This memorandum analyses the key risks associated with the development and implementation of large-scale international energy and infrastructure projects. It assumes that the project will be financed on limited recourse terms, by one or more bank(s) or financial institution(s). Specifically, it looks at what makes, or does not make, a project "bankable" (or financeable) and how a project's risk allocation must be adjusted in order to make it bankable.

Bankability, as the name suggests, means the acceptability to the lenders of a project’s overall structure, including: parties, products, markets, legal regimes and documentary terms, as a basis for raising finance for the construction and operation of the project on a limited recourse basis. “Limited recourse” means the lenders to the project look primarily, but not necessarily exclusively,  to the assets and revenues of the project as the primary source of repayment of their loans. The shareholders of a project that is financed on limited recourse terms would expect their liability for such loans to be limited to, their equity in the project, and  other support or guarantees that they have agreed to provide to the lenders. Indeed, this is one of the main advantages for shareholders in raising limited recourse financing. 

There are some general principles concerning bankability that will apply to most projects and then there will, of course, be other issues that apply on a project-by-project basis. This memorandum deals with these general principles.

The approach in this memorandum is to primarily consider the risks associated with a project from the lenders' perspective. It is axiomatic that many of these risks will also be of equal concern to the shareholders. Indeed, in many cases the interests of the lenders and the shareholders will be aligned. What will not necessarily be aligned, however, is the respective appetites of the lenders and the shareholders to assume risk. The lenders, on the one hand, will earn fees and interest for assuming such risks, whereas the shareholders will look for a return on their equity, which will be many multiples of the income that the lenders will expect to earn on their loans. If follows, therefore, that the lenders will have a considerably more conservative approach to evaluating the risks, while the shareholders will be prepared to assume a far greater degree of risks. The higher the shareholders' expected return on investment the more risks they will generally be prepared to assume. It is also the case that, as industry participants, the shareholders will have a much deeper understanding of the construction, operational, technological, marketing and other (non-financial) risks associated with the project.

It is important to understand that the essence of limited recourse financing of a project is that the risks are allocated by the developer (or "project company") to the party that is best able to manage and mitigate these risks. This provides the greatest chance of effectively managing and reducing these risks. An arbitrary allocation of risk or allocating a particular risk to a party that does not have the technical, administrative or managerial experience and competence to understand and manage that risk, will inevitably lead to problems. The end result of a carefully structured project utilising limited recourse financing will be that very little risk will be left with the project company. This is the ideal outcome for the shareholders, lenders and key stakeholders, as in reality, for most projects, the project company is essentially just a vehicle established to set up the project, by the shareholders and others, including the contractor, operator, suppliers, offtakers, and buyers, who will all assume pivotal roles in the successful development and operation of the project.

Set out below is a diagram showing the key parties and contracts associated with an independent power project. Most of the parties and contracts will be similar for many other energy and infrastructure projects.

General bankability principles

This section reviews some general, non-project specific bankability principles. For each principle, an illustration of particular circumstances or issues is provided to further illustrate or explain the issue in question.

Approach to risk sharing

The lenders will expect a “fair and reasonable” approach to the sharing of risks among the various parties. How this will be achieved will, of course, depend on detailed discussions and negotiations between the parties, but broadly speaking, the approach will be that each material individual risk should be allocated to, and assumed by, the party best able to manage that risk.  The lenders will not accept risks being allocated to the project company which it is not in a position to manage or allocate to other parties. From the lenders' perspective, risks that are "parked" with the project company are, essentially, being assumed by the lenders, particularly in a default situation.

Illustration:

• where a government entity is responsible for supplying fuel or utilities (typically water or power) to a project, if the government is late in delivering the utilities or, say, the fuel delivered does not match the agreed fuel specification, then the government can expect to pay compensation to the project company; 
• the risk that a project may be delayed or face cost overruns is typically allocated to the construction contractor under a fixed price turnkey construction contract under which the construction contractor will be required to complete construction of the project on time and on budget and to compensate (albeit subject to limits) the shareholders if the project is delivered late and/or over budget. This is because the construction contractor it is able to best understand and manage this risk and to price it accordingly; and
• where a government, having agreed certain planning and environmental exemptions at the approval stage of a project, subsequently introduces new legislation rescinding or materially changing such exemptions with the result that the project is exposed to delays and/or increased costs, then the government can expect to pay compensation to the project company.

Change in law

The lenders will require protection against changes in law that may have a material and adverse effect on the project or the project’s economics such that the risk profile of the project is changed in a material way. Where there is no specific government involvement in a project, then the lenders’ recourse is likely to be limited to political risk or commercial insurance, or recourse to the shareholders. However, where there is a significant government involvement in a project (whether as a sponsor or shareholder, or perhaps fuel or utilities supplier) then commonly the lenders will seek direct contractual commitments from the government under a host government agreement (or similar arrangement).

Illustration: An independent power project has been operating for a number of years under existing environmental laws. A new government introduces wide ranging changes to permitted omissions from power projects which means all power plant operators must undertake expensive modifications to the plant to comply with the new laws. The project company has insufficient cash flow to finance such unforeseen capital costs leaving the shareholders to fund these costs or face  the project going into default.

Equity contributions

The lenders will require the shareholders to contribute an “appropriate” level of equity to a project. What this appropriate level of equity is, will depend on many factors, including: the risks perceived by the lenders in such project, whether the shareholders are actively participating in the project (e.g. as a contractor, operator or offtaker), and prevailing market conditions. Thus, for example, if a project has little active sponsor involvement other than through equity contributions and is a project that the lenders perceive to be at the higher end of the risk spectrum, then the lenders will likely require a higher debt-to-equity ratio for that project (say, 60:40 or even 50:50). A related issue will be the timing of equity contributions. Typically, lenders will want equity to be injected into a project either upfront or on a pro rata basis with their loans. Shareholders will prefer to back-end their equity (i.e. after all the debt has been drawn down).  It is sometimes possible to bridge these different expectations through the use of equity bridge loans under which the project company borrows the equivalent of the equity contributions of the sponsors from commercial banks who are prepared to lend to the project company on an unsecured basis (but subordinated to the project loans) with the support of shareholder guarantees.

Illustration: Lenders will not want to take the risk that a particular shareholder will not be in a position to fund its equity contribution to the project. If the lenders have concerns about the financial stability of a shareholder, they will either insist that its equity is injected up front, i.e. before the lenders fund any loans, or, if the equity is to be contributed pro rata to loans, they will insist on a letter of credit from a creditworthy financial institution or, perhaps, a parent company guarantee if the parent has a strong balance sheet.

Technology risks

Lenders are usually unwilling to assume risks associated with new technology.  If new technology is involved, lenders will typically expect completion guarantees (or other forms of support) from the shareholders, to indemnify the project company against any delays, increased costs, or underperformance associated with the technology not meeting the pre-agreed design and technology specifications. The lenders will usually insist on a robust completion test to demonstrate that, for example, in the case of an industrial plant, it is capable of operating at the design and nameplate capacity for a period of 6 to 12 months before any completion guarantees will be released. Technology proven to operate in one part of the world may not be accepted by lenders if local conditions (such as climate, water quality or other natural conditions) may affect performance. If the plant can only operate at, say, 90 per cent of the nameplate capacity, then the lenders may require the loans to be reduced proportionately to re-balance the economics of the project. 

Illustration: A petrochemical plant utilising significant new technology has been built and is ready for testing. The lenders have required extensive reliability tests to demonstrate that the plant can operate according to its design specifications. During testing it transpires that an essential part of one of the processes does not function as expected, resulting in significant re-engineering and consequent delays. Who will bear the costs arising from the delays? If the shareholders have provided completion guarantees, then they will assume these risks and will seek recourse from the technology providers. If not, then the project may face a default before it is even commissioned.

Consents and permits

The lenders will require that all essential and material consents and permits required to construct and operate the project are granted to the project company at the outset of the project.  The lenders will not want to take the risk that, say, an essential building permit or operating permit, without which the project cannot be built or operated, is not granted or renewed by a government body (or is renewed with more onerous conditions).  Ideally, lenders will want all consents granted at the outset of the project and for either the life of the project or, at least, until the lenders are repaid in full.  Where this is not possible, lenders will want comfort that the government in question either has a track record of granting and/or renewing such consents or is prepared to compensate the lenders if such consents are not granted.

Illustration: A hotel and leisure project (involving an integrated casino) is nearing completion and has applied for its gaming and liquor licences. Since the inception of the project there has been a change of government which is now insisting that local citizens must pay a sizeable entrance fee (the government is seeking to protect its citizens from the perils of gambling) as a condition for the issue of gaming licence. Had the licence, together with detailed conditions, been obtained at  the outset, it would have been more difficult, and controversial, for the government to have backtracked on its original terms.

Expropriation or nationalisation

Any expropriation or nationalisation of all or part of the project (whether assets or the shares in the project company) should, where there is government involvement (e.g. a government concession), give rise to a claim for compensation by the lenders from the government for a sum equal to their outstanding loans and related costs and expenses.  The shareholders will also want to be compensated for their contributed equity in such circumstances and, possibly, a sum to compensate them for foregone future equity returns.  It may be possible for the lenders (or the sponsors) to buy political risk insurance that covers them against expropriation or nationalisation.  However, these insurances are expensive and often subject to limitations.

Illustration: A newly elected government, elected partly as a mandate to improve passenger rail services, terminates a number of private rail concessions on the basis that the train operators have failed to invest sufficient capital in new (and more environmentally friendly) infrastructure and rolling stock. Low traffic volumes have left the train operators starved of cash. The loss will fall to the shareholders as the new government deems the train operators to be at fault. Some of the shareholders were protected from this loss because they bought private political risk insurance which covers the equity invested by them in the project.

Third parties – direct agreements

Where a project is reliant on another party (e.g. a contractor, operator, supplier or technology provider), then the contractual arrangements agreed between the project company and such third parties must be sacrosanct.  In other words, the project company will not be permitted to agree changes to these contractual terms, waive non-performance, or change key commercial terms without the prior consent of the lenders.  These arrangements will be enshrined in “direct agreements” (sometimes referred to as "consent and acknowledgements") entered into between the project company, the third party and the security agent for the lenders.  In this way, the lenders will have a direct contractual relationship with the third parties to enforce such restrictions as well as requiring that such contracts, in the case of a project company default, must afford the lenders either cure rights or rights to step in and take over the project company’s rights and obligations under such a contract so as to preserve the commercial arrangements for the benefit of the lenders.  These direct agreements will be in addition to the usual security that the lenders will take over such third party contracts (e.g. an assignment of the project company's rights and benefits) and, as such, there will sometimes be a degree of overlap in their respective terms.

Illustration: The project company which operates a refinery project has the benefit of a long-term fuel supply contract from a partially state-owned company. The government has granted a non-assignable guarantee to the project company covering minimum fuel supply quantities and quality over the life of the project. The project runs into difficulties and the project company extracts some concessions from the government but in exchange the government seeks concessions under its guarantee. The lenders have no direct agreement with the government and so no standing with the government to negotiate terms. The project is in default so a further default relating to a different fuel supply contract does not help the lenders.

Related projects

Where a project is dependent on the successful completion and/or operation of another project, the lenders to each project in the chain will want to carefully analyse, assess and allocate the risks associated with delays and/or non-completion of the other project(s).  The different groups of lenders in such a chain of projects are taking “project on project” risk, which they will want to manage and mitigate.  How these risks are allocated and mitigated will vary from project to project but will invariably involve complex intercreditor issues that need to be understood and agreed from the outset of the first project in the chain.

Illustration: Projects-on project risks can be best illustrated with the LNG industry, where there is a complex chain of inter-related projects typically comprising:

• the development and operation of the upstream gas field;
• the contractor of the pipeline system transporting the upstream gas to a liquefaction plant;
• the construction and operation of the liquefaction plant;
• the acquisition and operation of a fleet of LNG tankers; and
• the construction and operation of a re-gasification plant.

One of the keys to managing project-on-project risks in these projects is to try and achieve common ownership in as many phases of the projects as is possible. Where this is not possible, it will be necessary to allocate the risks as between the various stages of the overall project.

Taxation

The lenders will want the project to be protected against changes in taxation (including customs duties) that may adversely impact on the economics of the project.  Ideally, the lenders would like a commitment from the relevant government not to change its taxes or introduce new taxes that will have a negative impact on a project’s economics.  Unsurprisingly, most governments are unwilling to concede tax veto powers to commercial lenders.  A compromise that is often agreed in government concession based projects, is that the project is protected from “discriminatory” taxes; that is, the government will not impose a project-specific tax that, in effect, discriminates against a particular project, but is not prevented from, say, introducing an industry or country-wide tax that covers all similar projects (including the affected project) in the country.  However, even this may be too much for some governments to swallow.

Illustration: A company operates a private port concession. The government decides to increase customs duties on certain categories of goods imported through the private port. The project company has a "comfort letter" from the government stating that "absent exceptional circumstances, it will not take any action that will have a materially adverse effect on the company". This comfort letter is not legally binding on the government who, in any event, are citing exceptional circumstances requiring the increases in tax revenues from the port. As a result of the tax changes and traffic volumes (and therefore revenues for the project company) are projected to fall materially.

Dividends and distributions

The lenders will want to prevent the shareholders from taking out dividends or making other distributions (whether in the form of equity returns or, under management, services, or similar contracts) from the project company before the lenders have been repaid.  Such a position is not usually acceptable to most shareholders (except, perhaps, where it is accepted by the shareholders that the level of project risks is very high). The compromise is usually that the lenders will permit dividends and other distributions to be extracted once the project has been commissioned and has started repaying the loans; and even then, only so long as the key project financial cover ratios have been met, the debt service reserve account is fully restored, the project is not in default, and possibly some further project specific conditions or restrictions.  The timing of payment of dividends and distributions to shareholders can have a material impact on the shareholders’ return on equity and so these terms will be heavily negotiated between the lenders and the shareholders. 

Illustration: A desalination plan has been completed and the shareholders are looking to extract dividends from the project. However, the companies law in the country only permits dividends to be paid out of profits. While the company is generating significant revenues, these do not constitute profits as a significant statutory reserve must first be built up (in effect a "cash trap"). The shareholders could have reduced the effects of these provisions had they injected all or part of their equity by way of shareholder loans. The lenders insisted that shareholder loans be subordinated to their loans, but since the concept of subordination was legally untested, they insisted on "pure" equity being invested.

Security

The lenders will expect perfected security interests over all of the property and assets of the project company and also over the shares owned by the shareholders in the project company.  This will include the project’s land, physical assets, plant and machinery, inventory, bank accounts, project contracts and commercial agreements, insurances, technology licences and other intellectual property, licences and permits, and all other rights and interests of the project company.  The purpose of such security is two fold.  Firstly, to prevent other creditors from acquiring rights against the project company and its assets that might interfere with the project or its operation and, secondly, to enable the lenders (in certain jurisdictions at least) to take over the control and management of the project on default and, ultimately, to sell the project or its assets to a third party. 

Illustration: A wastewater treatment plan is located in a country that has very undeveloped security laws. In particular, it is doubtful if effective security can be taken over bank balances or over after-acquired property. For the company's large cash balances, the solution is for the cash to be paid into offshore bank accounts where effective security can be taken. For the after-acquired property the solution lies in amended pledges being taken over such property at regular intervals. Both solutions involve complicated security arrangements and, potentially, more risks for the lenders.

Cash controls and waterfalls

In all project financings, lenders will, in addition to taking security over all cash flows, want to exercise significant control over a project’s cash flow.  To this end, lenders will require all the project’s cash flows (whether in the form of equity contributions, drawdowns, sales proceeds, insurances or liquidated damages) to be paid into designated bank accounts.  These bank accounts will prescribe what monies can be withdrawn and for what purposes and specify any detailed conditions that may attach to any withdrawals. Typically, these accounts would include: disbursements, receipts, compensation and insurance proceeds, and debt service reserve accounts.  Where possible, the lenders will also want these accounts to be held offshore in a jurisdiction where they can take effective security over them and insulate them from political interference or attachments.  The main receipts account will typically be subject to a “payments waterfall” that will prescribe the order in which payments into this account will be applied (e.g. operating costs, lender fees and expenses, outstanding interest, outstanding principal, debt service reserve payments, loan prepayments and payments to shareholders).

Illustration: A telecoms project goes into default as a result of breaching certain cover ratios. It is a term of the financing documents that, upon a default, all cash in the (secured) bank accounts can only be withdrawn with the permission of the banks. The company is desperately seeking a release of cash to pay its operating costs but even this requires the sanction of the banks. The company would have been well advised at the outset to have insisted that, even during a default, the company could use its cash balances to pay its operating costs. In certain circumstances lenders will agree to this.

Creditworthiness

The lenders will look very carefully at the creditworthiness of all third parties involved with a project, regardless of whether they have payment obligations towards the project company.  In the case of third parties delivering services, such as suppliers and contractors, the lenders will want to be satisfied that these companies are financially robust and able to deliver the commitments assumed by them.  If not satisfied, the lenders may ask for parent company guarantees and/or supporting bank guarantees.  In the case of third parties that have payment obligations towards the project company, the lenders will want to be satisfied that these companies have the financial capabilities to meet these financial commitments over the life of the project.

Illustration: The importance of creditworthy and financially robust project counterparties can be well illustrated in the example of a cross border pipeline project for the export of crude oil from country A, through transit country B and exported from a port in country C. The upstream exporting oil companies in country A must have the balance sheet and financial resources to support not only the ship-or-pay tariffs that will underpin the building of the export pipeline, but also the minimum availability/usage payments that will finance the development and operation of the port in country C, which relies on the export of crude oil. A financial calamity affecting the upstream exporting oil companies will adversely affect all the downstream projects and their shareholders as well as the governments in all three countries.

Finance risks

Lenders will be concerned to make sure that interest rate, currency and commodity risks of the project are hedged (where appropriate) or otherwise mitigated.  In particular, given the current very low interest rate environment, lenders are likely to require appropriate interest rate hedging for the life of the loans in the expectation that interest rates can only rise over the life of the project. Where there is a mixed currency financing package, it may be that it is not possible to obtain long term hedging for a local currency as the market is simply not deep enough. In this case, the lenders will have to settle for the maximum term the local market will offer and renew the maturity of the hedge in due course.  If the majority of the capital costs for the project and the loans are denominated in the same currency as the project’s income stream then there should not be a requirement for currency hedging.  If there are significant currency mismatches in a project’s structure, the lenders may require that this risk is hedged or otherwise mitigated.  In certain projects, particularly mining projects, commodity price hedging may be required.

Illustration: Financing aluminium smelter projects is always challenging. On the cost side, the reduction process of converting alumina into molten aluminium uses considerable amounts of electricity making the process expensive. On the marketing side, the price of aluminium is extremely volatile and it is simply not possible to obtain long term offtake contracts at other than market prices. The delta between the costs of production and the sale price is therefore critical in the project's economics. A way of insulating these risks is to link all or a significant part of the electricity price to the London Metal Exchange (LME) price for aluminium, thereby hedging the project against significant market price adjustments.

Environmental and social risks

Lenders (in particular development agencies and export credit agencies) will pay particular attention to the environmental and social risks of the construction and operation of the project.  Most development agencies and export credit agencies have guidelines and rules for environmental and social policies on projects in which they lend to or invest in.  Detailed expert reports will be required to ensure that there are no negative environmental or social (e.g. population displacement or disruption) implications for the project.  Shareholders will be committed to establishing environmental and social plans for the development of the project and the operation of the project must adhere to those plans throughout the life of the project.

Illustration: Any financing of an offshore oil and gas project will need to address significant environmental risks, as the Macondo disaster in the Gulf of Mexico all too readily illustrates. In the United Kingdom Continental Shelf an added challenge facing developers and lenders alike is the UK government's insistence that developers set aside a specific reserve to cover future abandonment costs which may include dismantling the platform and towing it onshore for scrap or other uses. This adds significantly to the operating costs of offshore oil and gas projects. The lenders will, of course, want to take security over the abandonment fund but will find that the fund can only be utilised for meeting the costs of abandonment and not for repaying loans on a default.

Insurance risks

A comprehensive insurance package is, of course, mandatory for any energy or infrastructure project. Risks may include fire, storms, earthquakes and the like. The most important cover is for the costs of rectifying the loss or damage to the project's assets. This is usually covered by a construction "all risks" policy. Further cover will usually be taken out to cover any delay in commissioning, "delay in start up" (DSU) and any interruption in a project's revenues flowing from loss or damage to project assets, "advance loss of profits" or "business interruption" cover. Finally there will be "third party liability insurance" to cover the project against third party claims for which the project is responsible. Lenders will take security over these insurances and will typically require all insurances proceeds to be paid into designated security bank accounts controlled by the lenders.

Illustration: In certain countries the law stipulates that all (or a significant part) of insurances for energy and infrastructure projects must be insured in the local market, usually with local insurers. This is a form of protection for the local insurance market. Another issue is, however, that in many cases the balance sheets of these local insurance companies is just not robust enough to underwrite multi-million dollar claims. The solution is for the lenders to require all (or a substantial part) of such insurances to be re-insured in the international market. The lenders will take security over the re-insurance contracts  and the proceeds or, if for some reason security cannot be taken, enter into a "cut- through" arrangement pursuant to which all the parties agree that the proceeds of any claims under the re-insurance contracts will be paid direct to the lenders.

Raw materials (supply) risks

Any project that relies on the supply of raw materials for the operation of the project will need to take appropriate steps to protect itself against those raw materials either ceasing to be available or not being up to the required specification. For a power station the key raw material will be fuel which will typically be gas, oil or coal and the project company will want to enter into a long term fuel supply contract with a reliable and creditworthy supplier. The lenders will usually want the term to be at least the duration of the bank financing plus a tail of two or three years. Almost as important as certainty of supply is ensuring that the fuel in question is of the requisite quality. Fuel that is not of the correct specification can seriously undermine the proper operation and economics of a project.

Illustration: The project company will want to protect itself against the raw material supply and quality risks. Usually this will be achieved in allocating the risks in the supply contracts. In certain cases, a "tolling" arrangement may be put in place. An example of this might be a gas fired power station where the government (or a government controlled company) will supply the gas to the project, and the government (or other government controlled company) will purchase the power. The power purchase agreement will allocate all fuel risks to the power purchaser so that if the project company is not able to supply power owing to, say, an interruption of fuel (or the fuel not being of the correct specification), then the project company shall be entitled to be paid as if it were supplying power to the power purchaser. Another example of tolling projects is a refinery where the project company will simply refine the products supplied to it and deliver the refined products back to the supplier.

Offtake (revenue) risks

Just as important as securing the raw material (supply) risk is securing the offtake (revenue) risks. For some projects that are exposed to market and/or demand risks, for example a toll road project or a steel plant with no long term offtake contracts, the project company will need to assess and manage these risks. Not surprisingly, these projects that are exposed to market risks are more difficult to finance. At the other end of the spectrum is an independent power project where a utility (usually generated by a government) will contract, on take-or-pay terms, to purchase the plant's output so long as the plant is "available". For those projects that do benefit from a contractual offtake, the key elements, as with the raw materials contracts, is the term of the contract and the creditworthiness of the buyer. The lenders will want a contract matching the term of the debt plus a tail of two or three years and an entity with a strong balance sheet. Equally important will be the pricing terms and what price risks the project company will be exposed to (if any). The lenders will, of course, take security over the offtake contracts and require payment to be made direct to secured bank accounts.

Illustration: One of the challenges of financing independent power projects in developing countries is that it is often the case that the state utility that is purchasing the power will not have a strong enough balance sheet to make the project bankable and where government guarantees may not be available then other structures will be required to overcome these risks. In some cases it may be possible to sell power direct to strong local industrial companies under long term supply arrangements, or the utility may agree to grant security over certain revenues from key customers. Short term letter of credit facilities covering, say, a twelve month period may also provide a measure of support. However, the more complex the offtake arrangements the more challenging it will be to put in place a long term financing.

Currency risks

Many projects are exposed to currency risks. An independent power project with a local customer base will have revenues denominated in the local currency whereas all or part of its debt is likely to be denominated in a foreign currency (usually US$). If the local currency depreciates against the foreign currency then the project will be exposed to a financial risk. Similarly, if the project is importing raw materials that are priced on a foreign currency there will be a currency risk. Hedging may be a solution, but it rarely is because of the costs involved and the lack of long term hedging options for most local currencies. The other two risks associated with currencies are convertibility and transferability. Some governments impose restrictions on access to foreign currencies and may impose limits. So a project that earns its revenues in a local currency will need consent from the government to access foreign currency. Even where a project earns foreign currency (e.g. selling minerals or hydrocarbons priced in a foreign currency), there may be restrictions on the project company transferring the foreign currency abroad. Political risk insurance cover may be available to mitigate either or both of these risks, although this can be expensive.

Illustration: Currency risks impact many projects in developing countries, particularly where the local currency market is small and volatile. If political risk insurance cover is not available or deemed too expensive, then it may be possible for the project company (or the lenders) to obtain a foreign currency undertaking from the local government or its central bank. Whilst such an undertaking may not cover the currency revaluation risk, it will usually cover the convertibility and transferability risks. Thus, the government or central bank will commit that, if the project company proffers local currency to meet its foreign debt service, the government or central bank will make available the required foreign currency and permit that foreign currency to be paid overseas to meet the project company's foreign currency debt service commitments.

Force majeure risks

The legal concept of force majeure is that a party should not be held responsible for performing its obligations under a contract where that performance is prevented by circumstances beyond that party's control. While force majeure provisions will be found in many commercial agreements, they are very rarely found in financing documents on the simple basis that an obligation to repay a loan is absolute and shall not be excused in any circumstances. The way in which a force majeure clause works is that, upon the occurrence of the triggering event, if that event prevents a party from performing its obligations, then the duty to perform those obligations will be suspended for the duration of the event. Once that event ceases then the original obligation will be reinstated to its original terms. Often the force majeure suspension provisions will not be open ended and subject to a cut-off date (3, 6 or even 12 months) at which time either party, may be given the right to terminate the contract. In project financings it will be important to ensure that force majeure provisions are consistent across the spectrum of project agreements so that the project company is not in a position where, for example, one of its raw materials suppliers can claim force majeure in certain circumstances but no force majeure relief is available under an offtake or sales contract as a result of interruption of raw materials supply. Mitigation of force majeure risks is possible for certain risks through commercial insurance (e.g. floods, storms, earthquakes, and other similar events). 

Illustration: An industry standard (FIDIC) force majeure definition is "Force Majeure" means an event or circumstance (i) which is beyond a party's control, (ii) which such party could not reasonably have provided against before entering into the contract, (iii) which, having arisen, such party could not reasonably have avoided or overcome, and (iv) which is not substantially attributable to the other party.

Force Majeure may include, but is not limited to, the following events or circumstances, so long as all these conditions (i) to (iv) above are satisfied:

1. war, hostilities (whether war be declared or not), invasion, act of foreign enemies;
2. rebellion, terrorism, revolution, insurrection, military or usurped power, or civil war;
3. riot, commotion, disorder, strike or lockout by persons other than the contractor's personnel and other employees of the contractor and subcontractors;
4. ionising radiation or contamination by radio-activity, except as may be attributable to the contractor's use of such radiation or radio-activity;
5. operation of the forces of nature such as earthquake, hurricane, lightning, typhoon or volcanic activity; and
6. a change in the laws of the country, or in the judicial or official governmental interpretation of such laws, made after the contract becomes legally effective.

Political risks

Political risk can be a major factor, particularly in developing countries, and can add significant costs to the project. A number of these risks have been specifically covered in this memorandum (e.g. change in law, currency, consents and nationalisation). There are, however, other risks that are commonly referred to as "political". Given the magnitude and political sensitivity of many energy and infrastructure projects and the fact that the host state or agencies of the state are likely to be involved, these projects can rarely be treated simply as ordinary commercial developments albeit on a larger scale. Such projects are an area where commercial, legal and political considerations intermingle.

The projects will invariably require government authorisation and may need further state cooperation and support during operation. The state or its agencies will often be in a position to revoke authorisations, impose new taxes and even nationalise or expropriate the project. Political risks can include:

• nationalisation;
• confiscation or expropriation, with or without compensation;
• the imposition of, or adverse changes in, exchange control regulations;
• import restrictions/quotas on fuel or equipment;
• restrictions on remittances;
• higher or selective taxes, duty or withholdings;
• currency devaluation;
• political instability following changes in government;
• disputes between state and local governments or between government departments; and
• corruption.

In addition to political risks arising in the country itself, a number of cross-border political risks can occur, for example

• restrictions on export licences for equipment or technology; and
• blockades or embargoes.

Illustration: Project sponsors and lenders will analyse and seek to mitigate political risks. A number of questions may be relevant. Is the institutional structure sufficiently clear, such that the relevant authorities can be identified and a decision or authorisation obtained which will bind other state authorities? Is the project one which is fully authorised and preferably one which, perhaps as part of an agreed development programme, is in tune with policy and likely to be promoted? What level of support and assurance will the state give as to, for example, the continuation of permits or the availability of hard currency? Can assurances given be enforced against the state entities providing them?There may be a number of ways of mitigating against political risk. Political risk insurance cover may be available from multilateral agencies, for example, under the World Bank guarantee programme. Export credit agencies also provide political risk cover. Political risk cover may also be available from private insurers, although the cost is often high and the areas of coverage under these guarantees or insurance policies differ widely.

Transportation risks

Where a project is dependant on external transport systems either for delivering raw materials to the project site or delivering the project's output to market, the shareholders will need to consider how to mitigate the risk of an interruption in operations caused by an event affecting the transportation arrangements. Raw materials may be delivered to the project site by rail, road, or sea (or any combination) and the same is the case for the project's output. Securing long term transportation contracts with reliable operators will be key, as will be the ability of the project to have back-up transportation arrangements in place. Appropriate access rights to railways systems and ports must be negotiated in advance with the appropriate authorities. Who bears the transportation risks will depend on the individual circumstances of the project, but if a project can allocate these risks to its suppliers and buyers then this will leave the project to focus on its primary business. Some transportation risks, for example, strikes affecting essential transportation, can be insured against, but many must simply be allocated among the various parties. 

Illustration: An aluminium smelter typically has to manage a number of potentially competing transportation risks. On the supply side, it will need as essential raw materials pitch and coke and also alumina. Both will need to be delivered to the plant either by rail or by sea. On the sales side, the project company will be selling aluminium products and similarly, these will need to be transported by rail or sea. If the delivery or sale is by sea, the project company will need to determine whether to purchase or sell on CIF or FOB terms. Normally, the project company will not arrange shipping itself so it will purchase on CIF terms and sell on FOB terms. An added complication, if both the raw materials and products are being shipped, will be securing sufficient port access and berthing facilities and arranging the logistics for deliveries on exports. Typically, a project will want to hold sufficient back-up supplies to cover any delays in delivery of raw materials and have sufficient storage facilities to cover any delays in exporting products.

Conclusion

While not all of these risks will be relevant to every project, many of them will be, and the shareholders, the governments and other key stakeholders will need to structure the various elements of the project with these bankability requirements in mind.  In many (but not all) cases, the interests of the shareholders (and sometimes the governments) and the lenders, will be aligned in relation to these risks. For companies not experienced with these type of transactions, the following advice may be helpful:

1. Undertake at an early stage, a thorough due diligence of the proposed project, the project's economics and the key project counterparties with whom you will be dealing.
2. Appoint experienced legal and financial advisors early in the process and ask them to undertake a detailed risk analyses of the proposed project and do not commit to participating in a project without a clear appreciation of the risks inherent in it.
3. Agree with your advisors what are the minimum legal, technical and financial foundations of the proposed project and address at an early stage risks identified in the risk analyses that must be borne by or shared with others.
4. Agree written "head of terms" with key project counterparties (e.g. suppliers, contractors, operators and offtakers) covering key legal, commercial and financial terms before committing to involve these counterparties in the proposed project.
5. If a joint venture is proposed with one or more companies, negotiate a joint venture agreement or joint development agreement, again, before committing to involve these counterparties in the proposed project. If you are bidding for a project then a joint development or bidding agreement should suffice.
6. Establish at an early stage with your advisors whether the proposed project and project structure is "bankable" and, if not, what structural changes must be made to make it "bankable".
7. If other similar projects in the same country have been successfully closed, try and find out key terms and risk allocation from these projects and ascertain whether these will form a base or precedent for the proposed project.
8. With so many counterparties involved, in different workstreams (technical, construction, legal, financial, etc.), invest sufficient time at the outset to organise your team (internal and external advisors) such that different workstreams can progress in parallel. A common mistake is not to involve the proposed lenders until all the project contracts have been settled. If the lenders raise concerns, it may be too late (or commercially disadvantageous) for you to have to go back and re-open "settled" project contracts.
9. Try to keep the overall structure as simple as possible. Seemingly minor adjustments can have a significant knock-on effect, usually quite unintended, on other parts of the project or other project counterparties.
10. A limited recourse project financing is like a jigsaw puzzle with many pieces all of which have to fit together in the correct order for a project to succeed. Every party will have specific requirements, not all of which will fit the puzzle. Flexibility and an open and creative approach will go a long way toward a successful closure of the proposed project.