Lecture 3: Risks and Risk

Allocation
International Commercial Law
Professor Joseph McCahery

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Today’s Lecture
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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1. Background
▪ Risk
• Measurable probability that the actual outcome will deviate from
the expected outcome.
• Risk can be divided into two categories:
• Exposure
• Uncertainty

• Risk Management involves:

• Complex risk analysis
• Risk allocation and risk mitigation given the idiosyncratic and
illiquid nature of such investments 3
1. Background
• Project finance risk divided into:
• Commercial risks
• Macro-economic risks
• Political and regulatory risk

• Risks associated with project finance asset are due to:

• Underlying nature of asset itself
• Contracts with public sector
• Exposure to environment in which it operates

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1. Background
• Project finance risks: carbon project

Source: OECD, 2017 5

Road Map
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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2. Project Viability
▪ Definition
Project viability is a process of determining the technical, financial
and economic viability of a proposed project
Appraising a project is based on:
• The project’s technical feasibility
• The economic viability
• If there is a surplus of inputs that cannot be traded out of the firm
• If inputs are reusable without reducing their value, e.g. know-how or
patent
• Whether the transaction costs of organizing multi-product operations are
less then the benefits

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2. Project Viability
▪ Analyzing Project Viability

• Verifying technological processes and optimal design of facility

• Long-term investors require confirmation: construction timetable proposed
facilities, operational characteristics and profitability for capital raising

• Economic viability
• When the project’s expected net present value is positive
• Depends on marketability of the project’s output, ie, price and volume

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2. Project Viability
▪ Analyzing Project Viability

• Adequacy of supply of raw materials

• Proof of reserve estimates (measured by quantity, grade and rate of extraction)

• Creditworthiness
• Debt raising level function of capacity to service debt from project cash flow
• Measured by value of project assets, expected profitability, amount of equity sponsor’s
capital at risk plus any supplemental credit support by third parties)

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2. Project Viability
▪ Five Case Model--UK

Source: World Bank

Road Map
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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3. Project Risk
• Basic steps to risk identification analysis
• 1. Identify all project risks
• 2. Assess magnitude and probability of risks
• 3. Mitigate risks
• 4. Allocate risk to participants
• 5. Individual participant should further reduce allocated risk
spreading mechanism

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3. Project Risk
• Preliminary risk analysis

Source: Dept of Environment and Local Government, 2000 13

3. Project Risk
• Project Development Lifecycle
• Three phases
• Construction or precompletion phase
• Postcompletion phase
• Risks common to both phases
• Inflation
• Exchange rate
• Interest rate

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3. Project Risk
• Basic steps to risk identification analysis

Source: Moody’s, 2020 15

Road Map
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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4. Risk Allocation
▪ Risk allocation: project risks should be borne by the most
suitable participant whose risk preference is higher

• Risk allocation is based on commercial and negotiation strength

of different participants
• Price involved in negotiation of contract secondary to type of
risk that participant will have to bear

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4. Risk Allocation
▪ Risk Evaluation and Allocation

Source: Escap 18
4. Risk Allocation
▪ Project risk analysis
• Main risk controller-–who can control the risk

• Main risk bearer—participants must consider ability to take risk

• Willingness to control risk environment (ie, to prevent or manage risk)

• Cost control—party who can identify and manage risk at the lowest cost

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4. Risk Allocation
▪ Project risk categories:

• Capacity of resources: access information and undertake necessary

resources to manage risk

• Incentives of risk: manage risk in effective & efficient manner

• Risk relativity: risks should be considered relative to other project risks

• Minimize transaction costs: limit monitoring, negotiation and

management costs

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4. Risk Allocation
▪ Constraints on effective risk allocation

• Risk and Project Company: ability to absorb risk may be limited if it

wishes to raise highly leveraged project finance

• Risk and Value for Money: ability to transfer risk to project company may
depend, in some cases, on creating large safety margin

• Risk and Lenders: sponsors and lenders have upsides and downsides

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4. Risk Allocation

Source: KPMG-NZ
Road Map
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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5. Risk Factors
▪ Definitions
• Credit risk—risk of loss due to another party’s financial instability
to meet contractual obligations
• Counterparty risk—risk that other party fails to meet contractual
obligations for reasons other than inability to pay
• Interest rate risk—decline in value of asset over time due to
fluctuations in interest rates
• Revenue risk—risk that conditions adversely impact projects
future earnings
• Political risk—risk that government actions will affect project

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5. Risk Factors
• Construction risk—risks associated with the design, financing,
construction and testing of the project faciltity
• Technology risk—risk in project that incorporates an unproven
technology that may have to be altered or modified
• Commodity price risk—risk due to increase/decrease in price of
commodity sold
• Operating risk—risk associated with project’s operational
limitations and reserves sufficient to cover maintenance costs, IP
and other sufficient rights to ensure daily operation of facility

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5. Risk Factors
• Credit risk challenges
• Refinancing—increasingly common due to partially amortizing
debt and shorter contract terms.
• Three types of transactions likely to involve restructuring and
refinancing risk.

Source: Morningstar, 2024

5. Risk Factors
▪ Risk Categories Across Project Phases

Source: OECD, 2015 27

5. Risk Factors
▪ Merchant Risk in Power Plant Projects
▪ Market move away from fixed-price revenue contracts to wholesale or short-
term power purchase agreements (PPA)

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5. Risk Factors
▪ Merchant Risk in Power Plant Projects

• Uncertainty can lead to volatility • Short-term price spikes and

price volatility
• Uncertainty in price forecasts
due to:
• Technology changes and
regulatory policy
• Cost of commodities

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5. Risk Factors
▪ Merchant Risk Mitigation in Power Plant Projects

• Price Exposure Analytics • Structural enhancements

• Compare break-even price to • Enhanced reserving—six
minimum historical annual price months or more to deal with
increase short term shocks
• DSCR 1.0x in any year of the • Cash sweeps
debt’s life (falls short of many • Flexible amortization
lender’s minimum thresholds)
• Tolling agreement—contract
• Rating agencies: require buyer reserves right to take
investment-grade project to output by agreeing to pre-
break-even at lower price than determined premium
minimum historical annual price

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5. Risk Factors
▪ Institutional Investors: Attractive risk-adjusted returns

• CEIT Fund’s risk tools:

• Base case set of returns (based on
conservative estimates)
• Diversified portfolio of plants rather
than specific project
• Long-term, O&M contracts fixing
costs for life of asset
• Purchase price facility reducing price
by investors after 24 months
• Cash reserve facility (liquidity support
in case of lower-than-expected net
cashflows)
• Sharing up-front structuring costs
• Return of full-value of reserve facility
(at end of fixed term price regime)

Source: CEIT, 2017

5. Risk Factors
▪ The Commercial Risks: BUILDING BLOCKS:
1. Commercial Viability
− Technically Feasible: construction completed on schedule, within budget and operated
at design capacity
− Economic Viability: whether project’s expected net present value is positive
− Marketability: confirm projected supply/demand conditions over life of project
2. Construction Risks
− Increase in project construction costs (start-up, site, design, owner’s risk, modifications)
− Delay in completion
− Counter-party risk (technical and financial capacity)
3. Revenue Risks
− Offtake contract: volume and price risks (ability of Offtaker to pay)
− Hedging contracts product price hedging
− Contracts for Differences (adjustment between strike price and spot price)
− Projects without volume or price risk adjustments
− Concessions (traffic risk issue)
− Availability-based Contracts (long-term usage risk)
4. Operating Risks technology, general operation, degradation, maintenance and
− Technology (more suitable for established technologies)
− Project Operation (loss of revenue or higher capacity charge)
− Degradation
− Maintenance and Life Cycle Costs
5. Input-Supply Risks
− Input-supply contracts (credit risk, supply or price risks)
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5. Risk Factors
▪ The Commercial Risks: BUILDING BLOCKS II:
1. Uninsured Risks
− Force-Majeur and Insurance: gaps between scope of insurance and F-M losses
− Insurance costs: cap and floor system; open risk for other types of projects
− Unavailability of insurance: best efforts or Offtaker/Contracting Authority assume risks
2. Environmental Risks
− Environmental impact assessment
− Equator Principles
− Waste disposal (technical and financial capacity)
3. Contractual Mismatch
− Relief events causing delay in project completion
− Relief event causing interruption in availability
4. Recourse to Sponsors: subscribe equity share in project company
− Contingent equity commitment (7-8% of total project costs)
− Limited recourse guarantees
− Cost-overrun guarantee
− Completion guarantee
− Input supply guarantee
− Performance guarantee (may be cross-guaranteed by contractor or manufacturer)
5. Risks for Offtaker/Contracting Authority (provide a guarantee not affected by privitzation)
− Payments on Termination: does not pay more than project worth if takes over reverting
asset-backed contract
6. Why do Projects Fail
− Structural and financial weakness of projects
− Higher number of defaults were deals with
Source: speculative
Lapidus, 2020 grade rating 33
5. Risk Factors
▪ Bhogapuram International Airport

Source: Lapidus, 2020 34

5. Risk Factors
▪ Risk and Risk Mitigation

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5. Risk Factors
▪ Risk and Risk Mitigation

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Road Map
• Background
• Project Viability
• Project Risk
• Risk Allocation
• Risk Factors
• Risk Instruments

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6. Risk Instruments
▪ Mechanisms to mitigate investor risk

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6. Risk Instruments

Instruments

Minimum payment (Contracting Authority)

Guarantee: Default
1. Guarantees Guarantee: Refinancing
Exchange Rate Guarantees

Wrap insurance
2. Insurance (private sector) Technology guarantees
Warranties
Commercial and political risk insurance

3. Hedging Derivatives (CDS)

Interest rate swaps
Forward contracts
Options
4. Grants Revenue grant
Lump sum grant
Grant on debt interest
Tax devices SPVs
5. Subordinated debt & mix of
Subordinated debt
Debt
Equity
debt/equity Securitizations

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6. Risk Instruments
▪ Guarantees
• Designed to shift risk to parties that prefer direct involvement in
project
• Example: New project technology may require long-term
guarantee by sponsors, cross-guaranteed by either contractor or
manufacturer.
Typically used by company with no little or no liquid collateral available

• Benefits
Mitigates credit risk (directly) and is liquid since it derives from a better rated
entity. Receiving party can substitute credit risk of guarantor to the credit risk of
the project company
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6. Risk Instruments
▪ Transnational Guarantees
• Designed to meet condition of financing in international projects

• Concerns
• Legal certainty with respect to enforcement of terms
• Currency uncertainty (eg, enforcement actions against guarantor)
• Tax: need to consider gross up and other provisions if there is any uncertainty
regarding local laws

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6. Risk Instruments
▪ Limited Guarantees
• Designed to supply minimum credit enhancement for some type
of projects
Hard budget constraint needed in some cases to avoid moral hazard problems

• Structured in terms of:

• Limited amount
• Effective period
• Scope
• Extend of Liability

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6. Risk Instruments
▪ Limited Guarantees

• Claw-back: mandates that project sponsor return cash distributions to project

company linked to certain triggers (ie, debt levels, etc)

• Triggers can be hard to set in some instances (agency issues)

• Cash deficiency: mandates project sponsor supply cash to cure cash deficiency
of project company

• Completion: project sponsor agrees to advance supplemental capital to

complete project (due to cost overruns, budgeting or other construction
overruns); includes capital equipment and other construction related costs
needed to complete project

• Project sponsors are able to seek guarantees from construction companies,

equipment suppliers and other participants generally

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6. Risk Instruments
▪ Indirect Guarantees are based on underlying credit of project
participant (ie, where revenue stream can be attached)

• Take or pay offtake contract: generates stable cash flow to service

debt (no significant revenue risk is left with Project Company)

• Offtake contracts may represent sole source of income or project

• Lender requires offtake contracts to meet pre-agreed criteria

• Form:https://www.sec.gov/Archives/edgar/data/1556766/000119312512
436698/d400066dex1032.htm

• Validity of agreement as guarantee will depend on function of plant

production, which could be interrupted for various reasons

• Take and pay: offtaker pays only what he or she buys given
characteristics of the contract 44
6. Risk Instruments
▪ Insurance is needed to deal with risk that cannot be contracted
for at a reasonable price
▪ Ex: required if SPV’s cost of risk mitigation using insurance policies is less
than premium for risk expressed in interbank rates requested by banks if
no coverage exits

• Deal breaker in some projects (eg minimum accepted levels for

lenders that will finance deal)

• Types of insurance: self-insurance, contract for benefit of named

insured with non-vitiation for breach, re-insurance (indemnity
between insurer and reinsure, with potential cut through
provisions that can be made for proceeds to be directed to a
beneficiary)
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6. Risk Instruments
▪ Main issues
• Pricing of insurance package
• Quality of insurers and reinsurers and their rating for entire loan
period
• Possibility that sponsors will not renew or reduce insurance
program
• Problems related to the project risks that were underwritten
• Problems including sponsors not being eligible for coverage;
payment to parties not entitled

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6. Risk Instruments
▪ Types of Insurance Policies

• Non-payment risk (policies covering damage for the SPV due to political or business
reasons; may deal with medium or long-term receivables)

• Investment risks (polices protect SPV for risks of currency incovertibility, etc)

• Collateral deprivation risks: (policies that protect against loss of assets and failure of
concession authority to repurchase the structure)

• Contractual frustration risks (policies calling of guarantees and failure to deliver parts of
pieces that are functional to project)

• Credit enhancement (insurance that can be required to guarantee a credit from a third
party)

• Transfer risk (policies used where there is little political stability to ensure against
failure of retransfer payments)

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6. Risk Instruments
▪ Insurance

• Coverage can be obtained for • All site equipment risk policy

the following • Third party liability of board of
• Set up delay directors
• Third party liability
• Employer’s third-party liability
• All risks—material and direct
damage
• All assembly risk policy
• Delay in start up due to assembly • Indirect damage—business
incorporation
• General 3rd party liability
• Employer’s third-party liability
• Third party pollution problems

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6. Risk Instruments
▪ Political Risk Insurance

• MIGA (multilateral investment • IFC (international finance

guarantee agency) corporation)
• New investment in member • Provides co-financing program to
country attract commercial lender
• Insurance covers: equity and debt • Sell participation interest in B
(ie, medium and long term loans
guarantees) • Key issue: protection against
• Key issue: currency conversion currency conversion issues
issues

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6. Risk Instruments
▪ Political risk insurance is specialized form of insurance that deals
with political uncertainty or instability (Overseas Investment
Corporation, ADB, World Bank, etc)
▪ Contracts typically cover following issues:
• Confiscation, expropriation, nationalization
• Forced abandonment of venture
• Transfer risks
• Host government refusal to repurchase structure
• Unilateral contact rejection
• War, etc

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6. Risk Instruments
▪ Hedging
• Forwards and futures contracts enable project sponsors to sell
their output for future delivery (ie, guaranteed a quantity and
price for commodity that can be sold on this basis)
• Forward contracts typically obligates seller to deliver:
• Specified quantity
• Particular commodity, currency or other item
• On specified future date
• At stated price
• Typically cancelled before delivery—out-of-the-money party pays
the in-the-money party the agreed amount
• Contracts are not freely transferable and may be cancelled prior to
delivery if both parties consent
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6. Risk Instruments
▪ Hedging
• Futures contracts --standardized exchange traded contracts to
purchase or sell for fixed price a specific interest rate, index etc
Traded on organized exchange—party agrees to sell commodity (short
position) on a specific future date and other party agrees to accept delivery
and pay for the commodity on a specific future date (long position)
• Party required to pay small margin as good faith deposit
• Futures held to maturity are closed by delivery of underlying commodity
or cash settlement

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6. Risk Instruments
▪ Fixed for Floating Price Swap between project company and
swap provider will be a swap of floating rate payment for fixed
priced payment obligation
• Project company makes floating price payments and swap provider to make fixed
payments (additional credit support needed for project company to support
floating rate payment to swap provider such as a letter of credit to swap provider)

Source: Lapidus, 2020 53

6. Risk Instruments
▪ Overview of Risk Instruments

Source: Lapidus, 2020 54

Risk Management: Things to Remember
• Risk-management: identification and management of main risk factors
• Risk allocation framework: technical, construction, operating, environmental,
revenue, financial, force majeure, political/regulatory and default
• Risks refocused in terms of Macro-risks (external to project); Micro-risks
(stakeholder risks arising in procurement process)
• Projects failure from: technology or design failures, operational
underperformance, poor hedging and variation in input prices, structural and
financial weaknesses
• Other factors: political interference, capital raising problems, expropriation,
etc.

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