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ENGINEERING MANAGEMENT – ENG 5101

ENGINEERING PROJECT FINANCE

INTRODUCTION

Project Finance is a specific technique which is used to finance infrastructure and other
capital-intensive projects, such as airports, roads, bridges, power plants and
telecommunications networks.

There are two distinguishing features of Project Finance. First that the providers of finance
to the project (whether banks, shareholders or a combination of the two) bear many of
the risks of the project. And second that the funding is secured for the project alone, with
no requirement that the funding is guaranteed by the sponsors of the project (Gatti,
2008). Because of this Project Finance is most commonly used for the funding of large,
capital intensive projects, which are capable of providing stable financial returns.

Recent examples of Project Finance projects include the Dartford River Crossing and M6
Toll Road in the United Kingdom, Athens International Airport in Greece, Shajiao Power
Plant in Guangdong province in China and the Mozal Aluminium Smelter in Mozambique.

Project Finance as a specific financing technique has grown rapidly over the last 30
years, with global funds raised growing from US$217 Billion in 2001 to US$328 Billion in 2006
(Thomson One Banker). Today Project Finance projects can be found in all but the most
unstable corners of the globe. During the global credit crunch of 2007/2008 the volume
of deals contracted significantly, but the market bounced back in 2010, particularly in
India, the Middle East and Africa.

The purpose of this study is to equip Project Managers with a core understanding of the
field of Project Finance and the know-how to work on Project Finance Projects. No prior
knowledge of finance is assumed, but the unit does contain a number of numerical
examples, including cash flow analysis and explanations of typical financial instruments
that are used in project finance.

The Project Finance module aims to:

1. Introduce the field of project finance and the typical types of projects for which
project finance is used.
2. Identify how to structure a project finance project, how to raise finance and the
typical financial instruments used and how to assess the project risks.
3. Understand the key features of BOT (Build Operate Transfer) and the Private
Finance Initiative (PFI).

HISTORY

Project Finance is not new. Prior to the beginning of the 20th century most infrastructure
projects were financed using private funds. Examples of this include the US railroad
network which was constructed between 1840 and 1870, the 101mile long Suez Canal in
Egypt which was constructed by a privately owned French company in the 1860’s and

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the Clifton suspension bridge in the UK – build between 1831 and 1864 by Isambard
Kingdom Brunel. Tellingly the latter two projects were dogged by a lack of funding and
this, coupled with rapid industrialisation in the developed world led governments to start
to see their role as the funder and provider of infrastructure.

Infrastructure projects in the first half of the 20th century were funded through general
taxation or through government borrowing and were built by the government owned
and managed public sector. The financing of infrastructure by private capital did
continue throughout the 20th century but was limited to commercially exploitable sectors
such as Oilfield exploration in Texas and Oklahoma in US in 1930s and in Europe in the
1970s, and for the construction of power plants in US.

In the 1980’s the political environment changed again. Under budgetary pressure and
keen to reduce the burden of taxation on their electorate, governments, led by the US
and UK, began to see private capital as a source of funding for infrastructure projects. In
tandem with this grew an ideological view that the private sector could deliver
infrastructure projects more efficiently that the public sector. Private finance seemed to
provide a win-win solution: additional funds to allow the unmet demand for new
infrastructure – roads, schools, airports etc., to be met AND efficient market driven
delivery of those projects by a competitive private sector.

This change in the political climate led to a broadening of the field of project finance
from oil and gas and energy into a much wider range of sectors including mining,
telecommunications, roads, ports, airports and bridges, water and waste treatment and
even into the provision of schools, hospitals and prisons.

Figure 1: Changing role of government in the provision of infrastructure projects

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Let’s start with a text book definition of project finance:

“A specific finance technique in which the project lenders look only at the cash flow and
earnings of the project as a source of funds for repayment of their investments and not
at the credit worthiness of the sponsoring entity. The assets of the project are collateral
for the loan and the lender has limited recourse to the project sponsors (Merna and
Owen, 1998)

There is a lot of information and some jargon in this definition which we need to unpack
in order that you understand the basic principles of project finance. Central to project
finance is that the funding of the project does not depend on the credit worthiness of
the sponsor (or party proposing the project) (Gatti, 2008). Instead lenders to the project
can only be repaid from the cash flows that the project generates, for example from the
toll-revenues generated by a toll road, or sale of electricity from a power generation
plant. The project assets (i.e. the toll road or power plant itself) are the only collateral for
the loan. The lenders to the project in most cases will have no or limited recourse (a jargon
word for access to) the assets of the project sponsors. This is quite different to traditional
corporate finance where the loan is backed by the entire balance sheet of the borrower.
Due to the limited recourse nature of the financing of the project, project finance is often
used by companies as a method of undertaking more risky projects than those which
would be financed traditionally.

Project Finance is best illustrated through example projects – The Dartford River Crossing
and Eurotunnel;

Example 1
• The Dartford River Crossing is the 3rd River Thames Crossing at Dartford on the M25
London orbital motorway.
• Comprises two two-lane tunnels carrying traffic to north and a four-lane cable-
stayed bridge carrying traffic to south.
• Capacity of two original tunnels exceeded by 25,000 vehicles per day in 1987/88.
• Private company “Dartford River Crossing Company” formed to build and operate
the bridge Revenue stream from tunnel tolls and tolls on new bridge

Example 2
• Channel Tunnel is the longest undersea tunnel in the world.
• The three tunnels, each 50km long, bored at an average 40m below the sea bed,
linking Folkestone in Kent to Coquelles in Pas-de-Calais
• Bid approved 1986, Formation of Eurotunnel plc
• Construction 1987 – 1994
• Operation 1994 to present
• Revenue from operation of tunnel and shuttle services
o 46,000 passenger per day

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o 1,296,269 trucks transported in 2006

o 195m passengers and 176m Tonnes freight have passed through the Tunnel
since opening.

KEY FEATURES

A project finance project will exhibit several key features as depicted in Figure 2 below;

Figure 2: Key features of Project Finance

SPECIAL PURPSE VEHICLE (SPV) - At the heart of any project finance project sits
the Special Purpose Vehicle (SPV), sometimes known as Project Company. The SPV is
created solely for the purposes of undertaking the project. It is legally and financially
independent from the sponsors of the project although it’s main shareholders are often
the project sponsors. The establishment of the SPV is key to separating the project from
the “business as usual” activities of the sponsors and is required to ensure that lenders to
the project do not have full recourse to the assets of the sponsoring companies in the
case of the project running into financial trouble. In a project finance deal, it is the SPV
that raises the required funding for the project, builds and operates the infrastructure
facility and collects the revenues from the facility, as shown in Figure 3. These revenues
are then used to repay any lenders to the project, with any residual funds being used to
pay dividends to sponsors.

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Figure: 3 The role of the Special Purpose Vehicle in Project Finance

VARIETY OF PARTICIPANTS - Project Finance involves a variety of participants. In

addition to the project sponsors who propose the project and provide the initial funding
for the SPV, there will be engineering and construction firms, legal and financial experts
and host government involvement to provide the requisite permissions for the project to
operate. The funders of the project will include banks and multi-lateral agencies. The role
of all these parties will be further explored in chapter 2. The typical project finance deal
can comprise up to 15 different parties, connected via up to 40 legal contracts (Esty,
2004).

NON-RECOURSE OR LIMITED RECOURSE FUNDING - is a key feature of project

finance deals. Non – recourse means that the lenders to the project have no recourse
(or no claim over) to the assets of the sponsors of the project. Limited recourse funding
means that the sponsors will have limited obligations and responsibilities to the lenders.
Such recourse maybe required in higher risk projects. For example, sponsors may be
required by lenders to guarantee loans made to the SPV during the high risk construction
phase of a project, with these guarantees expiring once the facility begins operation.
Alternatively lenders may require that sponsors inject more funds into a project in the
event of the project getting into difficulty.

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OFF-BALANCE SHEET ENTITY - Because project finance is non- or limited

recourse funding this allows the project to sit outside the balance sheet of the sponsors.
The SPV is known as an off-balance sheet entity as the project or SPV borrowings do not
appear on the sponsors’ balance sheet. This is helpful to project sponsors as the SPV
borrowings will not affect the sponsors’ general credit rating and debt/equity ratio,
thereby allowing the sponsors’ balance sheet to fund other projects using the traditional
corporate finance route. NOTE: Under US Financial Accounting Standards Board, any
significant undertakings of project sponsors must appear in the account footnotes.

SOUND INCOME STREAM - The next key feature of project finance is the
requirement for the project to have a sound income stream. As outlined in section 1.2
above, lenders to the project can only be repaid from the cash-flows that the project
generates. Investors and lenders have no other way of getting their money back. The
cash-flows generated by the SPV must be adequate to cover the operating costs of the
facility, meet the interest payments on any loans and ultimately to repay those loans. As
a consequence of this project sponsors are often required to provide proof of income
streams, for example a power purchase agreement for a wind farm project or an agreed
payment mechanism for the operation and maintenance of a new stretch of the
motorway network.

VARIETY OF FINANCIAL INSTRUMENTS - Project Finance projects will typically be

financed using a range of financial instruments. The SPV will raise the required funding via
three main instruments – debt, equity and mezzanine finance.

• Debt finance provides a specified return to the lender over a pre-determined

period of time. For example the SPV may borrow £500m from a number of banks
to build an infrastructure facility. The SPV is required to make regular interest
payments on the loan and to repay the principal – that is the £500m - over an
agreed period of time.

• Equity finance (often referred to as equity or risk capital) is the provision of funds
to the project by investors in return for shares in the SPV.

• Mezzanine finance is a collective term for a number of financial instruments that

are primarily debt but also share some features of equity. Chapter 4 will provide a
detailed analysis of each of these three main instruments and examples of project
scenarios in which they are most likely to be found. It is important to note however
that debt, equity and mezzanine finance are not exclusive to project finance.
Rather they are standard financial instruments used throughout corporate
finance, but the project structure in which they are used is specific to project
finance.

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RISK ALLOCATION - One of the advantages of project finance is that it can act as
a system for allocating risk amongst a number of parties involved in a project. Large
infrastructure or capital intensive projects are by definition risky, and the risks to the future
cash-flows can be minimised by allocating the project risks to the participant in the
project who is best placed to manage them. For example construction risks should be
allocated to the construction contractor as he is the party best able to handle these risks.
For lenders to projects, diligence in understanding project risks is essential to successful
project finance lending.

VARIETY OF CONTRACTS - The need to allocate risks effectively accounts for the
last key feature of project finance – that of a variety of contracts. A project finance
project interlocks a number of participants from construction contractor to end output
purchaser through a series of contracts. These contracts are essential to allocate all the
major risks of the project to the party best able to understand and control it. If risks are to
be effectively managed in a project finance project the contractual arrangements must
correctly allocate risks and incentivise the parties to perform.

DIFFERENCES BETWEEN PROJECT AND CORPORATE FINANCE

Now that we have introduced the key features of project finance, we should be able to
identify the major differences between corporate and project finance.

A sponsor of an infrastructure or capital intensive project can fund the project in two
distinct ways. Either he can use corporate finance – where the project is financed through
the company’s balance sheet using either internally available funds generated by the
company’s profitable activities, loans from banks or by issuing new equity to shareholders.
Alternatively that new project is incorporated into a new entity known as a Special
Project Vehicle and is financed off-balance sheet. This, as we have learnt already is
Project Finance. Both corporate and project finance use similar financial instruments, for
example bank debt and equity capital but the structure of the projects are very different.

Corporate finance is usually viewed as the traditional method for companies to finance
projects.

In corporate finance all possible investment projects are assessed using a required rate
of return that the company expects from its projects. If individual projects can generate
the required rate of return then they will be funded either using internal cash flows or

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external debt. The repayment of any loans provided to the project are guaranteed, (or
backed by) all the assets and cash flows (i.e. the whole balance sheet) of the company
carrying out the project. If the project is not successful then the lenders should still be
repaid from these total assets and cash flows.

Project finance is the opposite of this. In project finance the SPV and the sponsoring
company are separate entities. Each project to be financed using project finance is split
out into a new SPV and assessed and funded separately from the sponsoring company.
As stated previously if the project does not succeed, then lenders may experience
significant losses, as they have no or very limited claims on the total assets and cash flows
of the sponsoring company. As a result of this project finance is typically more expensive
than corporate finance by virtue of the complex structure required with its associated
legal costs, the detailed evaluation of the project required by lenders and because
lenders assume more risk in a project finance deal.

Figure 4 provides a summary of the key differences between Project and Corporate
Finance.

Figure 4: Difference between corporate and project finance

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The advantages of project finance over corporate for the project sponsor is that:

1. The deal can support higher debt equity ratios than corporate finance (thereby
increasing the rate of return to sponsors;

2. It can be protect the corporate balance sheet and preserve credit ratings even if
investing in a higher risk project;

3. It can be a way of benefiting from interest tax shields, or tax benefits from host
government in a particular country;

4. The high level of risk allocation in a project finance deal can allow it to be seen as an
organisational approach to risk management;

5. Creating a project company isolates the sponsors from risk of project, otherwise a risky
project could bring down a whole firm.

Case study (Course Work to be Issued)

To embed the lessons from this topic, we will now look at a real-life case. The case study
is entitled BP Amoco (A). Policy Statement on the Use of Project Finance. This case study
provides an excellent overview of BP Amoco’s policy on funding large scale projects and
the circumstances under which project finance as opposed to corporate finance should
be used. It also explores the advantages and disadvantages of project finance from a
sponsoring company’s perspective. Do remember when reading this case study that BP
Amoco is a very large, well capitalised oil company with an excellent credit rating.
Consequently BP Amoco can finance many large infrastructure projects using its own
balance sheet – a luxury that many less capitalised businesses cannot afford. The specific
circumstances under which project finance is used with BP Amoco therefore quite
limited, but the principles explored in the case study may nevertheless be widely applied.

Take out time to read the case study (to be issued) and then answer the following
questions;

1. What is size of asset base of BP and Amoco respectively?

2. What were main reasons given for the merger between BP and Amoco?
3. What is the annual capital expenditure of the combined firms?
4. Highlight the main differences between exhibit 7.6A and 7.6B?
5. List the costs of using project finance according to BP Amoco?
6. According to BP/Amoco what is the major benefit of project finance?
7. What are the three circumstances in which BP Amoco uses project finance?
8. What are the key features of BP Amoco that allows it to take this view of project finance?

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