Tag: Project Finance Principles

As discussed on the Project Finance Principles page, the Project will attempt to pass as much risk through to the EPC contractor as possible.

This is achieved through the following:

• Fixed price and date-certainty mean that the risk of overruns on price or time are for the EPC contractor’s account
• Any compensation for risks outside of the control of the EPC contractor which the EPC contractor may enjoy will typically be limited to the compensation which the project enjoys from the offtaker. This is typical for, amongst other provisions,  force majeure and change in law
• Any provisions which may lead to termination of the offtake contract, or any of the project’s other contracts, will, to the extent applicable, be mirrored in the EPC contract, often with a slightly more onerous threshold, so that the project can terminate the EPC contractor before the other contract is terminated and attempt to fix the situation. In some situations, the project may acquire the right to reject the plant and demand full repayment of money paid to the EPC contractor
• The EPC contractor will pay liquidated damages at a pre-defined rate per day of late delivery, or per percentage point downside performance, upon failure to meet the guaranteed performance levels of the plant when undertaking the completion tests. These liquidated damages are typically capped, and usually guaranteed by a liquid, on-demand bank performance bond.

The EPC contractor will usually only receive funds as certain construction milestones are reached, and signed off by the Owner’s Engineer. The project may also hold back a retention payment until after the performance tests have been passed adequately.

Projects will typically sign an EPC contract with a single counterparty, which will be tasked with delivering the full project on a fully-wrapped, turn-key, date-certain, fixed price basis. As the name suggests, the EPC contractor will typically design the plant, procure the supplies required to construct the plant, and then complete construction.

By engaging with a single counterparty, the project aims to avoid interface risk, in terms of which it is difficult to assign responsibility for delivery failures to one of several construction counterparties. Although this means that the EPC contractor is fully responsible for delivery of the plant, the EPC contractor may still use subcontractors. However, the EPC contractor ‘wraps’ this risk, by taking responsibility for their performance. There are some exceptions to this rule, where the project may enter into a major supply contract for the technology required to build the plant, and a balance of plant contract for the ancillary services. An example of this sort of split contract construction arrangements is used in wind farms, where turbines are procured in a Turbine supply Agreement, and the balance of the plant (civils, wiring, transformers, erection, etc) in a Balance of Plant Agreement.

The contract will be for a fixed price so that the project will be able to ensure that it is sufficiently funded in order to complete construction without running out of funds. Similarly, date certainty is important, since the project will be incurring interest during the construction period, and may have penalties in the offtake contract if it is unable to start producing output on time.

Offtake contracts (particularly single-offtaker contracts) will typically contain provisions relating to the following:

• Price and price escalation
• Minimum supply obligations and consequences of failing to meet them
• Take or pay provisions (how much the offtaker must pay each period, irrespective of whether he takes the output)
• Pass through provisions for events outside of the project’s control, such as force majeure and change in law
• Consequences of failing to meet obligations for each counterparty, which might include a right for the project to put the project’s assets to the offtaker for certain unremedied offtaker breaches of contract
• Details relating to guarantees by offtaker parents (often in a separate document)

A project may also have a multiple offtaker business model. If this is the case, the project will need to prove to the lenders that sufficient offtakers will materialise. Proving this may take the form of statistical traffic studies (toll roads) or resource assessments (oil and gas / mining) in which the extent of the reserves are ascertained with varying degrees of probability (Proven vs Probable reserves).

Project financiers will typically not take market risk – that is, they will usually require that the project has already signed up sufficient clients to cover the project’s debt repayments, rather than relying on the project’s ability to do so in the future.

An exception to this may be where there is a demonstrably deep and liquid market for the project’s offtake, such as for many mining operations. Project financiers may nonetheless require that the price of the offtake commodity is hedged.

Projects will need to have a revenue stream which is estimable in advance with a high degree of certainty. This means that the project may enter into a long-term offtake agreement with a creditworthy offtaker with fixed price and minimum purchase obligations, sometimes referred to as a ‘take-or-pay’ obligation, in terms of which the offtaker will pay a minimum amount per period, irrespective of whether he chooses to take delivery of the plant output or not. The take-or-pay amount is usually sized to be sufficient to cover the repayment of the capital cost of the project, using the project’s weighted average cost of capital.

The offtaker or its parent may provide guarantees to the project that it will meet its payment (and other) obligations.

Power plants are a good example of single-offtaker projects

The offtaker for a project is the counterparty, or counterparties, which purchase the output of the project.

The creditworthiness and continued existence of the offtaker is of great significance to the project and to project financiers, since the entire cash flow stream of the project is predicated on the offtaker’s continuing ability to make payment. Consequently project financiers will usually undertake a full due diligence on the offtaker.

Projects using project finance will seek to pass as much risk as possible to other project counterparties. These project counterparties will typically include:

• Project offtaker
• Engineering, Procurement and Construction (EPC) contractor
• Operator
• Project suppliers
• Project administrators

Often a project will have no employees, rather laying off work (and risk) to third-party contractors

Because projects are typically technical in nature, project finance lenders rely heavily on advisors. A typical project finance transaction will usually incorporate due diligence from technical advisors, legal advisors, insurance advisors and a model auditor.

Project finance loans are typically made against the future cash flows of the project, rather than against the assets of the project. For this reason, project sponsors and lenders put significant effort into ensuring that the project’s cash flows are well known in advance, and relatively immune to adverse scenarios.

Mechanisms used to ensure this include:

• Pre-agreed offtake contracts with creditworthy counterparties specifying both price and quantum of offtake
• Statistical studies relating to the number of widgets which the project can produce and sell
• Pre-contracted operations contracts with long-term, certain pricing
• Pre-contracted engineering, procurement and construction contracts with pre-agreed pricing
• Passing of downside risk to counterparties – for example through pre-agreed liquidated damages relating to delivery failure
• Comprehensive modelling of the project’s cash flows

Project finance loans are typically non-recourse or partial-recourse. This is effected by setting up a Special Purpose Vehicle (SPV) which will enter into the financing arrangements with the lenders. Certain eventualities may require guarantees from the project sponsors or equity holders – for example they may provide indemnities (guarantees) to the lenders to cover eventualities where certain of their actions lead to the failure of the project.
As a comparator, under a full-recourse loan, the project sponsor guarantees repayment, irrespective of the outcome of the project.