Risk, Risk Allocation, Risk Mitigation & How to Ensure Flexibility In Project Finance
Risk and the risk mitigation instruments have been assessed in order to ensure flexibility in the view of Project Sponsors and Project Company and these elements have been examined in detail according to project finance documental phases and project finance contracts individually. Privileged analysis states project financing is dependent on contracts and governed by contract law. Generally, project finance risks are allocated to project participants, which are mentioned above, best able to manage the risks. However, the risk mitigation instruments incorporated in the project's contractual arrangements need not be all encompassing to provide the security investors require. Commitments might be limited in scope, amount, and duration. Commercial risk mitigation instruments commonly used in project finance by private lenders and sometimes by sponsors, generally these are the equity investors.
According to a research majority of the project finances (approximately over than %80) has faced with obstacles, namely; cost overruns, delay on completion milestones dates and lastly cash flow projection problems. As it seems, project finance is over risky and it can be easily affected by any small commercial condition. Therefore, project sponsors are in a need of greater flexibility in order to mitigate and curb the effects of economic hard times. Project's development phases are divided into two parts namely; Construction period including start up and testing and operating period. Possible risks for the construction phase are; Cost overturns, delays, start-up and testing problems, contractor payment defaults, hidden defects and force majeure.
Risk mitigation instruments for these risks are;
- Liquidated damages; cost overruns, delays, start-up, and testing problems.
- Performance bonds; contractor payment defaults
- Retain age accounts; contractor payment defaults
- Warranties; Hidden defects
- Contingency funds; cost overruns, delays, start-up and testing problems, contractor payment defaults and force majeure
- Insurance; delays, force majeure
Possible Risks for the operation phase are; operating efficiency problems, increase in routine O&M, increase in major O&M, market demand and pricing, input availability, force majeure
Risk mitigation instruments for these risks are;
- Take-or-pay; market demand and pricing
- Put-or-pay; input availability
- Pass-through; increase in routine O&M, market demand and pricing, force majeure
- Debt service reserve funds; operating efficiency problems, increase in major O&M, input availability, force majeure
- Maintenance reserves; increase in major O&M
- Cash Traps; operating efficiency problems, increase in routine O&M, market demand and pricing
- Insurance; Force majeure
- Tracking accounts; market demand and pricing
- Equity kickers; market demand and pricing
Some of them are appropriate measures to be adopted by project sponsor in order to get over the hard times. In case of cost overruns "contractual undertakings can provide the infusion of additional equity by the project sponsor, other equity participant or standby equity participants." And the other ways of risk mitigation are, standby funding agreements and the other alternative way is the establishment of an escrow fund or contingency account in order to complete the project. The ability of projects sponsors to produce revenue from project operation is the foundation of a project financing; the contracts constitute the framework for project viability and control the allocation of risks. Revenue producing contracts, such as off take agreements are critical. As a guarantee is a personal instrument given by the guarantor, it is only as good as the credit-worthiness of the guarantor. The off-taker purchaser must be creditworthy. The creditworthiness of the contractor determines the strength of contractual undertakings as a risk mitigation instrument. Thus, project sponsors consider all the possibilities and take into account their contractual arrangements. Ensuring flexibility in these contracts and having guarantees will facilitate their burden during hard times.
There are three main groups of instruments are used in risk mitigation during this period. These are contractual arrangements and associated guarantees, contingency funds and lines of credit, and private insurance.
The instruments most commonly used to mitigate risk, namely; contractual arrangements, contingency reserves, cash traps, insurance, and risk compensation devices. During operating period many contractual structures that can allocate risks, take-or-pay, put-or-pay, and pass-through structures are possibly the most frequently applied.
For the project sponsor, project finance enables him to insulate project risks from his portfolio of investments. He avoids the risk of bankruptcy from the failure of one project. Although he may be required to provide guarantees as credit support, the guarantee amount may be limited to a level he is comfortable with. Moreover, the impact of a guarantee on his balance sheet is less damaging compared to a direct loan even though the extent of liability is the same. Due probably to market inefficiency, in order to guarantee which is reflected as a footnote to the balance sheet tends to be viewed less unfavorably rather than a loan reflected directly on the balance sheet. Indeed, other credit enhancement devices like take-or-pay contracts may not even be reflected on the balance sheet. Such off-balance sheet financing can be extremely attractive to project sponsors as it enables them to avoid the restrictions on borrowing and creation of security interests found in their constitutional documents or existing credit facilities.