Principles of Project Finance

tion inevitably becomes weaker than it was when the Host Government first

wanted to attract the investment.

So just as a project has to be commercially viable (cf. §8.4), it must also be

politically viable. The fundamental issue is whether the project is beneficial to

the country; if it is not beneficial, e.g., because the cost of its product or service is

out of line with local costs, investors and lenders cannot just rely on Project Con-

tracts and ignore this political aspect. And a high rate of return, which is meant to

compensate for risk, may paradoxically increase the risk if it becomes politically

unacceptable.

The project also has to be set up in a way that leaves the Host Government in a

position to make future changes in the market in which it operates. For example,

if the state-owned power distributor is to sign a long term PPA, the Host Govern-

ment will have to consider whether this contract could be an impediment to a

future privatization of the electricity industry, and if so how it can be structured

to leave future flexibility in this respect.

More specifically, the Project Company may be subject to political risks relat-

ing to the project’s presence in a particular country and its relationship with the

Host Government, rather than to the commercial and financial risk aspects of the

project covered in Chapter 8 and Chapter 9. These risks are discussed in detail in

this chapter.

§10.2 CLASSIFICATION OF POLITICAL RISK

Political risks fall into three main categories:

Investment risks. The standard “investment” risks are:

• currency convertibility and transfer (cf. §10.3)

• expropriation of the project by the state (cf. §10.4)

• political violence (i.e., war and civil disturbance—also known as political

force majeure) (cf. §10.5)

Investors and lenders into the country where the project is situated (the

Host Country) are likely to be concerned about these issues if the project is

located in a developing country that is politically unstable or has a lower

credit rating.

These risks may be passed on by the Project Company to the Host Gov-

ernment under a Project Agreement or Government Support Agreement, by

requiring the Offtaker or Contracting Authority (guaranteed by the Host

Government) or the Host Government itself to compensate the Project Com-

pany for losses caused by them. However when the time comes the Host

Government may simply be unwilling or unable to fulfill this obligation, and

some form of political risk coverage (cf. Chapter 11) may be required.

204 Chapter 10 Political Risks