To

appear in Journal of Structured Finance, Winter 2016

A Framework for Understanding and Modeling Risk in Mega-projects and
its Impact on the Markets for Project Finance

Atanu Mukherjee1 and Purnendu Chatterjee2
{atanu.m@aculead.com}, {pc@tcgny.com}

Abstract

This paper discusses our approach to characterizing risk of large projects from the
perspective of project finance markets. Unlike current statistical and correlation
based mechanisms of risk characterization, we evaluate the dynamic nature of
complexity in large projects based on causality and explore its relation to risk. We
then suggest a framework to understand and model complexity and risk so as to distil
it into components, their interactions and their impact on access to project finance
and risk premiums. We then argue that adoption of such a framework can have a
transformative impact on mega-projects and the markets for project finance and
suggest how innovations in project finance can be accelerated using our framework.
We believe that infrastructure projects, project finance industry, banks, institutional
investors, mega-project sponsors, governments and multi-lateral agencies will
benefit from such a framework by being able to model, measure and monitor mega-
project dynamic risk characterization so as to structure, organize and finance projects
effectively on an ongoing basis. This we think will eventually expand the market by
increasing the number of participants, leading to enhanced market liquidity and
opportunity expansion in functional project finance markets.

Introduction

The worldwide market for infrastructure projects is estimated at over 40 TT$ over
the next twenty years [1]. Large multi-billion dollar industrial infrastructure projects
in areas like energy, steel, petrochemicals, and transportation can yield superior
long-run commercial and social returns but are prone to cost and time overruns.
These can often be severe leading to eventual project suspensions and
abandonments. Megaprojects are complex undertakings, with uncertainties and
changes being the norm and the success of the project depends on the ability to
characterize and control risks across the project lifecycle. This means that for these
projects to be successful they need to be structured, organized, financed and
managed in a way, which accommodates change, characterizes risk while minimizing
late cost, functionality and schedule impacts.

A key requirement for mega-projects is the need for project financing. Project
financing is different from traditional corporate financing of projects in that the
repayment of debts is tied to the cash flows generated from the project alone, and
any recourse to debt recovery in the event of default is collateralized only to the
assets of the project. The corporations liability as a sponsor of the project is limited
to its equity or debt participation and the project finance agencies recourse to
recoveries cannot be collateralized to the corporations other assets and cash flows.

To appear in Journal of Structured Finance, Winter 2016

This separation is necessary to encourage sponsors to undertake large and complex
projects without jeopardizing their current operations while financing it through
project finance markets at an appropriate cost of capital reflective of the risks of the
project.

Financing projects at this scale requires the participation of capital markets, the
government and multilateral agencies. Unfortunately, financial markets have proven
unequal to the task of funneling savings from places where incomes exceed
consumption to places where infrastructure investment is needed. In a world with
such huge infrastructure needs, the problem is not a surplus of savings or a
deficiency of good investment opportunities. The problem is probably related more
to the underdeveloped frameworks, instruments and institutions for infrastructure
investments, which incentivize a financial system to intermediate savings and
investment on a global scale [2].

In the aftermath of the 2008 financial crisis, most of the existing structuring
mechanisms and instruments for large project financing disappeared dealing a
severe blow to the capital markets for project finance in more mature markets of
Europe and the United States [3] . In the past one of the biggest constraints to project
finance in mature markets has been the perceived dangers surrounding the initial
construction phase of a project. This had lead to the muted development of project
bond markets. On the other hand markets for project finance in developing
countries - which has the most need for infrastructure capital - are underdeveloped.
Large transaction values, long tenors, ambiguity and uncertainty which results in
inadequate characterization of value and the risk spreads, are the primary
deterrents to markets for non-recourse or limited recourse project financing. Thus
the incentives to participate by banks, institutional investors and other financial
intermediaries in financing such large projects are significantly reduced. Because of
the large transaction values, the liquidity requirements from the market are also
high, and absence of scale in market participation makes the markets illiquid. While
mature markets have functioning project finance and limited project bonds market
[4]
, the avenues for project finance in developing countries today are very few. The
options in these countries are limited to some traditional large liquid banks and
institutions like Exim and IFC funding projects through some forms of syndication.
This has resulted in few participants leading to high market concentration and
artificial bucketing of all mega-projects into the generally undesirable below the
investable BBB category. Inadequate characterization of risks thus engenders
conditions in a funds-scarce market for higher project risk premiums resulting in
depressed project returns and often derailing the commercial viability of the project.

This situation is largely because of the ambiguity in the understanding of the
dynamics of large-scale projects consequently resulting in a lack of clarity on the
understanding of project value, characterization and assessment of risk and
structuring the project finance. Traditional methods of statistical risk modeling
techniques applied to mega-projects fall short of providing any meaningful value in
risk assessment due to the highly inter-coupled, feedback driven and non-linear
nature of interactions in a mega-project. Additionally, the unique and craft nature of
each mega-project limits the extent of reasonable analysis based on correlations of
comparative data.

To appear in Journal of Structured Finance, Winter 2016

If the causative factors driving the dynamic behavior of projects, its management
and hence its associated risks can be characterized, quantified and monitored in a
more accurate manner, the transparency and understanding will result in meaningful
assessment of dynamic risk profiles resulting in better risk assessments and
investments at appropriately priced project risk premiums. It will also expand the
market by attracting many more participants by drawing in large institutional
investors (e.g. insurance, pension funds) whose investment horizons match that of
the project tenors thus making the markets sufficiently liquid. Inclusion of more
institutional investors to complement existing banks, and enhanced market liquidity
also leads the way towards greater financial innovation and opportunity expansion
in fully functional project finance markets. This can have a transformative impact on
the industry and society.

The project finance industry and mega-project sponsors need a framework to be
able to model, measure and monitor mega-project dynamic risk characterization so
as to structure, organize and finance projects effectively on an ongoing basis.

Approach to Characterization of Risks in Megaprojects

In the context of mega-projects we view risk as the possibility that events, the
resulting impacts, the associated actions; and the dynamic interactions among the
three may turn out differently than anticipated [5]. Risks and uncertainty combine
with indeterminacy to create ambiguous decision-making contexts. Decision analysis
methodologies that have emerged over the last fifty years have been applied to
mega-projects with a hope to understand, anticipate and mitigate a mega-projects
turbulence. Some of the risks that can be identified through statistical analysis have
been applied with some success. The heuristics and correlation based mechanisms
used to establish causal relations for risk characterization traditionally are weak as
they systematically ignore feedback effects, multiple interconnections, non-
linearities, time delays, and the other elements of dynamic complexity seen in large
projects. Various methods to infer causality used today is based on things like
temporal and spatial proximity of cause and effect, temporal precedence of causes,
covariation, and similarity of cause and effect. These methods lead to difficulty in
complex systems like large projects where cause and effect are often distant in time
and space, where actions have multiple effects, and where the delayed and distant
consequences are different than proximate effects. Further, the assumptions in the
traditional models are typically at higher levels of aggregation of the project and
often underestimate the tail behavior and non-stationary effects that are typically
encountered in mega-projects The multiple feedbacks in complex systems cause
many variables to be correlated with one another, confounding the task of judging
cause through aggregate level black-box empirical observations. This leads to
inaccurate representation of risk because the causality is frequently misattributed
and we often hear consequences attributed to fat-tail effects and the likes.
Understanding and modeling causality based on system structure and interactions is
thus a determining factor in understanding the underlying behavior of these
projects. In mega-projects indeterminacy arising from possible external and internal
events, nonlinear interactions, feedbacks along with randomness and uncertainty

To appear in Journal of Structured Finance, Winter 2016

thus calls for a more careful and rigorous causality based approach to model and
characterize risk.

Our approach to modeling causality in a dynamically complex system like large
projects is based on the fact that system structure gives rise to behavior and hence is
key to understanding cause-effect relationships in terms of attributions, feedbacks,
delays and non-linear and higher order effects. Essentially, our claim is that if we do
not understand how large projects are structured, how the elements interact with
each other at the project, macro and industrial sector level, and how things like
change, shocks and delay effects propagate through the project - one cannot
characterize large project behavior and scenarios and hence one will erroneously
attribute causality and largely mischaracterize risk.

In other words, establishment of causality based on current models is largely based
on aggregate level black-box empirical observation and statistical inference in an
"open loop" system. Causality estimation based on facts, data and intuition around
system structure and behavior in the context of the macro-industry dynamics allows
us therefore to understand attributions, feedback effects and time delays in a
iterative top-down, bottoms-up manner in a "closed loop" system based approach.
We characterize risk based on this model of causality by framing dynamic models of
project structure and interactions and infer patterns of behavior based on hybrid
simulations using techniques from system dynamics [6] and traditional Monte-Carlo
mechanisms.

The Nature of Risk in Megaprojects

Megaproject risks differ according to types of projects depending upon the intensity
of technical, market, and institutional difficulties that they pose to the promoters.
Integrated steel plants, for instance, are technically complex and challenging to
execute, but they typically face fewer institutional risks, as they are socially desirable
because of their employment generation capabilities and industry multiplier effects.
The market risks are moderate though as they are particularly appealing in
developing countries with a high appetite for gross capital formation. On the other
hand power projects in developing countries, while technically less challenging can
have significant institutional and supply side market hurdles. This is particularly true
if the state owns the resources and institutional mechanisms for resource allocation
is in its formative stages. Whereas, petrochemical complexes have higher
completion risks, low institutional risks and lower market risks. Since the output can
both be sold in domestic and international markets, the primary market risk is that
of volatile prices than of capacity utilization.


Megaproject risks can be largely put in the following categories

1. Market Risks Market forecasts for steel, transportation and power projects are
based on assumptions about the structure and drivers of demand and supply.
Demand projections for high-volume commodity outputs from mega-projects, often
turn out to be widely off the mark. In some cases, errors result from shortfalls in

To appear in Journal of Structured Finance, Winter 2016

overall economic growth and in others, because of the unanticipated nature of
changes in the structure of demand. Dynamic demand models, which model the
underlying causality and interactions, supplemented with traditional methods is, in
our opinion, a better indicator of demand behavior and associated variability.
Similarly, supply risks also involve price and access uncertainties. Particularly, in a
developing country supply risks can be very important as nascent state institutional
mechanisms can misallocate raw material supply capacities [7]. Understanding
supply options and alternatives therefore becomes very important in the context of
the market risk characterization for mega-projects.

2. Execution Risks The Achilles heel of mega-projects is in technical, engineering,
design and construction risks during the execution phase. While mega-projects
usually have mature technology, arguably the principal risk in cost and time
escalations is in the design, engineering and construction phases of these projects.
The nature and scale of impact of risks in this phase can be severe both in terms of
direct project costs and importantly in terms of opportunity costs lost due to
schedule escalation. The resulting tardiness in time to capture capacity and
escalation of product price due to increased project costs can drive many projects
uncompetitive in the highly competitive global commodity markets. The Chevron
Gorgon LNG project in Australia jumped from by over 15 BB$ to over 50 BB$ [8] and
with a looming supply glut of LNG, the viability of the project remains to be seen.
Similarly, the Kashagan oil project in Kazakhstan, currently tracking at 50BB$, is 35
BB$ over budget and nearly a decade behind schedule [9].

Apart from institution related external shocks - poor project shaping ( aka as Front
End Loading ) , changes in scope, productivity, workforce availability, ordering
delays, project supply chain disruptions, rework cycles and technology uncertainties.
can escalate a projects time and cost baselines many fold. In our evaluation and
simulation of large projects using integrated steel plants as some of the candidate
models, we find that interactions of these factors form the basis of execution risk in
large projects. It has been argued that overall risk exposure could be minimized if
risk could be assigned, allocated and transferred based on the capacity of the party
to bear and control the risk in a large project [10]. Thus, frequently attempts are made
by mega-project sponsors to control the execution risk by transferring the
engineering and construction risk to turnkey contractors. However, if the project
execution risk is not well understood and its impacts not reasonably well
comprehended, attempts to transfer engineering and construction risks wholesale to
an EPC (Engineering Procurement & Construction) contractor may well increase the
risk of the project as the incompleteness of information is likely to leave sufficient
gaps for re-negotiations, escalations and claims in the contractual mechanisms. We
think that dynamic modeling of project behavior along with reasonably accurate
stochastic characterizations of the risk levers in the execution phase give us better
ability to characterize the dynamic behavior of the project during execution. This
gives us the ability for better qualitative and quantitative attribution of risks during
this phase which can then be used as a basis for allocation, assignment and transfer
on a more reasoned basis.

3. Institutional Risks Mega-projects depend on laws and regulations that govern the
appropriability of returns, property rights, and contracts in a country. Institutional

To appear in Journal of Structured Finance, Winter 2016

risks are greatest in developing countries, where laws and regulations are in
formative stages or are being reformed. Most common among these, are the
regulatory risks associated with delays and difficulties in obtaining approvals for
environmental, land, or social permits. Government agencies in many developing
countries have labyrinthine bureaucracies, which can delay and effectively endanger
projects simply by not granting permits. Rules on competition, pricing, entry,
unbundling, regulated rates of returns and other elements have adverse impacts on
mega-projects in most developing countries. Sovereign risks involve the likelihood
that a government will decide to renegotiate contracts, concessions, or property
rights. Changes in rules, property rights, and so forth, triggered by general economic
or political shifts are sovereign risks, which can lead to expropriation risks. The
seeming unpredictability of these events and the degree of adverse impact on a
project can well lead to catastrophic results, like what happened with Enrons
Dabhol Power Corporation in India [11]. In hindsight though, the seemingly
unpredictable event of reneging on off-take agreements in the Dabhol project was
an event waiting to happen. A more reasoned approach to understanding the
potential market side risks in the shaping phase would perhaps have revealed flaws
in the business model of generating power based on naphtha and LNG at four times
the prevailing local power price that was clearly unsustainable. Although, the
disruption manifested itself in terms of institutional behavior the underlying driver
was probably due to inadequate diligence in the shaping phase to understand the
market risk.

The ability to enumerate and model causality based on scenarios of known-
unknowns can provide useful insights into the nature of the impact of such events on
a mega-project. This provides the project sponsors and participants the ability to
design options that can be exercised in the event such risks unfold. The ability to
inject external events in a mega-project simulator during the project lifetime allows
the project sponsors and participants to take more real-time decisions on risk trade-
offs and alternative strategies for coping with institutional risks.

The Dynamic Interaction of Risks over the Megaproject Lifecycle

The market, execution and institutional risks in megaprojects interact over time in a
way where the risks emerge and characterize themselves from the point of decision
to initiate a project, through execution to the operation and end-of-life.

A typical mega-project lifecycle has three broad phases and the dynamic interaction
of risks manifests themselves in varying magnitudes during each of these phases as
illustrated in Fig 1 below.

1. Shaping Phase - This is the initiation and exploration phase which has the highest
risk and is typically financed by risk capital of the sponsoring parties [12] . Working
details to ensure viability, front end loading and pre-feasibility, identification of
known execution risks, sponsor identifications, financing alternatives and
evaluating options are key activities. While from a project finance perspective
there is little, if any, capital committed by the financing institutions it lays the
groundwork for all future phases and key to understanding, shaping and
mitigation of risks in the later phases. However, in our experience with many

To appear in Journal of Structured Finance, Winter 2016

large projects, we find that more often than not sponsoring parties

2. Execution PhaseThis phase entails the design, engineering, construction and
commissioning of a mega-project and has the maximum investment intensity.
For instance project finance requirements for large integrated steel plants can
range from 3 BB$ to 20BB$ over a period of 3-5 years and many risks emerge and
evolve during that time period. Similarly, a LNG plant can range 20 BB$ to 45
BB$ and if not shaped and managed pro-actively, the execution risks can escalate
the project cost many times. Diligent shaping has far reaching impacts on risk
characterization and reduction strategies during this phase. Characterization and
mitigation strategies for execution risks during this phase largely shape the
financing options and the risk premiums of financing.

3. Operations Phase Transition to successful and continued operation requires
that market risks are understood and performance of the plant reaches its
quality and capacity goals. While it is not possible to completely anticipate the
supply and demand side risks during operations, the deeper understanding of the
industry dynamics at both a macro and micro level can lead to a model
framework that can be made sufficiently robust to indicate ranges of variation on
demand and supply side parameters to address the effects of external shocks
and variations. Insights on potentially knowable external shocks are industry
expertise and knowledge dependent and a project can yield useful information in
framing the project investment strategy and mitigation mechanisms through
potentially exercisable options.

Fig 1- Phases in mega-project execution

It might be now useful to look at how the different risks interact over time across the
mega-project lifecycle. Institutional risks, for instance, usually diminish soon after
permits are obtained. However, they may re-emerge and affect the supply side or
demand side of market risks. For example a retroactive promulgation of ordinance
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To appear in Journal of Structured Finance, Winter 2016

canceling the mining block allocations for a steel plant can negatively affect the cash
flows in the operations phase and adversely affect the returns temporarily or
permanently. Pricing de-regulation may emerge well after the initiation of the mega
project and may manifest itself in competitive demand side and supply side pricing,
which will positively affect the cash-flows in the operations phase and hence the cost
of capital. Institutional risks may also affect the execution risks due to duties, taxes
and labor laws, which may positively or negatively affect the project cash flows.

Execution risks on the other hand can be characterized as engineering design is
initiated during the shaping phase, and construction plans are firmed up. As the
execution phase evolves in the early stages and the parties get better visibility into
the parameters, which have higher likelihood of changes and impact on schedule,
resources and costs, the execution risks can be better understood. This will be able
to provide the sponsors and the project financing institutions, a more objective and
dynamic risk trajectory of project execution. Generally speaking though, the
execution risks will start dropping after the initial engineering and design phase
completions.

However, it is impossible to know the magnitude of all the risks and shocks that a
mega-project will encounter particularly during its protracted execution phase and
to a lesser extent in its operations phase. Known risk levers, whose magnitude may
be unknowable in advance but demand appropriate actions when they manifest
themselves, can be tested for their effect in a model simulator. Our model
framework acts as a management flight-simulator for the reasoned assignment of
knowable risks within which risks are discovered, imagined, and assigned to a coping
strategy. The mitigation and coping strategies can be simulated using financial
mechanisms, institutional shaping, and project execution trade-offs. These what-if
simulations have the ameliorating effect of lowering the risk trajectories by testing
the effect of mitigation mechanisms thus helping increase the incentives to invest
through private placements, institutional investor participation and capital markets
while appropriately marking the risk premium of mega-projects.

A Framework for Modeling Causality Based Risk Characterization of Megaprojects

In the preceding sections we outlined the nature of complexity, causality and risk in
large projects due to non-linear interactions, feedback delays along with the random
nature of variability, which leads to indeterminacy of outcomes in various forms.

Our approach to modeling causality in megaprojects is based on iterative staged
approach which decomposes the structure and interactions into two stages. The first
stage lays out the project in the context of the industrial sector and the related
macro-economic dynamics by using a more top down model. This pre-supposes a
keen understanding of the working of the industry sector and the related macro-
economic and policy environment. In the second stage we model the dynamics of
the project using a more detailed bottoms-up approach and integrate its outcome to
the first stage.

Stage One Model

To appear in Journal of Structured Finance, Winter 2016

The top down Stage One model structure is built around three inter-related blocks of
demand, supply and price along with representations of shocks on the demand and
supply blocks for each sub-area of the model. We call this pattern an archetype as
it is the building block for representing the sub-areas and interactions between them
for the Stage One model. Fig. 2 below is our representation of the archetype.

Fig 2- Project investment causal model archetype

In the representation the boxes represent the stock variables and the arrows with
polarity are a simplified representation the causality. A (+) arrow means that an
increase (decrease) in the causative variable increases (decreases) the affected
variable. A (-) polarity means that an increase (decrease) in the causative variable
decreases (increases) the affected variable. The cause-effect relationships of these
variables may have time delays or propagation delays, in that the effect of a change
of the causative variable on the affected variable is delayed based on the nature of
the causative relationship. These causal variables along with time delays and feed-
backs interact with each other in self-reinforcing or balancing manners to exhibit a
pattern of outcomes over time which may otherwise appear counter-intuitive.

We will briefly describe one of the instances of the archetype, the Project
Investment archetype in the figure, which is primarily driven by Project Starts
(Drivers). The Project Starts will use price of steel as the signal and can also be due
to government investment initiatives, especially in a developing economy. As the in
number of project starts increase so does the demand for investments
(DemandFunds), however there will be lag for the investment demand to be realized
because a project start may have significant front end engineering and shaping
required e.g. with an average of 12 months before the actual demand for the
investment is realized for application to the project execution. This lag is
represented by the random variable Price Demand. Similarly, project starts will signal
banks and financial institutions to prepare for supplying funds (SupplyFunds) and
there could be a preparation lag by institutions (Price Supply). The interaction of
demand for project investments and supply of funds from the market will determine
fund gap or glut in the market (Fundsr). The increasing fund gap between demand
and supply of funds will increase the price of funds (PriceFunds) with a propagation
lag (Fundsr) as it gets applied to the project finance markets. Increasing price of
funds will in turn increase the supply of funds with a time lag (Price Supply) which will
decrease the gap, Fundsr. Similarly, increasing price of funds (PriceFunds) will
negatively affect the project starts thus reducing funds demand after a lag (Price

To appear in Journal of Structured Finance, Winter 2016

Demand

) and so on. The demand and supply variables may be subject to shocks
(ShockSupply, ShockDemand). A positive supply and demand side shock in the
investment archetype could be sudden easing of monetary policy and a negative
shock for projects in emerging markets could be throttling down quantitative easing
in the US. Again these shocks manifest themselves with lags (Shock Demand ,Shock
Supply
). These interacting loops of demand, supply with lags will exhibit a stable or
unstable dynamic behavior over time.

We have used this primary archetype for the other building blocks in the Stage One
model and then modeled their inter-relationships and an instance of the model for
the steel industry is shown in Fig 3. It integrates the product market, raw-materials
market, project investment, land, labor, and technology & equipment instances of
the basic archetype and drives the Stage Two model through new project starts with
the project execution model [Fig 5- Project Work-Rework Model] archetype. We use
a hybrid continuous and discrete mechanism to simulate Stage One and the Stage
Two models to understand the overall behavior of the project in the context of the
macro-economic and industrial environment.

Fig 3 Stage One model

Stage Two Model

The Stage Two Model is embedded in the Stage One Model which is more of a
bottom-up project execution dynamics model based on our analysis. Stage Two
model uses the outputs of workforce, supplier and resources like land as stocks from
Stage One model, which otherwise would have been defined exogenously.
Similarly, Stage Two models outcomes further drive the supply and capacity addition
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To appear in Journal of Structured Finance, Winter 2016

parameters in the Stage One model.

In our analysis of mega projects, ( a mega project being defined by us as one with a
minimum project cost of 1 BB$ and spanning over 36 months) we find that the
degree and range of indeterminacy of outcomes can be made more tractable by
understanding causality across the various interacting external and internal factors
within the project lifecycle. In particular we think that and interacting nature that
drive complexity and its effect on risk characterization in large engineering projects
are particularly relevant in the execution phase of the project. This is especially
germane from a project financing perspective as majority of the financing is in a
large project is gated on understanding and mitigation of execution risks. We begin
by laying out a framework for understanding complexity and critical areas of risk
assessment and characterization, which addresses the execution phase of a large
project through our Stage Two Model.

We find that multistage project architectures, change, rework and information and
physical delays are inherent characteristics of large projects. They interact in
seemingly unpredictable ways to create impacts, which are delayed, non-linear,
indirect and self-reinforcing. The nature of the interactions is such that it is difficult
to perceive the full significance before or even after the occurrence. This results in
misunderstood risk characterization in execution and an obvious inability to
comprehend the interconnectedness of the risks. Current traditional models of risk
for large projects do not have appropriate mechanisms for understanding the self-
reinforcing degenerative dynamics of the risk factors, which often results in incorrect
conclusions and ineffective coping strategies. These counter-intuitive effects then
often prompt dysfunctional management actions that often further destabilize the
project.

Execution complexity and its effect on risk at that stage can be better understood by
understanding the structural determinants of complexity in large projects. We find
that the major determinants of complexity

a. Structure and Form Large projects have many interacting and overlapping
stages across design, engineering, construction and commissioning. For
example stages of design , also known as Front End Loading (FEL) in industry
parlance, can be stage gated across three overlapping and interacting phases
which can extend over 18 months and consume anywhere from 100,000 to
500,000 engineering hours [13] . The iterative and interactive nature of
internal and external factors shapes the FEL stage. We find that the initial
stages of FEL are largely impacted by market factors and institutional factors (
e.g. land and zoning regulations, feedstock policy, sourcing constraints,
environment, competitive dynamics) . Similarly, successful engineering and
construction demands that the project is partitioned and structured in a way
which assigns functional coherence within partitions with clear interface
definitions and dependencies while maintaining interface integrity across
partitions. Structural integrity of these partitions is very important for
successful project execution due to the sheer scale of engineering and
construction. An adequately partitioned multi-staged engineering and
construction phase may have well over 100 interacting and concurrently

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executing partitions or packages spanning over 15-25 million engineering
and construction hours of work [14 , 15] . As mentioned earlier, sponsors,
especially exhorted by financing agencies, frequently outsource the
partitioning complexity and the associated risk through a turnkey EPC
contracting mechanism with the hope that the turnkey contractual
mechanism will transfer the risk of partitioning complexity and execution.
This is a big fallacy and rarely does a contracting mechanism solve the
problem of partitioning complexity and its related execution. That is because
it is highly unlikely that a sponsoring agency can design a bulletproof turnkey
incentive-contract mechanism for risk transfer without clearly understanding
the underlying drivers of execution risk which is closely related to the form,
function and interaction of work within and across the partitions [16] . A large
project may also have procurement across a global project supply chain
ranging anywhere from 200 to 2000 suppliers. In our analysis using our
models, procurement structuring and sequencing and supply chain
interaction and delays have profound and counter-intuitive adverse impacts
on project cost and timelines as it directly impacts the erection-sequence
within and across partitions. Concurrent and stage-gated partitioning is a key
determinant to the structure of the organization across the sponsors,
contractors, consultants and the vendors from a perspective of project
execution. The structure of the resultant organization is a key determinant in
the speed and accuracy of decision making. The delay effects of decision
making creates substantial cascading impacts in terms of time and cost
across the project depending upon when and how they occur in the project
lifecycle.

b. Structuring and partitioning large engineering projects is thus a key
determinant in our framework for understanding project behavior and hence
the nature of the risk that may evolve. In our projects we have found that
Design Structure Matrices (DSM) [17] as a useful tool to structure projects
from partitioning, decoupling, sequencing and interfacing perspective.
Structuring thus forms one of the fundamental basis for understanding
complexity and associated risk behavior in our framework. Fig 4 illustrates
how we structure and partition mega-projects using DSM for large integrated
steel project. It is not atypical to have over 40,000 tasks across partitions in
the matrix.

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To appear in Journal of Structured Finance, Winter 2016

Fig 4- Design structure matrix of partitioning mega-projects

c. Changes and Rework- One clear outcome from the analysis of our large
projects is the importance of changes and the ability to manage the impact
of changes and re-work on the risk profiles and the success of project. After
plans are in place, during the shaping and FEL stage changes occur. They
occur on most projects and throughout the life of many projects. They are
the means by which projects products are refined and improved. Some
changes are institutional mandated (e.g., labor laws, resource allocation
policy, environmental regulations), some are market driven (e.g., changing
structure of demand or feedstock capacity), and some reflect changing
technical and performance requirements. The ability to progressively
delineate change scenarios and understand the critical levers for managing
and adapting to change is crucial in outlining possible project outcomes and
their deviations from planned goals. This then provides the sponsors and
project participants the ability to learn and pro-actively manage change in a
manner which minimizes the deviations and risks while conforming to the
dynamic market requirements. One of the important and seemingly
indeterminate aspects of change is what we call as the second order
cascading impact of changes on project outcomes. Traditional project risk
analysis methods typically underestimate the impacts of the second-order
effect of changes as they are frequently unforeseen and because they tend to
appear unexpectedly later in projects. Frequently, second order impact of the
effect of changes manifests itself as cost of reworking previously completed
work. Cost of changes has a cascading multiplier effect when multiple
changes occur across the lifecycle of the project. The degree of rework varies
depending upon the project stage when the change is occurring. For example
a late stage design change discovered during construction phase will have a
much more pronounced impact than an early stage engineering change
before the construction has started. Changes will have other multiplier

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effects like productivity impacts, resource availability, coordination effects

and quality depending upon when and how they occur. For example, our
model simulations consistently corroborate the fact that sustained overtime
causes direct productivity loss [18] and finds that knock-on productivity losses
through attrition, new worker learning curves and morale effects can be
substantial. Such productivity loss also occurs on unchanged workpeople
get tired and are less productive on whatever they are doing. Overtime
induced productivity loss thus in general means higher cost to perform the
workhence, the second-order impact. Through this and several other
paths, changes cause productivity impacts that can substantially increase the
cost of executing the entire project. Although challenging to quantify and
explain, this secondary impact may well be the single largest source of
project performance problems.
Change impact quantification and causal attribution is thus a key element in
identifying the possible impacts on the project in terms of cost and time
escalations. From a risk characterization perspective as a function of change,
we need to understand the scenarios and the project response to the
following questions a) What would happen if b) When is it likely to happen
c) What is the major cause of the change
The ability to model and manage the injection and mitigation levers for
change and rework is thus the second important structural factor
contributing to the impact on project outcomes and the risk behavior.
d. Feedback and Delay Second-order impacts in large engineering projects are
not only because of scope changes or visible direct changes like addition or
modification of work. Delays occur due to changes as well as information -
e.g. late arrival of data from equipment suppliers, late basic engineering
development, approval cycles, delays in management response to changes
and rework discovery time-constants. Some of the delays, what we refer to
as time-constants and information delays are intrinsic to the nature of the
work and organization. For example the rate at which rework is discovered
follows a pattern which is dependent on the organization, project type,
nature of work and the stage of the project execution and is difficult to
change in a short span of time. The rapidly growing impact of many small
delays especially the intrinsic time-constant based delays at various
stages can snowball into a large and seemingly unforeseen project impact.
Understanding the timing and patterns of material and information delays
thus plays a significant role in terms of its effects on the possible project
outcomes. Qualifying and quantifying the causal effect of delays and its
mitigation strategies is thus important in understanding risk characterizations
of large projects. This is the third building block for understanding the nature
of risk in our framework.

Our Stage Two model models these three structural blocks and along with Stage Two
model archetype (depicted in Appendix 1- Figure 10), we have found it to be a
reasonably accurate representation of the project execution dynamics. The Stage
Two model archetype is the work-rework-delay cycle which has been applied to

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modeling execution dynamics of projects across design, engineering and
construction phases as shown in Figure 10.

Fig 5 - Project work-rework cycle model

Using scenario simulations to determine the interactions and the outcomes, the
causal models at this stage are essentially the embodiment of our mental models
and along with variations and simulated shocks on project parameters and inputs
from the Stage One model, the outputs typify the possible range of outcomes.

Synthesis of Framework by Integrating Stage One and Stage Two Models

As discussed earlier, our approach is both top-down and bottom up based on staged
iterative evaluation of the causality at the macro and the micro level in the context
of the mega-project in the industrial sector and the macro-economic environment.
Specifically,

1. A top-down macro-level industrial and sectoral dynamic model which feeds
into the project execution model. In the process many of the factors that
would have been taken as exogenous, are endogenous to the execution
model providing better fidelity on project behavior patterns in terms of
outcomes, resiliency and sensitivity to these events.

2. It models the project as a set of interactions across project work items and
resources along with delays, feedbacks, behavior functions and policy
response at an aggregate level. The level of aggregation is dependent on the
expected granularity level of the output desired.

3. We also model the individual unit of project work from dynamic bottoms up
perspective through the work-rework cycle [19] as opposed to the static work
unit modeled in typical project approaches. This unit of work-rework is then
aggregated at different levels of the model [ Figure 10]
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4. Our partitioning of the project also follows a bottoms-up approach to

aggregate and determine couplings across activities. This allows us to
structure the project into partitions or packages. These packages and
couplings then form the basis of work items for the causal model.

This then forms a more realistic basis for characterizing risk behavior of the project
and provides us the basis for structuring, organizing, managing and potentially
insuring mega-projects by integrating both micro and macro level effects in the
context of the large project. Figure 6 below pictorially depicts our framework.

Fig 6- Framework to Model Large Project Dynamics

Risk Scenario Analysis Using the Framework

Our scenario analysis for understanding the dynamic response of the modeled
project starts by trying to understand the major internal and external input levers
which can change both in terms of extent/range and immediacy in terms of time.
For example based on organizational knowledge and experience, we know the
extent to which labor productivity changes over time if schedules are changed and
over-time is increased. Similarly, based on the remoteness and location of the
project we have reasonably good estimates of the effect of a supply chain disruption
on the magnitude of introduced delay for an equipment supply. We can enumerate
with a reasonable degree of accuracy all such important internal and external levers
affecting the project. The model can evaluate how these changes, delays and
disruptions propagate through the system and manifest in terms of schedule and
cost impacts. Fig 7 represents an example screen on the projects sensitivities to
disruptions and changes.

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To appear in Journal of Structured Finance, Winter 2016

Fig 7- Example screen on project outcome sensitivities to changes

In essence our scenario evaluations attempt to recognize the major sources and
ranges of overall execution risk factors and interconnectedness of key risks. Based
on this understanding we evaluate various options for desensitizing the projects and
assess the value of reducing the range of uncertainty surrounding the significant risk
factors. For example, mitigation measures to limit the magnitude of change in
engineering by limiting the design-approval cycles. We may find that shifting the
deadlines gives us a window of change while minimally impacting the direct and
opportunity cost. We may find that simulating a range of price shocks in feedstock
may lead us to look at flexible design options in the project for a plant capable of
handling multiple feed stocks e.g. a dual feed ethylene cracker plant option based on
naphtha and natural gas or options for scrap, ore or pellet charge for iron
manufacturing.

Once we have reasonably desensitized the project along with mitigation and action
plans, we will have a reasonably good estimate of the magnitude of variability of the
risk factors. Here are some of the typical questions and what ifs the framework
helps answer

Market Risks
1 Is there an opportunity for investment in a project in the
market?

How would the commodity price evolve?

How would raw material availability and pricing evolve?

Impact of availability and pricing of

Land

Equipment & technology

Labor & workforce

1. Potential return envelope

2. Capacity bounds
3. Market segments

1. Price evolution trajectory
2. Price bounds and sensitivities

1. Raw material supply trajectory
2. Raw material price envelope

1. Impact of returns on project
2. Feasibility of new projects

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Execution Risks
1 How should the project be structured?

1.
2.
3.

3
4

Impact of

Timing and magnitude of Scope changes

Delays in decision making

Delays in discovering rework/changes

Impact of supply chain disruptions

Impact of unavoidable events

Labor strikes

Forces majeure

Inter-contractor dependencies

1.
2.
3.
4.

Complete (EPC) and discrete

turnkey option
Number of packages
Difference in cost between
contracting options
Cost impact
Schedule impact
Workforce impact
Trade-off zone

We can then embark on the next stage of characterizing these range constrained
input risk factors using statistical functions. These we believe are much more
accurate and controlled representation of uncertainties as they are steeper and
tighter patterns and limits the fat tail effects encountered in other non-causal
statistical modeling approaches at aggregate levels of work. We layer the Monte
Carlo simulations based on these patterns on our causal models to characterize and
pattern the behavior of the project over time.

Shaping Markets for Project Finance through Financial Innovation

We think that our project dynamics and risk framework fill an important need in the
area of risk analysis, characterization, rating and monitoring of large projects. This in
turn can help in attracting and structuring syndications and private placements as
well as enable better functioning of project finance markets. While the applicability
of our framework to syndication and private placements for project finance
transactions is straightforward, we next discuss its applicability in exploiting the
capital markets for project finance.

As discussed earlier, in the current market large international project finance
transactions are primarily served by commercial banks and some multilateral
institutions like the EIB, ADB, Exim, Mitsubishi UFJ and IFC. The commercial banks by
their charter and the nature of their business are not the best suited for finacing
large scale, long tenor project transactions. The Basel III liquidity requirements
further limits the ability of the banks to participate in such transactions from a
liquidity requirements perspective [20]. The project finance markets for
infrastructure financing fits more comfortably with natural long term institutional
investors e.g. the pension funds and insurance companies, who seek a diversified
portfolio of assets to match their long term liabilities. However, particpation by
these institutions is gated by their pre-requisite for investment grade rating of
projects at least at the A- level. In our opinion, there are currently no known
mechanisms or institutions to rigorously and accurately analyze, rate and monitor
risk for large industrial infrastructure projects, with a result that most of the projects
are rated much lower than investment grade. This mismatch between need for
liquidity and financing and the availability of liquidity can be perhaps be bridged
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though our framework to enable an ecosystem of institutional investors, banks, risk
arbitrageurs and financial products. This in turn can eventually help enable a vibrant
capital market for project finance.

Up until the financial crisis of 2008, participation of long term institutional investors
in the project finance markets, especially in Europe, was enabled through monoline
insurers [21] . These were AAA rated entities providing credit insurance (known as
wrapping), typically for BBB-/BBB and below rated projects, thereby enhancing the
rating to AAA and enabling debt to be sold to a bond market. The monolines
provided risk analysis, credit structuring and monitoring skills that meant
institutional investors did not have to invest in developing specialist in-house project
evaluation and risk analysis teams. After the financial crisis, the ratings of these
companies began to crumble and this business model no longer worked. As a result
the project bonds almost completely disappeared as funding option in project
finance markets.
Today the institutional investors (i.e. insurance companies and pension funds) face
increasing investment pressure to find attractive investment opportunities. As a
result, investors are re-exploring investment opportunities in industrial
infrastructure. The common deal breakers of the past (e.g. construction risk;
deferred draw-downs in accordance with construction progress rather than one
single disbursement of the total amount at the start of construction) are now
increasingly accepted. The most significant challenge though is in the risk
assessment, monitoring and credit rating requirements of investors. Institutional
investors do not have the resources, expertise, analysis frameworks and monitoring
systems for them to be able to evaluate and participate in this market. Especially,
the incomplete characterization of execution risks tends to restrict the ability of
mega-projects to achieve a high credit rating and is typically bucketed at either
default ratings of BBB or goes unrated. Significant bond market liquidity only really
exists for credit ratings at BBB+/ A- and above. Under these circumstances, achieving
this level of rating for a mega-project to attract financing will typically require
significant market and construction/delivery risk mitigation in the form of corporate
and third party credit support through parent company guarantees, letters of credit
or surety bonding. This is both unattractive and expensive for contractors and
sponsors and therefore inhibits the development of the project finance market.

Alternative credit enhancement structures thus provide an opportunity for
securitizing project finance transactions and making the investment opportunity
attractive to different class of investors with various risk appetites. Some of these
structures like the EIB Project Bond Initiative [22] and the Hadrians Wall Capital
product [23] are useful innovations in this area. They are different than monoline
insurance, wherein essentially, monolines swapped their AAA credit rating for
guarantees on project finance risks for a fee. In the current products the senior
level tranches are credit enhanced, in that the first loss tranch of the debt for the
project through the subordinated notes is funded in the form of draw-down rights
or a fund for mezzanine like debt. This credit enhancement of the senior notes draws
in the participation of long tenor institutional investors increasing the liquidity of the
market. Additionally, one can imagine the growth of complementary risk insurance
products around all the risk categories, and this in effect can raise the ceiling on

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project bond issues, improving their ratings and elevating them to investment-grade
status.
However, for these credit structures to work on a consistent and long term basis, the
risk characterization, analysis and monitoring needs to be reasonably bullet proof.
We think that a delegated and objective institutional structure based on our
framework is an appropriate mechanism to evolve such financial innovations for the
project finance markets. Fig 8 below illustrates how this would work in conjunction
with an EIB, NDB, AIIB and such multilateral institutions.

Fig 8- Risk framework applied to financial innovation in project finance

We think that our framework can help in eventually evolving the markets for project
finance to a higher level of liquidity and access by supporting both the capital
markets and the syndication and private placement markets. Its adoption along with
the right institutional structures can advance the state of the project finance markets
with more mature capital markets, while enabling the creation of competitive capital
markets for project finance in developing markets. Fig 9 illustrates how we envision
the markets for project finance to develop.

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To appear in Journal of Structured Finance, Winter 2016

Fig 9- Development of markets for project finance

Conclusion Characterization of risks and understanding its interaction behavior is
key to accurately structuring and financing large projects. The risk characterizations
based on understanding and modeling of causality from inception to completion
along with the layering of the stochastic nature of the related internal and external
factors leads to transparent project assessments, more accurate risk
characterizations and access to funds at appropriately marked risk premiums.
Characterization of risk also allows matching risks with a financial structure that
allocates risks to the appropriate parties who are best able to bear them through a
combination of debt, equity, recourse and guarantees. We believe that such an
approach to modeling mega-project risks will enable the creation of market for
project finance along with financial devices that enable more widespread access to
funds for mega projects.

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Appendix -1

Fig 10 - System dynamic model for execution phase of a mega-project

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References

1. Cohen and Steers, Global Infrastructure Report 2009
2. World Economic Forum Infrastructure Investment Blue Print, 2013
3. Investment and Investment Finance in Europe, European Investment Bank,
2013
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00144feab49a.html#axzz3XTElxe6a ]
5. Mapping and Facing The Landscape of Risks, Donald Lessard and Roger Miller
in The Strategic Management of Large Engineering Projects, 2001
6. Industrial Dynamics, Jay Forrestor, 1961, MIT Press
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http://timesofindia.indiatimes.com/specialcoverage/15739564.cms ]
8. Gorgon Project LNG Cost Jumps $15 Billion , Financial Times, December 6,
2012 [ http://www.ft.com/intl/cms/s/0/62e4f5e8-3f84-11e2-b0ce
00144feabdc0.html#axzz3XTElxe6a ]
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Strategic Management of Large Engineering Projects, 2001
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Reform , U.S. House of Representatives February 22, 2002
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Projects , Roger Miller and Serghei Floricel in The Strategic Management of
Large Engineering Projects, 2001
13. Internal communications M. N. Dastur and Co.
14. Internal report M. N. Dastur and Co.
15. Chenierre Energy, Sabine Pass Presentation, Platts 13th Annual LNG
Conference 2014, Houston, TX
16. Industrial Megaprojects , Edward Merrow, John Wiley and Sons, 2011
17. A model based method for organizing tasks in product development, Steven
Eppinger et. al. , Journal of Research in Engineering Design, Vol6, 1-13, 1994.
18. Effect of Scheduled Overtime on Labor Productivity, H Randolph Thomas,
Journal of Construction Engineering and Management, Vol ' 118, No. 1,
March, 1992
19. System Dynamics Modeling for Project Management, John Sterman, Working
Paper MIT Sloan School of Management, 1992.
20. Basel III : The Liquidity Coverage Ratio and liquidity risk monitoring tools [
http://www.bis.org/publ/bcbs238.pdf ]
21. Monoline Revival Could Aid Infrastructure , Financial Times , 22nd July 2012 [
http://www.ft.com/intl/cms/s/0/9790c5c2-d27b-11e1-8700-
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[ http://www.eib.org/products/blending/project-bonds/index.htm]
23. Hadrians Wall Capital, http://www.hadrianswallcapital.com/

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Authors

1.

Atanu Mukherjee Vice Chairman of Board, AcuLead Corporation, Houston, TX and President, M.N.
Dastur and Co., Kolkata, India

Atanu provides the strategic leadership at AcuLead Corporation and also leads Dastur, a consulting
firm which focuses on the metals, mining, energy and infrastructure industry worldwide. He holds
a joint graduate degree in Engineering and Management from the Massachusetts Institute of
Technologys School of Engineering and the MIT Sloan School of Management. He can be reached
at atanu.m@aculead.com / atanu@alum.mit.edu

2.

Dr. Purnendu Chatterjee Chairman of Aculead Corporation, Houston TX and The Chatterjee Group
(TCG), New York

Purnendu leads TCG, a 2 BB$ private equity group investing in industrials, technology and
infrastructure worldwide. He is also the Chairman of AcuLead, an energy engineering and
technology consulting firm. He holds a Ph.D. in Engineering from the University of California,
Berkeley. He can be reached at pc@tcgny.com

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