Professional Documents
Culture Documents
Chap 16 Project Finance
Chap 16 Project Finance
Culwell and Philip J. Tendler of Pillsbury Winthrop Shaw Pittman LLP, available at 1-800-260-4754; www.pli.edu ($250.00; (c) The
Practising Law Institute). Reproduced with permission. All rights reserved.
16:4.5
162
Project Finance
16:4.6
163
16:1
16:1
Introduction2
From its earliest modern-day roots dating to the first half of the
twentieth century,3 the form of limited recourse financing that has
become known as project financing has grown to a multi-billion
dollar worldwide industry, with the capacity to attract vast amounts
of capital for infrastructure development. In an early example of the
form in the 1930s, a state or local government in the United States
would issue tax-exempt bonds on behalf of a private business to attract industry, and lend the proceeds to the private business to be
used solely to develop an industrial facility in the locality. The loans
would be secured by the industrial facility assets. The government
bonds would be secured by and payable solely from the proceeds of
payments made by the private party in repayment of such loans,
and would not have recourse to the full faith and credit of the governmental issuer.
The fundamental principles of a project finance transaction have
not changed significantly over the years. Project financing, however,
has shown itself to be a highly versatile technique, adaptable to a
broad and constantly growing array of applications, including some
of the largest and most capital intensive infrastructure developments in the world. These transactions appear across a wide range
of diverse industries, and reach locations in every region of the
globe.
2.
3.
This chapter was prepared in the spring of 2006 and reflects practice and
matters that were extant at that time.
Precursors to modern-day project financing techniques have actually been
traced back to various points in history, including as far back as Greek and
Roman times. Present-day project financing practices, however, are more
tangibly rooted in the innovations of twentieth century bankers and lawyers.
164
Project Finance
16:1
Today, project financing of development is found in virtually every country, and may be the most common structure for infrastructure finance in the world. Project financings are used to finance:
Ports, airports, roads, bridges, rail lines, and other transportation infrastructure
165
16:2
16:2
166
Project Finance
16:2.1
16:2.1
Project Parties
167
16:2.1
168
Figure 16-1
Example of a Project Finance Contract Structure
Project Finance
169
16:2.1
16:2.1
[A]
Project Owner
[B]
Sponsors
The Sponsors are the holders of the equity in the Owner. Traditionally, the majority of the equity was owned by one or more creditworthy parties who were significant players in the relevant
industry. For example, the majority equity Owner in an independent
power generation project might be a significant independent power
producer with a fleet of similar assets. More recently, private equity
investors (including hedge funds) have been attracted by the relatively high returns and ratable income streams that project investments can produce, and have invested significant sums in projects.
Finally, in international projects it is fairly typical for offshore investors to include in their Sponsor group a local partner whose local
knowledge and understanding will be helpful in bringing the project
to fruition.
Generally, the Sponsors have an equity contribution obligation to
the Owner in a specified amount, which is reflected in an agreement with the projects Lenders. While sometimes funded in advance, this equity is more typically required to be contributed
simultaneously and pro rata with the making of loans by the Lenders to construct the production asset, with the entire amount accelerated and required to be contributed immediately if the Lenders
declare an event of default and accelerate the loans.
1610
Project Finance
16:2.1
[C]
Host Government
[D]
EPC Contractor
[E]
Generally, the Owner employs an O&M (Operations and Maintenance) Contractor or Operator to operate and maintain the plant.
One reason for the employment of an Operator (as opposed to the
Owner operating the plant), is the general preference of Lenders to
have a third party to whom they can look to recover damages (at
least to a limited extent) if the plant is not operated properly. This
also enables the Lenders to monitor and ensure that the operating
costs remain within the parameters assumed in the projects economic model.
1611
16:2.1
[F]
Fuel/Feedstock Supplier
[G]
[H]
Insurer
[I]
Output Purchaser
1612
Project Finance
16:2.1
[J]
Financing Parties
[K]
Swap Providers
Traditionally, swap providers have provided interest rate protection in project financing transactions. Most common are interest
rate hedges in which the variable rate obligation undertaken by the
Owner is swapped for a fixed rate obligation, thereby locking in the
interest cost to the project. Again, this technique is used to lock in
the cost of the financing. While the locked rate will be higher than
the prevailing variable rate, Lenders often insist that the Owner
swap all or a majority of its debt to a fixed rate to provide the assurance of a known financing cost. In addition, swaps may be used in
connection with project financings to provide an assured cost for
commodity supply to the project.
Swap providers are often also part of the lending syndicate. The
projects obligations to them are generally secured equally and ratably with the loans. Since breakage obligations to swap providers
can be very large and unpredictable in amount because they are subject to market forces, a great deal of recent attention has been focused on the terms of the swaps and intercreditor issues between
the swap providers and the Lenders.
With the multiplicity of parties in a project financing, it is easy
to see why the documentation for such transactions is complex.
Each partys obligations address a particular aspect of the projects
development, construction and operation, and the obligations of all
parties must fit together as seamlessly as possible. In addition, all of
the rights of the Owner are subject to the security interest of the
Lenders, who require the entry of each contractual third party into a
1613
16:3
16:3
1614
Project Finance
16:3
Finally, over the past twenty years there has been an increasing
focus on public-private partnershipsthat is, project development
structured with the participation of both host government and private capital support. For example, in a large dam project which has
public benefits such as irrigation and environmental mitigation, the
government might pay for and own the dam, while a private party
might fund the construction and installation of power generation
equipment which could be used by the private party to generate and
sell electricity under a long-term Power Purchase Agreement for a
term of years.
The financing of an international project can come from a variety
of sources. There are multilateral agencies whose objective is to provide development financing in emerging markets. The World Bank
has been an important source of such financing, both directly and
through its investment arm, the International Finance Corporation
(IFC). There are also regional multilateral Lenders that provide investment funds, such as the Inter-American Development Bank. In
addition, many industrialized countries have export credit agencies
whose objective is to encourage the use of equipment manufactured
in their country by providing financing on favorable terms, or to assist in the development of markets for their countrys products.
In addition to these sources, private commercial banks all over
the world are involved in providing credit to fund project development and construction on the basis of project financing structures.
Long-term bond funding that includes U.S. investors may also be
provided under a Rule 144A structure (as discussed in section
16:4.5[B]). Frequently, private capital will join with multilateral
sources to provide the large amount of capital needed for a significant infrastructure development plan. In emerging markets in particular, because of the importance to the country of continuing
access to multilateral sources of funding, the inclusion in the financing group of such sources increases the comfort level of the private Lenders as to the stability of their investment.
Typically, a project financing consists of construction loans provided under a credit agreement or an indenture, which is disbursed
into a construction fund, against requisitions supported by invoices
and other evidences of costs incurred. At completion, the financing
typically converts to a longer term term loan structure, with a
payment schedule that amortizes in accordance with the projects
pro forma financial statements, and provides a coverage cushion
based on the projects anticipated net cash flows.
The financing also typically includes letters of credit to cover
guarantees to contract counterparties, such as major suppliers and
purchasers of output, and funded reserves to cover anticipated costs
such as routine and major maintenance, operating costs, and a debt
1615
16:4
16:4
16:4.1
1616
Project Finance
16:4.1
1617
Figure 16-2
Key Project Contractual Relationships
16:4.1
1618
Project Finance
16:4.2
16:4.3
Commercial Risk
[A]
The principal construction phase risks encountered in an infrastructure project are the risks of cost overruns, completion delays,
and the failure to satisfy required performance standards. These
risks are allocated between the project company and the contractor
in the EPC Contract and also, to a certain extent, between the
project company and the Offtaker in the Offtake Agreement. The
mechanisms for allocating risks in the EPC Contract and the
Offtake Agreements are discussed later in this section.
[B]
The operating phase risks include operating performance shortfalls, operating cost overruns, fuel risk (consisting of price, supply
and transportation risk), and market risk (consisting of demand,
price and inflation risk). These risks are principally allocated in the
Fuel Supply or Feedstock Agreement, the O&M Agreement, and the
Offtake Agreements, each of which is discussed in greater detail later in this section.
16:4.3
Political Risks
[A]
The principal political risks for an international project are expropriation risk, regulatory risk, contract risk and currency risk.
These risks are discussed in section 16:9 in the context of the
unique risks that arise in international projects, but are summarized briefly below for purposes of this discussion. Expropriation
risk includes the risk of an outright nationalization of project assets
or rights or the equity ownership in the project company in a discriminatory or arbitrary manner or without just compensation.
1619
16:4.3
[B]
Legal Infrastructure
In many regions of the worldparticularly in emerging countriesthe legal system presents a unique set of risks. Many countries place restrictions on foreign investment into their markets. For
example, the company or foreign investment laws of some countries
require that the majority interest in a domestic enterprise be held
by a domestic party. Some countries have burdensome tax regimes
which could include generally higher tax rates, filing fees, stamp
taxes and duties. The absence of a developed body of regulatory and
administrative laws, or a predictable and reliable jurisprudential
system, can also be a common feature in emerging market countries. It presents particular problems with respect to project agree-
1620
Project Finance
16:4.3
[C]
Physical Infrastructure
[D]
1621
16:4.4
16:4.4
[A]
Implementation Agreement
An Implementation Agreement can take many forms but is generally an agreement with a government agency or entity. The Implementation Agreement is used by a host government to encourage a
capital intensive project to be built in the host country. It is the
principal agreement through which most political risks will be managed. Not all projects will benefit from an Implementation Agreement or other direct governmental participation. If a country has a
favorable investment climate or a history of successful foreign investment, then an Implementation Agreement may not be necessary. For example, if the government of Trinidad and Tobago desired
to have a power project built, there might be no need for an Implementation (or similar) Agreement to support the local utilitys power purchase obligations. On the other hand, a power project
developed in Pakistan, where the investment climate lacks a similar
history, would likely require an Implementation Agreement to attract desirable Sponsors and financing packages.
An Implementation Agreement will address many of the host
countrys political, regulatory, legal and financial risks. It will include performance undertakings by the host government with respect to issues such as the term of the project, change in laws,
expropriation and political force majeure, foreign exchange avail-
1622
Project Finance
16:4.4
1623
16:4.4
is important for the project company to have access to foreign exchange to repay the debt obligations, and for the project Sponsors to
be able to repatriate their profits in foreign exchange. As discussed
elsewhere, the issue of access to foreign exchange is particularly important for a project whose revenues are denominated in the host
countrys currency. In projects that generate product for export, foreign exchange is not as acute a concern because the revenues are often paid in foreign exchange directly into accounts located in
international money centers (for example, New York or London).
This, however, is not a complete protection against currency risk.
For example, in 2003, Argentina required exports of certain natural
resources (or products derived from natural resources such as propane), to be diverted to domestic needs and at a price inconsistent
with the market price for such resources. Despite having long-term
sales contracts that generated foreign exchange, projects in Argentina were required to divert their export sales to internal sales. This
change ultimately impacted many projects in Argentina that had
previously remained viable despite the Argentine financial crisis. It
resulted in a limitation of exchange for debt repayment because the
payments for the natural resources were made in Argentine pesos
and the price paid for the propane was no longer market. Most, if
not all, of the project financings in Argentina prior to the 2001 Argentine political crisis did not benefit from an Implementation
Agreement because Argentine political risk was generally viewed as
acceptable.
An Implementation Agreement will often provide investment incentives in the form of tax benefits and customs duty relief. Tax
benefits are often in the form of a tax holidaya negotiated period of time during which the project company is exempt from tax liability in the host country. A tax holiday is often considered
necessary to make a project commercially viable, especially during
the period in which the project company will have debt service obligations. A tax holiday is justifiable from a local perspective because
of the benefits the host country will derive from attracting large infrastructure projects, such as the creation of local jobs and the provision of necessary equipment and services.
One of the key risks to consider in an international project is the
risk of a change in law after the capital investment is made or the
obligation to make the capital investment is incurred. The Implementation Agreement should address change of law risk. The Implementation Agreement may effectively grandfather the project
so as not to subject it to a change in law that adversely affects the
project. Or it may give the project company the benefit of a most favored nation provision, which will allow the project company to
1624
Project Finance
16:4.4
[B]
All infrastructure projects require a site for the project and easements or rights-of-way for access to and from the site. Rights to the
site itself may be granted through the grant of fee title, the grant of
a leasehold or easement estate, or a permit or other authorization
from the government for government-owned land. A fee simple
grant is ideal and easier to finance, but in some situations outright
ownership of the site is not possible. In some countries, for example, a fee simple estate (or its equivalent) may not be granted to a
private entity, or there may be restrictions on foreign ownership of
land. In other situations, the Sponsors may be granted a lease or a
permit to use the site for the project. If this is the case, the lease or
permit for the site must be for a period no shorter than the useful
life of the project. In addition, the leasehold interest must be mortgageable to the Lenders. If the project company is unable to assign
collaterally its leasehold interest, the project will not be financeable.
It is also important to coordinate with local counsel to determine
any preexisting rights to or restrictions over the project site. Many
developing countries do not have real property title insurance. In
the absence of title insurance, title risks can be mitigated by a review of the title report or survey map by an engineer, a physical inspection of the property, adequate representations and warranties in
the site acquisition agreement and, finally, a title opinion from local
counsel. Local counsel should also be able to advise as to title exceptions or encumbrances. Such encumbrances may include easements
or other similar rights held by third parties, financial liens on the
project site, covenants, conditions and restrictions that run with
the real property. In addition, local counsel should advise as to preexisting rights with respect to the site, including rights as to which
the project company may be deemed to have constructive knowl-
1625
16:4.4
edge such as rights discernible from public title records or a site inspection.
Site acquisition is generally dealt with primarily through the use
of local counsel. However, it is important not to rely solely on local
counsel for this purpose. It is ultimately international project counsel that will have a full understanding of the projects overall requirements. This is particularly the case, as countless experiences
have shown, with respect to tracking the rights-of-way needed for
construction activities, as well as the transport of feedstock and
product output to and from the project site.
One must also consider environmental risks in connection with
site acquisition. The risk of preexisting environmental conditions
on or impacting the site will be addressed in the site acquisition
documentation. Preexisting conditions require an analysis of soil
and groundwater contaminants (on the project site and its neighboring environs). It is also important to consider the risks posed by the
presence of existing structures on the property, endangered species
and historical, archeological and religious artifacts. A project Sponsor can mitigate certain of these risks by employing a competent environmental consultant, commissioning an environmental site
assessment (especially to identify preexisting conditions), retaining
local counsel to advise on environmental issues, and procuring an
environmental indemnity for preexisting conditions at the site from
the seller. Environmental issues have become an area of particular
sensitivity to Sponsors and Lenders alike. As will be discussed in
greater detail in the section 16:6, Lenders are increasingly applying
more stringent World Bank or other applicable standards in situations where the local laws would otherwise have granted the project
greater latitude.
[C]
1626
Project Finance
16:4.4
[C][1]
Since the goal of the EPC Contract is to provide a fully completed project on a timely basis, the EPC Contract will allocate certain
price risks (including the risk of cost overruns), performance risk
and delay risks to the EPC Contractor. The EPC Contract will use
the following mechanisms to allocate and mitigate these risks:
(i)
[C][2]
1627
16:4.4
[C][3]
Scope of Work
The EPC Contract should have a detailed scope of work provision and accompanying schedules that specify complete design and
engineering criteria and technical specifications for the project. The
procurement obligations should be comprehensive and provide for
the obligation to procure all materials and equipment, machinery,
tools and consumables (for example, fuels, chemicals and utilities).
The EPC Contract should also require the EPC Contractor to pro-
1628
Project Finance
16:4.4
vide all of the qualified, experienced and licensed personnel that are
required to complete the work. The procurement obligations should
allocate to the EPC Contractor the risks of importation and transportation of all equipment and materials to the site.
The EPC Contractor s scope of work should also include a training program. The EPC Contractor will be required to train the
project companys personnel and the projects Operators. The EPC
Contractor will also be required to produce various documentation
for the project company, including manuals, as-built diagrams for
startup, operation, maintenance, quality control, safety procedures
and training. The EPC Contract should carefully identify the permit
requirements for the project and the party responsible for obtaining
each permit. The project company and the EPC Contractor will
each have obligations to procure certain permits. Typically, the
Owner is responsible for obtaining permits pertaining to the right to
build a certain type of plant meeting certain specifications on site,
while the EPC Contractor is responsible for all permits pertaining to
the construction itself and all construction related activities.
The project company will also have certain additional, though
limited, obligations under the EPC Contract. Failure to comply with
these obligations will generally be a defense to certain of the EPC
Contractor s guarantees or give the EPC Contractor the right to a
change order for an increase in the contract price or an extension in
the construction schedule. These additional obligations will usually
include the obligation to provide access to and the provision of a
project site, including an area for construction, lay down areas, storage facilities, interconnection lines, temporary roads and parking.
The project company will likely be required to procure fuel and certain utilities (water, sewer, telephone) in defined quantities. This
will include fuel for startup, testing and commissioning the project.
[C][4]
Performance Guarantees
An EPC Contract will establish strict performance targets, usually for project output, efficiency and reliability, which the project
must meet in order to achieve completion. These performance guarantees are set at negotiated levels, and the procedures under which
the plant is tested in order to determine whether the guaranties
have been satisfied are likewise negotiated and expressly covered in
the EPC Contract. When plant construction has reached a stage
where the plant is deemed to have achieved mechanical completion,
it will undergo a series of tests under the agreed procedures to determine compliance with the performance guarantees.
Usually (for power projects, for example), the performance guarantees (at least for output and efficiency) are two-tiered. The full
contracted guarantees will be set as the higher tier, which the EPC
1629
16:4.4
[C][5]
Liquidated Damages/Bonuses
The EPC Contractor s principal obligation is to deliver a completed plant on time and in compliance with the specified performance guarantees. Timely completion and the achievement of the
performance guarantees are usually enforced with the use of liquidated damages, and incentivized through the payment of bonuses.
Liquidated damages for delay (Delay LDs) will typically be based on
a specific amount payable per day for each day of delay in achieving
substantial completion beyond the target date specified under the
EPC Contract. The use of delay damages will usually only partially
mitigate completion risks, however, because the EPC Contractor s
liability for delay liquidated damages will be subject to a cap. In addition, rarely can the delay damages be set at a level that keeps the
project company whole with respect to costs or penalties incurred or
revenues foregone during the period between the guaranteed substantial completion date and the actual substantial completion date.
While the daily amount payable as liquidated damages is theoretically calculated to take into account additional interest during
construction costs, liabilities under the offtake and fuel supply
agreements, and lost revenue under the offtake agreement, Delay
LDs (under present market conditions) are not typically set to recover all these costs. In practice, the Delay LDs are set at levels to
incentivize the EPC Contractor to achieve completion as soon as
possible. If the amount of the Delay LDs is too small, the EPC Contractor may be incentivized to mobilize labor to another project
with more demanding liquidated damages. On the other hand, if the
delay damages are so high that the EPC Contractor quickly hits the
cap on liability, the EPC Contractor may determine that completion
is not possible within the short time period and may elect simply to
pay the maximum delay liquidated damages and divert personnel to
another more profitable project.
1630
Project Finance
16:4.4
In the event that, after final testing, the project does not satisfy
the full performance guarantees, the EPC Contractor will be liable
for performance liquidated damages (Performance LDs). The Performance LDs are amounts calculated based on the margin by which
the project fails to satisfy the specified performance targets. These
Performance LDs will also be subject to a cap. As mentioned, a typical EPC Contract will also have a minimum performance guarantee
which must be satisfied by the EPC Contractor. The failure to
achieve the minimum level cannot be cured or remedied by the payment of performance liquidated damages. In fact, the Performance
LDs are only payable once the minimum performance guarantees
are met (and substantial completion has been achieved), based on
where plant performance (as tested) actually falls between the minimum performance standards and the higher contract full performance guarantees. Failure to achieve the minimum performance
levels will subject the EPC Contractor to either unlimited liability
(in some instances) or to liability up to the amount of the full EPC
Contract Price (in most instances).
An EPC Contract may also use bonus payments to incentivize
the EPC Contractor to complete the project early, or for exceeding
the performance guarantees. If the Offtake Agreement permits the
project to commence commercial operation early, then in addition
to reducing the project companys interest during construction, early completion can allow the project company to begin generating
revenue sooner. In such a situation, bonuses would be a fair incentive to offer the EPC Contractor. Likewise, the Offtake Agreement
may provide for a capacity payment based on the contract capacity
of the project. If the project tests at a contract capacity higher than
the nameplate capacity, the project company would benefit from
higher capacity payments and can, hence, offer a portion of this
benefit as an incentive bonus to the EPC Contractor under the EPC
Contract.
[C][6]
Change Orders
the project company requests changes in the EPC Contractor s scope of work,
1631
16:4.4
(iii) the EPC Contractor is entitled to a price increase or schedule extension based on the terms of the EPC Contract.
Change orders requested by the project company are negotiable
and generally require the agreement of the EPC Contractor, unless
the EPC Contract allows for cost-plus based change orders. Change
orders suggested by the EPC Contractor will be at the project companys discretion and also subject to the negotiation of an acceptable change order with the EPC Contractor. An EPC Contract will
also identify a limited set of circumstances under which the EPC
Contractor will be entitled to require the project company to issue a
change order. These circumstances are usually limited to increases
in contractor costs or extensions of time required as a result of
changes in law, the project companys breach or default, the discovery of unusual and unforeseen site conditions, and certain force majeure events. From the project company s perspective, it is
important that there be limits to the EPC Contractor s ability to request a price increase or an extension of time for completion, and
that there be a clear procedure for making such claims. The EPC
Contractor should be obligated to notify the project company within
a short period after the EPC Contractor has notice or knowledge of a
potential claim. Failure to make a timely claim should result in a
waiver of the claim. Without procedural and timing limitations, the
project company may receive a large claim for change orders at the
end of construction that date back to the beginning of the project.
A critical issue related to change orders which the parties often
fail to consider when negotiating the EPC Contract is the issue of
which party owns the float. As discussed, an EPC Contract will
have a date certain for achieving substantial completion, which determines when Delay LDs begin accruing. To arrive at this date certain, the EPC Contract will have interim milestone dates by which
key components of the project must be completed in order to reach
completion or commercial operation by the date certain. These
agreed interim milestone dates will be developed by the EPC Contractor and will have a built in time cushion to protect the EPC
Contractor for unanticipated delays. This cushion is referred to as
the float. In simplified terms, if the EPC Contract only entitles
the EPC Contractor to an extension of time because the underlying
event giving rise to the delay would reasonably be expected ultimately to delay completion past the date certain, then the project
company is considered to own the float. However, if the underlying
event causing the delay would not reasonably be expected ultimately
to result in a delay past the date certain, but nevertheless the EPC
Contract entitles the EPC Contractor to a schedule extension, then
the EPC Contractor is considered to own the float. For example,
assume the EPC Contactor is entitled to a schedule extension as a
1632
Project Finance
16:4.4
[C][7]
Payment Terms
The typical EPC Contract payment terms call for the payment of
fixed-lump sum price in installments based on the milestone or
progress payments. Milestone payments are conditioned on meeting
certain project milestones, the achievement of which will usually
require a certificate from an independent engineer confirming that
the project milestones have, in fact, been satisfied. The payment
terms will usually allow the project company to withhold as retainage a percentage of each payment due. The purpose of retainage is
to provide the project company with economic leverage to ensure
completion of the project, particularly in circumstances where the
1633
16:4.4
[C][8]
The EPC Contract will have provisions defining the events that
constitute a default and provide specific remedies for such defaults.
The defaults will include customary defaults, such as breach of payment and performance obligations, breach of representations and
warranties and bankruptcy-related defaults. The EPC Contractor s
failure to reach substantial completion or commercial operation by
1634
Project Finance
16:4.4
the guaranteed substantial completion date will also typically constitute a default. The project companys remedies should include
the right to take possession of work in progress, the right to assume
all contracts with subcontractors and the right to complete the construction in the event of a material breach of the EPC Contract.
These rights are both customary and critical for the project company. If construction is already delayed, the inability to take possession without delay in an attempt to complete the project as soon as
possible will have adverse ripple effects through the Offtake Agreement, the Fuel Supply Agreement and usually the financing agreements.
[C][9]
Dispute Resolution
Disputes under an EPC Contract are often resolved with the use
of international arbitration tribunals. It is very important for the
project company to require that the EPC Contractor continue working during a dispute. If the EPC Contractor is permitted to suspend
work while a dispute is being resolved, there will be inevitable delays in the project that likely will not be subject to Delay LDs and
will give the EPC Contractor additional leverage in negotiating a
settlement to the dispute. It is also important to require that the
EPC Contractor have similar provisions in the EPC Contractor s
major subcontracts.
[C][11] Conclusion
The EPC Contract must be carefully coordinated with the other
project documents. The Offtake Agreement may require that the
1635
16:4.4
project company begin performance by a date certain and the Feedstock Agreement may require the project company begin receiving
fuel or other feedstock by a date certain. If the project has not
achieved commercial operation by or prior to such dates, the project
company will begin to incur costs and penalties. In addition, the
EPC Contract must ensure that the project is capable of meeting
minimum guaranteed deliveries under the Offtake Agreement and
minimum guaranteed receipts under the Fuel Supply Agreement.
The EPC Contract must provide for the appropriate level of performance guarantees for plant output, efficiency and reliability, in order to achieve these minimum requirements. Liability caps under
the EPC Contract must be carefully considered with the obligations
and liabilities under the other key documents. Proceeds from liquidated damage claims for performance guarantees will often be required to repay a portion of the project financing debt. If there are
damages and other penalties, the proceeds must also sufficiently
cover these risks or such risks will fall on the project company. If
the risks fall on the project company, the Lenders will often require
equity contribution guarantees from the Sponsors, since Lenders
will usually not permit the project company to accept residual performance risks.
[D]
Offtake Agreement
Offtake Agreements are the agreements that provide for the revenue stream to the project company. Hence, Offtake Agreements typically receive the most attention in negotiations by the Sponsors,
and the most scrutiny in review by the Lenders. In a power project,
the Offtake Agreement will usually be a Power Purchase Agreement
or a tolling agreement. In a petrochemical project, it will be the contract that governs the sale of the chemical produced by the project.
A long-term Offtake Agreement with a creditworthy counterparty is
usually required in order for an infrastructure project to be financeable. Some projects can be financed without an Offtake Agreement
covering all or a significant portion of the product produced. These
projects are referred to as merchant projects, and the key to successfully structuring a merchant or a semi-merchant project is the ability for the project company to demonstrate, usually through the use
of an independent third party market consultant, that there is adequate demand for the product such that a long-term Offtake Agreement is not necessary. After the recent failure of many U.S.
merchant power projects, the ability to finance purely merchant
projects has been more difficult unless the merchant portion of the
project is limited. If there is a long-term Offtake Agreement which
provides sufficient revenue to service the debt, the Lenders may allow the Sponsors take the merchant risk for the excess capacity.
1636
Project Finance
[D][1]
16:4.4
1637
16:4.4
[D][2]
Key Provisions
The key provisions of most international project offtake agreements include the following:
(i) the term of the agreement;
(ii) conditions precedent to effectiveness;
(iii) purchase and sale obligations;
(iv) construction obligations;
(v) restrictions on the Offtaker s ability to resell the product;
(vi) pricing;
(vii) plant outages;
(viii) measurement or metering;
(ix) operating obligations;
(x) force majeure;
(xi) changes in law;
(xii) events of default and remedies;
(xiii) credit support obligations;
(xiv) assignment prohibitions;
(xv) indemnification;
1638
Project Finance
16:4.4
[D][3]
[D][4]
An international PPA will also address certain construction obligations of the project company. Power purchasers in the United
States are generally only interested in plant output and not in its
physical construction. In many international PPAs, however, the
PPA will address construction obligations. Such construction obligations may include the obligation to construct the plant in accor-
1639
16:4.4
[D][5]
The PPA will likely also include specific testing obligations for
the plant. Failure to satisfy certain tests will likely result in reductions in revenue payments to the project company. If the project
company fails to satisfy the required tests, the power purchaser
could decide to downgrade the amounts of assured capacity acquired under the PPA, which would result in the reduction of fixed
payments along the life of the PPA. Since revenue reductions will
make debt service obligations more difficult, the EPC Contract
must provide for corresponding performance liquidated damages so
that the proceeds of these damages can be used to prepay indebtedness. If properly structured, the debt prepayments would reduce the
debt in such a way that the project is not materially disadvantaged
as a result of failing to satisfy the testing requirements under the
PPA. There may also be an acceptance requirement by the power
purchaser and a deadline by which the plant must be commercially
operational. These requirements should be reflected in the EPC
Contract acceptance and commercial operation date provisions. The
acceptance provisions are important for the power purchaser because they describe how the plant will be deemed capable to pro-
1640
Project Finance
16:4.4
duce energy. It is unlikely that the plant will operate at full load
from the outset, but rather will undergo a series of operations tests.
During the test period, fuel will be consumed and certain energy
(though not assured) may be produced. In some cases the project
company will be allowed to sell the energy generated during testing,
but since test energy is not continuous, the power purchaser will
only be willing to pay for the electricity actually delivered, and not
the capacity charge associated with overall plant availability during
the operations period. The power purchaser will inspect the facilities and equipment and, once found acceptable, the plant will be
commissioned. Thereafter, the plant will operate commercially,
which means that the full supply and payment obligations of the respective parties will become effective.
[D][6]
Conditions Precedent
A PPA may also have conditions precedent which must be satisfied prior to the agreement becoming effective. The key conditions
precedent should include the availability of adequate fuel supply,
procurement of key permits and achievement of financial close. If
the conditions precedent are not satisfied in a timely manner, then
the PPA may be terminated without further liability. This protects
both the project company and the power purchaser. If the project
company cannot obtain financing, adequate fuel supply and key permits, it will not want to incur liability to the power purchaser. The
power purchaser, for its part, will not want to be indefinitely bound
under a PPA with a project company that is incapable of getting the
project developed and financed in a timely manner, and would rather prefer to look for an alternative Sponsor group or put the project
out to bid after a date certain. To the extent possible, events under
the control of one of the parties to the PPA should not be included
as conditions precedent to effectiveness.
[D][7]
Outages
A forced outage is meant to be a temporary and short curtailment of a power plants delivery obligations that becomes necessary
to prevent major damage to people or property. A forced outage
generally means an outage for which the project company is excused
under limited circumstances from its ordinary availability requirements before being subject to liquidated damages or other penalties.
The power purchaser will generally refuse to accept the risk of supply failure or outage arising as a result of an Operator error. An outage due to the failure to run the plant correctly, or failure of the
project companys equipment, will generally be a forced outage as to
which liquidated damages will usually apply. To the extent possible,
the project company should be permitted to pass through these
1641
16:4.4
[D][8]
Pricing
The price to be paid the project company under the PPA is usually comprised of a contract capacity charge and an energy charge (for
the energy actually provided). The concept of capacity is unique to
PPAs because of the unique nature of electricity. Electricity cannot
be stored and must be used as soon as it is generated, and must be
generated as soon as it is required. Power purchasers generally buy
the ability to generate electricity on demand up to a certain amount,
in addition to the actual energy generated. Capacity payments are
sometimes referred to as demand charges, since the charge is based
upon the power purchaser s peak demand for energy at any given
time. The price paid by the power purchaser for the ability to demand purchased capacity is referred to as the capacity charge. In order to determine if the project company has available the required
capacity, the PPA will usually require scheduled capacity tests to determine whether the plant will generate the contracted quantity of
energy. Determining a power plants capacity at any given time can
be important in a natural gas fired power plant, because such plants
may have a degradation factor of between 2% to 5% per year until
the next major maintenance. In the event the tested capacity is less
than minimum contracted capacity, the project company may be required to pay a penalty. If the tested capacity is higher than the contracted capacity, the project company may be entitled to an increase
in the capacity payment.
The level of the capacity payments should be structured to pay
for the projects fixed costs, including fixed operation and maintenance costs and financing costs. The capacity payments will usually
begin once the power plant achieves commercial operation, but
from that point on, the project company must also make the capacity available to the purchaser. In the United States, the declaration of
commercial operation is usually at the discretion of the project
company and not of the power purchaser. Although declaration of
commercial operation will commence the flow of capacity payments, a project company will not declare commercial operation
1642
Project Finance
16:4.4
1643
16:4.4
In a PPA that adopts a take-or-pay obligation, the power purchaser assumes the obligations to pay for a certain quantity of capacity
and energy, regardless of whether the power purchaser has actually
taken such energy. Such obligations must be well-defined so the
Lenders and the Sponsors are ensured a continuous flow of revenue.
The project company will also be under an obligation to produce a
minimum amount of energy and must meet a minimum level of
availability in order to be entitled to the capacity payments. There
has been substantial litigation over take-or-pay obligations in the
United States that are relevant in the international context as well.
Some of the issues involved may be ameliorated by structuring the
provisions to establish a fixed charge for the capacity that is payable
even in the event of an outage, and a variable charge for energy produced that reflects all variable costs. This structure will have a similar resulta fixed stream of revenues will be available to the project
company to allow the project company to repay project debt. Under
this structure, however, the power purchaser is not paying for power
it did not receive.
[D][9]
Operating Obligations
1644
Project Finance
[E]
16:4.4
[E][1]
1645
16:4.4
[E][2]
[E][3]
Generally, the term of the Fuel Supply Agreement will be coextensive with the Offtake Agreement, or at least cover the term of
the projected debt. However, as discussed below, if there is assurance as to adequate nearby fuel supply and transportation available
to the project, a project company may be able to have a shorter term
Fuel Supply Agreement or several alternative fuel supply arrangements.
Shorter term Fuel Supply Agreements can present both opportunities and risks for the project company. There are methods for mitigating these risks. Likewise, a project may be financeable if all
parties can get comfort on effectively creating a firm fuel supply obligation through the use of several interruptible fuel supply agreements. In order to be financeable, an independent third-party fuel
supply report acceptable to the independent engineers is usually required. In the context of interruptible or short-term fuel supply arrangements, fuel cost and availability risk will receive extra scrutiny
from Lenders. By contrast, Lenders will be more comfortable with a
structure where fuel availability and price are passed through to a
credit-worthy Offtaker, such as in a tolling agreement.
[E][4]
The pricing for fuel supply can vary substantially based on the
type of fuel, location of the project, and the liquidity and depth of
the market for the commodity. In certain international projects (for
example power or other chemical projects), where there may be only
a single source of natural gas supply and transportation, and in other situations where market liquidity is an issue, the Fuel Supply
Agreement may be structured to provide both a variable component
(based on units of energy supplied) and a fixed component that may
1646
Project Finance
16:4.4
escalate on an annual basis and may vary based on the daily contract quantity (DCQ) to be provided. In contracts structured on this
basis, a DCQ may be established for the term of the contract. The
applicable daily quantity operates as a limit on the amount of fuel
the project company may nominate for delivery on a particular day.
Some fuel supply or transportation agreements contain a takeand-pay obligation. Under such a provision, a percentage of the
monthly contract quantity (the DCQ multiplied by the number of
days in the month) is required to be paid for by the project company/buyer whether or not the buyer requires the supplies. The takeand-pay quantity, which is sometimes as high as 75% to 85% of the
monthly contract quantity, operates as a minimum quantity for
each monthly period (subject to offset for amounts that the supplier
is unable to supply). Many contracts with take-and-pay payment requirements also have make up mechanisms that permit the buyer
to recover the value of the take-and-pay payments for some period
after the take-and-pay payments are made, through later deliveries
of quantities of fuel without charge, after the buyer has taken a certain percentage (usually higher than the take-and-pay percentage) of
the monthly contract quantity.
In addition, it is fairly typical for the fuel supplier to negotiate
for some form of security for the projects obligations to the fuel
supplier. This security may take the form of a letter of credit or a
performance bond, covering the payments for some period of time,
or less frequently, a lien on the project assets subordinate to that of
the Lenders.
[E][5]
Failure to Deliver
1647
16:4.4
[E][6]
The feedstock supply arrangements for an LNG receiving terminal project are quite different from the fuel supply arrangements for
a typical power project. A power project, whether gas or coal fired,
may often have several potential sources of supply and transporta-
1648
Project Finance
16:4.4
tion. In addition, there are well-developed practices and conventions that have been adopted to achieve coordination between the
fuel supply arrangements and the offtake contracts for a typical
power project.
In contrast, an LNG receiving terminal has limited supply and
transportation options. The supply needs of such a facility are long
term, and are not tied to a daily schedule. As a result of these different business characteristics, among others, there is a developing
trend towards obtaining LNG supplies on the spot market for LNG
receiving terminals. Spot market sourcing can complicate the fuel
supply arrangements for an LNG receiving terminal and increase
the projects fuel supply risk. It seems likely that over the medium
to longer term, LNG receiving terminals will opt for a mix of firm
or long-term supply arrangements for a base load amount, combined with spot market agreements.
Another issue for LNG receiving terminals is that, in contrast to
power plants (which, as noted above, have well developed conventions for coordinating the fuel supply arrangements with the offtake
arrangements), the fuel supply arrangements for LNG receiving terminals may not fit well with the offtake arrangements, especially
when the receiving terminal is located in a country with a developed
competitive natural gas market, such as in the United States, the
United Kingdom, and other parts of Europe. In such cases, it is important to design the offtake agreements to conform as closely as
possible to local natural gas supply agreements.
For example, LNG supply arrangements may not provide cover
damages for failure to deliver, and generally have a very broad definition of force majeure. In addition, quantities required to be delivered under an LNG supply agreement are usually based on
minimum contract quantities rather than daily quantities. In the
case of a failure by the LNG supplier to supply a daily quantity that
is needed by the terminal, the project company may not be excused
from its product supply obligation, and may have to purchase natural gas in the market or pay its Offtaker cover damages for loss of
the bargain, based on the difference between the spot price of natural gas and the price of natural gas under the Offtake Agreement.
This risk usually cannot be passed on to the LNG supplier under
the market standard LNG supply agreement.
In addition, there may be exposures to the terminal Owner resulting from the mismatch between the typically broad force majeure provisions in the LNG supply agreement and the narrow force
majeure clauses that are typical in standard U.S. gas supply agreements. In this situation, if the receiving terminal does not receive
LNG as a result of a hurricane which delayed the LNG vessel, for
example, the LNG supplier will not have liability, but the project
1649
16:4.4
[F]
Most infrastructure projects enter into an Operation and Maintenance Agreement (O&M Agreement) with a third-party Operator,
or, in some cases, an affiliate of the Sponsor. In either case, the
Lenders will require the Operator to be a party with a proven name
and reputation in the operation and maintenance industry, direct
experience with a similar project or similar technology, experience
in the country in which the project is located, human and technical
resources, and creditworthiness. In the case of a third-party Operator, these issues will be important not only to the Lenders, but also
to the Sponsors, because the Operator must be able to support the
contractual obligations, which include performance guarantees,
warranties, indemnities and liquidated damages.
The O&M Agreement establishes the standards to which the
Operator must adhere in its operation and maintenance of the
project. These standards include acting in accordance with prudent
operating practices, and operating the plant to comply with all
project documents and warranties and in accordance with applicable laws and permit requirements.
The payment terms under an O&M Agreement can vary and are
frequently heavily negotiatedthere may be a fixed periodic fee plus
out-of-pocket costs as negotiated, or a cost-plus arrangement. Generally, there are also bonus and liquidated damages provisions that
depend on contractually established performance standards, with
the liquidated damages usually capped at the total amount of the
fees payable under the contract.
The central feature in an O&M Agreement will be the description of the scope of work delegated to the Operator. The scope of
work will generally include operations, maintenance and repair obligations; administrative obligations; the obligations to coordinate
with the EPC Contractor upon project completion, to hire and train
personnel, to monitor warranties under the EPC Contract or equipment supply contracts, to manage and/or purchase the supply of all
inputs (including raw materials, parts, fuel and labor), to obtain and
1650
Project Finance
16:4.5
16:4.5
[A]
1651
16:4.5
commercial banks, particularly in the United States, have been reluctant to hold long-term assets on their balance sheets. A common
structure to address this latter issue is the mini-perm loan, in
which the commercial operations phase of the financing is amortized over a long-term schedule, but with a bullet maturity of the
entire principal amount after a relatively short period (say, four
years). This mini-perm period provides the project with a reasonably sufficient time horizon to arrange for long-term financing.
The relatively short mini-perm period creates refinancing risk
which the Lenders seek to mitigate through the imposition of tight
debt service coverage ratios and other conditions to limit the
amount of cash that can be distributed to the Owners. When this
structure came into common use in the 1990s, refinancing risks
were not considered to be that worrisome. However, especially in
the U.S. power sector as a result of overbuilding and other structural issues, many of the power projects financed in this manner could
not find long-term take-out financing, resulting in widespread defaults and Lender takeovers of project assets.
In addition, because of the close monitoring of a project credit,
commercial bank financings also tend to have a tighter covenant
package. Accordingly, many changes that may occur during the
course of an operating project (such as amendments to contracts,
replacement of supplies, and similar events) will require consents or
waivers from the Lenders.
Commercial bank financing also can create interest rate risk for
the project because it is typically floating rate financing at a spread
over LIBOR or some other base rate. The floating interest risk can
be partially mitigated with the use of interest rate hedges, but the
providers of these hedging arrangements require security, and the
exposures under the interest rate hedges in the event of adverse
events affecting the project can increase the projects risk profile. In
addition, the existence of the hedges operates to limit significantly
one of the advantages of floating rate debt, which is the ability to
prepay at any time without premium. If the interest rate risk has
been hedged, and the hedges are out of the money, then there can be
very substantial penalties involved in breaking the hedge to permit
the prepayment.
[B]
1652
Project Finance
16:4.5
1653
16:4.5
[C]
1654
Project Finance
16:4.5
[D]
Lease Financing
[E]
Local Financing
In international financings, it is becoming more common to include a tranche in a project financing sourced from local markets.
Although this tranche can add to the complexity of the financing
arrangements, the host country generally views such participation
favorably because it allows local financiers to participate in an important project and can also improve the image of the project locally. It can also help to mitigate political risk, as the government may
be more hesitant to take actions adverse to a project if the local financial participant will be likewise adversely affected. While most
projects are not completely financeable from local financing, this
trend is also changing, especially in Middle Eastern countries
1655
16:4.5
where, today, there are large amounts of capital available to be deployed. Many infrastructure projects in the Arabian Peninsula are
financed entirely from local funds, which can afford the project
companies a reduced financing cost.
[F]
[G]
Subordinated Debt
[H]
1656
Project Finance
16:4.6
16:4.6
[A]
Limited Recourse
1657
16:4.6
[B]
Many of the representations and warranties in the project financing documents will be identical to the representations and warranties in a corporate financing. These include, for example, the
traditional representations and warranties addressing the formalities of formation, existence, good standing, power and authority,
due qualification, legal enforceability of the agreement, possession
of consents, absence of litigation, and compliance with laws. The
project financing representations will be expanded to give the Lenders comfort that the relevant facts pertaining to the project are consistent with the Lenders understanding and analysis that formed
the basis for the Lenders internal approval for the project financing.
These representations will be tailored to the specific project and will
focus on the essential elements of the project financing, including,
in particular, the project documents, budget and projections. The
representations relating to the project budget and projections will
focus on the construction budget and the expense and revenue projections for the project. The customary representation with respect
to the construction budget is that it fairly reflects the construction
costs for the project. The customary representation with respect to
expense and revenue projections is that they fairly reflect anticipated expenses and revenues.
These representations will form the basis of the financial model
prepared by the project company and accepted by the Lenders. The
financial model, in turn, forms the basis for determining whether a
project is financeable. The model will determine a base case for the
project. This base case projection will project the most likely results
of revenues and expenses and must be reviewed and accepted by the
independent engineer. There will also be models based on varying
cost and pricing assumptions covering both optimistic (or upside)
and pessimistic (or downside) scenarios. Generally, for a project to
be financeable, the likely downside projections should still project
funds sufficient to service the projects fixed costs, including fixed
operation and maintenance costs, taxes and debt service.
The representations and warranties relating to the project documents will include representations that the project company has
provided the Lenders with true and correct copies of each such
project document on the date of closing, that the project documents
are enforceable, that there are no breaches or force majeure events
existing under the project documents, and that the performance of
such project documents do not violate any other project documents
or applicable laws. The representations and warranties will also include a provision stating that the project company has obtained all
required permits and licenses to operate the project in accordance
with applicable law and in accordance with each of the project docu-
1658
Project Finance
16:4.6
[C]
Covenants
A financing agreement for a project will also have many covenants that are included in a typical corporate credit facility. Some of
these relate to the need for the Lenders to maintain the project as
expected and not to permit the project company to take actions or
fail to take actions that may adversely impact the project or the
Lenders collateral. These covenants are often very restrictive and
subject to significant negotiation. It is the covenant package that
typically gives Sponsors pause in deciding whether to project finance a transaction. A few of the more commonly negotiated covenants are described below.
The project company will be obligated to maintain stringent insurance requirements. These requirements can be costly for the
project company and often do not provide for changes in market
conditions. For example, projects financed before September 11,
2001, generally required terrorism insurance. After September 11,
terrorism insurance generally became unavailable or cost prohibitive. Many project financings required waivers or amendments to
the terms of the agreements that required the maintenance of terrorism insurance. A well-crafted covenant to provide insurance
should ensure that the obligation to provide insurance is based
upon what is reasonably available and commercially feasible in the
commercial insurance market. This will be a heavily negotiated provision because such a provision allocates a degree of insurability
risk to the Lenders.
The project company will be limited with respect to what it can
do with proceeds from claims received under the EPC Contract or
any other project document or with respect to insurance proceeds.
The negotiation will usually relate to whether the proceeds will be
used to repay indebtedness or whether the project company can use
the proceeds to repair the damage or pay damages which may arise
under another project document.
The project company will be obligated to cause the project to be
constructed in accordance with the EPC Contract. The project company will be limited in its ability to enter into any change orders under the EPC Contract without Lender consent. There will usually be
a de minimis exception for change orders that do not exceed a negotiated amount individually or in the aggregate with all prior charge
orders. The project company will also be prohibited from changing
1659
16:4.6
the construction budget or the construction schedule without consent from the Lenders.
A project company will be limited in its ability to enter into additional material contracts and will be obligated to assign collaterally
to the Lenders any such contract entered (as well as provide a consent from the counterparty with respect to such assignment). The
key negotiation point with respect to this covenant is the materiality standard. The project company will desire the ability to operate
the business in the ordinary course and to enter freely into contracts in the ordinary course. The Lenders will desire to limit the
project companys ability to enter into long-term financial commitments, which might increase project risk or decrease the Lenders
collateral value.
The project company will be required to deposit all project revenues into a collateral account and will be required to use all proceeds of the project in a narrowly tailored manner. When project
revenues are deposited into a collateral account, the revenues will
not be accessible by the project company except in accordance with
the waterfall provisions of the collateral account agreement.
A project company will be limited in its ability to effect any material disposition of assets. This restriction may not appear too different from a typical secured credit facility, but it will often provide
far greater limitations as to what assets can be disposed of without
Lender consent.
One of the more heavily negotiated covenants in a project financing credit facility is the clause dealing with restricted payments. The project company will be restricted from making any
distributions, dividends or other payments to the Sponsors unless
certain conditions are satisfied. These conditions are highly negotiated but usually include the following:
(i)
canceling or terminating material project documents or consenting to or accepting the cancellation or termination of
the material project documents prior to the scheduled expiration thereof;
1660
Project Finance
16:4.7
16:4.7
Security Documents
In project financings, the borrower s obligations under the financing documents are generally secured by all of the assets of the
project company for which a security interest can be granted. These
include a security interest in all personal property of the project
company (which will include the plant, equipment, spare parts and
other physical assets as well as technology licenses, intellectual
property and other intangible assets of the project company), a
pledge of the equity interests of the Sponsors in the project company, and a mortgage over the real property rights of the project company, whether based on a fee interest or leasehold interest in the
project site. Project financings usually contain provisions requiring
all drawdowns under the financing package and all revenues generated by the project, including liquidated damages, to be deposited
into a deposit account with a depositary bank. The funds in these
deposit accounts will also be pledged to the secured parties. Finally,
an important part of the security package in a project financing is
the collateral assignment of the material project documents.
[A]
Personal Property
1661
16:4.7
matter of local law or the law governing the license, property or contract over which a security interest is granted.
[B]
Real Property
[C]
Project financings contain strict controls on the project company s use of borrowed funds and on all revenues received by the
project company, whether through sales under the Offtake Agreement or receipt of proceeds from insurance claims or other project
document claims. Borrowed funds will usually be deposited into
some form of a disbursement account and all disbursements will
usually require a certification from the independent engineer confirming that construction can be completed on or before the scheduled date certain, and that the project company will not suffer cost
overruns to complete the construction based on firm debt and equity commitments.
Once a project has achieved commercial operation, all revenues
generated by the project company will be deposited into a separate
collateral account, often called the revenue account, and will also be
subject to strict disbursement requirements. The ability to access
the funds from the revenue account will be based on the use of the
funds. The provisions governing the disbursement funds from the
revenue account are typically referred to as the waterfall provisions. Waterfall provisions can be quite complicated. Funds from
the revenue account will usually be disbursed in an order such that
the project company can continue to operate, make debt service
payments, pay taxes, fund revenue accounts, and finally fund the
distribution account. The term waterfall refers to the requirement
that revenues be disbursed to fund fully first the account at the
highest priority level, prior to funding the account at the next priority level, and so on down the waterfall. Some of the more difficult
negotiations will relate to where debt service payments will be
placed in the waterfall. Obviously, the Lenders will desire debt service to be at as high a level as possible. The project company, how-
1662
Project Finance
16:4.7
ever, will seek to make sure that certain mandatory payments are
made so that the project company can operate at a minimum level.
For example, fixed operating and maintenance costs and payment of
taxes are often above debt service because the project assets will
quickly lose value if not operated and maintained at a minimum
level. Tax payments are also high in the waterfall so as not to run
afoul of a countrys revenue service.
Another negotiated provision will relate to the required reserve
accounts for the project, the minimum amounts required for these
reserves, and their placement in the waterfall. Every dollar deposited into a reserve account will result in ultimately less revenues left
over for the distribution account. Reserves will almost always include a debt service reserve account which will often require the reservation of funds sufficient to pay six months of debt service.
Another common reserve account is dedicated to meet major maintenance requirements. As mentioned above, ordinary operations
and maintenance costs will be paid even before debt service in the
waterfall, but major maintenance will only be required from time to
time on a relatively predictable schedule. Major maintenance is
usually funded from the major maintenance reserve account, and
this reserve account will likely be funded after debt service and the
debt service reserve in the waterfall. The primary negotiation issues
surrounding the major maintenance account will relate to its size
and how it should be funded. The project company may prefer the
amount to be as low as possible, and want the ability to fund on a
pro-rata basis. For example, if major maintenance costs are projected to be US$10 million in a particular year, the project company
would prefer to fund one-twelfth of this amount during each month.
All revenues in excess of this amount would drop further in the waterfall and ultimately become available for distribution. Sometimes
in lieu of a major maintenance reserve account, the Lenders may accept (or require) that the project company enter into a long-term
service agreement with the equipment supplier, which will include
the costs of a major overhaul. Under a long-term service agreement,
the project company will pay a flat monthly amount to the equipment supplier for scheduled maintenance and overhauls and priority service in the event of an outage.
[D]
1663
16:5
m e n t s ( a n d t he L e n d e r s d e c i s i o n t o e x e r c i s e t h e i r r i g h t s
thereunder), the documents must contemplate the ability of the
Lenders (or their designee) to step into the role of the project company and perform the project companys obligations under the und e r l y i n g p r o j e c t c o n t r a c ts , a n d f u r t h e r m u s t o b l i g a t e t h e
counterparties under such contracts to perform their respective obligations thereunder in favor of the Lenders or their designee.
Most project documents have provisions allowing the project
company to assign collaterally the project documents to the Lenders
and reflecting the agreement of the contract counterparty to execute
consents to such an assignment. The Lenders will always require a
consent to the assignment executed by the project contract counterparties. These are sometimes difficult to negotiate because the assignment process (and negotiation of the consent permitting the
assignment) usually occurs during the financing phase, long after
the underlying project document has been executed. The Lenders
will sometimes seek, through the consent, to amend the underlying
project agreement, changing the agreed terms in ways the Lenders
believe are necessary to achieve a financeable project. This will, of
course, require further negotiation among the Lenders, the project
company and the counterparty to the specific project agreement in
question.
16:5
This section addresses several critical provisions typically included in the documentation of all project finance transactions. These
provisions do not necessarily relate to the specific substance of the
underlying transaction, but rather identify mechanisms to anticipate potential issues that would arise in any project transaction,
and provide a structured framework for resolving such issues. This
section addresses four of these concepts: force majeure, choice of
law, dispute resolution, and default and remedies.
16:5.1
Force Majeure
1664
Project Finance
16:5.1
Ordinarily, a party that cannot perform its contractual obligations will be in default and liable for damages under the contract.
The occurrence of a force majeure event excuses the performance of
the obligations of the party claiming relief to the extent that such
obligations cannot be performed due to the occurrence of such force
majeure event. A well-crafted force majeure provision usually obligates the party claiming relief to notify the other party upon or
within a reasonable time period after the occurrence of the force
majeure event, and to take all reasonable steps to alleviate the effects of the force majeure event as soon as reasonably possible. In
addition, there may be a provision allowing the counterparty to terminate the agreement if the claiming party has not resumed performance within a specified time period after claiming relief. Typically,
force majeure provisions will not grant the claiming party relief
from the performance of the contract for any period longer than the
period during which the event actually impairs (or could reasonably
be anticipated to impair) the claiming partys performance.
In recent years, there has been a propensity towards elaborate
force majeure definitions that include descriptions of every conceivable act of God type event that could affect the project, with a
catchall at the end intended to include any other similar or dissimilar event that could impair the performance of a partys obligations. A well-crafted provision will qualify each of the items listed
as force majeure events by a requirement that the event claimed actually be beyond the reasonable control of the party claiming force
majeure. As a simplified example, explosions are sometimes included in the kitchen-sink variety of force majeure definitions. The
occurrence of an explosion should not, by itself, however, end the
inquiry. If the explosion occurred due to the failure of a party to
conduct its work or performance in a manner contractually or customarily required, than the failing party should not be entitled to
the benefit of the relief afforded by a balanced and well-crafted force
majeure provision.
It is worth noting that labor disruption constitutes a unique variety of force majeure in that it is capable of resolution through negotiation. While it largely depends on the relative bargaining power of
parties, force majeure provisions will typically exclude labor disruptions that are limited to the site or the party in question, on the rationale that the risk of such disruptions should rest with such party.
Accordingly, labor disruptions are usually required to be industry- or
region-wide to constitute force majeure, or at least broader than being aimed solely at the project or party in question. Once a labor
disruption falls within the defined realm of force majeure, however,
the party that is confronting the disruption is usually permitted latitude to settle the dispute at its discretion, without violating the
terms of the force majeure provision.
1665
16:5.2
16:5.2
Choice of Law
In any complex transaction involving multiple parties with differing goals and incentives, it is likely that disputes will arise. As
one of the primary goals in structuring a project finance transaction
is identifying and either eliminating or assigning risk, it is important that project finance contracts contain provisions that address
the risk of such disputes. The relevant provisions that do so are the
choice of law and dispute resolution provisions.
A choice of law provision specifies which jurisdictions law will
be used in interpreting an agreement and in adjudicating any disputes arising in connection therewith. The importance of a carefully
considered choice of law provision, especially in international transactions, cannot be overstated.
The law governing any project contract sometimes depends upon
the location of performance of the contract, as a particular jurisdic-
1666
Project Finance
16:5.2
tion may insist (as a matter of its public policy) that its law be applied with respect to certain types of agreements or with respect to a
particular class of assets, regardless of the dictates of the relevant
agreements choice of law provision. Such a possibility highlights
the need to have knowledgeable local counsel that can provide guidance regarding choice of law provisions and other local laws or customs impacting the relevant agreements. Or, alternatively, even in
the absence of an overriding public policy imperative, the host
country may insist (as a negotiating matter) that its law govern the
principle documents between the project Sponsor/Owner and the
government or its instrumentalities. In other instances, Sponsors
have the bargaining power to insist on the selection of a neutral
choice of law governing the essential contracts between the parties.
This is particularly the case in emerging countries that are newly
inviting foreign investment into a particular sector, and do not have
the leverage to dictate critical provisions such as choice of law.
This issue of which law should govern the project documents
can be controversial. Lenders will generally prefer that the project
documents be governed by the laws of a neutral jurisdiction (New
York or the United Kingdom) rather than the laws of the jurisdiction in which the project is located. Certainly in the loan or financing documents, the Lenders are likely to insist on the application of
either New York or English law. Beyond concerns of neutrality, these
jurisdictions are perceived as having a sophisticated and welldeveloped body of law applicable to complex commercial (including,
specifically project finance) transactions and documentation.
Hence, in international project finance transactions, New York or
English law is quite commonly selected even if such jurisdictions
bear no apparent relation to the transaction at issue. New York, for
example, has a statutory provision enabling the selection of New
York law as the governing law by contractual parties, regardless of
whether the contract bears any relationship to New York, provided
that the contract has a transaction value of at least US$250,000.
It is important to note, however, that the security documents in
a project financing will need to be governed by the law having jurisdiction over the particular asset pledged as security. For physical assets this will likely be the law of the jurisdiction where the asset is
located or registered. Hence, the security documents are generally
governed by the law of the country in which the project is located.
The need for reliable local counsel to assure that the security arrangements are effectively documented, registered and perfected
should not be underestimated.
1667
16:5.3
16:5.3
Dispute Resolution
1668
Project Finance
16:5.3
1669
16:5.4
16:5.4
1670
Project Finance
16:6
assume any contracts with subcontractors and arrange for completion of the project. The EPC Contractor may become liable for any
excess completion costs incurred as a result of its default. In contrast, failure by the Owner to perform its limited obligations under
the EPC Contract might relieve the EPC Contractor of certain of its
affected performance obligations, but will not result in the Owner
having to pay liquidated damages or other similar amounts to the
EPC Contractor.
As with other contracts, the ability to obtain specific performance as a remedy is rare in project contracts as well. It may be
available in situations where performance is unique and cannot be
replicated or remedied fully by monetary damages. The delivery of
land comprising the project site, or the obligation of an EPC Contractor to perform work in accordance with the EPC Contract and
achieve the minimum performance guaranties required by the contract are two prominent examples where project contracts may expressly make available specific performance as a remedy.
16:6
Environmental Issues
This section provides an overview of the framework for environmental compliance standards applicable to many international
project financings. It focuses on developments within the International Finance Corporation (IFC), the World Bank, the OECD, and
among private financial institutions that are affecting this landscape. While environmental standards have generally evolved over
the last thirty years, the last few years in particular have seen significant developments that are the focus of this section.
Environmental compliance presents a distinct transaction cost
and project risk to be managed and structured within the context of
an overall project. One way that project participants have sought to
manage environmental transaction costs in projects is through
standardization. The trend in this area has been for project parties
to apply the IFCs environmental and social safeguard policies to
their projects, in many cases, regardless of whether a multilateral
institution (such as the IFC) is involved in the particular project.5
5.
There are also sources of international law that have developed over the
past decades which have helped to establish common international standards for environmental protection. These primarily include the following
treaties: Agenda 21 and Rio Declaration on Environment and Development, adopted by the United Nations in 1992; the World Charter for
Nature, U.N. General Assembly Resolution 37/7; the Basel Convention on
the Control of Transboundary Movement of Hazardous Wastes and their
Disposal of 1989; the Convention on Environmental Impact Assessment
in a Transboundary Context on 1991; and the Convention on the Protection and Use of Transboundary Watercourses and International Lakes of
1992.
1671
16:6.1
As discussed at the end of this section, this approach has been reflected in adoption of the Equator Principles by leading private financial institutions, and the best practices of many project
Sponsors, governments, and multilateral institutions such as the
OCED and the World Bank.
In view of this convergence around the IFCs environmental policies, section 16:6.1 provides a summary description of the IFC polices and a primer on developments relating to the IFC s wideranging Safeguard Policy Update that is presently nearing completion. Section 16:6.2 provides a discussion of the World Banks Ext r a c t i v e I n d u s t r i e s Re v i e w, w h i c h b e g a n i n 2 0 0 0 , a n d i t s
implications for international projects. Section 16:6.3 contains a
discussion of the 2004 OECD Guidelines for Multinational Enterprises that have an environmental application. Finally, section
16:6.4 introduces the Equator Principles launched in 2003 and ends
with a few concluding remarks regarding the tendency towards standardization in the area of environmental compliance.
16:6.1
As discussed in section 16:10, the IFC is the private sector investment arm of the World Bank Group, which unlike the World
Bank, lends directly to private entities. In 1998, the IFC adopted
ten environmental and social policies (Safeguard Policies) to which
projects are expected to adhere in order to receive IFC financing.
These policies, which are still in place, focus on the following areas:
environmental assessments;
natural habitats;
pest management;
indigenous peoples;
involuntary resettlement;
forestry;
safety of dams;
international waterways;
1672
Project Finance
16:6.1
[A]
ensure that affected communities are engaged on issues relating to the project that will impact their lives;
[B]
The first aspect of compliance with this standard is the preparation of a social and environmental assessment (S&EA). The S&EA
is a broad undertaking that varies from project-to-project and country-to-country. It must consider all risks and impacts of the project,
including the issues identified in the other performance standards,
which may necessitate the preparation of such diverse specialized
studies or plans to address:
population resettlement;
biodiversity;
indigenous people.
1673
16:6.1
The geographic scope of the S&EA is not just the project site, but
encompasses the projects area of influence. The IFC will broadly
construe an area of influence to include project impacts that are global or transboundary in nature, as well as areas potentially affected
by the cumulative impact of the project. It does not, however, include potential impacts that would occur independently of the
project. The size, scope and scale of the S&EA will ultimately depend on the IFCs classification of the project into one of the three
following categories:
Category A projects are expected to have significant adverse
environmental impacts that are diverse, irreversible, or
unprecedented.
Category B projects are expected to have limited adverse
social or environmental impacts that are few in number,
generally site-specific, largely reversible, and readily
addressed through mitigation.
Category C projects are expected to have minimal or no
adverse impacts.
Regardless of how a project is classified, at a minimum, S&EA
documents must describe:
the project and its social and environmental impacts, including an analysis of reasonable alternatives to the project
and a justification of the approaches to the social and environmental design of the project;
maps and drawings of the project and a delineation or description of its area of influence;
the legal and regulatory framework, the applicable IFC performance standards, and the environmental, health and
safety performance levels established for the project;
[C]
The IFC will also require the submission of a social and environmental management plan (SEMP). However, the size and scope of
the SEMP will vary depending on the nature of the environmental
impacts identified in the S&EA. The SEMP should contain a comprehensive set of actions the Sponsors will adopt in order to meet
the mitigation measures identified in the S&EA, and a completion
1674
Project Finance
16:6.2
schedule for each milestone event. Finally, the SEMP should specify
the mechanisms by which the Sponsors will monitor compliance.
[D]
16:6.2
1675
16:6.3
proposed a number of recommendations regarding policy in the extractive industries that its board of directors agreed to implement.
One recommendation was that the clarity and accessibility of its environmental policies be continually improved. Other recommendations pertained to the use of social and environmental assessments,
increasing community participation and transparency, and establishing certain no-go zones in environmentally sensitive regions
of the world. These policies and their implementation will all be
heavily influenced by the IFCs Safeguard Policy Update. In fact, the
World Bank is deferring a number of important decisions regarding
the implementation of the EIR until the IFC concludes its Safeguard
Policy Update.
16:6.3
Another important set of standards for environmental compliance in international project finance is derived from the OECDs
Guidelines for Multinational Enterprises (Guidelines). The Guidelines are recommendations promoted by OECD governments to
multinational enterprises operating in or from OECD member
countries and apply to global conduct by multinational companies
from OECD member countries. In many cases, the Guidelines call
for adherence to host country or international law. But they also
provide guidance in instances where such laws are absent or deemed
insufficient. The Guidelines were first issued in 1976 and readopted
by the OECD member countries, as well as by Argentina, Brazil and
Chile in 2000. Although the Guidelines are voluntary, they reflect a
set of best practices applicable to Sponsors and to financing parties.
One chapter of the Guidelines is specifically focused on environmental performance.
In addition to such topics as public consultation and disclosure
of environmental, health and safety impacts, the Guidelines focus
on the establishment and maintenance of environmental management systems (EMS). While an EMS is meant to be applied at the
enterprise, rather than the project level, the OECDs discussion of
environmental management systems shares a lot in common with
the IFCs social and environmental management plan. The EMS
contemplated by the Guidelines should include procedures to:
collect and evaluate adequate and timely information regarding environmental, health and safety impacts;
1676
Project Finance
16:6.4
16:6.4
Equator Principles
The Equator Principles are the newest addition to the set of environmental standards that effect international project financings.
They were first adopted by ten leading banks in 2003, and have
since been adopted by nearly thirty additional financial institutions
(collectively, Equator Banks). The Equator Principles are a baseline
framework for environmental compliance standards applicable to
projects with a total capital cost of US$50 million, or higher. When
a financial institution voluntarily adopts the Equator Principles it
signals its intent to provide loans only to projects which comply
with the IFC Safeguard Policies. In addition to the US$50 million
threshold, the Equator Principles apply globally to project financings
in all industry sectors. The major implication of the Equator Principles for project Sponsors is that projects will need to comply with
IFC policies, regardless of whether the IFC or another multilateral
institution that requires compliance with IFC policies is involved in
the project. This means that the IFCs Social and Environmental
Assessment and Management Program mandated by its Safeguard
Policy Update is now essentially the norm for large-scale project financings.
What remains to be seen, however, is the precise manner in
which Equator Banks will apply IFC policies to projects in which
there is no IFC involvement. The IFC policies are not a set of steadfast procedures or rules. Rather, they reflect a body of thought and
approach to environmental compliance. The Equator Banks application of the policies may turn out to be different from the IFCs.
For instance, it remains at the discretion of the Equator Banks to
determine whether a project cannot comply fully with the Equator
Principles, and if so, whether to proceed with project financing. In
addition, the interpretation and implementation of IFC policies requires significant time, expertise and judgment, and different Equator Banks may apply the Equator Principles in a divergent manner,
either in their capacity as co-Lenders on a particular project or from
1677
16:7
one project to the next. Although the Equator Principles mark a significant step in conforming market standards for environmental
compliance in international project finance, the process is still in its
early stages and it is difficult to predict its evolution. As a result,
market precedent from landmark project financings, combined with
the evolving recommendations of multilateral organizations such as
the World Bank Group and the OECD, will continue to play an important role in determining the landscape for environmental compliance in international project finance.
16:7
Insurance
Employers liability/workers compensation insurance covers liability for injuries to employees during construction
and operation of the project.
Environmental liability insurance covers liability for, or injury resulting from, any violation of environmental laws
during construction or operation of the project.
1678
Project Finance
16:7
The principal forms of insurance required during the construction phase include the following:
Delay-in-startup insurance covers the increased costs resulting from a delay in project completion caused by an insured
loss. This is intended to offset against the greater-than-expected cost of interest during construction and the loss of
revenue arising from the delay.
Operators all risks insurance covers loss or damage after operation has begun. This insurance generally provides broad
coverage for all risks except for those that are specifically excluded from the policy.
Operators loss of revenue (or business interruption) insurance covers loss of revenue that results from damage to the
project caused by an insured loss.
The allocation of responsibility for the maintenance of the foregoing insurance among the parties to a project transaction will vary
from project to project. Typically, however, as can be expected from
the discussion in other parts of this chapter, the party required to
obtain insurance will be the party to whom the underlying risk being insured against is most optimally allocated. For example, the
risk of environmental liability arising from preexisting site conditions is typically an Owner s risk to be covered by Owner-procured
insurance, whereas the risk of environmental damage from construction risks should be borne by the EPC Contractor and covered
under its all risks insurance policy or separately procured by the
EPC Contractor. Generally, the EPC Contractor s all risk policy will
provide the principal insurance covering the project and the site
during construction, with the responsibility for maintaining the operations phase insurance shifting to the Owner or Operator after
construction. In addition, insurance is sometimes procured at the
1679
16:7
(ii) the occurrence of a loss that falls outside the policy coverage, or is expressly excluded;
(iii) the insurance carrier seeking to void the policy on grounds
of nonpayment of premiums, nondisclosure, fraud, misrepresentation or failure by the insured to comply with other
policy requirements;
(iv) failure by the insured to make a timely claim or provide
timely notice of an insured event;
(v)
1680
Project Finance
16:8
16:8.1
16:8.1
1681
16:8.2
ships or disregarded entities (in effect, mere branches) for U.S. tax
purposes, as the parties may elect.
These particular tax differences may be critically relevant to
Company A, and completely irrelevant to Company B. However,
any choice of entity resulting from this analysis may have tax importance to Company B for other reasons (for example, in its home
jurisdiction). This is an example of the kinds of harmonizing
choices required to fashion a plan workable for all parties.
16:8.2
1682
Project Finance
16:8.3
16:8.3
Some of the most dramatic effects of tax planning for an international development project relate to the nature and location of the
equity ownership structure. For example, Company A or Company
B (or both) may wish to create a mezzanine holding company outside their home jurisdiction, through which their investment into
the project company may be channeled.
In this case, let us assume that they will jointly create such a
company (MezzCo) in Country Z. Usually, the primary tax reason
for such a strategy is that dividends from the project company to
MezzCo will be taxed at a lower rate than if the same dividends
were received by Company A or Company Band in some cases,
they may not be taxed at all. The latter result may apply if Company Z is a tax haven country that imposes no tax, or if its tax law
exempts dividends from qualified subsidiary investments (such as
under the participation exemption provided by the Netherlands
and other EU countries).
As a result, dividends to MezzCo could be reinvested in other
projects in countries outside the United States and Country Y, without being reduced by any current tax in the home countries of Company A and Company B. In that way, their investment can
effectively compound on a pretax basis, until the earnings are ultimately repatriated home. This strategy may be particularly significant when Country X is a less-developed country that offers
significant tax inducements (such as an income tax holiday for
some initial period of years), to offset the political risk of the investment. If all dividends were remitted directly to Companies A and B,
and were fully subject to current tax in their hands, the economic
incentive of the tax holiday would be defeated.
Of course, for this strategy to work, the parties must successfully
avoid any tax regime in Country Y or the United States that would
tax the parties immediately on their share of the income of
MezzCo, even if the income were not distributed to them. Many jurisdictions have regimes (like the rules concerning controlled foreign corporations in the United States) which seek to tax investors
immediately on their shares of the passive income of offshore subsidiaries. In the United States, this result may be avoided if the
project company can be treated as a partnership (or a disregarded
entity) for U.S. federal income tax purposes. In that case, MezzCos income would be treated not as passive dividend income but
as income from the active conduct of the project companys business, and would not immediately be accrued to Company A.
In some cases, a further benefit of the MezzCo strategy may be a
favorable tax treaty between Country X and Country Z. For example,
such a treaty might provide for a reduced rate of withholding tax on
1683
16:8.4
dividends from the project company to a resident of Country Z. Ordinarily, the fact that MezzCo is formed under the laws of Country Z
would make it a resident of that Country. The tax authorities of
Country X, however, may take a different view. They may consider it
necessary that MezzCo have sufficient personnel, activities, office
space and other indicia of real presence to be classified as a bona
fide resident of Country Z, entitled to the protection of the treaty.
In addition, even if such presence is established, the favorable
result may still not be assured. For some time now, the United
States has been engaged in a program to renegotiate and update its
existing tax treaties with foreign countries to include a limitation
of benefits provision. Under such a provision, the eligibility of a
company formed in Country Z to be treated as a resident of Country Z and entitled to the benefit and protection of its tax treaties,
may be blocked when a majority of the companys Owners are located outside Country Z. Other countries have been moving similarly to restrict the benefit of their tax treaties.
16:8.4
Conclusion
16:9
This section addresses two types of riskscurrency risk and political riskthat are unique to international projects, and discusses
techniques that have been developed to mitigate these risks, or shift
them to parties better suited to manage them. This section also includes a case study in connection with the discussion of change in law
risk, examining the experience of four multinational consortia that
project financed several multi-billion-dollar heavy oil projects in Venezuela in the late 1990s, and the shifting Venezuelan fiscal laws that
have affected these projects to the date of this chapter s preparation.
16:9.1
Currency Risk
Inconvertibility risk
Transfer risk
Devaluation risk
1684
Project Finance
[A]
16:9.1
1685
16:9.1
nues in local currencies, many countries limit the amount of foreign exchange that can be maintained offshore. For these reasons,
Sponsors often seek special agreements with host governments that
address offshore bank accounts, currency convertibility and transfer
issues.
A well-structured host government (concession, implementation
or stabilization) agreement that does not require the project company to access the local currency market in order to obtain foreign
currency, and does not require local government approval to transfer
hard currencies abroad, will reduce the currency inconvertibility
and transfer risk to which the project is exposed. In this case, the
risk becomes limited to the risk that a host government will breach
the contractual obligations set forth in the agreement with the
project company. This is a political risk that is addressed in section 16:9.2.
Currency inconvertibility and transfer risk can also be shifted to
insurers. There are a variety of public and private sources that underwrite policies to insure against these risks. The public sources
include multilateral and bilateral institutions, such as the Multilateral Investment Guarantee Agency, International Finance Corporation, Inter-American Development Bank, European Bank for
Reconstruction and Development, U.S. Overseas Private Investment Corporation and the Asian Development Bank. Each insurer
has different pricing structures and limits on the amount of risk
that it will underwrite. In addition, the policies will distinguish between coverage for the projects debt and the equity investment of
the Sponsors. Events that are generally excluded from coverage under inconvertibility and transfer risk insurance policies include:
[B]
1686
Project Finance
16:9.2
16:9.2
Political Risk
Expropriation risk
[A]
Political Violence
Politically motivated violence in the host county can have obvious adverse effects on a project. Unless a country suffers a prolonged period of civil insurrection, the temporary nature of much
political violence usually allows a project to weather the storm
provided the project has adequate cash reserves. In light of the un-
1687
16:9.2
foreseeable, country-specific nature of political violence and the inability to mitigate this risk, however, risk insurance that covers
political violence may be highly desirable. As with any political risk
policy, it is essential to obtain a thorough understanding of the legal
definitions that delineate what will constitute an insured political
violence event. While political risk insurance is covered in section
16:9.3, Table 16-1 below illustrates a typical formulation of, and
common exclusions from, the definition of political violence negotiated as part of a political risk insurance policy covering political violence.
Table 16-1
Common Formulation
A violent act undertaken with the
primary intent of achieving a
political objective, such as declared
or undeclared war, hostile action by
national or international armed
forces, civil war, revolution,
insurrection or sabotage.
May Include
(negotiable)
Civil
disturbance or
strife
Terrorism
May Exclude
Student violence
Labor violence
Environmentally
motivated
violence
In addition, coverage for political violence events typically pertains to a loss of assets or income directly related to the political violence. Since political violence can often take place at a national
level but reverberate through an economy, the nature of what constitutes a direct loss can often be subject to dispute. For this reason,
if political risk insurance is sought, it is important to tailor the covered events as closely as possible to the likely forms of political risk
that can foreseeably affect a project.
[B]
Expropriation Risk
1688
Project Finance
16:9.2
Conditioning the grant or renewal of a key permit or government consent on concessions by the project that will degrade its financial returns
Under accepted rules of customary international law, it is unlawful to expropriate property (on either an outright or indirect basis)
without just compensation. State regulatory actions applied on a
nondiscriminatory basis, however, are not considered to be forms of
expropriation, even if those actions (or inactions) have an adverse
economic impact on a project. Legal definitions of what constitutes
creeping expropriation have been imprecise and generally do not address what distinguishes it from other noncompensable types of
government regulation. This legal uncertainty makes it more difficult to challenge successfully creeping expropriation by host governments under multilateral and bilateral investment treaties or before
arbitral tribunals. In part, this legal uncertainty may be due to the
country-specific nature of government interference in the private
sector and the intentional deference afforded by the drafters of some
sources of international law to arbitral tribunals to address this issue on a case-by-case basis. Arbitral decisions interpreting various
free trade agreements and bilateral investment treaties have led to
the emergence of several broad criteria that provide a framework for
determining what constitutes creeping expropriation as opposed to
noncompensable government regulation. These criteria include:
6.
INDIRECT EXPROPRIATION AND THE RIGHT TO REGULATE IN INTERNATIONAL INVESTMENT LAW, ORGANIZATION FOR ECONOMIC CO - OPERATION AND DEVELOPMENT, Working Papers on International Investment
Number 2004/4.
1689
16:9.2
ment Treaty).7 Although these recent agreements attempt to differentiate between noncompensable government regulation and
creeping expropriation, they also acknowledge that a determination
of indirect expropriation will ultimately be a case-by-base, factbased inquiry. Hence, the determination of what constitutes indirect expropriation can be expected to change over the life a project
depending on the country in which the project is located and the
particular political necessities that give rise to a host governments
actions. As a result, bilateral investment treaties and free trade
agreements often serve as just a tool for mitigating, rather than a
blanket assurance against, expropriation risks.
[C]
Price controls
For this reason, many Sponsors and Lenders try to enter into
agreements with host governments that seek to stabilize the legal
regime to which the project will be subject. The benefits and limitations of these agreements are discussed next.
[C][1]
7.
1690
Project Finance
16:9.2
Grant of permits to the project (so long as the company fulfills its obligations to obtain the permit)
Although topics such as expropriation are covered in bilateral investment treaties, host government agreements are tailored to specific projects and create direct contractual privity between a project
or its Lenders and the host government. If a host government
breaches its obligations under a stabilization agreement, the beneficiaries would have a contractual claim directly against the host government. While this can be difficult to enforce, many host
governments, depending on the importance of the projects development to the country, will waive their rights of sovereign immunity
in order to permit the beneficiaries to enforce the stabilization
agreement against the government, either locally, or abroad. Unless
a host government has significant assets abroad, the most valuable
judgment will be one that can be enforced locally. Therefore, the extent to which the host country has a truly independent judiciary
will have a strong bearing on the ability to prosecute successfully a
claim against a host government for breaching a stabilization agreement.
Other than through third-party insurance for political risk events
(discussed in section 16:9.3, below), it is very difficult to insulate
against risks such as expropriation or change in law. Although stabilization agreements can help establish expectations based on adherence to contractual obligations, as previously discussed, those
agreements can be breached. Accordingly, Sponsors often explore
other ways to mitigate political risk. The importance of incentivizing a host government for a projects success cannot be understated.
For instance, if a state-owned entity is also a project participant
such as an Offtaker and the prices in the Offtake Agreement appear
too high, the contractor the projectis likely to come under scrutiny by the host government or a successor regime. A good example
of this is the famously plagued Dabhol project in Maharashtra, India where the widespread perception that the price agreed by the prior (ousted) local government for power was simply too high led to
project cancellation and litigation.
Other ways to incentivize host governments are through equitable forms of profit sharing, either in the form of taxes, equity in the
project, or, in the case of extractive industries, royalties or other fees
1691
16:9.2
associated with production. In addition, the fact that so many international project financings are structured as joint ventures with
many different types of Lenders and multiple suppliers and Offtakers would serve as a form of political risk mitigation as well.
This is because it may be more difficult for a government to take an
adverse action against a project if many different types of parties
would be affected by the governments action. It is often thought
that including multilateral and bilateral lending institutions as financing parties will minimize political risk, as discussed further in
section 16:10.1.
[C][2]
8.
The four Orinoco Projects and their sponsors are as follows: Petrozuata
(ConocoPhillips (50.1%), PDVSA (49.9%)); Hamaca (ConocoPhillips
(40%), Chevron (30%), PDVSA (30%)); Sincor (Total (47%), PDVSA (38%),
Statoil (15%)); Cerro Negro (ExxonMobil (42%), PDVSA (42%), Veba Oel
(16%)).
1692
Project Finance
16:9.3
Venezuela and that any efforts to interfere with them could impair
Venezuelas future ability to access international capital markets
and attract foreign oil company investment. Although it is uncertain whether any of Venezuelas actions at the time of this writing
constitute clear breaches of the Orinoco Projects contracts, it would
appear that with oil prices presently hovering between US$60 and
US$70 per barrel, Venezuelas ability to gain economic leverage to
the detriment of the Sponsors without attracting a full-blown legal
battle has been successful. In the end, the economic and political
realities are that the projects are continuing to service their debt,
and some Sponsors are seeking to pursue additional investment opportunities in Venezuela, although perhaps with eyes more keen to
the governments ability to change any future projects essential financial terms.
16:9.3
In addition to expropriation claims that can be brought under international law, there are a variety of insurance products available
to cover not only expropriation events, but currency risk and political violence as well. Political risk insurance, like most forms of insurance, is expensive and subject to many exclusions. In seeking
political risk insurance, it is important to take care that the policy is
as closely tailored to the anticipated risk as possible. In many cases,
the decision to obtain political risk insurance for a project is driven
less by the concerns of the Sponsor (who is willing to limit its losses
to its nonrecourse equity investment in the project) and more by financing considerations. That is to say, it is often the financing parties who insist on covering their loans with political risk
insurance. In the case of a typical project financing that is highly leveraged, it is not difficult to see why this is the case: Lenders, and
not Sponsors, bear most of the political risk during the initial years
of the project, once the project has been completed.
Political risk insurance used to be dominated by multilateral and
bilateral institutions. In recent years, however, political risk policies
have increasingly been offered by private insurers as well. In addition, bilateral agencies have begun to offer more complex political
risk insurance products in order to keep pace with the changing profile of financing sources, such as capital markets investors that provide financing to projects. Until several years ago, political risk
insurance was only available to protect equity investors and commercial bank Lenders. However, with the growing use of project
bonds, many insurers developed policies to enhance bonds issued by
emerging market issuers, such as project companies, to U.S. investors. A good example of this is the U.S. Overseas Private Investment
Corporations (OPIC) capital markets political risk insurance policy.
1693
16:9.4
16:9.4
Conclusion
1694
Figure 16-3
Political Risk Insurance Claim Process and Timeline
Project Finance
1695
16:9.4
16:10
16:10.1
[A]
A major difference between bilateral lending agencies (which include ECAs) and MLAs is their mission: bilateral agencies primarily
exist to promote the export of goods or services that are obtained
from the agencys country of origin, whereas an MLAs mission is
1696
Project Finance
16:10.2
broader in scope and is focused on promoting development and economic growth. MLAs are organized and funded by a group of countries and may have a global or regional focus. Bilateral lending
agencies are organized by individual nations and are funded by their
organizing governments and the revenues generated from their operations. In addition, because of each ECAs mandate to promote its
host countrys goods or services, there are many technical requirements for projects that obtain export credits. For instance, ECA involvement will mean that there will be heightened verification
procedures for obtaining accurate information on the country of origin of goods and services used in the project. When determining the
origin of goods and services, this usually means not only the
country where the invoice is issued or the nationality of the subcontractor, but where the goods are produced or manufactured as well.
A list of bilateral and multilateral agencies and their common acronyms is found in Appendix 16A at the end of this chapter. Each of
these private sources provides an array of financing products commonly seen in project financings, such as loans, loan guarantees, interest rate support, and political and commercial risk insurance.
16:10.2
[A]
1697
16:10.2
Multilateral Investment Guarantee Agency (MIGA) promotes foreign direct investment in developing countries by
providing investment guarantees to the private sector that
insure against political risks.
Most dispute resolution procedures in bilateral investment treaties and free trade agreements are submitted to ICSID.
[B]
10.
Countries with ECAs that have adopted the Consensus Rules are: Australia, Canada, the European Community, Japan, Korea (Republic of), New
Zealand, Norway, Switzerland and the United States.
The text of the December 2005 revisions to the Consensus Guidelines is
available at http://webdomino1.oecd.org/olis/2005doc.nsf/Linkto/td-pg
(2005)38-final.
1698
Project Finance
16:10.2
Table 16-2
OECD Terms and Conditions Applicable to
Project Finance Transactions
Term
Tenor
Condition
14 years, maximum (generally)
10 years if ECA credit is more than 35% of
total syndication and in a high income
OECD country
Principal Amortization:
Size of Installments
Principal Amortization:
Frequency
Principal Amortization:
Weighted Average Life
Interest Payments:
Frequency
1699
Int'l Corporate Practice.book Page 100 Saturday, November 17, 2007 4:17 PM
16:10.3
16:10.3
[A]
Chad-Cameroon Pipeline
11.
16100
Int'l Corporate Practice.book Page 101 Saturday, November 17, 2007 4:17 PM
Project Finance
16:10.3
[B]
In contrast to the Chad-Cameroon financing, in the BTC financing, MLA and ECA participation enabled the Sponsors to borrow
substantial amounts that would not likely have otherwise been
available. With the exception of US$923 million of Sponsor senior
loans to the project company, approximately 65%, or US$1.7 billion
out of BTCs US$2.6 billion of project debt was either tied to or
covered by MLA and ECA funding.12 Put another way, the principal
reason for involving the MLAs and ECAs in the BTC financing was
to increase the amount of debt financing.
Although the BTC pipeline reached financial close successfully,
such concentrated ECA involvement was not without tremendous
logistic challenges for the Sponsors. For instance, as previously noted, ECA credits must be tied to eligible goods and services. A key
principal in multisource project financings is that commercial Lenders desire for the ratio of their credit extensions to remain balanced
12.
Stewart Robertson & Craig Jones, How Sponsors Financed the First Caspian Pipeline to the Mediterranean, INTL FIN. L. REV., Mar. 2004. BTCs
total project costs were US$3.65 billion. The debt, consisting of
US$2.589 billion, included the following tranches: IFC/EBRD/A/B loans
(US$500 million); ECA loans (JBIC, NEXI, US Exim, ECGD, Hermes,
Coface and SACE) (US$766 million); Japan Bank for International
Cooperation (JBIC) overseas investment loan (US$300 million); Overseas Private Investment Corporation (OPIC) covered loans (US$100
million); Sponsor senior loans (US$923 million).
16101
Int'l Corporate Practice.book Page 102 Saturday, November 17, 2007 4:17 PM
16:10.3
with credit extensions by ECAs, and among the ECAs, no one ECA
should advance more than its pro rata share of credit. Coordinating
the draw downs under BTCs multiple tranches of ECA and commercial (covered) bank debt required care in taking all this into account, while at the same time ensuring that project costs being
reimbursed by drawdowns under ECA facilities matched the timing
of production, shipment and deliver y of eligible goods and
services.13
[C]
Delay
13.
16102
Int'l Corporate Practice.book Page 103 Saturday, November 17, 2007 4:17 PM
Project Finance
16:10.4
16:10.4
Conclusion
MLAs and ECAs, with their unique ability to absorb political risk
coverage, are the only sources able, in many instances, to fill financing gaps in project financings in countries that present political risk
and have low sovereign credit ratings. The need for ECAs and MLAs
to bear a portion of this risk is not just driven by risk adversity on
the part of commercial sources. Bank regulatory considerations
such as capital adequacy requirements also limit the exposure that
different commercial financial institutions can afford in non-OECD
countries. As a result, Sponsors will likely need the participation of
MLAs, ECAs, or both, when they seek project finance in countries
or regions that pose political risk concerns.
16103
Int'l Corporate Practice.book Page 104 Saturday, November 17, 2007 4:17 PM