PROJECT FINANCE AS COMPLEX CONTRACTING & RISK DIVISION EXERCISE

1. PROJECT FINANCE AS COMPLEX CONTRACTING & RISK DIVISION EXERCISE Prof David K. Linnan LAWS #602 October 4, 2004

2. WELCOME INDONESIAN STUDENTS & INTRODUCTIONS 1. Find course webpage http://www.lfip.org/laws602/index.htm 2. Join course listserv laws-602 via http://www.lfip.org/laws602/admin.htm 3. What is project finance?

3. COURSE ADMIN THEORY & ASSIGNMENTS 1. Mondays law together, Saturdays finance with Indonesian students (Wednesdays drafting assignments separately with US students) 2. First assignments for today already were a. View “Is the International Water Business Really a Business?” (2002 SAUR Int’l CEO) b. Read “Flexibility in Long-term Contractual Relationships: The Role of Co-operation” (Campbell & Harris) MORE LATER RE FUTURE ASSIGNMENTS

4. CONTRACT CONCEPTS I DISCRETE VERSUS RELATIONAL CONTRACTS 1. Traditional law of contracts single, fast & discrete transaction (buy or sell finished good, traders) 2. Long-term contracts are different, how? a. Party attitudes? b. Changed circumstances? c. Good faith future negotiation? [civil vs common law views?] d. Do parties often claim legal “rights,” or just try to resolve w/o legal recourse? e. Project finance as 20 year+ contracts means?

5. CONTRACT CONCEPTS II DISCRETE VERSUS RELATIONAL CONTRACTS (CONT’D) 3. Are all industries likely going to be the same in behavior under longterm contracts? a. What will determined outside suppliers’ & “business partners’” behavior? b. How do manufacturers behave under changed circumstances and why? c. How do financial institutions behave under changed circumstances and why? WHAT DOES BANKRUPTCY & INSOLVENCY BEHAVIOR HAVE TO DO WITH THIS? CAPITAL STRUCTURE (DEBT VS EQUITY)?

6. APPROACHES POTENTIAL PROJECT FINANCE VIEWS 1. Contract as strict risk splitting device among parties (risk allocation) [Off the record, sponsor & counterparties] [Off the record, banker view] 2. Contract as legal form, but actual business is joint venture/partnership in concept 3. Idea of dividing up business activities as which ones done better via market & contracts vs firms a. Econ choice vs contract approach b. Firm as organization vs production entity in contract (governance) model

7. ROLES WHAT’S VIEW IN SAUR WATER CEO STREAMING TALK? 1. Infrastructure as traditional state task. a. Why & which ones? b. Services always? Ownership of assets? c. Direct government role or state-owned enterprise (SOE or BUMN)? d. Economic vs public law reasons? e. Why change now? 2. Relationship to privatization as result, greenfield vs ? 3. How many separate private sector roles? a. Management of on-going business b. Maintenance c. Planning/expansion d. Financing/management construction or expansion e. Re SAUR CEO, everything but fixing tariff as the governmental role HOW MANY WAYS COULD THESE FUNCTIONS BE SPLIT UP VIA CONTRACT & WHAT WOULD THEY LOOK LIKE?

8. CONTRACTS CONTRACTING OUT SEPARATE ROLES? 1. Management of on-going business a. Management contract b. Form of remuneration & incentives? c. Social service vs business 2. Maintenance a. Operational aspect (single task) b. Relationship to existing services 3. Planning/expansion a. Segment (partial) of construction function b. Difference in risks from normal operations? 4. Financing/management construction or expansion a. What is benefit/calculation in building vs supervising 3-P building? Who owns? b. How to test formal acceptability & what risks there? c. What is benefit/calculation in private operaqtor vs state funding expansion? 5. Following SAUR CEO idea, tariff as the governmental role but relationship of it to above?

9. LINES OF BUSINESS? WHY ARE FOLLOWING TYPICAL PROJECT FINANCE CANDIDATES? 1. Water (cleaning & distribution) 2. Waste (collection, treatment & disposal) 3. Electricity (generation & distribution) 4. Transportation (toll roads, bridges, airports, cargo ports, mass transport) 5. Natural resource industries (petroleum, gas & mining, extraction, transformation & transport) PRACTICALLY SPEAKING, ANYTHING GENERATING STEADY, CALCULABLE LONG-TERM REVENUES TO AMORTIZE DEBT

10. CAPITAL STRUCTURE? RELATED CAPITAL STRUCTURES 1. Does previous idea that anything generating steady fee income determine determine capital structure? 2. What is the likely mixture of debt & equity in “separate roles” as with SAUR water business? Why? 3. Are the risks all the same in different infrastructure “lines of business”? Why?

11. WATER BUSINESS DECOMPOSING WATER BUSINESS RISKS 1. Is water business high technology requiring imports vs local products, plus in-puts (currency & technology risks)? 2. What are capital requirements for water treatment vs water distribution & where (investment intensive, fixed in place)? 3. Does water treatment yield a local versus internationally marketable product or service (is price set locally or in int’l market)? 4. Who are the customers, how to market (paying customers industrial vs retail, currency risk, delivered where)? 5. Is water an ephemeral service/product versus one that can be stored/exported/used locally vs abroad & over time (use or lose vs store of value; airplane seats example vs gasoline)? 6. Labor relations & employees in existing operations (operational risk & changes)? 7. Is water treatment & distribution government owned or regulated , collateral regulation as environment (political risk where over time)? 8. Greenfield operation vs pre-existing history & idea of incentives to fail if pre-existing history (SOE issues, former SOE as regulator)

12. ROAD BUSINESS DECOMPOSING TOLL ROAD BUSINESS RISKS 1. Is toll road high technology requiring imports vs local products, plus in-puts (currency & technology risks)? 2. What are capital requirements for toll roads & where (investment intensive, fixed in place)? 3. Does toll road yield a local versus internationally marketable product or service (is price set locally or in int’l market)? 4. Who are the customers, how to market (paying customers industrial vs retail, currency risk, delivered where)? 5. Is toll road an ephemeral service/product versus one that can be stored/exported/used locally vs abroad & over time (use or lose vs store of value; airplane seats example vs gasoline)? 6. Labor relations & employees in existing operations (operational risk & changes)? 7. Is toll road government owned or regulated , collateral regulation as environment (political risk where over time)? 8. Greenfield operation vs pre-existing history & idea of incentives to fail if pre-existing history (SOE issues, former SOE as regulator)

13. ELECTRICITY BUSINESS DECOMPOSING ELECTRICITY BUSINESS RISKS 1. Is electricity high technology requiring imports vs local products, plus in-puts (currency & technology risks)? 2. What are capital requirements for electricity & where (investment intensive, fixed in place)? 3. Does electricity yield a local versus internationally marketable product or service (is price set locally or in int’l market)? 4. Who are the customers, how to market (paying customers industrial vs retail, currency risk, delivered where)? 5. Is electricty an ephemeral service/product versus one that can be stored/exported/used locally vs abroad & over time (use or lose vs store of value; airplane seats example vs gasoline)? 6. Labor relations & employees in existing operations (operational risk & changes)? 7. Is electricity government owned or regulated, collateral regulation as environment (political risk where over time)? 8. Greenfield operation vs pre-existing history & idea of incentives to fail if pre-existing history (SOE issues, former SOE as regulator)

14. SEPARATE ROLES HOW TO APPLY SEPARATE ROLES ANALYSIS & DOES IT MAKE SENSE? 1. General management contract a. Fee for service? b. Incentivized as with partial sharing revenues/saved costs, etc.? 2. Operation of specific function (e.g., maintenance or operations) a. Compensation scheme? b. Management authority (overlap problem)? 3. Planning/expansion a. Compensation scheme? b. Special risks in new activities/construction? 4. Financing/management construction expansion a. Who borrows money & why? b. Who owns & why? ANALYZE WATER VS ELECTRICITY VS GAS PRODUCTION & DISTRIBUTION

15. VISUALIZING ELECTRICITY IDEA OF PROJECT 1. Why do as single project vs decomposing functions? 2. What is the organization of risks/contracts in domestic/int’l project & why? 3. Drawing example on document camera to visualize risk & assignment; why & where?

16. LAW VS BUSINESS? CORPORATE & PROJECT FINANCE 1. How much is legal as opposed to business function? 2. Can you do one function without the other? 3. How do the differing perspectives of lender vs sponsor/organizer come through?

17. UPCOMING I UPCOMING ASSIGNMENTS 1. For Saturday, October 9 (Indonesian students only) a. Read Klein & Coffee, Business Organization and Finance (9th ed) pp. 316-36 b. Do Problem Set A under course webpage “Problems” http://www.lfip.org/laws602/docs/laws602projectlink_a.htm (Problem Set A answers will be distributed in advance to UI/UGM instructors, leave to them how to check student homework)

18. UPCOMING II UPCOMING ASSIGNMENTS (CONT’D) 2. For Monday, October 11 (all students) a. Read (i) BIS press release June 26, 2004 re Basel II Accord on capital adequacy http://www.bis.org/press/p040626.htm (ii) BIS Working Paper #159 The term structure of credit spreads in project finance (August 2004) http://www.bis.org/publ/work159.pdf (iii) Quantitative Impact Study 3 – Overview of Global Results http://www.bis.org/bcbs/qis/qis3results.pdf

19. UPCOMING III UPCOMING ASSIGNMENTS (CONT’D) 2. For Monday, October 11 (all students, cont’d) b. View (i) Indonesian Government Infrastructure Presentation, December 10, 2003 Pre-CGI Meeting http://wbln0018.worldbank.org/eap/eap.nsf/Attachments/CGI- 1203-infrastructure/$File/Infrastructure.pdf (ii) Infrastructure in East Asia & Pacific: The Way Forward, July 27-29, 2004 (ADB & World Bank Bali Workshop) a. Agenda http://lnweb18.worldbank.org/eap/eap.nsf/Attachments/schedule/$F ile/BaliAgenda.doc b. Powerpoint re funding requirements http://lnweb18.worldbank.org/eap/eap.nsf/Attachments/investment/ $File/mk.ppt#1

20. THANK YOU PRESENTATION ASSIGNMENTS OCTOBER 11 1. US students to do presentation on 2a material (BIS material) as it relates to risk control, capital adequacy & pricing of project finance generally 2. Indonesian students to do presentation on 2b material (pre-CGI & Bali workshop material) in relation to question whether BIS material & real infrastructure pricing issues from private sector perspective are adequately reflected in IFI & government materials [Plus can any of the Indonesian faculty tell us BI formal or informal view of Basel II?] WILL LATER DICTATE STANDARDS FOLLOWED BY BI & FOREIGN REGULATORS, SO BANKERS MAY WISH TO READ FOR TECHNICAL DETAILS ENTIRE Final Basel II Report http://www.bis.org/publ/bcbs107.htm