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INTRODUCTION TO

PROJECT FINANCE

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OUTLINE

1. What is Project Finance?2. How does project finance create

value?3. Project valuation4. Case analyses

5. Recap

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What Is Project Finance?

Definition Major characteristics

Schematic example of a projectstructure Major project contracts

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Definition:

Project Finance involves one or more corporate sponsors investing in and owning a single purpose, industrial asset through a legally independent project company financed with

limited or non-recourse debt.

A relevant question to investigate:

SPONSOR + PROJECT?

Finance separately with non-recoursedebt? (Project Finance)

Finance jointly with corporate funds?(Corporate Finance)

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Major characteristics:

Economically and legally independent project company Founded extensively on a series of legal contracts that unite

parties from input suppliers to output purchaser Project assets/liabilities, cash flows, and contracts are separated

from those of the sponsors, conditional on what accounting rulespermit

Investors and creditors have a clear claim on project assets andcash flows, independent from sponsors financial condition

Debt is either limited (via completion guarantees) or non-recourse to the sponsors

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Highly leveraged project company with concentrated equityownership Partly due to firms need for flexibility and excess debt capacity

to invest in attractive opportunities whenever they arise

Syndicate of banks and/or financial institutions provide debt Typical D/V ratio as high as 70% and above Debt has higher spreads than corporate debt One to three equity sponsors Sponsors provide capital in the form of equity or quasi-equity

(subordinated debt) Governing Board comprises of mainly affiliated directors from

sponsors

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Historically formed to finance large-scale projects

Industrial projects: mines, pipelines, oil fields Infrastructure projects: toll roads, power plants,

telecommunications systems

Significant financial, developmental, and social returns

Examples of project-financed investments $4bn Chad-Cameroon pipeline project $6bn Iridium global satellite project

$1.4bn aluminum smelter in Mozambique 900m A2 Road project in Poland


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Statistics as of year 2002

$135bn of capital expenditure globally using project finance $19bn of capital expenditure in the US

Smaller than the $612bn corporate bonds market, $397bn assetbacked securities market and $205bn leasing market;approximately same size with the $27bn IPO and $26bn venturecapital market


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A simplified project structure example:

A nexusofcontracts

that aidsthe sharingof risks,returns,andcontrol

Source: Esty, B., An Overview of Project Finance 2002 Update: Typical project structure for an independent power producer

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Major project contracts: The Offtake Contract:

A framework under whichProject Company obtainsrevenues

Provides the offtaker(purchaser) with a securesupply of project output, andthe Project Company with theability to sell the output on apre-agreed basis

Can take various forms, suchas Take or Pay Contract:

Power Purchase Agreement (PPA)

Input Supply Contract:

The Offtake Contract for theinput supplier

Provides the Project Companythe security of input supplieson a pre-agreed pricing basis

The terms of the Input SupplyContract are usually crafted tomatch those of the OfftakeContract (such as input

volume, length of contract,force majeure , etc.)

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Major project contracts: Construction Contract:

A contract defining theturnkey responsibility todeliver a complete projectready for operation (a.k.a.Engineering, Procurement,Construction (EPC) Contract)

Operation and MaintenanceContracts: Ensures that the operating

and maintenance costs staywithin budget, and projectoperates as planned.

Permits: Contracts that ensure permits

and other rights for construction and operation of the project, as well as for investing in and financing of the Project Company

May be provided by centralgovernments and/or localauthorities

Government SupportAgreements: Provisions may include

guarantees on usage of publicutilities, compensation for expropriation, tax exemptions,and litigation of disputes in anagreed jurisdiction

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OUTLINE


value?3. Project valuation4. Case analyses

5. Recap

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How Does It Create Value?

Drawbacks of using Project Finance Value creation by Project Finance

Organizational structure

Agency costs, debt overhang, risk contamination, riskmitigation Contractual structure

Structuring the project contracts to allocate risk, return,and control

Governance structure Benefits of debt-based governance Case examples to value creation

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Drawbacks of Using Project Finance Structure:

Takes longer to structure andexecute than equivalent sizecorporate finance

Higher transaction costs due tocreation of an independent entity

and complex contractual structure

Non-recourse project debt ismore expensive due to greater risk and high leverage

High leverage and extensivecontracting restricts managerialflexibility

Project finance requires greaterdisclosure of proprietaryinformation to lenders

Still, the combinationof organizational,financial, and

contractual features may offer anopportunity to reducenet cost of financing and improveperformance

Structure matters, contrary toMM Proposition!

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Structural decisions may affect the existence and magnitude of costsdue to market perfections:* Agency conflicts* Financial distress* Structuring and executing transactions

* Asymmetric information between parties involved* Taxes

Value Creation

Organizational Structure

Contractual Structure

Governance Structure

Why does structure matter?

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Organizational structure Agency costs, debt overhang, risk contamination, risk

mitigation Contractual structure



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Value creation by organizational structure:Agency Costs

Agency conflicts betweensponsors (owners) andmanagement (control)

High levels of free cashflow leading tooverinvestment innegative NPV projects

Risk shifting/debtshifting by managers toinvest in high risk,negative NPV projectsto recoup past losses

Refusal to makeadditional investment

Concentrated equity ownership andsingle cash flow stream provides criticalmonitoring

Strong debt covenants allow bothsponsors and creditors to better monitor management

High debt service reduces the free cashflow exposed to discretion

Extensive contracting reducesmanagerial discretion

Cash Flow Waterfall mechanismfacilitates the management and allocationof cash flows, reducing managerialdiscretion. Covers capex, debt service,

reserve accounts, and distribution of residual income to shareholders Given the projects are defined within

narrow boundaries with limitedinvestment opportunities, moral hazard(risk shifting, debt shifting, reluctance toinvest) is minimized

Problems Structural Solutions:

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Agency conflicts betweensponsors and creditors:

Distribution of cash flows, re-investment, and restructuringduring distress

Moral hazard (such as riskshifting and debt shifting)encouraged by full recoursenature of debt to sponsor

Cash Flow Waterfall mechanismreduces potential conflicts in distributionand re-investment of project revenues

Legally/economically separate projectcompany eliminates potential for riskshifting and debt shifting

Concentrated debt ownership is preferred(i.e. bank loans vs. bonds) to facilitatethe restructuring and speedy resolutions

Usually subordinated debt (quasi equity)

is provided by sponsors

Strong debt covenants allow better monitoring

Single cash flow stream and separateownership provides easier monitoring


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Conflicts between sponsors andother parties (purchasers,suppliers, etc.)

Vertical integration is effective inprecluding opportunistic behavior butnot at sharing risk. Also,opportunities for vertical integrationmay be absent.

Long term contracts such as supplyand off take contracts: these aremore effective mechanisms thanspot market transactions and longterm relationships.

Joint ownership with related partiesto share asset control and cash flowrights. This way counterpartyincentives are aligned.


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Conflicts between sponsors andgovernment: Expropriationthrough either asset seizure,diversion, or creeping

Since project is large scale and thecompany is stand alone, acts of expropriation are highly visible in theinternational arena which detractsfuture investors

High leverage leaves less on thetable to be expropriated

Multilateral lenders involvementdetracts governments fromexpropriation since these agenciesare development lenders andlenders of last resort. However theseagencies only lend to stand aloneprojects. High leverage also reducesaccounting profits thereby reducingthe potential of local opposition tothe company.


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Value creation by organizational structure:Debt Overhang

Sponsors under -investment inpositive NPV projects whensponsor has:

limited corporate debt capacity

agency or tax reasons thatexclude equity as a valid option

pre-existing debt covenantsthat limit possibility of new debt

Non-recourse debt in anindependent entity allocates returnsto capital providers without any claimon the sponsors balance sheet.Preserves corporate debt capacity.

The fact that non-recourse debt isbacked by project assets/cash flowsand not by the sponsors balancesheet increases the chances of analready highly leveraged sponsor toseparately finance a viable project


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Value creation by organizational structure:Risk Contamination

A high risk project maypotentially drag a healthysponsor into distress, byincreasing cash flow volatilityand reducing firm value.

Conversely, a failing sponsor can drag a healthy projectalong with itself.

Very large projects canpotentially destroy thesponsors balance sheet andlead to managerial risk aversion

Benefit from portfoliodiversification is negative (riskis higher) when sponsor andproject cash flows are stronglypositively correlated.

Project financed investment exposesthe sponsor to losses only to theextent of its equity commitment,thereby reducing its distress costs

Through project financing, sponsorscan share project risk with other sponsors: Pooling of capital reduces each

providers distress cost due to therelatively smaller size of theinvestment and therefore the overalldistress costs are reduced.

Separate incorporation eliminatespotential increase in risk whenfinancing a project stronglycorrelated to sponsors existingasset portfolio.


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Value creation by organizational structure:Other motivations

Joint venture projects withheterogeneous partners: Financially weaker partner cannot finance its share of investment through corporateborrowings, and needs projectfinance to participate

Location: Large projects inemerging markets usuallycannot be financed by localequity due to supply

constraints. Investment specificequity from foreign investors iseither hard to get or expensive.

The stronger partner is better equipped to negotiate terms withbanks than the weaker partner andhence participates in project financeeven if it can finance its share viacorporate financing

Debt may be the only option andproject finance the optimal structure.

Besides, host government may grantthe project tax holiday, whichprovides sponsors exemptions fromtaxation


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mitigation Contractual structure Structuring the project contracts to allocate risk, return, and

control Governance structure

Benefits of debt-based governance

Case examples to value creation

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Value creation by contractual structure:

An introduction to risk management

Risk management defined Sources of risks Who bears risk?

Mechanisms for reducing cost of risk

Contractual structure in Project Finance to reduce cost of risk andcreate value

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Value creation by contractual structure:An Introduction to Risk Management

Risk Management:

The process of identification, assessment, mitigation, and allocation of risksto reduce cost of risk and improve incentives

Sources of risk:

External: Markets: Availability and quality of products, inputs, and services

used Financial markets Government policy Natural resource availability and quality Natural disasters, politics

Internal: Incentive problems during construction and operation stages Relationships between management, sponsors, lenders, workers,

suppliers, government(some addressed in the previous slides under value creation byorganizational structure)

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Who bears risk?

Sponsors bear the residual gains and losses, and make key investment decisions.In simple terms,

Return to equity = Revenues Material / service costs Labor costs - Depreciation Interest expenses Taxes

Variability in RHS variables lead to changes in return to equity

Other earners of net income (or net value added) from investment can also share risk :

Net Value added = Return to equity + Interest expenses + Taxes + Labor costs

= Revenues Material / service costs Depreciation

Profit sharing mechanisms or tax incentives may change how variability in income is shared among sponsors, lenders, government, and labor

Output purchasers and input suppliers can also share the risks as theyexperience variability in their markets


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How are costs of risk reduced?

Some risks can be reduced by spreading the burden across many participants; someother risks cannot be spread, but can be shifted or reallocated

Different stakeholders in a project may have different preferences, and hencedifferent willingness and capacity to bear risks Cost of risk is lower to those with greater capacity and willingness to bear risk Risk-return trade-offs may enable integrative (not necessarily competitive)

negotiations among different stakeholders and may create value in a projectsetting

Gains in economic efficiency can be achieved if overall cost of risk declines throughrisk shifting and reallocating: The same risk will have a lower cost if born by parties better capable and willing

to do so


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Mechanisms to reduce cost of risk:

Capital, financial, and futures markets: Mix of debt and equity (capital structure) and probability of default Risk spreading / pooling Risk diversification Insurance markets (for residual risks) Derivative financial instruments (not available for asymmetric risks) Futures markets

Real options: Design flexibility into project to allow for responses of newinformation or market changes

Project design itself for risk mitigation (elements of production process,technology used, etc.)

Project Finance mechanism : complex contractual arrangements involvingall mechanisms of contractual risk allocation and reduction to deal with riskin large scale investments


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Generally well developed capital, financial, and futures markets may not always beavailable

Special contractual arrangements are often required to manage risk to make projectsviable

The aim of extensive contracting is to reduce cash flow volatility, increase firm valueand debt capacity in a cost-effective way

Guarantees and insurance for those risks that cannot be handled through contracting

Elements of contracting: General form:

Exchange risk (x) for return (y) Additional considerations:

Participation or partial transfer of ownership Timing of x and y Contingency of x and y (under what circumstances) Penalties on non-performance Bonus on performance

Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk

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Contracting criteria: Contract with lowest cost not necessarily best contract Effective contracts may provide:

Better risk shifting: better distributions of cost Better incentives: higher project returns or lower total project risk as a result of

incentives Change the incentive structure to change the probabilities of different outcomes

stakeholders have incentives to increase probability of success and reduce probabilityof failure in project

Zero Sum (Competitive) versus Positive Sum (Integrative) perspectives Cost focus is implicitly a zero sum perspective: one stakeholder gains and the

other stakeholder loses

Integrative focus is explicitly a positive sum perspective: By crafting the rightcontract, one stakeholder can gain without necessarily costing to the other one(due to differences between perceived values, preferences, and risk bearingcapacity) contracts that create increased value through risk sharing and /or improved incentives


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Sources of contracting benefits: Stakeholders differing risk preferences Differing capability to diversify Differing capability to manage risks Differing information or predictions regarding future Differing ability to influence project outcomes

Risks manageable via contractual structure or other mechanisms inProject Finance:

Pre-completion risks : Resource, technological, timing, and completion risks Post-completion risks: Market risk, supply risk, operating cost risk, and force

majeure

Sovereign risks : Inflation risk, exchange rate volatility, convertibility risk,expropriation Financial risks: Default risk


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Value creation by contractual structure:Pre-completion risks:

Risk Solution

Construction cost overruns: reduce equityreturns, and DSCR

Pre-agreed overrun funding (contingency finding)Fixed (real) price contract, as the EPC contract isnormally the largest cost item in budget (60-70%)Contractor takes junior debt and/or equity stake inoperations (BOT or BOO)

Delay in completion: failure to meet themilestones increase costs, reduce equity returns,and reduce DSCR

Financing costs, especially as debt will beoutstanding longer

Revenues from operating the project willbe lost or deferred (significant risk alsoespecially if part of financing depends onearly revenues)

Penalties may be payable under contractto input suppliers or off-taker

Completion guarantees, date-certain EPC contractPerformance bondsCompletion bonuses/penaltiesReputable contractor Close monitoring / testing of project execution(operational, financial, etc.) for early detection of problems

Careful definition of completion in all the contracts(EPC contract, input supplier contracts, off-taker contract, etc) so that it is acceptable and manageableby all parties involved

Process failures Process / Equipment warrantiesTested technology

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Risk Solution

Nonperformance on completion: due to poor design, inadequate technology

Debt recourse to sponsors (from lenders perspective) Performance LDs (liquidated damages): Pre-agreedlevel of loss to be born by the contractor. Covers theNPV of loss due to nonperformance over the life of theproject The Project Company should be aware of the

uncertainty regarding the LDs and should allow amargin when negotiating the calculations with thecontractor

Natural resource risk Independent reserve certification

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Risk Solution

Third party risks: The contractor may be dependent on thirdparties such as suppliers of utilities tocomplete the project

The project may be dependent oncompletion of another project worst type of third party risk especially when the projectfinancing is dependent on it.

If the third party is not otherwise involved in theproject, incentive mechanisms to keep the timetableIf the third party is involved with a project contract,the contract should include terms such that the thirdparty should be held responsible for the delay lossesContractors good relationships and experience with

the third parties may be a plus

Financing the projects as one package may beexamined as a potential solution, as long as thesponsors interests on both sides can be aligned

Sponsor- related risks (Lenders perspective):

Sponsor commitment to the project Financially weak sponsor

Require lower D/E ratio

Starting with equity: eliminate risk shifting, debtoverhang and probability of distress (lendersrequirement). Add insider debt (Quasi equity) before debt: reducescost of information asymmetry. Attain third party credit support for weak sponsor (letter of credit)

Cross default to other sponsors

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Value creation by contractual structure:Post-completion risks:

Risk Solution

Market risk: Uncertainty regarding the future priceand demand for the output

Volume risk: cannot sell entire output Price: cannot sell output at profit

Long term off-take contract with creditworthy buyers: take and pay, take or pay, take if delivered contracts:

Price floors A fixed price growth path An undertaking to pay a long-run average priceSpecific price escalator clauses that would maintain thecompetitiveness of the product, such as indexing price tothe price of a close substitute or cost of major input

Hedging contractsOperating cost risk: Uncertainty regarding thechanges in the operating cost throughout the lifeof the project

Risk sharing contracts to increase correlationbetween revenue and some cost items:

If there is an off-take contract, linking input supply priceto it:

Basing the product price under the off-take contract on thecost of the input supplies (more likely if input supply is awidely traded commodity like oil)

Basing the input supply price to product price under the off-take contract: (more likely if the input is a specializedcommodity, or if there is no off-take contract and risk ispassed to the input supplier)

Price ceilings Profit sharing contract with labor Output or cost target related pay

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Value creation by contractual structure:Post-completion risks:

Risk Solution

Input supply risk: Uncertainty regarding theavailability of the input supplies throughout the lifeof the project

If there is an off-take contract, linking the terms of theoutput contract with input supply contracts such as thelength of contract, volume, or force majeureIf there is no off-take contract, making the inputsupply contract run for at least the term of debt An input supply contract is off-take contract for thesupplier

Organizational risks: Incentive problems relatingto management or workers

Profit sharing / stock optionsOutput or cost target related pay for workers

Operating risk: operating difficulties due totechnology (being degraded or obsolescent),processes used, or incapacity of operator teamleads to inefficiencies and insufficient cash flow

Performance warranties on equipmentExpert evaluation and retention accountsProven technologyExperienced operator/management team

Operating/maintenance contracts to ensureoperational efficiency Allowances for service / upgrade built into equipmentsupply contractsInsurance to guarantee minimum operating cash

Force majeure risk: Likelihood of occurrence of events like wars, labor strikes, terrorism, or nonpolitical events such as earthquakes, etc.

Insurance for natural disasters

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Value creation by contractual structure:Sovereign risks:

Risk Solution

Exchange rate changes: Uncertainty regardingthe changes in the exchange rate throughout thelife of the projectImplications of a sudden major local currencydevaluation in cases where the project revenue isin local currency and debt in foreign currency

Revenues, costs, and debt in same currency(indexing if they are not in the same currency)Market-based hedging of currency risks (though notwidely used)For protection from a sudden major devaluation, arevolving liquidity facility can be utilized to cover thetime lapse between the devaluation and thesubsequent increase in inflation that shouldcompensate the project company for debt payments

Currency convertibility / transferability risk: As it isoften not possible to raise funding in localcurrency in developing countries, revenuesearned in local currencies need to be convertedinto foreign currency amounts needed by offshoreinvestors/lenders, and then need to be transferredoutside the country to pay for them. Additionally,foreign currency may be needed to importmaterials, equipment, etc.

Government Support Agreement: Governmentguarantee of foreign exchange availability: However, if the host country gets into financial difficulty and runsout of foreign currency reserves, then the governmentmay forbid either the conversion of local currencyamounts to foreign currency, or the transmission of these amounts abroad The support agreement maybecome invalidEnclave projects: If the project revenues are paidfrom a source outside the host country, the project canbe insulated from foreign exchange and transfer risks(Example: sales of oil, gas across borders)

Offshore debt service reserve accounts

Value creation by contractual structure:

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Risk Solution

Hyperinflation risk: Relative changes in the priceof inputs and output may adversely affect theproject

Indexing the output price (in the long term salescontract) against the CPI and or industry price indicesin the host country where the relevant costs areincurred (Indexing means increasing over time againstagreed, published economic indices)

Expropriation: Direct, diversion, creepingGovernments breach of contract and court

decisions

Government guarantees or regulatory undertakings tocover taxes, royalites, prices, monopolies, etc.

Involvement of multilateral/bilateral agenciesOffshore accounts for proceedsGovernments equity ownership Using external law or jurisdiction

Legal system: Unclear and/or inconsistent legal/regulatoryframework for projects operations

Insufficient protection of private investment andprivate ownership/control of project

Bureaucratic hurdles Changes in law, such as imposition of newenvironmental/health/safety requirements, pricecontrols, import duties/controls, increase in taxes,royalties, deregulation, amendment or withdrawal of projects permits, changing the control of company

Government support agreementUsing external law or jurisdiction

Involvement of multilateral/bilateral agencies A general principle is that the party who is paying for the output under a project contract should pay for thelosses incurred due to changes in law specific to theindustry, because such change is reflected in theentire industry and any extra costs will normally bepassed on to end users; therefore an offtaker whodoes not bear this risk would earn extra profits at theexpense of the project company

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Risk Solution

Political risks: Likelihood of occurrence of politicalevents like wars, labor strikes, terrorism, etc.

Political risk insuranceInvolvement of multilateral agencies (WB/IFC)(structuring legal/financial documents, mediation innegotiations, sovereign deterrence, halo effect) Bilateral agencies: Export credits from ECAs (whoprovide PRI)The private insurance marketContractual sharing of political risks betweensponsors and lenders

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Value creation by contractual structure:Financial risks:

Risk Solution

Default risk: Ensure sufficient debt service coverageDecrease debt/equity ratioMatch term of loan to productive life of assetsMatch repayment schedule to expected cash flowsBonds with interest rates indexed to product salesprice

Match currency of loans to currency of revenues

Interest rate risk: Interest rate swaps and hedgingInterest rate caps

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Value creation by governance structure:

Benefits of debt-based governance

Tighter covenants limit managerial discretion and enforcesgreater discipline via better monitoring

High leverage reduces free cash flow exposed to discretion

High leverage reduces expropriation risk High leverage also reduces accounting profits thereby

reducing the potential of local opposition to the company Tax shields

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2. How Does It Create Value?





Governance structure Costs and benefits of debt-based governance Case examples to value creation

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Background:

The project included a 12,500 km submarine telecommunications systembetween Australia and Japan via Guam at a cost of $ 520M. The projectwould use Telstras two landing stations at Australia. In Japan, it needed toeither obtain permit from the government for building new stations, or

contract or partner with other companies to obtain access to the existingones. Japanese Government seemed not likely to approve building of anew landing station. Most significant risks were market and completionrisks.

The lead sponsor, Telstra, has to structure the project company, selectingan ownership, financial, and governance structure.

Case examples to value creationAustralia-Japan Cable Structuring a Project Company:

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Issues:

1. Selection of strategic sponsors who would bring the most value to theproject

2. Mitigation of market risk: Growing demand and capacity shortfall thattriggers competition, rapid improvements in cable technology and

resulting price decline necessitates moving very quickly3. Completion risk: Potential delays due to environmental approvals andother permits

4. Management of possible agency conflicts between:1. sponsors and management2. sponsors and other parties (capacity buyers (purchasers), suppliers,

etc.)3. sponsors and creditors - decision of how many and which banks to

invite to participate


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1. Telstra partnered with Japan Telecom (who would bring its landingstation in Japan and was interested in buying capacity) and Teleglobe (amajor carrier who would bring significant volume) as sponsors( reducing cash flow variability)

2. Other equity investors to be selected would be high rated sponsors whowere also capacity buyers. They would be made to sign presale capacityagreements ( reducing variability).

3. Capacity agreements with high rated sponsors would also beinstrumental in raising debt with favorable conditions

How project structure may help:


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4. Contemplated on concentrated equity ownership to maintain moreeffective management and monitoring

5. As for an interim management team, sponsors would also be made equalpartners in control, regardless of individual ownership shares

6. A permanent management team was discussed, that would workexclusively for the project:

Management compensation package was easier to craft, since it wasa single purpose company with limited and well-defined growthopportunities

Single cash flow easier to monitor



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7. Decided on high leverage and project finance structure to help: limit the amount of equity they needed to invest to an acceptable size share the project risk with debt holders enforce management discipline by reduced free cash flow and

contractual agreements

8. Bank debt with a small banking group was preferred rather than projectbonds to have flexibility The initial tranche of bank debt would be secured and repaid in 5

years with presale commitments The second tranche would also be repaid in 5 years, but from future

sales, acting as trip wires for the management team



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Background:Calpine, a small power generator with high leverage (~80%), sub-investment grade rating, and little debt capacity, has to decide how tofinance its aggressive growth strategy, facing increasing pressure for speed, efficiency, and flexibility in a soon-to-be competitive commoditymarket.

The growth strategy includes building and operating a power systemconsisting of multiple power plants. Project financing and corporatefinancing alternatives are considered.

Calpine Corporation


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Issues:

1. Speed was very important to gain first mover advantage

2. Necessity to be a low-cost producer in a commodity market

3. Operating a system of power plants to gain scale economies and alsothe flexibility to switch between the plants to offer uninterruptedservice


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Issues:

4. Using corporate finance as the financing method:

Benefits: Issuing high yield bonds would not require collateral and reduce

legal fees Bonds would leave Calpine free to switch between plants in the

power system Costs:

The high-yield market was thinner and more volatile compared toinvestment grade market, creating pricing and availability risk

As a firm with high leverage and sub-investment grade rating, thehigh cost of corporate financing might lead Calpine to miss theopportunity to invest in a positive NPV growth project (DebtOverhang)

A large debt issue might further jeopardize Calpines debt rating


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Issues:

5. Using project finance as the financing method:

Benefits: Opportunity to finance the growth strategy even if Calpine had low

investment ratings and limited debt capacity Costs:

Time consuming and expensive to set-up and execute individualdeals

Limited size and absorption capacity of the project finance market

Possible restrictions to flexibly switch between the plants in thepower system if each plant would be collateralized separately


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A hybrid structure was crafted that combined elements of both projectand corporate finance:

1. Project Finance:i. Calpine project financed a portfolio of plants rather than a single

plant. This reduced legal and other fees, transaction costs, andsaved time.

ii. Project finance allowed raising a large amount of debt on a non-recourse basis, which was impossible at the parent level

2. Corporate Finance:

i. The structure gave Calpine flexibility to build the plants usingequity, and manage them flexibly as part of a power system (whichwould be impossible with separately project financing the individualplants)



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Background: A large and well-capitalized company, BP Amoco tries to decide on thebest way to finance its share in the $8 billion development project of Caspian oil fields, undertaken by a consortium of 11 companies.

Each of the partners had a choice in how to finance its share of the total

investment. Of these companies, 5 formed a Mutual Interest Group(MIG) to obtain project loan with assistance of IFC and EBRD. Thealternatives BP Amoco considered for its share were corporatefinancing, project financing, or a hybrid structure.

BP AmocoCase examples to value creation

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Issues:

1. Project Risks: The project had considerable political, financial,industrial (price and reserve volatility), and transportation related riskslargely due to the unique region it was located.

2. Risk management: Protection of BP Amocos balance sheet from riskcontamination or distress costs from investing in a risky asset

3. Involvement of multilateral organizations: Increased capacity to raisecapital


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Using corporate finance as the financing method:

Benefits: Financially strong enough to support a corporate funding strategy

with favorable terms Easier to set up and less costly

Costs: Project might create additional risks in BP Amocos current asset

portfolio Risk contamination BP Amocos absence in the IFC/EBRD finance deal for the MIG

would make it harder for the weaker partners to negotiate goodterms, reducing flexibility in operations and management

BP Amocos using corporate funding while at least some of the other partners using the IF/EBRD deal might potentially createdisagreements

Other partners might accuse BP Amoco as free rider, since BP Amoco would benefit at no cost from the political risk protectionIFC/EBRD deal would have provided

How they funded the initial phase would change possibilities of financing for the coming stages

Case examples to value creationHow project structure may help:

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Using project finance as the financing method:

Benefits: Reducing projects potential negative impact on the balance sheet:

The project was very large and posed too many risks which BP Amoco could not bear alone, meaning a potentially huge negative

impact on the balance sheet if financed solely by internal funding More protection from the many project risks due to risk sharing Accommodating the financially weaker partners in the consortium to

negotiate better deals with creditors for the sake of future managerialand operational flexibility

Benefiting from IFC/EBRDs existence to shield from possibleconflicts with the host governments

Costs: Harder, costlier, and more time consuming to set up Less flexibility compared to corporate finance alternative

Case examples to value creationHow project structure may help:

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OUTLINE


value?3. Project valuation 4. Case analyses

5. Recap

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Project Valuation

Background Approaches to calculating the Cost of

Capital in Emerging Markets

Country Risk Rating Model ( Erb, Harvey andViskanta)

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Background Projects are characterized by:

unique risks high and rapidly changing leverage imbedded flexibility to respond to changing conditions (real options) changing tax rates early, certain and large negative cash flows followed by uncertain positive cash flows

Traditional DCF method is inaccurate: Single discount rate does not account for changing leverage Ignores imbedded options

Idiosyncratic risks are usually incorporated in the discount rate as a fudge factor

Traditional CAPM method is inaccurate: Many mega projects are in emerging markets Many of these markets do not have mature equity markets. It is very difficult to estimate Beta

with the World portfolio. The Beta with the World portfolio is not indicative of the sovereign risk of the country

(asymmetric downside risks). E.g. Pakistan has a beta of 0.

Most assumptions of CAPM fail in this environment

More appropriate approaches to project valuation may include: Usage of non CAPM based discount rates especially for emerging markets investments Changing discount rate to account for changing leverage Incorporate idiosyncratic risks in cash flows and account for systematic risks in discount rate Valuation of real options Usage of Monte Carlo simulation

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Approaches to calculating the Cost of Capitalin Emerging Markets

World CAPM or Multifactor Model (Sharpe-Ross) Segmented/Integrated (Bekaert-Harvey) Bayesian (Ibbotson Associates) CAPM with Skewness (Harvey-Siddique) Goldman-integrated sovereign yield spread model Goldman-segmented Goldman-EHV hybrid CSFB volatility ratio model CSFB-EHV hybrid

Damodaran

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Approaches to calculating the Cost of Capitalin Emerging Markets

Many of these methods suffer problems because:

Method does not incorporate all risks in the project Assume that the only risk is variance, and fails to capture

asymmetric downside risks Assume markets are integrated and efficient Arbitrary adjustments which either over or underestimate risk Confusing bond and equity risk premia.

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The Country Risk Rating Model

Erb, Harvey and Viskanta (1995) Country credit rating a good ex ante measure of future

risk: Some of the factors that influence a country credit rating are:

political and other expropriation risk, inflation, exchange-rate volatility and controls, the nation's industrial portfolio, its economic viability, and its

sensitivity to global economic shocks The credit rating may proxy for many of these fundamental

risks as it is survey based Impressive fit to data Explains developed and emerging markets

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The Country Risk Rating Model

Returns and Institutional Investor Country CreditRatings from 1990

R 2 = 0.2976

-0.1

0

0.1

0.2

0.3

0.4

0.5

0 20 40 60 80 100

Rating

A v e r a g e r e

t u r n s

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The Country Risk Rating Model Cost of Capital = risk free + intercept (slope x Log(IICCR))

Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating Gives the cost of capital of an average project in the country in $).

If cash flows are in local currency, convert into $US: Calculate the difference between the multiyear forecasts of inflation in the host country and

those in US Use the difference to map out the expected exchange rates Use calculated expected exchange rates to convert cash flows into $

Adjust for industry risk: Calculate the country risk premium from ICCRC:

Country risk premium = Country cost of equity capital US cost of equity capital

Calculate US industry cost of capital by using industry beta Add the country risk premium to US industry cost of capital

Adjust for project specific risks that deviate the project from the average level of risk in the hostcountry Risks incorporated in cash flows or industry adjustment:

Pre-completion: technology, resource, completion.

Post-completion: market, supply/input, throughput. Risks incorporated in discount rate: Sovereign risk: macroeconomic, legal, political, force majeure. Financial risk.

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value?3. Project Valuation4. Case analyses

5. Recap

OUTLINE

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Chad-Cameroon Petroleum Developmentand Pipeline Project

Petrozuata and Oil Field DevelopmentProject

Financing the Mozal Project

Case analyses

Chad Cameroon Petroleum

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Chad-Cameroon PetroleumDevelopment and Pipeline Project

Background Corporate finance vs. project finance

Why is there a difference between financing of field and exportsystems?

The role of World Bank Assessment of project risks and returns Real options Project update

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Background

ExxonMobil, Chevron, and Petronas undertake a $4 Billionpetroleum development and pipeline project in Chad, whichpresented a unique opportunity to stimulate Chads economicdevelopment, and yet entailed environmental and social risks.

Corporate finance for the development of the field system andproject finance for the pipelines

Debate on unstable political structure and how Chad would use itsshare of project revenues WBs introduction of Revenue Management Plan to target Chad

Governments returns from the project for developmental purposes,and debate on the likelihood of effectiveness of such a plan

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Corporate financing for the field system:

The lead sponsor, ExxonMobil had AAA debt rating, very strong balancesheet ($145M assets) and $16M cash flow Could afford the fieldinvestment in a less costly way relative to project financing

ExxonMobil was actually a huge portfolio of upstream businesses(exploration, development, production of crude oil and natural gas),downstream businesses (transportation, marketing, and sales), as wellas chemical byproducts and operations in mining. With less than perfect

correlation among its assets, ExxonMobil might actually have been ableto eliminate the idiosyncratic risks via adding a field development projectto its portfolio. Corporate financing as opposed to project financinghelped ExxonMobil keep the project as part of its portfolio and reducethe risks.

Besides, the vertically integrated business model made it a naturallycost-efficient choice for ExxonMobil to hold the assets collectively with

corporate financing rather than individually with project financing Corporate financing probably also enabled managerial flexibility anddiscretion over the use of oil wells, drilling equipment, etc. thatconstitute the field system

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Corporate financing for the field system:

Field development was the less risky part of the entire project for thesponsors, because upstream operations including field developmentand production was one of the core business areas where they werevery strong at. This reduced the cost of bearing these risks themselvessince they were better equipped than anyone else.

Project financing for a field development project would also not be aviable financing option, as the lenders generally would be reluctant to

finance until after all reserves are proven and capable of production. The crude oil prices for the last 18 months ranged from $9 to $42,averaging $20 per barrel, which, even after discounted for the lower grade, was considerably higher than the projects $5.20 exploration anddevelopment costs. With a total proven plus probable reserves of 917Mbarrels, downside exposure to price and resource risk was alreadymostly eliminated No serious need to protect from the downside risk

(via risk sharing )with project finance and incurring higher interest ratesand loan fees. Corporate financing probably also helped save both the costly delays at

the development stage of the project and the structuring costs, whichwould be incurred in project financing

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Project financing for the export system:

Export system was the riskiest part of the project. Project financing for the export system mainly enabled the sponsors to spread the politicalrisks as much as possible via the presence of outside lenders such asWB, IFC, ECAs.

The expectation was that the Chad and Cameroon Govts would be lesslikely to take or tolerate adverse actions against the project in fear of

jeopardizing future funding from the WB and other international

financing institutions who were lenders of last resort Additionally, it facilitated alignment of Govts interests with the projectthrough equity ownership, which would not have been possibleotherwise as Govts could not afford on their own

Project financing also created the opportunity for the pipeline companies(JV between Govts and the sponsors) to issue limited -recourse debt,guaranteed by the sponsors through completion

Project financing enabled external monitoring from the lenders ExxonMobil also reduced total investment commitment to the project

under the corporate/project finance structure, compared to that under acomplete corporate finance structure

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The role of World Bank:

WB involvement assured sponsors the much needed protection against thepolitical risk Besides direct investment through A loans, it mobilized other funding sources like

ECA and other banks through a syndicated B loan WBs extensive lending and policy experience with Chad offered the leverage

that sponsors did not have The project with potentially high returns and developmental impact for Chad was

also aligned with WBs policy objectives WB facilitated extensive consultation process including supporters and

opponents: The process helped sponsors restructuring the project to minimizethe social and environmental impact (such as increasing the benefits toindigenous people and changing the pipeline route to protect the natural habitat)

WB also initiated a Revenue Management Plan to help prevent probablemisuse of Chads revenues by the Govt, and target them for developmentalpurposes to increase welfare

Insisted on an open and transparent project planning process Established capacity building programs to develop the infrastructure for a well-functioning petroleum industry and investment climate in both Chad andCameroon

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The role of World Bank:

WB involvement also ensured that sponsors did not abandon theproject due to huge political risks and looked instead for safer opportunities in other countries, leading to a missed opportunityfor Chad

Without the WB, the Govt might turn to neighboring countriessuch as Sudan and Libya for partnering in oil export. Thispotentially would have adverse consequences in case theproject revenues were utilized to finance non-developmentalpurposes such as war.

Such an alternative would mean longer and hence more expensivepipelines

The projects exposure to social risks would increase, as thepipelines would inevitably cross the northern part of the country with

social unrest and upheavals.

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Subjects of opposition:

The environmental and social impacts were claimed to be irreversible The revenue management plan was claimed to be flawed and to lackeffective oversight

Govt claimed to have little intention of allowing the plan to affectlocal practice

Criticism on oversight committees composition and power The RMP was a concept untested

According to Harvard Law School, Oil will not lead to development inChad without real participation, real transparency, and real oversight,none of which currently exists

The revenue management plan also regarded as infringement of sovereign rights

The sovereign rights controlled by undemocratic rulers versus

people The beneficiaries of the project were claimed more to be the corporatesponsors and commercial banks, as opposed to people of Chad

Valuable funds could have been used in alternative causes, rather thanpotentially strengthening a corrupt Govt

Assessment of Project Risks and Returns:

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Assessment of Project Risks and Returns:Chad

Benefits: Project provides an important opportunity for Chad to reduce poverty, though contingenton Govt commitment

Receive up to $125M per year from the project, increasing Govt revenues by more than 50% Chad has few other alternatives if any for development

RMP provisions and future linking of developmental funds to Govt compliance maydeter potential misuse of project revenues by the Govt

Project helps leveraging WB and other financial resources which Govt could not havemobilized by itself

Leveraging technical expertise of the reputable sponsors significantly reduces Chadsexposure to operational risks

Potential employment opportunities created for local people in operations Environmental/social concerns seem to be well addressed in contingency plans with

extensive public consultation Another positive externality may be WBs capacity building efforts to establish the

sufficient infrastructure for a well-functioning petroleum industry and investment climatein Chad

Greatest protection from downside risk (i.e. price or volume risk) compared to corporatesponsors, probably because bulk of the revenues (royalties) independent from price or reserve levels.


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Assessment of Project Risks and Returns:Chad

Risks: The realization of the opportunity for economic development strictlydependent on Governments commitment in implementation of RMP

RMP is claimed to lack credible oversight and enforcementmechanisms, which would work against the people of Chad due toundemocratic and oppressive Govt in power

RMP was a concept yet to be tested with the project; even WBadmitted the project to be an experiment, which increases peoplesexposure to risk

Chad has to put its only natural resource into the project under projectfinance structure and RMP, which considerably eliminates sovereigndiscretion and flexibility

Impositions on the allocation of revenues may turn out to beconstraining for a future democratic government who wants toimplement other projects to the benefit of people of Chad

Governments compliance to RMP is a requirement for future WBloans, which extends the potential influence of the project-specificimpositions and commitments to non-project specific areas, increasingChads exposure to risks

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Assessment of Project Risks and Returns:Sponsors (Exxon Mobil)

Benefits: The presence of WB/ECA/IFC along with participation ongovernments in equity financing significantly reduced political riskexposure

Project might have helped portfolio diversification Low construction risks (sponsors expertise and reputation in the

industry) Low operating risks (positive NPV under most scenarios in Exhibit 5

with different price and reserve levels) Low financial risks, considering the DSCR (as high as 2:1) and low

breakeven finding and development costs compared to price The presence of WB/ECA/IFC in the deal, alignment of Govt

interests via equity ownership through project finance structure, thelinking of installment of future development funds to Governmentscompliance to the RMP significantly reduced political risk exposure.However,


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Assessment of Project Risks and Returns:Sponsors (Exxon Mobil)

Risks: Back- loaded cash flows to Govt may be perceived as unfair

and may result in expropriation Still chances are low, as Govt would not probably want to

jeopardize future capital inflows by risking its relations with WB

and the rest of the financial community The Govt would not want to forego serious amount of revenues

in the form of dividends, taxes, royalties. Any social or political instability in either Chad or Cameroon

would adversely effect the export of oil through the pipelines

across the two countries However, the construction of pipelines underground may have

helped reduce the negative consequences of being exposed tosuch risk

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Real options

Shadow costs: In case WB is not involved in theproject, it is likely that the Govt will go with Libya

Temporary stop option if oil price drops

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Project Update

After WB approved the deal, President Deby used part of the proceeds to

buy weapons Huge criticism by social activists/interest groups against WB and sponsors WB responded by requiring that the proceeds should be repaid out of

general revenues, suspended new loan programs, and also set up a newoversight body headed by external people

After these reforms, WB and IMF permitted debt relief to Chad

In December 2005, the National Assembly of Chad amended the countrysPetroleum Revenue Management Law in the following ways*:

broadening the definition of priority sectors to include, among other areas,territorial administration and security; and by allowing that further changes in the definition of priority sectors can be made by decree;

eliminating the Future Generations Fund, thus allowing the transfer of morethan US$36 million already accumulated there to the general budget

increasing from 13.5 % to 30% the share of royalties and dividends that canbe allocated to non-priority sectors that are not subject to oversight and control

* Chad-Cameroon Pipeline Project, World Bank Web Site

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Project Update

WB considered these changes a breach of contract, and on January, 2006,it suspended new loans and grants to Chad, as well as disbursementsunder eight ongoing IDA operations in the country.

The suspension automatically freezed the flow of part of Chads oilrevenues within the offshore escrow account

WB states in its web site that it remains in dialogue with the Chadianauthorities, and is determined to safeguard the oil revenues intended for poverty reduction programs included in its original agreement with Chad,while recognizing the fiscal strains currently experienced by the governmentof Chad.

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Petrozuata and Oil Field Development Project

Background Why use project finance? Risk management

Pre-completion risks Post-completion risks Sovereign risks Financial risks

Real options Cost of capital calculation Project update

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Background

Petrozuata is a $2.4B integrated oil field development project in Venezuela.The project is planned to be financed under project financing structure. Theproject sponsors Conoco and Maraven are subsidiaries of Du Pont andPDVSA, a Venezuelan state owned enterprise. The sponsors decide on60% debt financing, and seek for alternative ways to raise the requiredfunds. The alternatives considered are project bonds, securing of which arecontingent on securing investment-grade rating for the project; or bankloans, which may need to be covered by PRI provided by multilateralagencies.

The priority and challenge for the sponsors is to craft the projectsoperational and financial details so as for the project to achieve aninvestment grade rating.

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Why use Project Finance?

Strategic reasons in the long run: $2.4B Petrozuata will be the first in aseries of projects planned which total as high as $65 B.

PDVSA needs to preserve debt capacity for future funding needs. Success in this project will be a proof of concept for the rest. Project finance structure provides PDVSA a wider capital access

Debt financing for PDVSA more expensive under corporate financestructure:

PDVSA has low credit rating (long-term senior unsecured debt rating B fromS&P), thereby relatively high cost of debt ~ 10.17% (Exhibit 10b)

Under project financing, if the project can secure BBB investment grade rating,lower cost of debt ~ 7.70%

A gain of 2.47% However, huge transaction and contracting costs as well as the longer time

needed to structure a project financed deal should be weighed against thepotentially lower cost of debt to see if there is a net gain in terms of costs

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Positive-sum as opposed to a zero-sum deal for PDVSA and Venezuela:

Cost focus would be a zero sum perspective for both PDVSA and Conoco (oneparty gains and the other loses)

Involvement of experienced Conoco and Du Pont in the deal may help increasethe aggregate net cash flows to the project, due to efficiency gains as well as risksharing/allocation benefits (positive-sum perspective)

Massive tax benefits

Under project finance, the project is subject to significantly lower income tax rates (34% asopposed to 67.7%) and royalties.

Avoidance of possible risk contamination

But losing the benefit of co-insurance which would come with corporate financing

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Resolving possible agency conflicts

High leverage and dedicated cash flows via the cash waterfall structure helpsprevent opportunities for risk shifting, underinvestment, or cross-subsidization of negative NPV projects

From lenders perspective, separated cash flows also allow easier monitoring and possibly lower monitoring costs

Project finance allows better allocation or sharing of risks via contractualrelationships, thereby reducing the cost of risk

k

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Risk management

Identification and mitigation of:

Pre-completion risks: Resource, technological, timing, andcompletion risks

Post-completion risks: Market risk, supply risk, throughput risk,and force majeure

Sovereign risks: Inflation risk, exchange rate volatilityconvertibility risk, expropriation

Financial risks: Leverage risk under the constraint of investmentgrade rating

P l i i k d i i i

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Pre-completion risks and mitigation

Resource Risk : Quantity and quality of the crude oil

+ Petrozuata being a development and not an exploration project: An independent evaluation found that the field contain 21.5

barrels of oil. Assuming production level of 120,000 BPCDand 35 years project life, 7% of these reserves is sufficient to

sustain the project+ Variability in the available crude oils quality was not deemed tobe significant to reduce the efficiency of upgraders

+ Additional value creation for Conoco from corporate perspective: In addition to being an equity holder in the project, Conoco

would also benefit from low-cost reserves and long-runsupply of crude oil the project would provide (with off-takecontracts) for its refinery business

P l i i k d i i i

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Pre-completion risks and mitigation Technological risk: How proven is the technology used? How experienced

are the contractors to handle technological risks? The ability to handle suchrisks are important to prevent likely cost overruns or construction delays

+ Conoco had sufficient project experience and technological knowhowwith its proven production and refining technology

+ Maraven also had significant production technology and experience- The pipelines would run 125 miles between the oil fields and the coast,

increasing risk exposure+ The terrain between the oil fields and the coast was relatively flat

and sparsely populated, which would ease pipeline construction+ Most of the pipelines would be laid underground

+ The well drilling technology to be used had been an established one,used in both the Oronoco belt and all around the world

+ EPC contracts for the downstream facilities and pipelines were plannedto put out to bid to a consortia of leading international contractors+ Contracts for upstream constructions were planned for experienced and

authorized Venezuelan companies

P l i i k d i i i

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Pre-completion risks and mitigation Timing and completion risk: Failure to meet the intermediate milestones

in a complex project may jeopardize the timely completion of the entireproject as well as increasing costs

The project is a complex one consisting of multiple components including fieldfacilities, pipeline system, and the upgrader facilities

Sponsors dependent on proceeds from selling the early production oil to fundpart of the construction

Failure to meet completion criteria would make all non-recourse debt due andpayable

+ Both Conoco and Maraven had significant project experience to handle theexecution complexities

+ An independent evaluator assessed their execution plan and concluded that themilestones are aggressive but within reach, and that the plan complies with localand international regulations and standards (a factor that would help mitigatelikely regulative delays)

+ Both sponsors made commitments (such as contingency funding for unexpectedcost overruns) guaranteed by parent companies to ensure successful completionof the project

P l i i k d i i i

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Post-completion risks and mitigation Market risk: Uncertainty regarding the future price and demand for the

output

The price of oil is volatile+ The off-take agreement with Conoco secures a significant portion of

the output to be purchased for 35 years at a price pegged to marketprice of Maya crude

+ Petrozuata being a low cost producer with breakeven price wellbelow industry average could still operate even if prices felldramatically

Currently there is no broader market developed for syncrude+ However, in expectation of the development of such a market in the

near future, Petrozueta retained the option to sell the syncrude tothird parties if they demand at a higher price than Maya crude.

+ According to an independently conducted assessment, thedevelopment of a third party market was expected in 3-5 years, andthat the syncrude output would sell at a $1/barrel premium.

P t l ti i k d iti ti

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Post-completion risks and mitigation

Supply risk: Uncertainty regarding the availability of the inputsupplies throughout the life of the project

+ The project will be self sufficient in terms of electricity, gas,and water after completion.

+ During construction, the supplies such as water, electricity,hydrogen supply and diluent supply will all be contracted tofirms owned by the Venezuelan Govt

P t l ti i k d iti ti

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Operating cost risk: Uncertainty regarding the changes in the

operating cost throughout the life of the project

+ An independent consultant assessed the project andconcluded that the cost estimates are reasonable consideringindustry standards

S ig i k d itig ti

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Sovereign risks and mitigation

Exchange rate risk: Uncertainty regarding the changes in the

exchange rate throughout the life of the project

Free floating of the Bolivar against $ may result in appreciationof the currency, leading to increased local costs and tax liabilities

+ Conversely, a likely depreciation of the Bolivar would increasethe revenues (in $) against the local operating expenses (inBolivar) in relative terms.

+ No strong signal inferred from the case as to either of thedirections

+ No significant risk as both revenues and debt service weredenominated in $

S ig i k d itig ti

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Inflation risk: Relative changes in the price of inputs and output

may adversely affect the project- Serious inflation levels that reached 100% in 1996


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Sovereign risks and mitigation Expropriation risk: Sovereign risk in the form of governments direct seizing of

project assets, project cash flows (diversion), or changing tax policy (creeping)

- Risk of Governments changing the currently preferential tax and royaltytreatment

- Possible negative influence of Govt on the effective functioning of offshoreproceeds account

- History of nationalization in the 1970s+ Govt cannot afford to risk the future funding opportunities for the planned series

of upcoming projects by getting involved in any form of expropriation+ The Govt owns a serious portion of the assets anyway (PDVSA and Maraven as

sponsors)+ Any expropriation attempt may face a retaliation from US where PDVSA has

assets (CITGO)+ Govt interests aligned with the projects success, as Govt receives tax and

royalty payments, as well as benefits of employment opportunities created and

access to the refining technology+ Project output syncrude has a narrow market limiting Governments motivationfor a diversion attempt


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Force Majeure risk: Likelihood of occurrence of political events like

wars, labor strikes, terrorism, or nonpolitical events such asearthquakes, etc.

Venezuelas historic political and economic instability Oil facilities are generally targets of terrorism due to their

significance in economy Projects agreements were defined to be invalid in case of force

majeure events+ The pipelines will be constructed underground, and in a sparsely

populated area

Financial risks and mitigation

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Leverage risk: Balancing the incentive to maximize the equity

returns (via leverage) against the likelihood of default and failure toget an investment grade rating+ The target leverage of 60% turns out to be just right to allow for a

minimum DSCR of about 2.08X (in year 2008), which exceedsthe minimum acceptable ratio of 1.80X allowed for an investment

grade rating+ More equity commitment actually signals that sponsors perceive

the project as right

Real Options value of flexibility

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Real Options value of flexibility

Option to delay the project Option to increase the production Option to sell the excess capacity to future projects in

the area Option to abandon the project, since the project consists

of several stages

Cost of capital calculation*

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pProject Risk Mitigation(-10 to 10; where 10=risk completely eliminated, 0=average for country)

Weights Score

Impact onCountryPremium

Sovereign0.40 9.00 -6.64 Currency (convertibility)0.12 -5.00 1.11 Expropriation (direct, diversion, creeping)0.04 9.00 -0.66 Commercial International partners0.03 3.00 -0.17 Involvement of Multilateral Agencies0.04 -3.00 0.22 Sensitivity of Project to wars, strikes, terrorism0.04 0.00 0.00 Sensitivity of Project to natural disasters

Operating0.05 0.00 0.00 Resource risk 0.03 0.00 0.00 Technology risk

Financial 0.03 3.00 -0.17 Probability of Default0.03 2.00 -0.09 Political Risk Insurance

Real Options (some handled through cash flows)0.05 8.00 -0.74 Project impacts other projects0.05 5.00 -0.46 Option to delay the project0.05 8.00 -0.74 Option to increase/decrease production0.05 5.00 -0.46 Option to abandon the stages of the project

1.00 Sum of weights (make sure = 1.00)

*C. Harveys International Cost of Capital Calculator

Cost of capital calculation*

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*C. Harveys International Cost of Capital Calculator

Cost of Capital Worksheet

Risk Premium CalculationInputs Output Category

5.60 U.S. risk free in %7.00 U.S. risk premium in %

90.70 Current U.S. Credit Rating32.00 Institutional Investor country credit rating (0-100)

31.04 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

18.44 Country Risk Premium

Industry Adjustment0.60 Beta (Industry)

-2.80 Sector adjustment

Project Cost of Capital 19.44

TN

Exhibit 9

Exhibit 11

What happened?

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What happened?

The project received ratings that exceeded the sovereign ratings by fivenotches Completed a $1B bond issue, which was five times oversubscribed, and a

total of $450M bank financing (with 14 years maturity at 7.98%, 12 yearsmaturity at 7.86%)

The project considered by analysts as one of the best structured and bestexecuted project finance deals ever done, 1997

PDVSA continued to structure deals for the Orinoco Basin Venezuelan economy was hit hard by the decline in crude oil prices S&P revised its outlook for Petrozuata to negative, as a result of the cost

overruns, lower than expected early production revenues, falling prices, andpolitical uncertainty

As economic situation worsened, Govt demanded and received

extraordinarily high dividends from PDVSA reaching up to 134% of projected income in 1999 Hugo Chavez won the 1998 elections and announced not to interfere with

foreign oil investments


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Background Risk management

Completion risks Operation risks

Sovereign risks (Major risk group in this project and the reasonfor project financing) Financial risks Real options

The role of IFC Project update

Background

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Background

Mozal is a $1.4 B aluminum smelter project in Mozambique. Thesponsors are Alusaf, a subsidiary of a South African naturalresource company, and IDC, a government-owned South Africandevelopment bank with long-standing relationship with Alusaf.

The sponsors are interested in structuring a limited-recourse

financing deal with IFC involvement.IFCs concerns are the size of the project, as well as the politicalrisks of doing business in Mozambique.

Risk Management

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Risk Management

Identification and mitigation of:

Pre-completion risks: Technological, timing, and completion risks Post-completion risks: Market risk, supply risk, and force

majeure Sovereign risks: Inflation risk, exchange rate volatility,

convertibility risk, expropriation Financial risks: Leverage risk


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Timing and completion risk: Mozambique has complex bureaucratic processes that may delaygetting the necessary permits to proceed with the construction

The conditions of the basic infrastructure (like the insufficiency of connecting roads, or dependability of electricity supply) may slow downthe construction efforts

Sponsors dependent on cash generated during start-up for funding$34M of the project

+ Sponsors had a proven track record with the Hillside project where theywere able to complete the project four months ahead of schedule and21% under budget

+ The same contractors and construction team used in the completion of the Hillside smelter would be called for the project.

+ Sponsors planned a $75M contingency budget for the constructionperiod


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Post completion risks and mitigation

Technological risk: How proven is the technology used? How experiencedare the contractors to handle technological risks? The ability to handle suchrisks are important to prevent likely cost overruns or construction delays

+ Mozal would use proven, state-of-the art smelting technology (Pechineytechnology from France) that was used in the Hillside smelter

+ Both sponsors have significant experience in the smelting industry withHillside being their most recent undertaking

+ Alusaf was the subsidiary of the South Aftrican Gencor group, whichwas the worlds fourth largest aluminum producer

Market risk: Price of the output The sponsors planned to purchase all of the output subject to long-term

purchase agreements, but at market prices

The market prices had been declining for the last couple of years, andthe trend was expected to continue due to the developing scrap market+ Mozal would be a low cost producer in the industry (lowest 5% in terms

of cost) , having higher margins than other players to absorb potentialmarket price declines


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Post completion risks and mitigation

Supply risk and operating costs: Availability, quality, and price of thealumina, electricity, and labor Alumina accounted for 33% of production costs

+ The sponsors planned to link the price for alumina to LME aluminummarket prices

+ Alumina would be imported from a supplier of Alusafs affiliatedcompany Billiton under a 25 year supply contract

Electricity accounted for 25% of production costs+ The electricity price would also be a function of aluminum prices+ Eskom and Mozambican Electric company would provide

inexpensive electricity under a 25 year contract whereby the pricewill be fixed in the early years and then tied to aluminum prices

+ The majority of unskilled labor would come from Mozambique, decreasing

labor costs compared to industry averages+ Other inputs would be supplied from the same contractors who supplied theHillside smelter under similar long-term contracts

Sovereign risks

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Sovereign risks

Expropriation risks :- Outright seizure of assets very unlikely:

- The scale of the project relative to the size of the poor economy (9% of GDP), combined with short-term survival concerns may be tempting for a shortsighted Govt to expropriate

+ Govt wouldn't want to curb the investments, because they areinterested in development

+ Govt cannot afford an outright seizure, due to potential reactions fromWB/IFC, as this would jeopardize the much needed future developmentfunds

+ Following a direct seizure, international suppliers may not be willing towork with the Govt, and Mozambique does not have local suppliers of the raw materials to go on with the business alone

Sovereign risks

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Sovereign risksExpropriation risks :

- Seizure of cash flows (diversion) low risk:- Govt may divert the aluminum and sell it to others + However, the spot market for aluminum is very thin for Govt to divert

and easily sell the output+ Potential reactions from WB/IFC

- Changing of taxation creeping moderate risk:

- Govt may remove the privileges that the smelter would be exempt fromcustoms duties and income taxes- It is highly likely that the Govt may change the 1% sales tax, which is

more critical than the income tax

Sovereign risks

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Sovereign risks

Political events: Political instability Risk of war: not completely eliminated Legal instability Bureaucratic hurdles Underdeveloped infrastructure Unskilled / untrained labor

Macroeconomic risks: Currency exposure:

+ Not a major risk as the major inputs and all the output would bedenominated in $.

Convertibility risk:+ Not a major risk since the proceeds will be kept at an overseas

trustee

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Sovereign risks mitigation

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Government and local commitment

+ The Govt and Mozambique would benefit from the developmentalimpact of a successful project+ Increasing GDP by 9%, exports by $430M, spurring local business,

upgrading and expanding local infrastructure (i.e. power, roads),technology transfer, creating permanent employment opportunities(873 jobs) and 5000 construction jobs as well as human capacitybuilding

+ Diligent environmental and social impact analysis by IFC+ Social programs planned for Mozambican people

+ Govt established a special committee to ease the bureaucratic /administrative hurdles for the Mozal project

+ Govt signed an Investment Protection Agreement with South AfricanGovt for cross -border projects

+ Government committed to economic and legal reforms In addition to the positive externalities outlined above, Govt might havealso been given an equity share to better ensure it has a vested interestin the projects success to minimize risk of expropriation (See Chad -Cameroon Case)


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Using high leverage:+ Ensures cash flows are kept low so that temptation for seizure is low+ Besides, the project structure was designed in such a way to allow

for higher interest payments when sales increase, minimizing thecash balances

+ High leverage also ensures that as long as the sponsors provide on-going benefits, it is to the Governments benefit not to expropriate

+ Even in case of expropriation, governments generally feel obliged to payfor the projects foreign debt because of undesirable repercussions inthe international community for not doing so.


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g

Political risk insurance:

As much as IFC involvement was the critical issue, securing political riskinsurance was important as well to provide comfort to potential lenders:

+ Political risk insurance is an instrument to help shift (not mitigate) thepolitical risks (like expropriation, war, breach of contract, or currencyinconvertibility) to parties that are best able to bear it

+ PRI providers generally have a more diversified portfolio than banks to

absorb these risks+ PRI providers are more competent in analyzing sovereign risks,whereas commercial banks in analyzing commercial risks

+ A French ECA supporting the use of the French technology was expected toprovide 85% insurance for loans from French banks, and IDC was inadvance discussions with the South African ECA for insurance for $400 Msenior debt

+ The French ECA may be more willing to bear the political risk thanbanks do because it attaches a higher value to the project in order tobe able to export the technology

+ Similarly, the South African ECA may be more willing to bear thepolitical risk than banks do because it attaches a higher value to theproject in order to be able to promote the south African exports

Real options

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p

Option to expand+ Mozal would be constructed with all the infrastructure to double the capacity

when needed.

The role of IFC

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Appraising the project + Helps uncover the information about the project, as well as sponsorsand governments involved, which may not be readily available tolenders

+ Acts as a mediator between the governments and sponsors to ensureall issues are addressed and han

Documents

Aydemir 2006