Analysis of Risks to a Project Developer in a Term Sheet Or a Power Purchase Agreement (PPA)
Project Finance has become an increasingly attractive technique for financing infrastructure projects in developing countries over the last twenty years. Furthermore, the use of project financing raises difficult legal issues with respect to the ability of developing countries' governments to control the provision of public services that are intimately connected to these infrastructure projects. Project finance has several advantages, such as the opportunity for investors to participate directly in an otherwise inaccessible and lucrative-albeit risky-market and the ability to participate in high-risk investments without diminishing creditworthiness. Lenders for projects are primarily large international commercial banks, such as ABN Amro and Citibank, or multilateral lending agencies, such as the International Finance Corporation (IFC) and the European Bank for Reconstruction and Development (EBRD). They will in no doubt, therefore, seek to put in some issues in a term sheet.
The first step in setting up a project financing usually involves the sponsors or developers forming a project company known as a special purpose vehicle or entity, which is designed to construct, own, and operate the project facility. Thus project finance benefits sectors or industries in which projects can primarily be structured as a separate entity from their sponsors or developers.
Thus it is the project company, which is the entity that is borrowing funds for the project. The lenders loan money to the project company with the assets and cash flow of the project acting as the security interest for the project loans.
Definitions and Meanings
European Investment Bank defines project finance as "a loan made primarily against cash flows generated by the project, rather than relying on a corporate balance sheet, the security value of the physical assets or other forms of security".
A project developer is the sponsor or the borrower for the project.
A power purchase agreement (PPA) is an agreement which serves as one of the pre-requisites for the lender to borrow funds for a project. It is a contract that "there will be ready market for the project on completion".
A term sheet is an outline of the principal terms and conditions proposed for the project and investment. It is not in itself a legal document but a sort of draft proposals subject for approval by all parties involved.
Types of Risks
In project transactions, there are typically numerous parties from different jurisdictions involved, and accordingly, the laws of many different jurisdictions are potentially applicable to any given transaction. Thus the uncertainties or fears expressed by each party translate to a risk of a sort. It becomes important that the terms sheet or the PPA or the PSA be analysed accordingly and where necessary, find the appropriate legal regulations or instruments to mitigate any risks.
Risks are different for each project - they are often country-specific, and differ depending on the kind of project one wishes to undertake.
There are, generally different kinds of risks with the magnitude being different from one project to another project. Some of the acceptable forms of risks that should be considered at all costs are as follows:
- Sponsor risks
- Pre-completion risks
- Inflation and foreign exchange risk
- Operating risks
- Technological risks
- Completion risk
- Input risk
- Approvals, regulatory and environmental risk
- Offtake and sales risk
- Political risks
Believe it or not, when all the risks-financial, construction & completion risks, technology & performance risks, foreign exchange & availability risks- are critically analysed, it could be deduced that they are to a greater extent linked to government's policies; in other words, political activities or ideologies. Linking political risk to regulatory risk in most of his study, Louis T. Wells, Jr described Political and regulatory risks as a key impediment to private investment in the infrastructure sectors of developing and transition economies; and are defined as" threats to the profitability of a project that derive from some sort of governmental action or inaction rather than from changes in economic conditions in the marketplace: in each case, action or inaction by political authorities or their agents, rather than changes in supply and demand of goods and services, must be the proximate cause of the change in profitability"(Moran H Theodore ,1999). Planning and political risk occurs due to the long gestation periods of infrastructure projects. During these long periods, projects are vulnerable to changes in policy (Vickerman, 2002).
Despite the appeal of project finance, the extensive amount of political risk associated with it is very high. For this report, political risk is going to be mentioned and analysed most as the main risk to the project developer.
Political risk:
Generally, the main known political risks are the following:
-Expropriation:
The act of taking something from its owner for public use. There are many instances in the former eastern Europe and especially in Africa, where governments decide at the break of the day to take something from a private individual for the use and benefit of the public in the name of what they term as "people's power" ," revolution" and so on. This is very upsetting and makes project development a high risk to a project developer.
-Nationalisation:
Transfer of business from private to state ownership. This is not usually experienced in the west as in South America and Africa. Political ideologies in most part of these continents are influenced by one-party state cronies who believe in nationalism than in capitalism. There is the saying that "once bitten, twice shy"; most of these governments are in the developing countries and have the fear that as the west colonised them in the past it could happen again.
-Change of law:
The host government can change the laws overnight and this can affect a project. Sometimes for economic and political reasons, tax laws are enacted which might not be to the advantage of the project developer in terms of the cost increase to certain elements which could increase the purchase price of the product on completion and can jeopardise the PPA.For example an increase in the fuel tax can affect the supply of fuel to the project. Environmental-related issues are also to be blamed for reasons in change of law to please environmentalist pressure group and sometimes for political reasons. Any or all of these could one way or the other affect the project developer in an on-going project or proposed project.
Furthermore, there could be a breach of contract for political reasons.
Thus accordingly, Theodore, (1999) divided the political and regulatory risks that private infrastructure investments and for that matter the project developer are exposed to, into three overlapping categories:
a) Parastatal performance risks: risks of non-compliance with supplier agreements or purchase agreements by the government or government entities leading to political risk. This is to say that government agents or authorities will fail to honour their part of the obligation thereby politicizing the issue.
b) Traditional political risks: risks relating to political uncertainty, lack of Government support, delay in clearances (which primarily have to be taken from government authorities), currency convertibility and transferability, expropriation and breach of investment agreement. This could take any form from delaying permits to failing to sign licenses on time because someone is not happy because no gifts might have "passed under the bridge". There is therefore, the tendency that the project developer will face this exposure, which lenders would not be happy with.
c) Regulatory risks: risks arising from the application and enforcement of regulatory rules, both at the economy-wide and the industry- or project-specific level. They overlap because they affect one or the other politically. Within emerging economies and under developing countries, regulatory bodies are being set up as independent bodies to minimise the political risk faced by the investors. However, in many instances, these so called independent bodies may come under tremendous pressures from their governments and tend to get influenced. For instance, a regulator, for political reasons, may make decisions relating to tariffs that render a project unattractive to investors, sometimes with the view to transfer the deal to a family friend or a political crony. This is a very common practice in Ghana.
Furthermore, infrastructure projects are subject to continuous interface with various other regulatory authorities that expose them to possible regulatory actions thus affecting their profitability. It is conceivable that explicit tariff formulae ensuring remunerative pricing at the start of the project can be negated subsequently by regulatory authorities on the grounds that tariff was too high. This issue is also very common in Ghana where the term "big elephant" has become synonymous with projects that have been abandoned over the years due to the above political reasons.
Nonetheless, the following risks can be argued to have their roots in one political activity or the other.
Legal risks
Following change of law in political risk discussed above, possible legal risks to a project developer include inadequate legal, legislative, and regulatory framework on sales tax, export & import restrictions, pensions, health and safety rules and penalties for non-compliance. Sometimes the case and administrative laws in the country concerned are not developed. These issues are of great concern to lenders and for that matter the project developer will have to deal with this risk.
Construction & completion risk
Another key risk is construction and completion risk. In the event when construction of the project is delayed for any reason whatsoever, the completion date might be affected.Levnders, therefore, focus upo
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