Project Financing Definition

1. Project Financing Definition • The International Project Finance Association defines Project finance as “financing of long-term infrastructure, industrial projects, power plant, etc., where project debt and equity used to finance the project are paid back from the cash-flow generated by the project.” • The two key aspects of project financing are: • 1. The project revenues (cash flows) are expected to service debt or equity interest taken by the providers of capital. • 2. The loans are secured by the project assets or, to the extent security interests are restricted or have limited value, are secured by contingent support from sponsors and other project participants.

2. Sources of Funds • Funds for project financing comes from variety of sources: such as: • equity capital, • governmental aids, • loans, which can be export (Eurobonds, private placement and commercial papers), • loans at favorable terms from development institutions such as the World Bank or the Agency for International Development, • loans from multilateral agencies (IFC, ADB), commercial bank term loans or loans backed by export credit guarantees.

3. Project Financing Risks • GENERAL RISK • Completion Risk • MARKET RISK • FEEDSTOCK RISK • POLITICAL RISK • FORCE MAJEURE • PERMITS • SPONSOR RISK • LEGAL RISK • ENVIRONMENTAL RISK • Foreign exchange risk • Interest rate risk

4. General risks • May be related to deficiencies in the feasibility studies: Too often preliminary studies fail to show upside potential and downside risk of the project. • Many developing countries, have spent time and money studying or constructing projects that turned out to be unfeasible. For example, • During the late 1970s and early 1980s, there were a substantial number of “white elephant” projects undertaken in developing countries for reasons relating more to national pride and other social considerations than to economic viability. • Projects that succeeded in the 2000s, are likely to be governed primarily by market driven considerations. • The World Bank and the European Bank for Reconstruction and Development will finance feasibility studies, as will the Overseas Private Investment Corporation (OPIC).

5. Market Risk • Related to the assessment of whether market exists for the energy produced. This part of the feasibility study is therefore key to the success of the project. • Cash flow projections may be affected by a number of factors, such as economic and industry cycles, demand from the retail and whole sale end users driving request for electrical power. • Competition from other producers, albeit non-existant in the emerging markets. • Market risk could be mitigated to some extent by putting in place contractual assurances. • Two major types of agreement can be entered into, and these are: take or pay • contracts or tolling agreements. • Take or pay contracts are contracts (generally used for commodities like electricity, oil and gas). In a typical take or pay contract structure, the contract is entered into between the project company and the buyers, but all payments arising from the contract are assigned by the project company to the lenders. • Production payment agreement (PPA). The financial effects of such contractual scheme are those of a financing arrangements (taking equity interest) through the purchase of a stake in the economical activity of the project. Such assignment guarantees the right to receive part of revenues generated from sales of electricity, up to retirement of the debt.

6. Tolling Agreement • Tolling agreements are agreements to put a specified amount of raw material per period through a particular processing facility. The toller, who is going to be the purchaser of electric energy (Dispatching), provides the toll processor (Power Plant owner) the natural gas for the production of electric energy and generally pays for transportation costs to the power plant. In this contractual scheme, therefore, both the fuel availability risk and the fuel supply risk are to be borne by the toller, while the toll processor is involved exclusively in the productive process. • The toller pays the toll processor a fee (called toll) • Clearly, the tolling agreement is closer to a conversion contract (or a service contract) than to a sale: the power plant does not sell energy, the toll processor is therefore a servicer and not a seller. • Usually, the toll processor shall: • Generate electrical energy with the gas or oil supplied by the toller, • Supply energy exclusively (optional) to the toller; • Hold the gas in custody on the toller’s behalf. Usually, the toller shall: • Supply natural gas and fuel oil; • Absorb electric energy in the determined amount or (optional) in minimum amounts (“take or pay” clause); • Pay the toll processor for the energy supplied, which usually includes: • a conversion fee (for the service); • a capacity availability fee; a fee for other services rendered by the toll processor connected to the energy generation.

7. Feedstock Risk • Related to the availability of feedstock (be it oil, natural gas, water etcetera). • Power plants require significant amounts of fuel to operate on ongoing basis, it is key to the success of the project to make sure that such fuel is available and will remain available during the operation of the plant. • In order to limit such the availability risk, lenders will normally require long-term supply contracts with the principal suppliers to ensure adequate supplies of the necessary volume and quality of feedstock at prices consistent with the financial projections for the project.

8. Political Risk • Political risks may be considered a sub-category of force majeure events. Political risks represent a significant factor in structuring the financing of a developing country power project. • Such risk may include: • Terrorism, war, civil war, rebellion, revolution; • Prevention of, or delay in, the payment of external debt by the host government or by that of a third country through which payment must be made; • Expropriation by the host government, either of equity debt interests or assets, or even bank accounts; • Cancellation or non-renewal of export licenses; • Actions or failure to act by governments in breach of international law, causing delay or stop in payments; • Destruction of all or part of the manufacturer's assets or debt servicing ability, or interruption of the manufacturer's operations.

9. Force Majeure • Force Majeure is a risk of a prolonged interruption of operations for period after a project finance project has been completed due to fire, flood, storm, or some other factor beyond the control of the projects sponsors. • Force majeure risks are circumstances that are not within the reasonable control of the parties. The acts beyond the control of the contractor, including acts of God, natural disasters, insurrections, civil disorder, strikes as well as political violence and other political acts

10. Permits • Permits are usually the responsibility of the sponsors or contractors. In order to attract lenders to the project, sponsors and contractors must be able to show that they have fully analyzed the regulatory structure of the host country and acquire, all necessary permits to get the project underway.

11. Sponsor Risk • Lenders analyze in depth sponsors’ and other participants’ strengths and weaknesses. Such analysis usually focuses on the strict financial strengths of the sponsor, such as • Balance sheet strength, proforma and projected earnings performance, and managerial skills of its directors. • The analysis of the track record of the sponsors in similar projects, and focuses also on examining, last but not least, the political support for the project, which is paramount.

12. Legal Risk • The contract should be carefully drafted to include provisions of governing law and consent to foreign jurisdiction. In case the consent to foreign jurisdiction is agreed, it will be necessary to ascertain whether local government will enforce and recognize foreign decision, or will tend to retry the matter in the court. • In some developing countries issues of sovereign immunity arise. Sometimes sovereign nations refuse to acknowledge foreign jurisdictions. Usually a provision waiving sovereign immunity both as to the arbitration and the enforcement of the arbitral award is included in contracts. It would be desirable to insert arbitration provisions in the contract, even though lenders are usually not willing to derogate to court jurisdiction. • Sponsors will usually insist for negotiating an arbitration clause or by applying • international conventions, such as the Convention on the Settlements of Investment Disputes Between States and Nationals of Other States (ICSID),

13. Environmental Risk • Projects In the past, were largely constructed with little regard to environmental issues or the adverse social impact of the project on local populations. • Lending institutions, host countries and sponsors are focusing much more attention on these issues today and in the future, particularly for projects that involve the production of significant hazardous waste. • As developing countries do not currently have a detailed codified body of environmental law, lenders will require project compliance with international environmental standard such as the World Bank guidelines or the standards from environmentally advanced countries, such as the U.S.

14. Financing project • Financeability of projects depends on country risk availability, mitigation and ratings. • The role of Export Credit Agencies & Development Agencies will be crucial. • Capital markets will play a minor role in project financing, especially in sub-investment grade countries. • Introduction of new insurance products may encourage both Bank & Capital Market Debt, • Domestic banks should play a greater role with local currency financing, overall project financing will become more expensive when available for emerging market economies

15. Benefits of PPP • Cost saving • Expedited completion • Improved quality and system performance • Substitution of private sector resources for the constrained public resources • Access cheaper source of funding

16. PPP Advantages • Accelerating the implementation of high priority projects. • Transferring private sector comparative advantage in procurement of service and technology to the public sector. • Delivery of new technology, engineering, design, etc • Reducing the role of government and encouraging privatization. • Innovative financing offered by private sector for funding public projects

17. PPP Domain of Responsibilities & Options Design bid, build Private contractor fee basis Build, Operate, Transfer (BOT) Build, Operate, Own (BOO) Design build Design, Build, Finance, Operate (DBFO) Public Ownership Private Ownership

18. Definition BOT • The build-operate-transfer (BOT), build-operate, and own BOO, and design-build-operate-maintain (DBOM) model is a form of public private partnership PPP that combines the design and construction responsibilities with operations and maintenance. These integrated PPPs transfer design, construction, operation and maintenance of a single facility or group of assets to a private sector partner. ResponsibilitiesA single design-build-operate contract for the entire project with financing secured by the public agency, under which the contractor provides long-term operation and/or maintenance services, with the public sector sponsor retaining the operating revenue risk and any surplus operating revenue.

19. BOT • Build-operate-transfer Public Sector (owner) Public Sector/Owner Toll from project by end users Funding Vehicle Engineering & Design Contractor Operator

20. DBFO • The Design-Build-Finance-Operate (DBFO) contract, where the responsibilities for designing, building, financing and operating are transferred to private sector partners. • Various risks in the various stages are transferred to the private sector • With respect to the degree to which financial responsibilities are actually transferred to the private sector, there is a great deal of variety in DBFO arrangements in the United States and Europe,. • Practically all DBFO projects are either partly or wholly financed by debt leveraging revenue streams dedicated to the project.

21. DBFO Approach • The DBFO approach transfers responsibilities for designing, constructing, financing and operating projects to the private sector, allowing it to consider these obligations as an integrated whole throughout the contract period. A 30-year term was chosen in order to maximize the benefits of this so-called “whole-life” costing approach. • The objectives for embarking the DBFO initiative are: • to minimize adverse environmental impacts while maximizing benefits for motorists; • to transfer various risks to the private sector; • to promote technical, operational, financial and commercial innovation; • The shadow toll approach has also proven attractive for investors. Its main benefit is that it minimizes traffic risk. Given that drivers themselves do not have to pay tolls, their choice of travel path is made solely based on time, distance, and convenience, and is therefore much easier to predict. • The United Kingdom maintains extensive records of traffic volumes and this data has enabled concessionaires to project revenue streams accurately enough to obtain financial guarantees from AAA-rated insurance companies, enabling concessionaires in turn to float their own AAA-rated bonds.

22. DBFO • User fees (tolls) are the most common form of revenue stream. However, others ranging from lease payments to shadow tolls and vehicle registration fees. • Future revenues are securitized to issue bonds or other debt that provide funds for capital and project development costs. The public sector may provide grants in the form of cash or contributions in kind, such as right-of-way. In certain cases, private partners may be required to make equity investments as well. • In Europe, Latin America, and Asia, where the DBFO approach is commonly used to develop new toll road projects, the debt is issued by private concession companies who are fully responsible for designing, building, financing, and operating the projects. • It is often more cost-effective for public project sponsors (in the USA) to issue debt than their private sector partners, because of their ability to issue low- interest tax-free debt.

23. Definition DBOM • ResponsibilitiesDBOM is a public private sector contract for procurement of public goods, where as project financing is secured by the public agency, under which the contractor provides long-term operation and/or maintenance services, with the public sector sponsor retaining the operating revenue risk and any surplus operating revenue.

24. Definition BOO • The build-own-operate model, a private company is granted the right to develop, finance, design, build, own, operate, and maintain a project. • The private sector partner owns the project outright and retains the operating revenue & risk and all of the surplus operating revenue in perpetuity. While this approach is more common in the power and telecommunications, it has also been used to develop transportation infrastructure.

25. Design-bid-build • Is the traditional project delivery approach that was used for most of the 20th century to procure public goods. • The design-bid-build model unbundles design and construction responsibilities by awarding them to a private engineer and a separate private contractor. By doing so, design-bid-build separates the delivery process into three phases: • 1) Design, • 2) Bid, and • 3) Construction.  

26. Project Delivery • four major components of project delivery are: • contracting • compliance with environmental requirements • right-of-way acquisition • project finance

27. Types of private sector involvement • Types of private sector involvement in infrastructure development contracts: • Contracting out • Private financing of public facilities • Leasing • Joint ventures • BOT • DBFO • BOO • Privatization

28. Phases of a PFI Project • Identification • Tender Prepared by Government for qualified bidders • Selection • Development • Implementation • Construction • Operation • Transfer

29. Project Phases • Economic framework • Government’s role and support • Transfer technology and capacity building • Procurement issues • Financial and economic appraisal • Risk management