Qualitative Risk (2)

Question 1

what do banks understand by supply risk

Answer 1

Ensuring a reliable supply of raw materials, necessary fuels and other inputs is naturally a major element in the securing of steady and dependable cashflow for the servicing of debt by any project.

Question 2

minerals projects

Answer 2

upstream oil & gas, mining of metal ores, quarrying) have a special type of supply risk. This is because they generally have a limited reserve of material to exploit. Such deposits are “wasting” assets and once they are exhausted, no cashflow will be generated1.

Question 3

renewables projects

Answer 3

ome renewable-energy projects also exploit naturally-occurring reserves – of wind or solar energy for example – which will not be exhausted. How much wind or solar irradiation will be available over a given period, however, is a matter of estimation. Project lenders have had to develop suitable methods for the assessment and mitigation of these risks.

transactions which require steady supplies of a fuel (such as a gas-fired power station) or feedstock (crude-oil refinery)
In such cases the risk is that the project will not be able to secure sufficient volumes of what it needs to operate at a price which will allow the generation of steady-state debt-servicing cashflow. There is thus a volume and a price risk.

Question 4

volume risk

Answer 4

Of the two risks, project lenders will probably be more concerned by the existence of a significant volume risk

Question 5

price risk

Answer 5

Prices can of course be volatile, but project lenders tend to be much more comfortable to accept a risk which they can assess through cashflow modelling and which may be capable of being managed (e.g., through price hedging).

Question 6

quality issue

Answer 6

Certain projects may not be able to tolerate inputs whose quality lies outside a fairly narrow band. Combined-cycle gas-fired power stations, for example, are normally designed to run on gaseous fuel within a given “envelope” of calorific value and gas content (methane, nitrogen, other hydrocarbons etc.).

Fuel outside this envelope may be unacceptable for use and needs to be rejected. At the very least its use may cause significant performance shortfalls. Many biomass-based renewable power projects are very sensitive to the water content of their fuel (woodchips, straw, chicken-litter) and higher-than-expected moisture content will affect power output and therefore cashflow. The quality range of feedstocks which an oil refinery is able to accept is a critical factor in determining its refining margin and therefore its cashflow.

Question 7

What do banks understand by reserve risk?

Answer 7

The factor which connects all reserve/resource-based projects is that the values we use for reserves or resources are generally estimates rather than precisely calculated quantities.
The calculation of these values is based on limited information, some extrapolation and the making of certain (hopefully clearly stated) assumptions. It is almost impossible to take away all trace of subjectivity from the calculations. Lenders recognise this and handle reserve and resource estimates with caution

Question 8

estimating oil and gas reserves

Answer 8

Oil and gas reserve estimates are based on a limited number of physical penetrations of the underground petroleum reservoir. A discovery well will perhaps have been supplemented by a number of “appraisal” wells designed (among other things) to build up a better idea of the reservoir, to establish its upper and lower limits and to collect fluid samples.

Question 9

offshore wells balance

Answer 9

such wells are enormously expensive, and a balance must be struck between:

• drilling further to build up additional data and reduce risk; and
• moving forward to field development on the limited information already available.

Furthermore, although the wells already drilled will give information on issues like the permeability and porosity of the rocks encountered, the ratio of oil/gas-bearing rock to non-reservoir rock and the amount of water saturation in the reservoir, this information is truly accurate only for a limited space around the well-bore. It will be necessary to extrapolate from this data to the wider field, where conditions could be (in fact are very likely to be) somewhat different.

Extra dimension of risk in mining and reservoirs
mining reserves add an extra dimension of risk in that they may not be homogenous in composition across a single deposit. There is potential for major variations in quality (e.g. in terms of grams of ore per tonne of rock) from one part of the ore body to another. The completeness of the owner’s understanding of the ore body will often therefore depend to a significant extent on the closeness of the drill holes which have been drilled to appraise the deposit.

Question 10

front-loaded cash generation profiles

Answer 10

Projects based on oil and gas deposits and mining reserves frequently also have a front- loaded cashflow generation profile
In the case of a single oil or gas field this is frequently because pressure in the reservoir declines over time, making extraction more and more difficult/expensive. Therefore, production is highest in the earliest part of the reservoir’s life. A “plateau” production level may be maintained for a period, but inevitably production will begin to fall off until the economic cut-off point – the point where production costs exceed production revenues.

Question 11

Factors of oil and gas and mining projects

Answer 11

a. a limited overall store of value, because they are wasting assets;
b. a front-ended cashflow profile;
c. significant scope for a difference between projected and actual reserve recovery.

Question 12

Power projects from renewables

Answer 12

Should not suffer from:
a. a limited overall store of value, because they are wasting assets;
b. a front-ended cashflow profile;

Question 13

Potential for variation between actual and projected amounts of energy turned into electrical power

Answer 13

verage wind-speeds vary significantly from season to season and from year to year. They will even vary very significantly within a particular wind-farm site, especially where the individual wind-turbines are at different heights. Close observations over an extended period of time (a number of years rather than one full operating season) will allow a skilled analyst to build a detailed model of a particular site’s wind resource. This model can then be tested against actual experience with real turbines once they are in place and generating. If the actual experience matches closely with predicted performance, the accuracy of the model will be progressively confirmed. Otherwise, the model will need to be revisited. This is of course very useful – but by this stage the project lender has already lent!

Question 14

Mitigating and allocating supply volume risk

Answer 14

In some projects there is little or no volume risk to be considered on the supply side. Lenders to a newbuild gas-fired power station in the UK or the USA, for example, can have a high degree of confidence that it will be able to source its supplies of gas from a deep and well-supplied spot gas market, subject of course to being able to pay the prevailing price.

The situation for lenders to a newbuild power station in an emerging market may be very different.
Spot gas markets of any size are very unusual in such countries. In these markets prospective project lenders would be very likely to highlight a major volume risk in the area of fuel supply and seek to have it mitigated

Question 15

Mitigating this volume risk

Answer 15

The most usual way of doing this is to seek a long-term fuel supply agreement (e.g. with the state gas company) which provides for:
* certainty of fuel supply over at least the life of the project loans – ideally with a “tail” of a few years after the loans are scheduled to be repaid;
* penalties in the event of:
o non-supply;
o supply of fuel of an inferior quality.

Question 16

supply or pay contracts

Answer 16

penalties in the event of: o non-supply; o supply of fuel of an inferior quality.

can be very helpful in mitigating supply risk, but (as ever) their value is heavily dependent on the quality of the counterparty and the terms of the supply agreement itself. Once again, the “devil is in the detail”.
If does not supply the contracted volumes it will be obliged to pay pre-agreed penalties designed to cover the project’s fixed costs during the period of non-supply - including debt service.

Question 17

Looking into the company behind supply or pay contracts

Answer 17

Need to look into:
Ability to supply
Creditworthiness
If company is in fact a substantial and well-established agricultural supply company with other sources of revenues and assets, and a creditworthy balance sheet, then its commitments under a supply agreement with substantial penalties for non-supply will have real value.

Question 18

In cases where banks might accept weak supply contracts with weak penalties, the supplier normally:

Answer 18

• was a nationally owned entity with close commercial ties to the project company (perhaps as one of the sponsors in a joint venture project with an international company);
• had undoubted access to the gas or feedstocks required;
• had a strong track-record of meeting commitments to the letter or supplying an acceptable alternative.
  Although banks may accept an apparently weak supply arrangement in such cases, a detailed review of the supply contract is still of course absolutely necessary.

Question 19

termination clauses

Answer 19

Given the importance of eliminating volume risk, lenders will pay particular attention to the termination clauses and will want to keep the circumstances under which the supplier may terminate the contract down to a very short list. Clearly termination for non-payment by the SPV must be possible, but even here the lenders may seek some form of direct agreement with the supplier so that:
a) they are notified of any looming default by the SPV; and
b) have the right to step in and “cure” the default by making payments.
c) Another key area of documentary due diligence for the lenders will be the area of force majeure . A particular concern will be that the supplier might be able to claim FM – and thereby be relieved of some or all of his obligations under the supply contract – while the SPV will not be able to claim FM under its other contractual obligations.

Question 20

Force Majeure

Answer 20

. These are, in general, happenings which are defined as being unforeseeable and beyond the control of the parties concerned.
Natural catastrophes or acts of god
Government actions - failure for a government to perform after its given a particular commitment
Political events such as war, strikes etc may also apply

Question 21

Lenders trying to mitigate FM

Answer 21

The project SPV sits at the centre of a carefully-balanced risk allocation structure and – being a thinly- capitalised and highly-leveraged animal – it cannot afford to accept much in the way of new liabilities or costs. For this reason, lenders seek to be protected from the impact of FM events as far as possible, which is best achieved by protecting the SPV itself from FM events.

Question 22

When undertaking FM contractual due diligence, lenders will try to ensure that:

Answer 22

• FM events in the project’s contracts are “symmetrical” wherever possible – thus if a power generation project’s construction contractor invokes FM, e.g., because of a strike at a supplier, the SPV should have the ability to call FM under any power sales agreement for the same cause, so that it does not incur penalties for non-performance under other contracts (such as O&M and fuel supply contracts);
• insurable FM events are properly insured;
• the impact of FM events which cannot be insured or where the cost of insurance would be excessive is tested by means of cashflow sensitivities – e.g. by running an interruption of operation sensitivity to model the impact of a prolonged strike.

Question 23

When lenders accept reserve risk on a single asset (oil, gas, windfarm etc) they will insist that the reserves to which they give value are:

Answer 23

a. economically recoverable – resources which are present physically but whose cost of extraction would exceed the revenue they would generate do not qualify as reserves;
b. based on the highest probability level in terms of the level of ultimate production, which equates to the lowest predicted production volume.

Question 24

European lenders calculation of bankable reserves:

Answer 24

Will be on a “probabilistic” analysis of likely production outcomes
the estimation of mineral reserves in particular requires values to be given to a large number of variables (rock permeability and porosity, water saturation in the reservoir, viscosity of the reservoir fluids etc.)

Question 25

Monte Carlo simulation

Answer 25

In a probabilistic analysis of reserves a very large range of potential values is run for these variables, in a very wide range of combinations – usually through computer based “Monte Carlo” simulation. This simulation work generates a probability curve, which plots the probability of production against the volume likely to be produced. Reserve values are read off conventionally at recovery probabilities of 90%, 50% and 10%. Thus, the P90 reserve in the above example is 100 million barrels (mmb). This means that there is a 90% probability of recovering at least 100 mmb from the reservoir. This volume is also referred to as the “1P” reserve. It may help to see the P90 reserve as the “low estimate”. The P50 reserve has a 50% probability of being met or exceeded. It may be helpful to see this as the owner’s “most likely case”. The P50 reserve in the case above – which can also be called the “2P case” – is 500 mmb. The P10 case (a billion barrels in the case above) is the 3P reserve, which has only a 10% chance of being exceeded.

Question 26

How sponsors of an oil&gas/mining field size their production facilities

Answer 26

Sponsors of single-asset oil & gas field or mine developments will, in all probability, size their production facilities based on the P50 reserve, together with a production profile generated by reference to that reserve.

Question 27

How lenders size the facilities

Answer 27

Lenders will usually insist on using the P90 reserve, together with a corresponding production profile, when calculating cashflow for banking purposes. Similarly, financings of projects which use a non- exhaustible natural source of energy (wind, solar irradiation) will generally be based on a P90 estimate of the wind and solar resource3. As well as insisting on using low estimates for ultimate recovery, lenders generally also require an independent confirmation of the borrower’s reserve and production schedule estimates, to be carried out by a well-qualified third-party consultant.

Question 28

mitigating supply risk

Answer 28

> cashflow modelling While an uncovered volume risk may well be an “on-off” switch, cashflow sensitivity to supply price volatility is generally more likely to influence the debt:equity ratio or the risk margin than to prevent a transaction proceeding

Question 29

Structural methods of supply price risk mitigation

Answer 29

Can be used to eliminate or at least reduce input price volatility or the impact of such price changes on project cashflow: Supply price hedging Feedstock/fuel payment subordination Pass-through pricing Tolling

Question 30

supply price hedging

Answer 30

– If the input to be purchased is widely-traded, it may be possible to limit the impact of market price volatility through forward purchases from physical market players or by purchasing financial derivatives from banks, traders and others.

Question 31

2. Feedstock/fuel payment subordination

Answer 31

– I have known occasions in emerging markets where a state-owned supplier of inputs has accepted that payment for the inputs should be conditional upon full payment of debt service to the lenders, as a means of support to a state-sponsored project in periods of weak cashflow. Any accumulated unpaid amounts in respect of inputs are later paid out of post-debt-service cashflow, following payment for current inputs – assuming of course that sufficient cash is available.

Question 32

3. “Pass-through” pricing

Answer 32

– Let us consider the position of a state-owned power purchaser which wishes to: a. secure access to additional sources of gas-fired power generation, as a matter of urgency; b. have the provision of such capacity funded by the private sector. If the only viable source of gas in the country is the power purchaser’s sister company – also state-owned – the price of gas supplies may be completely in the hands of the state and the volatility of these prices may be a risk which the SPV would find difficult to accept (certainly if the intention was to target a high debt:equity ratio) In such circumstances it may be sensible to pass increases in gas supply costs straight through to the power buyer through the pricing provisions in the power purchase agreement, or at least to pass them through once a certain gas price threshold has been reached. Up to this “cap” level the SPV would accept gas price risk, so that efficiency improvements will be required if the sponsor’s return is to be maintained.

Question 33

Tolling

Answer 33

– In this type of structure a third party will typically accept the responsibility for volume and price risk on both the supply and offtake side, effectively removing it completely from the project SPV A gas company wishes to have the ability to generate electrical power when power prices are high (i.e., there is a so-called “spark spread” or arbitrage opportunity between gas and power). It does not need to own a power plant, however. It enters into a contract with a project-financed power station, on the basis of which it will instruct the project SPV when to generate and will also supply gas as fuel The power generated will belong to the gas company, which will pay the power project: a. a regular “capacity” or “availability” payment in order to have access to power generation capacity; b. an operating charge to cover variable op-costs when the plant generates. It will be clear that in this case the power project has no volume or price risk on either the supply or offtake side. Its lenders are in effect largely indifferent to whether it generates or not (so long as it always available and therefore in receipt of the availability payment). When it does generate, fuel is supplied free of charge and other operating costs are covered by the operating payment.

Question 34

What do Banks understand by “Sales/Offtake Risk”?

Answer 34

lenders approach sales or “offtake” risk in quite a similar way to supply risk – that is, they tend to divide it into volume and price elements. The volume issue arises because the project SPV may be exposed to the risk of having no (or an inadequate volume of) purchasers for the goods and/or services it will produce Where a deep and liquid spot market exists for the project’s output – as is generally the case for crude oil – there is not really a volume risk. Price risk may of course still be a concern. The price paid for a particular type of crude will generally be set by reference to its quality (sulphur content, specific gravity and other factors) in comparison with one of the so-called “marker blends” like West Texas Intermediate (WTI) or Brent (North Sea) whose characteristics serve as a pricing benchmark. If the quality of a particular crude is very low – it is high in sulphur and very viscous for example – then only a limited number of refineries may be able to handle it. In such circumstances we may approach an offtake volume issue, since specific contracts may be required to book suitable refining capacity. For most crudes, however, the issue is really one of price

Question 35

Spot markets

Answer 35

Spot markets exist in some highly industrialised developed markets for gas also. They rarely exist in emerging markets. Thus, if a gas resource is developed in such a market, it is usually so that the gas can be used by a particular buyer (such as the state-owned power generator). Delivering the gas will involve the installation of infrastructure. If the primary buyer fails it may prove very difficult to find an alternative (creditworthy) buyer – quite apart from the need to lift the pipeline and point it in a different direction! Here there is a very real volume risk.markets

Question 36

Volume risk and physical goods

Answer 36

Volume risk does not only apply to the production of physical goods of course. Infrastructure and PPP projects often deliver services, as well as the assets needed to provide such services. For such projects the volume risk is frequently some form of “traffic” uncertainty (road, bridge, tunnel) or the risk that there will be low levels of utilisation of a social asset once it has been constructed (hospital, school, student accommodation). As with supply risk, banks tend to be more relaxed regarding price risk. Once again, while the volume issue can be an “on-off” switch, price risk on the offtake side tends to be easier to evaluate and (very importantly) to manage than volume risk – as we shall see.

Question 37

Mitigating offtake volume and price risk

Answer 37

Where lenders do not perceive a volume risk (as in the case of crude oil for which a deep spot markets exist) their attention may focus rather more on the risk of sale price variations, especially where there is potential for great volatility – as with many commodity prices. Where the price risk in question is that of a widely traded commodity, it may be possible to undertake hedging to mitigate that risk. For the precious metals – especially gold – it may be possible for the project SPV to borrow a physical metal such as gold, sell the gold for cash to finance the project and then repay the gold loan with physical ounces of gold production when the project comes into operation. In this way the risk of gold price fluctuation is removed.

Question 38

spv hedging sales

Answer 38

Rather than managing risk through its borrowings in this way, the SPV may be able to hedge its future sales – e.g. of oil, gas or ore – by using a range of instruments. The most popular of these are the outright forward sale (or “swap”), the option and the “collar”, with the choice of instrument often being driven by the SPV’s willingness (or otherwise) to pay fees and its wish or need to keep some exposure to the benefits of a rising commodity price.

Question 39

Swaps, options, floors

Answer 39

A swap offers complete protection against price falls, but at the cost of losing all benefits if the price should rise. An option offers “floor” protection while keeping exposure to price upside. A collar retains some upside, with the cost of the floor being effectively paid by giving away upside beyond a certain price level.

Question 40

SPV maximising debt capacity

Answer 40

If the project SPV wishes to maximise debt capacity then it might be inclined to hedge a large percentage of its future production, so as to get the benefit of the firm forward price (or floor at least) in the bank’s base case cashflow projection. Any production which is not hedged will be included in the base case cashflow by the lenders on the basis of their standard price forecast or “deck”. This forecast, which each lender will revisit quarterly or semi-annually (or more frequently if prices are very volatile), will naturally be relatively conservative given the lenders’ risk–reward relationship with the project. There is thus a significant benefit in hedging in terms of potential debt capacity, even if commodity price upside is lost

Question 41

banks consideration to amount hedged

Answer 41

Banks will however tend to be quite careful regarding the maximum level of output which they will permit to be hedged on a firm basis (i.e., other than through options, which need not be exercised). Their concern is that the project SPV might under-produce against the hedged volumes. If this happens and the price has turned against the SPV it might find itself having to make cash payments in compensation or entering into the market to buy physical volumes to close out its hedges. This could cause the SPV to bleed cash at alarming rates at a time when its actual production is already underperforming base case projections. This scenario has been behind the demise of a number of project borrowers in the extractive industries area.

Question 42

swap in detail

Answer 42

The simplest instrument is a swap. Very straightforward indeed. It can be “physical” in the sense that it is done with a market buyer who deals in the real commodity. Or it can be a financial derivative product with a financial institution, which does not want physical delivery, but which makes or receives balancing payments depending on which way the commodity price moves. In a physical swap, the SPV will simply deliver its output and receive the swap price. In a derivative transaction, the swap price acts as a basis for a cash settlement. Thus, if the market price at the swap date is: * Lower than the swap price – the SPV receives a payout * Higher than the swap price – the SPV makes a payout Either way (physical or derivative), if the project SPV puts a swap in place, it is effectively fixing the price of its output at the forward market price. It loses the downside risk on price – but it loses all its exposure to the upside too.

Question 43

options in detail

Answer 43

The put option product allows recovery of upside – but at a cost. If the SPV buys a put option at a particular forward commodity price (the “strike” price) it has the right – but crucially not the obligation – to exercise its option if the price is different from the strike price. Thus, if the market price at the time for settlement is: * lower than the strike price – the SPV exercises its option and receives a payout * higher than the swap price–the SPV does not exercise its option and simply takes the market price available. This means that in a put option transaction, the commodity seller (SPV) will never make a payout and will effectively benefit from a price “floor” (such transactions are also called floors for obvious reasons) while keeping full exposure to the upside. Although to say “full” exposure is not strictly correct, since to buy the option the SPV will have to pay a premium up front. The size of this premium will be influenced by a number of factors – in particular the strike price which the SPV wants to set and the degree of market price volatility. So, any upside which is enjoyed by the SPV will be partly consumed by the premium. Even if the market price is below the strike price and the SPV exercises its option (to use the floor which it provides), some of the revenue received will have effectively been used up in the premium.

Question 44

collars

Answer 44

Many companies do not like the premium associated with an option but still want to have the benefit of the floor. This can be achieved by having the SPV sell a call option at the same time as it buys its put option. The effect of this is to put in place a floor and a ceiling. If the market price at the time of settlement is: * lower than the put strike price – the SPV receives a payout * higher than the call strike price – the SPV makes a payout so that a minimum and a maximum sale price is secured. Thus, the SPV has a floor for cashflow projection purposes while retaining some limited upside potential. This type of product can frequently be structured so that the two premia (put and call) effectively cancel each other out, giving a “zero cost collar”.

Question 45

Structures of offtakes designed to mitigate volume and price risk

Answer 45

Take it offered Marketing agreement Take-or-pay (TOP) Tolling Agreement Capacity-based concession

Question 46

take it offered

Answer 46

This type of offtake structure is typical of the renewable energy industry. In many renewable regimes the operator of the grid is obliged to take the power generated by “green” generators, even if this means instructing other power plants (e.g., oil-fired) to stop generating. This effectively takes away the volume risk and is a very positive feature of such projects from a bankability perspective (especially where the price is also predictable and subsidised

Question 47

marketing agreement

Answer 47

This form of offtake is common in petrochemicals projects. Many such projects in the Middle East are joint ventures of local and international companies, with international partners responsible for marketing the SPV’s production. The project company receives “net-back” pricing – i.e., market price minus marketing agent’s commission minus transport costs – and the international partner offers no commitment to take a particular volume of product. The project company retains volume risk – since it will need to cease operations if the international partner cannot dispose of product – and price risk (because sales are at market If the project SPV has volume and price risk, then so do its lenders. In such cases lenders will tend to use market analysis to try to understand and reduce their exposure. The key inputs from a consultant will probably be a suite of price forecasts (base case, downside case) for use in cashflow forecasting, supported by detailed market analysis – supply and demand forecasts, competing projects, legislative and regulatory factors, and product substitution etc

Question 48

Take-or-Pay

Answer 48

Many natural gas and liquefied natural gas sale & purchase agreements (SPAs) between gas/LNG producers and offtakers include a TOP quantity for which the buyer is obligated to pay, within a larger Annual Contract Quantity (ACQ). The buyer pays for the amount between ACQ and TOP only if it is taken. The buyer usually has the right to take later (at nil cost) the volumes which he has paid for but not taken. TOP removes volume risk for the TOP element of sales and banks are therefore likely to use this volume for running their base-case economics. Gas price may be fixed, floating, floating between a floor and a ceiling based on a basket of factors – a wide range of pricing structures is possible. The key benefit of this structure, however, is generally the way in which it transfers volume risk to the buyer.

Question 49

Tolling agreement

Answer 49

Tolling structures are widely used in the power sector, the oil refining sector and the liquefied natural gas sector. In tolled power projects the power buyer typically secures use of the power station’s capacity by making a capacity or availability payment, structured to cover fixed costs (including debt service). Variable costs are covered by an operating charge. Independent power projects in developed, liberalised and regulated gas markets have frequently sold a portion of their capacity on a tolling basis, with the balance sold “spot”. It is also possible to structure oil refinery sales on a tolling basis, with the toller supplying crude, offtaking refined products and paying a charge per tonne of crude refined. Many LNG regasification terminals operate on a tolling basis, regasifying LNG into gas for a fee per tonne of gas processed. Where operations are on a pure tolling basis, for the full amount of project capacity, volume and price risk are fully removed. This gives particularly high predictability of project cashflow.

Question 50

capacity-based concession

Answer 50

Some concession-based projects have full volume risk (e.g., toll roads where the end-user pays a fee to use the asset and revenue therefore depends on the traffic actually experienced). Some infrastructure / PPP projects, however, are specifically structured so that the volume and price risk are retained by the State. In such cases the grantor of the concession (e.g. Ministry of Transport) agrees to pay a capacity/availability charge (to include debt service) in return for construction and operation of an asset, with an operating charge being paid to cover period-by-period operating costs. The project company will typically not collect tolls. Many road projects in in the UK have been structured in this way. Social infrastructure assets such as hospitals, schools and even prisons can also be structured on a capacity basis. This is a frequent methodology in UK PFI (PPP) structures. In such cases the grantor of the concession (e.g. the Ministry of Health) pays a single regular payment (the Unitary Charge or Payment) – e.g. monthly. While it includes availability and operating elements, these are not separately identified as such. Rather the level of the payment is calculated over the whole lifetime of the project, taking into account a number of input costs and indexation factors. The payment of the unitary charge is often subject to achievement of a minimum level of capacity. The charge is also subject to adjustment based on the project company’s performance against a set of “Key Performance Indicators”, with penalty points being incurred for underperformance. Passing a certain level of penalty points results in a reduction of the unitary charge. In capacity-based projects like these, volume risk is eliminated for the SPV, and so is price risk, subject to the SPV delivering the required assets to the agreed level of capacity and also operating efficiently. In effect the volume and price risk are transferred to the offtaker (the State). This is one of the (if not the) key reason why such projects can be geared to very high levels

Question 51

COMPLIANCE RISK ANALYSIS & MITIGATION What do Banks understand by “Compliance Risk”?

Answer 51

include those risk factors which arise out of the project’s interface with public bodies and the wider world, especially from the point of view of the laws, regulations and any voluntary guidelines to which the SPV is subject. These issues are quite often matters of due diligence, with the lenders wanting to “tick the box” before funds are advanced. This is not always the case though – especially as far as environmental, social and governance issues are concerned, as we shall see

Question 52

Mitigating approvals and permits risk

Answer 52

Banks do not normally accept approvals and permits risks. They insist that all permits and approvals to which the project is subject must be in place before any loan funds may be drawn. This is achieved by including a “condition precedent to loan drawdown” to that effect in the loan agreement. This effectively means that the risk - that approvals and permits might not be obtained – is transferred to the sponsor, who must spend equity money until all consents required have been received. In some cases, it is necessary to proceed step by step, since it is not possible to obtain all permits in advance. This is particularly the case with operating permits in some jurisdictions, where the consent to operate can only be obtained in the later stages of the construction process. Clearly here banks will need detailed legal and other advice to ensure that by allowing drawings they will not be left exposed by a refusal by a public body to grant a consent. Where the risk seems low, they may agree to proceed without formal support from the sponsor, but their basic point of departure will be that this is not a risk which lenders should accept.

Question 53

Mitigating Environmental, Social and Governance (ESG) Risk

Answer 53

Banks are very sensitive regarding the environmental and social impacts of companies and projects which they finance. There is an important “reputational risk” factor here. Lenders are acutely vulnerable to carefully coordinated and forceful campaigning by vocal pressure groups, who can do serious damage to the reputation of banks, and thereby to their business, through negative publicity aimed at existing and prospective customers, ethical investors and other influential stakeholders.

Question 54

the equators principle

Answer 54

Banks’ desire for a common structure for assessing and managing the social and environmental issues associated with projects and for a level playing field to avoid lenders “competing on the environment” led in 2002/2003 to the creation of the “Equator Principles” (EPs). “The Equator Principles (EPs) is a risk management framework, adopted by financial institutions, for determining, assessing and managing environmental and social risk in projects and is primarily intended to provide a minimum standard for due diligence and monitoring to support responsible risk decision-making.” Based on the International Finance Corporation (IFC) Performance Standards and World Bank Environmental Health and Safety Guidelines, the Equator Principles have been widely used since their inception in 2003 by financial institutions for the assessment and management of the impact of large-scale development projects on the environment and society.

Question 55

The EPs apply globally to all industry sectors and to four financial products:

Answer 55

Project Finance Advisory Services; Project Finance; Project-Related Corporate Loans; and Bridge Loans. The key objective is for the EPFIs to implement the EPs in their policies (internal, environmental and social), procedures and standards for financing projects so that they will not provide project finance or project-related corporate loans where the client will not, or is unable to, comply with the EPs.

Question 56

In pursuance of this goal, EPFIs are required to classify projects in one of the following categories by reference to a broad range of principles:

Answer 56

* CATEGORY A For projects with potential significant adverse E&S risks and/or impacts that are diverse, irreversible or unprecedented. * CATEGORY B For projects with potential limited adverse E&S risks and/or impacts that are few, generally site-specific, largely reversible and readily addressed through mitigation measures. * CATEGORY C For projects with minimal or no E&S risks and/or impacts.

Question 57

the principles include

Answer 57

* Environmental and Social Assessment; * Applicable Environmental and Social Standards; * Environmental & Social Management System and Equator Principles Action Plan; * Stakeholder Engagement; * Grievance Mechanisms; * Independent Review; * Covenants; * Independent Monitoring and Reporting; * Reporting and Transparency. The EPs are increasingly having a substantial impact at the level of loan documentation for project financing, with EP-driven conditions precedent, covenants and events of default now being a common feature of project loan documents7

Question 58

future environmental legislations

Answer 58

From the very beginnings of project finance lenders have had the acutest possible interest in understanding whether environmental legislation might change, forcing for example the spending of additional monies to bring a project back into compliance (e.g. by retrofitting flue-gas desulphurisation equipment to existing power stations to clean up gases released into the atmosphere). In a limited-recourse financing for an SPV whose sponsor refuses to fund such expenditure through equity, the lenders to the SPV may have little choice to fund it with additional debt or see their cashflow cease altogether. Bankers have therefore always been keen to ensure that a project they are financing will be able to meet likely future, as well as present, environmental regulations.

Question 59

Mitigating regulatory risk Role of regulators

Answer 59

n the renewable energy sector, regulators now frequently also play an enabling role - as well as a controlling one – by administering the grid access and price support mechanisms which have been introduced into many markets to encourage the development of “green” power generation. The power regulator thus often has the main responsibility for administering mechanisms such as feed-in tariffs and “green certificates”, including in some jurisdictions the ability to influence, control or even fix the price of the “green megawatt”.

Question 60

Considerations of lenders for regulators

Answer 60

Whether a regulator is playing the classic role or acting as more of an enabler, his ability to affect the cashflow of a project is considerable. Even before agreeing to consider a financing for a project in a regulated market, a lender must do substantial due diligence on the regulatory regime if he is not already familiar with it. A decision by the regulator to “change the playing field” by reducing the permitted rate of return in the gas distribution sector or by exercising any powers he has to reduce the market price of green power will have a direct impact on a project’s projected cashflow envelope and therefore on its debt-servicing cushions.