Different counterparties to the project may be required to provide guarantees that their performance will meet a certain minimum standard. For example, the Engineering, Procurement and Construction contractor may be required to guarantee the date of completion, and the minimum performance levels of the plant. Similarly, the operator may be required to guarantee a certain minimum availability for the plant, or the fuel supplier the calorific value of the fuel.
In assessing guarantees , whether as project or lender, it’s helpful to examine three specific characteristics of the guarantees, being effectiveness, importance and reliance:
Effectiveness:
Is the guarantee effective in covering lost revenues? To do this, compare the rate of accrual of the guarantees per day of delay or per percentage point downside performance with the resulting loss of revenues.
For example, if the delay liquidated damages (LDs) accrue at a rate of USD 0.5m / day, and the project would have generated USD 5.0m on that day had it been operating, then the rate of accrual for the delay LDs is not effective in compensating for the lost revenues.
Similarly, if the project is completed and handed over to the owner underperforming relative to its guaranteed performance level by 2%, the NPV of free cash flows after opex at the guaranteed performance level is USD 1.0 billion (using the WACC as the discount rate, perhaps), and the rate of accrual of performance LDs is USD 25m / percentage point downside performance, then, per percentage point downside performance, the project will lose USD 20m NPV over its lifetime, but will gain USD 25m immediately, and the rate of accrual of the LDs will therefore be effective in replacing the forfeited revenue stream.
To establish effectiveness, one normally needs to refer to the schedules of the construction, operations or supply contract.
In some instances it is not appropriate to use lost revenue as a comparator – for example where liquidated damages are payable for failure to deliver under a small supply contract. More on this near the bottom of this article.
Importance:
Is the cap on liability sufficiently high so as to make the guarantees meaningful?
Simply put, if the cap on delay LDs means that the delay LDs run out after one week, then the delay LDs are not meaningful. Similarly, if the performance guarantee cap is low such that only very little downside performance revenue loss is covered by the contractor, then the performance LDs are not meaningful. Determining a level of meaningful guarantees is best done with the assistance of a technical advisor and the project model, which, in conjunction can tell the owner or lender what sort of underperformance is possible or likely, and the impact thereof.
To establish importance, look for the limitation of liability clause of the construction, operations or supply contract.
Reliance:
Finally, assuming the rate of accrual and the cap on guarantees are suitable (or sufficient), we should ask ourselves whether we are able to place reliance on the guarantor or security. If an on-demand bank guarantee has been provided as security for the guarantees, then we can most likely place significant reliance on the guarantees, at least until the amount of the bond has been exceeded. Thereafter, we may need to look to the credit quality of the contractor, or, if a Parent Company Guarantee has been provided, to the credit quality of the parent. There is a significant difference between an on-demand guarantee and a PCG, even from a very creditworthy parent. In the former case, the project (and vicariously, the lenders) may simply deliver the bank guarantee to the guarantor and demand the funds, whereas in the second instance, litigation or at least negotiation may be required.
Other considerations:
Note that a rate of accrual or a cap sufficient to transfer all risk of delay or underperformance to the contractor may not be available. In such instances, it is desirable, if only as second prize, to ensure that the guarantees are sufficiently robust so as to significantly incentivise the contractor to meet his performance guarantees.
Situations like this arise for contracts which have a small value relative to project revenues, but which would prevent the operation of the project if the services provided are absent. If the services under such a contract can be replicated, the guarantees may be sized to cover the difference in price between the original contract and the (possibly temporary) replacement. Example of such a contract may be a water supply contract, or a limestone supply contract for a coal power station.
However, projects may have vital contracts with no available replacement and a small contract value, for which guarantees provide very little risk mitigation, other than alignment of incentives. An example of such a contract is a pipeline/transport agreement for a gas powered power plant. In such instances, incentivisation may be all that is possible.