CHAPTER 5 ALLOCATION OF RISK

He who doesn'l take risks, doesn't drink champagne. - Alexander Lebed (95 -! ",#$ssian %eneral and politician
A successful project musl benefit from workable, commercially viable and cost-effective risk sharing- Given the differing interests and objectives of the parties involved, effective risk allocation will be an essential part of the drafting of the project documents and an integral part of the project's success. Risk management based on efficiency is, of course, an ideal, a goal. n practice, risk tends to be allocated on the basis of commercial and negotiating strength. !he stronger party will allocate risk that it does not want to bear to the weaker party. !his scenario does not necessarily provide the most effective and efficient risk management.'"# mproperly allocated risk will have an impact on the entire project and may affect the stronger party as well as the weaker. $fficient allocation of risk will generally result in a more successful and profitable project and will benefit each of the parties involved. An oft-%uoted approach to #efficient# risk allocation places each ruk on the party best able to manage that nsk. &hile a useful role of thumb, ttui it a grots simplification 'ee chapters (-) of *elmon. +roject ,inance. -.! +rojects and Risk /01234 for e5ample, risks also need to be borne by the party that has an interest m managing proactively. and has or will obtain the resources needed to address risk issues as and when they arise 6the sooner the better7 in a manner intended to reduce their impact on the project. !he nsk bearer should also understand the risk, be aware of its namre and conse%uences, and hflve access to die right support, technology and resources 10 manage the risk when it crystalli8es, and its impacts 6in particular those to which the project is most vulnerable3. 9onsideration also needs to be given to the party that can manage he nsk at he least cost $fficient risk allocation re%uires consideration of value for money and a host of other issues. -usiness Roundtabie in #9ontractual Arrangements# A 9onstruction ndustry 9os: $ffectiveness +roject Report. !he -usiness Roundta;e. ;ew <ork 6.ctober &9'!" (22

(2=
(ri)a* 'ie$r +n)amtnl m infraimirlurr

Figure 5.1 : Efficient Risk All c!ti n

fill= ,rani-tr ,inancing for a project is provided by lending institutions, banks, bondholders or other entities which are not generally in the business of construction or operation of such projects. ,urther, lending institutions are generally heavily leveraged in the range of eight or ten to one. (#' !hese lenders will not be in a position, and therefore will not want, to lake many of the risks commonly associated with such projects. n order to avoid bearing project risk, he lenders will insist in he conte5t of their review of the project documents that, as far as possible, 6he project risks are allocated to the project participants, such as the construction contractor and the operator, and away from the project company, their debtor.

Figure 5.": Risk All c!ti n in Pr #ect Fin!nce

Risk ln ;evin and ,abom. +roject ,inancing >t (1 /?tb edition (@@23.

./m s $%&' f'( $- t$t

(2A !he projetl participants will charge higher fen 6a nsk premium3 for bearing such project risks, which will be included in the contract price, increasing the financial e5posure of the lenders. -ut such increased sums will represent value for money for the lenders, since the project participants are better placed to manage such risks and the lenders will be able to evaluate their e5posure and cost the risk.

5.1

ALLOCATION OF

RISK

n most conventionally financed projects, il is accepted that certain risks 6such as market risk, certain political risks and completion risk3 will be allocated by the grantor to the project company in reunion to the role the project company plays in he project. ,or bearing such risks, the project company is compensated by return on its investment. Boweve!, project financing is obtained primarily through the lenders, rather than the investment or liability of the shareholders. !he project company, as a special purpose vehicle, must avoid taking on risks which the lenders are not prepared to assume. !he lenders will be compensated for their financing of the project in the form of a rate of interest appropriate to structured lending and will not benefit from project revenues which are higher than forecast. Residual risk will be borne in the first instance by the project company and therefore by the lenders !he lenders will attempt to limit their assumption of project risk by allocating to the project participants the risk placed on the project company through the concession agreement. ,igure 2.) provides a rough guide to the impact these risks can have on the various phases of a project, but is merely a rough generalisation since +++ projects will differ in scope, content and nsk structure. !he period termed #pre-construtu.in# on the chart indicates the site investigation, testing and basic design phase, before the commencement of work on the site.

0hap$r i Alto1aliim a-gisk

Ascertaining which parties will be affected by a particular element of risk can be %uite complicated since project participants may assume several project roles 6for e5ample. he construction contractor may also be one of he shareholders andCor the operator3. ,igure 2.D shows generally the risks shared by project participants, assuming the project company, and therefore the lenders, will bear a portion of each of these risks. Also known as a #risk matri5#, project participants will use far more comple5 and sophisticated veisions of this matri5 to chart risk allocation and establish project strategy. t provides a more easily digestible representation of the risk allocation that will be described in greater detail in the drafting of the project documents. Again, the risk matri5 provided below is only meant as a rough guide and should not be considered lo be e5haustive or e5clusive, since each project will have its own uni%ue circumstances, re%uirements, relationships and parlies. ,igure 2.D is complicated by the broad definitions of the risk categories, a necessity given the number of actual risks to be encountered as well as the individual nature of each +++ project and therefore the risks involved. t is also complicated by so much of the project risk being shared between several of the project participants. ,or e5ample, he operation risk is shared by the grantor where a change in law, a -orce ma2e$re event or other government risk occurs4 the construction contractor bears the risk for construction defects which might affect operation, while the offtake purchaser and the input supplier will be responsible for their interfaces with the operator and the operator will be responsible for operating and maintaining the project in accordance with the operation re%uirements, leaving the balance of the operation risk for the project company.

-+ = M

)eg
E E E

2 i' .u

3F

I 1
s

4hople ' Alhaaltm o- #at

1*1
!he effort io transfer all project risk to the project participants is known as #back-to-back# risk allocation. !he concession agreement will define what risk the grantor will take. All other project risk is borne by the project company. !he other project documents will transfer the risk allocated to the project company by the concession agreement #back-to-back# to the other project participants. 9omplete back-to-back risk allocation will result in the transfer of all project risk assumed by the project company to the other project participants, as shown on ,igure 2.2. Rarely, if ever, will a +++ project achieve complete back-to-back allocation.

Figure 5.5: +!ck,t ,+!ck Risk All c!ti n

Grantor

+roject 9ompany

'ubcontractors &hen drafting the project documents, one or more of the following mechanisms may be used to achieve back-to-back risk allocation. G +rovisions dealing with risk allocation can be drafted using terms and language mirroring thai of the concession agreement and other relevant project documents. ,or e5ample, identical descriptions of force majeure, or descriptions of events entitling the project company under the concession agreement, or the construction contractor under he construction contract, to e5tensions of time, will reduce ambiguity and gaps as between the two agreements. Bowever, in order for this back-toback allocation to function properly, the governing law clauses should be identical and the dispute resolution clauses should be linked 6for e5ample, through joined multi-party arbitration3. G .ne practical solution to avoid difficulties of matching cost and time risk is lo include #if and when# language 6also known as #pay-when-paid# and #lime-whentime#3 in the project documents. ,or e5ample, the construction contract can state that the construction contractor is entitled to time e5tensions under certain circumstances, if and when such

(ri)ait 'ector +n)tinntnl

in h-rmtr$r5irr

e5tensions are granted to the project company under the concession agreement. 'imilarly, the project documents may include pay-when-paid provisions which specify that project company obligations under the construction contract to pay e5tra costs to the construction contractor are conditional upon the prior recovery of such costs by the project company under correlative provisions of the concession agreement. 'uch provisions may be restricted al law.'# G ,inally, it is also possible to include in the project agreements an overriding provision that imposes on the project participants an obligation to perform so that the project company will not be in breach of its obligations under the concession agreement or which re%uires the construction contractor to undertake obbgalioita placed on the project company by the concession agreement or other agreements. !he follow ing is a discussion of certain basic project risks encountered in a typical +++ project, and how those risks are generally allocated among the project participants. t should be noted that considering risks in isolation is often unsatisfactory and does not provide a complete view of the project re%uirements. !he nature of the project participants and the project will have a fundamental impact on the risks encountered and their allocation. 'pecific risk management and mitigation instruments may be used, which are nol discussed here, for e5ample insurance.#D !herefore, the following nsk allocation analysis should only be used as a preliminary review. $ach project should be considered as a one-off with a uni%ue allocation regime.

5."

-E.ELOP/ENT RISK

!he development phase involves the preparation and procurement of the project up to financial close, including invitation to tender and bidding4 negotiation of the various project documents4 and obtaining debt and e%uity funding. Given the nature of he +++ project, its comple5ity and the length of negotiations, nsk borne during the development phase can be considerable. #= n the Hnited Iingdom these provisions ire regulated by the Bousing Grants. 9onstruction and Regeneration Act (@J 'ee also chapter K2 of 'criven. +ritchard and *eHnon 6(@@@3 supra note @1. i' 'ee sections D.D.).( and L 2.2.2 for further discussion of insurance. #' ,or further discussion of procurement and public procurement, see +bid at chapters ). (2 and (?.

0hopitr 3 Allocation o- #$6

!he early phase of development will generally be undertaken within the auspices of a procurement process, wherein the grantor defines the parameters of the project and goes to the market, or to parties with which be is familiar. ",, identify potential sponsors. !his process is oflen regulated by local law and may be influenced by he rules set out by multilateral organisations. !he grantor will put together a procurement package, including a call to lender, setting out the project re%uirements. !he tender package will be sent to all interested bidders !he process may include a prc-%ualiMcation phase and e5tensive diplomatic missions by each of the interested sponsors' representatives in order to secure a preferential place among the several biddcis. !he piujcci company will probably not e5ist at this stage,' (K therefore the sponsors will undertake the early development tasks directly. !he sponsors will need to undertake planning and feasibility studies and testing and review of technical, environmental and other ic%uirements of the grantor. !he cost of such reviews, including preliminary design and creating an appropriate consortium of project participants, will involve a reasonably heavy outlay of funds by the sponsors .nce he project company is formed and funded and has won the project, the sponsors will want lo recuperate their costs. !his can be accomplished by selling the project to the project company((( or treating the investment in the development costs as in-kind e%uity investment. Bowever, the lenders may want additional capital invested in the project company and will therefore want the sponsors' compensation for development costs to be treated as subordinated project company debt, to be repaid only where sufficient cash is available to the project company after the project ralios have been satisfied.

50

CO/PLETION RISK

!he construction phase involves potentially ihe most costly project risk. !he nature of PPP projects is such that an incomplete project will be of limited value. !herefore, both the grantor and the lenders will have a significant interest in ensuring thai the works are completed in accordance with the projeel Although some jurisdictions re%uire the entity that submits the pre-%ualification application to be the same legal entity that submits the bid and in rum signs the concession agreement, for e5ample the Russian Law on 9oncession 6K11?3. !his means the project company must be formed before submission of3 pre%ualifkation applicar:N. ll should be noted that #selling# the project to the projecr company may involve ta5 liabilities or other unwanted legal conse%uences.

(ri)ate 'ector +n)estment in 7n-rtatr8clttre

specifications. 9ompletion risk includes construction, testing and commissioning of the project. !his risk is then allocated to the construction contractor by the projccl company.

5.).1 C nstructi n
!he project must be built in accordance with the re%uirements set out m 6be concession agreement. !hese re%uirements will describe the performance to be obtained from the finished works, other re%uirements of the offtake purchaser and the characteristics of the project, including the re%uirements of the operator and, in particular, the grantor for operation, maintenance and the life-cycle of the project. 9onstruction nsk includesO G the ade%uacy of the design of the works4 = he nature of the technology to be used and the risk of defects in e%uipment or materials, ' unforeseen events or conditions, such as e5treme weather or unforeseen subsurface conditions4 G environmental risks arising during construction4 G the availability of labour and materials, whether skilled labour can be procured locally, to what e5tent both labour and materials will need to be imported, visas and licences for such importation and restrictions imposed by local labour laws Pincluding working hours and holiday entitlement3. v the availability of e5perienced rnanageinent, commined to the project4 - the availability of associated infrastructure and services, such as access roads, the provision of services to the site 6including water, electricity and other utilities3 and transportation to the site for labour and materials4 ' the programme for completion, whether the time for completion is realistic in view of the labour and materials re%uired for the project, the technology in %uestion, the limitations of the host country mfrastructure, climate and market, design re%uirements, and testing and commissioning4 G the cost of completion, changes in the market for labour and materials, services necessary for construction, financing cosls, administrative costs and other costs subject to change over the period of the construction contract4 and

0k9$rr i A:ocat;: o- #$t

G political and natural force majeure 9onstruction nsk will generally be allocated to the construction contractor, as it is the construction contractor who designs and builds the project. n order to ensure proper back-to-back apportionment of the construction obligations, the re%uirements for the project should be defined veiy specifically and completely in the construction contract based on the re%uirements and the specifications for the concession agreement. Any gap or inconsistency may defeat the back-lc-back allocation of risk and leave additional residual risk with the project company. !he project company may want to impose a fitness for purpose standard on the construction contractor A fitness for purpose obligation will help maintain the fi5ed price, by placing on the construction contractor the obligation to ensure the design is sufficient for the purpose intended for the project, and therefore decrease the need for variations in the scope of works.#(

5. I : C 11issi ning
After the construction contractor has finished construction of the project, it must satisfy certain tests and inspections in order to demonstrate compliance with the project specifications, successful connections with any e5ternal network 6such as a power grid or a water system3, and proper management of interfaces between different e%uipment and technologies used in the project. !he responsibility for commissioning the project is generally allocated to the construction contractor. !he commissioning may be earned out in part, or verified, by he operator and possibly an independent engineer, but the responsibility for successful completion of commissioning will remain pnmarily that of the construction contractor. !he commissioning re%uired by the project company to ensure compliance of he constructed project will need to be specifically defined. !he independent engineer will probably be involved, or at least present, during this testing. !he operator and possibly he offtake purchaser may also want to play a role in the commissioning of the project in order to ensure thai the project as completed is in compliance with their re%uirements. !he project documents will need to define a procedure for the performance of these tests and the involvement of the various interested project participanls. 9omimssioning will often involve a performance component to ensure thai tninimum levels of performance are achieved before taking-over by the project ,or further discussion of the #fitness for purpose# standard, see chapter ((

(??
(ri)ate 'ector +rr)espnem in +n-rastr$ct$re

company. ,or this reason the construction risk and the performance risk, discussed below, will overlap to some e5tent. 9ompletion, as evidenced by successful commissioning, generally involves a substantial transfer of risk away front the construction contractor, through taking-over, and a si8eable payment to the construction contractor as an incentive to conmlete the project successfully. -y adding a performance element into completion, the project company increases the risk allocated to the construction contractor. ( Given the construction contractor's need to ensure performance of the finished project, new or innovative technology is seldom utilised in project financing. ' !he construction contractor will not wish to warrant the performance of new technology, nor that design and construction will meet the projected time and cost commitments. ,urther, ihe lenders are not normally prepared to bear the project risks involved in new or untested technology. Guarantees may, however, be available from suppliers of e%uipment involving new lechnology, the benefit of which will be given to the project company.

5.).)

Ti1e f r c 12leti n

!he lime for completion will be of great importance for the project company, the grantor and the offtake purchaser. !he project company will want to commence operation of the project as soon as possible in order 10 earn ma5imum revenue and improve return on investment !he grantor and the offtake purchaser will have put the project out to tender owing lo a pressing need for the service to be rendered and will therefore want the construction completed in the least possible time. !he government may have given political undertakings to complete the project within a specific time frame or before the ne5t election. As the construction and commissioning risks are placed on the construction contractor, so too will be he risk of timely completion. f the construction contractor tails to complete the works on time, sanctions will be imposed, lo reflect the losses the project company will incur, which may include debt servicing re%uirements, input supply agreement penalties, offtake purcbase agreement penalties and concession agreement penalties.

(rinsky6icQ3 supra note 2( at 2.

0hapler i Allocalam o- got

H>

5.3

COST INCREASE RISK

!he risk thai the amount forecast for the cost of construction and operation of the project in the financial model will, for some reason, be surpassed will need to be allocated As this risk is basic to the interests of the lenders 6who want to maintain a strict definition of their financial e5posure, the project cover ratios and he net benefit anticipated from the revenue slreaml. the risk of cost increase allocated to the project company will be passed very carefully on lo the project participants, as far as possible, and away from the project company. 9ost increase risk will be measured first between bid date and financial close. Lenders will not permit financial close unless the cost profile of the project as forecast at financial close provides a financially viable project tram their perspective e%uivalent to that identified at the lime of bid ,or this reason, mechanisms may be included in the project to adjust the bid price for changes in cost between bid date and financial close. !his risk is often shared between the grantor and the project company. !he management of cost increase risk between bid date and financial close will depend on the period between these two dates, the stale of the market and the nature of the particular project, and for these reasons w ill not be discussed in any detail here. 9ost increase risk will also arise as between financial close and from time to time throughout project implementation. !his risk is also generally shared between the grantor and the project company, but with the grantor taking a markedly smaller portion of this risk. 9ertain of the elements of post-financial close cost increase nsk arc discussed below. 9hange in law and other similar events which can increase the project cost will be discussed later.

5.3.1

E4c5!nge r!te risk

!here will often be interplay between currencies within the contest of the project.#= !he project participants may have revenues in one or more currencies, but costs in several others. 0ovement of funds between currencies can render the project vulnerable to changes in e5change rates. 'uch changes can often alter markedly the relevant revenue stream of the venture. !he power project developed by $nron in *habol. ridia, suffered from e5treme e5change rale shifts 6revenues in rupees and lending costs in H' dollars3 defeating its economic and commercial 'ee also section R. i on currency issues.

1*1
(ri)ate 'ector +n)estment in +n-raimc<re

viability. !he Asian crisis in ihe late (@@1s resulted in similar problems in power and water projects in ndonesia. !hailand and the +hilippines. *evaluation can have the same effect, where a currency is pegged against another currency 6usually the H' dollar3, the government may choose lo alter the relationship between those currencies or allow the currency lo float. !his happened in Argenuna in K11(. !he peso was pegged against the H' dollar, but due to the associated stress on the economy the peso was allowed lo float in the market. !his had a significant effect on the rale of e5change between the peso and the H' dollar. Any H' dollar dominated debt was affected accordingly. As an e5ample, the -uenos Aires &ater 9oncession was financed using foreign denominated debt. !he cost of that debt in pesos 6in which the revenue stream was denominated3 increased significantly with the devaluation. !his nsk can be managed by matching currency uf funding to cost and repayment re%uirements, by allocating it lo the project participants 6for e5ample, by re%uiring the construction contractor to denominate a portion of the contract price in local currency or by borrowing in local currency3 andCor by hedging the risk directly on the currency market. $ach of these solutions will be subject to market restrictions. Bedging may be impossible or prohibitively e5pensive 6especially over the long-term3. Local lending markets may not have sufficient capacity lo source the whole of the debt Another possibility is for the project company to allocate e5change rate nsk to the offtake purchaser by calculating the relevant portion of he payment obligation in the currency of the project company's e5penses 6i.e. the currency of operating costs, capital costs, input costs andCor debt servicing3 or in a basket of currencies 6where the project company has e5penses in several currencies3. f e5change rate risk cannot be managed within the project, government guarantees 6such as minimum revenue guarantees3 can address e5change rate risk by setting minimum revenue levels in the currency of debt. +artial risk guarantees 6see chapter A3 could also be used for events of devaluation.

5.3."

Interest r!te !n6 refin!ncing risk

!he interest charged for debl is either fi5ed at the time of borrowing 6fi5ed rale debt3 or varies based on radices or some other formula 6variable rate debt3 or some combination thereof. $ven where debt is sourced in local currency, and therefore avoids foreign e5change nsk, it may not be possible to access fi5ed rale local currency debt for the tenor needed to project finance. Lenders need access to

0hapter 2 Allocation )- #isk

1(
similarly fi5ed rale, long tenor assets in order lo be able to lend on such basis without tunning refinancing nsk 6the risk thai at the end of the tenor of the lender's asset, it will not be able lo find replacement funding on similar terms3. &here the project company mobili8es variable rate debt, the project company runs the risk that the rate of mlcresl will increase over tune. $ven where the project revenues increase with inflation, there may not be a linear relationship between inflation and interest rates leaving a potential revenue gap. !he Asian *evelopment -ank 6A*-3 is currently considering a contingent debt product that would provide the project company with access to debt once e5change rates e5ceed an agreed band. !his product would be offered to projects whose revalue stream was linked to inflation, under the theory of purchasing power parity whereby inflationary pressures on phces will over lime compensate for shifts in foreign e5change rates. !he A*- can take a longer-term perspective than commercial ienders and is therefore well placed to provide such a product. !his risk can be hedged through credit derivatives, by swapping for a fi5ed interesl rate, at a price. Bowever, such hedging arrangements may not be available for the whole of the debl lenor. !he project company can also borrow at shorter tenor, with a large bullet payment at the end of the tenor, which is then refinanced. !he refinancing risk of the project company can be mitigated through partial credit guarantees'# or by a third party guaranteeing access lo debt of the right tenor and interest rale at the time of refinancing.

5.3 0 Infl!ti n
nflation will affect project costs. !he project agreements will be fi5ed pnee. as far as possible, in order lo place the commercial risk of cost increase, including inflation risk, on the project participants and away from the project company. +rojections for inflation will be fed into the financial model for he project, and form an important part of project structuring, but any significant variation between actual and forecast inflation can have a serious impact on project viability 'ec chapter A on &orld -ank guarantees.

178
(maH 'tclor +mtimtm m l*-raitn*=5,rt

5.3.3 T!4es
!he projeel company may wish the grantor or he offtake purchaser to bear the risk of increased ta5es. Bowever, the authority acting as the grantor in the project may not be the same entity that regulates ta5ation4 in feet, the grantor may be politically or legally segregated from the national ta5 authority. $ven so, the grantor will generally be considered to be better placed to manage the ta5 risk, particularly where the grantor is funded by ta5 revenues, the reasoning being that the ta5 risk should come out of the same pocket that holds ta5 receipts. &here the project company must bear the risk of increased ta5ation, which could in turn increase the cost of project tasks, the project participants 6through fi5ed price project agreements3 will have to take a portion of the nsk of these added costs while the shareholders will bear the cost of additional ta5es on projeel revenues. $ven where the grantor will not take the whole of the risk of change in ta5, it may bear the risk of discriminatory ta5ation 6ta5ation aimed at the project or the projeel company3 as the only party capable of managing such a risk. -y allocating this risk to the grantor, an incentive is created, on he part of the host government, not to impose additional ta5es on the project

5.3.5 In2ut 2rice incre!se

n order to manage the risk that the price of inputs might increase, and therefore increase the cost of operation and decrease project revenues, the project company will enter into an input supply agreement to ensure that the pnee paid for inputs is consistent with tbe revenue of the project. !he cost of inputs under the input supply agreement is often fi5ed 6although inde5ed3, with only limited opportunity for modification 6for e5ample, where market prices are significantly different from the negotiated prices3. Recent spikes in the cost of petroleum products and therefore other fossil fuels provide a painful reminder of bow critical input supply increases are to project viability. !ransportation of input lo the project site may be more cH -cult to obtain at a fi5ed price. Also, where there is a free and li%uid market for 6he input, the project company may have to pay market price or may choose not to have an input supply agreement and instead purchase input from the spot market !he cost of a long-term, fi5ed price input supply agreement can be high, so only essential inputs 6such as coal supply for a thermal power plant i normally justify such a costly risk mitigation mechanism.

(A(

5.3.* C nstructi n c st incre!se

Given the time frames involved in +++ projects and the construction period, costs specific to construction, such as the cost of labour and materials, are likely lo change. !he project company and he lenders will want the construction contract lo be let for a fined price with e5tremely limited opportunities for the construction contractor lo increase the contract price. As far as possible, the responsibility for causing any increase to the cost of construction will be allocated to the construction contractor or the other project participants. ,or e5ample, where the works must be varied to lake into consideration changes in the offtake purchaser's re%uirements, the increased cost of construction will be allocated lo the offtake purchaser. !he critical nature of cosi inflation risk is highlighted by recent e5perience with dramatic increases in the global cost of slecl and cement, not to mention transport of materials. $ven where allocated to tbe construction contractor, such increases in cosi may not be tenable for a projeel and can create significant stress on project viability.

5.3.7 O2er!ti n c st incre!se

!he projeel company will need to manage its operating costs in relation to the revenues it receives from the project. deally for the project ccanpany. he operator will be paid a fee based on the output the projeel achieves 6although the operator will be insulated from any reduction of output caused by construction defects, market risks or other risks not attributable lo the operator3. Bowever, particularly in developing countries, the operator may not be willing to bear this long-term risk and may only be willing to fi5 a profit fee and identify a budget for operating costs which are then paid by the project company. 9ertain specific risks may be borne by the offtake purchaser 6such as damage due to failure of he offtake purchaser's infrastructure or increases in the underlying cost of operation, possibly inde5 linked3 and the input supplier 6such as damage caused by improper input %uality3. !he construction contractor will usually be responsible for the cost of repair of any defect discovered during the defects liability period. !he project company will then bear all residual operation cost increase nsk. !he project company's share of this risk is generally larger than other cost increase risks.

5.3.9 C st f s2!re !n6 re2l!ce1ent 2!rts

!he construction contractor will generally be re%uired lo provide ihe operator with a certain supply of spare parts upon completion of the project !he project company may in rum be re%uired to provide the grantor with spare parts al the end

!K
(ri)ate 'rcl$r 7n)esomertt at +lt-i-attr8caire

of ihe concession period. !he cost of these spare parts will be affected by market forces. !he project company may also need to provide for replacement parts, either as part of the operation and maintenance agreement fee, or separately. !he nsk involved in changes in such costs will generally be managed by either applying a market price or fi5ed price or including the price of the parts into the fi5ed price of the construction contract or providing for a separate contract with a supplier, fi5ing ihe cost of parts for the duration of the concession period or some pan thereof !he issue of the cost of spare and replacement parts corresponds necessarily wilh projected life-cycles for plant and e%uipment and other indications of the type and %uantity of such parts which will be needed for the project. 'ome or all of the nsk of the accuracy of such projections could be allocated to the party providing the projections, which is often the construction contractor. Replacement parts may also be needed where technology updates are necessary for he continued performance of the project. !his will be particularly relevant in information technology and telecommunications projects, where software and. in some cases, hardware, updates will be key lo competitiveness and offtake pricing of the project

5.3.: -ecre!se in fft!ke 2rice

ncreases in project cost are measured against he income made by the operation of the project. !herefore, where ihe project produces a stream of output which is to be sold and the pnee received for the output of the project decreases, the gross margin will decrease. n order to provide a secure payment stream, the projeel company will enter into an offtake purchase agreement to ensure the amount of revenue the project company will receive from output &here output is reduced owing to risks not allocated to the project company, the offtake purchaser will still pay the tariff under a take-or-pay obligation- .fftake purchase agreements are not appropriate for every +++ project, in particular where the payment stream is provided by the grantor, or where there is a vibrant market for the offtake.

5.3.18 C ;er!ge f c st ;errun risk

As noted above, cost increase risk is substantially allocated to the projeel participanls through the projeel documents. Bowever, the lenders may want additional facilities put in place to protect against failure of the project from cost

0hapter 5 Allocation o- #ah

(A) overruns. !hese facilities will generally involve additional funds available to die project, as follows.

5.>.& .& 0ontingenc8

&hen budgeting for project costs, a contingency will normally be included for unforeseen costs. 9learly the amount of contingency built into the project cost model will make the project relatively more e5pensive. 9ompetitive pressure from the bidding process is intended to drive down these added costs.

5.>.& .! 'ponsor s$pport

+rovision may be made for the shareholders to advance the funds needed to complete the projeel when cost overruns have occurred. !his additional capital may be provided in he form of a stand-by subordinated loan or as a stand-by capital contribution. +rovision for such capital will need to be made in the shareholders' agreement, direct agreements andCor the lending agreement, and will usually be subject to caps of total amounts to be provided and conditions thai must be satisfied before the obligation arises.

3.>. l..i 'tandb8 credit -acilit8

Lenders may provide standby credit facilities for cost overruns. $ither the lending agreement or a separate agreement with the lenders will provide for such a facility !he project company will generally need lo pay an additional availability fee for stand-by facilities.

5.>.& .> #isks arising between bid s$bmission and -inancial close
Although careful forecasts will be made at the time of bid, project agreements such as the construction contract and the financing agreement that set prices, interest rates and fees will not be binding until financial close. !he project company and the grantor generally share the nsk that inflation or interests rate changes between the date of bid submission and financial close e5ceed reasonable forecasts.

5.5

PERFOR/ANCE RISK

lo order for the projeel lo maintain sufficient revenues to satisfy debt servicing and to provide a return for the shareholders, the project must perform to specified +b?i Q(1

(AD
(ri)ate 'ector in)estment in +n-rastr$ct$re

levels. !herefore, performance re%uirements are provided in the concession agreement and the offtake purchase agreement which re%uirements are then passed on lo the projeel participants 6in particular, the construction contractor and the operator3. !he nature of the performance element will depend on the type of project. ,or e5ample, a roadway will only necessitate limited performance re%uirements for construction, related to the effect of bad weather, lighting, drainage, and wear and tear.

5.5.1

-esign !n6 c nstructi n

!he construction contractor will be responsible for designing and building a projeel capable of performing in accordance with the specified standards. Bowever, this aspect of the performance risk will not be borne entirely by the construction contractor, whose liability will generally be limited, often to the contract price or some portion thereof. Residual risk will be borne by the projeel company, and therefore the lenders. !he lenders will generally <e willing to bear some portion of the performance risk to he e5tent that it is based on proven technology, thai the technology is projected to remain competitive with the relevant industry and the project life is significantly longer, often at least twice as long, as the life of the debt. m((= !he technology used in the project will be warranted <= the construction contractor to a certain e5tent4 for e5ample, by it providing performance-related damages, an appropriate defects liability period and possibly a latent defects liability period. !he project company may also wish to obtain further guarantees from suppliers and designers where relevant. !hese other entities may be best able to cure any defect in technology or to update technology, as necessary. 'uch arrangements can give he project company the opportunity to utilise the latest technology with the best output available while allowing the e%uipment supplier or construction contractor to ensure a return on its research and development investment. nsurance can also be obtained for the technology used in a project, including, for e5ample, business interruption insurance for failed technology. !he project company will want to assess the nature of the risk, the cost of such insurance and whether the resultant decrease in lending costs or actual increase in security merits the cost of insurance. !msley6(@J3 supra note2l at'.

0hapter 3 Allotono* o- #ah

!'

>50 O2er!ti n
!he operator will he responsible for mainlining the project and operating it so that the re%uired performance levers arc attained. !he operator will therefore bear performance risk other than that related lo the design and construction of the project, the %uality of the input used or the manner of offtake or use of services from the project. Bowever, it should be noted thai the operator, particularly if it is a non-shareholder operator, may not be willing lo bear such a large part of he operation nsk, especially where it relates to cost of asset replacement, by accepting compensation based entirety on performance of the works. !he operator will probably limit its overall liability lo the profit fee it is lo cam on operation costs.

5.5 0

In2ut su22l=

n order for the project to reach the recruited performance levels, the input provided must be of a %uality sufficient for efficient operation. !he input supplier will be responsible for ensuring that the input provided is of such amount and %uality that the project can achieve the performance levels re%uired. !herefore, the input supplied will be tested before lis acceptance and the input supplier responsible for damages incurred if it is not of the agreed %uality.

5.5.3

Offt!ke 2urc5!ser infr!structure

!he construction contractor may be responsible for the construction of some portion of the transportation system for projeel offtake from the projeel, generally to the edge of the sile. .r the construction contractor will be responsible for providing some portion of the works needed for the offtake purchaser andCor project company lo use the facilities provided by the project. !he operator will be responsible for the operation of the project. Any shortfall in ihe performance of the project will be ihe responsibility of the construction contractor for defects, and of the operator for failure to operate and maintain such infrastructure in accordance with me specification. !esting of offtake is likely to occur at some point before delivery to or use by the offtake purchaser so that the risk of any defect caused by any subse%uent transportation is placed on die offtake purchaser. !his last point is of particular interest in the case of +++ power projects, where the project company will not want the testing to be affected by any default in the offtake purchaser's transmission lines or ihe grid. ,or instance, ihe fre%uency of ihe grid will affect the output of the plant. Any such knock-on impact would be the responsibility of he offtake purchaser, lo the e5tent that he cause of the defect in

(AQ
(mair 'ector +n)es5men m +n-iaarwcl$re

the transmission system or grid does nol have its origins in the operation of the plant itself.

5.*

OPERATION RISK

!he operation of the project involves certain risks of operation, performance and maintenance. Generally this nsk is shared by the operator and the project company, after takeover of the project from the construction contractor until the end of the concession period. .peration risk will includeO G the risk of defects in design, e%uipment or materials beyond the construction contractor's defects liability period4 G the availability of labour and materials, the cost thereof, whether skilled labour can be procured locally, to what e5tent both labour and materials will need to be imported, visas and licences for such importation and restrictions imposed by local labour laws4 G changes in operating re%uirements, owing to changes in law. regulations or other circumstances4 S the cost of asset replacement and major maintenance4 G the availability of e5perienced management, committed to the project for the duration of the concession period4 G the availability of working capital financing to cover short-term financing needs4 - the availability of locally sourcedCcost-efiective supplies and services4 v the availability of associated infrastructure and services, such as access ioads. the provision of electricity and other utilities to the site and transportation to the site for labour and materials4 G the programme for operation and maintenance and whether that programme follows a logical regime, correlated with the offtake purchaser's needs, and a realistic approach given the nature of the site country, government regulations on labour and operation and the technical re%uirements of the project4 and G othe! costs subject to change over the period of the concession.

.apitr 5 A@ocono* o- #$k

5.*.1 O2er!ting st!n6!r6s

n addition lo its responsibility to operate the project to given performance levels, the operator will be re%uired to operate the project in a proper and careful manner, so as to comply with applicable law, permits and consents4 and to avoid damage to the project, the site, local or related infrastructure facilities and neighbouring properties. !herefore, any costs or damages that might arise from the operation of the projeel, e5cept hose damages which are attributable lo one of the project participants or some third party, shall be to the account of the operator. !he e5tent of this responsibility will be carefully defined and limited. !he project company will bear residual costs and risks.

5.*." Tr!nsfer f kn ?,5 ? !n6 tr!ining

.ften in projects involving advanced or comple5 technology, one of the selling points for he grantor is the transfer of know-how to either its own personnel or local partners or subcontractors. !he grantor will often re%uire the construction contractor or the operator lo train personnel for the operation and maintenance of the project. !his training must be considered carefully in its detail, including the number of people lo be trained. ,ollow-up training may be re%uired. ntellectual property rights should also be considered within the conte5t of he project. !he project company should have a clear incentive lo provide such training, in the form of compensation or penalties, to ensure that training is provided in the manner and to the e5tent agreed. -reach of contract remedies will often be insufficient to protect the grantor against he failure lo receive training.

5.*) /!inten!nce
!he operator will also be responsible for the proper maintenance of the project until transfer to the grantor. !owards the end of the concession period il will be less important lo the operator to continue to maintain the project as before, since the operator will soon be transferring the project, and its revenues will no longer be as closely dependent on he proper and efficient operation of the project t may therefore be important lo the grantor lo re%uire thai the operator continues maintenance of the project lo ensure that the project does not re%uire substantial investment in replacement parts. !he creation of an incentive for continued maintenance may also re%uite some withholding of revenues 6or the delivery of a performance bond3 until satisfactory transfer of the works in a condition consistent wilh the handover standards

171
r9mHr iTt>r

li0imnl Q( ln"rmmcl-rr

5.7

/ARKET RISK

!he lenders will sol want to bear market risk in relation to the project, and will therefore re%uire that the contractual structure of the project allocates market nsk away from the project company and to the project participants. !he following are a few of the primary market risks which arc likely to be encountered m a +++ projeel 6though clearly many of the risks discussed earlier in this chapter can be considered market risks3.

5.7.1 Offt!ke @ ut2utA 2rice

!he most important market risk is the price obtained for project offtake or output Given the importance of the project's revenue stream in relation lo repayment of debt, ihe lenders will re%uire that market risk either be reasonable, foreseeable and manageable, or that market risk for the price of output be passed lo an offtake purchaser. l is relatively rare in +++ projects for the projeel company to bear full market risk on revenues, being usually limited to projects with output for which a very strong and fluid market is available. !his, for e5ample, may be the case in the electricity sector in developed countries or in the oil and gas industries globally. $ven m these cases, the lenders may re%uire contracts for differences or futures contracts lo hedge the risk of output price fluctuation 0ore commonly, the offtake purchase agreement will establish the price to be paid for output and will ensure a projeel revenue stream, subject to the proper operation of he project.

5.7." In2ut c st risk

!he cost of necessary inputs represents another area of substantial market risk. &here the project re%uires input for operation, and where the market for such inputs is not sufficiendy fle5ible or there is some concern as to its future viability, the lenders may re%uire that the project company enters into an input supply agreement. !his #input# may involve a service, for e5ample the transportation of coal for a coal-fired power plant or the disposal of sludge for a waste water treatment plant. !he input supply agreement will fi5 the cost of input supply, often over the period of the concession. !he cost of input will often form part of the calculation of the price paid for output by the offtake purchaser. n this way, he market risk for cost of input is allocated away from the project company and therefore the lenders

0harA' U :'=-'V iA(

5.9

POLITICAL RISK

+olitical risk, such as events of wa5. rebellion, default or failure of public sector entities, change in law and delays by authorities, can be a contentious issue. !he project company will not generally be able lo avoid or manage this nsk, and conventional insurance coverage may not be a practicable alternative. !he projeel company will attempt to allocate as much of this risk as possible to the grantor through the concession agreement. !he grantor may accept such risk as the sole party who may be able lo influence its advent and mitigate its effects. Bowever, host governments may not be willing lo bear all political risk, and may re%uire the project company to bear certain aspects or the majority of this risk as pan of the risk borne by anyone investing in that country. !he projeel company may in turn look to specialist political risk insurance or lo nternational ,inancial nstitution 6 , Iy0ultilateral Agency 60LA3 involvement or financial products(=1 to help mitigate this risk.

5.9.1 Aut5 rit= !1i en!<ling legisl!ti n

!he first %uestion to be asked when a government entity is involved in a projeel is whether that entity has the right or ihe power ()ires" to enter into he obligations involved in the project and what administrative or legal re%uirements must be satisfied before the obligations can become binding '# .ften, major infrastructure projects re%uire the permission of a governing body, cither the stale or the relevant local authority. Bowever, the identity of this authority may be different from the grantor which will gram the concession agreement 'eparate enabling legislation may be re%uired before the construction of the project can begin. .btaining such enabling legislation should generally be a condition precedent to the project documenls. !he continued effectiveness of such permission or legislation would be the responsibility of the grantor.

5.9." C5!nge in <u6getB g ;ern1ent r 2 litic!l !t1 s25ere

&hen faced with a government entity in a projeel it is important to ascertain whether the obligations once undertaken will continue where that entity's make-up changes !he membership of the government may change, budget restrictions may be altered, or he political atmosphere may simply become such that foreign involvement in mWastructure development is no longer desired. &here a '= 'ee chapter A for further discussion of risk mitigation producrs. ((( Hltra vires is discussed further in seclion R.)

(ri8atr 'ector +m)esrmeii in n

O. ". government xtk.es on such obligations, wilt they be adopted, or must they be adopted, by subse%uent governments or governing bodies where the identity of its members or even its political colour changesX !he risk of a change in political climate can have a greater effect on +++ projects than most others, particularly in developing countries. As an e5ample, a hydroelectric project in 'outheast Asia was significantly delayed following disagreements between the governments involved and uncertainties over the new government's willingness to work w ith the &orld -ank, one of the primary lenders. !he e5periences of $nron in ndia should provide an effective warning of the dangers of this nsk.#( !he grantor is the only project participant with the ability to manage the risk of change in political climate. ,or this reason, this nsk is often the responsibility of the grantor. Bowever, simply placing the risk on the grantor will not necessarily protect he projeel company and the other projeel participants, as the fact that he political change has affected the project will probably adversely affect the projeel participants regardless of the grantor's responsibilities. !hree methods of mitigating this risk areO G the consideration of the host government's interests, and their implementation in the project !hus, the host government should have an interest in the success of the project, and should receive benefit from itO G the involvement of local lenders and local shareholders or subcontractors, and G the involvement of some other government body, or possibly an international or multilateral organisation. &here the host government has an interest in maintaining the project's viability. he risk of political change is decreased. !his may involve providing benefits to local communities such as employment, housing, remvesuneot in the enfnoajajty, making use of local supplies, services and financing, or providing some valuable training, service .r investment- +roject participants can also fulfil bost government interests by providing a benefit lo individuals who hold political power or by '=' !he Bouston, !e5as-based firm of $nron invested in the H''K.' billion *habol power project in the stale of 0aharashtra, ndia. After a change in government of the stale, the victorious righi-wmg nationalist alliance cancelled the projeel !he *habol project has since been renegotiated, at a lower price, and e5panded. #$nron and .n and .n# !he $conomist at @K6lDUune (@@A3.

ll supporting local politics. Bowever, it is difficult to ensure that the interests of one government or individual will be he same as the interests of subse%uent governments and individuals. An effective method of mitigating the risk of political change may be lo involve a multilateral organisation, such as the $uropean -ank for Reconstruction and *evelopment, the Asian *evelopment -ank or the &orld -ank, or an e5port credit agency in the project. Grantors will not generally ignore the interests of a multilateral organisation which provides them with financing for other projects. ,urther, a common precondition to the involvement of 'uch an organisation will be the membership of the national government m that organisation. Bost governments will generally not violate the interests of an e5port credit agency because that agency, although it might be private in nature, will have an e5plicit mandate from its government. ,or these reasons the involvement of such organisations can be an efficient method of mitigating the nsk of change in host government interests.

5.9.) E42r 2ri!ti n

it is a basic principle of international law that a sovereign government has the right lo e5propriate property within its territory for public purposes. = !he project company will need to put in place guarantees and undertakings to protect against this risk. &here the grantor involved in the project is the same authority that would e5propriate property, the concession agreement can act as a specific undertaking to restrict the grantor's right to e5propnale the projeel assets. !his may not, however, be effective under applicable law, nor indeed be enforceable against the grantor. A more efficient protection is to establish a regime for compensation for such e5propriation. Assurances can also be obtained from other government entities or by way of constitutional reform or enactment of legislation. As noted above, the involvement of an international or multilateral organisation in the financing of the project can put international political pressure on the host government .ften such pressure can provide a more effective protection for the project company than most other forms of guarantee &here the host government does e5propnale project property, international law states that the injured party must be compensated promptly, ade%uately and A sovereign state holds the power of disposition over its lemtory as a conse%uence of title -rownlil 6( &.3 supra note (() at (K). 'ee also 9hapter R for further discussion of e5propriation.

(=K
(ri)ate 'ector tn)tibnet* $i &$C? irr

effectively. !his position is often supported by national law. D( !he projeel company may want to identify in the concession agreement that ade%uate compensation must be paid and bow ade%uate compensation will be calculated. !his provision is sometimes known as a #compensation clause#. As an e5ample of e5port credit agency assistance. $9G* of the Hnited Iingdom, through the Hnited Iingdom's ,oreign .ffice, has negotiated various nsurance nvestment Agreements with countries around the world. !hese agreements arrange for suitable compensation payments in the evenl of any e5propriation or creeping e5propriation by a foreign country of assets ownod by Ber 0ajesty's Government or -ritish companies.

5.9.3

C5!nge f l!? r t!4!ti n

A project will be subject to ihe risk of a change in the laws 6or ta5ation3 of the host country or some other country. !he nsk of change in law will generally be bome by the grantor, or apportioned between the grantor and the project company. !he concession agreement may use one or a combination of the following approaches.

5.B.>.& %ramorrisk
n certain cases, in particular in host countries whose political systems tend to be less stable, the grantor may need lo bear the risk of change in law before a project can be considered bankable. !his is often the case in projects located in developing countries whose political history may include hostility lo foreign investors.

5.B.>.! Apportionment o- cost

!he change in law risk can be shared between the parties by apportionment. ,or e5ample, the project company may be re%uired to bear the risk of minor changes in law, where the cost of compliance does not e5ceed a specified amount 6generally based on a percentage of the contract price3, or the cost of changes m law up to a ma5imum percentage of the construction cost over the first few years of the project 6used in certain +, projects3. !he latter may be an effective solution where the project company is able to pass this risk lo the construction contractor. !he grantor will need to be aware of the cost to the project company of bearing change in law 0aryan6l=J3 jupnnote (() at (KK

.mptrr i Allocalirm o-Cak

19)
risk, which is generally prohibitively e5pensive 10 insure and difficult lo pass on 6to he e5tent it has an impact on capital works3 to any of the project participants,

5.B.> 3 Apportionment o- risk

Another melhod of allocating change in law nsk is to isolate nsk for different types of change in law. !he grantor may deem that the host country's legal system is sufficiently slable so that the project company should accept that he risk of trading in that country will include changes in law. as would any other pnvalc company operating in that country. Bowever, the project company will not wan: to bear the risk of changes in law which target the project, in particular, or the sector in which the project is involved 6which can amount to creeping e5propriation, for e5ample, if a special la5 or higher level of service delivery were placed on the projeel company, or on all private infrastructure companies3- !herefore, the grantor may retain the risk of discriminatory changes in taw, i.e. those changes which are specific to he sector involved, private financing of public projects generally or the projeel itself.

5.9.5 C5!nge in tec5nic!l reDuire1ents

9hange in law can include a number of different aspects of legislative, legal, judicial and administrative obligations such as changes in the administrative re%uirements placed on the projectO for e5ample, permits, consents or import licences. Bowever, technical re%uirements imposed by professional associations, or groups with a mandate which falls short of bringing them within the concept of administrative institutions, may not fall within the definition of #change in law#O e5amples would include certain environmental or safely re%uirements. 9onsideration should be givoi to the risk of change in such technical re%uirements, and how such nsk is to be apportioned.

5.9.* I11unities
'overeign entities have certain immunities before their own and foreign courts.# !he immunities most commonly attributed to sovereigns by national courts are jurisdiction and e5ecution4'D= which can generally be waived or limited at law. &here issues of sovereignty arc a concern and no method of waiver or other resolution is available, parties may wish to consider the services of he ,or further discussion of immunities see chapter ', in particular secuons R.? and -.@. C&at ((A.

(n)t$t 'ector +n)eitmtnl in +n-Da2o$ct$re

nternational 9entre for 'ettlement of nvestmenl *isputes 6 9' *3, a body created under the auspices of the &orld -ank but wholly independent. t provides dispute resolution services for disputes of all types between private sector investors and their public sector partners. !he treaty which established (9' * re%uires its signatory states to recognise 9' * awards as if they were final judgements rendered by their own national courts. !his therefore mitigates sovereign immunity risk. As a precondition, the contract musl make reference to 9' * dispute resolution or the parties must consent to 9' * jurisdiction.

5.9.7 Pu<lic 2erce2ti n

&here the grantor is a political entity, it takes on a further political risk in that the project is placed in the hands of a private seclor entity not necessarily affected by the political repercussions of its actions. !he public may not understand that the grantor is removed from the day-to-day operations of the public service which is the subject of the project and thus any mismanagement or politically unpopular decision made by the project company may be imputed to the grantor. Although the contract may provide for granlor influence in the selection of personnel to achieve a desirable image, the effectiveness of such influence may be practically minimal. !hus, the grantor will want lo consider the independent status of the project company and the potential effect the project company's actions may have on the grantor's political position and public perception.

5.9.9 P litic!l risk insur!nce

+olitical risk insurance or guarantees may be available for the project 9ertain government or private organisations 6such as e5port credit agencies3 provide such a service. !hey are generally supported by national governments and provide insurance for certain political risks. !he purpose of such agencies is to support national commercial interests 6for e5ample, the supply of goods and services from lhat country3, therefore the nature of the project and project participants will influence which organisations can be involved in the projeel and to what e5tent they will provide political insurance or other services. An e5ample of such a national agency is the .verseas +rivate nvestment 9orporation 6.+ 93 of the Hnited 'lates Government. t was established to support the Hnited 'tates' private sector investment in developing free markets by providing financing, e%uity capital pre-investment assistance and political risk

0hapter 5 Allocation o- #itk

insurance. !he insurance available from .+ 9 is generally limited lo ihe risks of currency convertibility, e5propriation and violence of a political origin. (D Guarantees in action !he Bub +ower +roject was a -.! project developed in +akistan in the mid- to late (@@1s at a forecast total project cost of H'Y(,R billion, involving H'')AK million in e%uity and ESS1.D? billion in debt financing. Tarious guarantees were provided by the &orld -ank, the $5port- mport -ank of Uapan 6now U-l9-i, 9.,A9$ of ,rance, 0 ! of Uapan and 'A9$ of taly. !he +rivate 'ector $nergy *evelopment ,und of +akistan, which is in turn financed in part by the &orld -ank, also provided subordinated loans.(D= ,or the Bub project, the &orld -ank provided partial risk guarantees for the following project risksO(D' G where the project company is no longer able lo convert local currency lo foreign currency4 G where a change in +akistani law alters the economics of the transaction4 G where a government entity fails lo perform its obligations to the projeel company under certain of the projeel agreements4 G where the government revokes or fails lo provide government consents re%uired for the operation of the project or servicing of debt4 G where the government e5propriates project company assets4 and G where the project company is unable to generate sufficient revenues due to war or civil disturbance in +akistan. -etancourt. #.+ 9 +olitical Risk nsurance for nfrastructure +rojects in $merging 0arkets# +roject ,inancing in $merging 0arkets (@@?O 'uccessful *evelopment of +ower. 0ining. .il and Gas, !elecommunications and !ransportation +rojects at (A@ 6(@J3.

1F*
'ector trne2,mem in in-rastr$ct$re

,or a projeel lo be eligible for .+ 9 involvement, it must demonstrate a positive effect on the Hnited 'tates' economy. !he project must also contribute significantly lo K the economic and social development of tbe host country. Restrictions on the identity of the party able lo obtain such insurance may have an impact on the decision about which of the project participants will bear which political risks. !he availability of political risk insurance may be a linchpin to a successful project. Lenders may not be willing to bear political risk and such insurance may simplify the provision of commercial funding. 9ertain countries continue to struggle with the implementation of project financing structures due to intransigence on these issues.

5.9.: S urce c untr= 2 litic!l risks

!he above-mentioned risks will also apply to the countries from which the plant, e%uipment, materials and specialised labour lo be used in the project are sourced. !hus, where an embargo, change in la5 regime, change in nr refusal of e5port licensing or other such political risk occurs in the source country, the project could be affected. ,or this reason, the parties will need to consider such risks in respect of source countries, their application to the project and how best lo allocate and manage hem

5.9.18 C5 ice f l!?

Although this does not result in a purely political risk, it should be noted that the project documents may be subject to the influence of differed legal systems. $ach contract will normally include a choice of law clause, and parlies will want lo apply a legal system with which they are comfortable and whose laws and contractual implied terms support thai party's intentions '# !herefore, a public sector grantor may not be willing to submit to any legal system but his own. while the lenders will want the lending agreements and possibly ihe construction contract and the operation and maintenance agreements lo be subject to a familiar legal

K*uvail, #&orld -ank 'upport for +rivate 'ec lor +rojects# +roject ,inancing in $merging 0arkets (@@?O 'uccessful *evelopment of +ower, 0ining, .il and Gas,
!elecommunications and !ransportation +rojects at AK 6(@@?3. ibid. Chidat (RD. N 'ee sections 2.R ?. R.R. R.@ and R.(R for further discussion of choice of law and rroplied terms.

0lmpler & Al@,ionem o- Hak

It? system 6generally $nglish Hw or the laws of ihe 'tale of ;ew <ork3. !his u particularly important in relation lo taking security, though conflict of law principles will apply lo many security issues. Baving the projeel documents subject to more than one legal system increases the likelihood that gaps will appear in back-to-back risk allocation. Bowever. he commercial reality is that mismatches in choice of law will often occur.

5B:

EN.IRON/ENTAL RISK

$nvironmental nsk has became a far more central consideration over recent years, particularly in developed nations. nternational conventions and the pressure applied by developed nations have encouraged developing nations to follow suit ,or this reason sponsors and governments alike will warn to consider carefully possible changes in environmental regimes and the potential conse%uential effects on the project

5.:.1

Len6er s2ecific issues

!he e5tent of environmental nsk will depend to some degree on the parties involved in die financing of the project ,or e5ample, a number of the key commercial lenders involved in projeel financing have signed on to he e%uator principles 6see -o53 which focus heavily on the importance of environmental responsibility. &here .+ 9 is involved in a projeel it will re%uire an environmental assess men: of he project. .+ 9 will apply the stricter of the local environmental regulations and those applied by the &orld -ank.# !he &orld -ank follows a concept known as #sustainable development# which broadly means #development that meets he needs of the present without compromising the ability of future generations to meet their own needs#.#(( 'imilar environmental assessment is re%uired by many of he primary multilateral financing organisations, such as ihe A*- and the $-R*. nternational environmental management standards have also been developed by the nternational .rganisation for 'tandardisation 6 '.3 in its '. (D111 series. -etaneourl P(1J3 Qtpn noli (DA ir (R2. #.ur 9ommon ,uture. &orld 9ommission on $nvironment and *evelopment# 6 (@RR3 as cited in Iwvia, #$nvironmental ssues in mcmitional +roject ,inance# +roject ,inancing in $merging 0arkers (@JO 'uccessful *evelopmeni of +ower. 0ining, .il and Gas. !elecommunications and !ransportaiicm +rojects at K21, K2?6(@J3. !he heightened importance of environmental issues is partially the result of the restructunng of the &orld -ank after (@RA 'ee generally Ibid at K@D.

Annie 'tem* linaanml in fcgf $%uator +rinciple= !he $%uator +rinciples'# 6 he +rinciples3 is a set of social and environmental benchmarks adopted by most international banks for managing social and environmental issues in project financing transactions. Adoptees of he +rinciples committed not to finance projects that do not comply with the +rinciples. !he $%uator +rinciples was originally developed by a group of private sector banks, led by A-; A0R., 9iugroup, -arclays and &estL-, to model on the environmental standards of the &orld -ank and the social policies of the +9. !he +rinciples was launched in Uune K11) and revised in Uuly K11? to reflect the updates of +9 performance standards. !he +rinciples now apply globally to all new projects and eiisting project e5pansions with capital costs above 'l.million. !he +rinciples also emend to project finance advisory activities. !he definition of #environmental damage# will change rapidly as our awareness of the effects of our actions on our surroundings increases. nternational organisations such as the &orld -ank have also permitted increasing involvement of ;on-Governmental .rganisations 6;G.s3 in defining and analysing environmental re%uirements. !his represents a potentially unlimited and undefinable risk. $nvironmental assessment of major projects can take as much as si5 to KR months and account for 2-(1 per tent of projeel preparation costlst !he primary aspects of a +++ project relevant to environmental risk includeO G buHding the project 6including the design and construction of the works34 v the maintenance and operation of he project4 and G he %uality of input provided. !he performance re%uirements linked with environmental issues will be defined by e5isting applicable law, the re%uirements of the grantor and any re%uirements imposed by lending agencies. !he $%uator +rinciples - A financial industry benchmark for determining, assessing and managing social A environmental risk in project financing#, Uuly K11? www.e%uator-princ iples. comCprinciples, shtml '* Ibidu K?(-K?K.

0hapter 5 Alloc*E o- #isk

5.:." Assessing en;ir n1ent!l i12!ct A- environmental impact assessment 6I A3 and statement 6$('3 will generally be re%uited either by the host country before a major project can be let or by the
successful project company. !he assessment will identify and help to allocate environmental risk. $nvironmental risk will be allocated between the grantor and the projeel company and then passed by the project company to the construction contractor, the operator and the input supplier. Allocating the responsibility between these entities for such nsk may not be straightforward. ne cause of environmental damage may be difficult to identify and the potential level of damages such that project participants will not wish to bear such risk. An important element of environmental risk relating to environmental regulation is the liability placed by law on the project company for environmental damages. 0any countries apply a higher standard of liability on the owners of property where activities on lhal property may cause env rronmenlal damage. t may prove difficult, if not impossible, for the project company lo allocate this liability lo other project participants owing lo the nature of the applicable legal liability.#

5.:.) /!n!ging en;ir n1ent!l risk

!he project participants may be advised to undertake preventative measures lo avoid disputes on environmental issues, such as byO ls= G meeting representatives of he local population and ;G.s early regarding any potential environmental impact of the project and available mitigation measures4 G enlisting he assistance of local e5perts, with credibility among the local population and the host government4 ' using the assistance of local partners for project development. G using project investment and project revenues to feed back into he local community, both economically and socially4 - creating appropriate lines of communication and contacts with host government authorities and agenciesO ,or further discussion of environmental liability, see chapter K( of 'cnven, +ritchard and *elmon 61:::A supra note :i i 0odltTed -TJUI KOTVU @1::*A supn note I % 1 at

1:8
(mctrr 'ector iir)tstmer$ m +n-immcmrtr

> ensuring appropnalc due diligence on local national and international environmental re%uirements4 G ensuring sharing of information with appropriate authorities in order lo obtain feedback and early approval4 and G developing an envuonmental management procedure for those involved in the project. !he lenders will wish lo pay special attention lo envuonmental risk, particularly where they are emitted to step in lo the project !he lenders will not want lo take on increased environmental risk if they step in. $5port credit agencies arc particularly sensitive to environmental risk, as are multilateral agencies, as discussed above. !hese entities will have their own particular environmental policies. !hey may not want lo be party lo he mortgage documents, in the event that the presence of a governmental body might encourage the host country or ihe relevant regulatory agency to pursue large claims against the lenders for environmental damage.

5.18

SOCIAL RISK

nfrastructure projects often 6ail due lo inattention to social risk, the reaction and interaction between the project and society wnt large - driven and defined by political philosophy, social mores and public demand. !he delivery of +++ infrastructure services 6in particular utilities like water and power3 is a public service, living in a commercial conte5t !his social aspect makes PPP investments more vulnerable lo social risk. 'ocial risk assessment and mitigation needs lo be an integral part of project design and implementation. Rather than rely on force majeure or change in law clauses to capture society's response to ihe commercial and financial arrangements represented by the project, proactive nsk management provides a more effective method of protecting the project from social risk. ,or e5ample, where a project re%uires the resettlement of indigenous populations, the mere compliance with law is often insufficient to manage the associated social nsk. nstead consultations with both the government and ihe project company can do much lo manage social risk &here service delivery is to be transferred bom a public to a private entity, efforts to reassure consumers can do much to mitigate risk.

F Allocaoan o- #$t

(=(

THIIMIM III'*'
n (@@@. the -olivian government swarded Aguas de !unari the right to operate all water resources in 9ochabamba. As part of the YK.2billion. D1ycar concession, the Aguas de !unari consortia envisioned a water network thai was projected to double the e5isting coverage area and also introduce electricity production. .n Uanuary K111. Aguas de !unari raised water tariffs an average of )2J to about 'K1 a month in a province where average wages do not e5ceed U!M. a month !o customers, they were simply paying more fur the same service. *emonstrations erupted shortly after he rate hike and the situation %uickly escalated, with ensuing riots causing the death of A people. Hpon heavy public pressure, the government rolled back the tariff and revoked the concession !he municipal utility again assumed water operations. 'ocial nsk. when properly managed, provides positive benefits for the projeel. *elivering services in a manner consistent with consumer demand can reduce the cost of service delivery and mitigate disputes. Reducing legal challenges proactively limits delays and costs in the long-term. ,inally, the grantor and the project company are beller of! having a frank discussion and establishing at contract agreed methods for managing social risk. Avoiding the issue and hoping for the best, though a common approach to social risk management, has proven particularly ineffective

5.11

CRE-IT RISK

!he project company and the lenders must be comfortable that the projeel participants are able to assume their projeel obligations, in order lo ensure the financial viability of the project. !his will include the financial stability, technical capacity, available resources, longevity, and nwuurerial capacity of each such participant. !he projeel company and he lenders will need to take a view on ihe ability to bear risk of the various project participants. &here he project company or the lenders are not comfortable with the ability of a projeel participant to bear risk, various methods aic available lo provide additional &orld -ank .$* +recis. # -olivia &ater 0anagement A !ale of !hree #, ;umber KKK, 'pring K11K

1:1
(ri)ate 'ectai tn)e2rmera in +n-raslr$cD$r)

protection lo he project, including the provision of third party warranties, bonds and guarantees. !hese may be limited to the most sensitive obligation of the relevant party. ,or e5ample, the most important credit nsit relates to the project payment stream, either from the grantor or the offtake purchaser. f this entity is a bad credit risk, me project company or ihe lenders may re%uire a guarantee from the busi government or some other creditworthy third party, letters or credit, an escrow arrangement over the entity 's income or a combination thereof.