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3.4.2. Risk control in project financing
Risk control includes the process concerned with identifying, analyzing, and responding to project risk. The risk management process follows the major processes identification, quantification, response development and response control47.
Major risk associated to industrial projects has already been identified earlier (chapter 4.7) and a qualified quantification can be done quickly when applying the only criteria that matter for the economic success of the investment. These are the risk dimensions business failure, volatility (liquidity) and strategy (profitability).
Possible response to the individual risk can be avoidance, reduction, transfer or compensation48. In order of priority the risk can now be analyzed and appropriate measures incorporated.
| Risk | Possible measure |
|---|---|
| Political/ Country risk | Export credit insurance, Involvement of local parties and government |
| Force majeure | Insurance |
| Legal risk | Legal opinions, consultancy |
| Financial risk | Sponsor’s guarantees (cash deficiency agreements), hedging of currency, debt service buffer, worst case scenario for economic evaluation, due diligence |
| Project development risk | None, remaining risk of sponsor |
| Completion risk | Completion and performance guarantee by general contractor; experience of general contractor, |
| Technology risk | Application of proven and established technology; reputation of technology provider |
| Operating risk | Operating contract with reputable operation company; Training and availability of qualified personnel |
| Supply risk | Long term supply contract (deliver or pay), creditworthy supplier, supply production facilities completion guarantee |
| Off take risk | Long term off take contract (take or pay), market risk remains with off-taker, creditworthy off-taker |
Table 10: Measures to control risk in project finance49
The downside risk contemplates the highest value at risk in the end of the investment phase and is present as long as production has not yet started. This value at risk can be reduced through a completion guarantee from a creditworthy general contractor against penalty or liquidated damages. The performance of the production facilities may be guaranteed by the technology provider by the same means50.
Volatility risk can be answered through the built up of a minimum cash reserve to reduce the probability of illiquidity. Especially lenders require a minimum for the so called debt service cover ratio51 to reduce the possibility of default. The consideration of a worst case scenario for the project’s cash flow, hedging or long term contracts for feedstock and product prices are also often applied52.
Strategic risk is mostly concerned with the profitability of the project. Competiveness in cost of production (and to market) and the customer value of the produced goods are key factors.
Side note
Side Note 2; Principal Agent risk
One characteristic of project finance is that usually no party would be able to realize the project itself. It participates in the project financing scheme and enters into multiple contracts in the trust that all the other contractual partners have the same intention and target and will indeed be capable to comply with guarantees promised. Controlling the activities of the other party is not an option as it is a further characteristic of project finance that the party which is believed to be best suited for a to be responsible for. In summary these issues can be summarized into
| Risk | Possible measure |
|---|---|
| asymmetric information | transparency in acting and reporting;
screening (principal) and signalling (agent) monitoring and reporting |
| differing intentions | harmonizing/ aligning targets
transparency, bonus programs, commitment |
| unfair action in case contracts lack definition or possible to interpret | trust screening/ signalling |
Side noteSide Note 3; the product off-taker is compensated for market risk
Risk that can not be avoided, reduced or transferred is then assigned to the party which is most capable to control it and this party is now entitled to be compensated for taking this risk.53. The product off-taker that agreed to a take or pay contract is taking the market risk but in turn is rewarded through the margin between the take-or-pay price and the product market price.
47 PMI Guide to Project Management, p 111
48 Following PMI Guide to Project Management, p 119
49 Böttcher, Blattner p 138, 139; Finnerty p 89ff
50 The value at risk until project start up can not be transferred in total because penalties or liquidated damages against the suppliers are almost always capped to a percentage of suppliers scope and not applicable to consequential damages as possible additional cost for financing in case of delay
51 Shareholders are prefer a low DSCR as this reduces the return on equity
52 Böttcher, Blattner p 138, Finnerty p 89ff, Reuter 68ff
53 Böttcher, Blattner, Finnerty, Reuter, Nevitt/ Fabozzi