Risk Analysis and Risk Allocation

Week 3
Index

1 Project Finance as a Bulk of Risks: The Need of Risk Management

2 How to Map Risks in a Project Finance Deal: Risk Taxonomy
3 Pre-Completion Risks: Technology and Construction
4 Post-Completion Risks: Supply Risk, Operational and Performance Risk, &
Demand Risk
5 Risks Common to Both Phases
6 Wrap Up: The Risk Matrix

LEGEND:
Additional content 1
CLIP 1
PROJECT FINANCE AS A BULK OF RISKS:
THE NEED OF RISK MANAGEMENT
Project Finance as a Bulk of Risks

Analyzing risk and understanding sources of risk is crucial.

Unexpected risks can jeopardize cash flow stability.

Effective risk management involves:

1. The identification of sources of risk;

2. The allocation of risk to the parties in the best condition to
control them and manage them;

... so that the SPV becomes a Remote Bankruptcy Vehicle.

2
CLIP 2
HOW TO MAP RISKS IN A PROJECT FINANCE DEAL:
RISK TAXONOMY
How to Map Risks in a Project Finance Deal
Tip #1
Mapping of project risks following project life-cycle:

1. Pre-completion phase risks

2. Post-completion phase risks
3. Risks common to both phases

Project absorbs cash: the
project is not able to generate
any cash flow and all the money
is committed to building the
infrastructure.
The project first recovers the deficit
of cash and then generates a cash
surplus.
3
CLIP 3
PRE-COMPLETION RISK: TECHNOLOGY AND CONSTRUCTION
Pre-Completion Risks
Types
Planning
• The design of the project is not correct or the advancement of
the work is not properly scheduled.

Technology
• The technology for the project does not perform as originally
expected.

Construction
• The contractor delivers the infrastructure with a delay.
• The project is delivered but it performs below the agreed upon
standards.
• The final cost of construction far exceeds the original budget.
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 Pre-Completion Risks
Responsibilities & Solutions
The contractor takes on most of the responsibilities that arise in the
Responsibility
construction phase by entering a turnkey construction contract (TKCC) which includes
specific penalties.

The key elements for the TKCC to be bankable are:

1. The provision for a maximum cap which excludes extra cost for the SPV;
2. The provision for the refund by the contractor of damages to the SPV for
delay in construction (determined on a daily basis and proportional to the
damages to the SPV);
3. And the provision for the payment of damages if performance is not in line
with a originally agreed minimum standard (tested by an independent
technical engineer at completion).

• The TKCC is generally backed by a bank guarantee (bonding).

• To cover all the risks that do not fall under the control of the contractor the SPV
typically enters insurance policies (among others: ALOP, Advance Loss Of Profits). 5
CLIP 4
POST-COMPLETION RISK: SUPPLY, OPERATIONAL
AND PERFORMANCE RISK, & DEMAND RISK
Post-Completion Risk

Supply risk: Definition

• Particularly for plant, a shortage of raw material can hamper normal
plant operations
• Higher prices of raw material than forecast

Put or Pay Agreements

The SPV enters a contract with one or a small number of suppliers to which
they commit to provide a certain quantity of raw materials:
• At certain specific dates;
• at a certain level of quality;
• And at a predetermined price.

If the supplier does not provide raw materials it is required to find alternative
sources of supply, and to bear the extra cost if the alternative source is more
expensive than the original one. 6
Post-Completion Risk

Operational/Performance risk: Definition

• Malfunctioning
• Bad procedures
• Not careful maintenance of plants and equipments

O&M Agreement
The SPV enters a contract with one O&M agent by which it commits to refund
damages to the SPV for the losses incurred due to any performance below the
pre-specified service level agreement (SLA).

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Post-Completion Risk

Demand risk: Definition

The budgeted amount of revenues is higher than actual revenues due to a fall
in demand, drop of prices of SPV’s product, service, or both.

Take or Pay Agreement

The SPV enters a long term contract with one or more buyers of the
products/services it will generate whereby it commits to provide supplies to
the off-taker who is unconditionally required to pay the predetermined price
(even if it is not able to withdraw the production).

Demand risk cannot be completely covered if production is sold on the retail

market.

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Post-Completion Risk

Counterparty risk: Definition

One or more of the parties involved in the project are not able to keep up
with their obligations.

Sponsors and creditors require counterparties to be stable and financially

sound.

Creditors require that all the counterparties of the vehicle can be substituted
if they are unable to perform as expected (Direct Agreements).

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CLIP 5
RISKS COMMON TO BOTH PHASES
Risks Common to Both Phases
Risks that are common to both the pre-completion and post-completion phases and
cannot be allocated to any specific counterparty by means of a contractual obligation
are as follows:
• Natural disasters (or Acts of God, Force Majeure)
• Political risk: change in law, investment risk
• Environmental risk: public opposition, contamination risk

For the most part these are covered by insurance policies (in the case of investment
risk these are provided by Export Credit Agencies).

To safeguard the value of cash flows lenders typically require to hedge against all
fluctuations of macro variables (condition precedent)
• Interest rate risk
• Exchange rate risk
• Inflation risk (only for base risk: revenues and costs linked to different inflation
rates)
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CLIP 6
WRAP UP: THE RISK MATRIX
Wrap Up: The Risk Matrix
TYPE OF RISKS

PRE-COMPLETION PHASE RISKS

Technological, Planning or
Construction Risk
Design Risk

WHO SPV Sponsors' guarantees to lenders

Included in the construction Fixed price turnkey

Contractor agreement agreement

Technology
Penalties to be paid
Supplier
Operator
Buyers
Suppliers
Export Credit
Agency (ECAs)
Banks
Insurance
Insurance policies
Companies
Independent
Assessments on technological
Engineering validity 11
Firms
Wrap Up: The Risk Matrix
TYPE OF RISKS

POST-COMPLETION PHASE RISKS

Operational Risk Suplly Risk Demand/Market

Risk
SPV
WHO Turnkey Agreement
Contractor
(first test)
Technology
Supplier

Penalty payments and

Operator removal of operator
(later tests)

Buyers Take or Pay

Pur or Pay
Agreement or
Suppliers
through Pur
Agreements
Export Credit
Agency (ECAs)
Endorsement credit Endorsement
Banks to back supplier's credito to back
loans buyer's loans
Insurance
Insurance policies
Companies

Independent Certification of later

Engineering Firms testing 12
Wrap up: The Risk Matrix
TYPE OF RISKS

RISK FOUND IN BOTH THE PRE- AND POST-COMPLETION PHASES

Exchange Rate Environmental Regulatory Political Country
Interst Rate Risk Inflation Risk
Risk Risk Risk Risk Risk
Current matching
SPV
WHO by advisors
Limited to
Contractor obtaining
building permits
Technology
Supplier
Operator
Establishing pre-
Buyers agreed inflation
adjustments
Establishing pre-
Suppliers agreed inflation
adjustments
Credit Credit
Export Credit
insurance insurance
Agency (ECAs) programs programs
Derivative
products and
Banks Derivative products
coverage
instruments
Insurance Insurance
Insurance policies
Companies policies
Independent
Engineering
Firms
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 Wrap Up: The Risk Matrix
RISK FOUND IN BOTH THE PRE- AND POST-COMPLETION PHASES PRE-COMPLETION PHASE RISKS POST-COMPLETION PHASE RISKS

Technological,
Environmental Regulatory Political Operational
Exchange Rate Risk Interst Rate Risk Inflation Risk Country Risk Planning or Design Construction Risk Suplly Risk Demand/Market
Risk Risk Risk Risk
Risk Risk

Current matching by Sponsors' guarantees

SPV
advisors to lenders

Limited to
Included in the Turnkey
obtaining Fixed price turnkey
Contractor construction Agreement
building agreement
agreement (first test)
permits

Technology Supplier Penalties to be paid

Penalty
payments and
Operator removal of
operator (later
tests)
Establishing pre-
Buyers agreed inflation
adjustments Take or Pay

Pur or Pay
Establishing pre-
Agreement or
Suppliers agreed inflation
through Pur
adjustments
Agreements

Credit
Export Credit credit insurance
insurance
Agency (ECAs) programs
programs

Derivative products Endorsement

Derivative
Banks and coverage credit to back Endorsement
products
instruments supplier's loans credito to back
buyer's loans
Insurance Insurance
Insurance policies Insurance policies Insurance policies
Companies policies
Assessments on
Independent Certification
technological
Engineering Firms of later testing
validity
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