Chapter no 1
In this modern age of globalization project finance has become one of the pillars to instigate a project whether an industrial project or a factory. A project finance is the financing of a long-term infrastructure industrial project, and public services, based on a non-recourse or limited recourse financial structure, in which project debt and equity used to finance the project are paid back from the cash flow generated by the project. The debt in project finance is not based on project sponsor’s credit or any physical asset of the project rather it is based on technical and economic performance of the project.
There are two types of project finance non-recourse project finance and limited recourse project finance, former is the common project finance, which is predicated solely on the merits of the project. In non-recourse project finance, project lender’s assessment is therefore based on the underlying cash flow revenue of the producing project contracts, independent of the non-project assets of the project sponsor. A contract in the project finance is essential form of project’s operation because if the risks are allocated in a unacceptable way from the project lender’s perspective, credit enhancement from a creditworthy third party is needed in such forms as letter of credit, capital contribution, guarantee and insurance, (which will be discussed later) forms under a contract which is enforceable and have value to the lender as collateral security. On the other hand, in a limited recourse financing, the obligations and responsibilities of the project sponsor is crucial and the financing is limited recourse (Debt). Whatever the potential risks in the project is determined by the unique risk presented in the project and the appetite of credit markets to accept the risk.
In a structured project finance, project sponsor assumes some uncertainty in the project finance, which in return for a reduction in the risk premium otherwise payable to various contracting parties is called structured project finance. The financing in the structured project finance is not without recourse to the project sponsor because lender will require that the risks not allocated to the various project contracting parties such as non-contractor or fuel supplier be retained by the project sponsor. In project commercial structure, the type of financing structure is selected for a project defines the commercial structure.
Another form of financing is balance sheet financing, in which the company uses retained earnings or short-term debt to finance the development and construction of the facility. Upon completion, when the project requires permanent financing, long-term debt, equity sales, or other corporate finance techniques are used to obtain the needed funds. Wherever, the debt is used, the lending decision is based on the overall corporate balance sheet.
Last but not least, Corporate finance is the area of finance that deals with providing money for businesses and the sources that provide them. These sources provide capital to corporations to pay for structural improvements, expansion, and other value-added projects and enterprises. Capital is a good that can be used now. For this lesson, it will primarily refer to money. The purpose of corporate finance is to maximize shareholder value. There are many methods that a corporation can utilize to maximize shareholder value. The philosophy of corporate finance to qualify for balance sheet must satisfy the following criteria:
- Whether the corporation has access to the needed capital at reasonable debt,
- whether the project feasibility study project a return on investment acceptable to the project sponsor’s internal investment criteria,
- whether the project risk are satisfactory,
- Whether other types of financing provide greater advantages to the project finance.
Use of Project finance:
Since the age of globalization and emerging market, project finance is the most significant solution for infrastructure, factory, industry and construction especially where the demand for infrastructure far outstrips the economic resources, it provides a financing scheme for important development.
Advantages of Project finance:
- Elimination of, or limitation on, the recourse nature of the financing of a project.
- Off-balance sheet treatment of debt financing
- Leverage of debt to avoid dilution of existing equity
- Avoidance of restrictive covenants in other debt or equity arrangements that would otherwise prevent project development.
- Arrangement of attractive debt financing and credit enhancement, available to the project itself but unavailable to the project sponsor as a direct loan.
- Internal capital commitment policy
- Diversification of project sponsor to eschew political risks
- Limiting collateral to project assets.
- More incentive to lender to corporate
- Matching specific assets with specific liabilities.
- Expanded credit opportunities.
Disadvantages of Project finance:
- Complexity of Risk
- Increased Lender Risk
- Higher Interest rate
- Lender supervision
- Lender reporting requirement
- Increased insurance coverage
- Encourages potentially unacceptable risk taking
In project finance, risk is the crucial factor that determines the potential ability of project failures. Risk is defined as “Uncertainty in regard to cost, loss or damage”. The importance of risk structuring is to identify, analyze, quantify, mitigate and allocate so that no individual risk threatens the development, construction, or operation of the project in such a way that project is unable to generate sufficient revenue to repay the project debt. To mitigate the risk, it is done by contracting-out-process-allocating risk among parties in contract form. Risk in multinational project financing may be classified into two categories: transnational and commercial risk. To understand the process of risk allocation, risk matrix is used as a tool that helps to identify the risk and provides in depth understanding of the allocation. Project finance can be nonrecourse or limited recourse, to the project sponsor, the financial responsibility for various risk in a project financing must be allocated among the parties that will assume recourse liability and possess adequate credit to accept the risk allocated. There are four general risks in the project financing;
- Development Risks
- Design Engineering and Construction risks
- Start-up risks
- Operating risks
Development Risk: Development risks is the primary risk that triggers project sponsor and project lender. Risk during the primary stage includes government permit, public opposition to the project and weaknesses in the business framework of the deal. Risks are very high during development stage as potential rewards are high and funds at risk are relatively small, yet, they increase with each day of development.
Design Engineering and Construction Risk: The risk during design engineering and construction risk is usually high fluctuate change in work, change of price during currency inflation, construction delays, material shortage, design changes required by law and strikes. Losses in such stages can be significant particularly for construction lender. For example, if the project is unsuccessful during construction phase, it is evident that the project assets will not likely to pay sufficient debt for construction loan. Therefore, a managed risk profile is incepted during project development, which renders guaranteed completion dates, prices and performance levels. In some projects, construction lenders will require project sponsors to guarantee the availability of funds for project completion, thereby requiring limited recourse to the project sponsors for the construction loan.
It is the most important risk period for project finance because achievement of the performance guarantees through performance tests signals at the end of the contractor risk period. Until this time, the contractor is responsible for almost all construction risks, pursuant to the turnkey construction contract. During the start-up phase, permanent lenders and equity investors, including sponsors require the contractor to prove that the project can operate at a level of performance necessary to service debt and pay operating costs.
Operating risks are the risks which instigates in preliminary operation. Each operating risk effects whether the project will perform at projected level, to produce sufficient funds to cover debt service and operating costs and provide a return on equity invested. A typical example of operating risks are decrease in demand for the output of the project, unavailability of the raw material, technical problem, inflation, foreign exchange rates and convertibility, strikes, supply risks, regulatory risks, political change, and management inefficiencies. To mitigate the risk, allocation technique is useful such as take-and pay, off-take purchaser contracts, fixed price fuel and raw material supply contracts and political risks insurance are significant.
Components of Project Finance and Participants:
- Project Sponsor: A project sponsor is the entity that coordinates the development of the project. There may be one project sponsor or groups or companies or joint venture companies. The special-purpose entity (SPE) is developed by the project sponsor to enter into the project contracts and own the project assets. The objective of project sponsor includes limited exposure of the sponsors other assets to a project failure by using nonrecourse or limited recourse financing, off-balance sheet accounting treatment, use of high leverage financing structure, flexible with loan agreements, internal capital commitment policies; political risk diversification risk sharing; collateral limited to project assets and etc.
- Construction Lender: The construction lender in project finance is concerned with the design engineering and construction risk because completion of the project is a condition precedent to the payment of the construction loan with the proceeds of the permanent financing, or if the construction and permanent loan are part one facility to the repayment of the debt from operating revenues. It is concerned primarily with construction contract including the provision of timely completion and performance at expected level. It is evident that sufficient funds should be available to complete the construction of the project on time and failure to meet the expected time will cause to pay damages or other contracting parties to terminate the contract.
- Permanent Lender: The permanent lender are the one which arranges sufficient debt to finance the total construction cost of the project. Permanent lender wants a risk-free project to avoid in paying damages. Permanent lender is one who makes permanent loans on real property. Contrast with construction lender or bridge lender. In the field of commercial properties, many permanent lenders include large prepayment penalties in their loan documents. Permanent lender can also provide loan financing even with a material adverse change to the economic condition of a project participants, provided that the change is temporary. It provides credit support to financing.
- Contractor: A contractor is one in project finance that provides available product to the project sponsor. The contractor is obliged to deliver the project at a fixed or predictable price, on a date certain, warranted to perform at agreed levels. There can be uncertainty in providing the delivering causing project to delay such as increase price, environmental risk. The main aim of the contractor is to limit risks of any change in the cost of the project, to provide excuses for delivery.
- Operator: The uncertainty that exists between project sponsor and operator is the price and performance of the project. The project sponsor wants to ensure that the operating price is fixed and predictable to analyze while the operator wants to limit price risk. This is an operator used in adaptive control. Essentially, the projection operator makes sure that the parameters being estimated remain within a set.
- Technology owner:
Technology owner is not a direct participant in the project financing rather the contractor and Project Company has a license agreement with the technology owner for use of the technology. The technology owner gives guarantee to the technology performance and provides assured for the availability of the technology to the project.
Supplier in the project finance is one that deliveries the material and product to the project where necessary. For example, fuel, raw material and other with acceptable excuses for non-delivery. The project sponsor however, seek predictable price, quality and delivery of the products at minimum price and uncertainty.
- Output purchaser: Output purchaser is in the same position as the project company when the project company purchase fuel or raw materials. The output purchaser desires firm price and quality with a minimum uncertainty.
- Host Government: The host government is one where project is situated and host government can benefit on a short-term basis from the success of the project. Short-term, the government can use the project for political benefits and for attracting other developer to a country. In long term could enhance economic prosperity. Other benefits includes new technologies and the associated intellectual property, training of the citizens in that new technology, job creation and increased tax revenue.
- Other Government- Export and Transit Countries: A project might requires the cooperation of other countries, besides the host country, for the project success. For example, the fuel supply could be insufficient in the host country, requiring a supply from another country.
- Equity Investors: Equity investors brings investment capital to project supplementing equity invested by project owners. The equity can take various forms, including (i) Limited or general partnership, formed to the project company (ii) lessor equity in a single-investor lease transaction (iii) lessee equity in a sale-lease back transaction (iv) stock ownership of the project company organized.
- Multilateral and Bilateral Agencies: Multilateral and bilateral agencies provide resources to the project. Political and governmental funding constraints drive each somewhat.
In any project financing, whether domestic or international, the project is subject to the jurisdiction of the government and its action. Thus, this can result in various risks to the project, such as success of the project, cash flows, and operating costs. There are limits on the control a project sponsor can have over the political stability surrounding project, yet, there are techniques to mitigate the risk. Following are some ways to mitigate and allocate the risks;
- Project sponsor support
- Through guarantees and other credit enhancement
- Host-government guarantee
- Political risk insurance
- Reserve funds
- Formation of joint ventures
- Participation by bilateral and multilateral institutions in the project
- Participation by local banks in financing
- Contractual protection (choice of law, international arbitration, offshore accounts and implementation agreements).
Currency Related Risk
The currency-related risk is present in every transnational project transaction. It is a very important risks because in long-term nature of the underlying contracts will materialize the currency related risk. For example, foreign exchange risk arises in a project finance most often because of the differences in the revenue currency and debt and expense currency. In a project, revenue paid will most likely be paid in the host country ‘s local currency. However, the project company incur debt and contractual obligations in another currency. There are three areas where foreign exchange risk instigates; unavailability of foreign exchange; transfer of exchange out of the host country and depreciation in the value of the host country currency.
- Unavailability of foreign currency: The risk is concerned with the ability of the currency into foreign change, as predecessor to moving money out of a country. This risk will lead project entity to unable to convert local currency into foreign country in which loan or other payments must be made. To mitigate this risk is to produce revenue in a hard currency. If the government entity is making the payment under the revenue producing contract, this should provide the convertibility assurances needed for the project. Or the project finance entity could be tied to a local export business that generates foreign currency. This is called countertrade. Also, to sign an agreement with the host country in relation to currency convertibility or obtain political risk insurance covering currency of convertibility that can be obtained from organizations such as Overseas Private Investment Corporation (OPIC).
- Currency Transferring: The transferring risk arises in which local currency cannot be transferred out of the host country. The government holds key to the gates of transferring the currency. For example, the central bank of the host country converts the local currency into foreign exchange on its books, acknowledges the obligation but refuses to make the transfer out of the country. Also, at times, the host government imposes burden for approvals and conversion fees to complete the transaction. To mitigate such risk in the same way as discussed above.
- Currency Devaluation: It is the risk which is used to describe where loan is made in a foreign currency and repayment is made by a borrower with earnings only in local currency. The risk is that the local currency depreciates to a point where the borrower is unable to generate sufficient local currency for the conversion necessary for debt service. Fluctuations in currency rate can also affect what comes into and out of a project the amount of revenue generated by a project; the price of inputs, and the return on equity. Protection against this risk is limited and not covered under insurance policies that protect a project against political risk. However, there some mitigation such as matching revenue currency to debt currency, raising debt in local currency and forward contract with banks.
Thus, in summation to minimize the risk in the project finance, it is evident for the project finance entity to provide payment in hard currency, foreign exchange risk insurance and indexed local currency payments.
Permit, concession and license risk:
- Permits: The project company must apply for the permit to develop, construct, start-up, operation and financing of the project. There are various risks that could be surrounded to project finance for not obtaining the permit for ownership because of the law and sovereignty of the host county. To reduce the risk of not obtaining the permit due to some uncertainty, the implementation agreement between the host government and the project finance entity must t agree to the terms as listed below:
- Waive all permit requirement
- To the extent legally obtainable
- Pay the project sponsor any increased cost due to delay of the failure to obtain the license.
- Concession and Licenses: The right granted by the host government to a foreign entity to develop, construct, own and operate in manner as the law of the host country. The concession agreement is used in a build own transfer (BOT), in which a private own entity is awarded the right to build and operate a project that would otherwise be developed, owned and operated by the host government. It is a temporary privatization in the sense that at the end of the concession, the project is transferred to the government. The concession agreement allows the host government to retain the control over the management of the project. This, however, allows the host government to regulate the facility, operate and maintain the project finance entity. IN this instance, project sponsor, project lender require certain assurance from the host government.
The risk in incorporating the project finance entity in the host country can be anomalous in terms of its laws, political circumstances and environment. Also, expropriation risks follows the path of political circumstances that are carried out in the host country. Changing in the law risk is very crucial for project finance entity because once the project is under operation, the import and export tariffs can be hurdle for the entity followed by tax laws and custom duties. To mitigate the risk, there should be nondiscrimination clause that should be included in the implementation agreement, to prevent any destabilization to the project finance entity.
In pith and marrow, the legislative and judicial laws should be analyzed before the project finance entity incorporates in a host country because contractual obligations are essential and could lead to pay liquidated damages. Environmental laws, tax laws, trade laws and sovereignty should be considered and negotiated before incorporating a project finance entity.
Chapter no 4
Project finance and Commercial Risks
Commercial risks, besides transnational risk discussed in preceding chapter, involves not only domestically but also includes in international project finance. Following are some risks that involves in commercial risks;
- Probability of Risk evolving into a project problem
The risk includes construction cost, completion delays, inaccurate cash flow projection, market problem, political risk and problem inefficiencies.
- Due Diligence
Due diligence in a project finance is an important process for risk identification. It is an interdisciplinary process of legal, technical, environmental and financial specialties, designed to detect events that might result in total or partial project failure. Participants involved are lawyers, engineering firms and fuel consultant.
- Feasibility study in risk identification
In many project finance, project development has progressed beyond the feasibility study, which gives details about whether the project is financially viable when lawyers are instructed to prepare necessary documentation.
- Categories of Commercial Risk:
There are nine categories of commercial risk that is attributable to project failure. Three causes of project failure exists during the design engineering construction phases of the project, a delay in the projected completion and resultant delay in the commencement of cash flow, an increase in capital needed to complete construction and the insolvency or lack of experience of the contractor or a major supplier. The other six risk involves in start-up and operating stages of the project; technological failure, changes in law, uninsured losses, shifts in availability or price of raw material, shifts in demand or price of output and negligence in project operation.
Project finance convolutes billions of dollars for incorporation and the risk involves are very significant in terms of its operation. For instance, credit risk is very essential in laying the foundation of project finance as allocation of risk is worth to those creditors who have potential resources to perform their obligations in project finance. Following are some significant risk involves in project finance;
- Increase in construction cost of the project, which is a potential risk for the project. If the project cost more than the funds available from the construction loan, other debt sources, and equity is perhaps the most important risk for the participants in a project financing. There can be various reasons for the enhancement of the construction cost such as inaccurate engineering plans, inflation, and problems with project start up.
- Delay in completion: A delay in project completion may result in an increase in project construction costs and a concomitant increase in debt service costs. The delay may also affect the scheduled flow of project revenue necessary to cover debt service and operation and maintenance expenses. To alleviate such risks the participants could allocate the risk in the following ways, such as fixed price, firm completion date, construction contract, performance bonds, project sponsor completion guarantees, selection of proven technology with which the contractor and operator have experience and reserve funds to cover the cost overrun.
- Force Majeure in Construction Contract: International projects includes various forms of contracts and agreements to negotiate the construction contract and other contracts to enhance the viability of the project finance. Sometimes the contracts are negotiated with various lawyers and teams resulting in uncoordinated force majeure provisions. If there is inconsistency in the force majeure clause, then the resurrection clause, be purported which includes that the contractor agrees with the project company where force majeure inconsistencies exist between the contracts, the contractor will not relief available to the project company under other relevant contracts.
The contractor and subcontractor must complete their work on time in order to eschew any liquidated damages. The building material should also be available to avoid the risk of delaying the project. This also provides the material at a reasonable price to furnish the project finance entity to avoid any cost overruns and delays. Commercial risk is very phenomenal in terms of providing resources to the project finance especially in terms of site location and technology, which renders project finance the ability to operate the project at the expected cost. The problems that can arise in such commercial risks is unavailability of site and unproven technology, which ignores the viability of using innovative technology.
The significance of commercial risks also involves shortfall in mineral reserves and raw material for the mineral projects and other could cause enormous delay to the project operation, results in cash flow delay. The off-take purchaser is crucial with regards to the operation of the facility because if the creditworthiness of the off-take purchaser should be enough to enhance the foundation of the project finance. For such production of the off-take purchaser, there are two stages for a project to generate revenue, one is to price, which is reasonable for the purchaser to buy the product, and access to the purchasers for sale of the projects output. This chain relates to all other identified risks to be allocated and analyzed in order to furnish the project revenue. Failure of the project to perform is a risk to project participants, which would results in decreased revenue and operating costs.
The operating of the project facility is essential in a long-term project’s success because the design and processing of the project entity primarily base on the operators performance. The entity operating the project must possess sufficient resources to generate the efficiency of the project at the levels necessary to generate cash flow at projected levels. General operating expenses also matters to operate a facility, for instance, if the general operating risk is greater than the estimated cost, would result in greater risk to the project participants. For example, inexperience management, unable to obtain permits and licenses, high interest rates, inconsistent force majeure clause and environmental protection laws.
The commercial risks are very significant in order to analyses and identify in order to mitigate the losses. The technique which is used to curtail the commercial risks are contractual obligations, equity funding must be adherent and insurance. Once all these risks are identified then and allocated then the project finance entity would be able to generate cash in order to repay the creditors.
Chapter no 5
Project finance participants and their roles:
The initiative of project finance comprises of the participants which are as follows:
- Project sponsor: The project sponsor is the entity or group of entity, interested in the development of the project and that will benefit, economically or otherwise, from the overall development, construction and operation of the project. It is also called developer. Project sponsor can be one or a group of companies.
- Project Company: A project company is the special purpose entity that owns, constructs, operate and maintain the project. There are a lot of factors that involves in Project Company such as local laws of the country, liability limitation, real property in the host country and investors participation.
- Borrowing Entity: Borrowing entity is same as that of Project Company which includes funding the project company. There can be a single borrower or multiple borrowers which are used to fund the project. Sometimes combination of project sponsor, project operator and owner forms a joint venture to develop the project.
- Commercial Lenders: Commercial lenders includes banks, insurance companies, credit corporations and other lenders to provide debt financing for project. The institutions may be situated in the country where project is based or in the host country. Commercial lenders in the host country sometimes also includes in the host country to prevent any discriminatory actions by the host government.
- Bond Holders: Bond Holders are the one who purchases project debt in the form of bonds, and represented by a bond trustee. It is sometimes incorporated as a financial institution that acts as the representative for the bondholders in the managing the debt transaction.
- International Agencies: Bilateral and multilateral agencies are also included that funds the project finance entity such as World Bank, International Finance Corporation, regional development banks and other international agencies provide significant support for project financed.
- Suppliers: The supplier provides raw material, fuel and other inputs to the project.
- Output Purchaser: The output purchaser is the purchaser of all or some of the product or service produced at the project. In some nonrecourse and limited recourse project financings, the off-take purchaser provides credit support for the underlying financing.
- Contractors: Contractor is the entity responsible for the construction of the project, which bears the responsibility in most projects for containment of construction-period costs.
- Operator: The operator in the project finance entity is the one who is responsible for the operation, maintenance, and repair of the project. In majority of the projects, project company owners are the operators that is responsible for all the cost and operations.
- Financial Advisor: Financial advisor is retained by the project sponsor for the purpose of financial advice and preparation of the memorandum. Memorandum includes all the details of the project technical and economic feasibility.
- Technical Consultants: Technical consultants are retained by the project sponsor for the purposes of retaining advice for the project sponsor and project lenders that have limited knowledge of fuel, insurance, engineers and environment.
- Local Lawyers: Local lawyers in the host country typically includes for the purpose of purporting legal and political advice for the purpose of the project.
Chapter no 6
Project Finance structures:
The structure of project finance is unlimited by the creativity and flexibility of bankers and lawyers. The structure is based on three macro variables: nonrecourse financing, limited recourse financing, and project output interest financing. The former two provides debt repayment from the cash flows of the project. Output interest financing structures are centered on the purchase of an interest in the project output, which purchase price is used to finance the facility.
Commercial loan financing lends money to the project company for the construction and operation phases of the project. The type of loan is either nonrecourse or limited recourse, the lender receives security as collateral. The commercial loan has two phases, one is construction phase, in which money is advanced under construction agreement, since the project is not generating any revenue, and interest is capitalized. The other is Operation phase, in which operation lender will advance the entire amount, and amount will be disbursed soon the first day the commercial operation instigates. This commercial loan financing helps to initiate the project finance entity, and its cost. Also, there are export credit financing which includes all the cost related to import and export financing, which includes to promote the trade among the countries. Hence, there are import-export financing agencies which provides funding to the project finance entity. There are three types of lending in which export-import bank use to provide load to the project entity, direct lending, intermediary lending (Bank to Bank) and interest rate equalization.
Also, lease financing can provide colossal benefit to the project company in several ways such as control over the project, total financing, lower financing costs tax deductibility of rent, shifting of residual risk equity risk taker replaces lender. It benefits the project finance entity in a way that can take initiative to complete the project on time. Bond financing, is another type of financing which is used as commercial loan, in which the bond holder acts as the agent and representative of the bondholders.
Bot (Building own transfer) is one of the common form of infrastructure development in developing countries because host government provides a concession ( a right to build and operate the project) to the project sponsor, which agrees to build and operate the project for a specified period. At the end of the operation period, the project sponsor either transfers the project to the host government or renegotiates with the government for an extended period of operation. The benefit that host government can take from this is to provide a needed project to its citizenry without an effect on the government’s budget.
Hence, project financing structure are of many types as discussed above and other such as co-financing, production payment and forward purchase agreement which helps to invest in the project finance entity in order to materialize the project. The forward purchase agreement is similar to production payment in which the agreement is signed between the project company and a special purpose entity created by the lenders under which that entity makes an advance payment for the projects production. This advance payment is used to pay project development and construction cost. Sometimes special purpose entity provides grantee for off-take purchaser and take or pay contract for the project finance. After the completion of the project company it delivers goods and services to pay back the money to the production.
Chapter no 7
Selecting of Project finance ownership structure:
Selecting the type of structure for project finance is very critical because it impacts diverse area of the project finance entity in terms of project operation, for example, Project Company will have different rules to operate. To organize a project company is also of a concern because under the laws of the host country or the project sponsor’s organization is to determine the viability of the project finance. There are some pre-development activities that generally begins to full development of a facility. For a pre-development activities, the development agreement must be signed if more than one project sponsor is interested in project feasibility. In the agreement the project sponsor concedes on how to proceeds with an analysis of project feasibility, and how the project will be developed if it is to be proceeds. The development agreement contains some provisions as follows:
- Definition of project
- Roles and Responsibilities
- Tasks and Schedule
- Cost funding
- Management and Voting
- Antitrust and Restrictive Trade Practices
The type of a structure that project finance entity can adopt needs to be determined through some factors that may be considered in determining the entity for project finance as
- Need for leverage
- Grade of Investment
- Tax law and treaties
- Project Management
- Lender preferences
- Transferability of Equity Interests
To avoid any interference of parent company, usually special-purpose entity is created as subsidiary for the purpose of investment and other project activity.
Special Purpose Entity:
Special Purpose entity is created to own the project and no other assets. As a consequences, unrelated, non-project risk is segregated from the project financed. To maintain such protection, there should be special documents that needs to be protected for the purpose of maintaining special purpose entity. There are some restrictions on the entity’s powers to undertake activities other than the project; debt limitations; restrictions on mergers or reorganizations; and maintenance of separateness for purposes of both avoiding piercing the corporate veil and substantive consolidation”.
After fulfilling all the prerequisites as stated above, the project finance entity may choose any structure to best suitable that accommodates the project finance;
- General Partnership: A general partnership is a business entity created by and operated pursuant to contract, statute, or both, in which all partners share proportionately in the management and income of the business undertaken. The liability of the partnership is joint and several liability and does not afford nonrecourse or limited recourse liability.
- Limited Partnership: A limited partnership is similar to a general partnership except that it has both general partners and limited partners. This form of organization of a business entity is available both in the United States and in England. The liability of partner is to a limited to limited partners.
- Limited Liability Company: it is similar to limited partnership, liability of the members of the company is limited to the extent of their capital contribution.
- Joint Venture: A joint venture is a combination of entities to achieve a common purpose. It is a flexible form of business enterprise that allows the member companies great flexibility in how the venture will be managed and controlled.
- Development Consortium: It is similar to joint venture. A consortium is the term typically applied to a group of large, well-capitalized corporations that collectively develop a project. The relationship of the members and regulate day-to-day activities.
- European Economic Interest Grouping: It is relatively a new concept for business to enhance economic corporation in the European Community. EEIG is a business organization of other entities formed under the laws of member states of the European community and that are subject to administration in different member states.
The single-purpose corporate subsidiary is the most common project financing structure. In this structure, the sponsor incorporates an entity, frequently wholly owned, solely to develop, construct, own, operate and maintain a particular project at a specific site. This allows the owners to enjoy limited liability and liability can be forfeited. Although a loss of this liability protection, called a piercing of the corporate veil, is relatively limited in England, and more troublesome in USA. A legal concept that separates the personality of a corporation from the personalities of its shareholders, and protects them from being personally liable for the company's debts and other obligations. This protection is not ironclad or impenetrable. Where a court determines that a company's business was not conducted in accordance with the provisions of corporate legislation (or that it was just a façade for illegal activities) it may hold the shareholders personally liable for the company's obligations under the legal concept of lifting the corporate veil.
Chapter no. 8
Feasibility study is an analysis and evaluation of a proposed project to determine if it (1) is technically feasible, (2) is feasible within the estimated cost, and (3) will be profitable. Feasibility studies are almost always conducted where large sums are at stake. Also called feasibility analysis. Feasibility study is for the project sponsor, who allocates resources pursuant to proposed projects for limited development funds. The study contemplates overall description of the project and its location including surrounding topography, weather, drainage, major landmarks, population, water, access to transportation and housing. The participants in feasibility study and assessment includes contractor, operator, supplier, off-take purchaser, local and central government of the host country and other major participants. Moreover, feasibility study also includes the type of technology that should be used for the purpose of the project and all other sources of infrastructure needs and its availability.
The assessment of the project is very crucial because project sponsor and project lenders can evaluate the project’s risks and potential return in order to pay back the creditors loan.
Economic information is very significant for the purpose of project’s expected construction, operating, and financing expenses. This also purports the estimate of credit enhancement for the project if the project potentially deteriorates the pecuniary measures. The assessment also includes the host government’s risks with regards to political and environmental risks, which estimates the derogatory remarks for the project.
Needs assessment is particularly important for off-take purchaser in order to determine the viability of the product and service that needs to be provided by the project. Further, independent engineer is retained by the project lender to review technical feasibility, which includes;
- Engineering and Design
- Operation and maintenance
- Input supply
- Off-take production
- Financial projection
Chapter No 9
Environment of the host country is very important to instigate a project finance entity because higher the risk, lesser would be the viability of the project to operate in a situation which involves political risks, social and human rights conditions, economic conditions and legislative conditions. If all such mentioned conditions are at the lowest ebb, then the potential of the project to operate and negotiate with the host government is ignoble. It is evident that complete stability is, of course, utopian. Political stability is subject to institutional and electoral influences. Political stability includes the following;
- The degree of stability
- Government attitude towards the foreign investment and its needs.
- The extent of government involvement in the economy of the host country.
- The economic projections for the host country.
Social and human rights violation is crucial for the success of the project because if the violation of political and social groups are at peak, then the success of project finance would dwindle because there would be high atrocities, which could defame the project structure in the long-term.
Besides predictable political stability, project finance requires the establishment of a legal framework for ongoing business. The framework must include the basic legal provisions to accommodate the project needs and fulfill predictable issuance of permits, enforcement of contracts, and reasonably efficient dispute resolution through arbitration.
The purpose of Economic feasibility study (EFS) is to demonstrate the net benefit of a proposed project for accepting or disbursing electronic funds and benefits, taking into consideration the benefits and costs to the agency, other state agencies, and the general public as a whole. The project sponsor must analyze the financial information necessary to decide whether the proposed project is viable. The economic feasibility includes the following;
- Construction budget: the construction budget is the combination of development costs, site acquisition, the construction contract price, construction permit costs, start-up cost, including fuel and other inputs needed to conduct performance testing at the end of the construction period.
- Operating Budget: It is the estimate of the cost necessary to operate the project. These costs include management cost, fuel, raw material, operators fuel, labor costs, insurance, disposal costs, and similar other operating expense.
- Debt service cost: This type of cost includes interest, fees, and other amounts payable to the lender. The economic analysis will provide a general summary of expected debt terms, including, principal amount, fees, interest rate and etc.
- Working Capital: A project financing is based on the ability of the project to generate sufficient cash flows to repay the debt. It is evident that at the early stages of the operating stage of the project, no revenue will be generated, might cause 60 day delay between the time, the product is produced or the service is provided. Therefore, economic feasibility study will provide analysis about the funds available until the revenues are generated.
Thus, economic feasibility study is based on the assumption made in the financial projections. Increase in interest rate, inflation, foreign exchange rates, price for fuel, and raw material available to instigate the project in the economic projection could deter. The economic assumption renders viable sources to evaluate the project’s predictability based on the economic assumption.
The environmental issue is one of the main issue in project finance entity because as we can see that the World is experiencing some rising temperature and making things difficult to furnish. For example, 2016 is experienced to be the warmest year, rising in global temperature causes heat waves and this leads to countries enact new legislation to curb carbon dioxide from the air and also dwindle the transportation leverage for the people. The significant one is the issue of amending legislation or new laws that might limit the project’s performance and operation, thus, would result in unavailability of the funds to pay the debts. Increased in project construction and operation costs, capital costs related to equipment and maintenance to satisfy new laws and standards of the host country would have significant effects on a project and its sponsor.
In many states, local government and central government are increasingly protective of the environment, particularly in the areas of air, water and pollution to purport protective regulatory authorities, which would indirectly also impact project finance entity. Multilateral and bilateral agencies such as African Development Bank, Asian Development Bank and the Inter-American Development Bank consider protection of the environment a necessary component of their activities.
Before executing the project, project feasibility report renders the environmental consideration for the project finance. In some countries, laws relating to project finance are very diverse, for example, environmental impact and its effects could deter the success of the project finance. To mitigate the losses, there must be structured plans and agencies in the jurisdictions to curtail the effect of environment. The type of information required as follows:
- Plant and Animal Habitat
- Health Hazards
- Historic and Cultural Significance
- Transportation, Public service and Utilizes
- Indigenous people
After purporting all the pros and cons primitive to above mentioned points with regards to environment, then comes the permits, which is essential for a project finance to operate. The environmental feasibility report also contains the identification of all governmental permit necessary to conduct and operate the project. The permit required for the project varies with the type of project, for instance, raw material used, discharges and emissions. Examples of permits that could apply include permits for air emissions, wastewater discharges, ash disposal, hazardous waste disposal and landfill construction and operation.
On the other hand, public opposition can also become obstacle for a project finance entity because public might deteriorate the success of the project finance and opposes for the entity to obtain the permit. Multilateral agencies also put pressure to project sponsors to control the environmental effects of a project, by conditioning guarantees or loan availability on compliance with minimum environmental standards. Consequently, World Bank is under pressure to enhance the environmental conditions in developing countries through its lending and investment activities.
It is very important to analyze the site of the project finance before taking initiative of the project finance. It must be understood thoroughly including historical documents, land documents, and similar information. Developing countries sometimes lack the type of environmental laws commonplace in the industrialized country, whereas the country will enact more stringent environmental protections, at the insistence of its population or through World Bank requirements, is too speculative to answer.
Last but not the least, equator principle, is a risk management framework, adopted by financial institutions, for determining, assessing and managing environmental and social risk in projects and is primarily intended to provide a minimum standard for due diligence and monitoring to support responsible risk decision-making. The guidelines is further divided into three categories such as assessment, management, and documentation.
Chapter no 12
Project Documents include project charter, statement of work, contracts, requirements documentation, stakeholder register, change control register, activity list, quality metrics, risk register, issue log, and other similar documents. The sponsor will see and approve the project management plan. Generally, contracts are the king in project finance. Documentation is essential in order to trace project finance deals and contracts. With regards to transnational project finance following are some documentation which is crucial primitive to enforcement throughout the world;
- Governing law: In some counties, law prohibits selection of any governing law other than the local law.
- Forums: Equally important is the selection of the method by which disputes can be resolved and where those disputes will be resolved. The provisions in the forum must make it clear the party’s intention in relation to solving the dispute.
- Contract formation: formatting the contract is equally important as governing law because the contract with the supplier and other participants of the project finance will furnish the project utilities in general. Every country has different law with regards to contracts and it varies from country to country, that is why governing laws are very crucial in formatting the contract.
- Contract Structure and Validity:
It is evident that many international contracts look identical, local laws determine the element is necessary to ensure validity. The analysis of local lawyers are very essential before executing it to the parties.
- Formalities: The reviewing of the local laws are essential and its procedural requirement must be obtained before executing the project finance. Almost every country in the world requires procedural requirement to be sustained before contracting the parties.
- Enforceability of Risk Allocation: the most important mistake that team of transnational project finance makes is the allocation of risk and remedies. Liquidated damages payable primitive to delay in completion of the project or any sort of damages may not be enforceable in some counties. Therefore, the review of these provision is essential.
- Currency Issue: As discussed currency would devalue the currency of the host country.
- Government Action: Unpredictable risks can ignite during the action s of the government and control the project finance entity.
- Term: the terms of the contract is sometimes governed by local laws.
- Language: The parties should concede on the language they use in the contract and execute it. Although it will be helpful for the parties to choice one language that can be understandable by both the contracting parties.
Moreover, the type of documents are important in a nonrecourse or limited recourse project financing such as;
- Organizational document
- Agreement with host country
- Real property agreement
- Construction Documents
- Operation and Maintenance documents
- Fuel Supply documents
- Utility Documents
- Off-take revenue agreements
- Transportation Documents
- Financing Documents
To protect the interest of the project sponsor, it is crucial that the project documentation should be negotiated will satisfy the requirements of the lending community. In this instance, financial cooperation clause shall be incorporated to agree with reasonable demands of a project lender that it imposes conditions to financial closing. Similarly, terms documents contain brief summary of the contracts and its condition including supply for input that helps to negotiate with the host country’s requirement. Completion is another clause that should be incorporated in the contract agreement in relation to the time taken to complete the project, if any delay arises then the obligation to pay liquidated damages also arises regardless of the construction and operation phase of the project.
Moreover, the contract must contain take-or-pay contract where the obligation of the purchaser to pay the contract amount even if no good or service is produced by the project company. It is also called hell or high water. Lastly, the Force Majeure should also be incorporated in the contract because any unforeseeable circumstances that prevent someone from fulfilling a contract. Inconsistent force majeure clause can be cured with resurrection clause, in which the contractor agrees with the developer that where force majeure inconsistent exist between the contracts, the contractor will not receive relief greater than the relief available to the developer under the other relevant contract.
Thus, the clauses above is very important primitive to contract, and any breach of contract clause will result in liquidated damages, or damages. Internationalization is a recently coined term that places its interpretation and enforcement in international arena.
Chapter no 13
Representation and Warranty plays an important role in the project financing especially in relation to the project contract. In a contract, facts are traditionally memorialized in the representations and warranties section.
A representation is a statement by a contracting party to another contracting party about a particular fact that is correct on the date when made. A representation can be made about the past or present facts but never a future fact. A warranty, on the other hand, is the duty created in the contract. A representation induces a party to enter into contract and can exist though no valid contract is created. Historically, breach of warranty could be breach of contract and can lead to pay for damages. The remedy for breach of warranty is damages.
The purpose of representation and warranty in project finance contract is to set forth in the contract the factual basis under which each of the contracting parties is prepared to enter into the transaction. Each contracting party sets their goal in the contract deal of the project finance in the representation section of the contract.
The role of representation and warranty is based on the merit of the project finance, representation and warranty section particularly, in the project finance loan agreement provides a checklist of essential elements of project finance. Each element of the project finance is determined and verified, in order to accommodate project finance. When the parties make representation in the contract, the warranty stipulates the viability of the service and its completion. Mechanics of representation and warranties are as follows:
- Affirming the Basic Assumption: This includes the formation of the contract in writing between the contracting parties. This also includes Legal Status and authority to enter into transaction.
- Additional Facts Received in Negotiation Process: During the negotiation process the representation and warranties are refined as the contracting parties disclose facts that may present potential problems.
- Date Reprenstation and Warranties Are Made: Representation and Warranties are made on the date when the contract is executed, some of the contracts include loan agreements, provide that one contracting party is executed from taking a specified action, such as making further loans.
- Materiality and Knowledge Limitations in Representations and Warranties:
The materiality limitation the contracting party accepts from the scope of the representation and warranty those facts that are immaterial in effect. The knowledge limitation, the contracting party limits the statement to only those facts now known, if it later becomes untrue no breach of representation warranty occurs. A materiality limitation is sometimes requested when the contracting party represents and warrants that it is complying with all laws and governmental obligations or that it is in no breach of any agreement.
There are various samples that render ambience to representation and warranty primitive to contract in project finance. The preamble of representation and warranty section announces the representations and warranties made by one contracting party to another party in various contracting clauses such as in formalities agreement, corporation agreement, power and authority agreement, in debt agreement, force majeure clause, project contract, permits, compliance with laws, and completion agreement. Thus, all such agreements provide representation and warranty in relation to the project finance entity.
Chapter no 14
For a transnational project the involvement of government is crucial in order to regulate the project and satisfy the demands that project needs. It is also important to cherish the economy of the country and take advantage to the extent it benefits both the parties. Preliminary-host country agreement is an agreement through which project finance entity plans with the government to take initiative for the project. The purpose of government patronizing the project with agreement for reform, such as through privatization and enact legislation needed for a project.
Bidding program is a competitive process undertaken by a government that allows for the efficient selection of provider of goods or services in transnational manner, based on selection criteria formulated by the government, for the purpose of selecting a low-cost provider best capable of project completion and operation. Project sponsor do not always look favorably on bidding processes. Although bids limit renegotiation of the contract and also not very successful to achieve their goal. The advantage of bidding process is that it can encourage private sector. The disadvantage is that as this process gets harms by nonpublic opening for bids.
To curb the burden in the bidding process, pre-qualification process should be followed. The process called Request for Qualification (RFQ), which includes qualifications of the bidder, experience, performance in similar project, financial creditworthiness, technical expertise, technology type, and non-financial resources, such as financial experience of managerial, professional and technical staff. The advantage for RFQ is that it limits the number of bidder in the bidding process and refines the process.
Then comes the process of Request for Proposal (RFP)
A request for proposal (RFP) is a document that solicits proposal, often made through a bidding process, by an agency or company interested in procurement of a commodity, service, or valuable asset, to potential suppliers to submit business proposals. It is usually evaluated on the basis of evaluation and scoring, self-scoring, non-self-scoring, model contract, bid meetings, security, promotion of public bids by agencies, and bidding in the project finance context.
Letter of intent is usually a written expression of getting into agreement with the host country at a later date. The negotiation of letter of intent is also called memorandum of understanding. It is a non-binding agreement.
Concession and Licenses:
The concession agreement is right to develop, own, construct, and operate a project under the authority granted by the host government. The term concession agreement, license, service contract, and development agreement are sometimes used interchangeably. The concession agreement is basically between the project sponsor and the host government, which describes the project and render the terms of the governmental license for project ownership, development, construction, operation and exploitation. The concession agreement contains, terms of the concession, description of project company’s rights, permissible equity structure for the project company, management of the project company, restrictions on foreign ownership and control of the project company, and fixed rate of return on equity permissible for the project sponsors, the manner by which the host government will be compensated for granting the license. The concession agreement also includes dispute resolution, Example of BOT structure, where private entity is awarded the right to build, own, and operate a project that would otherwise be developed, owner, and operated by the host government. It is a temporary privatization in the sense that at the end of the concession, the project is transferred to the government.
It is an agreement between the host government and the project sponsor that addresses financial and political elements necessary in a project financing that are absent, or at least predictable in the host country. In this agreement, it is necessary for the host government to provide support and assurance necessary for project development, financing and operation. Thus, implementation agreement is to curtail the risk and foster development effort, capital investment and development in an uncertain environment. Implementation agreement addresses any or all of the following uncertainties:
- Sovereign Guarantee
- Permits and other governmental Approvals
- Currency Concern
- Tax Benefits and Customs Relief
- Legislative protection
- Authorization to do business
- War, insurrection, General Strikes
- Exclusive Right to Develop Project
- General Cooperation for Project Development
- Good Citizenship
- Enforcement and Dispute Resolution
- Constitutionality Consideration of Implementation Agreement
- Stabilization Clause
In support of the above mentioned agreement, host government may also require some additional agreements from project sponsors such as the following;
- Infrastructure Development: Land/Air, Transportation, availability, cost, Cabotage
- Product or Service
- Completion Dates: three types Calendar, Counting and Sunset
- Expansion Right or Requirements
- Social Program Support
- Option to Acquire Raw Materials in the Host country
- Importation of Construction Equipment
- Price Regulation
- Government Owner natural Resources
- Local Restrictions on Sale
- Export Restrictions
- Import Restrictions Employees
Risks that may incur in the future:
Political risks arises in the host government in the form of change of government, change in laws and regulations could deter the progress of project finance entity. In this instance, political insurance risk is provided to a project by an organization such as multilateral Insurance Guarantee Agency, approval must be obtained from the host country. To alleviate the risks involved, the agreement should be binding to the government, if for instance, the new government comes in, has to remain prudent in terms of project finance regulations. Also, the new government should follow the actions of predecessor government.
Waiver of Sovereign Immunity:
By an agreement with the host country, a sovereign immunity waiver is required, which stipulates that Sovereign immunity prevents an allegedly wronged party from brining cause of action, valid as it may be, against a government unless the government consents. This doctrine incepted from England, and no court was above the sovereign of the country. In United States, Foreign Sovereign Immunities Act 1976, allocated to the courts the determination of sovereign immunity. Similary in UK the State Immunity bAct of 1978 contemplates.
Act of State Doctrine:
The act of State Doctrine provides that U.S courts will not consider whether the official acts of a foreign government carried out in its own territory are actionable
Chapter no. 15
Construction contract in an internatinal project financin serves to give the project company fully completed and equipped facility. It delievers the product with specified criteria for a fixed or predictable price. The contract requires the contractor to provide all enginerring and construction work including equipment and supplies, and start-up costs.
The contract in a project finance typically includes; a detailed contract,all-inclusive scope of work, a fixed price for all the work necessary to complete the project, performance gurantees and warranties, liquidated damages for failure to satisfy the demands of the project, performance tests to confirm completion, and assurance of financial creditworthniess of the contractor.
The allocation of risk betweent the project company and the contractor is essentail beccause construction cost in the project financing must be allocated to a creditworthy contractor, the risks involves the following;
- Increase in construction cost
- Delay in Completion
- Performance Guarantees
- Force Majeure International Construction Contracts
- Experience, Reputation and Resources of Contractor
- Building Materials
- Raw Materials Supply and Utilities
It is evident that to alleviate all the risks associated with construction contract, would only be effective if the contractor is creditworthy. It must have sufficient financial resources, both at the time of contract execution and during performance, to undertake the obligations in the contract. There are four types construction related contracts;
- Engineering contracts: it provides special assistance in project design, bidding and review, and administration of the work.
- Procurement Contract: It provides for the orderly procurement of work and supplies for a project. The contract includes architect/engineer to establish bidding procedures for machinery, equipment, material, and supplies to perform an economic analysis of the bids and administrating accounting records.
- Construction Contract: it governs the complete construction of the contract.
- EPC Contract: the Engineering, procurement, and construction) contract combines the three stages of construction under one contract. It is sometimes called a fast-track contract, in that it enables progress on a project to proceed on an overlapping basis, at a faster pace than if the three stages followed in series.
The type of contract also varies, it could be fixed price contract variable price contract. The latter contract is usually when there is an inflation in the host country, while the former one is based on a fixed sum to construct a project. Cost plus fee Contract, is the contract where Project Company pays the contractor the costs of construction, plus a fee. While the construction company is more likely to receive a lower construction cost. Cost PLUS fee Contract with incentive is another type of contract, which purports that the modified version of contract by adding a maximum price and an incentive fee payable to the contractor based on their performance. Provisions in the contract are included that limits the contractor to keep the cost low. If the cost increases, the contractor usually absorbs the cost.
Typically provision of the construction contract includes scope of the work, a detailed listing of each of the contractor’s and the project company’s responsibilities, compensation and payment terms, subcontracts, acceptance and performance testing, changes in the work, rejection of work, warranties, title to work, remedies for breach, performance and warranty bonds, insurance, dispute resolution, indemnification, assignment, suspension of work and termination and force majeure clause.
Input contract is essential for project finance in order to generate cash from the entity. Contracts that represent the cost of fuel, supply of raw material and other inputs to the project company are of a particular importance because these contracts affect cash flow. In some projects, long-term contracts is not necessary because supply and transportation are widely available. But where needed, supply or pay contract is often the structure used, in which, supplier agrees to provide goods, such as fuel, or services, such as fuel transportation. If it cannot provide the available goods and services, then supplier either manages to provide from alternate sources at its expense or pay damages to the project finance company. In some projects as discussed above, that it is not necessary for a contract because availability of the goods and services. Some important risks that might give rise to the project company from input contract are as follows:
- Increase in Input Costs
- Delay in Completion Transportation
- Availability of Supply
- Disruption in Transportation
- Force Majeure in International Input Contracts
- Experience and Resources of Input Supplier
As discussed above the risks that can be involved in input contract, there are number of input contracts depending on the type of Project Company Entity;
- Fixed Amount: In this type of Contract, the supplier agrees to provide services at a fixed amount and the Project Company agrees to purchase the product at a specific amount agreed. This gives no party any uncertainty for the change of amount.
- Requirement Contract: This type of Contract allows the project company to only purchase those supply and transportation service that it requires.
- Output Contract: An output contract requires the supplier to supply and sell to the project all of its production or output from a specified sources, but there is no assurance for the project company that the output will be sufficient to provide the requirements for the facility.
- Spot Contract: Under Sport Contract, the project company agrees to purchase the services on the terms available in the market at the times of purchase.
- Dedicated Reserves: In certain circumstances, where project feasibility is sensitive to input costs, supply or transportation availability, the supplier is required to set aside input reserves for use only by the project. For example, coal, gas reserves.
- Firm versus Interruptible: Firm contract requires an input, such as fuel, be supplied and transported to the project without interruptions in favors of other customers. Interruptible contract favors the needs of contract holder.
- Subordination of Project Costs to Debt Services: It is a technique where supplier to the project input, such as fuel, may be asked to forgo the receipt of a portion of its payment in certain negotiated scenarios. These subordination costs would be pain, if at all, in the further when debt service payment are no longer in jeopardy.
- Commodity of Supplier as Project Partner: In this type of Contract, the supplier in the project company is the partner, can greatly reduce input price risks.
Generally, in United States Courts hold parties responsible for their contractual obligations Lowa Electric light & Power Co v Atlas Corp, the court requires a supplier of uranium to perform the contract it has entered with a utility, thought the price to the supplier had increased substantially. If the price has increased as predicted or the contract is a long-term contract the reliability of creditworthiness is extremely important. It is evident that before the execution of the contract, sufficient financial resources should be analyzed. If there is no alternative of credit enhancement is available then supplier or transporter must be substituted.
Chapter no 17
Operation and Maintenance Agreement:
A project sponsor has two options either to operate the project itself or retain a project operator to operate the project. Self-operation can only be successful if there is one project sponsor with operating facility to the project. This requires Operation and Maintenance agreement, which is similar to construction contract as discussed above. The Operation agreement must provide its facility to the project sponsor that it requires to operate even in international project company. The agreement is based on the performance criteria and operates at a fixed or predictable cost. There are certain risks associated with operation and maintenance agreement as well, for instance, if the estimated budget exceeds funds available from project revenue, then there will be a significant risk in a project financing. In this instance, the potential credit resources must be analyzed before executing the agreement. The operation and maintenance agreement includes the provision such as detailed scope of work, fixed or variable price for all of the work necessary to operate the project, performance guarantee, liquidated damages for failure to satisfy performance guarantee, and a showing of creditworthiness of the operator because creditworthiness determines the strength of the contractual undertaking as a risk mitigation instrument.
There are certain risks that would instigate during the operation and maintenance agreement as mentioned below;
- Increase in Operating Cost
- Performance Guarantee: If not then liquidated damages payable, which is the estimated payment by the operator and Project Company of the consequences of deficient operation by the operator of the project. Liquidated damages compensate the project company for increased operating costs.
- Force Majeure in International Operation Contracts: If the operator is excused from operating the facility under force majeure clause but the project company is not excused if its obligation to deliver under an off-take agreement, the project could lose its revenue stream. Inconsistent force majeure clause can be cured with so-called resurrection clause. In which the operator will not receive relief greater than the relief available to the project company under other relevant contracts, particular off-take contract.
- Experience and Resources of Operator: If operator has low commitment to the industry must be substituted.
- Raw Material Supply and utilities: Must supply the raw material within the acceptable range of the project company. Responsibilities lies with the operator.
- Coordination: Even if the contract is completed the operator must coordinate its operation activities with other activities at the site, such as at a site used by a manufacturing company. Without coordination, the risk of construction delays and operating costs overruns increase.
To curtail the risk, the only factor to take into account before executing the contract is the operator is creditworthy or not to undertake the contractual obligation. There are certain of operation and maintenance contract as discussed below:
- Fixed-Price Contract: This is very rare in project finance to operate it in a fixed sum
- Cost-plus fee Contract: under this contract, the owner pays the operator the actual costs of project operation incurred by the operator, plus a fee. In this instance, the owner is most likely to receive the lowest operating costs.
- Cost-plus-fee Contract with incentive fee: This contract is modified by adding a maximum price and an incentive fee payable to the operator based on cost or budget performance. In this instance, the operator is required to keep the cost at the lowest ebb possible. If the cost exceeds the maximum price guarantee, the operator absorbs the cost.
Project Finance Off-take Sales Contract:
The off-take sales contract is the agreement that provide the revenue flow to a project. These are the agreements, in which Project Company sells its product or services. In a long-term contract creditworthiness is essential but not necessary in nonrecourse or limited recourse project financing. There are six types of off-take sales contract as discussed below;
- Take or Pay Contract: It refers to contractual obligation between a purchaser of a facility and a project company, in which purchaser agrees to make payments to the project company for the goods or services produced at the facility. Under this structure, off-take purchaser makes payments for capacity whether or not the project company actually generates the good or service at the purchaser’s request. The price can be fixed or variable.
- Take and Pay Contract: Under this contract, the purchaser is required to take and pay for the project output or to pay the project company as if it did take the output. However, the buyer is only obliged to pay if the project company has actually produced and delivered the product or service. If the purchaser does not want the output, it is not required to do so.
- Blended Contract: Under this contract, the payment of the purchaser are required in specified cases of service interruption. Such payment can be loan or advance payment, which is the project company then credit against service provided later.
- Long-term Sales Agreement: In a long-term contract between the project company and a purchaser agrees to purchase specified quantities of the project’s output. The term of the agreement usually five years.
- Spot Sales: It is the contract to sale at the market price existing at the time of sale. Such sales are sometimes pursuant to a contract or purchaser order.
The usefulness of the contract to both the project company and the lender depends upon enforability, the fundamentals of contract law that must be applied. There are certain risks that could rise and deteriorate the productivity of the contract as mentioned below:
- Commercial Impracticability: It is important to note the distinction between impossibility and frustration (often called impracticability or commercial frustration). Impossibility involves cases in which a party is unable to perform due to a supervening event occurring after execution of the contract. The doctrine is embodied in U.C.C 2-615 provides the performance under a contract will be excused if the party has not assumed the risk of some unknown contingency.
- General Contract theories: General mistake, basic assumptions and unconscionability.
- Output and Requirement Contract: Sometimes the off-take purchaser is frustrated based on the services provided by the project company. A requirement contract is an agreement in which the project company promise to sell and deliver all the buyer’s requirement of specified goods, and the buyer promises to refrain from buying comparable goods from any other supplier.