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Introduction to Project Financing
In general energy projects can be financed using either an ‘on balance sheet’ or an ‘off balance sheet’ (or project) approach. The ‘on balance sheet’ approach means that whatever loans, credit or cash is used, this is shown on the purchasing company’s balance sheets, and the providers of the finance can claim against the assets of the purchasing company in the event of default on payment.
New generating capacity is often financed using project finance (also known as limited recourse, non-recourse or ‘off balance sheet’ finance). Project finance is often known as off-balance sheet finance because the financing is arranged such that no one sponsor bears the majority of the project risk. If structured properly, the risk sharing feature allows the project sponsors to avoid listing the project on any of their corporate balance sheets. Here financiers primarily rely on the cash flows generated from the project for repayment. While project assets are pledged as security for the loan, the assets are not readily available as a source of repayment. Also, the financing is "limited recourse" in that the lender may not look to cash or assets outside the project as additional support for the loan unless these assets or cash are specifically dedicated as security for the project. An example of extra security would include a guarantee from a project sponsor, a performance warranty from the operator, or additional equity contributions from investors.
A particular benefit of project financing is the fact that there is typically a longer maturity period than for ‘on balance sheet’ financing. Because of the contracts and required documentation, banks have greater control over the project, and therefore are willing to lend for 12-14 years (for international banks, and possibly longer for local ones) rather than the five to seven years that is typical for a balance sheet based loan.
- In practice numerous parties are involved in a project financing:
- debt is provided by commercial bank loans;
- equity is provided by the companies involved in the project and also possibly by institutional investors;
- export credit agencies provide guarantees on some of the cross border loans;
- comprehensive insurance will be put in place;
- key parties to the transaction, such as fuel suppliers or power purchasers, will have entered into long-term contracts with the project; and
- lenders will review all key contracts for the project.
Gearing (the ratio of debt to equity) is much higher in project finance than in ‘on balance sheet’ finance. In some countries, finance organisations indicate that for renewables-based projects they would, typically, require 30% to 50% equity (although part of this may be accepted in the form of grants).
The main advantage of project finance is that it enables the project developers to finance projects which could not be financed on the strength of their own resources. The security from the loan comes from the long-term security of the supply and off-take contracts as well as the contractual risk allocation. In project finance, the rule is to transfer risks to those better able to manage them. For example, construction risk is best managed by the construction contractor.
Another advantage of project finance is its off-balance sheet nature. Often several companies will group together to form a joint venture to develop a project. In this case, project finance is often the preferred financing method for the joint venture partners where they consider the projects non-core business. Many of the banks interviewed during this study indicated their preference for such consortia, provided that they met certain conditions. In particular they had to be legally established and recognised entities, the respective roles of the members need to be both defined and appropriate, and finally that all members of the consortia should contribute towards the equity part of the finance package.
The disadvantage of project finance, being more complex than on balance sheet finance, is that it takes much more time and effort to arrange, and hence is more expensive up front. This has been noted as a particular problem with renewables projects. In many cases the size of project loans required to finance a move towards cogeneration in a sugar mill, palm oil plant or similar are viewed as too small to be efficiently administered by banks. The problems in moving towards the micro scale loans required by solar home systems are even more pronounced. In practice this can mean that project finance may require interest margins to be higher. Also, because of the required financial reporting, the time required to comply with the requirements of the financiers will be longer and the costs greater. It is worth noting that the all-in costs of project finance can be less than the traditional ‘on balance sheet’ loan.
Financing on a project finance basis places a heavy emphasis on legal documentation and contracts since there is no corporate sponsor fully guaranteeing the repayment of the project loan. The legal documentation and contracts transfer risk away from the financier. All legal documentation and contracts requirements must first be satisfied before financiers will advance funds. Requirements can be diverse but typical key requirements are that:
- firm long-term contracts with creditworthy parties for all project activities are obtained (fuel-supply, off-take sales, operations and maintenance agreements, etc.);
- fixed-price, turnkey design and build contracts are placed with experienced contractors;
- guarantees, warranties or bonds for completion and performance are provided from sponsors and contractors;
- all contracts and insurance polices are assigned to the bank, so that the lender can take over the project in the event of non-performance by the project company.
Finance for power projects is obtained from single sources or from packaging different types of funds. The manner in which the funds are brought together usually reflects the specific requirements of any given scheme. In general the two most basic forms of capital funds are debt and equity. There are key differences between these. A bank is the usual source of debt financing for a project, shareholders or investors provide equity financing. The bank and equity investors receive income in very different ways, and have different roles and requirements.
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