MSc Management of Projects

Project Finance Week 6: Risk Management in Project Finance

Objectives of the session

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To introduce a framework for risk management in an infrastructure project Identification of risks Assessment of risks Mitigation of risks Residual management of risks Case study A2 Motorway Poland
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1. Why is risk management important Effective risk management is a key component of all successful projects The project manager needs a framework to manage the various risks so that the project is delivered on time, on budget and to required quality

The goal of risk management Large infrastructure projects are risky Lenders and investors only see returns if projected cashflows are delivered

Goal of risk management is to reduce cash flow variability in a cost effective manner to increase project debt capacity

The risk framework

Risk Management

Residual Risk Identification Risk Risk Mitigation Assessment Management Risk

Gatti, 2008

2. Risk Identification A risk is any event or constraint that prevents you achieving the projects goals and objectives (Burke 2003) Risk identification is first step in risk management Not one off but continuous process through life of project

Risk Identification

Risk Identification in Project Finance

Construction Risks

Operating Risks

Risk Identification Political Risks

Financial Risks

Construction Risks delay in completing the project due to contractor delays project completion will involve cost overrun project fails to meet the performance specification on completion

Makes lenders/investors nervous as delays project cashflow

Operating Risks project unable to run at desired efficiency cost of operating and maintaining plant is higher than planned Operation halted due to legal issues inconsistent supply of raw materials breach of contract by suppliers and purchasers of output price increases for raw materials inadequate demand for the output of the project
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Political Risks
Risk of government expropriation of project facilities Government withholds granting of license or approvals

Imposition of increased taxes

Political Risks

Risk of war, political unrest etc

Imposition of exchange controls

Enactment of new laws that affect operation

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Political Risks can be acute Managing political risk is one of hardest jobs for project manager
Project depends on government concessions/permits Tariffs/ prohibitions imposed on project output Additional taxes imposed Renegotiation of revenue sharing agreements

Often outside control of project manager

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Financial Risks
Foreign Exchange Risk
Project inputs and outputs are denominated in different currencies Particularly acute in developing world where inflation is high Lenders insist loans denominated in hard currency Exposure to movements in interest rates

Interest Rate risk

Remove risk by using fixed rate debt, where possible Project inputs are subjected to price inflation (e.g fuel cost rises) Project sponsors will want to pass these increases onto customers Avoid fixed price off-take contracts where possible Occurs if project cannot generate sufficient revenues to meet its liabilities

Inflation Risk

Liquidity Risk

SPV cannot meet debt service payments when they fall due Requirement for SPV to fund reserve account before any dividend distribution

Equity Risk

If share price of SPV falls, it may have difficulty raising additional finance

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Risk Identification techniques Intuitive methods (E.g. Brainstorming) Inductive methods (E.g. what if questions, hazard studies, failure mode analysis etc) Deductive methods (E.g. So how questions, Accident investigations based on hindsight and past experience) d t i ) Log risks identified in a risk register

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Burj al Arab Hotel - Video

Worlds tallest hotel, built on a man made low lying island, 270m off coast of Dubai. Construction started Nov 1994 Completion in time for Dec 1999

Identify the major risks to the Burj al Arab project in terms of 1. Construction risks 2. Operating risks 3. Sovereign/Political Risk 4. Financial Risk
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3. Risk Assessment

Risk Assessment

Qualitative
Compile list of risks Assess likely consequences Ignores probability of occurrence

Quantitative
Sensitivity Analysis Probability Analysis Simulation tools often used Based on past experience
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Break Now

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4. Risk Mitigation Two aims

Risk Mitigation

To reduce the potential impact of any risk occurring To increase the projects control over the risks

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Risk Mitigation Goal of risk management is to reduce cash flow variability

Risk Mitigation

Risk Avoidance
Eliminate source of risk within project, or avoid projects with that risk Reduce probability or lessen impact on project Allocate risks to parties best able to handle them

Risk Retention

Risk Transfer Risk Reduction (Allocation)

Retained intentionally or unintentionally

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at minimum cost

Mitigation of construction risks

Turn key contract contractor designs, builds and hands over operating facility for a fixed price. Avoids gaps in contractual structure and potential disputes

Fixed price lump sum contract reduces likelihood of cost overruns

Cost overruns mitigate through additional equity in by sponsors, or standby funding arrangements

Completion test E g production test of facility as trigger to release sponsors from E.g. particular undertakings to lenders

Liquidated Damages in Construction Contract Payments made by contractor in event of late or deficient performance.
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Mitigation of operating risks

Long term supply contract ensures supply of raw material at predictable price. Check creditworthiness of the supplier

Take or pay contracts minimise cash flow risk to SPV by entering into contract with third party who agrees to purchase specified amount of projects production, whether or not it actually takes delivery

Take and pay contract similar to above, but buyer only pays if actually takes delivery

Throughput agreements apply in cases where service provided, e.g. transmission of product through a pipeline. User agrees to supply minimum amounts for processing through pipeline.
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Mitigation of political risks

Lend in conjunction with multilateral agencies (World Bank etc.) reduces risk of unhelpful attitude from host country y

Political insurance from national export agency (in conjunction with supply of equipment to a project) gives increased protection similar to above

Obtaining host government assurances - from relevant government departments in host country as regards obtaining permits and consents

Lobby the host country central bank may guarantee availability of hard currency

Thorough review of host country legal and regulatory regime reduces scope for future challenges to project, ensures project complying with all country legislation
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Financial Risks Financial risk can be mitigated through the use of hedging h d i The taking of one risk to offset another Why do it ? Makes for easier financial planning and reduces odds of a cash shortfall or cash flow problem

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Financial Risks Hedging tools include Futures and Forwards, Options and S O ti d Swaps Together known as derivative instruments or derivatives Derivatives are contracts Value of derivative depends on underlying value of another asset Viewed as side bets on the value of underlying asset

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Summary of financial instruments used in risk mitigation

Futures contracts are advanced orders to buy or sell an asset. Price fixed today but final payment does not occur until the delivery date. Used in project finance to offset fluctuations td t til th d li d t U di j t fi t ff t fl t ti in commodity prices

Forward contracts - are tailor-made future contracts to overcome fluctuations in interest rate and foreign exchange. Long term agreements can be used by SPVs to manage their currency risk, and interest rate risk.

Swaps - Traditionally the exchange of one security for another Recently swaps have Traditionally, another. Recently, grown to include currency swaps and interest rates swaps.

Options the right to buy or sell an asset at a given price on or before a given date. Project companies can use call and put options to control input and output prices 24

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Risk Allocation Aim is to allocate or transfer risks to party best able to manage them at minimum cost Complex contractual structure of project finance projects exists largely as a result of the need to allocate risks within the project
Concession Agreement

Risk Allocation

Supply Contract

Off-take Off t k Contract

Loan Agreement

SPV

Operation Contract

Shareholders Agreement

Construction Contract

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Risk allocation
Design and Construction Risks Commissioning Risks
Always transfer to construction contractor as he is in best position to control and manage Structure payment mechanisms to incentives contractor to perform

May be transferred to construction contractor under turnkey contract Alternatively may remain with the SPV

May remain with SPV, or be allocated to the operator via the operating contract

Operating Risks

Political Risk

SPV will seek a contractual agreement that if legislation changes then SPV will be compensated Governments will resist such contract clauses Individually negotiated between SPV and lenders/investors.

Financial Risks

Residual value risk, where facility is handed back to government at end of 26 concession, will remain with SPV or operator, as incentive to maintain facility

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Residual Risk Management

Risk Mitigation

Rigorous risk management process (risk log, identified owner for each risk, identified risk mitigation actions for each risk) Regular review of project risks

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Case Study A2 Motorway Poland

1. What was the role of the Polish government in the project 2. List the main sources of revenue from the project 3. Outline the main risk identified in the project (construction operation (construction, operation, sovereign or financial) 4. How were the risks mitigated and allocated in the project
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Next Week READING WEEK NO LECTURE

Next Lecture Tuesday 15/11/11 9am Performance Bonds/Insurance and Financial Restructuring Pre Reading Required Case Study Bulong Nickel Project,

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