Pretprius, Frederik, Et Al., Project Finance For Construction & Infrastructure, Blackwell Publishing, 2008.

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Project Finance For
Construction & Infrastructure
Principles & case studies
Frederik Pretorius
Department of Real Estate and Construction,
The University of Hong Kong
Paul Lejot
Faculty of Law, The University of Hong Kong
Arthur McInnis
School of Law, City University of Hong Kong
Douglas Arner
Faculty of Law, The University of Hong Kong
Berry Fong-Chung Hsu

Department of Real Estate and Construction,
All associated with the Asian Institute of International Financial Law,

10.1002/9780470697825.fmatter, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/9780470697825.fmatter by Cochrane Philippines, Wiley Online Library on [21/02/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
© 2008 by Frederik Pretorius, Paul Lejot, Arthur McInnis, Douglas Arner and Berry Fong-Chung Hsu
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competent professional should be sought.
First published 2008 by Blackwell Publishing Ltd
ISBN: 978-1-4051-5127-6
Library of Congress Cataloging-in-Publication Data
Project Finance for Construction & Infrastructure: principles & case studies/
Frederik Pretorius . . . [et al.].
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-1-4051-5127-6 (hardback : alk. paper)
ISBN-10: 1-4051-5127-7 (hardback : alk. paper)
1. Project management–Finance. 2. Infrastructure (Economics)–Finance. 3. Construction
projects–Finance. 4. Public-private sector cooperation. I. Pretorius, Frederik.
HD69.P75P724 2008
624.068′1–dc22
2007017022
A catalogue record for this title is available from the British Library
Set in 10/13 pt Trump Mediaeval

by SNP Best-set Typesetter Ltd., Hong Kong
Printed and bound in Singapore
by Markono Print Media Pte Ltd
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Contents
Preface vi
Acknowledgements ix
About the Authors x
1 The Nature of Project Finance 1

1.1 The world of projects today 3
1.2 Corporations, finance and projects: important concepts 5
1.3 The project company business model 12
1.4 The project cycle 21
1.5 System concepts and the project company 29
1.6 Plan of the book 39
Key concepts 42
2 Complex Transactions 43
2.1 Transactions, the cost of transactions, transaction
cost economics, and projects 44
2.2 A more formal approach to disaggregation of transactions 51
2.3 The influence of agency on transaction costs – agency costs 58
2.4 Corporate finance context 64
2.5 Incentive conflicts in corporate finance 69
2.6 Transaction costs and agency – theoretic logic of
the project finance model 75
Key concepts 78
Appendix 2.1 Comparison of long-term debt instruments 79
A2.1.1 Syndicated loans 80
A2.1.2 International bonds 86
3 Financial Evaluation 93
3.1 Valuation and the project company 94
3.2 Valuation and the project company as a single-asset business 111
3.3 Capital budgeting decisions 135
Key concepts 149
iv Contents
4 Managing Risk in Project Finance Transactions 150

4.1 The project cycle revisited 152
4.2 Risk management approaches 155
4.3 The project company and risk identification 169
4.4 Risks in the construction phase 188
4.5 The institutional environment and risk 195
4.6 Risk management and project lenders 203
Key concepts 214
5 Continuing Evolution: from PF to PFI, PPP and beyond 216

5.1 Introduction 216
5.2 PFI origins 219
5.3 Types of PFI 221
5.4 PFI features 223
5.5 Procurement process principles 225
5.6 Contract and control structure 231
5.7 The special purpose or project vehicle and financing 232
5.8 PFI/PPP and rational privatisation 233
5.9 Risk management 234
5.10 Financial risk in PFI and PPPs 239
5.11 Challenges for PFI and PPP and the responses 239
5.12 The lessons 242
Key concepts 244
6 The Relevance of Sound Demand in Infrastructure Project Finance:

the Sydney CrossCity Tunnel 245
6.1 Infrastructure finance: the Sydney CrossCity Tunnel 245
6.2 History of the CCT project 246
6.3 Cheung Kong Infrastructure Holdings Limited 252
6.4 The bidding process 256
6.5 Valuing the project 257
6.6 Assessing project risks 261
6.7 Capital structure 262
6.8 Completion of the deal 266
6.9 Project outcomes 278
7 Financial Structure and Infrastructure Project Finance:

the Hong Kong Western Harbour Crossing 280
7.1 Refinancing the Western Harbour Crossing, Hong Kong 280
7.2 History of the Western Harbour Crossing 281
7.3 Valuation of the project 302
Contents v
8 Institutional Risks and Infrastructure Project Finance:

the Dabhol Power Project 308
8.1 Dabhol Power Project 309
8.2 Development of the Dabhol Power Project 312
8.3 Power purchase agreement 314
8.4 Epilogue 321
8.5 Analysis 321
9 Extreme Complexity in Transacting: public private partnerships

at work in the London Underground 324
9.1 Public private partnership: London Underground 324
9.2 Two countries, two systems 325
9.3 Public private partnership 328
9.4 Endnote 346
References 348
Index 354
Preface
Project finance is not a recent phenomenon, nor has it offered any real or lasting
controversy in academe’s quest for meaning in finance. As a subject of study it is not
particularly complex either – indeed, it is a practical subject, much of it simply out-
lining how finance is structured for particular ventures and why it is generally accom-
plished in a distinct way.
We believe this book will be a useful resource to academics who find themselves
in particular situations which mirror our own, and may be explained as follows. A
fundamental problem of many taught courses at undergraduate and graduate level in
many disciplines is that students lack the luxury of studying applications in the field
utilising a generic approach to the subject or its uses, as majors in that subject might
do. There are good reasons for this, including modern trends to provide more and
more interdisciplinary interpretations of subjects that were once considered entirely
specialist in nature. Unfortunately, circumstances often require subjects to be taught
by instructors who might not themselves have a similar interdisciplinary perspective.
In the study of all aspects of projects in the built environment, for example, this is
frequently the result of courses being taught by instructors with professional or tech-
nical backgrounds not necessarily associated with management or finance of large
projects, whether in infrastructure development, power generation, mining, oil and
gas, or some sector of real estate. Consequently such instructors may find themselves
relatively unfamiliar with institutional environments that govern the economics of
projects, and/or the design of business entities to facilitate the business objectives of
project promoters/developers, and/or the manner in which national or international
financial systems allocate finance to any such project. It may be argued that such
courses may produce students entirely familiar with technical aspects of large pro-
jects, and some economic and financial considerations; but who remain largely unfam-
iliar with the commercial and institutional context within which such analyses may
be conducted. In our opinion, this circumstance applies also to project finance.
In all, this situation is exacerbated by most generic finance textbooks, which are
typically aimed at students of corporate finance, investment finance or financial eco-
nomics. At best, they tend to confine project finance to a single chapter, or submerge
the subject in descriptions of syndicated lending. Further, finance texts that are
otherwise carefully crafted and pedagogically sound will often be country specific,
usually to the United States, and from a corporate finance perspective lean heavily
towards US corporate finance practice, corporate governance structures and problems,
and the influence of particular economic institutions such as complex tax laws, such
that underlying principles become skewed or obscured. This is also clearly reflected
Preface vii
in a large proportion of corporate finance research. United Kingdom or Common-

wealth derived applied finance books can be even more problematic, because so many
are written by professionals associated with project delivery (whether architects,
engineers, surveyors or lawyers) who may be far less familiar with commercial and
finance concerns than specialist aspects of project delivery. The problem may be
inevitable, given that so many international project finance techniques have roots in
Anglo-American commercial practice, but this ought not to influence excessively a
comprehensive treatment of the subject. This is well illustrated in the physical infra-
structure sector by the treatment of the build-operate-transfer concept (BOT) as a
project delivery mechanism or contractual arrangements governing physical construc-
tion, rather than primarily a model of funding for such projects based on principles
of corporate or project finance. In this way finance and construction contracting
arrangements become conflated or confused in the realisation of teaching
programmes.
Given all such considerations, this book has a simple aim. It is written primarily
to help non-finance students understand the economics and commercial aspects of
project finance transactions. In essence we have set about this task by viewing project
finance as having been deliberately mystified by academics, finance professionals and
the specialist media so as to differentiate their views or products, each conjuring new
jargon or acronyms for what are typically similar concepts or phenomena. Our response
is essentially to make project finance transparent by presenting in accessible language
the nature of such transactions and the context within which they occur: in each case
the simpler the better. We present it as a facet of corporate finance, albeit in our view
one illustrating in an interesting way where the focus of corporate finance research
has been directed over the last three decades, a period that embraces a transformation
in the multiplicity of financial sector activity. In keeping with the subject, our pre-
sentation is practical, and based upon first principles. As academics, we believe it is
also important to present theoretical matters that are relevant to the topic, but our
intention remains simply to demystify project finance. This means examining the
context in which project finance has been viewed, whether as a way to overcome
corporate or public sector balance sheet constraints, as a financing mechanism for
infrastructure schemes, or as a special category of corporate finance. Project finance
is all of these.
Of course, while project finance is based upon certain fundamentals, it continues
to evolve in form and practice through new components or applications. For example,
the widespread post-1980s drive to privatise government service delivery adds a
further perspective to the broadening application of project finance principles. Many
professionals from engineering, the built environment and law have become associ-
ated with the delivery of capital assets in private finance initiative (PFI) arrangements,
public private partnerships (PPP) or similar such ventures. These initiatives have
reflected problems typically addressed in the core project finance model, such as
managing incentive conflicts and other risks. In our view, an important observation
is that poorly conceived PFI or PPP arrangements may represent the flawed evolution
viii Preface
of a generally sound model, taking place under political pressure for the public sector
to devolve more and more risks to private sector agents. While aspects of PFI and
PPP transactions are within the project finance domain, they may be conceived
and constructed without due consideration of the high asset-specificity of project
finance, which is crucial in its transactional integrity. For teaching purposes there is
thus also significant importance to explaining typical PFIs and PPPs, making it clear
that while privatisation initiatives may achieve objectives in line with the project
finance model, they may often not meet the conditions required for successful project
finance ventures.
The book is intended as a textbook and source for teachers and students, not a guide
for researchers, although where appropriate it hopes to demonstrate clearly the practi-
cal relevance of academic research in the field. It is intended to be a post-entry level
textbook for tertiary education, but one that assumes no specialist corporate finance
or accounting knowledge. It seeks to introduce the vocabulary essential for an under-
standing of the relevance of these matters as the subject develops in the text. The
book is targeted at filling an important void in finance teaching literature, namely a
generic, non-national, non-locality specific project finance textbook for non-finance
students. The main transferable skill to be imparted by this text is an analytical
framework that can be applied to dissect and understand any project finance arrange-
ment, and possibly the structure of most business ventures in general, using systemic
and systematic analyses of those institutions and economics that surround these
transactions.
A last note for academics contemplating using this book: the cases in Chapters 6–9
were prepared in general to support instruction using the case study method. Thus
we have prepared teaching notes for the four cases covered in Chapters 6 to 9 – visit
http://www.acrc.org.hk/ and follow the instructions.
Frederik Pretorius
Paul Lejot
Arthur McInnis
Douglas Arner
Berry F-C Hsu
Hong Kong, August 2007
Acknowledgements
We have so many people to thank for their generosity in helping us complete this
project that it is impossible to do justice to all and inevitable that we would offend
some by not mentioning them. So we have decided instead to identify those people
and organisations without whom we could not even have started. First, we want to
thank all members of staff at the Asia Case Research Centre (http://www.acrc.org.
hk/) at the Business School of The University of Hong Kong for the fantastic intel-
lectual support we enjoyed from them during the writing of this book. In particular
Professor Ali Farhoomand, Director, and Ms Pauline Ng, Assistant Director, were
highly motivational, and Mary Ho, Grace Loo and Alison Bate were inspirational
under pressure. The Asian Institute of International Financial Law (http://www.aiifl.
com) in the Faculty of Law at The University of Hong Kong provided a scholarly
environment with distinguished visitors that helped discussion and kept us somewhat
focused. We also wish to express our gratitude to the Hong Kong Research Grants
Council which funded ‘An empirical investigation into project finance (PF) arrange-
ments in bank-dominated financial systems’ (HKU 7127/03E), a project which led to
many of the insights reflected in our book.
Our spouses and families absorbed an unfair share of the stress generated by this
project, and deserve thanks. Very special thanks to Adrienne.
Frederik Pretorius
Paul Lejot
Arthur McInnis
Douglas Arner
Berry F-C Hsu
Hong Kong, August 2007
About the Authors
Frederik PRETORIUS is an Associate Professor in the Department of Real Estate and

Construction at The University of Hong Kong and a Fellow with the Asian Institute
of International Financial Law, University of Hong Kong. Dr Pretorius holds a PhD
from the University of Hong Kong and an MBA and BSc(QS) from the University of
the Witwatersrand in South Africa, and concentrates on project finance, real estate
investment and finance, real options analysis and urban economics and development.
He has experience in Hong Kong, Australia, New Zealand and South Africa as an
academic and professional, in the corporate sector and as consultant for various activi-
ties and industries including regional economic development, real estate develop-
ment, building, and mining and process engineering.
Paul LEJOT is a Visiting Fellow with the Asian Institute of International Financial
Law, University of Hong Kong, and a Visiting Research Fellow at the ICMA Centre,
University of Reading. Formerly an investment banker with a wide transactional
command in structured debt, fixed income, regulatory capital, and financial restruc-
turing, and with extensive experience in Europe and throughout East and South Asia,
he is now engaged in research into financial market development and policy reform.
His interests include legal and institutional aspects of financial market behaviour,
regulation and development, transaction law and economics, and Asian regional
financial policy. Since resuming an academic career in 2003, he has published widely
on these topics and consulted with official organisations, in particular examining the
legal and practical obstacles that constrain capital market development and effective-
ness in Asia. His current work includes research and postgraduate course development
in law and finance, notably legal influences on development, instruments, institu-
tions and markets, as well as structured finance, regulatory arbitrage, and financial
derivatives.
Arthur McINNIS is a Visiting Fellow with the Asian Institute of International Finan-
cial Law, University of Hong Kong, and Managing Director, International Law Insti-
tute (Hong Kong). A former practising lawyer in North America and Hong Kong, he
currently teaches at The City University of Hong Kong, and has an international
reputation which is tied to more than 60 publications in the construction, contracting
and planning fields. Arthur is also the Honorary Legal Advisor to the Joint Contracts
Committee, the body which has lately published the new Standard Form of Building
Contract (Private) for Hong Kong. He is a founding member of the Centre for Infra-
structure and Construction Industry Development (CICID) and a former co-director
About the Authors xi
of the Asian Institute of International Financial Law (AIIFL) both at the University
of Hong Kong. Arthur’s expertise in the field of construction, projects and dispute
resolution is diverse with long experience at both Baker, McKenzie and Clifford
Chance. Arthur holds Diplomas in both Civil Law and Comparative Law from Sher-
brooke and Dalhousie Universities respectively. His first degree in Economics and
Political Science (Regina) was followed by an LLB degree (Sask). He also holds a Bach-
elor of Civil Law degree and an LLM from McGill University in Montreal and a PhD
in law from Queen Mary and Westfield College at the University of London.
Douglas ARNER is Associate Professor and Director, Asian Institute of International

Financial Law, Faculty of Law, University of Hong Kong. In addition, he is a member
of the Board of Management of the East Asian Economic Law and Policy Programme
and Co-Director of the Duke University-HKU Asia-America Institute in Transna-
tional Law. Prior to his appointment at HKU, Douglas was the Sir John Lubbock
Support Fund Fellow at the Centre for Commercial Law Studies at Queen Mary,
University of London, a consultant with the European Bank for Reconstruction and
Development, and Director of Research of the London Institute of International
Banking, Finance and Development Law. He has consulted, lectured, co-organised
conferences and seminars and been involved with financial sector reform projects in
over 20 economies in Africa, Asia and Europe. Douglas specialises in economic and
financial law, regulation and development. He is author, co-author or editor of eight
books and more than 50 articles, chapters and reports on these subjects. He holds a
BA in literature, economics and political science from Drury University, a JD (cum
laude) from Southern Methodist University, an LLM (with distinction) in banking and
finance law from the University of London (Queen Mary College), and a PhD from
the University of London.
Berry F-C. HSU, BSc, LLM (Alberta), MA (Oregon), PhD (London), Barrister and Solici-
tor (Supreme Court of Victoria) is an Associate Professor of Law in the Department
of Real Estate and Construction, and Deputy Director of the Asian Institute of Inter-
national Financial Law, Faculty of Law, University of Hong Kong. He is the author
of several books on the common law system, banking and finance, and taxation,
including Financial Markets in Hong Kong: Law and Practice (Oxford University
Press).

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10.1002/9780470697825.fmatter, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/9780470697825.fmatter by Cochrane Philippines, Wiley Online Library on [21/02/2023].

Berry Fong-Chung Hsu

All associated with the Asian Institute of International Financial Law,

Blackwell Publishing editorial offices:

First published 2008 by Blackwell Publishing Ltd

Library of Congress Cataloging-in-Publication Data

Set in 10/13 pt Trump Mediaeval

For further information on Blackwell Publishing, visit our website:

1 The Nature of Project Finance 1

4 Managing Risk in Project Finance Transactions 150

5 Continuing Evolution: from PF to PFI, PPP and beyond 216

6 The Relevance of Sound Demand in Infrastructure Project Finance:

7 Financial Structure and Infrastructure Project Finance:

8 Institutional Risks and Infrastructure Project Finance:

9 Extreme Complexity in Transacting: public private partnerships

in a large proportion of corporate finance research. United Kingdom or Common-

Frederik PRETORIUS is an Associate Professor in the Department of Real Estate and

Douglas ARNER is Associate Professor and Director, Asian Institute of International

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