Managing Risk in Financing Big Infrastructure Projects
Originally published: 17/07/2019 15:17
Last version published: 17/09/2019 07:03
Publication number: ELQ-44949-3
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Managing Risk in Financing Big Infrastructure Projects

A Classic Real Life case on Project Financing (The Tricks of the Trade) No matter what you do, you may still get stuck!!

Let’s see how project finance was used to construct a large new oil-fired power plant in Pakistan. First, a separate firm, the Hub Power Company (Hubco) was established to own the power station. Hubco then engaged a consortium headed by the Japanese Company, Mitsui & Co. to build the power station, while the British company, National Power became responsible for managing and running it. Hubco agreed to buy the fuel from Pakistan State Oil Corporation and also agreed to sell the output of the power station to another government body namely, the Water and Power Development Authority (WAPDA)

Hubco’s lawyers drew up a complex series of contracts to make sure that each of these parties is made accountable in a proper manner. In other words, the contracts were developed in a structured manner so as to ensure that all parties involved in the deal would shoulder an appropriate quantum of risk involved in this capital project. For example, the contractors (i.e. the Japanese firm) guaranteed to deliver the plant on time and ensured that the same would operate as per specifications. The British firm or the plant manager agreed to maintain the plant and operate it efficiently. Pakistan State Oil Corporation entered into a long-term contract with Hubco to supply oil to Hubco and WAPDA agreed to buy Hubco’s output for the next 30 years. In fact, WAPDA entered into a take-or-pay agreement with Hubco meaning that if it did not take the electricity generated by Hubco it still had to pay for it.

Now, since WAPDA would pay for the electricity with rupees, Hubco was concerned about the possibility of a fall in the value of Pakistani rupee. The State Bank of Pakistan, therefore, arranged to provide Hubco with foreign exchange at guaranteed exchange rates.

It may once again be noted that the effect of these contracts was to ensure that each risk was borne by the party that was best able to measure and control it. For example, the Japanese firm was best placed to ensure that the plant was completed in time, so it made sense to ask them to bear the risk of construction delays. Similarly, the British firm or the plant operator was best placed to operate the plant efficiently and would be penalized if it failed to do so. The contractor (Japanese Firm) and the plant manager (British Firm) were prepared to take on these risks because the project involved an established technology and hence there was relatively little chance of unpleasant surprises. While these contracts sought to be as specific as possible about each party’s responsibilities, they could not cover every eventuality. Hence, both the Japanese and British firm became major shareholders in Hubco as well. This meant that if they cut corners in building and running the plant, they would share in the losses of the project as well.

The project finance in Hubco was highly levered. Over 75% of the $1.8 billion investment in the project was financed through debt. A certain portion of this was debt was provided by a fund that was set up by the World Bank and western and Japanese aid agencies. However, the bulk of the debt was provided by a group of major international banks. These banks were encouraged to invest because they knew that the World Bank and several Governments (of a number of countries) were in the frontline and would take a hit if the project were to fail. But they were still concerned that the Government of Pakistan might prevent Hubco from paying out in foreign currency or it might impose a special tax or might even prevent Hubco from bringing in the specialist staff from foreign lands that it might require. Therefore, in order to protect Hubco against these political risks, the Government of Pakistan promised to pay compensation if it interfered in such ways with the operation of the project. This was supposed to keep the Pakistan Government honest once the plant was built and operating. Governments of developing countries (like Pakistan in this case) can be surprisingly relaxed in the face of the wrath of a private corporation but are usually reluctant to break an agreement that lands the World Bank into difficulties.
It is now evident that the arrangements for the Hubco project were complex, costly and time-consuming. In spite of such efforts, not everything was plain sailing. The First Gulf War suspended the project for over a year and it looked at one time as if it would be shelved.

However, the final reality was quite encouraging in the sense that ten years after the start of discussions, the final agreement on the project was signed and within a short period of time Hubco was producing a fifth of all Pakistan’s electricity.
However, that was not the end of the Hubco story. After the fall of Benazir Bhutto’s government in Pakistan, the new government terminated the contract with Hubco and announced a 30% cut in electricity tariffs. This inevitably led to a dispute with the World Bank, which spelled out that, until the dispute could be resolved, nothing would move in the form of new loans.

So, from HUBCO example we came to know that RISK CAN BE MITIGATE BUT CAN’T BE ELIMINATE

Evaluation Methodology (Financiers Point of View).

From the viewpoint of the financier, a project to be eligible for financial assistance should essentially have the following features.

a) Managerial Competence
b) Technical Competence
c) Commercial Viability
d) Economic Justification
e) Financial Soundness

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Further information

To evaluate the risk for projects

Revenues or Cost Savings Related to Project
Profits earned on Project
Cash Flows earned on Project
Operating Cash Flows for one-off projects
Free Cash Flows for projects requiring re-investment/continuity

Depends on the nature of project

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