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Risk and Risk Allocation

Professor Bob Dewing discusses project finance and provides an overview of Global Project Finance. The roles of stakeholders in project finance is reviewed in depth.

The final course of the specialization expands the knowledge of a construction project manager to include an understanding of economics and the mathematics of money, an essential component of every construction project. Topics covered include the time value of money, the definition and calculation of the types of interest rates, and the importance of Cash Flow Diagrams.

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Financial Modeling, Project, Finance, Real Estate

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Ibrahim Odeh, Ph.D., MBA
Instructor, Department of Civil Engineering and Engineering Mechanics, Columbia University

腳本

So before we can put a project together, we have

to understand the risks of the project and how we're going to allocate those risks.

This is very important.

Long before you put the financing in place, you have to understand

what the project risks are, and how these are going to be allocated.

We can not start thinking about cash flows until we've understood what the risks are,

and how we are going to manage those risks.

So looking at these risks become really part of the due

diligence process and project finances while

looking on the optimistic side here, if the equity sponsors, generally

look more in the case of the adverse consequences of many of these risks.

So that's from this course and how we are going to about it today,

is really looking at the adverse consequences of some of these risks and

not really the opportunities.

These risks are broken down into three different categories.

There's the commercial risks, there's the macroeconomic risks,

and there's the political risks.

So in the commercial risks, the very first risk is really the overall viability.

These commercial risks are all project related and very much project specific.

Is the Project Economic, is there a basis for this project?

If there is an economic basis, you can't have a stand alone entity.

[INAUDIBLE] expecting to have cash flows that are sufficient to meet his

obligations if the project in its initial stage isn't economic?

So just a basic economic test, is it economically viable?

Is there a market for whatever this project is meant to be doing?

You need to analyze and part of the due diligence.

Is there a general economic necessity for

this project and is there a market for these project?

What's the competition?

Is this project really an individual project or is it competing

with other projects or other corporate entities that have similar aspirations?

So what is a competition and

how are the competitors going to react to another project in the market?

What's it likely to do and the influence it's going to have in the market?

Projects are long term.

Sometime decades.

Is there a possibility of a paradigm change?

Probably not a paradigm change if you're a project financing a road.

But undoubtedly there's a possibility of a paradigm change if you

are financing the telecom business.

The assets that may look very sensible today, in three or

five years time may actually be totally unwanted and

may not have any cash flow at all and maybe so lessened.

So looking to see whether there's paradigm change possible in the market

is very important.

Is whatever the project producing affordable?

There are many places that people would like to build power plants,

but the local energy cost, energy price is so

low that new project development finds it very difficult to be

able to justify putting those sorts of assets into the market.

Is there a possibility of that project going ahead?

Well, yes there is, but it has to have different

structural consequences to the capital cost or the operating cost.

If the local expected off takers

of market can't afford the output.

Other unrealistic contracts, does the whole project rely

on something that is an unrealistic contract?

Does the project rely on an offtake or a supply that is totally not market-driven?

That is off market.

And if it is off market then Is that a realistic long term project or not?

There are some long term contracts that are off market and they were entered into,

clearly recognizing they were off market, and all the parties entered into that,

on a good phase basis in knowing that was a case.

But on the other times, there are sometimes contracts that designed that

are off market, or likely to be off market,

where all parties are not fully recognized of that situation.

And if a contract is truly off market, it's probably not good for

a long-term project financing.

So looking at some of these commercial risks too.

Next is the biggest risk and is also the biggest cause of loss or

failure in projects and that is completion risk.

Project financing is all about cash flow.

And if you have a project that is not complete and it's not built and operating.

It's not complete, it doesn't have any cash flow.

Cash flow lending is all about what project finance is.

You don't have any cash flow and you have a project that has breached

a third tenant of project financing which is principal risk.

The project is likely to cause a principal loss to investors and finances.

So, completion risk is the biggest risk.

How do we manage completion risk?

And well what is completion risk and how do you manage it?

Well first of all: completion risk is the risk that is not finished but

that is composed of two components.

It is composed of an economic component and a physical component.

First of all whatever is being built, needs to be physically complete, but

it also needs to be economically complete, and that is measured by cash flow.

So, a good completion, a completion agreement, and a completion test,

is going to be that it meets both the physical and the economic components here.

But what are the issues in completion risk?

First of all, you need a site.

Do you have the site?

Do you have the permits to operate on that site?

There are cases of projects that have reached physical completion, but

don't ever receive the permits to be actually be able to operate and

they set there idle with no cash flow.

Is the contractor who's building the project capable of building the project?

From an operational management point of view and

also from a financial point of view.

Is the EPC contract that goes into the construction

arrangement at the cost likely?

If you've got in EPC contract that is

of what would be considered to be reasonable.

The chances are that something is going to go wrong.

Is the project going to perform?

There's no point in having a project that is physically complete, but

only ever reaches 50 or 75% of its design capacity,

because then there will probably be insufficient cash flow to be able to meet

the obligations due to the finance years, and produce returns to the sponsors.

So, can the project perform?

And what are the third party risks?

It's unlikely that you're going to have a project that doesn't

have multiple contractors or multiple parties in this.

And are those third parties capable of completing the project?

So you could have a project that is 95% complete, and

all of the major engineering and procurement construction

contractors have completed their piece of the project..

But the environmental plant that is cleaning up the waste product,

either doesn't work or isn't complete or

sometimes hasn't even been started because of a third party risk.

And even though the 95% of the project has been complete

because one of the component isn't complete, it doesn't operate.

So, there are big completion issues here.

And project financiers spend as long dealing with completion

risks often as they do on all of the other risks in the project.

And historically it's been the source of the major catastrophes and

losses in project financing.

There's environmental risks.

One shouldn't avoid, one shouldn't overlook rather, pre existing risks.

There may have been pre existing conditions on the site or

within within the industry in the local region.

So, ensuring that those don't influence the project is very important.

We need permits, making sure you comply with the local law.

And then environmental risks are managed

now by a system called Equator Principles in project financing.

And Equator Principles are driven by World Bank standards and

it requires project finances really of any size

to have a project comply with equator principles.

There are essential principles that drawn up by the World Bank that determines

the depth of environmental analysis that needs to be done before

the project receives financing and also the continuing environmental analysis

that needs to be done post project financing and during the operations.

And then there's levels of review that need to be completed to ensure

compliance with both IFC World Bank guidelines,

and local regulations and a full justification

if some of those regulations can't or are not going to be complied with.

But this is a very transparent arrangement and

it allows project financiers to look at the environment consequences and

issues of a project and ensure that both they and the sponsors have covered

most, if not all of the critical issues in a project, and

this arrangement is also acceptable across nearly all of the stakeholders,

because it is so public and transparent.

There are operating issues in project financing.

Clearly things like technology,

is the project going to work as we just talked about in completion risk.

Project maybe built but is it going to work, and is it going to work long term,

not just short term?

Can you build it for what you anticipate and can you operate it for

what you anticipate?

How are you going to maintain it?

Is it going to depreciate?

Is it going to be obsolescent and is it going to degrade over time?

Is the performance going to fall off?

It may perform at 98% in the first five years,

but is it going to be able to perform 98% in the second and third five years?

Or is it going to fall away?

Again in the commercial risks,

what are the economic risks of revenue, volume and price?

Are people going to use the product and what are they going to pay for it?

Are there opportunities to manage those risks, both the volume risk by

having contracts or price risk by having somebody to agree on price.

And if you can't manage those volume and

price risks, what are the expected volatilities in those prices?

And the same thing goes for inputs too, volume and price.

Do you have to have a contract for the inputs, and if so,

how do you ensure that you get the volume or the price?

And if you can't get a contract for them, what's the availability of the inputs, and

what's the expectations for pricing, and is it likely to survive in the long term?

Finally is a couple of other commercial risks here.

There's a force majeure, these are risks that no one can really predict and

how you're going to manage these sorts of risks, [INAUDIBLE] likely,

what happens if there's a hurricane or a storm that causes the plant

to fall down or not fall down, but cease to operate for a period of time.

If there's ground movements and

the project can't operate, if there's other sorts of events, war, strike.

How do you manage those?

Some force majeure risk will be insured, but at the end of the day those risks that

can't be dealt with by outside parties fall back to the sponsors.

And of course if it's through the they will fall back to

the finances at the end of the day.

This is probably a good point just to raise here that one of the reasons that

sponsors and other stakeholders enter into project financing

is they got a contractual obligation to a project.

But they've only got that contractual obligation.

They don't have an ongoing obligation.

They may choose to support the project.

But in the ultimate, they have the walk away option.

And if you are a project financier, especially a bank or

an institutional investor, at the end of the day, if the project is really poor and

is not going to work, the sponsors do have and have paid for

the walk away option, it's not something that project financiers

really want to see because they try and avoid and structure these projects.

So that there isn't a principle risk, but at the end of the day if there is a true

calamity, the sponsors do have a walk away option.

And they don't have a moral obligation to support the project.

And finally on the commercial side,

there's the physical and legal structures of the project.

What does it look like from a composition point of view, a resilience point of view,

liquidity, transparency and enforceability?

So you may have these contracts.

But are they enforceable?

Are they transparent?

Can anybody fully understand the projects and

the contracts, and do they understand how they work?

And can you enforce those contracts if you have to?

Is there a local system for

or another legal system for actually being able to enforce these contracts?

And does the project have enough liquidity built into its structure to be able

to manage the inevitable changes that are going to occur during the project?

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