Project Finance: Practical Case Studies

• revenue risk mitigation, including coverage against commodity pricing risk, revenue
  guarantees for toll road projects and coverage against default of offtakers;


• substitutes for liquidity mechanisms, such as fully funded debt-service reserves and
  standby letters of credit; and


• political risk coverage.

Contingent capital is a form of targeted risk coverage that can reduce a project’s cost of

financing. The insurer provides a facility under which capital is injected into the project in the

form of debt, equity or hybrid securities upon the occurrence of a predefined trigger event or

set of events. In this way contingent capital allows the project to increase its capital base only

when necessary, thereby increasing its return on invested capital.^5

Recent crises in Asia, Latin America and Eastern Europe have reminded lenders and

investors that political/economic events do not merely have the potential to cause losses, but

actually cause them, according to Gerald T. West, Senior Advisor at the Multilateral

Investment Guarantee Agency in Washington, DC.^6 These events have stimulated the

demand for political risk insurance, leading to expanded coverage and new products from

multilateral agencies, national agencies and private insurance providers. In recent years pri-

vate insurers have lengthened the terms of their coverage and increased their share of the

political risk insurance market. Recent innovations include capital markets political risk

insurance, which can be used to raise the credit ratings of bonds that finance projects in

emerging markets.

Increasing and then decreasing risk tolerance

Until 1997, there were trends of lengthening maturities, thinning prices (which was

reflected in spreads over benchmark funding indices), loosening covenants, extending

project finance to new industries and geographical regions, and a willingness on the part

of lenders and investors to assume new risks. This was partly a result of more institution-

al investors becoming interested, and developing expertise, in project finance. These

trends reversed as a result of the worldwide ripples caused by the Asian financial crisis

starting in 1997, the Russian default in 1998 and the Brazilian devaluation in 1999. Banks

became less willing to commit themselves to emerging-market credits, and spreads on

emerging-market bonds widened. To be financed, projects required increasing support

from sponsors, multilateral agencies, export credit agencies (ECAs) and insurance com-

panies. Since the Enron debacle, investors and lenders have reduced their tolerance for

risk related to power companies with trading activities, overseas operations and difficult-

to-understand financial statements.

Commodity price volatility

Prices below long-term forecast levels sometimes place commodity-based projects such as

mines, petrochemical plants and oilfields ‘under water’ in terms of profitability. With

deregulation and merchant power, the ‘spark spread’, the difference between a power

plant’s input (fuel) costs and output (electricity) prices, may at times not be sufficient for

profitability.

INTRODUCTION

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