Yescombe Chap.

2 ’~
(Class 1)

Chapter 2

What Is Project Finance?

This chapter reviews the factors behind the recent rapid growth of project finance
(cf. §2.1), its distinguishing features (cf. §2.2), and relationship with privatization
(cf. §2.3), and also with other forms of structured finance (cf. §2.4). Finally, the
benefits of Using project finance are considered from the point of view of the vari-
ous project participants (el. §2.5).

§2.1 DEVELOPMENT OF PROJECT FINANCE

The growth of project finance over the last 20 years has been driven mainly
by the worldwide process of deregulation of utilities and privatization of public-
sector capital investment. This has taken place both in the developed world.~as well
as developing countries. It has also been promoted by the internationalization of
investment in major projects: leading project developers now run worldwide port-
folios and are able to apply the lessons learned from one country tO projects in an-
other, as are their banks and financial advisdrs. Governments and the public sec-
tor generally also benefit from these exchanges of experience.
Private finance for pubfic infrastructure projects is not a new concept: the En-
glish road system was renewed in the 18th and early 19th centuries using private-
sector funding based on toll revenues; the railway, water, gas, electricity, and tele-
phone industries were developed around the world in the 19th century mainly with
private-sector investment. During the first half of the 20th century, however, the
state took over such activities in many countries, and only over the last 20 years
has this process been reversing. Project finance, as an appropriate method of long-
term financing for capital-intensive industries where the investment financed has
 Chapter 2 What Is Project Finance? §2.2 Feature

Table 2.1 and real est,

Private-Sector Project Finance Loan Commitments, 1996-2001 Chapter 3.)
1996 1997 1998 1999 2000 2001 Assumin
($rnillions)
these figure:
Power 18,283 18,717 21,663 37,262 56,512 64,528 project
Telecommu~cations 13,296 19,864 16,275 24,929 36,735 25,445 It should
Infrastructure 5,037 7,436 9,006 12,673 16,755 14,473
O~and gas 12,552 12,638 by export c
3,417 15,386 10,666 7,792
Red estate andleisure 290 465 369 1,573 1,638 6,530 or other pul
Pe~ochemicals 4,100 4,603 3,129 5,356 3,337 3,898 certain stru.
Indus~y(process plant) 1,964 2,144 2,641 1,396 3,538 3,646 (cf. §2.4), a
Mining 1,234 6,307 2,694 1,377 629 2,323 (cf. Chapter
Total 47,621 74,922 66,443 92,358 131,696 133,481 can vary co~
Adapted from: Project Finance International, issues 113 (January 13, 1997), 137 (January 28, 1998), are reasonat
161 (January 27, 1999), 185 (January 26, 2000), 209 (January 24, 2001), 233 (January 23, 2002).

§2.2 FEA
a relatively predictable cash flow, has played an important part in providing the
funding required for this change, Project f
Some successive waves of project finance can be identified: from deal tc
¯ Finance for natural resources projects (mining, oil, and gas), from which deal has its
modern project finance techniques are derived, developed first in the Texas lying th~
oil fields in the 1930s; this was given a considerable boost by the oil price in-
creases, and the development of the North Sea oil fields in the 1970s, as well * It is pr,
as gas and other natural resources projects in Australia and various nomic~
developing countries. compm
o Finance for independent power projects ("IPPs") in the electricity sector (pri- ° It is us
marily for power generation) developed first after the Private Utility Regula- though
tory Policies Act ("PURPA") in the United States in 1978, which encouraged o There i
the development of cogeneration plants, electricity privatization in the ¯ speakit
United Kingdom in the early 1990s, and the subsequent worldwide process ° There ;
of electricity privafization and deregulation. recour~
o Finance for public infrastructure (roads, transport~ public buildings, etc.) was for the
especially developed through the United Kingdom’s Private Finance Initia- , Lender
tive ("PFI") from the early 1990s; such projects are now usually known as for inte
public-private partnerships (’qPPPs"). sets or
¯ Finance for the explosive worldwide growth in mobile telephone networks o The m~
developed in the late 1990s. owners
An analysis by industry sectors of the project finance loan commitments pro- assets ~
vided by private-sector lenders in recent years illustrates these trends (Table 2.1). a defau
The effects of recent electricity deregulation in parts of the United States and the
upsurge in worldwide investment in mobile phone networks are especially evident t For examp
in these figures. The steady growth in PPP-related project finance (infrastructure at $145 billion,
 §2.2 Featul~sofProjectFinance

and real estate) is also notable. (For a fuller analysis on a geographical basis, cf.
Chapter 3.)
2001
Assuming that debt averages 70% of total project costs, in 2001 on the basis of
these figures some $190 billion of new investments worldwide were financed with
64,528 project finance from private-sector lenders.
25,445 It should be noted that these statistics do not include direct lending for projects
14,473
12,638
by export credit agencies and multilateral development banks (cf. Chapter 11)
6,530 or other public-sector agencies. In addition, because (a) it is debatable whether
3,898 certain structured finance loans should be classified as project finance or not
3,646 (cf. §2.4), and (b) the borderline between project finance and financing projects
2,323 (cf. Chapter 1) is not always clear, market statistics compiled by different sources
133,481 can vary considerably;1 however, the overall trends in and scale of project finance
y 28, 1998), are reasonably clear.
,2002).

§2.2 FEATURES OF PROJECT FINANCE

dding the
Project finance structures differ between these various industry sectors and
from deal to deal: there is no such thing as "standard" project finance, since each
h deal has its own unique characteristics. But there are common principles under-
the ._xas lying the project finance approach.
1 price in- Some typical characteristics of project finance are
Is, as well It is provided for a "ring-fenced" project (i.e., one which is legally and eco-
t various nomically self-contained) through a special purpose legal entity (usually a
company) whose only business is the project (the "Project Company").
~ctor (pri-
It is usually raised for a new project rather than an established business (al-
y Regula- though project finance loans may be refinanced).
~couraged There is a high ratio of debt to equity ("leverage" or "gearing")--roughly
m in the
speaking, project finance debt may cover 70-90% of the cost of a project.
.e process
There are no guarantees from the investors in the Project Company ("non-
recourse" finance), or only limited guarantees ("limited-recourse" finance),
, etc.) was for the project finance debt.
tce Initia- Lenders rely on the future cash flow projected to be generated by the project
known as for interest and debt repayment (debt service), rather than the value of its as-
sets or analysis of historical financial results.
networks The main security for lenders is the project company’s contracts, licenses, or
ownership of rights to natural resources; the project company’s physical
aents pro- assets are likely to be worth much less than the debt if they are sold off after
"able 2.1). a default on the financing.
~s and the
ly evident ~For example, Euromoney’s Loanware database estimated the total project finance market in 2001
astructure at $145 billion, $12 billion higher than the figure in Table 2.1
 Chapt.er 2 What Is Project Finance? §2.3 Project Fi

{Investors{ { Lenders I other parties t

age. The Proj,
~
t Equity Project ¯ A Projec
i i Finance Debt either ar
th
Contractor ] - i ~. _~ I Operator in
I ~ mnance i a
o?"
~
1 Construction [ I¯ [ Operation &
p~
l Contract i I’ i.___Main ten, nee C°n tmc~t
p~
(e
Alternati
terms of
network)
. Other pI
! Input Supply Off-take Atun
Contract Contract under
i
comp]
" Alvin
Input Supplier I Of f taker

Figure 2.1 Simplified project finance structure. . AnOI

will b, ’
* AGe
¯ The project has a finite life, based on such factors as the length of the con- whict
tracts or licenses or the reserves.of natural resources, and therefore the proj- Offtal
ect finance debt must be fully repaid by the end of this life.
Project At
Hence project finance differs from a corporate loan, which is primarily lent tracts in Cha1
against a company’s balance sheet and projections extrapolating from its past cash are unique to
flow and profit record, and assumes that the company will remain in business for licenses from
an :indefinite period and so can keep renewing ("rolling over") its loans. matters, and
Project finance is made up of a number of building blocks, although all of these finance.
are not found in every project finance transaction (cf. §2.4), and there are likely to
be ancillary contracts or agreements not shown in Figure 2.1.
The project finance itself has two elements: §2.3 PRO
¯ Equity, provided by investors in the project
¯ Project finance-based debt, provided by one or more groups of lenders Project fiI

The project finance debt has first call on the project’s net operating cash flow; the either co:
equity investors’ return is thus more dependent on the success of the project. thi
The contracts entered into by the Project Company provide support for the st~
project finance, particularly by transferring risks from the Project Company to the rat
 §2.3 Project Finance and Privatization

other parties to the Project Contracts, and form part of the lenders’ security pack-
age. The Project Contracts may include the following:
. A Project Agreement, which may be
either an Off-take Contract (e.g., a power purchase agreement), under which
the product produced by the project will be sold on a long-term pric-
ing formula
or a Concession Agreement with ~he government or another public au-
thority, which gives the Project Company the right to construct the
project and earn revenues from it by providing a service either to the
public sector (e.g., a public building) or directly to the general public
(e.g., a toll road)
port Alternatively, the project company may have a license to operate under the
terms of general legislation for the industry sector (e.g. a mobile phone
network).
o Other project contracts, e.g.:
. A" turnkey Engineering, Procurement and Construction (EPC) Contract,
under which the project will be designed and built for a fixed price, and
completed by a fixed date
,r O~h~r . An Input Supply Contract, under which fuel or other raw material for
u~ofity the project will be provided on a long-term pricing formula in agreed
quantities
¯ An Operating and Maintenance (O&M) Contract, under which a third party
will be responsible for the running of the project after it has been built
o A Government Support Agreement (usually in a developing country),
*f the con- which may provide various kinds of support, such as guarantees for the
~ the proj- Offtaker or tax incentives for the investment in the project.
Project Agreements are discussed in detail in Chapter 6 and other Project Con-
~arily lent tracts in Chapter 7. Of course none of these structures or contractual relationships
past cash are unique to project finance: any company may have investors, sign contracts, get
tsiness for licenses from the government, and so on; however, the relative importance of these
matters, and the way in which they are linked together, is a key factor in project
.11 of these finance.
e likely to

§2.3 PROJECT FINANCE AND PRIVATIZATION

ders Project finance should be distinguished from privatization, which:
, flow; the either conveys the ownership of public-sector assets to the private sectorw
3ject. this does not necessariJy involve project finance: a privatized former
~rt for the state-owned company may raise any finance required through a corpo-
any to the rate loan
10 Chapter 2 What Is Project Finance? §2.4 Project t- ....

provides for services to be supplied by a private company that had pre- company-
viously been supplied by the public sector (e.g., street clemKng)u remains ~
again, this does not necessarily involve project finance: the private com- Build-transl
pany may not have to incur major new capital expenditure and so not ect, excep
require any finance at all, or may use a corporate loan to raise the finance ect until c
to make the investment required to provide the service. Build-own-,
ship rema
Project finance may come into the picture if a company needs finance for the con- a power s
struction of public infrastructure on the basis of a contract or licence, e.g.: work. Th~
An Off-take Contract, based on which a project will be constructed to sell its in the pro~
output to a public-sector body (e.g., construction of a power station to sell into this c
electricity to a state-owned power company) There are ot
A Concession Agreement under which a project will be constructed to pro- and the projec
vide a service to a public-sector body (e.g., provision of a public-sect.or hos- example, "BO~
pital building and facilities) as "BOOT."
A Concession Agreement under which a project will be constructed to pro- Clearly a Pr,
vide a service to the general public normally provided by the public sector whether or not
(e.g., a toll road) the short or the
A Concession Agreement or licence under which a project will be con- or is never hek
structed to provide new services to the public (e.g., a mobile phone project finance
network). in this way is nc
from the
Such Project Agreements with the public sector, which provide a basis for proj- importanc~.~
ect finance, can take several different forms: in a BOO but
Build-own-operate-transfer ("BOOT") projects: The Project Company vestors in asses
constructs the project and owns and operates it for a set period of time, earn-
ing the revenues from the project in this period, at the end of which owner-
§2.4 PROJI
ship is transferred back to the public sector. For example, the project com-
pany may build a power station, own it for 20 years during which time the
Although th
power generated is sold to an Offtaker (e.g., a state-owned electricity distri-
market calls "
bution company), and at the end of that time ownership is transferred back
"building bloc~
to the public sector.
example:
Build-operate-transfer (’’BOT") projects (also known as design-build-
finance-operate ["DBFO"] projects). In this type of project, the Project ° K the pro~
Company never owns the assets used to provide the project services. How- (e.g., oil),
ever the Project Company constructs the project and has the right to earn rev- * A toll-roa,
enues from its operation of the project. (It may also be granted a lease of the o A project
project site and the associated buildings and equipment during the term of date-terra
the project--this is known as build-lease-transfer ("BLT") or build-lease- * A mining
operate-transfer ("BLOT"). This structure is used where the public nature to extract ~
of the project makes it inappropriate for it to be owned by a private-sector the marke
 §2.4 Project Finance and Structured Finance 11

md pre- company--for example, a road, bridge, or tunnel--and tberefoi-e ownership

aing)-- remains with the public sector.
Ie com- Build-transfer-operate ("BTO") projects, These are similar to a BOT proj-
1 so not ect, except that the public sector does not take over the ownership of the proj-
finance ect until construction is completed.
Build-own-operate ("BOO") projects. These are projects whose owner-
ship remains with the Project Company throughout its hfewfor example,
the con- a power station in a pfivatized electricity industry or a mobile phone net-
work. The Project Company therefore gets the benefit of any residual value
in the project. (Project agreements with the private sector also normally fall
sell its
to sell into this category.)
There are other variations on these acronyms for different project structures,
I to pro- and the project finance market does not always use them consistently--for
:tor hos- example, "BOT’ is often used to mean "Build-Own-Transfer," i.e., the same
as "BOOT."
t to pro- Clearly a Project Company would always prefer to own the project assets, but
ic sector whether or not the ownership of the project is transferred to the public sector in
the short or the long term, or remains indefinitely with a private-sector company,
be con- or is never held by the private-sector company, makes little difference from the
project finance point of view. This is because the real value in a project financed
in this way is not in the ownership of its assets, but in the right to receive cash flows
from the project. But although these different ownership structures are of limited
for proj- importance to lenders, any long-term residual value in the project (as there may be
in a BOO but not a BOOT/BOT/BTO project) may be of relevance to the in-
vestors in assessing their likely return.
;ompany

h owner-
ect corn- §2.4 PROJECT FINANCE AND STRUCTURED FINANCE
time the
Although there are general characteristics or features to be found in what the
.ty distri-
a-ed back market calls "project finance" transactions, as already mentioned, all of the
"building blocks" shown in Figure 2.1 are not found in every project financing, for
example:
~-build-
~ Project If the product of the project is a commodity for which there is a wide market
es. How- (e.g., oil), there is not necessarily a need for an Off-take Contract.
earn rev- A toll-road project has a Concession Agreement but no Off-take Contract.
ase of the A project for a mobile phone network is usually built without a fixed price,
e term of date-certain EPC Contract, and has no Offtake Contract.
ild-lease- A mining or oil and gas extraction project is based on a concession or license
lJc nature to extract the raw materials, but the Project Company may sell its products into
ate-sector the market without an Offtake Contract.
12 Chapter 2 What Is Project Finance?

¯ A project that does not use fuel or a similar raw material does not require an Leverag~
Input Supply Contract ~:, This h
¯ Government Support Agreements are normally only found in projects in de- ~ busine
ve!oping countries. !i~i~ . 1S USU~
of its ~
There is, therefore, no precise boundary between project finance and other projec
types of financing in which a relatively high level of debt is raised to fund a busi- ect fin
ness. The boundaries are also blurred as transactions that begin as new projects Acquisi!
become established and then are refinanced, with such refinancing taking on more tion fil
of the characteristics of a corporate loan. .. debt. 1
Lenders themselves draw the boundaries between project finance and other combi
types of lending based on convenience rather than theory, taking into account that Asset fn
skills used by loan officers in project finance may also be used in similar types of easily
financing. Many lenders deal with project finance as part of their "structured nanch
finance" operations, covering any kind of finance where a special-purpose vehicle by the
(SPV) like a Project Company has to be put in place as the borrower to raise the Leasing
funding, with an equity and debt structure to fit the cash flow, unlike corporate financ
loans, which are made to a borrower already in existence (cf. §5.1). As a result,
project finance market statistics have to be treated with some caution, as they may
be affected by inclusion or exclusion of large deals on the borderline between proj- §2.5
ect finance and other types of structured finance.
Examples of other types of structured finance and their differences from proj- A pr.oie~
ect finance include the following: rather(
Receivables financing. This is based on lending against the established cash its avaa,,
flow of a business and involves raising funds through an SPV similar to credit line,’
a Project Company (but normally off the balance sheet of the true benefi- finance). P
ciary of the cash flow). The cash flow may be derived from the general busi- ings recorc
ne.ss (e.g., a hotel chain) or specific contracts that give rise to this cash flow and cheap
(e.g., consumer loans, sales contracts, etc.). The key difference with project A Proj~
finance is that the latter is based on a projection of cash flow from a project serve as th,
yet to be established. that they v
Although telecommunication financing is often included under the head- high level
ing of project finances it has few of the general characteristics shared by need to ha
other types of project finance. It could be said to come halfway between such time and
receivables financing and "true" project finance, in that the financing may (c) that th,
be used towards construction of a project (a new telephone network), but their debt
loans are normally not drawn until the initial revenues have been established cover any
(cf. §8.8.7). Thus tt
Securitization, If receivables financing is procured in the bond market (cf. these pro~
§5.2), it is known as securitization of receivables¯ (There have also been a tify the
few securitizafions of receivables due from banks’ project finance loan project
books, but so far this has not been a significant feature in the market.) or, where
Project Finance? §2.5 Why Use Project Finance? 13

s not require an Leveraged buyout (’"LBO") or management buyout ("MBO") financing.

This highly leveraged financing provides for the acquisition of an existing
I projects in de- business by portfolio investors (LBO) or its own management (MBO). It
is usually based on a mixture of the cash flow of the business and the value
of its assets. It does not normally involve finance for construction of a new
ance and other
project, nor does this type of financing use contracts as security as does proj-
to fund a busi-
ect finance.
ts new projects Acquisition finance. Probably the largest sector in structured finance, acquisi-
taking on more
tion finance enables company A to acquire company B using highly leveraged
debt. In that sense it is similar to LBO and MBO financing, but based on the
ance and other
combined business of the two companies.
tto account that
:imilar types of Asset finance. Asset finance is based on lending against the value of assets
easily saleable in the open market, e.g., aircraft or real estate (property) fi-
eir "structured
mrpose vehicle nancing, whereas project finance lending is against the cash flow produced
by the asset, which may have little open-market value.
ver to raise the
Leasing. Leasing is a form of asset finance, in which ownership of the asset
tlike corporate
I). As a result, financed remains with the lessor (i.e., lender) (cf. §3.4).
m, a~ they may
between proj-
§2.5 WHY USE PROJECT FINANCE?
.~ proj-
A project may be financed by a company as an addition to its existing business
rather than on a stand-alone project finance basis. In this case, the company uses
tabhshed cash its available cash and credit lines to pay for the project, and if necessary raise new
:PV similar to credit lines or even new equity capital to do so (i.e., it makes use of corporate
~e true benefi- finance). Provided it can be supported by the company’s balance sheet and earn-
~ general busi- ings record, a corporate loan to finance a project is normally fairly simple, quick,
this cash flow and cheap to arrange.
:e with project A Project Company, unlike a corporate borrower, has no business record to
from a project serve as the basis for a lending decision. Nonetheless, lenders have to be cbnfident
that they will be repaid, especially taking account of the additional risk from the
ader the head- high level of debt inherent in a project finance transaction. This means that they
Jcs shared by need to,have a high degree of confidence that the project (a) can be completed on
between such time and on budget, (b) is technically capable of operating as designed, and
inancing may (c) that there will be enough net cash flow from the project’s operation to cover
network), but their debt service adequately. Project economics also need to be robust enough to
~n established cover any temporary problems that may arise.
Thus the lenders need to evaluate the terms of the project’s contracts insofar as
d market (c/ these provide a basis for its construction costs and operating cash flow, and quan-
’e also been a tify the risks inherent in the project with particular care. They need to ensure that
finance loan project risks are allocated to appropriate parties other than the Project Company,
narket.) or, where this is not possible, mitigated in other ways. This process is known as
14 Chapter 2 What Is Project Finance?
§2.5 Why Use P~ w
Table 2.2
an investor’s
Benefit of Leverage on Investors’ Return
to the same
Low leverage High leverage financed wit
debt for a gc
Project cost 1,000. 1,000 hand, if it is
(a) Debt 300 800
(b) Equity 700 200
the (reduced
(c) Revenue from project 100 100 debt (reflect:
(d) Interest rate on debt (p.a.) 5% 7% Project fi~
(e)’ Interest payable [(a) x (d)] 15 56 equity, beca~
(f) Profit [(c) - (e)] 85 44 risk) than an
Return on equity [(f) + (b)] 12% 22%
investment i
therefore ha:
financial sW
"due diligence." The due-diligence process may often cause slow and frustrating other way ar
progress for a project developer, as lenders inevitably tend to get involved--di- higher risk,
rectly or indirectlymin the negotiation of the Project Contracts, but it is an un- project finar
avoidable aspect of raising project finance debt. (The issues covered during due in the projec
diligence are discussed in Chapters 8 to 10.) Tax benefits.
Lenders also need to continue to monitor and control the activities of the Proj- is that inter~
ect Company to ensure that the basis on which they assessed these risks is not un- which mak~
dermined. This may also leave the investor with much less independent manage- leverage. TI-
ment of the project than would be the case with a corporate financing. (The profit in the
controls imposed by lenders are discussed in Chapter 13.) uity of (
Besides being slow, complex, and leading to some loss of control of the proj- after-tai
ect, project finance is also an expensive method of financing. The lenders’ margin In major 1
over cost of funds may be 2-3 times that of corporate finance; the lenders’ due tions anywa
diligence and control processes, and the advisors employed for this purpose (cf. is depreciat~
§5.4), also add significantly to costs. duction of il
It should also be emphasized that project finance cannot be used to finance a Off-balance-sl
project that would not otherwise be financeable. ject it into tl:
A project
consolidatec
§2.5.1 Wrr~’ INVESTERS USE PROJECT FINANCE shareholder
through ajo
Why, despite these factors, do investors make use of project finance? There are as beneficia
a variety of reasons: pany’s shar~
volved in al
High leverage. One major reason for using project finance is that investments notes to the
in ventures such as power generation or road building have to be long term sheet figure,,
but do not offer an inherently high return: high leverage improves the return reasons (dis
.for an investor. purely to ke
Table 2.2 sets out a (very simplified) example of the benefit of leverage on Borrowing c~
nance ? §2.5 Why Use Project Finance? 15

an investor’s return. Both the low-leverage and high-leverage columns relate

to the same investment of 1,000, which produces revenue of 100 p.a. If it is
financed with 30% debt, as in the low-leverage column (a typical level of
debt for a good corporate credit), the return on equity is 11%. On the other
hand, if it is financed with 80% (prdject finance-style) leverage, the return on
the (reduced level) of equity is 22%, despite an increase in the cost of the
debt (reflecting the higher risk for lenders):
Project finance thus takes advantage of the fact that debt is cheaper than
equity, because lenders are willing to accept a lower return (for their lower
risk) than an equity investor. Naturally the investor needs to be sure that the
investment in the project is not jeopardized by loading it with debt, and
therefore has to go through a sound due diligence process to ensure that the
financial structure is prudent. Of course the argument could be turned the
trating other way around to say that if a project has high leverage it has an inherently
1--di- higher risk and So it should produce a higher return for investors. But in
arl lln- project finance higher leverage can only be achieved where the level of risk
~g due in the project is limited.
Tax benefits. A further factor that may make high leverage more attractive
~ Proj- is that interest is tax deductible, whereas dividends to shareholders are not,
~ot un- which makes debt even cheaper than equity, and hence encourages high
leverage. Thus, in the example above, if the tax rate is 30%, the after-tax
profit in the low leverage case is 60 (85 X 70%), or an after-tax return on eq-
uity of 8.5%, whereas in the high-leverage case it is 31 (44 X 70%), or an
~ proj- after-tax return on equity of 15.4%.
nargin In major projects there is, however, likely to be a high level of tax deduc-
¯ s’ due tions anyway during the early stages of the project because the capital cost
se (c£ is depreciated against tax (cf. §12.7.1), so the ability to make a further de-
duction of interest against tax at the same time may not be significant.
ance a Off-balance-sheet financing. If the investor has to raise the debt and then in-
ject it into the project, this wilt clearly appear on the investor’s balance sheet.
A project finance structure may allow the investor to keep the debt off the
consolidated balance sheet, but usually only if the investor is a minority
shareholder in the project--which may be achieved if the project is owned
through a joint venture. Keeping debt off the balance sheet is sometimes seen
~re as beneficial to a company’s position in the financial markets, but a com-
pany’s shareholders and lenders should normally take account of risks in-
volved in any off-balance-sheet activities, which are generally revealed in
ments notes to the published accounts even ff they are not included in the balance
~ term sheet figures; so although joint ventures often raise project finance for other
return reasons (discussed below), project finance should not usually be undertaken
purely to keep debt off the investors’ balance sheets.
~ge on Borrowing capacity. Project finance increases the level of debt that can be
16 Chapter 2 What Is Project Finance? §2.5 Why ,.,~
borrowed against a project: nonrecourse finance raised by the Project Com-
pany is not normally counted against corporate credit lines (therefore in this
sense it may be off-balance sheet). It may thus increase an investor’s overall
borrowing capacity, and hence the ability to undertake several major projects
simultaneously.
Risk limitation. An inve~tor in a project raising funds through project finance (a) ~
does not normally guarantee the repayment of the debt--the risk is therefore (b)
limited to the amount of the equity investment. A company’s credit rating is (c)
(d)
also less likely to be downgraded if its risks on project investments are lim- (e)
ited through a project finance structure.
Risk spreading / joint ventures. A project may be too large f.or one investor to
undertake, so others may be brought in to share the risk in a joint-venture Proj-
ect Company. This both enables the risk to be spread between investors and
limits the amount of each investor’s risk because of the nonrecourse nature of idea
the Project Company’s debt financing. ture,
As project development can involve major expenditure, with a significant maint
risk of having to write it all off if the project does not go ahead (cf. §4.2), a pro jet
project developer may also bring in a partner in the development phase of the
project to share this risk.
This approach can also be used to bring in "limited partners" to the proj- §2.5.2 T
ect (e.g,, by giving a share in the equity of a Project Company to an Offtaker
who is thus induced to sign a long-term Offtake Contract, without being re- EqlJ-11v
qnired to make any cash investment, or with the investment limited to a small provi(
proportion of the equity.) where
Creating a joint venture also enables project risks to be reduced by com-
bining expertise (e.g., local expertise plus technical expertise; construc- Lower
tion expertise plus operating expertise; operating expertise plus. marketing ect’s
expertise). In such cases the relevant Project Contracts (e.g., the EPC Con- as hi
tract or the O&M Contract) are usually allocated to the partner with the rel- is be "
evant expertise (but cf. §4.1). in re
Long-term .finance. Project finance loans typically have a longer term than 15%
corporate finance. Long-term financing is necessary if the assets financed ing 1
normally have a high capital cost that carmot be recovered over a short term and
without pushing up the cost that must be charged for the project’s end prod- finar
uct. SO loans for power projects often run for nearly 20 years, and for infra- pect
structure projects even longer. (Oil, gas, and minerals projects usually have that
a shorter term because the reserves extracted deplete more quickly, and cant
telecommunication projects also have a shorter term because the technology impl
involved has a relatively short life.) S~
Enhanced credit. If the Offtaker has a better credit standing than the equity cost
investor, this may enable debt to be raised for the project on better terms than
the investor would be able to obtain from a corporate loan. to si
Unequal partnerships. Projects are often put together by a developer with an Addi~
:ect Finance? §2.5 Why Use Project Finance? 17

:oject Com- Table 2.3

ffore in this Effect of Leverage on Offtaker’s Cost
tor’s overall
Low leverage High leverage
tjor projects
Project cost 1,000 1,000
,ject finance (a) Debt 300 800
is therefore (b) Equity 700 200
(c) Return on equity[(b) X 15%] 105 30
:dit rating is (d) Interest rote on debt (p.a.) 5% 7%
;nts are lim- (e) Interest payable[(a) x (d)] 15 56
Revenue required[(c) + (e)] 120 86
investor to
enture Proj-
a,estors and
"se nature of idea but little money, who then has to find investors. A project finance struc-
ture, which requires less equity, makes it easier for the weaker developer to
~ significant maintain an equal partnership, because if the absolute level of the equity in the
(cf. §4.2), a project is low, the required investment from the weaker parmer is also low.
phase of the

to the proj- §2.5.2 THEBENEFITS OF PROJECT FINANCE TO THIRD PARTIES

an "’aker
ut g re- Equally, there are benefits for the Offtaker or end user of the product or service
’.d to a small provided by the Project Company, and also for the government of the country
where the project is located:
ed by corn-
:; construc- Lower product or service cost. In order to pay the lowest price for the proj-
~ marketing ect’s product or service, the Offtaker or end user will want the project to raise
~. EPC Con- as high a level of debt as possible, and so a project finance structure
vith the rel- is beneficial. This can be illustrated by doing the calculation in Table 2.2
in reverse: suppose the investor in the project requires a return of at least
r term than 15%, then, as Table 2.3 shows, to produce this, revenue of 120 is required us-
:ts financed ing low-leverage finance, but only 86 using high-leverage project finance,
i short term and hence the cost to the Offtaker or end user reduces accordingly. (In
’s end prod- finance theory, an equity investor in a company with high leverage would ex-
~d for infra- pect a higher return than one in a company with low leverage, on the ground
sually have that high leverage equals high risk. However, as discussed above, this effect
uickly, and cannot be seen in project finance investment, since its high leverage does not
technology imply high risk.) (Also cf. § 13.1 for other issues affecting leverage.)
So ff the Offtaker or end user wishes to fix the lowest long-term purchase
the equity cost for the product of the project and is able to influence how the project is
terms than financed, the use of project finance should be encouraged, e.g., by agreeing
to sign a Project Agreement that fits project finance requirements.
,per with an Additional investment in public infrastructure. Project finance can provide
18 Chapter 2 What Is Project Finance? §2.5 Why Use.
funding for additional investment in infrastructure that the public tion), the t
sector might otherwise not be able to undertake because of economic or on an arm’
financial constraints on the public-sector investment budget. Additional i
Of course, if the public sector pays for the project through a long-term Pro- opens up r
ject Agreement, it could be said that a project financed in this way is merely to create i~
off-balance sheet financing for the public-sectdr, and should therefore be in- successful
cluded in the public-sector budget anyway. Whether this argument is a valid act as a sh~
one depends on the extent to which the public sector has transformed real proj- Technology
ect risk to the private sector. way of pr~
Risk transfer. A project finance contract structure transfers risks of, for ex- local econ,
ample, project cost overruns from the public to the private sector. It also
usually provides for payments only when specific performance objectives
are met, hence also transferring to the private sector the risk that these are
not met.
Lower project cost. Private finance is now widely used for projects that
would previously have been built and operatedby the public sector (cf. §2.3).
Apart from relieving public sector budget pressures, such PPP projects also
have merit because the private sector can often build and run such invest-
ments more cost-effectively than the public sector, even after allowing for the
higher cost of project finance compared to public-sector finance.
This lower cost is a function of:
o The general tendency of the public sector to "overengineer" or "gold-
plate" projects
¯ Greater private-sector expertise in control and management of project con-
struction and operation (based on the private sector being better able to of-
fer incentives to good managers)
o The private sector taking the primary risk of construction and operation
cost overruns, for which public-sector projects are notorious
¯ "Whole life" management of long-term maintenance of the project, rather
than ad hoc arrangements for maintenance dependent on the availability
of further public-sector funding
However, this cost benefit can be eroded by "deal creep" (i.e., increases in
costs during detailed negotiations on terms or when the specifications for the
project are changed during this period--cf. §4.6.3).
Third-party due diligence. The public sector may benefit from the indepen-
dent due diligence and control of the project exercised by the lenders, who will
want to ensure that all obligations under the Project Agreement are clearly
fulfilled and that other Project Contracts adequately deal with risk issues.
Transparency. As a project financing is self-contained (i.e., it deals only with
the assets and liabilities, costs, and revenues of the particular project), the
true costs of the product or service can more easily be measured and moni-
tored. Also, if the Sponsor is in a regulated business (e.g., power distribu-
 Project Finance? §2.5 Why Use Project Finance? 19

hat the public tion), the umegulated business can be shown to be financed separately and
of economic or on an arm’s-length basis via a project finance structttre.
Additional inward investment. For a developing country, project finance
a long-term Pro- opens up new opportunities for infrastructure investment, as it can be used
is way is merely to create inward investment that would not otherwise occur. Furthermore,
[ therefore be in- successful project finance for a major project, such as a power station, can
~ument is a valid act as a showcase to promote fttrther investment in the wider economy.
[ormed real proj- Technology transfer. For developing countries, project finance provides a
way of producing market-based investment in infrastructure for wbSch the
risks of, for ex- local economy may have neither the resources nor the skills.
:e sector. It also
~ance objectives
~k that these are

br projects that
sector (cf. §2.3).
PP projects also
run such invest-
allowing for the

" "gold-

~t of project con-
)etter able to of-

n and operation

e project, rathei
. the availability

i.e., increases in
fications for the

~m the indepen-
~nders, who will
nent are clearly
a risk issues.
deals only with
lar project), the
,ured and moni-
power distribu-
introduction

The scope of project finance both changed and expanded in the 1990s. The growing need
for power and other infrastructure facilities increased the demand for project financing,
while the sources of project finance broadened to include the capital markets. Financial
tools such as pooling, securitisation and derivatives provided new ways to mitigate project
risks. As investors and lenders became more familiar with project finance, they showed
increasing risk tolerance. As a result, the boundaries of project finance have widened. In
the mid-1990s banks and institutional investors financed projects with structures and terms
that would have been hard to imagine just five years before. The total world_wide volume
of p)oject finance increased rapidly from 1994 to 1997, lessened after the ~sian financial
crisis in 1997 and then increased to a new high ~n 21300. Project finance then dechned once
again along with the collapse of equities, particularly in technology and telecommunica-
tions; the related decline in technology and telecom capital expenditures; and the Enron
bankruptcy and associated scrutiny of power companies’ trading activities and balance
sheets (see Exhibit A).
Project Finance: Practical Case Studies consists of 38 case studies of recent project
financings. This first volume covers power and water (irrigation) projects, and Volume II cov-
ers resources and infrastructure projects. The project case studies were selected to exhibit the
types of projects most frequently financed in a variety of countries. Because these case stud-
ies illustrate different aspects of project finance across the major geographical areas, the
nature of their content varies considerably. For example, some contain a detailed description
of project documentation while others do not cover documentation at all. Some power pro-

Exhibit A
Global facility-type breakdown for project financings closed, 1994-2002
Loan Bond Sponsors’ Average
amount Per amount Per equity Per Total Number deal size
(US$ cent (US$ cent (US$ cent (US$ of (US$
~ar millions) of total millions) of total millions) of total millions) deals millions)

1994 28,603.44 85.3 564.00 1.7 4,380.70 13.0 33,548.14 85 394.68

1995 59,361.72 76.8 3,920.90 5.1 14,055.58 18.1 77,338.20 323 239.44
1996 113,810.40 64.6 13,789.45 7.8 48,649.81 27.6 176,249.66 649 271.57
1997 142,545.29 66.3 18,654.07 8.7 53,714.85 25.0 214,914.21 560 383.78
1998 115,103.37 61.3 18,141.53 9.7 54,545.66 29.0 187,790.56 485 387.20
1999 119,139.82 61.0 23,673.62 12.1 52,571.89 26.9 195,385.33 464 421.09
2000 161,556.30 67.3 23,544.30 9.8 54,893.64 22.9 239,994.24 459 522.86
2001 96,033.69 69.2 14,573.22 10.5 28,166.74 20.3 138,773.65 308 450.56
2002 56,062.16 72.7 7,782.03 10.1 13,252.75 17.2 77,096.94 247 312.13

Souice: Dealogic ProjectWare.

POWER AND WATER

Exhibit B
Summary of projects by industry and geographical area
Europe Latin
( inchtding America
the United (including North Multi-
Africa Asia Kingdom) Mex(co) America national

Power projects/portfolios 1 6
Power and water (irrigation) 1
Pipelines 1 ,3
Mines 3 2
Oil field 1
Refinery 1
Toll roads 3 1
Airports 1 1
Telecom 2 1

ject case studies are concerned primarily with negotiating contracts in countries that are just
beginning to privatise their electricity sectors, while others concentrate on ne@ financing
techniques and adapting to a merchant power environment.
The case studies in these volumes cover a broad range of industries and geographical
areas as illustrated in Exhibit B.

Industry sectors
Volume I- Power and Water covers issues such as the privatisation and deregulation of the
electricity industry, adaptation to merchant sales and pricing environments, negotiating initial
independent power projects in developing countries, political risk, recent financing innova-
tions, and the worldwide ripple effect of the California power crisis and the Enron bankrupt-
cy, including the pullback of large international power players.
In Vohtme I1 - Resources and Infrastructures, the pipeline project case studies discuss
the increasing willingness of both the bank and capital markets to take risks in a developing
country; the requirements for multilateral agency participation; and the need to address envi-
ronmental, social, and sustainability issues. The oil fieId production project case study
demonstrates how the credit rating of a solid export-oriented project with strong sponsors
can pierce the sovereign ceiling of a country with political difficulties. Similarly, the refin-
ery case study presents an example of a project with pure emerging-market risk that can sur-
vive in a difficult economic environment. The mining project case studies demonstrate
sensitivity to commodity price risk, the negotiation of a basic legal structure with a host gov-
ernment, and the construction and operating difficulties involved. The toll road project case
studies outIine bridge construction challenges, and issues related to the respective roles of
the government and the private sector in assuming construction and traffic risks, a flexible
repayment mechanism to cope with traffic risks, and problems when traffic does not meet
projections. The airport case studies present an example of a whole-business securitisation,
and describe difficulties related to lower-than-projected passenger traffic and ongoing nego-
tiations with the government on concession issues. Finally, the three telecommunications pro-
 INTRODUCTION

ject case studies discuss topics such as a

creative lease structure that provided Exhibit C
financir~g for a state-owned telephone Author’s project finance interview protocol
company, an aggressive multinational Description ol project, including type, location, size and other
network expansion that could not be specilications
supported when telecom capital expen- Reason for project and sponsors’ needs
ditures collapsed and an international How project participants were assembled
consortium’s overpayment for a local Legal structure of project entity, including a diagram of project
cellular telephone licence. structure
Analysis of proiecl risks and economic viability
Mos~ important projecl contracts and principal provisions
Geographical areas Allernative sources ol finance considered
The case studies in these volumes were How ~he financing team was assembled
Structure ol financing
intentionally selected to provide geo-
Pricing, maturibj and other financing terms, including guarantees
graphical diversity. Although, over the
and other third-party sources of support; insurance, collateral,
long term, there is not a great deal of and other forms of protection; and important features of financ-
difference between project financings ing documentation
in geographical areas per se, recent Accounting and tax considerations tot sponsors and investors
regional economic difficulties, such as Credit analysis from the investors’ and lenders’ perspectives
the Asian financial crisis, the Russian Credit rating
default and the Brazilian devaluation, Principal problems encountered with proiec~ and financing
have had medium-term effects both on Investors’ and lenders’ concerns before and since notes were
sponsors’ abilities to finance projects issued
and on the terms of available financ- Most innovative features ol the project
Most important lessons learned
ing. There also is a significant differ-
How ~he project illustrates current regional and country trends
ence between financing projects in
member states of the Organisation for
Economic ~ooperation and Development (OECD) and developing countries. Among
worldwide emerging-market considerations for projects across all industry sectors are pro-
longed negotiations; the familiarisation of government officials, lawyers and bankers with
financN1 and legal concepts new to the local market; and the enactment of new laws to
cover a broad range of issues, including commercial contracts, collateral and security inter-
ests, power and fuel purchase agreements, mineral rights and repatriation of profits and
capital. These issues are particularly apparent in Africa, which became a significant project
financing venue in the 1990s.

Content and research method

Prior to delving into the case studies in this volume, and those in Volume II - Resources and
Infi-astructure, this introductory, analytical chapter, replicated in each volume, discusses
current trends in project finance and important themes that run through the case studies.
When a specific case is referred to, the chapter in which it is discussed is noted if it appears
in this v’olume and a note to see Vol~r~e II - Reso~res a~d I@’ast~’~ct~re is provided if it
appears in Volume II. Information for both this chapter and the case studies was gathered
from the financial press; credit rating agency analytical reports; and on-site and telephone
interviews with commercial bankers, investment bankers, project sponsors, institutional
 POWER AND WATER

investors, rating agency anaIysts and

others. On-site interviews generally Exhibit D
ranged between one and two hours. Checklist for successful project financing
¯ The interviews were taped and the case 1. A credit risk rather than equity risk is involved.
studies were approved for accuracy by 2. k satisfactory feasibility sDdy anr~ tinancJal pja,r~ have been pre-
the interviewees. To help focus the pared¯
interviews and the content of the case 3. The cost of product or raw material to be used by the project is
studies, the author developed an inter- assured.
view protocol and used the ’Checklist 4. A supply of energy at a reasonable cost has been assured.
¯ for a successful project financing’ 5. A market exists for product, commodity, or service to be pro-
from Project Financing Seventh duced¯
Editiont (see Exhibits C and D). For 6, Transportation is available at a reasonable cost to move lhe prod-
more than 25 years, the seven editions uct to the market.
of Project Financing have been one of 7. . Adequate communicalions are available.
8. Building materials are available at the costs contemplated.
the most widely used sources of basic
9. The contractor is experienced and reliable.
information on project finance. For
10. The operator is experienced and reliable.
each project, it was understood that 1:1. Managementpersonne! are experienced andfeiiable.
some items on the interview checklist 12. New technology is not involved.
were more applicable than others. The 13. The contractual agreement among joint venture partners, if any, is
interviewees’ comments and the con- satisfactory.
tents of the case studies generally con- !4, A stable and friendly political environment exists, ficences and
centrate on aspects of the project permits are available, contracts can be enforced, and legal reme-
financings that were the most interest- dies exist.
ing, unusual or useful to the practition- 15, There is no risk of expropriation.
er. Each project has its own purpose 16. Country risk is satisfactory.
17. Sovereign risk is satislactory.
and momentum, and the case studies
18. Currency and foreign exchange risks have been addressed.
are not intended to touch on all of the
19. The key promoters have made an adequate equity contribution.
same issues. The project has value as collateral,
20.
21. Satisfactory appraisals of resources and assets have been
obtained.
The nature of project finance
22. Adequate insurance coverage is contemplated.
Project finance is generally defined as 23. Force majeure risk has been addressed.
the provision of funds for a single-pur- 24. Cost over-run risk has been addressed.
pose facility (or facilities) that gener- 25. Delay risk has been considered.
ates cash flow to repay the debt. Debt is 26. The project wil! have an adequate return for the investor.
secured by the project’s assets and cash 27. inflation rate projections are realistic.
flows, not by the assets or general cred- 28. Interest rate projections are realistic.
29. Environmental risks are manageable.
it of the project’s sponsor(s). Therefore
30. Compfiance with IJS Foreign Corrupt Practice Act of 1977.
the debt generally is issued with no
recourse, or, in some cases, with limited Source: Project Financing Seventh Edition.
recourse, to the project sponsors.
Project finance often is used for capital-intensive facilities such as power plants, refineries,
toll roads, pipelines, telecommunications facilities and industrial plants. Before the 1970s the
majority of project lending was for natural resource ventures such as mines and oilfields.
Since then the applications of project finance have broadened considerably, but power has
been the largest sector.
 INTRODUCTION

For lenders and investors the essence of project finance is the analysis of project risks,
including construction risk, operating risk, market risk (applying to both inputs and outputs
of a project), regulatory risk, insurance risk and currency risk. These risks often are allo-
cated contractually to parties best able to manage them through construction guarantees,
power purchase agreements (PPAs) and other types of output contracts, fuel and raw mate-
rial supply agreements, transport contracts, indemnifications, insurance policies, and other
contractual agreements. However, with projects in all sectors, sponsors, lenders and bank
investors are exposed to significant market risk. Although recourse to sponsors is usually
limited, they often provide credit support to the project through guarantees or other con-
tractual undertakings. For example, an industrial sponsor of a cogeneration project may
contract to buy steam from a project and another sponsor may contract to sell power to it.
Sponsors’ economic interests in the success of a project make impressive contributions to
the project’s creditworthiness. ~"
Project financing generally is done without recourse to project sponsorsl, ancj projects
are often, but not always, off corporate sponsors’ balance sheets. As it does with a sub-
sidiary, a sponsor includes a project’s assets and liabilities on its balance sheet when a pro-
ject is consolidated. When the equity method of accounting is used the sponsor’s
investment in a project is shown as a single amount on its balance sheet, and/gains or loss-
es on the project are shown as a single amount on its income statement. A sponsor gener-
ally uses the equity method to account for an investment in a project where it owns less than
50 per cent but can still influence its operating and financial decisions. If a sponsor has less
than a 20 per cent interest in a project it is presumed to lack significant influence over the
project’s management and neither consolidation nor the equity method is required.
Presumably, a sponsor’s investment in a project and the related income or losses would be
combined with other items on its balance sheet and income statement. It would be consid-
ered good practice o.n the part of the sponsor to include some mention of the project invest-
ment in the footnotes, particularly given the emphasis on disclosure and transparency in
today’s post-Enron environment.

Why project finance is used

Project finance can be more leveraged than traditional on-balance-sheet financing, resulting
in a lower cost of financing. In countries with power and other infrastructure needs, project
finance allows governments to provide some support without taking on additional direct debt.
The growth of project finance in recent years has coincided with a trend toward privatisation.
For sponsor companies project finance may accomplish one or more of the following
objectives:

o financing a joint venture;

¯ undertaking a project that is too big for one sponsor;
¯ assigning risks to parties that are in the best position to control them;
¯ insulating corporate assets from project risk;
o keeping debt off the corporate balance sheet;
¯ protecting their corporate borrowing capacity;
o maintaining their credit rating;
¯ improving corporate return on equity (ROE);
POWER AND WATER

restricting proprietary information to a limited number of investors;

avoiding double taxation;
sharing ownership of projects with employees; and/or
establishing a business venture in a foreign country.

Sources of capital
Historically, commercial banks have provided construction financing for projects, while insur-
ance companies have provided take-out financing with terms of 20 years or more. Banks have
been relatively more comfortable with construction risks and short-term loans, while insurance
companies have been more comfortable bearing the long-term operating risks after construc-
tion has been completed and the project has demonstrated its capability to run smoothly.
In the early 1990s, however, the investor base for project finance began to broaden. It
now includes institutional investors, such as pension and mutual funds, and investors in tffe
public bond markets in a growing number of countries around the world. %vo~important
developments made institutional investors more receptive to project finance investments than
they had been in the past: a ruling by the US Securities and Exchange Commission (SEC),
and the issuance of project credit ratings by the major credit rating agencies. /
SEC Rule 144a allows the resale of eligible, unregistered securities to qualified institu-
tional buyers and eliminates the requirement that investors hold on to securities for two years
before selling them. Recently, sponsors of some large power projects have aimed their financ-
ing solely at the institutional 144a market. Others have been able to reduce their financing
costs by committing themselves to full registration for sale in the pubic markets within six
months after their 144a securities are issued, thereby providing a more liquid market for the
institutional investors that hold the securities.
With respect to project credit ratings, as the capital markets became an important source
of funding the amount of rated project debt grew rapidly. For example, in 1993 Standard &
Poor’s (S&P) portfolio of rated project debt was US$5.8 billion. The agency then established
a project rating team in 1994. By mid-1996 it had rated US$16.3 billion and. by the end of
2002 US$106 billion of project debt had been rated. Debt rated by the two other leading cred-
it rating agencies, Moody’s and Fitch Ratings, has grown in a similar fashion.

Institutiona! investors’ needs

For institutional investors project finance offers a way to diversify and earn very good returns
for the amount of risk taken. As more power and other infrastructure projects are financed and
demonstrate a track record, more investors are becoming comfortable with the risk. William
H. Chew, Managing Director of Corporate and Government Ratings at S&P, sees project
finance as not just another Wall Street invention, but a growing investment vehicle with a
strong demand on both the buy and the sell sides. It provides the uncorrelated returns for
which portfolio managers have been looking, and risks that are different from the credit of the
sponsor or the offtaker of the project’s product.

Trends in project finance

Recent trends in project finance include the following.
 INTRODUCTION
Infrastructure requirements
There continue to be massive infrastructure requirements, particularly in developing coun-
tries. For example, the World Bank estimated that between 2001 and 2006 Latin America
alone would need more than US$70 billion per year in infrastructure investment to meet the
needs of its growing and largely impoverished population. Developing countries in other
regions have needs of a similar magnitude.

Privatisation
This is a worldwide trend that both reflects political currents and provides a way to supply
needed infrastructure in the face of government budgetary limitations. Variations on this
trend include public/private partnerships, notably the Private Finance Initiative in the
United Kingdom.

Legislative and regulatory frameworks

Historically, the lack of legislative and regulatory frameworks has been an impediment to
project financing in developing countries. Some case studies in these volumes, however,
show how sponsors of first-of-their-ldnd projects have worked with host governments to
develop legal and regulatory structures for future projects in emerging markets in Africa, Asia
and Latin America.

Financial innovation
As innovations are made in other financial disciplines, such as leasing, insurance and deriv-
atives-based financial risk management, they are applied quickly to project finance.

Broadened sources of funding

An ongoing trend since the early !990s has been the growing use of bonds, both investment-
grade and high yield, for project financing. These bonds have been sold to a broadening base
of institutional investors, leading to a growth in credit-rated project debt. Connected to this
trend, power project portfolios and investment funds comprising projects from different
industries are providing investors with a way to spread risks and project sponsors with an
additional source of financing. Also related is the growing flexibility between bond and bank
financing, which is helped by the increasing number of financial institutions with both com-
mercial and investment banldng capabilities which can offer both loan and bond alternatives
in a single project financing package.

Local currency financing

As the role of pension funds and other institutional investors broadens in many emerging mar-
kets, local-currency funding is becoming increasingly available for project financing. This
development is particularly helpful to sponsors of infrastructure projects that generate local-
currency revenues, as it allows them to avoid mismatches between those revenues and dollar-
denominated debt.

7
POWER AND WATER

Blending of project and corporate finance

A lack of risk tolerance and market liquidity sometimes prevents projects from being financed
off the corporate balance sheet on a pure non-recourse basis. Projects today are financed
along a spectrum ranging from pure proje~’t finance to pure corporate finance. A company
such as Calpine, which is essentially a power plant portfolio, is one example of the blurring
of the line between corporate finance and project finance.

Insurance
The role of insurance in project finance has increased steadily in. recent years. Historically,
the insurance industry has provided property and casualty coverage, and political risk cover-
age. Recently, insurers have become more active in covering completion risk, operating risk,
off-take risk and residual value risk.
Residual value insurance, for example, can help sponsors and lenders to refinance risk
when projects require loan pay-outs with longer terms than are available in the bank market.
If a balloon payment (the repayment of most or all of the principal at maturity) is not made,
or a project cannot be refinanced and the loan goes into default, the lender can seize the asset.
If liquidation proceeds are less than the amount of residual value coverage, a claim for the
difference can be made against the policy.2
Highly rated insurance companies with dynamic risk management capabilities can close
the gaps in capital structures of projects exposed to market risks. For example, in 1999 Centre
Group guaranteed the subordinated debt tranche for the Termocandelaria merchant power
project in Colombia. If the project’s cash flow was insufficient to make a debt payment, the
insurance company agreed to step in and make that payment. An insurer can provide a take-
out guarantee for project lenders when a PPA matures before a loan. Insurers can guarantee
that a project receives a minimum floor price, regardless of what happens to the market price
of its output. Insurers can provide standby equity and subordinated debt commitments and
residual-value guarantees for leases.3
The events of 11 September 2001 exacerbated an already difficult insurance market and
created a new problem for the insurance industry: how should exposure to terrorism be man-
aged? The combination of reduced capacity, underwriter defections and shock losses from 11
September has, at the time of writing, created one of the most difficult insurance markets in
history. Among the implications for project sponsors are increases in deductibles, which
require projects to assume additional risk; the reduced availability of coverage for terrorism,
new or unproven technologies, and catastrophic perils, such as earthquakes and floods; and
substantial premium increases.4
Over recent years the credit ratings of many infrastructure bond deals have been raised
to the ’AAA’ level by guarantees or ’wraps’ AAA-rated monoline insurance companies.
However, as the monoline insurers themselves have diversified from their US municipal bond
base their own risks have increased, beading to higher spreads on monoline-wrapped paper.
An emerging trend in project and concession financing is the use of targeted risk cover-
age, a structured financial mechanism that shifts specifically identified project risks to a third
party, such as a multiline insurance or reinsurance company, a designated creditor, or, con-
ceptually, any party that is willing to assume those risks, including project sponsors. The fol-
lowing have been among recent applications of targeted risk coverage:
 INTRODUCTION

revenue risk mitigation, including coverage against commodity pricing risk, revenue
guarantees for toll road projects and coverage against default of offtakers;
substitutes for liquidity mechanisms, such as fully funded debt-service reserves and
standby letters of credit; and
political risk coverage.

Contingent capit~il is ~t form of targeted risk coverage that can reduce a project’s cost of
financing. The insurer provides a facility under which capital is injected into the project in the
form of debt, equity or hybrid securities upon the occurrence of a predefined trigger event or
set of dvents. In this way contingent capital allows the project to increase its capital base only
when necessary, thereby increasing its return on invested capital.5
Recent crises in Asia, Latin America and Eastern Europe have reminded lenders and
investors that political/economic events do not merely have the potential to cause losses, but
actually cause them, according to Gerald T. West, Senior Advisor at the Multildteral
Investment Guarantee Agency in Washington, DC.6 These events have stimulated the
demand for political risk insurance, leading to expanded coverage and new products from
multilateral agencies, national agencies and private insurance providers. In recent years pri-
vate insurers have lengthened the terms of their coverage and increased their shar~ of the
political risk insurance market. Recent innovations include capital markets political risk
insurahce, which can be used to raise the credit ratings of bonds that finance projects in
emerging markets.

Increasing and then decreasing risk tolerance

Until 1997, there were trends of lengthening maturities, thinning prices (which was
reflected in spreads over benchmark funding indices), loosening covenants, extending
project finance to new industries and geographical regions, and a willingness on the. part
of lenders and investors to assume new risks. This was partly a result of more institution-
al investors becoming interested, and developing expertise, in project finance. These
trends reversed as a result of the worldwide ripples caused by the Asian financial crisis
starting in 1997, the Russian default in 1998 and the Brazilian devaluation in 1999. Banks
became less willing to commit themselves to emerging-market credits, and spreads on
emerging-market bonds widened. To be financed, projects required increasing support
from sponsors, multilateral agencies, export credit agencies (ECAs) and insurance com-
panies. Since the Enron debacle, investors and lenders have reduced their tolerance for
risk related to power companies with trading activities, overseas operations and difficult-
to-understand financial statements.

Commodity price volatility

Prices below long-term forecast levels sometimes place commodity-based projects such as
mines, petrochemical plants and oilfields ’under water’ in terms of profitability. With
deregulation and merchant power, the ’spark spread’, the difference between a power
plant’s input (fuel) costs and output (electricity) prices, may at times not be sufficient for
profitability.
POWER AND WATER

Interest rate volatility

In the early 1990s, declining interest rates increased the number of financially viable projects.
Although interest rates then rose slightly, they are again, at the time of writing, relatively low.

Bank capabilities
The number of financial institutions with broad project finance syndication capabilities is
shrinking, as is the number with specialised project finance groups. Institutions with broad
geographical scope and with both Commercial and investmentbanking capabilities have a
competitive edge in today’s market.

Bank capital requirements

In 2002, the Basle Committee on Banking Regulation charged its Models Task Force with
the role of analysing the unique credit considerations of structured credit products t~t~at ~ner-
ited special attention, including project finance. In its initial hypothesis, the Task Force
determined that project finance should have a higher capital weighting than unsecured cor-
porate loans because of its unique risk characteristics. Higher capital requirementCs for pro-
ject loans could both impair the profitability of such loans for banks and raise loan pricing
to uncompetitive levels, detering banks from participating in loan syndications. An initial
four-bank study conducted by S&P Risk Solutions indicated that project finance loans have
lower losses subsequent to defaults than unsecured corporate loans, partly because of cred-
it enhancements that mitigate risk, such as first-priority liens, cash-flow sweeps, covenant
triggers and limitations on indebtedness. Banks often use such features as early-warning
mechanisms to both alert themselves to project difficulties and encourage sponsors to cure
defaults by providing equity or other forms of sponsor support, or to work with the banks to
restructure the loans]

Rating triggers
The fall of Enron and numerous recent power company defaults have been caused by ’rating
triggers’, which are provisions in loan agreements that define credit-rating downgrades below
certain levels, often the minimum investment-grade level, as events of default.

Merchant power
Because of power price volatility and other recent market events, merchant power business-
es have been downgraded by credit rating agencies and have had increasing difficulty in rais-
ing new financing.

Refinancing of mini-perms
In the past several years, numerous merchant power plants have been financed by four-to-six-
year ’mini perm’ bank loans. Refinancing these loans will be a challenge in the current envi-
ronment. S&P notes that to do so power companies may be required to put up increased
equity, structure cash sweeps and provide increased security.8

10
 INTRODUCTION

Declining importance of trading

In an article published in October 2002, Robert Sheppard, a consultant and attorney based in
North Carolini~, predicted that the role of trading in the electric power industry would dimin-
ish in the coming years. He pointed out that supply/demand imbalances and price uncertain-
ty. in the 1990s were caused largely by an uncertain and changing regulatory environment, and
that the electricity market does not have many of the characteristics of other commodity mar-
kets in which users need to hedge, such as the unpredictability of supply or the potentially
ruinous consequences for producers or users who do not hedge. The majority of consumers
can bear electricity price risk without the benefit of risk-management intermediaries.
Sheppard believes that the historical business practices of the electric power industry will
reassert themselves as distribution companies once again recognise the benefits of stable,
long-term sources of supply, and that project developers will rediscover the advantages of
long-term debt supported by long-term contracts with highly rated power purchasers.?

Regulation of trading
As abuses such as power swaps transacted simply to inflate the revenues of counterparties
come to light, attempts are being made to reign in the largely unregulated energy trading mar-
ket. For example, in the summer of 2002 Richard Green, Chairman of Aquila, testified before
the US Senate Agriculture, Nutrition and Forestry Committee in favour of more regulation
and overseeing of the energy derivatives trading market, to remove uncertainty and increase
competitive power price transparency. He was in support of a bill introduced by Senator
Dianne Feinstein that would mandate the US Commodity Futures Trading Commission
(CFTC) and the Federal Energy Regulatory Commission (FERC) to oversee all energy trans-
actions with respect to fraud, and to require all energy derivatives trades to be subject to reg-
istration, reporting, disclosure and capital requirements. (It is noted in the Panda-TECO case
study, in Chapter 13, that later in 2002 Aquila decided to withdraw from energy trading and
return to its roots as a traditional utility, having acknowledged its own difficulty in managing
risk and malting a profit in this volatile and shrinldng market.)

Scepticism about deregulation

Along with privatisation, deregulation in the power industry was intended to attract capital and
ultimately result in lower consumer prices. However, the crisis that resulted from a flawed and
poorly implemented deregulatory structure in California has caused scepticism and slowed the
pace of worldwide power industry deregulation. In an article published in October 2002, Eric
McCartney, Head of Project Finance for the Americas at KBC Global Structured Finance,
pointed to the overall questioning and reassessment of why there has been such a push for elec-
tricity deregulation in the United States and other markets. Some interest groups are making
pleas to roll back electricity reform and return to the concept of vertically integrated monopo-
lies and cost-of-service regulation. McCartney notes that electricity prices in the United States
dropped 35 per cent in real terms between 1985 and 2000 but questions whether deregulation
had any influence on it. He also cites studies that conclude that less than 5 per cent of retail
consumers care about electricity deregulation because differences between suppliers would
amount to only a few dollars per month on their electricity bills. Industrial power users, on the
other hand, may stand to benefit more from deregulation,m

11
 POWER AND WATER

Uncertainties concerning transmission

One of the problems cited in the Panda-TECO merchant power case study is that insuffi-
cient transmission capacity limits the potential of an Arizona power plant to sell electric-
ity in the California market. As substantial numbers of new electric generation facilities
are added to the US grid, transmission congestion can be expected to intensify, particu-
larly in high-growth urban areas, causi.ng bottlenecks and pricing aberrations]~
McCartney of KBC notes that one of the reasons for inefficiency in the US electricity mar-
ket is the lack of investment in the transmission sector. This in turn is the result of regu-
latory uncertainty concerning transmission siting, transmission pricing methodologies,
interconnection rules and practices, the authority of the FERC over regional transmission
organisations (RTOs), and a scheme for investors in transmission facilities to recover their
costs and earn a fair profit. McCartney believes that the transmission sector has potential
for the application of the project finance model and financing in the commercial market~,,
but the development of that market is not yet sufficiently advanced and the ris’ks are not
adequately quantified. He observes that the project finance model needs a stal~]e ~egulato-
ry regime and a dependable stream of cash flow on which it can depend to service debt.
He sees the FERC regulated-return concept as a proven model that would have a stabilis-
ing effect on the development of the transmission and distribution business vthus encour-
¯
aging much needed investment.1’~ -~

Telecoms meltdown
The bankruptcy described in the FLAG (Fiberoptic Link Around the Globe) case study (see
Voh, me H - Resources and Infrastructure) illustrates problems faced by highly visible under-
sea cable competitors, such as Global Crossing and other recent projects, throughout the
telecommunications industry. Aggressive network expansion financed with high leverage
may have been a viable strategy while internet use, telecom traffic and related capital spend-
ing were growing rapidly, but when the telecom market collapsed FLAG and many other tele-
com projects did not have the cash flow to service their debt.

Effect of Enron
Many trends in project finance over the past year have been related to the collapse of Enron.
The role of off-balance-sheet, special-purpose entities in Enron’s loss of confidence and sub-
sequent bankruptcy has led some to question what the proper boundaries of project finance
are. However, a survey that the author conducted for an article in The Journal of Structured
and Project Finance (Spring 2002) found traditional project finance to be alive and well, and
not adversely affected by the Enron debacle.
The Enron bankruptcy and related events have changed neither the nature nor the use-
fulness of traditional project finance, but they have led to a slowing down Of some of the
more innovative forms of structured project finance. Among the other direct and indirect
effects of Enron have been increased caution among lenders and investors about the energy
and power sectors; increased scrutiny of off-balance-sheet transactions; increased emphasis
on counterparty credit risk, particularly with regard.to companies involved in merchant
power and trading; and deeper analysis of how companies generate recurring free cash flow.
There is now increased emphasis on transparency and disclosure, even though disclosure in

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