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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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Major characteristics:
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
Major characteristics:
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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
Major characteristics:
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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
1. What is Project Finance?2. How does project finance create
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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How Does It Create Value?
Drawbacks of using Project Finance Value creation by Project Finance
Organizational structure Agency costs, debt overhang, risk contamination, risk
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 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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Value creation by organizational structure:Agency Costs
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
Problems Structural Solutions:
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Value creation by organizational structure:Agency Costs
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.
Problems Structural Solutions:
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Value creation by organizational structure:Agency Costs
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.
Problems Structural Solutions:
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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
Problems Structural Solutions:
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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.
Problems Structural Solutions:
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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
Problems Structural Solutions:
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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, risk
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
Value creation by contractual structure:An Introduction to Risk Management
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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
Value creation by contractual structure:An Introduction to Risk Management
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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
Value creation by contractual structure:An Introduction to Risk Management
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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
Value creation by contractual structure:Contracting and Project Finance to reduce cost of risk
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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
Value creation by contractual structure:Contracting and Project Finance to reduce cost of 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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Value creation by contractual structure:Pre-completion risks:
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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Value creation by contractual structure:Pre-completion risks:
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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Value creation by contractual structure:Sovereign risks:
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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Value creation by contractual structure:Sovereign risks:
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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How Does It Create Value?
Drawbacks of using Project Finance Value creation by Project Finance
Organizational structure Agency costs, debt overhang, risk contamination, risk
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 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?
Drawbacks of using Project Finance Value creation by Project Finance
Organizational structure Agency costs, debt overhang, risk contamination, risk
mitigation Contractual structure
Structuring the project contracts to allocate risk, return,and control
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
Case examples to value creation
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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:
Case examples to value creation
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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
Case examples to value creation
How project structure may help:
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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
Case examples to value creation
How project structure may help:
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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
Case examples to value creation
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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
Case examples to value creation
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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
Case examples to value creation
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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
Case examples to value creation
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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)
Case examples to value creation
How project structure may help:
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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
Case examples to value creation
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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
1. What is Project Finance?2. How does project finance create
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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1. What is Project Finance?2. How does project finance create
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.
Assessment of Project Risks and Returns:
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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:
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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,
Assessment of Project Risks and Returns:
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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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Why use Project Finance?
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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Why use Project Finance?
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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Post-completion risks and mitigation
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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Sovereign risks and mitigation
Inflation risk: Relative changes in the price of inputs and output
may adversely affect the project- Serious inflation levels that reached 100% in 1996
Sovereign risks and mitigation
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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
Sovereign risks and mitigation
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Sovereign risks and mitigation
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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Financial risks and mitigation
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
Financing the Mozal Project
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Financing the Mozal Project
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
Pre-completion risks and mitigation
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Pre-completion risks and mitigation
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
Post-completion risks and mitigation
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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
Post-completion risks and mitigation
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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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Sovereign risks mitigation
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)
Sovereign risks mitigation
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Sovereign risks mitigation
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.
Financial risks and mitigation
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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