Principles of Project Finance

Thus, the additional financial liability that Sponsors incur may become very

significant in the absence of an EPC Contract.

Furthermore, the definition of “completion” in such cases has to be carefully

considered. It usually involves not just physical completion of the project, but a

demonstrated ability to operate as projected over a sustained period of time.

§8.6 ENVIRONMENTAL RISKS

The environmental aspects of a project may raise various contractual, legal,

and wider political risks. The possibility of preexisting pollution at the site will be

an issue under the EPC Contract (cf. §8.5.4), and the EPC Contractor is of course

required to construct the project to meet environmental standards on emissions,

etc. (cf. §7.1.8).

Even if the Project Company has obtained the necessary Permits to construct

and operate the project, it may still remain at risk from changes in law relating to

environmental aspects of the project (e.g., emissions) that require extra capital ex-

penditure (cf. §10.6).

Most public-sector lenders, such as the World Bank and European Investment

Bank, have their own environmental standards mandated by their members (i.e.,

state shareholders) and may require these to apply to projects even if local law

does not require this. In the worst case this could put the Project Company into de-

fault under the financing if it violates these standards, even though it is not break-

ing the law in the Host Country.

Even if the Project Company is acting within the local law, it may still be at risk

on wider political grounds. Public opposition to the project may cause the gov-

ernment to reconsider its obligations under a Project Agreement or Government

Support Agreement. Similarly, the lenders themselves may find themselves under

attack in their home countries for supporting a project that is perceived to be en-

vironmentally damaging; some lenders apply general environmental requirements

to all their loans.

Sponsors and lenders cannot rely only on keeping within the law of the Host

Country; they need to consider whether any environmental aspects of the project

leave them at risk of opposition to construction or operation of the project indi-

rectly discouraging lenders from getting involved with it. An EIA (cf. §7.4.1) is

an important part of the due diligence that should reduce any lender concerns.

§8.7 OPERATING RISKS

Once the project has been completed and is demonstrated to be operating to

specification, a new risk phase begins, that of long-term operation. Even if the

Project Company has hedged many of its risks through a Project Agreement, some

§8.7 Operating Risks 155

level of operating risk is likely to be left with the Project Company, and therefore

this aspect of the risks is closely reviewed by lenders.

The key operating risks include:

• Technology (cf. §8.7.1)

• General operation of the project (cf. §8.7.2)

• Operating cost overruns (cf. §8.7.3)

• Availability (cf. §8.7.4)

• Maintenance (cf. §8.7.5)

• Performance degradation (cf. §8.7.6)

§8.7.1 T

ECHNOLOGY

New technology. Even if the project passes its performance tests (cf. §7.1.6),

there may still be concern about the long term risks if it involves new

technology.

Lenders are always reluctant to lend against a project that is using new and

untried technology, whose performance cannot be checked against existing

references. The problem is that the new technology risk is unquantifiable and

cannot be covered by performance LDs from the EPC Contractor because

they do not cover a future deterioration in performance. In this context, new

technology has a wide definition: it includes major improvements to existing

technology, for example, a gas turbine for a power plant that is supposed to

deliver significantly greater efficiency than the manufacturer’s current

model. (It is also worth noting that insurance companies charge higher pre-

miums for new technology plants because of the increased uncertainty in

their risks.)

If new technology is being used the operating risk can be mitigated in var-

ious ways:

• The EPC Contractor may give a long-term performance guarantee, rather

than the warranties normally provided, which are limited both in amount

and to a term of 2 –3 years. The problem with this approach, however,

is deciding whether a problem with the plant in several years’ time is

caused by a defect in design or construction (the EPC Contractor’s fault)

or in the way it has been operated (the Project Company’s fault).

• The Sponsors may provide a long-term performance guarantee, perhaps

counterguaranteed by the EPC Contractor or the manufacturer of the plant

In summary, however, project finance is more suitable for established

technologies.

Obsolescence. The converse of this is the risk that the technology used in the

project may become obsolescent and thus uncompetitive in the market in

156 Chapter 8 Commercial Risks