with applicable environmental, health, occupational and safety
guidelines and policies; (v) the turnkey price has been paid in full by the project
company and the constructor has paid all liquidated damages due to the project
company under the EPC contract; (vi) all project contracts and supporting agree-
ments relating to the operating phase of the project, including without limitation
the supply agreements, the off-take agreement and the O&M agreement, have been
entered into by the project company, have become effective and remain in full
force and effect; (vii) the project company has delivered to the lenders a notice, in
form and substance satisfactory to the lenders, accompanied by an independent
engineer's certificate, attesting that the requirements set forth in paragraphs (i)
through (vi) above have occurred and have been satisfied, and (viii) the lenders
have notified the project company that such notice is acceptable to them and there-
fore that physical project completion has occurred.
Finally, the lenders may occasionally decide not to request any completion sup-
port from sponsors and bear project completion risk on the basis of the strong
turnkey commitment assumed by the constructor under the turnkey construction
contract, or otherwise based on some other kind of credit enhancement provided
by interested parties. It should be noted, however, that usually no constructor would
assume project risks beyond those normally associated with construction activities
under the construction contract. Therefore, risks such as force majeure and changes
in law generally must be assumed by the sponsors or any interested party or other-
wise be borne by the lenders.
S t e p 17. D e b t F i n a n c i n g
The project company secures all the debt financing required for undertaking the
project by means of one or more financial arrangements (jointly the "financial
arrangements") entered into with one or more lenders or investors on a non-re-
course or limited-recourse basis, i.e., the main source of repayment of the debt
financing will be the project revenues, the project company's assets given in col-
lateral and the various credit enhancements granted by the sponsors and the other
interested participants in the project.
The debt financing sometimes consists of (i) a construction loan facility, which
is used for the financing of all the construction and start-up project costs, and (ii)
a term loan facility, which typically is disbursed upon the occurrence of project
completion and is applied to take out the construction loan. Construction loans
usually are disbursed in multiple drawdowns based upon a construction loan dis-
bursement schedule and subject to the occurrence of certain major milestone events
for engineering, procurement, construction, commissioning, testing and start-up
of the project facility. Term loans are often disbursed in full in one balloon pay-
ment. Construction lenders and term lenders may or may not be the same depend-
ing upon the structure of the financial plan. If they are the same, the construction
loan typically will convert into a term loan on a conversion date upon physical
completion of the project and satisfaction of certain conversion requirements similar
to the requirements for the occurrence of project completion described above.
Moreover, the debt financing may consist of pure senior debt or of a combina-
tion of senior debt and subordinated debt or preferred stock (sometimes called
"mezzanine debt" or "mezzanine financing"). Senior debt financing typically is
provided by commercial banks, export credit and other governmental agencies,
multilateral, bilateral and regional agencies, and a myriad of capital markets in-
struments, such as medium-term notes, debentures, bonds, floating-rate notes,
commercial paper, and securitization of project loans.
Although the use of capital markets for purposes of financing a project through
a public offering or a private placement of debt securities (usually called "project
bonds") has increased dramatically over the last few years, 21 such financing alter-
native still raises issues not present in the more traditional commercial bank, ex-
port credit and multilateral lending, z2
First, the use of capital markets is not in most cases an option for financing
project construction and start-up unless a creditworthy guarantor stands behind
the project company, because investors generally are not prepared to bear con-
struction and start-up risk. 23 On the contrary, once a project has been completed,
has successfully operated for a reasonable test period (approximately one or two
years) and has established an acceptable operating performance track record, capital
market investors may be prepared to purchase a project bond for the refinancing of
the construction loans at a lower cost.
Second, proceeds from the sale of debt securities are typically received by an
issuer up-front in a single disbursement. However, projects usually require the
flexibility of multiple disbursements consistent with the project budget. Conse-
quently, if a capital market financing is used, the project company must absorb a
negative carry resulting from the difference between the offering yield of the
10ng-term debt securities and the yield of the short-term investments in which
the project company may invest such excess funds while not needed for project
specific purposes.
Third, commercial bank, export credit or multilateral lending offers greater flex-
ibility to a project company in terms of amendments, waivers and consents to the
existing documentation than a capital market facility. The ability of a project to
react ahead of changing circumstances is a key element of a successful project
financing. While a syndicate of banks, an export credit agency or a multilateral
institution is relatively easy to mobilize rapidly if an unforeseen event occurs, this
is not usually the case of capital market's passive investors or of indenture trustees
in place to act in the interest of bondholders. In fact, indenture trustees typically
are unwilling to take any decisions on behalf of the bondholders other than admin-
istrative and clerical matters, and the process of calling a meeting of bondholders
is not only cumbersome, time consuming and expensive but also does not guaran-
tee a satisfactory result because bondholders are passive investors by nature.
Fourth, as opposed to commercial bank, export credit and multilateral facilities,
project bonds require an appropriate rating by one or more recognized rating agen-
cies in order to tap either the public or the institutional investor markets, and gen-
erally only projects that receive an investment grade rating can face the capital
market arena. In fact, traditional sources of public debt, such as insurance compa-
nies and pension funds, are usually reluctant to invest or, sometimes are prohibited
from investing, in non-investment grade issues. However, securing an investment
grade rating for a cross-border project financing is not an easy target, especially in
the case of projects in non-investment grade countries.
Fifth, capital market facilities are not easy to integrate as part of a financial plan
that consists of several other types of lenders. Actually, the negotiation of inter-
creditor matters, such as sharing of collateral, order of drawdowns, etc., between
commercial bank, export credit and multilateral lenders on the one side and bond
arrangers on the other side is sometimes a very hard, time-consuming process.
Sixth, capital market issues require the disclosure of sensitive information to
prospective investors. In order to sell a project bond in the capital markets, a project
company must prepare a disclosure document informing investors of all material
facts and risks in connection with the investment. The disclosure document must
not contain any material misstatements or omit to state any material fact necessary
to make the statements therein, in light of the circumstances under which such
disclosure document is to be used, not misleading. However, project developers
may have concerns in disclosing sensitive information to the public and prefer to
keep such information more confidential within a limited number of banks, ECAs
and/or multilaterals.
Nevertheless, capital market funding may indeed be a viable alternative for a
project financing as it can provide a fixed-rate financing at a cheaper cost and for
a term usually longer than commercial bank, export credit and multilateral lend-
ing. Moreover, capital market facilites generally comprise a more limited, simpler
and faster structuring process, easier-to-meet conditions precedent for the under-
writing of the debt securities and more flexible covenants, representations and
warranties and events of default.
Finally, when project economics are strong enough to easily cover the payment
of debt service on senior debt and all operating and maintenance costs, a project
company may arrange mezzanine financing for a project. Mezzanine financing
offers investors an intermediate return on investment between senior lending and
common equity investment and carries a corresponding intermediate risk. z4 Mez-
zanine financing may be useful to complement the traditional two-tier capital struc-
ture for project financing, adding a third (intermediate) tier of capital between
senior debt and common equity. Mezzanine financing can be used to reduce the
exposure of senior lenders, equity investors or both to a project. However, mezza-
nine financing may raise certain complex intercreditor issues between senior lend-
ers and mezzanine investors as to, among other things, the following aspects: (i)
increase of amount of senior indebtedness of a project; (ii) uses of revenues of a
project; (iii) amendments, waivers and consents; (iv) block on payments to mezza-
nine investors; (v) acceleration rights and enforcement of security; and (vi) shar-
ing of payments. 25
Subordinated loans are the most typical method for providing mezzanine fi-
nancing. The subordinated debt typically is junior in liquidation and current pay-
ment to the senior and secured debt but ranks senior to the equity and, therefore,
principal and interest on subordinated debt are payable before dividend payments.
Vendors, sponsors, and other interested third parties usually provide subordinated
loans. Some lenders may agree to grant a subordinated loan to a project provided
that such loan entitles them to some sort of equity-kicker mechanism, such as
conversion rights, income participation rights or similar rights. Mezzanine financ-
ing can also be provided by means of preferred equity, which typically ranks se-
nior in liquidation to common stock and carries some sort of preferred income
participation component.
Table 8-1 is a comparison of the four main sources of debt financing for project
financing. 26
Step 18. Security A g r e e m e n t s
The principal of, interest on, and other payment obligations under, the financial
arrangements typically are guaranteed by various security agreements granted by
the project company or the sponsors, as the case may be, in favor and for the
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benefit of lenders (jointly, the "security agreements"). To the fullest extent per-
mitted by applicable taws, security agreements must create and perfect the follow-
ing security (the "security"): 27
A mortgage over the site and other immovables of the project together with
any fixtures and civil works constructed thereon (the "mortgage");
A pledge over the key movable assets, such as heavy equipment and ma-
chinery, other movables, such as equipment in general, inventory and raw
materials, and intangible assets, such as patents and trademarks (jointly, the
"pledge"); and
An assignment or security interest over (a) the main project contracts, 28
(b) the project company's accounts receivable, z9 (c) the insurance policies, 3°
(d) the various project accounts 3~ and any other project company's bank
accounts, (e) the project company's contract rights under the cash contribu-
tion agreement and other credit enhancement provided for the project, (f)
the various contractors' bonds granted in favor of the project company un-
der the project contracts, (g) the permits and authorizations necessary for
the construction, start-up and operation of the project and (h) the conces-
sion contract itself (collectively, the "security interest").
Ideally, a security package should allow the lenders, upon the occurrence of a
default, to "step into the shoes" of the project company, and to manage and operate
the project temporarily until a solution to such default is found.
To that effect, the counterparts of each project contract as well as the grantors of
all material permits and authorizations usually are required to agree and give in
writing their consent to the terms and conditions of the applicable security agree-
ments (the "consents").
Consents often consist of an acknowledgment of, and a consent by, counterparts
and grantors in respect of the following lenders' rights inter alia: (i) to cure project
company's defaults under project contracts and permits and authorizations and to
be entitled to certain grace periods before counterparts and grantors can pursue
any remedy upon default; (ii) to receive directly all payments from such counter-
parts, including any payments relating to project company's accounts receivable,
penalties and indemnifications and liquidated damages; (iii) to have the right to
directly enforce project contracts and to directly benefit from permits and authori-
zations; and (iv) to, upon a default scenario, take control of a project and foreclose
it as a going concern, all of the above without affecting or impairing the validity,
effectiveness and enforceability of any of such project contracts and permits and
authorizations.
Additionally, the sponsors are sometimes required to create in favor of the lend-
ers a pledge of all or a portion of their shares in the project company (the "pledge
of shares") in order to provide the lenders flexibility to choose to exercise their
remedies upon default either directly against the project company or by seizing
control of the project by taking the equity. 32
While a pledge of shares provides the lenders the right to "step into the shoes"
of the project company and to foreclose on the project as a going concern in a
simple and efficient manner, this type of security structure has disadvantages be-
cause it conveys the foreclosure of the project with all its existing debts, liabilities,
and contingent liabilities.
Alternatively, lenders may simply require the sponsors to maintain control of
the project company until the debt financing is repaid (the "share retention under-
taking").
S t e p 19. I n t e r c r e d i t o r A g r e e m e n t s
Finally, the lenders typically enter into one or more intercreditor agreements (the
"intercreditor agreements") in order to regulate the lenders' relationship as credi-
tors to the project company, to define the rules for the administration of their fi-
nancial arrangements and, in the event of foreclosure, to share the collateral pledged
in their favor.
The basic purpose of an intercreditor agreement is to prevent disputes among
lenders that may jeopardize the interest of all creditors. Intercreditor agreements
may address, among other things, one or more of the following matters: (i) the
appointment of an administrative agent for purposes of acting as agent on behalf
of the lenders in all matters relating to the administration of the loans, and the
obligation of the lenders to act only through such agent; (ii) the appointment of a
collateral agent or trustee for purposes of holding the security on behalf and for
the benefit of all of the lenders; (iii) the order of drawdown of funds under the
various financial agreements; (iv) the maturity of the various loans comprising the
debt financing and the repayment schedules of such loans; (v) the application of
project revenues to the amortization of the different debt facilities; (vi) the right of
the lenders to suspend or cancel the credit facilities only upon the concurrence of
other lenders representing a certain majority of the debt financing (usually from
51% to 75%); (vii) the right of the lenders to determine compliance of all initial
and subsequent conditions of disbursement only upon the concurrence of other
lenders representing a certain majority of the debt financing (usually from 51% to
75%); (viii) standstill periods during which no lender can declare an event of de-
fault, accelerate a loan or foreclose on security without the concurrence of other
Description o f a Project Finance Transaction 115
lenders representing at least a certain majority of the debt financing (usually from
51% to 75%), provided that, in some cases, such standstill periods and majority
provisions may not apply in respect of certain fundamental events of default, such
as payment defaults, cross-defaults, termination or material amendments of project
contracts, environmental covenant defaults, negative pledge defaults and expro-
priation and nationalization; (ix) the right of the lenders to grant waivers of com-
pliance with covenants, to grant approvals of certain actions by the borrower and
to amend the financial arrangements, only upon the concurrence of other lenders
representing at least a certain majority of the debt financing (usually from 51% to
75%); (x) the right of the lenders to materially amend or change the terms and
conditions of their respective loan agreements upon the concurrence of other lend-
ers representing at least a certain majority of the debt financing (usually from 51%
to 75%); (xi) the incorporation of certain "deemed waiver" provisions whereby
lenders are deemed to have approved conditions of disbursement, to have waived
any such conditions, to have waived any breach of covenant or any default by the
borrower, or to have approved the amendment of financial arrangements or ancil-
lary loan documents, by the mere lapse of time without the agent having received
a written notice to the contrary; (xii) the rules and procedures for loan acceleration
and foreclosure of collateral; and (xiii) a sharing of payments provision whereby
the lenders agree to a pro rata sharing of all voluntary and involuntary payments
received from the borrower, through the exercise of a right of banker's lien, set-off
or counterclaim, pursuant to a secured claim, a foreclosure, bankruptcy or insol-
vency procedure against the borrower or by any other means.
Although the project company typically acknowledges the existence of an
intercreditor agreement among lenders, the project company should not be per-
mitted to be a party to such agreement nor should it have any right to benefit from
any of its provisions. An intercreditor agreement should inure to the benefit of
lenders exclusively, and the project company should not have any right, remedy or
defense arising out of the terms of such intercreditor agreement.
When the debt financing of a project is provided by different lenders, such as a
syndicate of banks, an ECA or a multilateral agency, the various lenders some-
times agree to enter into a common terms agreement for purposes of simplifying
the process of preparing the legal documents in connection with the debt financ-
ing, making the terms of all the financial agreements consistent among each other,
and allowing the project company to have a uniform, users-friendly set of finan-
cial legal documents.
In simple terms, a common terms agreement is an agreement between the project
company, the various lenders, the agents to the various lenders, the security trustee
or collateral agent (if any) and the intercreditor agent (if any), that establishes
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Description o f a Project Finance Transaction 117
common provisions applying to the various financial agreements in connection

with a project, such as definitions, conditions precedent for disbursements, draw-
down schedules and drawdown mechanisms, representations, covenants and events
of default, information covenants, budgets and financial projections, insurance
requirements, project accounts and cash waterfalls, intercreditor provisions, agency
provisions, etc. However, each lender must separately with the project company
enter into a loan agreement describing the specific aspects of the credit facility
provided by such lender, such as amount of the loan, repayment schedule, fees and
interest rates, etc. Such loan agreement typically incorporates the terms and condi-
tions of the common terms agreement by cross-reference.
Figure 8-1 presents the different constituents and elements comprising a project
financing transaction.
Notes
1. The terminology BOO stands for build, own and operate and the terminology BOT stands for
build, operate and transfer. Both BOO and BOT refer to structures that utilize private investment to
undertake public sector infrastructure projects. However, there are several schemes similar to BOO
and BOT, such as BOOT (build, own, operate and transfer), BTO (build, transfer and operate), DBFO
(design, build, finance and operate), MOT (modernize, operate and transfer), LOT (lease, operate and
transfer), ROT (rehabilitate, own and transfer), etc. For an elaboration on BOT and BOO see gener-
ally Chapter 13 below; Marc Frilet, "Some Universal Issues in BOT Projects for Public Infrastruc-
tures," The International Construction Law Review (1997); Geoff Haley, The A-Z of BOOT How to
create successful structures for BOOT projects, IFR Publications (1995); and Port V. Ranganathan
and Thillai Rajan A., "Issues of Structure for Project Financing," Project Finance International, Issue
122 (June 4, 1997) at 46.
2. Liability limitation issues as well as tax reasons are the most typical driving forces for the
utilization of holding companies in project finance transactions.
3. The concession contract, the legal framework or other local regulations applicable to the project
may impose certain restrictions on transfer of interest participations in the project to third parties.
Such restrictions may be avoided or minimized by using a project holding company to allow the
sponsors to have liquidity at the project holding company shareholding level.
4. In the case of concessions, bidding documents usually contain certain technical, financial, eco-
nomic and environmental information related to the project. However, in most cases the bidders
retain independent consultants to double-check the data provided in such bidding documents.
5. See Ronald F. Sullivan, Financing Transnational Projects, International Business Portfolios
Series, Matthew Bender & Co. (1991) at 2-05/6.
6. In the case of concessions, the site as well as certain permits and authorizations needed for a
project are sometimes determined and granted pursuant to the terms of the applicable concession
contract or any other agreement or document in implementation of that concession.
7. The term of an off-take agreement must be consistent with the term of the concession contract,
the supply agreements, the O&M agreement and the construction contract.
8. For a case study of a power project in which the off-taker's obligations under the off-take agree-
ment are secured by a security interest over the off-taker's accounts receivable, see Kenneth Simon,
Patrick Lynch and George Rogers, "Fiducia Structure Supports 144A Financing of Termo Emcali,"
Project Finance International, Issue 129, Latin America Report, at 54.
9. When traffic projections are not strong enough to make a project bankable, toll road projects
can be structured as "shadow tolls," which are simply per vehicle amounts paid to the facility opera-
tor by a government authority or other funding source instead of or, as a supplement to, a toll payable
by facility users.
10. According to David Schumacher, Chadbourne & Parke LLP, "Fuel Supply and Transportation
for Project Finance Power Production Facilities," Project Finance Monthly (October, 1998) at 10
" . . . The fuel supplier's or transporter's obligation could be firm, interruptible or quasi-firm. A firm
obligation requires the fuel supplier or transporter to deliver fuel whenever called upon. An interrupt-
ible obligation allows the fuel supplier or transporter to refuse to deliver at its discretion. A quasi-firm
obligation requires the fuel supplier or transporter to deliver on a firm-basis during certain times and
on interruptible basis at other t i m e s . . . "
11. There are many types of pricing structures for supplies than can be utilized in project finance
transactions. Pricing mechanisms for supplies may consist of (i) a fixed price subject to an escalator
(e.g., inflation index); (ii) a two-part price, consisting of a demand (or fixed) price and a supply (or
variable) price, in which the demand price compensates the supplier for its firm-supply commitment
regardless of delivery, and the supply price is paid on each unit of supply actually purchased by, and
delivered to, the project; and (iii) a take-or-pay price, in which the project has to make periodic
minimum payments to the supplier even if it does not take the supplies, and the project company is
entitled to certain "make-up" rights to recover supplies that have been paid but not taken. See David
Schumacher, Chadbourne & Parke LLP, supra, at 10.
12. It should be noted, however, that sometimes transportation of supplies is handled separately by
a transportation company by virtue of a transportation agreement entered into between the project
company and a transporter.
13. Scheduling and nomination provisions are particularly important for those supplies, such as
electricity, in respect to which appropriate back-up reserves cannot be stored at the site and also in
transportation agreements where the transportation capacity of the transport company's facilities
may be limited.
14. Liquidated damages must be sufficient to impose a strong incentive for the supplier to perform
but also must contemplate the consequential losses and damages that such default may impose on the
project company, such as costs of purchasing the supplies at a higher price from alternative sources,
loss of revenues and penalties under the off-take agreement.
15. Good industry practices generally refer to those practices, methods, equipment, specifications
and standards of safety and performance, which may change from time to time, as are commonly
used by professional engineering firms performing design, engineering, installation, operation or
maintenance services on facilities of the type and size similar to the project facility, which in the
exercise of reasonable judgment and in light of the facts known at the time the decision was made, are
considered good, safe and prudent practice in connection with the design, installation, operation,
maintenance and commensurate standards of safety, performance, dependability, efficiency and
economy.
16. In the event that the facility is not completed in accordance with certain minimum specifica-
tions, performance liquidated damages may be as high as up to an amount sufficient to prepay the
debt financing in full and, eventually, compensate the sponsors for all or a portion of the equity
investment as well. However, it must be noted that generally such liquidated damages payment does
not exceed the aggregate tumkey price paid to the constructor. Otherwise, in the event of perfor-
mance shortfalls within certain acceptable performance thresholds, liquidated damages may consist
of a sum necessary to reduce the debt financing to an amount that would enable the project company
to comply with its debt service obligations without affecting the return on equity and the debt service
coverage ratios.
17. In general, the constructor is only entitled to request routine change orders which do not materi-
ally and adversely change or affect the specifications, prices and completion schedule of the facility.
18. Force majeure excuses under the construction contract must also have similar effects in the
other project contracts. They must have the effect of extending the term of the concession as well as
D e s c r i p t i o n o f a P r o j e c t F i n a n c e Transaction 119
the deadline for commencement of operations under the off-take agreement. Similarly, they should
also excuse the project company from complying with its obligations under, and should extend the
term of, the O&M agreement and the supply agreements.
19. An operating fee may be established as (i) a fixed price payable only if the project's operating
and maintenance expenses are kept below a certain pre-determined amount; (ii) a cost plus structure,
whereby the project company reimburses the operator for the operating and maintenance costs, plus
overhead plus a fixed or variable fee depending upon performance; or (iii) a bonus/penalty structure
intended to encourage the operator to maximize output deliveries and minimize operating and main-
tenance costs.
20. Subordinated debt is senior to equity but junior to any senior as well as secured debt. The use
of subordinated debt (also called "quasi-equity") may be beneficial to the sponsors because restric-
tions on payment of dividends on equity can be avoided and the sponsors can receive a return on
funds invested in the project company. Additionally, subordinated debt may render certain tax ben-
efits because interest on subordinated loans--as opposed to dividend payments--is in general tax
deductible. For an elaboration on subordinated loans, see generally Philip R. Wood, The Law of
Subordinated Debt, Sweet & Maxwell (1990).
21. Examples of recent large cross-border project bond issues are the Petrozuata $650 million bond
offering (Venezuela), the Ras Laffan Liquified Natural Gas Company $1.2 billion bond offering
(Quatar), the TermoEmcali $165 million secured notes offering (Colombia) and the Petropower $162
million trust certificates offering (Chile).
22. For an elaboration on project bonds, see generally Martin Bartlam, "Project Eurobonds," Infra-
structure Finance (September, 1997) at 107; lan R. Coles, "The Role of Securitisation in Project
Finance," Project Finance Yearbook (1993/4), Euromoney Publications, at 30; Bill Voge and Michele
Penzer, "Using the Capital Markets in Ras Gas," Project Finance International, Issue 115 (February
26, 1997) at 38; Karol Nielsen, "Teachers Takes a Hands-on Approach," Project Finance Interna-
tional, Issue 115 (February 26, 1997) at 43; Robert Rees, "Bonds and the Lewisham Link," Project
Finance International, Issue 115 (February 26, 1997) at 46; Martin Bartlam, "Adopting a New Ap-
proach to Financing Projects through the Bond Markets," Project Finance International, Issue 120
(May 7, 1997), at 43; Bruce Johnston, "Multisource Project Finance--The Intercreditor Issues," Project
Finance International, Issue 102 (July 3, 1996), at 44; Rob Wright, "Petropower Blazes New Trails in
Latin Capital Market Financing," Project Finance International, Americas Market Report (Spring
1996), at 10; Boey Kit Yin, "Romancing The Bonds," Project Finance International, Asia Pacific
Market Report (Summer 1996), at 23; Gregory G. Randolph and Alexander Schrantz, "The Use of the
Capital Markets to Fund the Ras Gas Project," The Journal of Project Finance (Summer 1997) at 5;
"Petrozuata--Bringing It All Back Home," Project Finance International, Issue 129 at 50; Bill Voge,
"Project Bonds Are A'Changing," Project Finance International, Issue 125 (July 16, 1997), at 78;
Philip Carter, "Credit Where Credit's Due," Project & Trade Finance (August, 1997), at 11; and
Arthur Mitchell, "Multi-source Project Finance Using the US Capital Markets," Project Finance
International, Issue 122 (June 4, 1997), at 42.
23. For an interesting case study of a power project bond in which bondholders have taken con-
struction risk, see Enid L. Veron and Louis A. Martarano "Enron's Sutton Bridge IPP-~A New Gen-
eration of Projects Taps the International Capital Markets," The Journal of Project Finance (Winter
1997) at 5.
24. See Alistair Macrae, "Mezzanine Debt Offers Added Funds for Project Finance," AsiaLaw
(October, 1998) at 24.
25. See Alistair Macrae, supra, at 24/6.
26. This table is based on "Table B: Comparison of Key Financing Criteria," by Arthur Mitchell,
"Multi-Soarce Project Finance Using the US Capital Markets," Project Finance International, Issue
122 (June 4, 1997) at 44.
27. The following description of security is merely a reference to the security agreements more
often than not used in international project finance transactions and represents a general description
of the kind of collateral that a lender may expect to receive in a project financing. The mere reference
to a mortgage, a pledge, an assignment or a security interest is not intended to categorize any of them
in any given type of security of a particular jurisdiction because the names, characteristics, formali-
ties, effects, scope, perfection mechanisms and types of security structures available to lenders inevi-
tably vary from jurisdiction to jurisdiction. Consequently, in a cross-border project financing the
lenders, with the assistance of local counsel, must analyze and understand the applicable local laws
of securities and guarantees, explore the different alternatives of security available in such jurisdic-
tion, determine its comparative advantages and disadvantages and determine the best available secu-
rity structure for the transaction. For an elaboration on comparative law of securities and guarantees,
see Philip R. Wood, Comparative Law of Security and Guarantees, Sweet & Maxwell (1995).
28. The assignment of main project contracts as well as the creation and perfection of a lien on the
project company's accounts receivable may prove to be a complex conflicts-of-law matter inasmuch
as the various project parties are frequently located in numerous jurisdictions. For an elaboration on
this topic from a New York law perspective, see Skadden, Arps, Slate, Meagher & Flom, supra, at 40.
29. If possible, arrangements should be made to have project revenues paid or transferred, as the
case may be, in hard currency to an off-shore project account, particularly in the case of export-
oriented projects. Off-shore account arrangements help to mitigate the risks of currency devaluation,
depreciation and inconvertibility as well as the risk of transfer restrictions in the host country. For an
elaboration on this topic, see Chapter 11 below, Currency Devaluation, Depreciation and Inconvert-
ibility Risk.
30. Lenders are usually named beneficiaries or loss payees as well as additional insured parties
under the respective insurance policies. For an elaboration on this topic, see Chapter 12 below, Com-
mercial Insurance.
31. Project accounts may include, among others, a revenue account, a funding account, a construc-
tion account, an operating account, a debt service reserve account and an insurance account. For an
elaboration on this topic, see Chapter 12, Project Accounts-Cash Waterfalls.
32. An interesting issue arises when the sponsors have contracted political insurance coverage for
their equity in a project. While lenders usually require a pledge of the shares of the project company
as part of the security package, political insurers also require as a condition for the payment of such
political insurance that the insured sponsors transfer to it such sponsors' equity interest in the project,
free and clear of all encumbrances and liens. Consequently, sponsors usually require lenders to a~ee
to release the pledge if any of the insured political events materialize. On the other hand, lenders
usually do not like the idea of releasing their share pledge in favor of the insurer because such politi-
cal event will also constitute an event of default under the financial agreements and, consequently,
lenders will be entitled to accelerate the loans and foreclose on the collateral. At the end of the day,
this is matter subject to negotiation among the parties and each particular transaction may provide a
different solution to this issue.
9
Advantages and Characteristics
of Project Financing
Advantages o f P r o j e c t Financing
Project financing is usually chosen by project developers in order to inter alia:
• eliminate or reduce the lender's recourse to the sponsors

• permit an off-balance sheet treatment of the debt financing
• maximize the leverage of a project
• circumvent any restrictions or covenants binding the sponsors under their
respective financial obligations
• avoid any negative impact of a project on the credit standing of the sponsors
• obtain better financial conditions when the credit risk o f the project is better
than the credit standing of the sponsors
• allow the lenders to appraise the project on a segregated and stand-alone
basis
• obtain a better tax treatment for the benefit of the project, the sponsors or
both
• reduce political risks affecting a project
Any combination of the foregoing reasons is usually sufficient to cause the spon-
sors to structure the financing of a project on a project finance basis.
Non-recourse or Limited-recourse Financing
Non-recourse or limited-recourse financing is usually the main reason why project

developers are interested in pursuing a project finance transaction. Project financ-
ing provides a financing structure that allows sponsors not to be accountable for
the debt financing of a project company or at the minimum permits sponsors to
limit such accountability to certain specific events.
Confusion often exists between the meanings of the terms "non-recourse" and
"limited-recourse" project financing to the extent that both terms are customarily
used interchangeably. However, they are not exactly the same. Non-recourse project
financing provides a structure that removes the developers from any obligation to
stand behind the project debt if the revenues of such project are insufficient to
cover principal and interest payments on the underlying debt x whereas limited-
recourse project financing limits such recourse obligation to certain specific pre-
determined events. However, as mentioned previously, depending upon the laws
and jurisdiction applicable to each particular case, sponsors may still be held re-
sponsible to the lenders in the event of fraud or inaccuracy of representations and
warranties made to the lenders in relation to the project or if the "piercing the
corporate veil" doctrine applies.
Off-balance Sheet Treatment
The off-balance sheet treatment of the project debt is another important advantage
of project financing. In a project financing, the debt of a project is exclusively
annotated in the financial statements of the project company and does not affect
the consolidated financial statements of sponsors.
Rules for financial consolidation are basic for structuring project finance trans-
actions. Generally, in order to obtain an off-balance sheet accounting treatment,
none of the sponsors shall individually own more than a fifty-percent participation
in the capital of the project company. Equity participations of fifty percent or less
are shown as a one-line entry in the consolidated financial statements of each of
the sponsors i.e., capital investment in other corporations. Therefore, the debt fi-
nancing of the project is not reflected in the consolidated financial statements of
the sponsors.
On the contrary, a more than fifty-percent subsidiary may require a line-by-line
consolidation mechanism if other consolidation conditions also exist and, conse-
quently, the debt financing must be reflected on the consolidated financial state-
ments of such sponsor. It should be noted, however, that certain long-term
Advantages and Characteristics of Project Financing 123
arrangements, guarantees and other types of credit enhancements typically granted

by project developers in project finance transactions may need be footnoted in the
sponsors' consolidated financial statements. Consequently, it is advisable to have
the auditors of the sponsors review the legal documents reflecting such commit-
ments or guarantees to determine in advance the accounting treatment that such
auditors will apply to those credit support commitments.
The accounting standards applicable to the sponsors inevitably vary from ju-
risdiction to jurisdiction and consequently the application of the general prin-
ciples exposed in this book must be double-checked in each particular case. For
example, consolidation rules under the United States Generally Accepted Ac-
counting Principles (U.S. GAAP) require not only more than fifty percent own-
ership but also the existence of effective management control over a subsidiary
and the existence of certain economic complementarity between the parent com-
pany and its subsidiary.
Highly-leveraged Debt Financing

Another advantage of project financing is that it permits the use of a highly lever-
aged capital structure for the financing of a project. Indebtedness levels acceptable
in project finance structures vary from project to project, but debt-to-equity ratios
of seventy percent or more are commonly accepted. This is a real advantage for
project developers because a high level of debt financing reduces the amount of
equity necessary for financing a project.
However, as mentioned previously, project financiers generally want to have the
sponsors "on the hook" and sponsors are often required to contribute a reasonable
amount of equity to the project company to ensure a high degree of involvement
in, and commitment to, the success of the project and to reduce the project's over-
all debt service obligation to acceptable levels according to the project's econom-
ics. Lenders usually want to ensure that sponsors will not yield to the temptation of
abandoning a project prematurely when the first problem comes up and a reason-
able level of equity exposure is often the best way to mitigate such risk. z
Avoidance of Restrictive Covenants

By using a project finance structure, sponsors may undertake new capital-inten-
sive projects without violating certain negative covenants by which they may be
bound. These restrictive covenants may consist of restrictions on new indebted-
ness, restrictions on granting guarantees or on creating liens (negative pledge),
limitations on new capital expenditures or on participation in new projects, and

restrictions based on certain financial ratios, such as debt service coverage ratio,
liquidity ratios and debt to equity ratio.
Project Isolation
By means of a project financing, the credit rating of the sponsors (and conse-
quently their cost of borrowing money in the financial markets) is not negatively
affected by the various, and usually significant, risks associated with a project
finance venture. Sponsors may undertake several large and, sometimes, highly-
risky projects without jeopardizing their overall credit standing. In fact, the risk
distribution component of project financing allows sponsors to participate in large
projects assuming only certain specific, limited risks and knowing that the failure
of one of those projects will not cause their bankruptcy? Conversely, the credit
risk of a project may be sometimes better than the one of its sponsors. In such a
case, a project financing may allow the sponsors to obtain cheaper financing than
a corporate loan based upon their own creditworthiness.
Isolation of a project also has benefits for lenders. It permits lenders to appraise
a project on a stand-alone basis and to carefully identify, quantify and manage all
the various risks associated with the construction, start-up, management and op-
eration of a project. It also allows lenders to exercise a thorough, on-going super-
visory and monitoring control of a project on an isolated basis. Project finance
structures generally provide lenders with strict control and supervision powers in
respect of a project. However, lenders must exercise such powers in a reasonable
fashion to avoid exposure to lender's liability. As a general principle, lenders should
abstain from having abusive control of the day-to-day operations of a project and
pursuing any act that may be interpreted as active intervention in the management
of the project company.4
Tax Treatment
The determination of the best legal structure for a project finance transaction and
the use of different legal vehicles for purposes of undertaking a project or structur-
ing its financing (e.g., a special-purpose company, a partnership, a trust structure,
a holding company, etc.) are generally based on the idea of maximizing the tax
benefits for the project company, the sponsors or both.
In fact, the type of legal structure selected for the equity and debt investments
may affect not only the tax treatment of a project in the host country, but also the
tax treatment of sponsors and lenders both in the host country and in their respec-
tive jurisdictions. Matters relating to inter alia taxation on repatriation of capital,
capital gains and dividends to the sponsors and taxation on remittance of princi-
pal, interest and fees to the lenders should be carefully reviewed before deciding a
structure for a transaction? Consequently, it is advisable that from the outset of a
transaction the consultants or tax advisors of the project company work closely
with its financial and legal advisors in the selection of the best legal structure for a
project and its equity and debt financing.
Political Risk Reduction
The number and variety of participants (domestic and international, from the pri-
vate and public sector, etc.) in project finance transactions usually reduce the amount
of political risk associated with a project. The reason is that if the host country
government intends to negatively affect a project in any manner whatsoever, it will
have to face pressure not only from the sponsors but also from various project
participants interested in the success of such project. 6
D i s a d v a n t a g e s o f Project F i n a n c i n g
Project financing also has disadvantages. In particular, using project finance tech-
niques usually implies a long, complex and cumbersome structuring process,
expensive structuring costs, comprehensive and expensive insurance coverage
and, in some cases, higher financial cost than conventional financing supported
by the sponsors' credit standing. 7 Consequently, the election of a project finance
structure for the financing of a project will depend on an adequate and careful
comparative analysis of the advantages and disadvantages of such financial struc-
ture vis-~-vis all other existing financing alternatives available for such particu-
lar project. Thus far, many project developers have chosen the project finance
technique as it has often proved to justify the special problems and disadvan-
tages described above.
Characteristics of Project Financing
The following table 9-1 shows a comparative analysis of the main characteristics
of a project finance transaction as opposed to a more traditional corporate loan.
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Notes
1. A typical non-recourse provision generally provides the following: "Notwithstanding any other
provision under the loan agreement to the contrary, there shall be no recourse against any affiliate of
the borrower or any of its respective stockholders, agents, officers, directors or employees for any
liability of the borrower to the lenders arising in connection with any breach of covenant or default
under the loan agreement and lenders shall look solely to the borrower and the project security in
enforcing rights and obligations under and in connection with the loan agreement."
2. See Clifford Chance, supra, at 6/7.
3. See Clifford Chance, supra, at 5.
4. According to Clifford Chance, supra, at 53, " . . . Suggestions for reducing the risk of lender
liability include: covenants in the documentation should be drafted carefully to ensure that the lender
is not seen to be effectively exercising control; restrictions might be better expressed as events of
default, rather than as direction to follow specific policies; lenders should be careful when proposing
to take an equity interest in the borrower and/or in having a nominee director on its board; lenders
should take care to minute meetings with the project sponsors and borrower, to minimize the risk of
allegations of misrepresentation or failure to negotiate in good faith; offers of finance should be
clearly stated to be subject to final documentation and to be indicative, rather than exhaustive, of
terms and conditions of the offer; events of default should be specific (it is perhaps dangerous to rely
solely on the ground of "material adverse change") and, where possible, subject to objective tests
rather than simply being dependent on the discretion of the lender; financial covenants which could
be regarded as imposing a "business plan" on the borrower should be avoided: it might be preferable
for the lender to ask the borrower to produce its own business plan for approval and then to provide
that failure to carry out that plan would be an event of default; and similarly, covenants prohibiting
the borrower from removing existing management or board members might be better expressed in
such a way that change of management constitutes an event of default . . . . "
5. The issue of whether there is a significant withholding tax on the payment of interest and fees to
foreign lenders is of utmost importance for the financial viability of a project. In general, loans from
multilaterals and export credit agencies are exempt from withholding taxes. Borrowings in the inter-
national capital markets are sometimes exempt also. But this is not usually the case for commercial
lenders and withholding taxes in such cases may be as high as 30% of the applicable payments. Since
lenders are expected to be reimbursed or "grossed up" by a borrower for any such taxes, the all-in cost
of the debt financing would go up accordingly. In some cases, the existence of tax treaties among the
applicable countries may have the effect of lowering or even eliminating such withholding taxes on
interest and fees that might otherwise be payable. See Ronald E Sullivan, supra, at 2-11.
6. See Chapter 12, Risk Reduction.
7. Numerous constituents are usually involved in the structuring process of a project finance trans-
action, such as legal and financial advisors, technical consultants, tax advisors, auditors, lenders,
sponsors, off-takers, constructors, operators, and government agencies. Consequently, the all-in cost
of a project financing must be calculated taking into account the numerous fees and expenses associ-
ated with its structuring process, such as fees and expenses of financial and legal advisors, lenders,
technical consultants, auditors, tax advisors, etc.
10
Appraisal Techniques
in Project Financing
here tends to be a natural sequence in the way projects are planned, structured
T and carried out by project developers. This sequence is often called the project
cycle. The project cycle can be identified as the process of carrying out a project
through the different stages of project identification, preparation, appraisal, nego-
tiation, implementation, supervision and post-project evaluation. Among these
stages, the project appraisal is a key step to ensure the economic and financial
viability of a project. The appraisal stage evaluates the adequacy of project returns
as well as the capital structure and the financial viability of a project.
Pro Forma Financial Statement Analysis
The financial viability of a project can be ascertained through a rigorous pro forma
financial statement analysis. There are three key financial statements: income state-
ment, balance sheet and cash flow statement. Projected financial statements are
used to calculate various financial ratios necessary to evaluate the financial viabil-
ity of a project.
These days, financial projections are made with the assistance of computer spread-
sheet programs, such as Excel or Lotus, and are based on assumptions relating to
the key variables affecting a project, such as revenues, cost of goods sold, capital
expenditures, labor costs, taxes, exchange rate, interest, inflation, etc. The finan-
cial statements projection sequence goes in the following order: first, the income
statement, second, the cash flow statement, and third, the balance sheet.
First, for purposes of preparing the income statement projection, revenues are
estimated from the projected sales volumes and the projected unit prices. The
projected cost of goods sold (CGS) is estimated on the basis of projections re-
garding the production volume, raw material and overhead costs, and direct la-
bor costs. Projected depreciation and amortization expenses are derived from
the projected depreciation and amortization schedule. Finally, projected interest
expenses are calculated based on the terms and conditions of the financial agree-
ments, including disbursement schedule, grace period, amortization schedule,
interest rates, fees, etc.
Second, for purposes of preparing the cash flow statement projection, the dif-
ferent projected cash flows of a project must be estimated. The cash flow state-
ment is composed of three elements: cash flows from operations, cash flows
from financing activities, and cash flows from investment activities. In order to
estimate the projected cash flows from operations, projections regarding net in-
come, depreciation and amortization, and deferred income taxes are derived from
the projected income statement while projections regarding the change in non-
cash working capital are extracted from the projected working capital schedule.
In order to estimate the projected cash flows from financing activities, the terms
of the financial agreements provide the necessary data relating to the debt fi-
nancing, including disbursement schedule, grace period, amortization schedule,
interest rates, fees, etc, while the common and preferred equity investments are
estimated from the equity investment plan. Lastly, the projected cash flows from
investment activities, which are composed of projected capital expenditures and
projected sale of non-current assets, are derived from the projected capital ex-
penditure schedule.
Finally, the projected balance sheet is estimated from both the projected income
statement and the projected cash flow statement. Among the projected current
assets, projected cash is derived from the cash flow statement projection, while
projected accounts receivable are estimated based on the expected number of days
for collecting accounts receivable, usually known as the average collection period.
Projected inventory is calculated based on the target number of days of total cost
of goods sold to be held in inventory. Projected fixed assets are extracted from the
projected capital expenditure plan, while projected depreciation and amortization
is derived from the projected depreciation and amortization schedule. Long-term
debt is based on the projected loan schedule while the projected accounts payable
are estimated on the basis of the desired number of days for payment of accounts
payable arising from the cost of goods sold. Finally, the paid-in capital is calcu-
lated from the equity investment plan and the projected retained earnings are de-
rived from the projected income statement.
Appraisal Techniques in Project Financing 133
Projected financial statements are prepared for the entire project life on an an-
nual basis. Then, key financial ratios are calculated for each year to evaluate the
financial viability of a project. A sound evaluation of a project company's finan-
cial viability can be obtained by a judicious analysis of financial ratios.
Financial Ratios
There are broadly five categories of financial ratios: liquidity ratios, leverage ra-
tios (also known as "debt management ratios"), activity ratios (also known as "as-
set management ratios"), profitability ratios, and market ratios. Liquidity ratios
are designed to measure the ability of an entity to meet the current debt service.
Leverage ratios indicate the degree of dependence of an entity on debt financing as
compared to less risky equity funding. Activity ratios demonstrate how efficiently
a business firm utilizes its assets, while profitability ratios demonstrate various
measures of profitability for a firm. Finally, market ratios show the stock market
perception of a firm's present and future performance.
Liquidity ratios consist of the current ratio (i.e., current assets divided by cur-
rent liabilities) and the quick or acid test ratio (i.e., current assets minus inventory
and prepaid expenses divided by current liabilities).
Leverage ratios consist of the debt to total assets ratio (also known as "debt
ratio") (i.e., total debt divided by total assets), the debt to equity ratio (i.e., total
debt divided by equity), the interest coverage ratio (i.e., earnings before interest
and taxes divided by interest expenses), and the debt service coverage ratio (i.e.,
earnings before interest and taxes plus depreciation and amortization expenses
divided by debt service payments).
Activity ratios include the inventory turnover ratio (i.e., sales or cost of goods
sold divided by inventory or average inventory), the average collection period (i. e.,
accounts receivable divided by the average daily sales revenues), and the total
assets turnover (i.e., sales revenues divided by total assets).
Profitability ratios consist of the basic earning power ratio (i.e., operating in-
come divided by total assets), the net profit margin (i.e., net income divided by
sales revenues), the operating profit margin (i. e., operating income divided by sales
revenues), the return on assets (i.e., net income divided by total assets), the return
on equity (i.e., net income available to shareholders divided by equity) and the
earnings per share (i.e., net income available to shareholders divided by the total
number of shares outstanding of a firm).
Finally, market ratios include the price earnings ratio (i.e., market price per
share divided by earnings per share) and the market price to book value ratio (i.e.,
per share market price times the total number of outstanding shares of a firm di-
vided by the net worth of such firm).
Current Ratio
The current ratio is computed by dividing current assets by current liabilities. Cur-
rent assets normally include cash, marketable securities, accounts receivable, in-
ventories and short-term prepaid expenses. Current liabilities consist of accounts
payable, short-term notes payable, the portion of long-term debt maturing within
one year, accrued income taxes, and other accrued expenses such as accrued wages
payable.
Typically, when a company is getting into a financial difficulty, it starts paying
its accounts payable more slowly, building up bank loans and other short-term
debt, disposing of marketable securities, reducing available cash, and so on. If
current liabilities are increasing faster than current assets, then the current ratio
will decline and the company's liquidity condition will deteriorate. The current
ratio is the most commonly used measure of short-term solvency because it pro-
vides the best single indicator of the extent to which the claims of short-term credi-
tors are covered by assets that can be converted into cash in a period roughly
corresponding to the maturity of the claims.
In principle, the higher the current and quick ratios, the more liquid the entity
is and the more capable such entity is of servicing current debt. However, ex-
tremely high liquidity ratios are not necessarily good as they may indicate an
excess of working capital, such as cash, accounts receivable or inventory. How
high should liquidity ratios be? There is no rule of thumb or correct answer.
Optimal liquidity ratios vary from industry to industry. For example, liquidity
ratios of a steel mill are quite high but it is market practice to accept low liquid-
ity ratios in retail operations. Consequently, the optimum liquidity of an entity
must be determined on the basis of industry average ratios reflecting that industry's
operational characteristics.
Quick or Acid Test Ratio
The acid test ratio is calculated by deducting both inventories and short-term pre-
paid expenses from current assets and dividing the remainder by current liabilities.
The quick ratio measures a company's ability to pay off the current liabilities with-
out taking into account non-liquid current asset items, such as prepaid expenses
and inventories. The rationale behind the quick ratio test is the following: Prepaid
expenses, such as prepaid rents and insurance premium, are not likely to be re-
converted into cash and therefore are subtracted from the current assets to com-
pute the quick ratio. Similarly, inventories are typically not as liquid as the other
current asset items, such as marketable securities and accounts receivable, and
therefore are also subtracted for the current asset calculation for purposes of com-
puting the acid test ratio.
Debt to Total Assets Ratio

The debt to total assets ratio (also known as "debt ratio") measures the percentage
of total financing of a firm provided by creditors. The debt to total assets ratio is
calculated by dividing total debt by total assets. Assets include all current and non-
current assets of a firm whereas debt comprises both current liabilities and long-
term liabilities. Creditors prefer low debt ratios, since the lower the debt ratio, the
greater the cushion against creditors' losses in the event of liquidation. On the
other hand, equity investors prefer high debt ratios, because high debt ratios allow
the maximization of net earnings available to equity holders due to the fact that
interest expenses, as opposed to dividend payments, are tax-deductible expenses.
Moreover, a high level of debt financing reduces the amount of equity necessary
for financing a firm and therefore permits shareholders to avoid diluting their eq-
uity and maximizes their return on equity.
Debt to Equity Ratio

The debt to equity ratio (also known as "D/E ratio") is computed by dividing total
liabilities by equity capital. Both D/E ratio and debt ratio are mirror images of the
same capital structure. For example, a debt ratio of 60/100 or 0.6 times implies a
D/E ratio of 60/40 or 1.5 times. Some financial analysts prefer to measure the D/E
ratio dividing only long-term liabilities by equity capital because current liabilities
include accounts payable and accrued expenses that do not strictly represent debt
capital as compared to equity capital. Either definition of D/E ratio is acceptable in
measuring the overall degree of dependence on equity capital versus debt capital
by a company to fund its total assets.
Interest Coverage Ratio

Interest coverage ratio (also known as "times interest earned ratio (TIE)") mea-
sures the ability of a company to meet interest payments and is calculated by di-
viding the earnings before interest and taxes (also known as "EBIT") of a firm
during the preceeding fiscal year by interest expenses coming due on the follow-
ing fiscal year. Since interest expenses are tax-deductible expenses, the ability to
pay current interest expenses is not affected by income taxes. Consequently, the
numerator is the operating income before taxes rather than after taxes.
Debt Service Coverage Ratio
The debt service coverage ratio indicates the ability of a firm to service principal
and interest on its debt and is calculated by dividing the earnings before interest
and taxes plus depreciation and amortization expenses (also known as "EBITDA")
of a firm during the preceeding fiscal year by the total debt service payments
coming due on the following fiscal year. Depreciation and amortization expenses
are non-cash expenses. Since the operating income is computed after subtracting
depreciation and amortization expenses, the latter is added back to the operating
income to estimate the gross internal cash generation of a firm.
Inventory Turnover Ratio
The inventory turnover ratio (also known as the "inventory utilization ratio") is
computed by dividing the sales or, sometimes, the cost of goods sold, by invento-
ries of a firm. Some financial analysts prefer to use the average inventory of a firm
rather than using the year-end inventories. The average inventory of a firm is esti-
mated as the sum of the beginning and ending inventories divided by two. A high
inventory turnover ratio implies an efficient utilization of inventories, resulting in
lower inventory financing costs. However, a high inventory turnover ratio may
lead to inventory shortages and delays in the delivery of goods to customers. Op-
timal inventory turnover ratios vary from industry to industry. Consequently, a
proper balance must be assessed by comparing a company's inventory turnover
ratio to the industry average ratio.
Average Collection Period (ACP)
Average collection period (ACP) is calculated dividing the accounts receivable by

the average daily sales of a firm. ACP indicates the average number of days that
accounts receivable remain outstanding before collection. Average daily sales are
computed by dividing the annual sales of a firm by 365 (or 360) days. ACP can be
evaluated by comparison with the credit terms on which a company sells its goods.
An optimal ACP depends on industry characteristics: a jewelry store usually has a
rather long ACP while a typical grocery store has a very short ACE An ACP longer
than the industry average may imply slack collection practices whereas a very
short ACP may result in sales losses due to unusually tight credit terms.
Total Assets Turnover
Total assets turnover is computed by dividing sales by total assets of a firm. This
ratio measures how efficiently a firm utilizes its assets in terms of sales generation.
Some financial analysts also calculate the fixed assets turnover ratio, which is the
ratio of sales to net fixed assets of a firm. Both ratios provide a measure of efficient
or inefficient asset utilization in terms of sales generation employing total or net
fixed assets.
Basic Earning Power Ratio
The basic earning power ratio is computed by dividing operating income by total
assets of a firm. This ratio measures the degree of operating income generated by
the total assets utilized for such purposes. The basic earning power ratio is useful
for comparing the basic earning power of firms in different tax situations and with
different degrees of financial leverage.
Net Profit Margin Ratio
The net profit margin ratio (also known as "profit margin") is computed by divid-
ing net income by sales of a firm and is used to measure the degree of net profit
generation per unit (e.g., U.S. dollar) of sales.
Operating Profit Margin Ratio
The operating profit margin is computed by dividing the operating income by

sales of a firm. This ratio measures the degree of operating profitability of a
firm per unit (e.g., U.S. dollar) of sales. The operating profit margin is a broader
ratio than the net profit margin, which is influenced by the degree of financial
leverage and taxes.
Return on Assets (ROA ) Ratio
ROA (also known as "return on total assets") is computed dividing the net profit
by total assets of a firm. This ratio measures the degree of net profit generation per
unit (e.g., U.S. dollar) of total assets. Since net profit is the bottom line of the
income statement and total assets indicate the size of the balance sheet, ROA is the
marriage of the income statement and the balance sheet.
Return on Equity (ROE) Ratio
ROE (also known as "return on common equity") is computed by dividing the net
profit available to shareholders by the stockholders' equity of a firm. This ratio mea-
sures the rate of return on the stockholders' investment. ROE is influenced by the
financial leverage insofar as the total assets applied to the business of a firm are
provided by both creditors and equity investors. Consequently, the more financial
leverage the higher the ROE. Of course, a high financial leverage structure exposes
a firm to debt service default risk during a recession period when such company may
experience difficulties in generating sufficient operating profit to service its debt.
Price Earnings (P/E) Ratio
The P/E ratio is computed by dividing the market price per share of a firm by the
earnings per share of such firm. The earnings per share (EPS) of a firm are calcu-
lated by dividing the net profit available to shareholders by the number of out-
standing shares of a firm. The P/E ratio indicates how much investors are willing
to pay per unit (e.g., U.S. dollars) of net income. All things being equal, a high P/
E ratio indicates that investors are bullish on the prospects for a company while a
low P/E ratio implies the opposite. A company P/E ratio can be compared to the
industry as well as the entire market P/E ratio to give a sense of a firm's position.
Market Price to Book Value Ratio
The market price to book value ratio (also known as "market/book ratio") is com-
puted by dividing the per share market price times the total number of shares
outstanding of a firm by the shareholders equity of such firm. This ratio provides
another indication of how investors regard the company's prospects.
P r o j e c t C a s h F l o w s Analysis
Project cash flows analysis is designed to measure the return on investments of a

project over its life span. There are three appraisal techniques most widely used
for appraising project cash flows: net present value (NPV), internal rate of return
(IRR) and modified IRR (MIRR). These methods essentially compare, usually on
an annual basis, the projected cash outflows with the projected cash inflows of a
project over the project life. However, in all these methods project cash flows are
distinct from the income statement profits or losses and from the cash flow items
in the cash flow statement. In a project cash flow analysis, projected cash outflows
and inflows are uniquely estimated for project's appraisal purposes.
Projected project cash outflows consist of projections regarding capital invest-
ment costs, physical contingencies, initial working capital requirements, and front-
end capitalized expenses, such as training costs and development expenses.
Projected cash outflows are reduced by investment tax credits, if any, and the af-
ter-tax salvage value of the replaced equipment or any equipment rendered redun-
dant due to the new investment. Both price contingencies (also known as
"escalation") and the interest cost during construction are excluded from project
cash outflows calculation even though they are included in the financing package.
Projected project cash inflows include projections regarding both operating cash
flows and termination cash flows. Projected operating cash inflows consist of pro-
jections regarding operating profits before income taxes plus depreciation and
amortization expenses. Projected financial expenses, such as interest and principal
and lease expenses, are excluded from operating cash flows because the different
alternatives for financing a project, such as debt or equity financing, are typically
decided once the project's NPV and IRR are estimated on a pure operating cash
flow basis. In other words, both NPV and IRR are calculated based on pure pro-
jected operating cash flows to be generated by a project without being tainted by
the cost associated with the financing alternative selected by project developers.
For this reason, the projected financing costs, such as interest and principal and
lease expenses, are not factored into the projected operating cash flows. Projected
depreciation and amortization expenses are added back since they are non-cash
expenses and they represent the original capital expenditures spread over the project
life. Capital expenditures are considered as initial project cash outflows, and there-
fore they do not need be re-subtracted in the projected cash flows during the project
operation period as depreciation and amortization expenses.
The projected termination cash flows include projections regarding the esti-
mated after-tax salvage value of the new equipment and other investments at the
end of the project life, any recovery of initial working capital, and the expected
clean-up costs. Depending upon the amount of projected clean-up costs, the pro-
jected terminal value may be either positive or negative. With the increased con-
cern for the environmental impact of new projects, clean-up costs can be
substantially high (e.g., nuclear power plant projects or open-pit mining projects)
and, therefore, should be properly calculated.
Once the respective projected cash outflows and inflows of a project are identi-
fied on an annual basis over the project life, NPV, IRR and MIRR can be calcu-
lated. NPV is calculated as the sum of the present values of net annual project cash
flows discounted at the company's discount rate, which is the firm's weighted
average cost of capital. If the NPV is positive, the project is considered worthwhile
to undertake.
One disadvantage of the NPV method is that it ignores the scale factor of a
project. If a firm should choose between two projects with two different NPVs, a
firm is likely to select the project with the higher NPV. However, that project may
cost much more than the other project, thus resulting in a lower NPV per invest-
ment unit (e.g., U.S. dollar). For example, if the NPVs of projects X andY are $1.5
million and $2 million, respectively, it may seem at first glance that project Y is
preferable to project X. However, let's suppose that the total project cost of project
X is only one-third of project Y's cost. In this case, therefore, project X would turn
out to be better than project Y even though the project X's NPV is lower than the
project Y's NPV. Unless an analyst considers the scale of project costs along with
the actual NPV values, a misleading conclusion may be reached by using only
NPV results. For this reason, the IRR method is also widely used for appraising
project cash flows because it takes care of the investment scale factor problem.
IRR is the discount rate that makes the NPV equal to zero. If the IRR is higher
than the company's weighted average cost of capital or discount rate, the project is
considered worthwhile to undertake. However, IRR is a mathematical solution
based on the rather unrealistic assumption that project cash inflows can be rein-
vested at the same IRR until the end of the project life. But the IRR is just a math-
ematically calculated number and has no relation to the probable reinvestment rate
of a firm. In order to overcome this problem, the modified IRR (MIRR) is calcu-
lated using the firm's discount rate as reinvestment rate as opposed to the IRR.
MIRR is the most appropriate method for appraising projected project cash flows,
especially when the calculated project IRR turns out to be rather high.
For example, assuming that there is a new uranium mine project with projected
cash flows of minus $80,000 at the beginning of the project (the initial project
cost), positive $500,000 at the end of year 1 (cash inflows due to profits, etc.), and
minus $500,000 at the end of year 2 (cash outflows required to clean up the envi-
ronmental contamination and to reclaim the land to its original status), the calcu-
lated IRR of this project is either 25% or 400%, even though the NPV at the discount
rate of 10% is negative $38,678. The reason why this project has two calculated
IRRs is due to the fact that the project cash flows change signs twice, from nega-
tive to positive and back to negative. Thus, in this case the IRR is meaningless,
since it is simply a mathematical solution of a polynomial equation with degree of
2 to find out the discount rate at which the NPV turns out to be zero. A more
meaningful solution is to use the MIRR, which assumes that the profit (cash in-
flow) of $500,000 at the end of year 1 can be reinvested at the discount rate of
10%, rather that at the mathematically calculated IRR. The MIRR in this case
turns out to be minus 21%, which describes more accurately the return on invest-
ment of this uranium mine project. The idea is that the higher the estimated IRR,
the more preferable the MIRR method as compared to the IRR method.
Since project appraisal necessarily involves using future estimated data, there is
always uncertainty over whether projected figures would turn out be correct or
not. Thus, using single best estimates of future expected costs and revenues might
be inadequate to the decision-makers. In order to deal with project uncertainty
risks, several methods have been devised, namely the sensitivity analysis, the sce-
nario analysis and the Monte Carlo simulation.
In a sensitivity analysis, the key variables of a project, such as project cost, unit
price, sales volume, etc. are re-estimated, normally in the direction of conserva-
tism. For example, the original cost estimate may be increased by 5% or 10%, while
the original unit price or sales volume may be revised downward by 10% or 15%,
etc. Using these more conservative estimates, NPV, IRR and MIRR are re-calcu-
lated, thus giving the management another insight into the project's attractiveness.
In a scenario analysis, usually three scenarios of project outcome are calculated.
For example, under the best case scenario the project costs may be reduced by 7%,
the sales volume increased by 10% and the unit price increased by 5%. Under the
worst case scenario, the exact opposite assumptions are made, while the average
case scenario typically captures the most likely outcome. Thus, three sets of NPVs,
IRRs and MIRRs are calculated to represent the best, worst and average case sce-
narios. In this way, the management can gain further insight into the degree of risk
involved in a project.
The most sophisticated risk appraisal method employs a computer simulation
of the future project outcomes, and this method is known as the Monte Carlo
simulation. Under this method, the single best estimates of key cost and revenue
variables of a project are replaced by probability estimates, which show the vari-
ous projected values of each key cost or revenue item as well as their correspond-
ing probabilities. Thus, the unit price may be set, for example, at $10 with a .25
probability, at $12 with a .40 probability and at $15 with a .35 probability. Using
these various cost and revenue numbers and their respective probabilities, a com-
puter simulation of, say, 500 runs, will be made using a random number generator,
selecting various values at random but according to their probabilities. The result
would be 500 different IRRs and their mean and standard deviation. With a Monte
Carlo simulation, the management can gain a greater insight into the project's risk
profile as compared to only one IRR in the case of single best estimates.
11
Risk Identification and Risk Assessment
isk management techniques for project finance transactions consist of a com-

R bination of five different but interrelated steps. First, all risks affecting a
particular project must be duly identified and understood at an early stage by
project participants (risk identification). Second, risks must be quantified and
assessed to determine their magnitude (risk assessment). Third, risk reduction
techniques must be applied to reduce the overall risk facing project participants
to the lowest possible level (risk reduction). Fourth, risks must be distributed
among the various project participants in a way that is mutually acceptable for
them (risk spreading). Finally, each participant may individually choose to fur-
ther reduce its allocated risks through additional risk spreading mechanisms such
as political and commercial insurance and derivative instruments (hedging and
insurance). ~
This risk management process is, however, an interrelated process and partici-
pants typically go back and forth in their analysis of project risks. At the end of the
day, risk allocation generally is determined on the basis of control over a risk,
reward associated with that control, role, creditworthiness and likelihood of miti-
gating such risk. Generally, the participant that can best exercise control over a
risk, that can effectively mitigate it or that will realize the greatest reward if a risk
does not materialize, typically is allocated such risk. ~
Risk identification and risk assessment steps are explained below.
Risk Identification and Risk Assessment
As mentioned before, the identification and assessment of various risks associated

with a project are the first two steps of the project financing risk management
process.
The following list enumerates some of the main risks that can negatively affect
the success of a project financing: 3
• construction cost over-runs

• construction delays
• non-completion
• defective performance after completion
• breach of contract by project participants
• inaccurate financial projections
• technical and technological risks
• supplies shortfalls
• increases in the prices of supplies
• project output market risk
• project output transportation risk
• operating cost over-runs
• poor management
• interest rate fluctuations
• currency devaluation and depreciation
• inflation risk
• existence of mineral reserves
• title issues
• internal problems of the sponsors
• inconvertibility risk
• transfer risk
• expropriation and nationalization
• changes in laws and taxes
• government breach of contract
• permits and authorizations issues
• acts of violence
• uncovered casualty losses due to force majeure
• local law issues
• environmental and social matters
The chances are not low that any of the risks listed above may impact on a
particular project. Thus far, many of the projects financed using project finance
Risk Identification and Risk Assessment in Project Financing 145
techniques have experienced some kind of problems, mainly relating to construc-

tion cost over-runs, construction delays, inaccurate cash flow projections, market
problems and political risks. 4
Although the types of risks to which projects are exposed can be categorized
into numerous broad headings, for purposes of this book the main risks affecting
the success of a project finance structure have been classified for instructional
purposes as commercial and financial risks, political risks, force majeure and other
risks. ~
Commercial and Financial Risks
The most typical commercial and financial risks facing a project financing are as
follows:
Construction Cost Over-runs
Construction cost over-runs occur when the actual construction and start-up costs
of a project are higher than the figures estimated in the financial plan. 6 Construc-
tion cost over-runs may be caused by several circumstances, such as construction
delays, inflation, construction supplies shortfalls, increases in the prices of equip-
ment and other supplies, increases in labor costs, force majeure, engineering or
design problems, 7 changes in the technical designs, technical defects, changes in
law and taxes, strikes and start-up-related problems.
Construction and start-up costs consist of all costs and expenses necessary to
finance and complete the project facility and achieve project completion date in
the manner contemplated in the financial and operating plans, including, without
limitation, all costs and expenses in connection with the negotiation and documen-
tation of the transaction and project documents, the formation of the project com-
pany, and all other costs and expenses required for the development, design,
construction, procurement, installation and start-up of the facility, including inter-
est expenses, maintenance expenses and any other costs and expenses during the
construction phase.
Construction cost over-runs are one of the major risks in a project financing. If
projected construction costs are exceeded, additional funds will be required for
the completion of a project. Additionally, if construction cost over-runs are not
distributed to a creditworthy third party (e.g., the constructor), such additional
funds need be financed by the sponsors through additional equity contributions or
subordinated shareholders' loans or otherwise by new debt financing not contem-
plated in the financial plan.
However, additional indebtedness would cause increased debt service payments

and, therefore, would negatively affect the ability of a project to service debt.
Consequently, equity contributions or subordinated shareholders' loans are gener-
ally preferable in order to maintain the senior debt service coverage ratios at a
level that would not jeopardize the success of a project.
Therefore, lenders must ensure that sufficient additional funds are and will be
available to finance construction cost over-runs. If no party is obligated to contrib-
ute additional funds, the lenders will be pressured into contributing such addi-
tional funds to avoid the collapse of the project. As Peter K. Nevitt says " . . . A
lender does not want to find itself trapped into having to finance a larger amount
simply because cost over-runs occur and no other source of funds is available. In
situations involving such risk, potential cost over-run risk will have to be covered
by interested parties to the transaction..." ~
Consequently, a project that intends to be financed using a project finance struc-
ture must contemplate a mechanism for allocating construction cost over-runs risk
which assures that a participant or interested party is committed to bear, or to
provide the necessary funds to finance, cost over-runs.
Most construction cost over-runs are usually allocated to a reputable, creditwor-
thy, and experienced constructor by means of an all-inclusive turnkey construction
contract. The uncovered risks, such as casualty force majeure events and political
risks, typically are neutralized by one or more of the following mechanisms: (i)
cash contribution agreements or completion guarantees whereby the uncovered
risks are shifted to the sponsors or any other interested party; (ii) casualty com-
mercial insurance covering casualty force majeure perils; (iii) consequential loss
commercial insurance; (iv) political insurance coverage; (v) contingent or stand-
by credit facilities granted by the lenders or other project participants for purposes
of making available additional financing to cover potential cost over-runs; (vi)
stand-by letters of credit and other sureties granted by interested third parties; and
(vii) escrow accounts for contingencies.
Construction Delays
Construction delays can present a series of difficult problems for a project's suc-
cess, namely (i) the increase in the interest burden of a project during the construc-
tion phase, which in turn leads to financial cost over-runs not contemplated in the
financial plan; 9 (ii) the delay in commencement of the operating phase and there-
fore the delay in commencement of the project revenue stream; (iii) the increase in
certain construction costs (e.g., labor); (iv) the imposition of certain penalties to
the project company under project contracts, such as the concession contract, the
supply agreements and the off-take agreement; and (v) in some cases, the early
termination of such project contracts.
Construction delays may result from several circumstances, such as defaults by
host country government or the off-taker, 1° defaults by the constructor under the
EPC contract, force majeure, changes in law and taxes, delays in obtaining the
necessary permits and authorizations, technical and technological problems, and
supplies and material shortfalls.
Construction delays are generally mitigated by means of the same mechanisms
used for construction cost over-runs.
Completion Risk
Even if a project has sufficient funds available to finance construction cost over-
runs or construction delays, there may occur certain circumstances (e.g., technical
and technological failures) that prevent or render impossible the completion of a
project. Such a project is typically called a "dead horse."
Lenders usually endeavor to allocate completion risk to one or more interested
parties to ensure the repayment of their loans in the event a project is not com-
pleted. However, it may sometimes be difficult to allocate or neutralize in full
completion risk, particularly in the case of large projects. If no parties are willing
to assume in full that risk, lenders may be forced to rely on certain risk reduction
and distribution mechanisms which would minimize the likelihood of occurrence
of a non-completion scenario, such as retaining independent advisors to conduct
feasibility studies, using proven technology, and entering into a turnkey construc-
tion contract with a reputable constructor.
Defective Performance After Completion

A primary pre-commissioning risk is that a completed project does not perform in
accordance with specifications, which generally occurs when a facility fails to
perform at an agreed capacity or efficiency.
Usually a minimum performance level is specified in the off-take agreement
and the construction contract below which the off-taker is not obligated to honor
its purchase obligations under the off-take agreement and the project company is
not obligated to accept the project facility from the constructor, respectively. This
is obviously another type of non-completion. In such a case, the off-take agree-
ment typically provides for a release of the off-taker and the project company from
their respective obligations under such agreement. On the other hand, the con-
struction contract generally establishes that the project company must be fully
reimbursed by the constructor for all amounts already paid by the project com-
pany under such construction contract. Such reimbursement obligation typically
is secured by performance bonds issued by commercial guarantors for the benefit
of the project company (and the lenders) and for the account of the constructor.
Any portion of the debt financing not covered by such reimbursement obligation
is typically further supported by the sponsors by means of certain limited guaran-
tees, such as a completion guarantee or a deficiency guarantee.
Where a facility achieves the minimum specified performance level, but such
level is actually lower than the anticipated project capacit) or efficiency, then the
off-taker generally is forced to comply with its obligations under the off-take agree-
ment and the project company must accept the facility from the constructor. How-
ever, the project company typically is entitled to liquidated damages from the
constructor in an amount sufficient to prepay the debt financing down to reduce
debt service to a level such that the lower projected off-take payments would be
adequate to service debt without affecting the debt service coverage or reducing
the return on equity. Liquidated damages payable by the constructor under the
construction contract are intended to be an incentive for the constructor to deliver
the plant in accordance with specifications. At the same time, a construction con-
tract may offer a reward to the constructor for assuming the risk of completion on
a date certain for a fixed price and at certain pre-determined specification by means
of bonus payments, which are usually payable if the project facility is completed
in advance of the scheduled completion date. ~
Sponsors may sometimes be required to provide credit support to mitigate the
consequences of any defective performance of the project facilities by means of a
limited guarantee, such as a cash contribution agreement. Such cash contribution
agreement generally requires the sponsors to provide sufficient funds as may be
necessary to either (i) prepay a portion of the debt financing and, consequently,
reduce the debt service burden of a project company to reasonable levels or (ii)
cover any project company cash shortfalls during the operating phase.
Project Contractors and Sponsors Breach of Contract
The experience, reputation, and creditworthiness of each of the participants in a

project to whom project risks are allocated are essential for the success of a project.
For example, the experience and credit standing of the constructor are of utmost
importance to avoid or at least minimize the occurrence of construction cost over-
runs or completion delays and to have a creditworthy counterpart capable of pay-
ing the liquidated damages provided under the construction contract. Similarly,
the experience and creditworthiness of the sponsors, the off-taker, the suppliers
and the operator are of tantamount importance for the success of a project. The
breach by any of such project participants of an obligation assumed under a project
contract might adversely affect or even jeopardize the project's success.
This risk can be mitigated by making sure that each of the participants in a
project has the necessary experience, track record and credit standing to assume
its respective obligations under the various project contracts. Otherwise, a credit-
worthy party should provide credit enhancement in support of such project
participant's obligations, such as payment and performance bonds, stand-by let-
ters of credit and corporate guarantees.
In summary, lenders should not only perform a credit analysis of the project
itself, but they must also review the reputation and creditworthiness of each par-
ticipant to whom one or more risks are allocated.
Financial Analysis Risk
The financial feasibility of a project must be verified beforehand through financial

projections showing that the expected cash flows of a project will be sufficient to
cover not only the debt service but also the operating costs and a reasonable mar-
gin for contingencies.
In order to avoid mistakes in the financial analysis of a project, the assumptions
used for the preparation of financial models must be realistic and conservative,
and to the extent possible, be based on studies performed by independent consult-
ants with experience in the respective subject matters.
Technical and Technological Risks
Lenders always want to minimize technical and technological risks associated with
a project. Consequently, lenders expect a project to employ reliable and tested
technology that allows completion and performance of a project facility in accor-
dance with specifications, prevents technology obsolescence, prevents operating,
technological, technical or mechanical failure or disaster, and prevents technical
or technological problems which may trigger construction cost over-runs, con-
struction delays or larger operating and maintenance costs.
Technical and technological risks are sometimes difficult to measure. How-
ever, project failure for such reasons may place the lenders in jeopardy. Conse-
quently, technical and technological risks must be carefully assessed based upon
the advice from engineering consultants and, if necessary, must be allocated to
an interested party, such as the constructor, the supplier of equipment and/or the
sponsors.
New Technology
In general, lenders in project financing are averse to a project employing new
technology. As mentioned above, lenders usually prefer proven technologies that
do not represent a major technological challenge. ~2However, this is not necessar-
ily a rule of thumb. Projects employing new technologies cannot be ignored be-
cause viable new technologies may represent great business opportunities. In some
cases, lenders are prepared to finance these kinds of projects so long as such new
technology risk is satisfactorily allocated to creditworthy parties, such as the con-
structor or the supplier of equipment, or otherwise is assumed by the sponsors by
means of a limited guarantee. 13
Availability and Prices of Supplies

The availability, transportation and prices of critical supplies for the start-up, main-
tenance and operation of a project (e.g., raw materials, energy, fuel, etc.) must be
adequately secured in a manner consistent with the operating and financial plans
of a project. The project must have supplies available at the time and in the amount
required to operate at full capacity and to deliver output in accordance with the
off-take agreement.
A delay or shortfall in the delivery of supplies to a project may prevent the
project company from complying with its obligations under the off-take agree-
ment. Additionally, it may affect the cash flow generation of such project and it
may make the project company potentially liable for penalties under the off-take
agreement. On the other hand, an increase in the prices of project supplies or in
their transportation costs may cause operating cost over-runs, unless the project
company is entitled to pass such cost over-runs through to the off-taker or another
interested party.
In general, the availability, transportation and prices of critical supplies for a project
are secured by means of long-term supply and transportation arrangements, such
as supply-or-pay contracts and transportation contracts. In some other cases, such
risks are assumed by the off-taker, the sponsors or another interested participant.
When the project company assumes responsibility for the procurement of sup-
plies, lenders must ensure that the project has structured a supply strategy that
both is commercially realistic and satisfies lenders' concerns in respect of supply
availability and prices. In that sense, lenders must analyze, among other things,
the alternative sources of supplies available to the project, the strength and amount
of suppliers available in the market, the characteristics of the markets relating to
supplies, the existence of monopolies, the means and costs of transportation avail-
able for supplies and related installations (e.g., harbors, warehouses, trains, roads,
airports, etc.) and the expected availability and future prices of supplies.
Finally, when a critical supply is a commodity, the project company may seek
protection against an increase in the international prices of such commodity through
hedging facilities, such as forward purchases, future contracts, options, swaps, etc.
Market Risk
As mentioned previously, the reliability of expected cash flows is essential to a

project finance transaction. Lenders typically require a level of certainty as to the
future demand (and the sale prices) of the output to be produced by a project.
Moreover, lenders usually verify the existence of a long-term need for a project
output and confirm that the project is capable of delivering its output at market
prices.
Expected cash inflows are usually secured by long-term off-take agreements,
such as take-or-pay agreements, take-and-pay agreements or through-put agree-
ments. ~4Other times, future project revenues are based on the existence of a well-
developed and efficient market for the project's output. However, when the project
output is a commodity, the project company may seek protection against a drop in
the international prices of such commodity through hedging facilities, such as
long-term contracts, forward sales, future contracts, options, swaps, etc.
While market risk may be mitigated by long-term off-take agreements, lenders
must still verify the competitiveness of a project in order to avoid or minimize
distortions caused by changing market conditions. 15 In that sense, lenders should
always perform a thorough analysis of output markets, output price dynamics and
project competitors because a variety of circumstances may arise which can nega-
tively affect market demand or prices for output and, therefore, project viability,
such as new technologies, product obsolescence, changes in demand, changes in
market needs and commodity price decreases. ~6
In some cases, sponsors may be required to assume market risk in certain cir-
cumstances, such as collapse of international markets, force majeure, political risks,
etc., and to provide certain limited guarantees to cover such risk, such as cash
contribution agreements, output price floors, output minimum sales assurances or
performance guarantees.
For example, in the case of toll road project finance transactions, sponsors are
sometimes required to assume any adverse differences between actual traffic flows
during a pre-determined testing period (e.g., 1 year) after project completion and
the traffic projections foreseen in the financial plan. Under such circumstances,
sponsors typically are required to provide enough funds to the project company as
are necessary to either (i) prepay a portion of the debt financing and, consequently,
reduce the debt service burden of the project company to reasonable levels, or (ii)
cover any project company cash shortfalls during the operating phase.
Transportation of Outputs
The means and prices of transportation of project output from the site to the
respective markets, and the facilities related to such transportation activities (e.g.
harbors, warehouses, trains, roads, airports, etc.) must be adequately ensured by
the project company. In general, a project company can adequately distribute the
risks associated with transportation of outputs by means of a long-term transpor-
tation contract under terms consistent with the project company's sales obliga-
tions under the off-take agreements. Alternatively, transportation risks (and related
costs) may be shifted to the off-taker pursuant to the terms of the off-take agree-
ment. Finally, certain residual transportation risks, such as force majeure and
political risks, are sometimes assumed by the sponsors under limited guaran-
tees, such as cash contribution agreements, performance guarantees or political
risk guarantees. For example, although an off-taker or a transportation company
may be prepared to assume all commercial risks relating to the transportation of
outputs, they may be hesitant to bear certain force majeure political risks that
may affect the means of transportation, such as terrorism or sabotage. In such a
case, sponsors are typically required to assume residual risks by means of grant-
ing a limited guarantee.
Operating Cost Over-runs

Similar to construction cost over-runs, increased costs in the operation and main-
tenance of a project not foreseen in the financial plan may negatively affect the
financial performance of such project and may even jeopardize the ability of such
project to cover debt service.
Some typical reasons for the occurrence of operating cost over-runs are the
following: project design mistakes; mechanical, technical or technological fail-
ures; excessive replacement of spare parts; unscheduled maintenance programs;
low productivity of the labor force; strikes and force majeure.
Operating cost over-runs are usually allocated to the constructor and the opera-
tor by means of various penalties, liquidated damages, performance bonds, in-
demnities or other risk distribution mechanisms established under the construction
contract and the O&M agreement, respectively. However, the sponsors or other
project participants usually provide further credit support for operating cost over-
runs by virtue o f limited guarantee mechanisms, such as cash contribution agree-
ments or performance guarantees.
Experience of Management
Efficient and experienced management is essential to the success of a project. The

management team of a project company must have the experience and expertise t6
manage a project. If none of the sponsors has adequate experience to manage, or
provide management for, a project according to state-of-the-art industry standards,
a project company must either appoint a group of reputable and experienced man-
agers or otherwise outsource the management of a project to a reputable and expe-
rienced management company.
Interest Rate Risk
Financial costs are among the most relevant costs in a project finance transaction.
Such costs typically fluctuate throughout the life of a project because project fi-
nance transactions are usually financed using variable interest-rate facilities. Con-
sequently, financial projections must include realistic interest rate assumptions
and the projected cash flows of the project must accommodate statistically reason-
able increases in interest rates without jeopardizing the project's feasibility.
If financial projections for a project indicate a tight debt service coverage
ratio and there is a risk that increases in interests rates may threaten the success
of a project, lenders will require the transfer of interest rate risk to a creditwor-
thy party using an interest rate protection agreement. Interest rate protection
agreements can be designed to transfer or mitigate such risk generally or in cer-
tain specific contingencies. Interest rate protection agreements usually consist
of different types of derivative instruments, such as swaps, futures, forwards,
options, caps, collars, etc.
Perhaps, the most common derivative instrument used for mitigating interest
rate risk in project financing is the coupon swap, where the project company swaps
its floating-rate interest payment obligations into fixed-rate. Under such swap ar-
rangement, the project company periodically pays fixed-rate interest payments to
the swap counterpart and at the same time receives from latter floating-rate pay-
ments, which are passed-through to the project company's lenders. However, swap
market players usually require strong credit counterparts and projects typically are
not eligible for swap transactions insofar as they are in the bottom end of the credit
spectrum. This obviously has an impact on price and availability of swaps for
projects. In terms of price, projects usually pay a premium for the increased credit
risk whereas in terms of availability, coupon swaps either are arranged by the lead
manager of the debt financing or otherwise are based on a guarantee support pro-
vided by a creditworthy participant in the project. ~7
Finally, in some cases, interest rate risk may be passed through to either the off-
taker or the government, who assumes such risk by means of certain adjustment
formulas of the output purchase price or tariff, as the case may be, intended to
reflect increased financial costs.
Currency Devaluation and Depreciation
When a project generates income in one currency (usually the local currency of
the host country) but has a portion of its costs denominated in one or more foreign
currencies, ~8it is exposed to the risk of fluctuations in the exchange rate between
such foreign currencies and the local currency in which the project is generating
its revenues. Currency exchange fluctuations may lead to a loss in value of the
currency of the host country in relation to the foreign currencies in which the
project must honor its financing and/or operating costs. Consequently, the cash
flows produced by the project may no longer be sufficient to pay such foreign-
currency-denominated obligations.
Lenders must always perform a detailed analysis of devaluation and deprecia-
tion risk and verify that the exchange rate assumptions used for the financial pro-
jections are reasonable to ensure that the project will be capable of resisting
unexpected exchange rate fluctuations.
In the case of countries with soft monetary systems that face high devaluation
and depreciation risks, the hedging of such risks through derivative instruments
(swaps, futures, forwards, options, etc.) is usually not available in the market. In
those cases, lenders should employ other distribution techniques in order to man-
age devaluation and depreciation risks, such as off-shore project accounts into
which payment in respect of export receivables are directly deposited, credit en-
hancements from the sponsors or other participants in a project, loans in local
currency to cover a portion of the financial plan and price-adjustment mechanisms
for the project output price or tariff based upon foreign exchange fluctuations.
A distinction must be made, however, between projects for the domestic market
of the host country and export-oriented projects, which usually involve a product
or commodity to be sold in the international markets (e.g. oil, gas, gold, coal or
petrochemical product). While domestic projects generate revenues in local cur-
rency and therefore have a significant exposure to devaluation and depreciation
risks, export projects generate revenues in hard-currency which can be used to
service the project's debt and consequently are not significantly exposed to for-
eign exchange fluctuations.
Consequently, in countries whose credit rating status is not adequate, whose
balance of payments is weak and/or whose foreign indebtedness is excessive, the
financing of a project on a non-recourse or limited-recourse basis may be hard to
implement, unless sufficient credit enhancement is provided by the sponsors or
any other interested party. However, export-oriented projects in such countries
may still be bankable for a project financing. Indeed, in some cases, the existence
of a hard-currency off-take structure, with export receivables payable by a repu-
table off-taker flowing into an off-shore escrow or trust account, may even allow
the credit rating for a project to be higher than the credit rating of the host country
itself. 19
International financing of a project which is expected to generate export rev-
enues can be collateralized by using off-shore escrow or trust accounts opened in
an international financial center, such as New York, London, Hong Kong or
Singapore. Foreign currency receivables out of exports are directly collected into
the escrow or trust account in order to ensure payment of operating and mainte-
nance expenses and debt service obligations on a priority basis. 2° However, there
is always the risk that if the project company fails to export the applicable prod-
ucts, the expected flows of foreign currency receivables into the escrow or trust
account will fail to materialize, leaving the creditors without an assured source of
repayments in hard currency. To mitigate this risk, lenders may require the ar-
rangement of a long-term performance guarantee under which the guarantor agrees
to indemnify lenders if the project company does not perform under the export
agreement.
Inflation
Unanticipated high inflation rates may adversely affect a project's feasibility. Con-
sequently, financial projections of a project must incorporate realistic inflation
rate assumptions. In some cases, inflation risk may be allocated to the off-taker or
the government by means of certain price-escalator mechanisms included in the
off-take agreement or the concession contract, as the case may be, such as periodic
adjustments of the output purchase price or tariff based upon a certain inflation
index.
Appraisal of Physical Assets
While lenders usually base their financial analysis of a project upon the projec-
tions of its cash flow streams, they also take into account the liquidation value of
the assets given in collateral. In this respect, lenders generally determine the actual
value of collateral by means of an independent consultant's appraisal of such as-
sets. Appraisals are important to determine the security coverage for a debt financ-
ing. Mistakes in appraisal figures may jeopardize the lender's position in a
foreclosure scenario.
Existence of Mineral Reserves

In the case of oil, gas or mining projects, it is of critical importance that the lenders
duly verify from the outset of a project the existence of enough economically
recoverable mineral reserves to justify undertaking a project and its consequent
debt financing.
The reserve risk is realized when actual mineral reserves are smaller than the
estimates used in calculating the financial projections of a project or when the
recovery costs of such reserves are greater than expected. In such circumstances,
the actual revenues of a project may be insufficient to cover operating and mainte-
nance costs and the amortization of, and interest expenses on, the debt financing, zl
Consequently, project participants should determine by means of appropriate
geological surveys and independent consultant opinions, among other things, the
existence, estimated amount and classification of such reserves and the technical,
economical and financial feasibility of extraction of such reserves for purposes of
preparing objective financial projections for a project. Verification of reserves is of
utmost importance to ensure that there will be a reasonable coverage for the ser-
vicing of the debt financing during the life of such reserves. A reserve analysis
must indicate that, by the time the loan is projected to be paid out in full, a reason-
able amount of reserves and future revenues will still remain.
In the case of reserve-based financings, it is usually preferable to tailor the debt
repayment schedule based on a percentage of the project gross revenues along
with a minimum payment schedule as opposed to a more traditional fixed-pay-
ment-and-fixed-maturity approach. This type of repayment mechanism protects
lenders in the event that the reserves are extracted faster than originally expected.
Otherwise, if the debt financing pays out in equal installments, then fewer reserves
will be available at the final maturity of the loan.
In general, lenders are reluctant to make reserve-based loans on a non-recourse
basis except in those cases where there are enough proved reserves to satisfy the
various reserve-coverage tests. 22 Consequently, any financing to a project which

relies on probable or possible reserves usually requires credit enhancement from
the sponsors or another creditworthy party to ensure that if any mineral reserve
risk is realized, the sponsors or another creditworthy party will assume the nega-
tive impact.
Some of the risk distribution mechanisms more frequently used in reserve-based
projects are limited guarantees, such as minimum production guarantees, perfor-
mance guarantees and cash deficiency guarantees, or certain indirect guarantees,
such as throughput and deficiency agreements. 23
Title Risk
Title to the land and/or the hydrocarbon or mineral field is a particularly important
matter in oil, gas and mining projects, but still must be considered in any kind of
project involving the acquisition of land. Lenders should be satisfied that the project
company has "good and marketable" title over the site and, in the case of oil, gas
or mining projects, over the applicable hydrocarbon or mineral field as well. Such
requirement is typically verified by a legal opinion issued by the project company's
counsel, which sometimes is confirmed by the lenders' local counsel and, in some
cases, is further satisfied by means of a title warranty or title insurance granted by
a creditworthy party.
Sponsors "A rrangements
Lenders are generally concerned about the internal arrangements among sponsors
because they want to know who has the decision-making power for a project.
Lenders usually analyze the various internal agreements among the sponsors of a
project in order to verify the existence of sufficient legal mechanisms (including,
without limitation, decision-making procedures and dispute resolution mechanisms)
in relation to the administration and operation of a project to avoid, or at least
reduce the likelihood of the occurrence of, internal conflicts that might affect project
Success.
Lenders generally pay particular attention to sponsors' arrangements relating to

inter alia the following matters:
• shareholding structure and changes in the interest participations of the

sponsors
• rules for transfers of equity participations and incorporation of new equity
holders
• responsibilities and obligations of the sponsors, particularly in relation to

equity contributions to the project company
• decision-making mechanisms, particularly voting rights, supermajorities,
minority rights and dead-lock provisions
• internal policies and procedures for the administration of the project
• election of the board members and senior management of the project company
• creation of executive committees
• annual budget and accounting reports
• arms-length principle for transactions between the project company and
sponsors
• dispute resolution mechanisms
Political R i s k s
Political risks, also known as country risks, appear when a lender makes a loan to
a company incorporated in, and with business and operations in, a country differ-
ent from the lender's country of incorporation (cross-border loan). Political risks
are distinct from sovereign risk. Sovereign risk arises when a lender makes a loan
to a government of a country different from the country in which such lender is
incorporated? 4 Political risks are also frequently considered as political force ma-
jeure events. Consequently, political risks are treated in two different sections of
this chapter, namely in the Political Risk and Force Majeure sections.
The main political risks associated with transnational project finance transac-
tions are the following: 25
Inconvertibility Risk
Inconvertibility risk arises when the government of the host country establishes
currency exchange controls and, consequently, adopts convertibility restrictions
that prevent the project company from converting its income (usually in local cur-
rency) into the hard currency required for the payment of debt service.
Lenders must carefully determine the likelihood of occurrence of foreign ex-
change controls or restrictions in the host country taking into account the foreign
exchange position and other macroeconomic factors affecting the host country as
well as any precedent of foreign exchange controls or restrictions in that country.
Inconvertibility risk can be reduced or distributed, as the case may be, by using
one or more of the following mechanisms: political risk insurance coverage; regis-
tration of the loans with the applicable governmental agencies, which in some
jurisdictions confers certain conversion and repatriation rights; use of off-shore

accounts; guarantees and assurances from the government of the host country and
credit support from the sponsors or other participants in the project.
Transfer Risk
A project is subject to transfer risk when the project company is allowed to obtain
foreign currency in the host country but is not permitted to remit such hard cur-
rency abroad. The typical case takes place when the monetary authority of the host
country does permit conversion of the project company's local currency into for-
eign currency but does not authorize the transfer of such foreign currency abroad.
Transfer risk can be managed using the same risk reduction and distribution
mechanisms employed for inconvertibility risk.
Expropriation and Nationalization
The risk of expropriation and nationalization of a project is realized when the

government of the host country decides to nationalize or expropriate the assets of
a project or the shares of a project company in a discriminatory or arbitrary man-
ner without a payment of just or fair compensation to the project company or the
sponsors, as appropriate, z6
The expropriation of a project may occur by virtue of one administrative act of
the host country government (direct expropriation) or as a consequence of a series
of hostile acts intended to force the sponsors to abandon a project (creeping expro-
priation). Creeping expropriation may be caused by various circumstances affect-
ing the economics of a project, such as changes in laws, unreasonable increases in
the applicable taxes, imposition of new taxes, unreasonable increases in the appli-
cable import and export duties, imposition of new import and export duties, failure
to grant or to renew the required permits and authorizations for a project, price
control interferences or changes in foreign investments policies.
The nationalization risk is of particular relevance in the case of emerging mar-
ket projects in certain strategic sectors (e.g., energy, oil and gas, public services,
etc.) where the existence or the blooming of nationalist policies may tempt gov-
ernments to expropriate those projects.
Lenders must evaluate this risk within the general analysis of the political risks
associated with a project. If necessary, lenders should require the implementation
of appropriate risk reduction and distribution mechanisms, such as political risk
insurance coverage, government guarantees and assurances or credit support from
the sponsors and other participants in the project.
Changes in Law and Taxes
Another political risk that may affect a cross-border project financing is a change
in the "set of rules" since the time a decision was made to undertake a project.
Changes in law and taxes may adversely affect the success of a project and may
render it unprofitable.
There are many types of government actions that can dramatically interfere with
the destiny of a project, such as:
• changes in the regulatory framework applicable to a project

• changes in the interpretation of the regulatory framework applicable to a
project
• unreasonable increases in the applicable taxes
• creation of new taxes
• unreasonable increases in the applicable import and export duties
• creation of new import and export duties
• international trade restrictions
• controls and other kinds of governmental interferences in the business, op-
erations and markets of a project
Changes in law and taxes may adversely affect a project's economics and the
financial standing of a project in several ways, such as increasing the tax, tariff or
duty burden of a project, affecting the competitive advantages of a project or im-
posing certain not-originally-contemplated capital investments. In the case of a
project with tight debt service coverage ratios, the occurrence of any of such cir-
cumstances may seriously threaten the success of such project. Consequently, lend-
ers usually require that changes in law and taxes risk be transferred to a creditworthy
party by way of support mechanisms providing for the transfer or mitigation of
such risk either generally or under certain specific circumstances.
In general, this risk cannot be adequately covered through political risk insur-
ance because most political insurers only offer programs covering changes in law
and taxes risk on a limited basis. 27 Thus, changes in law and taxes risk must be
reduced or distributed, as the case may be, by using other risk management tech-
niques, such as arrangements whereby the government assumes the obligation to
respect the regulatory framework applicable to a project (commonly known as
"stabilization agreements") or credit support from the sponsors and other partici-
pants in a project. In some cases, changes in law and taxes risk may be transferred
to either the off-taker or the government, who assumes such risk by means of
agreeing to certain adjustment mechanisms to the project outputs' price or to the
applicable tariffs, as the case may be, taking into account the adverse impact in the
project's economics caused by such changes in conditions.
Government Breach of Contract
Lenders typically want to ensure that the government of the host country will
comply with its contractual obligations assumed in relation to a project, because
any breach by a government of an obligation assumed under a project contract
(e.g., concession contract, off-take agreement, etc.) may adversely affect the suc-
cess of a project and may place the repayment of project loans in jeopardy.
A breach of contract by the government occurs when an authority of the host
country suspends, terminates, makes material adverse changes, does not comply
with its obligations in relation to, or does not recognize all or any substantial part
of the project company's rights under, a project contract.
Lenders should evaluate the government performance risk based on the credit
standing of such government, including precedents relating to compliance with
international agreements (e.g., repudiation, general moratorium, etc.). If not satis-
fied with such credit analysis, lenders must structure different political risk distri-
bution mechanisms, such as political risk insurance coverage, credit support from
the sponsors or other participants in the project or credit enhancement provided by
the government to guarantee its performance under a project contract.
When an agency of the government of a host country is the off-taker of the
project and such agency does not have an acceptable credit standing, participants
may consider requesting that instrumentality to provide to the project company
(and the lenders) acceptable credit enhancement, such as a guarantee from a credit-
worthy party, a stand-by letter of credit granted by a creditworthy bank or the
assignment of accounts receivable.
Permits and Authorizations
Various permits and authorizations often are necessary for construction, start-up,
operation and maintenance of a project. Additionally, certain jurisdictions require
permits and authorizations for foreign-currency-denominated debt financing. In
fact, permits and authorizations are sometimes required by applicable authorities
of the host country as a condition precedent for authorizing foreign lending to a
project company. In other cases, such permits and authorizations, albeit not man-
datory, are useful to give the lenders additional assurance against inconvertibility
and transfer risks.
Lenders usually perform a careful due diligence to ensure all permits and autho-
rizations necessary for the implementation of a project and its debt financing have
been obtained. The identification of all necessary permits and authorizations needed
for a project is usually done by the project company's local counsel with the assis-
tance of the constructor and the operator and is included in the project company's
local counsel opinion. Nevertheless, lenders typically request their legal advisors
to carefully analyze the matter and sometimes insist on including it within the
scope of his or her legal opinion.
Permits and authorizations can be divided into three broad categories, namely:
(i) permits and authorizations which normally can be obtained prior to loan dis-
bursement; (ii) permits and authorizations which cannot be granted prior to project
completion but can easily be obtained upon request and (iii) permits and authori-
zations which cannot be granted prior to project completion and can only be ob-
tained upon a discretionary act of the applicable authority.
Lenders must not allow financial closing to occur unless the project company
has obtained, or has made irrevocable arrangements for obtaining, to the extent
possible, all permits and authorizations needed for the construction, start-up, op-
eration and maintenance of a project as well as for its foreign-currency debt fi-
nancing. However, permits and authorizations mentioned in point (iii) of the above
paragraph are always a concern for the lenders because they cannot be obtained
prior to financial closing and, therefore, the project's success depends on obtain-
ing such permits and authorizations at a later time. In such a case, lenders must
analyze the process, cost, and likelihood of obtaining such permits and authoriza-
tions and, if not fully satisfied, must request the appropriate authorities to grant
certain assurances regarding the issuance of such permits and authorizations to the
project company. Otherwise, lenders must request the sponsors or some other cred-
itworthy participant to provide some type of credit support to mitigate such risk,
such as a completion guarantee or a limited-in-scope guarantee.
Political Violence
Political violence occurs when a large scale violent act or series of acts occur in a
host country, such as war, civil war, terrorism, revolution, insurrection, strikes and
general strikes or sabotage. Political violence may prevent, either temporarily or
permanently, the operation of a project and therefore may adversely affect its cash
flow generation.
Lenders must analyze the risk of political violence within the general political
risk analysis of the host country and, if not satisfied, they must request the project
company to reduce and distribute this risk to creditworthy parties using appropri-
ate risk management techniques. Such risk management techniques may include
political risk insurance, commercial insurance, agreements with or assurances
granted by the government of the host country or credit enhancement granted by
the sponsors or other participants in the project.
Force Majeure
Force majeure occurs when the construction, start-up, operation or maintenance

of a project is affected temporarily or permanently by a circumstance outside the
control of the project company and/or other participants in the project.
The traditional definition of force majeure includes those circumstances outside
the control of the parties, which could not be anticipated nor could they be avoided
by exercise of due care, and which render impossible or extremely difficult such
parties' ability to comply with their respective contractual obligations. Force ma-
jeure is a more comprehensive concept than the so-called act of nature or act of
God 2s because it includes not only actions of nature (e.g., earthquakes, hurricanes,
floods, etc.) but also acts caused by human intervention (e.g., wars, insurrections,
strikes, etc.).
Unless otherwise agreed to by the parties to a contract, while a force majeure
event is taking place, the party affected by such circumstance is typically released
from complying with its contractual obligations and is also exempt from any con-
tractual responsibility for breach of contract. Eventually, if an event of force ma-
jeure has continued for a certain period of time, the parties to a contract may be
entitled to terminate it based upon such circumstance.
Project contracts in project financing transactions typically include some force
majeure events which have nothing to do with the traditional concept of force
majeure and, even more, which may be foreseeable, predictable and, sometimes,
in the reasonable control of the parties. Such events are contractually considered
by the parties as force majeure and are usually tailored as a sophisticated contrac-
tual mechanism of risk allocation among project participants.
In project financing, the contractual definition of force majeure may comprise
one or more of the following events: declared war, undeclared war, coup d'etat,
civil war, revolution, insurrection, strike, mob act, terrorism, riot, blockade, em-
bargo, fire, sabotage, explosion, rain, flood, earthquake, changes in law and taxes,
expropriation and nationalization, permits-and-authorizations related issues, project
participant's breach of contract (including without limitation the government),
exchange controls and price controls, etc.
Force majeure can affect directly a project by means of an event occurring or
having a specific impact on a project (e.g., a force majeure event affecting the
project facility, such as an earthquake, flood, sabotage or strike). It can also affect
a project indirectly, either by means of an event affecting a project participant
(e.g., a force majeure event affecting an off-taker or supplier, such as acts of terror-
ism, nationalization and expropriation or strikes) or by virtue of a political risk
event affecting the host country in general (e.g., war, insurrection, revolution or
exchange controls).
Force majeure is by essence an equity risk. Thus, lenders, at least in theory,
neither should bear force majeure risk nor should they accept any force majeure
excuse in the financial arrangements. In other words, the project company should
not be excused in any event (including force majeure) from complying with its
debt service obligations. Ideally, the project company must allocate all force ma-
jeure risks that can affect a project success to creditworthy parties. However, al-
though all of the foregoing has been traditionally true, sophisticated sponsors are
more and more insisting on having the lenders (particularly in the case of multilat-
eral and regional agencies) share with them certain political force majeure events,
such as expropriation and nationalization.
In general, acts of God typically are managed through commercial insurance
policies specially designed for such purposes. Political force majeure is usually
managed by means of political risk insurance coverage or otherwise by other risk
distribution mechanisms, such as credit support techniques providing for the transfer
or mitigation of such risks either generally or under certain specific circumstances
to different project participants.
Certain force majeure events directly or indirectly affecting a project can some-
times be transferred to the off-taker, who assumes such risks by agreeing to con-
tinue making purchase price payments to the project even upon and during the
occurrence of such force majeure events. For example, in independent power
projects (IPP), the off-taker frequently assumes the adverse consequences of cer-
tain specific force majeure events and typically agrees to continue making pay-
ments to the project company even upon and during the occurrence of such force
majeure circumstances. Under a customary power purchase agreement for inde-
pendent power projects, the off-taker typically undertakes to make, even upon the
occurrence of certain force majeure events, certain capacity or minimum payments
to allow the project company to afford its fixed operating and maintenance costs,
its debt service payments and, sometimes, a reasonable return on equity. This ca-
pacity-payment structure usually reflects a particular shift of risks arrangements
agreed to by the parties to such agreement, z9
Other force majeure events may be allocated to other participants in a project,
such as the suppliers, the operator, the constructor or the government. And the bal-
ance, if any, should be borne by the sponsors, who may provide credit enhancement
for such risks by virtue of certain limited guarantee mechanisms, such as cash con-
tribution agreements, completion guarantees or limited-in-scope guarantees.
Lenders must also ensure that the various force majeure clauses included in the
various project contracts are similar, consistent and harmonic among one another
to avoid situations that could compromise the success of a project. For example,
upon the occurrence of a force majeure event that excuses the constructor from
completing the project facility on the expected completion date, the project com-
pany should either be allowed to claim such event as a force majeure event under,
and use it as valid excuse for noncompliance with, the other project contracts, or
otherwise have the right to pass through any penalties or liquidated damages under
any project contract to the constructor. Otherwise, the project company may be
held responsible for breach of contract and therefore be subject to penalties or
fines or, even worse, be exposed to the risk of an early termination of such project
contracts.
Moreover, the effects of force majeure events must be reflected in the different
project contracts in a symmetrical way. For example, clauses relating to grace
periods for determining the occurrence of force majeure, termination provisions
by virtue of force majeure events and the extension of the term of project contracts
pari passu to the length of the force majeure, must be carefully drafted to ensure
that the effects of force majeure would be consistent throughout the various project
contracts. For example, if a force majeure circumstance prevents the suppliers
from complying with their obligations under the applicable supply agreements for
a certain period of time and once such event is over the suppliers are able to extend
the term of the supply agreements accordingly, then the project company should
be allowed to do the same under the terms of the concession contract, the off-take
agreement and other project contracts dependent on the supply agreements.
Consequently, in order to avoid the occurrence of any such mismatches, lenders
must perform a thorough analysis of all project contracts for purposes of checking
that any force majeure event affecting any of the parties to such agreements is
similarly considered as force majeure in the other projects contracts.
Force majeure is an area of great concern for lenders because it can be devastat-
ing to a project's economics. The adverse consequences of a force majeure event
during the construction phase are significant. In addition to any physical losses or
damages caused by force majeure, the construction period and the expected comple-
tion date will be extended and, consequently, the project company will incur con-
struction cost over-runs, construction delays and increased financial costs as well.
On the other hand, if a force majeure event takes place during the operating phase,
the project company will typically cease to generate the necessary income to sup-
port the fixed operating costs and debt service.
Lenders should make sure that the project company has taken adequate steps to
ensure sufficient funds will be available to the project if a force majeure event
occurs. As mentioned above, such funds may be provided by insurance companies
pursuant to customary commercial insurance policies or by one more project par-
ticipant, such as the off-taker, the constructor or the government. Otherwise, they
must be provided by the sponsors.
Ultimately, the driving force in the foregoing matters is the question of who
bears what risk? The sophisticated force majeure puzzle typically devised in project
financing only reflects answers to such question. But the important thing is that
such puzzle must be a puzzle and not a Pandora's box. In other words, each of the
project participants, especially the lenders, must clearly understand the mechanics
and the consequences of applicable force majeure risk allocation tools--they all
must clearly know and understand who is assuming what risk.
Undoubtedly, the variety of circumstances that may constitute force majeure
and the fact that some of those circumstances may be hard to predict in most cases,
makes this risk one of the most difficult ones to identify, evaluate and distribute in
any project financing transaction.
Other Risks
There are also other matters that can also be categorized into any of the above-
mentioned types of risks; however, they deserve separate treatment because of
their particular importance in project financing. Such risks are those related to the
legal framework applicable to a project and to environmental and social matters
which may arise during the implementation of a project.
Legal Framework
In cross-border project financing, a project is located in the jurisdiction, and is

subject to the laws, of a host country. Consequently, lenders, with the assistance of
local counsel, 3° must perform comprehensive legal due diligence in connection
with the project in order to clearly understand in advance what set of rules are
applicable to such project and its related debt financing. 31
In that respect, lenders must analyze, among other things, the following local
legal matters: 32
1. Foreign Investments
• Are there any foreign investment laws and regulations?
• Are there any procedures for making foreign investments in the host country?
• Are there any approvals or authorizations necessary for making foreign invest-
ments in the host country? If so, what are the procedures and timing of obtain-
ing such approvals and what are the effects of such approvals or authorizations?
• Can such approvals or authorizations be suspended or cancelled? If so, in
what circumstances can they be cancelled or suspended and what are the
effects of a cancellation or suspension?
• What are the relevant government agencies in charge of administration of
foreign investment regulations? Is it a one step system or does the investor
have to deal with more than one government authority or agency?
• Are there requirements for qualifying as a foreign investor?
• Are there limitations on foreign investment in certain sectors or for certain
foreign investors?
• Are there restrictions for securing foreign indebtedness?
• Are there discriminations in treatment between foreign and domestic in-
vestors?
• To what extent do foreign investment laws protect foreign investors from
political risks?
• Are there any convertibility or transfer restrictions applicable to foreign in-
vestors?
• What are the repatriation rights of foreign creditors in general, particularly
with respect to interest, principal and other amounts payable under a loan
agreement?
• Are there procedures established for assuring the foreign creditors' repatria-
tions rights?
• Can a domestic borrower receive, hold and transfer abroad foreign currency?
• Can a domestic borrower open, hold and freely transfer hard currency to
offshore accounts?
2. Financial Arrangements
• What laws and regulations govern foreign loans to domestic borrowers?
• Are there special formalities applicable to foreign loans, such as public in-
strument, notarization or registration?
• Is approval or authorization required in connection with foreign loans?
• Should a loan agreement be pre-approved by an applicable authority or reg-
istered when signed?
• Are there special procedures for the disbursement of loans?
• Are drawdowns required to go through the central bank or applicable mon-
etary authority of the host country?
• Can disbursements be made directly to a borrower?

• Can drawdowns be disbursed offshore without affecting a lender's repatria-
tion rights?
• Are there limitations on the use of proceeds from foreign loans?
• Is charging interest on interest permitted?
• Are there restrictions in relation to interest and other charges?
• Are there limitations on early prepayments and acceleration of foreign loans?
3. Security 33
• What kind of security can be granted over the various assets comprising a
project?
• Is it possible to create security over all assets of a corporate debtor, such as
floating charges or other general charges?
• Is there a legal mechanism to create security over all assets of a borrower that
permits the transfer of a project in foreclosure as a going concern?
• Is it possible to create security over future or after-acquired assets?
• Is it possible to create non-possessory chattel mortgages or pledges?
• What alternatives exist for creating security over receivables?
• What are the pros and cons of each of the various means of creating security?
• What degree of formality is necessary for the various means of creating secu-
rity, such as written instruments, notarization and stamp duties?
• What are the rules, requirements and formalities for perfecting a security
interest, such as public registration, public filing, creditor possession, notifi-
cation to the account debtor, control or filing of financial statements?
• What are the effects of creation and perfection in each case?
• Does each of the above securities create a first-priority and first-ranking se-
curity over the collateral purported to be covered by each of them?
• Are there restrictions on the type of creditors entitled to security?
• Are there limitations on creating security in favor of foreign lenders?
• Are there restrictions for creating security in favor of several secured creditors?
• Can security be held through collateral agents or trustees?
• Are there limitations on secured debt, such as exclusion of future debt, maxi-
mum coverage amounts and limitations on interest and other financial charges?
• Can secured creditors restrict the redemption of security or the subrogation
rights of a borrower or a third creditor?
• Can security be created in foreign currency?
• If security cannot be created in foreign currency, how can secured lenders
protect themselves from foreign exchange fluctuations?
• If security can be created in foreign currency, is foreclosure in foreign cur-

rency permitted?
• If security can only be foreclosed in local currency, what exchange rate will
be used for converting such domestic currency into hard currency?
• What remedies exist in each kind of security?
• Is a public auction the only remedy available to secured lenders?
• Are private sales and temporary possession permitted?
• How long will it take and how much will it cost to foreclose security?
• Are there limitations on foreclosure, such as minimum base price for public
auction, compulsory grace periods, sale restrictions to nationals only, pre-
ferred creditors, restrictions regarding the bidders or public interest matters?
• Are there any bankruptcy stays on enforcement o f security or moratorium
procedures on secured indebtedness?
• What are the reasonable safe harbors in favor of secured lenders against the
security not being recognized as a perfected security interest on insolvency?
• What is the length of the suspicious period under applicable bankruptcy laws?
• What are the rights of priority of secured lenders over competing interests,
such as preferred creditors in bankruptcy (e.g., taxes, employees, bankruptcy
costs, etc.), attaching creditors, subsequent bonafide purchasers, second-rank-
ing secured creditors and liens?
• Can secured lenders purchase the collateral in a foreclosure procedure?
• Can the various types of security be foreclosed in whole or in part?
• Are secured creditors subject to any liabilities that may attach to secure as-
sets i.e., taxes, preservation duties or environmental liabilities?
• Do local insolvency laws recognize security created and perfected under for-
eign law?
4. Taxes
• What taxes and charges are applicable to a debt financing and its related
security?
• Are grossing up provisions permitted?
• Are there tax exemptions or benefits in respect of certain foreign, bilateral or
multilateral investors?
• Are there any tax treaties among the host country and the various countries in
which the lenders are domiciled?
5. Applicable Laws and Jurisdiction

• What rules apply to conflicts-of-laws and conflicts-of-jurisdictions matters?
• Can financial arrangements and project contracts be governed by foreign

laws?
• Can financial arrangements and project contracts be submitted to foreign
jurisdictions or arbitration?
• What are the procedures for recognition and enforcement of final and con-
clusive foreign judgments or arbitral awards?
• Can local courts review or re-examine the merits of a final and conclusive
foreign judgment or arbitral award?
• Can foreign judgments or arbitral awards be enforced in the host country in
foreign currency? If not, what is the applicable exchange rate and at what
time is it to be calculated? At the date the obligation was due, at the date of
the foreign judgment or arbitral award, at the date of the domestic judgment
or at the date of actual payment?
• Is the host country party to the United Nations Convention on the Recogni-
tion and Enforcement of Foreign Arbitral Awards (June 10, 1958)?
• Has the host country ratified the Convention on the Settlement of Investment
Disputes between States and Nationals of Other States (March 18, 1965)?
• Is the host country party to any other bilateral or multilateral treaties regard-
ing the foregoing matters?
Environmental Risks
The protection of the environment is currently a matter of significant public con-

cern in the international community. Nations have increasingly issued stricter en-
vironmental and social laws and regulations and, consequently, environmental and
social matters are playing a critical role in today's project financing practice. New
projects must be carried out in an environmentally responsible manner, which in
turn often requires greater capital investment and therefore more equity and debt
financing.
Environmental risk is not just the risk a project poses to the environment itself,
but also the risk that a project may be subject to new environmental and social
regulations enacted by governments. Environmental and social issues pose a seri-
ous concern for a project and its debt financing. Lenders may be exposed to lend-
ers' liability for having financed a project that was not environmentally sound.
Additionally, an environmental issue may jeopardize a project's economics.
The economics of a project may be negatively affected by the following envi-
ronmental costs: environmental studies, environmental insurance premiums, envi-
ronmental taxes and contributions, environmental risk management and supervision
programs and procedures, environmental auditing, additional capital expenditures

necessary to comply with new environmental legislation or to solve existing envi-
ronmental problems, cleaning up pollution, penalties or indemnification for envi-
ronmental liability and loss of revenues due to business interruptions caused by
environmental reasons. Moreover, an environmental issue may also negatively af-
fect the value of a lender's collateral.
There are many potential adverse manifestations of environmental risks in project
financing transactions. First, environment risks may result in increased costs for a
project. For example, an environmental issue may force a change in the project
specifications. An additional capital investment may be required to solve an envi-
ronmental problem. New environmental regulations may impose on a project ad-
ditional capital expenditures. Or cleaning up liabilities as well as environmental
fines and penalties may be charged to a project. Second, environmental problems
may cause significant unanticipated construction delays leading to delays of project
completion.
In order to minimize the occurrence of an environmental issue, lenders must
conduct environmental and social due diligence of a project to ensure that envi-
ronmental and social impact studies conducted under the supervision of the spon-
sors (preferably prepared by an independent consultant) are reasonable under the
circumstances and to determine whether a project complies and will comply with
the applicable environmental and social regulations. 34
An environmental and social impact study determines the nature and extent of
all environmental and social areas of concern for a project, evaluates the environ-
mental and social impact of such project, identifies ways to improving the project
environmentally and socially by preventing, minimizing, mitigating, or compen-
sating for adverse impacts, identifies and justifies the appropriate measures to miti-
gate areas of concern, and estimates the costs of such mitigation measures.
Environmental and social impact studies typically analyze, among other things,
the following environmental and social aspects: sustainable use of natural resources;
protection of human health; protection of local culture, cultural properties and
historic and archeological monuments; protection of endangered species and sen-
sitive ecosystems; use of dangerous substances and hazardous materials; major
environmental risks affecting directly or indirectly a project and mitigation mea-
sures; occupational health and safety, fire protection and prevention and life safety;
socioeconomic concerns; resettlement issues; use of petrochemicals and fertiliz-
ers; cumulative environmental impacts of existing projects, the proposed project
and future projects of imminent implementation; participation of the affected par-
ties in the design, review and implementation of a project through public hearings;
contamination issues; waste disposal issues and treatment of hazardous wastes.
As a general rule, lenders should only finance environmentally sound projects.

Ideally, a project should comply with the more stringent of the applicable environ-
mental local legislation and internationally accepted policies and guidelines for
protection of the environment in the particular industry. 35
As mentioned previously, changes in environmental laws and regulations and
the consequent cost over-runs for a project are an area of particular concern for
lenders because such changes may jeopardize a project's economics. In order to
minimize the occurrence of this risk, a project ideally should comply with both
domestic environmental regulations and certain internationally accepted policies
and guidelines for such industry, which may be indicative of world trends in the
relevant industry and be helpful to avoid future unexpected environmental require-
ments. In those countries in which local environmental legislation is still in the
process of being developed, internationally accepted policies and guidelines might
prove to be a reliable guide to the potential changes in the environmental regula-
tions of such countries.
Lenders must also be satisfied that all environmental permits and authorizations
and all environmental clearances have been or will be satisfactorily obtained by
the project company. In this respect, lenders must double-check (i) the environ-
mental and social aspects of a project that require governmental clearance; (ii) the
governmental agencies that have jurisdiction over each environmental aspect of a
project and (iii) the procedure and timing for obtaining governmental environ-
mental approvals and clearances.
In summary, lenders may obtain a measure of protection from environment-
related issues by conducting appropriate environmental and social due diligence
and determining whether a project is in compliance with and will comply with
applicable environmental and social regulations, policies and guidelines. Addi-
tionally, sophisticated lenders generally include in their credit agreements specific
environmental representations and warranties as well as covenants to ensure that a
project company has complied, and will comply, with all applicable environmen-
tal and social regulations as well as a specific condition of disbursement that sub-
ject drawdowns to the project being environmentally sound to the satisfaction of
such lenders. 36
Notes
1. See Stewart E. Rauner, supra, at 161.

2. See Scott L. Hoffman, supra, at 194.
3. An exhaustive list of potential risks associated with project finance transactions is almost impos-
sible to prepare because it will always fall short and miss risks which are unique to certain specific
industry sectors. The identification of all potential risks affecting a certain particular transaction
depends on the characteristics of a project and its industry specifics. In any event, a listing of risks is
helpful to give a sense of the most typical risks affecting a project financing.
4. See Scott L. Hoffman, supra, at 197 and note 33.
5. According to Scott L. Hoffman, supra, at 193/4, project finance risks can also be classified as
follows: design, engineering and construction risks, start-up risks and operating risks, where (i) de-
sign, engineering and construction risks are those risks inherent during the project design and con-
struction phase, i.e., cost over-runs, construction delays, force majeure, changes in law and taxes,
strikes, etc., (ii) start-up risks are those risks relating to that particular risk-shifting phase of a project
in which the constructor risk period ends and the operator and project company risk period starts, and
(iii) operating risks are those risks that arise after project completion has occurred, i.e., decreases in
the availability of raw materials or fuel, decreases in the demand of the output of a project, inflation,
currency fluctuations, strikes, technical problems, changes in law and taxes, management inefficien-
cies, etc.
6. Estimates of different construction costs should include a margin to cover contingencies. Gen-
erally this margin, even though it varies from project to project, is approximately between 10% and
20%.
7. In the event that a constructor subcontracts the design and engineering aspects of a project to an
independent engineering or architect firm, the constructor must remain liable to the project company
for any design or engineering problems or defects. The same applies to any other engineering, pro-
curement or construction aspect in respect of which the constructor may enter into a subcontract with
any third sub-contractor.
8. See Peter K. Nevitt, at 261.
9. This is a serious problem because interest accrued during the construction phase usually is
either capitalized for payment during the operating phase or otherwise financed by the lenders by
means of debt financing provided during the construction phase.
10. For example, when the host country government agency, acting as off-taker, has assumed the
obligation to obtain certain critical permits and authorizations for the construction phase, or when it
has committed to procure certain key supplies, materials or facilities for the construction of the project.
11. It should be noted, however, that in a non-recourse project financing, a bonus payment policy
must be consistent with the terms of the other project contracts so that if the facility is completed
earlier than the scheduled completion date, the parties to the other project contracts will be required
to perform at an earlier date, too.
13. See Scott L. Hoffman, supra, at 199/200.
14. Lenders should always carefully analyze the terms and conditions of an off-take agreement,
particularly in respect of (i) the creditworthiness of the off-taker, (ii) the term of the off-take obli-
gation, which should extend beyond the maturity of the debt financing, (iii) the provisions relating
to quantity and quality of the output to be delivered by the project, (iv) any force majeure, suspen-
sion and termination provisions, and (v) pricing provisions, including escalation and pass-through
formulas.
15. Lenders must verify that the terms and conditions of the off-take agreement are reasonable and
fair for both parties. The best way to ensure that a counterpart (in this case, the off-taker) will comply
with its obligations under a contract is to make sure that such contract is fair and reasonable from
such party's perspective.
17. See Ed Clarke and Michael Lousada, "Interest Rate Swaps in PFI Projects," Project Finance
International, PFI European Review (1998), UK PFI at 4.
18. Foreign-currency-denominated costs of a project may be due, among other things, to the fol-
lowing: hard-currency credit facilities, import costs relating to the importation of certain critical
equipment and supplies, and fees payable in connection with services contracted abroad.
19. For two case studies regarding the securing of investment grade ratings for projects undertaken
in non-investment grade jurisdictions, see "Petrozuata--bringing it all back home," Project Finance
International, Issue 129 (September 24, 1997), at 50/1 and Craig Falkenhagen, Susan S. Knowles
and Richard Mc Lean, "Cerro Negro, Venezuela's Second Heavy Oil Export Project, Is Funded,"
Project Finance Monthly Reports' (October, 1998) at 7.
20. For a description of how the implementation of an off-shore trust contributed significally to
enhance the credit rating of the Ras Laffan liquified gas natural project in Quatar over the Quatar's
credit sovereign ceiling, see "In Banks They Trust," lnfraz'tructure Finance (May, 1997).
21. See John M. Niehuss, "An Introduction to International Project Finance," International Bor-
rowing-Negotiating and Structuring International Debt Transactions, Second Edition, International
Law Institute (1986), at 225.
22. According to the Society of Petroleum Engineers (SPE) and the World Petroleum Congress
(WPC), petroleum reserves are those quantities of petroleum which are anticipated to be commer-
cially recovered from known accumulations from a given date forward. All reserve estimates involve
some degree of uncertainty. The uncertainty depends on the amount of reliable geologic and engi-
neering data available at the time of the estimate and the interpretation of these data. The relative
degree of uncertainty may be conveyed by placing reserves into one of two principal classifications,
either proved or unproved. Proved reserves are those quantities of petroleum which, by analysis of
geological and engineering data, can be estimated with reasonable certainty to be commercially re-
coverable, from a given date forward, from known reservoirs and under current economic conditions,
operating methods, and government regulations. Unproved reserves are based on geologic and/or
engineering data similar to that used in estimates of proved reserves, but technical, contractual, eco-
nomic, or regulatory uncertainties preclude such reserves to be classified as proved. Unproved re-
serves are less certain to be recovered than proved reserves and may be further sub-classified as
probable and possible reserves to denote progressively increasing uncertainty in their recoverability.
Probable reserves are those unproved reserves which analysis of geological and engineering data
suggests that are more likely than not to be recoverable. There should be at least a 50% probability
that the quantities actually recovered will equal or exceed the sum of estimated proved plus probable
reserves. Finally, possible reserves are those unproved reserves which analysis of geological and
engineering data suggests that are less likely to be recoverable than probable reserves. There should
be at least a 10% probability that the quantities actually recovered will equal or exceed the sum of
estimated proved plus probable plus possible reserves.
23. According to John M. Niehuss, supra, at 225 " . . . methods to minimize the mineral reserve risk
include: (1) requiring the producers to make up any shortfall in estimated production from other
sources (e.g. from other mines or wells or through open market purchases) or (2) a type of "through-
put and deficiency agreement" in which the producer agrees to supply a certain minimum amount or
make direct cash payments to purchasers and/or l e n d e r s . . . "
24. For a description of the various aspects of sovereign risk and loans to sovereign nations see
Philip R. Wood, Project Finance, Subordinated Debt and State Loans, Sweet & Maxwell (1995). For
an economists' perspective on country risk in the context of international lending transactions, see
Ingo Walter, "Country Risk and International Bank Lending," International Borrowing-Negotiating
and Structuring International Debt Transactions, Second Edition, International Law Institute (1986).
25. For a description of political risks in international financing of projects see Peter E Fitzgerald,
"Overview of Risks in International Financing," Project Financing: Building Infrastructure Projects"
in Developing Markets, Practising Law Institute (1996); Chadbourne & Parke LLP, Project Financ-
ing Techniques (1995).
26. Lenders must ensure that any compensation or indemnification payable upon a nationalization,
expropriation or early termination of a project is duly included in the security package. The idea
being that the lenders should have a first-priority and first-ranking security interest over any compen-
sation or indemnification payable by the government of a host country to the sponsors or the project
company, as the case may be, in the event of expropriation, nationalization or early termination of a
project.
27. Political risk insurance coverage for changes in law and taxes may be obtained when the gov-
ernment of the host country has assumed a standstill or stabilization contractual obligation with the
sponsors and has committed not to adversely change the rules applicable to a project. In such a case,
political risk insurance may be available on the grounds of breach of contractual obligations.
28. Black's Law Dictionary Deluxe, Sixth Edition (1990), defines the Act of God as " . . . An act
occasioned exclusively by forces of nature without the interference of any human agency. A misad-
venture or casualty is said to be caused by the "act of God," when it happens by the direct, immediate,
and exclusive operation of the forces of nature, uncontrolled and uninfluenced by the power of man,
and without human intervention, and is of such a character that it could not have been prevented or
escaped from by any amount of foresight or prudence, or by any reasonable degree of care or dili-
gence, or by the aid of any appliances which the situation of the party might reasonably require him
to u s e . . . "
29 For an elaboration on independent power projects (IPP) see Stephen Peppiatt, "Introduction to
Power Station Project Financing," International Tax & Business Lawyer, Vol. 13:46.
30. Local counsel legal opinions usually address most of the matters referred to in this section.
However, while local counsel opinions are typically delivered at the closing of the debt financing, the
issues must be understood and dealt with earlier in the process.
31. However, in an international project financing, lenders' due diligence review may not only
encompass the laws of the host country, but also, to the extent necessary, the laws of the lenders' and
sponsors' jurisdictions as well as the laws of the jurisdictions of the suppliers, off-takers, constructors
and operators.
32. The following list has been prepared from a lender's perspective and merely constitutes a
description of some of the most typical legal issues present in an international project financing.
33. For an elaboration on security in international transactions, see Philip R. Wood, Comparative
Laws of Security and Guarantees, supra, and Skadden, Arps, Slate, Meagher & Flom, supra, at 37/45.
34. The extent of environmental and social due diligence basically is dependent upon the nature of
a project and its potential environmental impact. For instance, the World Bank Group classifies projects
in four different environmental categories: Category A: Projects that may result in diverse and signifi-
cant environmental impacts. Category B: Projects that may result in specific environmental impacts
and require adherence to certain predetermined performance standards, guidelines, or design criteria
to avoid or mitigate impacts. Category C: Projects that normally do not result in any environmental
impact. Category FI: Projects financed through financial intermediaries.
35. For example, lenders may request that a project comply with the more stringent of the local
environmental regulations and the environmental policies and guidelines established by the World
Bank or the International Finance Corporation.
36. See Clifford Chance, supra, at 162.
12
Risk Management Techniques
s mentioned in the previous chapter, risk management techniques for project

A finance transactions consist of a combination of five different but interre-
lated steps, i.e., risk identification, risk assessment, risk reduction, risk spreading,
and hedging and insurance. Risk reduction, risk spreading, and hedging and insur-
ance are explained below.
Risk Reduction ~
Risk reduction techniques are intended to minimize the likelihood of realization

of risks that may negatively affect a project. Most of financial and commercial
risks cannot be adequately prevented by risk reduction mechanisms inasmuch as
they are dependent on non-project-related circumstances outside the control of
the participants (e.g., inflation, interest rate fluctuations, exchange rate move-
ments, macroeconomics trends, business cycles, etc.). However, there is still some
degree of risk-reduction power available to participants through exercising care-
ful and conservative business judgment, hiring independent experts to double-
check results of the feasibility study and the various technical, economic, financial
and legal components of a project and selecting reliable and creditworthy project
contractors)
Political risks are a different animal and can be effectively reduced using spe-
cific risk reduction techniques. The sponsors and other project participants can
structure various aspects of a particular transaction and its financing in a way that
prevents, or at least discourages, a host country government from politically inter-

fering in a project? Project participants can effectively design a political protec-
tive strategy by adopting one or more of the political risk reduction mechanisms
described below.
Political Risk Reduction Mechanisms
First, participants may seek to obtain government assurances regarding specific

political risks, such as nationalization and expropriation, changes in law and taxes,
inconvertibility and transfer risks, etc., whereby the government of the host coun-
try either grants a guarantee or gives some assurance in respect of certain political
risks. Such guarantees or assurances are advantageous because project partici-
pants may have a contractual basis for making a claim directly against the host
country government in the event of a breach of such governmental undertakings. 4
The likelihood of obtaining governmental assurances or guarantees varies from
transaction to transaction and depends to a great extent on the bargaining power of
the participants and the eagerness of the government to encourage private sector
participation in a particular project. However, recent market trends indicate that
governments are granting fewer broad government guarantees or assurances for
the development of infrastructure projects and that risks typically covered by gov-
ernmental guarantees and assurances are being allocated more and more to private
sector participants. ~
A second method for reducing political risk is to involve influential parties from
the host country (e.g., domestic corporations, banks and financial institutions, etc.)
as either investors or lenders for a project. Actually, the best protection of this type
is to have the government itself as an equity participant in the project or as a
guarantor of a portion of its debt financing. Host country government participa-
tion of this type discourages such government from taking action that would nega-
tively affect the economics of a project. 6
Another way to reduce political risk is to link the outcome of a project to a
variety of international economic interests to assure that any adverse action by the
government of the host country would be subject to a significant international
pressure. This method requires, for example, arranging debt financing through a
syndicate of international banks, contracting for construction and/or procurement
of a project with one or more international constructors and/or entering into a
long-term off-take arrangement with a foreign private-sector off-taker. The ratio-
nale here is that the more foreign participation or involvement in a project would
result in more international pressure for the host country, and consequently the
Risk Management Techniques in Project Financing 179
government of the host country would be less likely to undertake any adverse
action against such project. 7
Fourth, a commonly used political risk reduction mechanism is to have agen-
cies of one or more countries involved in a project. Examples of government agen-
cies are export credit agencies (e.g., the Export-Import Bank of the United States,
the Export-Import Bank and the Ministry of International Trade and Industry of
Japan, the Export Credits Guarantee Department of the United Kingdom, etc.) and
country-owned developmental institutions (e.g., DEG of Germany, Overseas Pri-
vate Investment Corporation of the United States, etc.).
Such protective strategy discourages adverse interference by the government of
the host country by assuring that such action would inevitably lead to direct con-
frontation between such government and the government of the applicable agency.
This strategy can be implemented in several ways. One manner is to arrange fi-
nancing or a guarantee facility from an export credit or developmental agency of a
developed country. Another way is to arrange from such agencies political insur-
ance coverage for the debt financing, the equity or both. In both cases, an adverse
action by the government of the host country affecting a project would inevitably
lead to an intense diplomatic pressure.
Similarly, participants may consider involving multilateral and/or regional
agencies in a project as an effective protective strategy for political adverse ac-
tions by the host country. Examples of multilateral agencies are the various mem-
bers of the World Bank Group, i.e., the International Bank for Reconstruction
and Development (IBRD), the Multilateral Investment Guarantee Agency
(MIGA), the International Development Association (IDA) and the International
Finance Corporation (IFC). Examples of regional agencies are the European
Bank for Reconstruction and Development (EBRD), the Inter-American Devel-
opment Bank (IDB), the Asian Development Bank (ADB), the African Develop-
ment Bank (AFDB), etc.
Multilateral and regional agencies provide a project with the so-called "political
umbrella." That is the participation of a multilateral or regional agency reduces the
risk that the government of the host country will interfere with a project's ability to
service its foreign debt and equity funding, since that action would jeopardize the
host country's chances of securing additional financial support from that particu-
lar agency and other international organizations. Multilateral and regional agen-
cies may participate in a project and its financial structure in several ways. One
way is to become equity participants in a project by subscribing a minority interest
in the project. Another way is to arrange a co-financing structure where part of a
debt financing for a project is provided by a syndicate of private banks and the
balance by the multilateral or regional agency. In this type of arrangement, both

financings are closely linked by cross-default provisions, by intercreditor arrange-
ments, by the sharing of security or, in some cases, by utilizing such multilateral or
regional lender as a collection agent for the payment of debt service. Multilaterals
may also arrange a financing structure under which the agency typically makes a
loan for its own account (sometimes called "A Loan") and a loan for the account of
its private-sector participants (sometimes called a "B Loan"), in which the lenders
participating in such loan benefit from the multilateral's "political umbrella. ''8
Project Accounts--Cash Waterfalls
Finally, given the limited-recourse structure of a typical project financing, access

to and control by lenders over the cash flows of a project company is a useful tool
for reducing and mitigating certain project risks, such as construction and operat-
ing cost over-runs, currency risk and other commercial and political risks. As project
finance transactions are becoming more complex, the use of off-shore accounts
and cash waterfalls is also favored by lenders as a way to organize the flow of funds
to and from the project company and to keep close track of project's revenues.
Control over project revenues is typically secured by collaterally assigning all
project revenues to the lenders or to a trustee or collateral agent for the benefit of
the lenders, and opening various project accounts, preferably hard-currency-de-
nominated offshore accounts, designed to organize and administer the project cash
flows. A lien on such project accounts (except for the company account) is usually
granted for the benefit of lenders or of the collateral agent or the trustee acting for
the benefit of the lenders. Such collateral agent or trustee, as the case may be,
usually has the sole dominion and control over such accounts and has the absolute
and irrevocable right to deposit moneys into and to withdraw funds from any of
such accounts in accordance with certain pre-established cash waterfalls, which
have the effect of dictating the priority of uses of such funds.
Offshore accounts are usually favored by lenders because they are useful to
mitigate currency and other political risks. As mentioned previously, when pay-
ments under an off-take agreement are made directly to an offshore project ac-
count in hard currency, currency devaluation and depreciation risks as well as
convertibility and transfer risks are significantly reduced. If, however, payments
under an off-take agreement are made in local currency to a domestic account,
such funds are more likely to be subject to currency devaluation, inconvertibility
and transfer risk. To mitigate these risks, funds out of a domestic off-take agree-
ment should be, to the extent possible, promptly converted into hard currency and
transferred to an offshore project account.
However, the establishment of project accounts in an offshore jurisdiction may
raise certain issues from the host country's perspective. Sometimes it is difficult to
convince the host country government to allow such remittance offshore o f hard
currency. In such a case, lenders may be forced to open project accounts in the
jurisdiction o f the host country, in which case lenders usually request that such
accounts be dollar-denominated to minimize any exchange rate fluctuations risk.
When all or part of the operating and maintenance costs are local-currency de-
nominated, the operating and maintenance account may be opened and maintained
sometimes for practical purposes in local currency and in the jurisdiction of the
host country.
Project accounts generally include, among others, a revenues account, a ,fund-
ing account, a construction account, an operating account, a debt service reserve
account, an operating and maintenance reserve account, an insurance account and
a company account. Such accounts typically are organized in such a way that at
any time when a project generates cash, receives a loan disbursement or receives
monies from any source whatsoever, a certain cash waterfall would occur.
For example, in the case o f funds out of a loan disbursement, a customary cash
waterfall will credit the monies to the funding account for further application in
the following order:
• First, to cover the payment of interest on construction loans, in the event

interest is not being capitalized;
• Second, to fund or replenish, as the case may be, the debt service reserve
account and any other reserve account, if any; and
• Third, to fund applicable construction payments in accordance with a certain
construction schedule by transferring funds to the construction account for
further credit to the constructor?
In the case o f project revenues during the operating phase, ~° a typical cash wa-
terfall will credit the monies out of project revenues to the revenues account for
further application in the following order (on a monthly basis): ~
First, to cover the monthly working capital and operating and maintenance
expenses requirements o f the project, l / b y transferring the necessary funds
to the operating account and then releasing such funds to the project com-
pany; 1~
• Second, a portion of the monthly revenues to a debt service payment account

in anticipation of payment of interest on senior debt which is becoming due
on the next interest payment date;
• Third, a p o r t i o n o f t h e m o n t h l y r e v e n u e s t o a d e b t s e r v i c e p a y m e n t a c c o u n t i n
anticipation of payment of principal on senior debt which is becoming due on
the next principal payment date;
• Fourth, to fund or replenish, as the case may be, the debt service reserve
account, TM the operating and maintenance reserve account ~5 and any other
reserve account; and
• Fifth, the balance (if any) to payments of subordinated debt and, afterwards,
to make equity distributions only upon the satisfaction of certain conditions
precedent (e.g., compliance with financial ratios, no event of default or po-
tential event of default, etc.). 16
Lastly, in the case of casualty insurance payments, a typical cash waterfall will
credit those funds to the insurance account for purposes of applying such funds for
the repair, restoration, rebuilding or replacement of the damaged assets or for the
prepayment of the loans, as the case may be, all of the foregoing in accordance
with the terms of the applicable financial agreements. A more detailed cash water-
fall for casualty insurance payments is described later in this Chapter in the Com-
mercial Insurance section.
R i s k S p r e a d i n g 17
In theory, a project financing can be structured in such a way that there is no

significant risk exposure for lenders and at the same time there is no recourse
liability of the project developers. This structure is usually called "non-recourse"
project financing. However, in reality, the illustrative list of risks and issues asso-
ciated with project finance transactions described in the previous Chapter indi-
cates that, in many cases, it is insufficient for lenders to rely solely on project
contracts as a protection from project risks. In most cases, some credit support
from the sponsors (or other creditworthy sources) is necessary to provide further
protection to lenders in respect of certain specific risks? 8 This structure is known
as "limited-recourse" project financing.
As mentioned previously, the financing of a project on a limited-recourse basis is
basically dependent on using various risk spreading mechanisms to shift and allo-
cate risks among the sponsors, lenders and interested parties in a manner satisfactory
to all project participants. In a project finance transaction, responsibility for project
risks should be allocated to the party that is in the best position to prevent or mitigate
the realization of such risk. Such party usually assumes recourse liability and poses
sufficient credit standing to accept such distribution of risks.19
However, there are no rules of thumb for risk allocation. The risk distribution
process varies from transaction to transaction and is usually dependent upon the
bargaining power of the participants and the ability of a project to cover risk con-
tingencies with underlying cash flows. At the end of the day, the ultimate driving
force of risk allocation is fairness.
The structuring of a project financing is indeed a process of fair distribution of
risks and rewards. Generally, the participant that can best exercise control over the
risk, that can best mitigate the risk and/or that will realize the greatest reward if the
risk does not materialize is allocated the risk.
Industry practices have already established a comfort range for this risk-reward
allocation process for each type of transaction. However, this risk-reward thresh-
old is constantly a moving target. Even more, it may sometimes be very elusive in
the case of transactions in developing countries where tough issues may translate
into unquantifiable risks for project participants. Consequently, while the prin-
ciples of risk spreading are inherent to project financing, the extent of the distribu-
tion process is transaction specific, and highly dependent on the business relationship
among sponsors, lenders and other project participants, z°Risk spreading techniques
are the foundation of most project financings because they provide the legal basis
for shifting critical project risks to various parties while still permitting off-bal-
ance sheet treatment of the debt financing for sponsors. Such parties are not neces-
sarily just the main sponsors of a project but a variety of interested beneficiaries of
the project, such as the off-taker, the suppliers, the constructor, the government
and the operator, zl
The off-taker typically is motivated to support financially a project in those
cases in which the development of such project is critical for its business and
operations, such as the construction of a dock, a storage facility, a railroad or a
pipeline, or in which the development of a project is needed by the off-taker to
assure a source (and the price) of a critical supply for its operations (e.g., gas or
electricity).
The supplier, needless to say, is eager to sell a product or service critical for a
project's operation and, therefore, may be prepared to take certain specific project
risks to induce the development of such project. The constructor is a typical inter-
ested party for a project which may assume, or be required to assume, certain
project risks. The prospects of being retained for constructing a large, potentially
very profitable, green-field project provides incentive for even the less aggressive
construction company to assume certain risks in connection with the construction
of the facility.
In general, governments are motivated to grant credit support for a project based
upon economic, political and social factors relating to the needs of a particular
country. The government of the host country may sometimes assume certain project
risks for purposes of fostering development, whereas governments of exporting
suppliers or importing users may accept some project risks in order to promote
development of domestic industries. Finally, operators may accept certain operat-
ing risks based upon the prospects of entering into a profitable O&M agreement.
However, the fact that in some cases one project participant may play at the
same time different roles in a project, for instance a sponsor who also performs as
constructor, operator, supplier or off-taker, may create some distortions in the
mechanics of risk distribution and may render an unbalanced risk-reward structure
among the different project participants. Lenders should analyze any potential
conflict of interests among the various roles being undertaken by each party and, if
necessary, should request such party to perform its different roles on an arms-
length basis.
While the sponsors are conceptually the fundamental equity-risk takers, allo-
cating risks to them is limited because of the limited-recourse nature of a project
financing. As Peter K. Nevitt says " . . . The key to a successful project financing is
structuring the financing of a project with as little recourse as possible to the spon-
sor, 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.. ?,22
Consequently, while the sponsors can be asked directly to assume some risks,
they will likely also be required to provide additional equity contributions upon
the occurrence of certain specified events and to secure for the project other forms
of credit enhancement, such as insurance, hedging and third-party guarantees. In
deciding on the use of a particular form of credit enhancement, project partici-
pants must carefully assess the pros and cons of each type of potential credit sup-
port, based upon a myriad of factors, such as terms and cost of credit support,
accounting treatment, tax treatment and enforceability. Lenders must ensure that
the combination of those credit support devices produces a bankable project with-
out burdening any participant to the extent that the debt financing associated with
such project would become essentially a recourse financing to such participant.
Different kinds of guarantees, long-term undertakings and other credit enhance-
ment mechanisms are used as risk spreading instruments in project financing. Credit
support may take the form of direct, limited, indirect, implied or contingent guar-
antees from the sponsors or any other interested parties, z3 Such credit support can
also take the form of advanced payments, production payments, commercial guar-
antees, government assurances, liquidated damages or indemnification obligations.
Direct Guarantees
Under a typical direct, unconditional, irrevocable and all-encompassing finan-

cial guarantee, a guarantor assumes the responsibility of performing all the pay-
ment obligations of a borrower in case of a payment default under the financial
arrangements.
By guaranteeing a debt financing, a sponsor or third party guarantor can secure
financing for a project without borrowing the needed funds directly and therefore
can avoid a direct liability on its balance sheet. However, a direct guarantee gener-
ally has to be disclosed as a footnote in the guarantor's financial statements. In
general, the presence of such disclosure is considered less damaging for a
guarantor's credit standing than the existence of a direct liability.
While guarantees are important for project finance transactions, they can
give lenders a false sense of security. 24 In general, the value of a guarantee is
directly related to the creditworthiness of the guarantor, the terms and condi-
tions of the legal instrument and the laws and jurisdiction governing the guaran-
tee agreement. Unless lenders satisfactorily address these issues, the value of a
guarantee may be nil.
First of all, if lenders want to shift project risks to a sponsor or a creditworthy
third party, they must make sure that such party has the financial standing to pro-
vide such credit enhancement. Secondly, the value of a guarantee is influenced by
the terms and conditions of the guarantee agreement and by the laws and jurisdic-
tion governing such legal document. Guarantees neither are easy to enforce nor
are they always enforceable in the manner expected by lenders. Consequently,
lenders must, to the extent possible, request the guarantor to provide a direct, un-
conditional and irrevocable guarantee obligation, as primary obligor and not merely
as a surety, and to waive any and all of the guarantors' defenses, rights, claims,
counterclaims, remedies and powers. Moreover, guarantees must be preferably
governed by the laws of, and submitted to the courts of, an internationally ac-
cepted jurisdiction that provides the lenders with certainty regarding the actual
value of a guarantee instrument.
There are two types of guarantors in project finance transactions: sponsor guar-
antors and third-party guarantors. While the obvious guarantors of a project fi-
nancing transaction are the sponsors, in some cases there may be a need for a
third-party guarantee either because the sponsors' credit enhancement is insuffi-
cient to support certain project risks or because a particular party is in a better
position to control and assume such risk. However, given the recourse limitation
of project financing, sponsors and other parties are often reluctant to provide a
direct, unconditional, and irrevocable guarantee and, therefore, lenders are usually
persuaded to accept from guarantors a guarantee limited in amount, time, scope or

a combination of them. 25
Limited Guarantees
While traditional guarantees are a direct, irrevocable, absolute and all-encompass-

ing commitment of a guarantor to perform all the payment or performance obliga-
tions of the guaranteed party, limited guarantees can be used to provide the minimum
enhancement necessary to finance a project without having a considerable impact
on the credit standing and financial statements of a guarantor. Even though limited
guarantees do not have the same strength as a direct, all-encompassing guarantee,
they are still very useful to support a project finance transaction because they al-
low project risks to be distributed among a number of participants with the net
effect as having one full, direct guarantee.
As mentioned above, a guarantee can be limited in amount, term, scope or a
combination of them. In fact, most limited guarantees are tailored in such a way to
combine some amount, timing and scope limitations.
Guarantees Limited inAmount. Guarantees need not cover all the lenders' credit
exposure in order to be a useful credit support tool and can accordingly be limited
in amount in certain circumstances? 6The most typical guarantee limited in amount
for a project financing transaction is the cost over-runs guarantee. In general, lend-
ers will finance a project only if its construction and operating costs are predict-
able or otherwise are backed up by a creditworthy party willing to assume cost
over-runs. A cost over-runs guarantee may take the form of a cash deficiency,
working capital or project funds agreement where sponsors agree to contribute
from time to time sufficient additional funds to a project to finance cost over-runs
by means of additional capital subscriptions, subordinated shareholders' loans or a
combination of both mechanisms. Such support commitment m a y or may not be
limited by a maximum guarantor's exposure. While cost over-runs risk is typically
a risk assumed by equity participants, it is very often allocated, at least partially, to
creditworthy parties (mainly, the constructor and the operator). In such cases, those
parties typically assume the risk up to a certain maximum exposure and the bal-
ance is covered by the sponsors by a cash deficiency support that may or may not
be subject to a certain guarantor's exposure limitation. 27
Another type of guarantee limited in amount is the deficiency or first-loss guar-
antee where a guarantor agrees to make up any deficiency or shortfall suffered by
a creditor after such creditor has pursued all remedies it has to a borrower. Such
deficiency guarantee is usually limited to a certain maximum guarantor's amount,
using either an absolute or a percentage figure. Deficiency guarantees usually cover

lenders' losses such as lost interest, unrecoverable expenses, and unpaid principal.
This type of guarantee is particularly useful where the borrower has a great deal of
marketable collateral and the lenders are comfortable that the project will only
have limited cash flow shortfalls even in the worst case scenario. A well-imple-
mented deficiency guarantee together with other credit enhancements provided by
project participants can provide lenders substantially the same degree of protec-
tion of a full, direct guarantee with much less impact on the credit standing and
financial statements of the guarantor. 28
Guarantees Limited in Time. Guarantees limited in time are usually used to

allocate project risks to various project participants during different phases of a
project's life. Depending upon the characteristics of a project, there may be a need
for a third-party credit support at a particular time or period of a project.
The most typical limited-in-time guarantee is the completion guarantee. While
sponsors of a project may be reluctant to grant a long-term, open-ended, direct
guarantee for the debt financing, they may feel comfortable in guaranteeing the
project during its construction and start-up period. The projections for a project
may indicate that the project will generate a sufficient revenue stream to support
operating expenses and debt service, provided that it is completed and it performs
to specifications. Consequently, lenders may want to ensure that a project will be
completed and will perform to specifications and would not be prepared to assume
any completion or start-up risk. In such a case, lenders usually request credit en-
hancement for managing this risk, which usually takes the form of a completion
guarantee, z9
A completion guarantee is essentially a guarantee limited in time because it
expires upon the completion date. The project sponsors usually supply completion
guarantees. A completion guarantee may consist of a performance guarantee where
guarantors undertake to cause the project to be completed by a date certain and to
provide additional funds to cover all cost over-runs, including in most cases finan-
cial increased costs. It can also consist of a payment guarantee to support the debt
financing until the occurrence of project completion date.
Guarantees Limited in Scope ("Contingent Guarantees"). While in many cases

lenders may be satisfied that a project is backed by sufficient credit support to
make it bankable, there may still be some remote contingent risks which may be
unacceptable to them. Lenders do not like to take equity risks, no matter how
remote or contingent they may be. In such cases, lenders typically insist that a
creditworthy party provide a so-called contingent guarantee where it agrees to
guarantee a debt financing only upon the occurrence of specific contingencies.

The determination of such contingencies varies from transaction to transaction,
but contingent guarantees usually cover risks such as residual force majeure events,
including political risks (e.g., nationalization and expropriation, terrorism, revolu-
tion, sabotage, etc.) and uninsurable casualties, changes in prices of supplies or
project outputs, etc.
Contingent guarantees can be drafted to define a contingency as occurring only
after certain other events have happened, including the failure of other interested
participants to perform the project company's obligations or after the lenders have
used their reasonable efforts to enforce performance or collection.
Contingent guarantees can serve as the ultimate back-up device, providing the
credit support that lenders require while having minimal impact in a guarantor's
financial statements.
Indirect Guarantees
In the typical case in which construction and start-up risks are distributed to the
constructor and the sponsors, such participants bear the risk of project completion
until the completion date. After completion, certain project operating risks some-
times shift to the lenders. However, while the lenders are generally prepared to
assume a higher level of risk in the operating phase than in the construction and
start-up stages, they cannot afford to bear all of the risks connected with such
phase. Consequently, lenders generally request the presence of certain credit en-
hancement mechanisms to spread significant operating risks that they are not will-
ing to assume, such as, among others, force majeure, market risk, supply risk and
transportation risk. 3°
Indirect guarantees are essentially used to shift specific operating risks to inter-
ested project participants. They usually consist of some form of long-term under-
taking intended to assure the projected revenue stream of a project or the availability
(and price) of certain critical supplies.
The most commonly used off-take indirect guarantees for project financing are
take-or-pay contracts, take-and-pay contracts, through-put contracts, tolling agree-
ments and unconditional long-term transportation contracts. 3t Each of these agree-
ments complies with the main purpose of providing a degree of certainty to the
cash revenue stream of a project because it constitutes a clear obligation to con-
tribute revenue to the project for a period of time, usually at least sufficient to
amortize the debt financing in full. These indirect guarantees are in general ac-
cepted by the accounting profession as being indirect for purposes of balance sheet
accounting and, consequently, must only be annotated in footnotes to the financial
statements of the applicable off-taker.
Put-or-pay agreements are the most usual supply indirect guarantees for project
finance transactions. If the economics of a project are highly dependent upon the
availability and prices of a certain supply to be used by a project, the best way to
manage this risk is to enter into a contract where the supplier indirectly guarantees
the availability and prices of supplies. Consequently, long-term supply arrange-
ments are significant for project finance transactions because they provide cer-
tainty for a project's economics.
EPC contracts and O&M agreements are also sometimes tailored as indirect
guarantees insofar as they may provide significant credit enhancement for the con-
struction and operating phases of a project by shifting risks from the project com-
pany to the constructor and operator, respectively. Finally, other types of indirect
guarantees commonly used in project financing for allocating certain supply and
market risks to interested parties are price support agreements and minimum de-
mand guarantees.
Take-or-pay Contracts. This type of indirect guarantee arrangement, often called

"hell-or-high-water contract," represents an unconditional contractual obligation
of the purchaser (off-taker) to make periodic payments to a project for fixed or
minimum quantities and quality of products, goods or services at fixed, escalated
or minimum prices, whether or not the project is capable of producing and deliv-
ering, or in fact does actually produce and deliver, such product, good or service to
the off-taker. 32
Take-or-pay agreements have the effect of protecting lenders from losses due to
output price fluctuations or the inability of a project company to produce and/or
deliver project output in due time and in due manner because of certain specified
events, including in some cases certain force majeure circumstances. Thus far,
take-or-pay arrangements have been used to structure different types of project
finance transactions, such as oil and gas pipelines, power projects, waste and water
treatment plants and refineries.
Take-or-pay contracts are called "hell-or-high-water contracts," because the
payment for the project product, good or service must be made unconditionally by
the off-taker regardless of any circumstance (including in some cases force ma-
jeure) frustrating the production or delivery of outputs. Take-or-pay contracts pro-
vide important credit enhancement to a project and therefore have the effect of
substantially increasing the chances that the project company will receive a mini-
mum cash flow stream.
The obligation to take-or-pay can be structured in a variety of forms. Minimum
payments sufficient to cover fixed operating costs and debt service whether or not
the output is actually delivered together with certain variable payments intended
to cover the variable operating costs upon the actual delivery of such output may
be one possibility. 33Alternatively, a large fixed payment together with certain make-
up rights i.e., the right of the purchaser to credit a portion of such fixed payments
to future payment obligations based upon the amount of output actually delivered,
may be another way of structuring a take-or-pay arrangement. 34
Other types of take-or-pay arrangements are (i) through-put agreements, also
known as use-or-pay or deliver-or-pay agreements, under which a user of a pipe-
line project (e.g., oil or gas pipelines) agrees to put a certain minimum quantity of
product through the pipeline and to pay for the use of such pipeline whether or not
it actually puts the product through; (ii) unconditional transportation agreements,
whereby a user of a means of transportation (e.g., railroad, containership, etc.)
agrees to use or otherwise pay for the mode of transportation and (iii) tolling agree-
ment, under which a user of a certain manufacturing or processing facility (e.g.,
water treatment plants, solid waste management projects, refineries, etc.) agrees to
provide specified minimum amounts of product for purposes of being processed
or manufactured in such facility and to make payments for the use of such facility
whether or not the product is actually delivered to the facility. 35
As mentioned before, from an accounting perspective, take-or-pay agreements
generally need only be disclosed in a footnote to the balance sheet of the off-taker,
but need not be recorded as a balance sheet obligation. However, certain so-called
"iron-clad take-or-pay agreements ''36 may be treated as direct guarantee obligations
by accountants.
In summary, take-or-pay contracts are useful tools for project financing inas-
much as such contracts (i) are more favorable to the off-taker's credit than a guar-
antee; (ii) do no appear as debt on the off-taker's balance sheet, yet provide
significant credit support for a project financing and (iii) may not violate pre-
existing loan covenants of the off-taker which restrict assuming additional debt or
lease obligations or providing guarantees. 37
Take-and-pay Contracts. Take-and-pay contracts are substantially the same as

take-or-pay agreements except for one important difference: the purchaser is not
unconditionally obligated to pay for the product or service, come "hell-or-high-
water," Under a take-and-pay agreement, there are no requirements for minimum
payments to support the project debt service and fixed-operating costs and the off-
taker must only pay if and when output is delivered. Take-and-pay agreements
represent an obligation to pay for a certain product or service (e.g., oil, gas, elec-
tricity, etc.) if and when it is delivered by the project company but whether or not
it is actually needed by the purchaser. 3s
Take-and-pay contracts are less helpful than take-or-pay agreements for pur-
poses of providing credit enhancement for a project financing because they do not
provide the same degree of guarantee support from the off-taker. However, take-
and-pay contracts are useful in providing credit enhancement in the form of a
long-term demand for output and as a way of mitigating output price fluctuations.
In fact, the combination of a take-and-pay agreement together with certain other
credit enhancements, such as operator's performance guarantee, commercial in-
surance policies or sponsors' limited guarantees may provide substantially the same
credit support as a take-or-pay commitment.
Take-if-needed Contracts. Take-if-needed contracts are a long-term sale and

purchase agreement under which the purchaser has the right to decide whether or
not to take the output from the project based upon its needs. This kind of off-take
contract generally is not very useful for project finance transactions because the
project company is at the mercy of the off-taker and no assurance is given as to
expected project revenues.
Put-or-pay Contracts and Transportation Agreements. Put-or-pay contracts,

also called supply-or-pay agreements, are long-term contractual obligations of a
seller (supplier) to unconditionally deliver a particular supply to a project at
fixed, escalated, variable or maximum price or otherwise to make a payment to
the project company equal to the costs incurred in obtaining such particular sup-
ply from another source together with any losses suffered by the project com-
pany as a consequence of the lack of delivery of such supply in due time and in
due manner. Under this type of agreement, a seller (supplier) is not excused
from performing under most circumstances, including in some cases certain force
majeure events.
Put-or-pay contracts allow the project company to meet production cost and
delivery targets agreed upon under the off-take agreement. Supply-or-pay agree-
ments are intended to ensure timely delivery to a project (at a price consistent with
the project economics) of a sufficient quality and quantity of a particular supply to
satisfy its commitments to deliver project output in accordance with the terms and
conditions of the off-take arrangements? 9
Supply-or-pay agreements may or may not include the transportation of the
supplies to a project site. In some cases, a project company may be able to pur-
chase supplies at the project facility on a "delivered" basis i.e., the responsibility
for arranging the transportation of the supplies to the project site remains with the
supplier. In other cases, the project company may enter into a firm or quasi-firm
transportation agreement with a transportation company for purposes of arranging
transportation of supplies provided by the supplier. Such a transportation contract
typically consists of an unconditional obligation of the transporter to deliver the
supplies to the project site on the terms and conditions, and at the prices, agreed
upon by the parties or otherwise to pay any difference in costs incurred in trans-
porting the particular supply by another mean of transportation together with any
losses suffered by the project company as a consequence of the lack of delivery of
the supply in due time and in due manner.
Price Support Agreements. Another type of indirect guarantee frequently used

in project financing is the price support agreements whereby output or supplies
price fluctuation risk is shifted from the project company to an interested party,
such as the suppliers, the off-taker or the host country government. By virtue of a
price support agreement, an indirect guarantor agrees to subsidize a project when
either certain project costs rise above a given ceiling (e.g., increases in the prices
of critical supplies) or the output prices drop below a minimum given floor. Price
support arrangements may take several forms, but they usually reflect a third party's
support of one aspect of the project economics over the operating phase. 4°
Minimum Demand Guarantees. Similarly to price support agreements, mini-

mum demand guarantees are intended to shift the risk of fluctuations in the de-
mand for project output to certain interested participants, such as the off-taker or
the government of the host country. A minimum demand guarantee typically rep-
resents a third-party guarantee of a minimum (floor) demand of the project output
intended to ensure a minimum cash flow stream for the project. As mentioned
before, minimum demand guarantees are sometimes used in toll-road transactions
when traffic projections are not strong enough to support a bankable project and,
consequently, a certain minimum traffic flow guarantee from the government, the
sponsors or any other interested party is needed to make such project financiable.
Implied Guarantees
Sponsors and other project participants may also provide support to a project by
means of certain non-binding commitments, which do not have the legal status of
a guarantee but still are useful to provide lenders some degree of comfort in terms
of such parties' support to a project.
Implied guarantees are not really guarantees, nor are they in most cases en-
forceable against the implied guarantors, but still may prove to be important in
project financing as they give the lenders a reasonable belief that the implied guar-
antors will stand behind a project if it experiences difficulties. 4~ Implied guaran-
tees may adopt a myriad of forms but typically consist of a variety of representations,
declarations, undertakings, actions, best-efforts commitments or intentions on the
part of sponsors, governments or other interested parties in connection with a project,

which are helpful to make a project bankable.
The most commonly used implied guarantee in project financing is the com-
fort letter or "keep well" letter, which consists o f a declaration of intent or un-
dertaking by a creditworthy project sponsor to supervise the management and
business of a project company. The term comfort letter is very general and com-
prises an array of different undertakings intended in one way or another to re-
flect some support for a project. Most of these undertakings share one c o m m o n
element: if the project's business and financial condition deteriorate, the implied
guarantor is expected to take the appropriate course of action to prevent the
project company's default.
For example, under a typical sponsors' comfort letter, a sponsor promises to
supervise the management of a project, to provide expertise to the project com-
pany and to contribute to the success of a project. Comfort letters may also include
a best-efforts commitment to stand behind the project company, an intention to
provide further funds to a project if necessary or an agreement to cause the project
to comply with its debt obligations, to the extent that in some cases they may be
tantamount to a binding and enforceable guarantee. 42
As mentioned before, the types of implied guarantees that can be used in project
financing are numerous and are not necessarily limited to comfort letters. For ex-
ample, the participation of strong, creditworthy sponsors in a project usually pro-
vides some sort of "support" of the seriousness of a project. The adoption by a
project company of a name similar, associated with, or which is a clear derivative
of, the corporate name of one of its trustworthy parent companies may carry an
implied support to a project because such parent company is not likely to permit
the occurrence o f a default scenario at the project company level that would affect
its overall reputation. The fact that the sponsors' financial arrangements may in-
clude broad cross-default provisions comprising the project company debt financ-
ing provides the lenders a degree of comfort because a payment default of the
project company may lead to a cross acceleration of such supporting parties' own
indebtedness. Finally, certain share retention undertakings ensuring that sponsors
will retain control of a project company also render an implied guarantee for the
project financiers. 43
Government Assurances
As mentioned above, transnational projects sometimes require a commitment, as-

surance, comfort letter, support letter, or declaration of intent by the government
of the host country in connection with such a project and its equity and debt fi-
nancing. Government assurances may consist of a wide range of support agree-

ments, from non-binding comfort letters or letters of intent to formal support agree-
ments, concession contracts or approvals of special laws or regulations.
In most cases, government assurances are granted by the host country govern-
ment by means of a support agreement (sometimes called "master agreement"), a
concession agreement, the approval of special legislation, the amendment of exist-
ing legislation applicable to a project, or otherwise.
A government support agreement usually is implemented by means of a formal
agreement between the government of the host country, the sponsors and the project
company under which the parties to such agreement, among other things, describe
the project and its cost and capital structure, the obligations of the sponsors and
the project company and the obligations, commitments and assurances of the gov-
ernment. Although the terms of government support agreements vary from trans-
action to transaction, they may include government assurances regarding inter
alia the following matters: 44
• taxes and royalties stabilization

• tax holidays and tax exemptions
• investments, guarantees and other credit support by the government
• identification and transfer of the site to the project company
• infrastructure support for the project, such as power, water, utilities arrange-
ments, communications, transportation and storage facilities
• exclusivity, non-competing and expansion rights in favor of the project
• import of construction materials and equipment
• export and import duties stabilization
• export and import duties exemptions
• expatriation of employees
• labor issues
• convertibility and repatriation rights
• currency devaluation and depreciation
• non-discrimination
• issuance of special legislation
• amendment of existing legislation
• granting of permits and authorizations
• regulatory framework stabilization
• assurances regarding changes in law and taxes
• expropriation, intervention and nationalization
• protection from acts of violence
• waiver of sovereign immunity and consent to arbitration
Similar to government support arrangements, concession contracts may not only

grant the necessary licenses for purposes of a project but also may include govern-
ment assurances, commitments or supports for a project.
Finally, in some cases governments may simply demonstrate their support for a
project by issuing a non-binding comfort letter or a letter of intent, which albeit
not legally enforceable, may prove to be useful as an implied assurance of a gov-
ernment in connection with a project.
Advance Payment Contracts

An off-take agreement may provide for advancing funds from an off-taker to a
project before project completion. Advance payments are often used as part of a
debt financing o f a project and are credited to a certain share o f future project
output. In other words, an off-taker, instead of lending money to a project, pur-
chases future production in advance from a project company at a price equal to the
present value of the future stream of output so acquired, discounted at a certain
applicable interest rate. 45
In an advance payment contract structure, while a project company is obligated
to comply with its supply obligations, most of the project risks are transferred to
the off-taker because the off-taker assumes the risk of losing its investment if the
project cannot perform. Advance payment contracts are a useful tool for credit
enhancement and for providing inexpensive financing to a project whose econom-
ics are not very strong.
Advance payment contracts are similar to production payment loans. Produc-
tion payment loans are typically used in reserve-based projects, such as oil, gas
and mineral ventures. In a production payment loan, the purchaser advances to the
company a certain amount of money in exchange for the right to receive either a
specific share o f future production or a payment out of the sale of such share of
production. In other words, the purchaser, instead of lending money to the project,
buys a ratable participation in the project production at a certain discounted price
and receives a portion of mineral reserves as collateral. When production takes
place, the purchaser receives either a certain portion of production or a payment
out of the sale o f such share of production to a third party.
Production payment loans are similar to reserve-based financing structures in
which the reserves are placed as collateral for the loans; however, there is a subtle
distinction. In a production payment loan, if the project does not produce, the
purchaser has no recourse to other assets of the borrower or to the sponsors, whereas
in a reserve-based loan lenders may have recourse, or limited recourse, to other
assets of the borrower or to the sponsors. 46
Commercial Guarantees
The most typical commercial guarantees provided among project participants in

project financing are bank stand-by letters of credit. 47 A bank stand-by letter of
credit is a guarantee obligation provided by a bank (the "issuing bank") at the
request and for the account of a bank client (the "account party") and for the
benefit of a third-party beneficiary (the "beneficiary") to guarantee the payment or
performance of an obligation assumed by the account party to the beneficiary in a
separate transaction. 48 In project financing, stand-by letters of credit are usually
provided for the account of certain project participants, such as the constructor or
the off-taker, and for the benefit of another project participants, usually the project
company and lenders.
The key advantage of bank stand-by letters of credit is that they are payable on
simple demand without any proof by the beneficiary of non-compliance on the
part of the account party. A clean and irrevocable bank stand-by letter of credit is
documentary by nature and simply requires presentation of the following docu-
ments: (i) a sight draft in the amount owing to the applicable beneficiary; (ii) a
certificate stating the non-compliance; and (iii) the original of the stand-by letter
of credit. In other words, if a beneficiary presents the issuing bank a clean and
irrevocable stand-by letter of credit together with the relevant documentation, the
issuing bank does not have to check whether or not there was non-compliance but
only has to verify whether the beneficiary has presented the proper documents.
Stand-by letters of credit are frequently used in project finance transactions as a
credit enhancement to support project participants' contractual obligations in con-
nection with a project and its financing. Stand-by letters of credit can be used as
bid, construction, completion, payment or performance guarantees or otherwise.
In project financing, stand-by letters of credit are usually issued in those cases in
which a project participant does not have sufficient credit standing to provide an
acceptable corporate guarantee for the benefit of another project participant or
when the project participant beneficiary of such guarantee expressly requires the
issuance of a documentary guarantee to avoid any future compliance issues on the
part of the guarantor.
For example, stand-by letters of credit are typically used in project financing to
guarantee the constructor's obligations under the EPC contract. Such guarantees
under an EPC contract typically may include inter alia a bid bond, a performance
bond, an advance payment bond, a retention money bond and a maintenance bond.
A bid bond is usually required in a bidding process to ensure the seriousness of
each bidder's offer. A performance bond provides a guarantee in the event that the
constructor fails to perform a contractual obligation for any reason whatsoever. An
advance payment bond guarantees up-front advances made by the project com-
pany to the constructor to assist the latter to finance the initial costs necessary to
get the construction started. A retention money bond is intended to substitute re-
tention of a portion of the periodic construction payments by the project company
and allows the constructor to receive funds immediately that would otherwise be
retained. Finally, a maintenance bond has the purposes of providing a guarantee
for backing the project constructors' warranties after completion. 49
Stand-by letters of credit are typically issued in accordance with the Uniform
Customs and Practices for Documentary Credit, 1993 Revision, Publication No.
500 (UCP500) and applicable laws.
Liquidated Damages and Indemnity Obligations

In project financing, liquidated damages (LDs) 5° are used as a risk distribution
mechanism to contractually allocate and quantify the damages suffered by a project
participant (e.g., the project company) as a consequence of a breach of contract
(e.g., construction delays, construction cost over-runs, defective performance, non-
performance, etc.) by another project participant contractually responsible for, and
who has contractually assumed the responsibility and the risk of, such obligation
or circumstances (e.g., the constructor, the operator, etc.) under a project contract
(e.g., the construction contract, the off-take agreement, etc.).
Liquidated damages are represented by a fixed sum and are an estimate of the
potential damages of a late or deficient performance or non-performance by a
project participant of an obligation assumed under a project contract. The main
purpose of liquidated damages is to avoid any future dispute regarding calculation
of damages and to give certainty as to the extent of the project participant's re-
sponsibility for a particular default under a project contract.
Additionally, liquidated damages are sometimes also utilized in project financ-
ing as an instrument for transferring certain project risks, such as force majeure
events, to a project participant. However, in some jurisdictions this kind of distri-
bution mechanism may address certain enforceability issues if there is a notorious
distortion between the amount of the LDs and the damages (if any) that would be
otherwise payable by virtue of applicable law. 5L
Similar to LDs, indemnity provisions may also be used as a risk-spreading tool
in project finance transactions. Indemnity clauses have the effect of contractually
allocating certain project risks connected to the indemnitor's or any other third
project participant's misconduct to the indemnitor. 52 Indemnity provisions typi-
cally require the indemnitor to hold the indemnitee harmless for damages, losses
or liabilities arising out of any breach of contract by, or caused by, the indemnitor's
or third party's (gross) negligence or willful misconduct or by the joint or concur-

rent (gross) negligence or willful misconduct of any of the indemnitor, the indem-
nitee or another third party. As in the case of LDs, indemnity provisions may not
be enforceable in certain jurisdictions. Generally, the validity and enforceability
of indemnity provisions depends on the specific terms and conditions applicable
to them and the applicable laws and jurisdiction.
Hedging and Insurance
As mentioned above, once all risks affecting a project have been distributed among
the various project participants, each participant is free to further reduce the risks
it faces by adopting a variety of insurance and hedging mechanisms. The use of
hedging and insurance increases the likelihood that the project will be profitable
for such particular party but the costs and fees involved reduce the expected re-
turns to the protected party.
Hedging and insurance, if correctly understood and used, are important to regu-
lating the degree of risk taking by each project participant during the life of a
project. If exposure to a project risk can be effectively mitigated by a project par-
ticipant at a reasonable cost, then the chances of allocating such risk to such inter-
ested party will be enhanced.
In this particular matter, however, it is important to distinguish the project com-
pany from the sponsors and other project participants. While the use of hedging
and insurance protection mechanisms may be a discretionary matter for sponsors
and other creditworthy participants in respect of the various project risks allocated
to each of them, this is not the case for all the risks left at the project company level
without any kind of credit enhancement.
In fact, the use of hedging and insurance is always required by lenders in respect
of those project risks left to the project company without any sort of credit en-
hancement. In theory, lenders should not assume equity risks left to the project
company, such as casualty force majeure (e.g., fire, flood, earthquake, etc.), politi-
cal force majeure (e.g., nationalization and expropriation, inconvertibility and trans-
fer risk, etc.), market risks (e.g. commodity price fluctuations), interest rate risk
and exchange rate risk. Consequently, lenders should only finance a project if, and
so long as, the project company has adopted, in a manner satisfactory to the lend-
ers, the appropriate hedging or insurance instruments for each particular risk, i.e.,
commercial insurance, political insurance, commodity derivatives, interest rate pro-
tection agreements and currency derivatives, respectively.
Hedging Techniques.
As described previously, there are numerous hedging techniques actively used

in the international financial markets that are useful tools for project finance
transactions. Generally, currency risks are mitigated by using foreign exchange
markets and foreign exchange risk management techniques, such as currency
swaps, futures, forwards and options, parallel or back-to-back loans, etc. Com-
modity price fluctuations are hedged using commodity derivatives, such as com-
modity swaps, options, futures, etc. Interest rate risk is managed by implementing
interest rate derivative instruments, such as interest rate swaps, futures and op-
tions, forward rate agreements, etc. Finally, credit risks are sometimes managed
by various credit derivative instruments, such as credit spread forwards or op-
tions, credit risk swaps, etc.
Insurance
Insurance in project financing can be classified into commercial insurance and

political insurance. Commercial insurance is generally available for virtually all
casualty risks as well as for certain political risks, whereas political insurance pro-
grams are available solely for certain specific political risks.
Commercial Insurance. ~3 The purpose of commercial insurance is to manage

the risks facing a business concern by allocating them to the insurance market and
improving the strength of such business. In a limited-recourse or non-recourse
project financing, lenders typically require that as much project risk as commer-
cially feasible be insured by the commercial insurance market in order to protect
the project company's ability to cover operating and maintenance expenses and
debt service obligations. Particularly, lenders pay attention to those loss exposures
that have been left at the project company level and, consequently, have not been
transferred contractually to an interested party.
Project finance transactions tend to be heavily insured compared to projects
financed on a corporate finance basis. In general, limits of indemnities and sums
insured are higher, deductibles are lower, self-insured risk is almost nil, the scope
of coverage is broader and the insurance package is much more comprehensive. 54
Due to the non-recourse or limited-recourse nature of project financing, lenders
must not accept self insurance for any risk left at the project company level with-
out any kind of credit enhancement. However, risks that have been allocated to
creditworthy project participants may be subject to self-insurance programs. There
is a direct relationship between the level of self-insurance and the level of indebt-
edness facing a corporation. The reason is that a corporation with no significant

indebtedness can afford having a portion of its risks self-insured because if a self-
insured risk materializes, the corporation can still borrow money to support the
loss. Whereas in the case of a highly leveraged corporation, such as a project com-
pany in a project financing, the use of self-insurance is considered risky because
there is no room for incurring additional debt.
Commercial insurance is generally available for all kinds of casualty risks, which
are the risks that happen by chance or accident and include, among others, physi-
cal loss or damage, defects in design, injury, defective materials and workman-
ship, force majeure, delay in completion and interruption of commercial operations,
as well as for certain political risks. Particularly, in project financing commercial
insurance is key to managing casualty risks and casualty force majeure as well as
certain political risks, such as acts of terrorism, sabotage, riot, strike, malicious
damage, expropriation and nationalization, changes in law and government breach
of contract. In fact, commercial insurance is one of the most important risk man-
agement mechanisms normally used in project financing for allocating casualty
risks and force majeure to third parties other than the sponsors.
Commercial insurance programs for project finance transactions are typically
arranged under two separate programs: the first one covering the construction,
testing and commissioning phase and the second one covering the operating phase.
During the construction phase, the responsibility for arranging and purchasing
insurance is usually shared between the project company and the constructor
whereas in the operating phase it is divided between the project company and the
operator. However, lenders usually require the project company to covenant to
obtain and maintain during both phases the necessary insurance in accordance
with a certain pre-determined insurance program and normally request all insur-
ance policies to name the project company as principal insured and any additional
participants having interest in such policies (e.g., lenders, constructor, operator
and subcontractors) to be named as additional insured parties.
Generally, the insurance program for the construction phase consists of con-
struction all-risk insurance (also called "builder's risk"), delay in start-up insur-
ance (also called "advance loss of profits"), marine cargo insurance, marine delay
in start-up insurance, and third party liability insurance, while in the case of the
operating phase the program includes property damage insurance, business inter-
ruption insurance (sometimes called "loss of profit"), machinery breakdown (also
called "boiler and machinery"), machinery business interruption and third party
liability insurance. Additionally, the project company is usually required to com-
ply with customary insurance practices for that particular industry as well as with
the applicable statutory requirements. Additional insurance may consist of
employer's liability, worker's compensation insurance, motor vehicle insurance

and fidelity guarantees.
Particularly important in project financing is the consequential loss insurance
i.e., the insurance against the financial consequence of a delay in project comple-
tion or an interruption of commercial operations, commonly referred to as delay in
start-up and marine delay in start-up insurance, and business interruption insur-
ance, respectively. Although the availability and premiums of consequential loss
insurance programs are in general largely influenced by the particularities of each
project, the capacity of the world-wide insurance and reinsurance markets at that
time, and the insurance market's willingness to provide such coverage, lenders
usually insist that the project company purchase as much consequential loss insur-
ance as commercially viable to ensure the project company's ability to overcome
the loss, cover fixed costs and service debt upon the occurrence of any of the
above-mentioned circumstances. 55
Delay in start-up and marine delay in start-up insurance must be carefully de-
signed to provide an indemnity amount sufficient to cover the expected financial
consequences of the delay for a reasonable period. In the case of business inter-
ruption insurance, parties need to decide whether such insurance must insure against
loss of revenues less variable costs, debt service costs and fixed operating costs in
proportion to the reduction in revenues or just debt service costs in proportion to
the reduction in revenues.
In project finance transactions, lenders not only take security over all material
insurance arrangements relating to or in connection with the project but also re-
quest to be named "loss payees" or "beneficiaries" as well as "additional named
insured parties" to such policies in order to enable them to have adequate control
over any insurance proceeds.
Generally, lenders request to be named "loss payees" or "beneficiaries" and
"additional named insured parties" of all casualty and consequential loss damages
insurance policies. In the case of third-party liability insurance, lenders may re-
quest to be named "additional insured parties."
Moreover, lenders typically require various amendments to material policies in
order to enhance the credit support provided by such insurance coverage. Among
other things, lenders may request the following so-called "banker's clauses:" (i)
the scope of the insurance program must remain the same throughout the term of
the debt financing; (ii) the provisions of the policies must operate as if each policy
were a separate policy covering each insured party (including the lenders as addi-
tional insured parties); (iii) the insurance must be primary and not excess or con-
tributory to any insurance or self-insurance maintained by the project company;
(iv) the insurance companies must deliver to the lenders from time to time certified
copies of insurance policies and their subsequent renewals in connection with the
project, marked "premium paid" or accompanied by any other written evidence of
payment satisfactory to the lenders; (v) lenders must be released from any obliga-
tion to pay insurance premiums and any other obligation under the insurance poli-
cies; (vi) in the event that the project company fails, or fails to cause any of its
contractors, to take out or maintain the full insurance coverage required by the
lenders, the insurance companies shall give notice to the lenders of any such fail-
ure and shall give them a reasonable opportunity to take out any such policies and
pay the premiums on the same; (vii) the insurance companies must waive any right
of subrogation, compensation, set-off or counterclaim that they may have against
any of the project company or the lenders; (viii) the insurance policies cannot be
materially amended, modified, reduced or limited in any manner without the con-
sent of the lenders; and (ix) reasonable notification provisions must be included
regarding termination or non-renewal of policies (customarily at least 30 to 45
days' prior written notice).
A particularly important "banker's clause" in project financing is the "breach of
condition" clause. Such clause prevents insurance companies from excusing pay-
ment on the basis of a breach of a condition or warranty or an act or omission, non-
disclosure or misrepresentation by an insured party.
"Breach of condition" clauses, also called "non-vitiation" clauses, have recently
been introduced in the insurance market and still are a hot issue of discussion and
negotiation in any insurance program for project finance transactions because in-
surers have been, and are still, reluctant to accept them.
In general, the grounds for avoiding an insurance payment are mistake, misrep-
resentation, non-disclosure, and breach of warranty or condition. Lenders usually
are particularly concerned about a misrepresentation, non-disclosure or beach of
contract on the part of the project company or the sponsors that may render the
insurance policies void. Lenders cannot know if the project company or the spon-
sors have made any kind of non-disclosure or misrepresentation or if the project
company has incurred or may incur breach of contract or warranty during the term
of the debt financing. Therefore, they typically insist that the insurance policies
contain reasonable non-vitiation clauses to the effect that insurance is not affected
by any such circumstances. If not provided by insurers, lenders may feel that the
insurance coverage does not provide sufficient support and may request some sort
of credit enhancement from the sponsors to cover any such risks.
Furthermore, when insurance companies are not financially sound, the lenders
may request a "cut-through" provision or assignment of reinsurance proceeds.
The purposes of such clause is to have the reinsurance claim proceeds paid di-
rectly to the insured parties rather than to the insurance companies and therefore
avoid any credit problem at the insurance companies level.
Another critical insurance issue in project financing relates to the application of

proceeds arising out of casualty, consequential loss and other material insurance
related to a project (usually called "loss proceeds"). Generally, lenders are named
"beneficiaries" or "loss payees" of casualty, consequential loss and any other ma-
terial insurance relating to a project, and any and all loss proceeds are paid directly
to the lenders for deposit into the insurance account. Upon the occurrence of an
event giving rise to a loss proceeds payment, lenders will usually apply such mon-
ies in the following manner:
• First, all loss proceeds in respect of casualty insurance not exceeding a

certain given maximum amount (commonly known as the "loss payee
threshold") are normally released to the project company for purposes of
the repair, restoration or rebuilding of the project;
• Second, in the case of casualty insurance loss proceeds exceeding the loss
payee threshold, 56 the project company must consult with the lenders to
determine whether it should repair or restore the damage or destruction
giving rise to such event of loss. If the project company and the lenders
agree to a plan for such repair or restoration and such repair or restoration
plan is feasible, then the loss proceeds shall be released to the project com-
pany for the prompt payment of the costs of such repair or restoration. On
the contrary, in the event that the lenders consider that the repair or restora-
tion of the damaged assets is not economically or technically feasible, then
such funds will be applied to the prepayment of the debt financing; and
• Third, loss proceeds arising out of any consequential loss insurance will be
applied directly to the payment of fixed operating and maintenance ex-
penses and debt service and the balance, if any, will be transferred to the
project company.
If and when an event of default under the financing agreements have occurred
lenders typically are authorized to apply all above-mentioned loss proceeds di-
rectly to the prepayment of the debt financing.
Finally, it should be noted that insurance programs for project finance transac-
tions are complex and cumbersome, and, sometimes, very expensive. Parties should
expect to encounter many problems in securing an insurance package acceptable
to both the lenders and the project company.
First of all, insurance and reinsurance markets are volatile and they may not be
prepared or ready to underwrite the insurance package proposed by the project
company or requested by the lenders. Secondly, insurance capacity requirements
for large capital-intensive project financings can only be secured if the risk is spread
among a substantial number of insurance and reinsurance companies in the world
insurance markets and such syndication effort can only be successfully completed
if a well-designed insurance marketing strategy is implemented by the project
company at the early stages of the project planning and development.
Thirdly, insurance sometimes can be very expensive and therefore may not be
available for a project at reasonable premiums. Fourthly, although insurance is a
useful tool for transferring fortuitous risks to the insurance market, it must be
noted, however, that insurance policies are not always "bullet-proof" and usually
contain exclusions and conditions that may prevent payment. In fact, the above-
mentioned "banker's clauses" are still a subject of considerable debate and the
insurance market has not yet accepted a standard of protecting clauses for project
financing transactions.
Lastly, insurance practices and insurance regulations vary from jurisdiction to
jurisdiction and sometimes such differences may affect or impair the chances of
obtaining an acceptable insurance program. Project participants may face prob-
lems in securing an acceptable insurance package in those jurisdictions in which
there is a statutory requirement to place the insurance, or a portion thereof, with
locally registered insurance companies or in which insurance companies are forced
to place all or a part of the reinsurance business with local reinsurance companies.
In summary, the project company and its insurance advisors must prepare at the
early stages of project planning and development the appropriate insurance pro-
gram for a project and shall check beforehand with the independent insurance
advisors whether such program is acceptable to the lenders while at the same time
must verify if it is commercially available in the insurance markets. In fact, an
early discussion between the independent insurance advisor and the project com-
pany together with its respective insurance consultants may prevent from incorpo-
rating in the financial agreements unrealistic insurance requirements that are not
suitable for a particular project or cannot be met by the insurance markets.
Table 12-1 describes the use of commercial insurance for the mitigation of ca-
sualty risks, force majeure and political risks:
Political Insurance Coverage. As mentioned above, political risks involving

construction, operation, owning or financing of a cross-border transaction may be
mitigated by means of political risk insurance coverage for the debt or the equity
financing. Political insurance coverage is typically provided by export credit agen-
cies, 57 multilateral or regional agencies and government development agencies.
Private sector may also provide commercial insurance for political risks; however,
private political insurance is generally more expensive, less comprehensive, more
short-term and more limited than the governmental and agency political insurance
programs. 58
o~
~°
i~
Generally, political risk insurers offer programs for inconvertibility coverage,

expropriation and nationalization insurance, political violence coverage (war, revo-
lution and insurrection) and government breach of contract insurance. The re-
quirements, the eligibility, the terms and conditions, the scope and the cost of such
insurance programs vary from insurer to insurer and therefore should be deter-
mined by project participants on a case-by-case basis. 59
There are significant advantages to including government, regional or multilat-
eral agency political risk insurance in a project financing. The inclusion of politi-
cal risk insurance granted by any of such agencies (i) reduces the amount of project
risk facing the commercial lenders; (ii) enhances the bankability of a project; (iii)
improves the political risk profile of a project; (iv) maximizes the debt capacity of
a project and therefore increases the return on equity, and (v) in the case of com-
prehensive coverage, allows the lenders to book their loans as a credit risk of the
country of the agency or as a credit risk of the applicable regional or multilateral
agency, as the case may be, which credit risk on an OECD-backed agency or on a
regional or multilateral agency is, at present, weighted as zero and twenty, respec-
tively, for capital adequacy purposes.
A l l o c a t i o n of Risks A m o n g P r o j e c t P a r t i c i p a n t s
One of the basic concepts in project financing is that lenders are not supposed to
be "equity-risk takers," which means that lenders must feel reasonably confident
that they will be repaid either by the project company, the sponsors or any other
interested party. As opposed to equity investors, lenders can only assume residual
risks because interest rates are much lower than equity returns and therefore the
risks facing lenders must be lower as well.
Ideally, lenders should only assume credit risks and should reject any attempt
from the sponsors to make them share the equity risks of a venture no matter how
good the compensation is for such equity-risk taking. However, this is just the
ideal but not necessarily the real world. Increasing competition in the project fi-
nancing industry has forced lenders to accept more and more exposure in projects
which are similar to an equity investor. Increasing competition has led lenders to
reducing pricing, lowering collateral requirements, extending maturities and as-
suming more and more equity risks. 6°This is particularly true for those risks (e.g.,
changes in law and taxes, residual casualty force majeure and political risks, etc.)
which for one reason or another are not allocated to a creditworthy party and are
not supported by any kind of credit enhancement and therefore are left at the project
company level. The current challenge facing the project finance community is
how project finance lending can still be maintained at an acceptable risk level
given that the overall risk of projects is increasing and that the fierce industry
competition is pushing lenders to take more and more risks.
Although there are no rigid standards for risk allocation in project financing
because each project has a different risk allocation structure, there are, however,
certain basic guidelines for risk distribution based upon the typical perception of
each project participant towards risk allocation. In this respect, an understanding
of how risks are perceived by each participant may contribute to designing a risk
distribution strategy satisfactory to all of them.
Sponsors are interested in several goals: From a short-term perspective they are
interested in recovering all development stage expenses and earning certain con-
struction, operating and other fees in relation to the construction, start-up, opera-
tion and maintenance of a project. In the long run, sponsors are interested in making
a reasonable return on their equity investment. Consequently, sponsors are the
natural "equity-risk takers," and therefore can be required to assume, among oth-
ers, the following risks: completion-related risks, operating risks, market risk, sup-
plies-related risks, environmental risks, political risks and casualty force majeure.
Construction lenders are basically concerned with the design, engineering and
construction phase of a project, since project completion is a condition of dis-
bursement of the permanent financing or, if the construction and term loans are
part of the same facility, it is essential to the repayment of the debt financing out
of operating revenues. Consequently, construction lenders are primarily con-
cerned with the terms of the construction contract as well as with the contractual
responsibilities of both the permanent lenders and the sponsors. Construction
lenders are particularly concerned with the conditions that may excuse perma-
nent lenders from taking out the construction debt. Permanent lenders always
require broader exit mechanisms, such as material adverse change provisions
(also known as "MAC clauses") relating to, among other things, changes in law
and taxes, changes in the financial condition of the project and its sponsors or,
even worse, changes in the economic environment of the host country as well as
in the international financial markets. Conversely, the construction lenders typi-
cally want to see objective conditions of disbursement in the term financing to
minimize such exit mechanisms. Finally, construction lenders want to see that
all construction- and completion-related risks are duly assumed by either the
constructor or the sponsors to ensure the completion of the project at due time,
in due manner and at a fixed price. However, depending upon the circumstances
construction lenders may end up assuming certain residual equity risks relating
to, among others, residual casualty force majeure, cost over-runs, construction
delays and political risks.
Term lenders analyze the project as a going concern and therefore are con-
cerned about interalia structure of project contracts, 61credit support issues, 62 market
risks, operating risks, force majeure, political risks and collateral and intercreditor
issues. Term lenders ideally want to lend to a project in a "quasi risk-free environ-
ment." However, permanent lenders often recognize the imperfect world of project
financing and accept to assume certain residual project risks, such as market and
operating risks, political risks and certain casualty force majeure events.
The tension between the constructor and the sponsors in project financing is
based on the lenders typically requiring that all construction and completion risks
be assumed by either of them. Consequently, sponsors usually want the construc-
tor to enter into an "iron-clad all-inclusive turnkey construction contract," under
which the constructor assumes the obligation to deliver the facility at a fixed or
predictable price, on a date certain, in accordance with specification, with perfor-
mance warranties and without significant exit provisions. However, the main ob-
jective of the constructor is to limit its firm commitment to risks within its reasonable
control and therefore endeavors not to assume any external risks, such as force
majeure, changes in law and taxes, permits and authorizations issues and other
risks that are out of its control. The constructor also is concerned with the terms of
the underlying financial documents, including whether the project company has
arranged sufficient debt financing to pay the constructor receivables, if lenders
will make payments directly to the constructor and if the conditions of disburse-
ment of the debt financing are reasonable.
The tension between the operator and the sponsors is similar to the tension that
exists between the sponsors and the constructor. Lenders normally request certain
predictability of the performance of a project and its operating costs. Sponsors
usually want to ensure that operating costs are sufficiently fixed or predictable and
want the operator to assume to the maximum extent possible operating cost over-
runs risk. On the other hand, the operator wants to reduce its exposure to operating
cost over-runs and other operating risks to the minimum.
Suppliers want to see their supply agreements to include broadest excuses for
non-delivery (including force majeure), flexible price adjustments formulas, ter-
mination provisions, cure periods for non-compliance and limited penalties and
payment guarantees. On the other hand, sponsors and lenders press for a firm-
price, quality and quantity output delivery commitment, with the minimum of
uncertainty in terms of price, terms and obligations of the supplier.
Finally, the tension between sponsors and off-taker is similar to the tension
that exists between the sponsors and the suppliers, except the other way around.
The project company and sponsors want the off-take arrangements to include
excuses for non-delivery (including force majeure), a firm-price, quality and
~I~
D~
i~
o~
0
i~i~ r~ ~
~
i~ ~O
~ ~ o o~o o
i~ ~ o~ i~
quantity off-take commitment, with the minimum of uncertainty in terms of the

price, terms and obligations of the off-taker, price adjustment and escalation
formulas, cure periods for non-compliance, payment guarantees, and limited
penalties and performance guarantees. On the other hand, the off-taker typically
insists on limited excuses for non-compliance on the part of the project com-
pany, liquidated damages and performance guarantees, and broad force majeure
and termination provisions.
Risk Allocation
Table 12-2 is a risk allocation chart representing the various alternatives of risk
distribution in a project financing transaction. The symbol "~'" indicates for each
project risk the most customary alternatives of risk allocation among project par-
ticipants. However, the chart does not reflect the type and scope of credit support
provided by each project participant for each particular risk that is allocated to it.
As mentioned above, depending upon the circumstances, such credit support may
vary from a full, direct and unconditional guarantee to a non-binding support com-
mitment or letter of intent.
It should be noted, however, that this chart is merely a description of the most
customary alternatives for risk allocation in project financing and that the final
outcome of a risk management process in each particular project financing trans-
action would most likely consist of a combination of one or more of the following
choices depending upon the particularities of each transaction. Consequently, the
following chart should not be interpreted as a "general principle" or "rule of thumb"
because risk allocation arrangements of real-life transactions may substantially
differ from the chart.
Notes
1. The contents of this section were prepared by the authors on the basis of the authoritative elabo-
ration of these topics by Stewart E. Rauner, supra, at 162/5 and Peter K. Nevitt, supra, at 272.
3. This strategy is called the "strategy of protection" by Moran, Transnational Strategies of Protec-
tion and Defense by Multinational Corporations: Spreading the Risks and Raising the Cost for Na-
tionalization in Natural Resources, 27 INT'L ORG. (1973) at 273, quoted by Stewart E. Rauner,
supra, at 162, note 71.
4. See Stewart E. Rauner, supra, at 162/3.
5. According to Felton Mac Johnston and Robert Shanks, "House of Cards," Project and Trade
Finance (February, 1996) at 40/2 "... while government guarantees have allowed high-priority projects
to be commercially financiable, relying upon government bodies to assume the project risks does not
offer a sustainable model for infrastructure development. Governments cannot afford the open-ended
contingent liabilities to finance all the major projects necessary to meet their growing infrastructure
n e e d s . . , what is clear is that without an alternative to uncontrolled governmental contingent liabili-
ties, private sector financing in developing country infrastructure will grind to a h a l t . . . ;" whereas
Gourd Hauls, "New Trends in Private Finance of Major Infrastructure Projects," Project Finance
International, issue 130 (Oct. 8, 1997), at 52, indicates that " . . . The new trends in the private
financing of major infrastructure projects center on three aspects. Firstly, the financing of infrastruc-
ture is expected to become more private in nature, with much less government support than in the
past. Secondly, the financing of infrastructure is expected to increase in volume. Thirdly, the reduc-
tion in government support will require a change in the traditional sharing of risk between the re-
maining p a r t i e s . . . "
9. The construction schedule is the schedule for the construction and start-up of a project agreed
to between the constructor and the project company in a manner satisfactory to the lenders, contain-
ing inter alia (i) a detailed budget of costs and expenses of construction and start-up of the project,
and (ii) a list of major milestones for construction and start-up of the project, which list usually
specifies for each such milestone the date on which such milestone is expected to be achieved and,
once achieved, the amount of payment to be made to the constructor. Generally, funds are released
from the construction account directly to the constructor only if and when an independent engineer
appointed by the lenders has issued a construction certificate certifying the occurrence of the pertain-
ing milestone in accordance with the terms and conditions of the EPC contract.
10. Project revenues during the operating phase generally consist of the aggregate of all revenues
of a project company, including without duplication, revenues from (i) the operation of the project;
(ii) interest accrued on any balance outstanding on the various project accounts; (iii) business inter-
ruption insurance payments; (iv) payment under project contracts (including but not limited to liqui-
dated damages, indemnities, etc.); (v) payments out of letters of credit or surety bonds granted in
favor of the project company and (vi) any payment of indemnification or compensations by virtue of
nationalization, expropriation, confiscation or early termination of a project.
11. Obviously, this flow of funds constitutes a mere hypothetical description of how a cash water-
fall can be implemented. However, cash waterfalls vary from transaction to transaction and are usu-
ally tailor-made for each project.
12. Operating and maintenance expenses include all expenses in connection with the ordinary
operation and maintenance of a project, including without duplication, all (i) expenses for adminis-
tering and operating the project; (ii) capital expenditures necessary for the operating and mainte-
nance of the project; (iii) supply, procurement and transportation costs; (iv) insurance costs; (v) taxes,
royalties and contributions payable by the project; (vi) working capital requirements of the project;
(vii) costs and fees in connection with obtaining and maintaining in effect all necessary permits and
authorizations and any license or concession granted to the project; (viii) labor costs and (ix) legal,
accounting and other professional fees in the ordinary course of business.
13. If the operation and maintenance of a project is being performed by an operator in accordance
with the terms of an O&M agreement, funds for operating and maintenance expenses of a project
typically are transferred directly from the operating account to the operator.
14. The debt service reserve account must have at all times sufficient funds to cover the so-called
debt service reserve amount. The debt service reserve amount is usually, at any date of determination,
an amount equal to interest on the loans for at least the next interest payment date based on the
outstanding amount of loans on the date of such determination together with the principal amortiza-
tion amount required for at least the next principal payment date. However, the debt reserve amount
is always subject to lengthy negotiations and, in some cases, lenders may insist on having a larger
debt service reserve amount. Generally, lenders require a larger debt reserve amount to cover contin-
gencies if the debt service coverage ratio is tight.
15. The operating and maintenance reserve account must have at all times sufficient funds to cover
the so-called operating and maintenance reserve amount. The operating and maintenance reserve
amount is subject to negotiations between lenders and sponsors and is highly dependent upon the
strengths and weaknesses of the project economics and the exposure of the project to operating risks.
16. Lenders may sometimes have the right to "claw back" cash distributions made to the sponsors
by the project company to fund unexpected costs, such as operating cost over-runs, increased finan-
cial costs, etc. This "claw back" commitment, which is a type of contingent guarantee granted by the
sponsors, allows the latter to take possession of any surplus project cash flows while at the same time
ensuring the lenders that if the project faces a cash shortfall sponsors will immediately return such
funds to the project.
17. The contents of this section were prepared by the authors on the basis of the authoritative elabo-
ration of these topics by Peter K. Nevitt, supra at 259/90 and Stewart E. Rauner, supra, at 165/81.
18. See Scott L. Hoffman, supra, at 204 as well as Peter K. Nevitt, supra, at 257, who indicates that
" . . . The objective of many project financings is to so combine and amalgamate various kinds of
guarantees and undertakings from various interested parties that the financial burden or risk of any
one party will not be onerous, but the combined guarantees and undertakings of all the parties will be
a bankable credit..."
19. According to Clifford Chance, supra, at 3 " . . . the extent to which any party will be willing to
accept project risk depends on the return it anticipates to receive. As an extension to this, the price
required by different parties for taking a specific risk can vary significally. Some risks may be unac-
ceptable to some parties regardless of the potential rewards..."
20. See Scott L. Hoffman, supra, at 194.
21. See Stewart E. Rauner, supra, at 167 and Peter K. Nevitt, supra at 257/8.
23. For a treatise on guarantees, see Michael Rowe, Guarantees--Stand-by Letters of Credit and
Other Securities, Euromoney Publications (1987).
25. See Peter K. Nevitt, supra, at 261 and Stewart E. Rauner, supra, at 168.
27. See Peter K. Nevitt, supra, at 26l.
28. See Peter K. Nevitt, supra, at 267 and Stewart E. Rauner, supra, at 168/9.
32. See Peter K. Nevitt, supra, at 278 and Stewart E Rauner, supra, at 172.
33. As mentioned above, this is the typical structure of a power purchase agreement for indepen-
dent power projects. A typical independent power project structure usually consists of a capacity
payment, or fixed-payment intended to cover fixed operating costs, debt service and, sometimes,
return on equity, and an energy payment, intended to cover variable operating costs.
36. Under some "ironclad take or pay contracts," if the project company incurs default resulting in
acceleration of the debt financing, the next payment by the purchaser consists of the full amount of
the debt.
38. See Peter K. Nevitt, supra, at 278/9.
39. See David K. Schumacher and Martin W. Gitlin, Chadbourne & Parke LLP, Fuel Supply and
Transportation Agreement (1997).
R i s k M a n a g e m e n t T e c h n i q u e s in P r o j e c t F i n a n c i n g 213
43. See Peter K. Nevitt, supra, at 267/8 and Stewart E. Rauner, supra, at 175/6.
44. For a comprehensive description of the various arrangements in the host country, see generally
Ronald E Sullivan, supra, at 2-1/2-44.
47. For an elaboration of stand-by letters of credit, see Michael Rowe, supra, at 109/163; Peter K.
Nevitt, supra, at 259/60; Charles del Busto, The New Standard Documentary Credit Forms for the
UCP 500, International Chamber of Commerce, ICC Publication No. 516; International Chamber of
Commerce, Documentary Credits: UCP 500 and 400 Compared and Explained, ICC Publication No.
511; and International Chamber of Commerce, The New ICC Guide to Documentary Credit Opera-
tions, 1993 Revision, ICC Publication No. 515.
48. Thomas Fitch, Dictionary of Banking Terms, Second Edition, Barton's Business Guides (1993)
at 579 indicates that " . . . a stand-by letter of credit is a letter of credit that represents an obligation by
the issuing bank on a designated third party (the BENEFICIARY), that is contingent on the failure of
the bank's customer to perform under the terms of a contract with the beneficiary..." and Gerald T.
McLaughlin, "The ABC of Letters of Credit: Important Financial Instruments," The National Law
Journal (Monday, July 28, 1996), establishes that " . . . A letter of credit is a financial instrument that
substitutes the payment obligation and creditworthiness of a more solvent party (usually but not
necessarily a bank) for the payment obligation and creditworthiness of a less solvent party (a buyer,
debtor or obligor)..."
49. See Peter K. Nevitt, supra, at 264/5.
50. According to Brian A. Garner, supra, at 530 " . . . Liquidated damages applies when the parties
to a contract have agreed in advance on the measure of damages to be assessed in the event of default
. . . ;" and Black's Law Dictionary, supra, at 391 indicates that " . . . Liquidated damages is the sum
which party to contract agrees to pay if he breaks some promise and, which having been arrived at by
good faith effort to estimate actual damage that will probably ensue from breach, is recoverable as
agreed damages if breach o c c u r s . . . "
52. According to Brian A. Garner, supra, at 437 indemnity is a " . . . security or protection against
contingent hurt, damage, or loss...;" and Black's Law Dictionary, supra, at 769 indicates that indem-
nity is " . . . An understanding whereby one agrees to indemnify another upon the occurrence of an
anticipated loss..."
53. The contents of this section were prepared by the authors taking into account the elaboration
on these topics by John McLane, "Insurance Issues in Project Finance," First Part, Project Finance
Monthly (August, 1997); John McLane, "Insurance Issues in Project Finance: A Method to Set-Up
New Programs," Second Part, Project Finance Monthly (September, 1997); Simon Clegg and James
Masson, "Insurance: Luxury or Necessity?," Project & Trade Finance (July, 1997) and Terry Pey,
"The Application of Insurance to Project Finance," Project Finance Yearbook 1995/6, Euromoney
Publications. The authors are particularly grateful to Jean-Michel Attlan, Senior Insurance Officer of
the International Finance Corporation, for the valuable contributions made to this section.
54. See, John McLane, "Insurance Issues in Project Finance," First Part, supra, at 11.
55. See John McLane,, "Insurance Issues in Project Finance," First Part, supra, at 12/3 who indi-
cates that " . . . When the requirements for this insurance [referring to the business interruption insur-
ance] exceeds market capacity there are four main options that can be considered: To reduce the
indemnity period o r . . . To insure on a selective basis, i.e., to insure increased debt servicing costs
alone thus reducing the indemnity limits o r . . . To increase the self-insured retention, i.e., the waiting
period or time deductible o r . . . A combination of the a b o v e . . . "
56. Lenders and the project company vigorously negotiate this maximum figure or loss payee
threshold. Lenders want to have flexibility and therefore usually advocate for a low figure whereas
the project company typically insists on a high figure to restrain a lender's ability to "kill the
project."
57. Examples of export credit agencies (ECAs) are the Export and Import Bank of the United
States (EXIM Bank), the Export-Import Bank of Japan (JEXIM), the Ministry of International Trade
and Industry of Japan (MITI), the Export Credits Guarantee Department of the United Kingdom
(ECGD), the Export Development Corporation of Canada (EDC), the Compagnie Fran~aise d' Assur-
ance pour le Commerce Ext6rieur (COFACE), the Banque Fran~aise du Commerce ExtErieur of France
(BFCE), the Export Finance and Insurance Corporation of Australia (EF1C), the Mediocredito Centrale
of Italy and the Compafila Espafiola de Seguros de CrEdito a la Exportaci6n of Spain (CESCE).
58. Examples of private political insurers are American International Underwriters, Chubb Group
of Insurance Companies, Lloyd's Group of London and Citicorp International Trade Indemnity, Inc.
59. An analysis of the different types of political risk insurance coverage offered by the various
multilateral, regional, bilateral, export credit and governmental agencies is beyond the scope of this
book.
61. Term lenders typically are concerned with, among other things, the adequacy and firmness of
project contracts as credit support devices, the legal enforceability of such project contracts, the
creditworthiness of each counterpart to a project contract, and the continued viability of project
contracts on a workout context.
62. Term lenders usually want to see a well-designed credit support structure capable of reducing
almost all equity risks to a minimum.

Estaban Buljevitch

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7

What is Project Financing?

Overview of Project Financing

Project financing is a financing technique by which lenders agree to look initially

1. Reinhard Zimmermann, "Non-Recourse--"The Most Condemnableof Loan Transactions,"

s an introduction to international project financing, a description of a typical

A concession or license (the "concession") for the construction, maintenance and

pose corporate subsidiaries of each of them (the "holding companies"), z consti-

Step 4. Project Studies

Step 5. Project Advisors

Step 7. Project Site

licenses, easements, rights-of-way, consents, approvals, rulings, tariff rates and

agreement and there is usually no certainty of an adequate project-revenue stream

The design, engineering, construction, erection, procurement, installation and com-

project facilities at a certain pre-determined fixed price, by a certain date, in accor-

The sponsors as well as the banks, financial institutions, institutional investors,

contributions inevitably vary from transaction to transaction depending on the

The equity capital requirements of a project can be secured by different spon-

Completion of the construction phase of a project is a matter of utmost importance

As opposed to a cash contribution agreement, which establishes a contractual

Step 18. Security A g r e e m e n t s

common provisions applying to the various financial agreements in connection

• eliminate or reduce the lender's recourse to the sponsors

Non-recourse or Limited-recourse Financing

Non-recourse or limited-recourse financing is usually the main reason why project

Off-balance Sheet Treatment

arrangements, guarantees and other types of credit enhancements typically granted

Highly-leveraged Debt Financing

Avoidance of Restrictive Covenants

limitations on new capital expenditures or on participation in new projects, and

Political Risk Reduction

Characteristics of Project Financing

i~, ~ .... ~ ~' ~

Pro Forma Financial Statement Analysis

Quick or Acid Test Ratio

Debt to Total Assets Ratio

Debt to Equity Ratio

Interest Coverage Ratio

Debt Service Coverage Ratio

Inventory Turnover Ratio

Average Collection Period (ACP)

Average collection period (ACP) is calculated dividing the accounts receivable by

Total Assets Turnover

Basic Earning Power Ratio

Net Profit Margin Ratio

Operating Profit Margin Ratio

The operating profit margin is computed by dividing the operating income by

Return on Assets (ROA ) Ratio

Return on Equity (ROE) Ratio

Price Earnings (P/E) Ratio

Market Price to Book Value Ratio

Project cash flows analysis is designed to measure the return on investments of a

isk management techniques for project finance transactions consist of a com-

Risk Identification and Risk Assessment

As mentioned before, the identification and assessment of various risks associated

• construction cost over-runs

techniques have experienced some kind of problems, mainly relating to construc-

Commercial and Financial Risks

Construction Cost Over-runs

However, additional indebtedness would cause increased debt service payments

Defective Performance After Completion

Project Contractors and Sponsors Breach of Contract

The experience, reputation, and creditworthiness of each of the participants in a

Financial Analysis Risk