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Risk Management
All finance arrangements involve exposure to various types of risk, what financial institutions do is to minimise the possible impact of this exposure. In practice this means that finance providers look to negotiate structures designed to protect themselves from potential downsides due to identified project risks. Hence the key to successful project financing is the management of the many types of risks involved.
Bankability is the term used to describe the risk analysis and management criteria used by the lenders in assessing the viability of a project. Lenders will want to "off-load" sufficient risks to acceptable third parties so that their own risk exposure is reduced to what they consider an acceptable level. It is on the structured analysis of the various components of the overall project risk that financing organisations such as banks concentrate. Each uses its own approach to constructing and analysing a risk matrix. In analysing projects risk will be assessed (and as far as possible quantified), normally against a series of headings, and if deemed unacceptable the application will be rejected. If the degree of risk is within ‘acceptable bounds’ the possible down sides will be assessed and a suitable risk premium added (this may be viewed as essentially equivalent to an insurance premium).
The following are examples of the main types of risk and the associated mitigation approaches; press on the titles to link to descriptive text below. This list is not exhaustive. The risks are not given in order of importance and will vary from project to project. Risks are interrelated. Each risk not only directly affects the project, but affects the other risk factors.
Operating and Technology Risk
Construction and Sponsor Risk
Technology Risk
Economic, Inflation and Environmental Risks
Country, Political. Legal, Foreign Exchange and Force Majeure Risks
Operating and Technology Risk
Once a project is constructed the lender will be primarily concerned with the project operator. The lender will require an appropriately qualified operator to maintain the plant and to meet the projected operating budget. The lender will review proposed operations to see if sufficient funds have been allocated for the operations and maintenance and that sufficient trained personnel are available to operate the plant. This is called ‘Operating Risk’.
Technology risk can be a very significant factor for little understood or new technologies. The main concern of lenders is that technology under-performance will adversely affect plant operations to the extent that the project is unable to make its debt repayments. Technology risk is seen by lenders as a sponsor risk. Lenders do not like lending to new technologies and prefer tried and proven technologies that have been financed in the past. Even new applications of standard technology are of concern. Typically lenders feel comfortable with 3-6 previous plants of the same technology with at least 5 years of reliable operation.
For new technologies the lender will ask for additional support and guarantees from the sponsors. Sponsors will not generally be prepared to assume the full risk themselves, and will require guarantees and warranties from the manufacturers of renewables equipment (and in turn of the component suppliers). Unless the manufacturers are large, creditworthy companies, they will be forced to provide private insurance or bank bonds to cover this risk. Where private insurance is used, the bank will want to be named on the policy. Because of the perception of technology risk commercial scale demonstration schemes are very important. It is one of the reasons why grants from multilateral aid agencies or government help may be applied at this stage in order to reduce risk by offsetting the financial exposure of the project to sponsors, the lenders and the investors.
Construction and Sponsor Risk
The key construction risks are: non-completion; late completion; and cost over-run. Of these the most obvious risk is the one where the project is never built. The loans could be completely drawn, the cash spent, but the project uncompleted. Without a completed project there is no cash flow and the loans will never be repaid and investors never receive a return. Sponsor risk relates to the risk that the company or companies running the project (sponsors or project developers) are not substantial and reliable. Banks look for evidence (e.g. through strong joint venture partners) that the resources and skills necessary to help resolve any problems encountered in the project are available.
Construction and sponsor risks are relatively easy to mitigate. This is because the construction period is for a limited period of time and once construction is complete to the financier’s satisfaction the risk is no longer relevant. Tools available to ensure that this risk is minimised, and appropriately assigned include the following:
- Allocation of the construction risk, as far as possible, to the contractors by negotiating a turnkey (ideally fixed price) construction contract. Such contracts will be carefully analysed to see who bears the risk of non-completion, late completion, or the possibility of cost over-run.
- The lender will require the sponsors to commit equity (or potentially secured assets), so that the sponsor has a serious interest in successfully completing the project.
- The developer being obliged to provide specified levels of support until satisfactory operational completion has been certified.
- Utilisation of independent engineering assessment, for example as part of the due diligence process.
Technology Risk
This can be a very significant factor for little understood or new technologies. The main concern of lenders is that technology under-performance will adversely affect plant operations to the extent that the project is unable to make its debt repayments. Lenders do not like lending to new technologies and prefer tried and proven technologies that have been financed in the past. Even new applications of standard technology are of concern. Typically lenders feel comfortable with 3-6 previous plants of the same technology with at least 5 years of reliable operation.
For new technologies the lender will ask for additional support and guarantees from the sponsors. Sponsors will not generally be prepared to assume the full risk themselves, and will require guarantees and warranties from the manufacturers of renewables equipment (and in turn of the component suppliers). Unless the manufacturers are large, creditworthy companies, they will be forced to provide private insurance or bank bonds to cover this risk. Where private insurance is used, the bank will want to be named on the policy.
Financiers look to minimise, and/or appropriately assign, technology risk by locking in sponsor commitment (e.g. via equity stake, or minimum ownership period). This process can be facilitated by grants from multilateral aid agencies or government targeted on offsetting the financial exposure of the project to sponsors, the lenders and the investors. In addition the following can be utilised:
- Utilisation of independent engineering assessment, for example as part of the due diligence process.
- The application of tried and tested technology (i.e. one that has been shown to operate in broadly similar contexts).
- Strong experienced sponsor with significant track record (and ideally an equity stake).
- Arrangement that tie the key parties into the project at least until the debt has been repaid.
- Provision of longer term performance guarantees and warranties.
- Adequate insurance cover.
Economic, Inflation and Environmental risks
The economic risk – or economic viability – is an early benchmark used to judge a project. Lenders carry out financial modelling exercises to assess this risk and to satisfy themselves that the project revenues will be sufficient to cover the operating costs and loan obligations. The lender will look at the all the project assumptions, consider if the projections are reasonable and then consider the likelihood that the project can maintain sufficient cash flow to meet its obligations. The cost of this process, which includes due diligence aspects, is one of the factors that contributes to the high fixed cost of loans.
A bank measures the ‘cash to loan ratio’ to gauge the ability of the project to meet the loan requirements. This compares the cash revenue that the project will generate with the amount loaned. Various terms are used by the banks. The most common are annual ‘debt cover ratio’ (DCR), ‘project life cover ratio’ (PLCR), and the ‘loan life cover ratio’ (LLCR). The DCR is the most common banking measure; they often require a minimum DCR of 1.5:1. The LLCR and PLCR are slightly different in that they take account of the time value of money, and use discounted values. Most banks have a requirement for a LLCR of around 1.4:1 or 1.5:1 (the PLCR required is usually be greater than this).
The equity investors will also examine the project’s projected economic performance. Their key measurement is usually the Internal Rate of Return (IRR). The IRR measures the return to equity on the money it invested (it is the discount rate which equates the Net Present Value of the cash flows to zero). The IRR also takes account of the time value of money.
Economic risks are usually analysed in ‘real terms’, i.e. net of inflation. However, the assumption that the effects of inflation can be dealt with separately does not always hold. For example if the project expenditures, receipts and loans are all in the same currency, there is relatively low inflation risk. However, if elements of the scheme are linked to different inflationary escalators (e.g. differences between input and output prices), then project economics can be at risk. Further risk arises in cross-border transactions where each country’s inflation rate may be different.
The environment is of growing concern to lenders, and they are increasingly concerned to protect themselves against environmental liabilities. The lenders will require that all planning, environmental and other consents and approvals have been obtained. Environmental impact statements will be required in light of local, multinational bank and World Bank guidelines. Lenders also tend to look to potential changes in future environmental regulation for risks to the project’s future economic operation.
The economic, inflation and environmental risk factors are particularly difficult to offset as they may not become apparent until well into the debt repayment period. However, there are a series of tools available to help manage/minimise these, including the following:
- Sponsor guarantees to support debt servicing obligations until the project has achieved certified operational completion or to support the entire debt servicing period (depending on the outcome of the risk assessment).
- Proceeds accounts are reserve accounts set up to carry a cash balance that covers debt servicing requirements, typically for six month. Such arrangements can be denominated in a chosen currency to minimise short-term foreign exchange fluctuations.
- Standby letters of credit can be put in place with the output purchaser to support the off-take contract whilst ensuring their commitment.
- Provision of a guarantee arrangement underwritten by the local government.
- Extra collateral may be used to provided in the form of other assets as security in addition to the proposed project assets as a gesture of commitment.
- Syndication arrangements involving to spread the risk by involving other experienced financial institutions.
- Entering into well understood (fixed) contracts which are viewed as essentially binding on all parties and that either assign or share the risks.
- Having in place clearly stated pricing adjustment mechanisms which guarantee to cover the main variables.
- Putting in place a regime where operating performance subject is the subject to ongoing review.
- The application of financial arrangements such as debt covenants and debt service reserves.
- Planning and designing the plant so that it is capable of exceeding current national standards (although exceeding these standards by too much may be perceived as costly and unnecessary over-engineering).
Country, Political, Legal, Foreign Exchange and Force Majeure Risks
Country risk is important because international banks set lending limits on a country by country basis. If a bank is exceeding its country limit, it cannot lend to a new project, even a superior one. Obviously, a more unstable environment warrants a lower country limit.
Political risks are inherent in doing business, especially in cross-border transactions. These risks come under especially sharp scrutiny in developing countries. The most basic risk is that of the change of government. Political risk can also be incurred through government inaction or direct action (of both national and local government). Inaction could be failure to issue permits as needed, or government failure to enforce local legal provisions. Examples of direct action include the following:
- preventing the local partner from making payments on foreign loans;
- changing the foreign-exchange or currency-use rules thereby preventing foreign banks from recovering their loans;
- introducing regulations affecting the price or the mechanisms for the sale of electricity;
- nationalising, or privatising, the industry or project;
- political violence, such as war or terrorism.
Legal risks exist where laws are uncertain or can change. Lenders will seek legal opinions from local counsel to ensure that all the project contracts are legal, valid, binding and enforceable under the relevant laws, and the manner in which the security taken by the lenders could be enforced.
So long as the capital expenditures, revenues, operating expenses and loans are in the same currency, there is no foreign exchange risk. If this is not the case, the financiers will be asking the following questions: is the exchange rate likely to move against the project so that it will not be able to meet its payment obligations (to its debt or foreign suppliers), is the project guaranteed the ability to convert its local currency income into foreign currency (at a favourable rate) to meet the external obligations? Force majeure risk means a risk that is beyond the control of all parties to the project, typically ‘acts of God’ and severe weather, and possibly including industrial action. Often, a force majeure clause is used to excuse any party’s performance in the face of occurrences beyond their control.
Country, political, legal, foreign exchange and force majeure risks are very by their very nature difficult to fully mitigate. However, they are also risks that are normally well understood by finance organisations as the basic principles (and impacts) of these risks are essentially equivalent to those in wider economy. Approaches that may be used to ensure that this risk is minimised, and appropriately assigned include the following:
- Policies which encourage private sector involvement, particularly where this involvement will risk management and promote risk transfer. However, basic market liberalisation measures also help here, as it current orthodoxy suggests that once introduced such measures are difficult to repeal.
- Clear and unambiguous statements of government support for the type of investment being made are very useful risk mitigants, especially if linked to some form of guarantee. Any such statement will, ideally, contain within it indications of the underlying benefits that the government wishes to accrue from supporting renewables. This will help potential investors ascertain the degree to which individual schemes are compatible with national programmes or aspirations.
- Insurance against political risk can be obtained. National export credit agencies (ECAs) provide this to their exporters, with limits. More extensive cover can be obtained from multilateral development agencies such as the World Bank and their Multilateral Investment Guarantee Agency. Political risk cover can also be obtained on the private market, such as from Lloyds of London.
- To protect themselves against fluctuations in interest rates and currency exchange rates, the sponsor may be required by the lenders to enter into ‘hedging contracts’. These are financial devices used to reduce losses as a result of future price movements.
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