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A project is a method of selecting and modifying of the information and perspectives of those concerned into a set of clearly defined goal, accomplishment criteria and evaluated risks. Project finance is the driver or the key aspect of a project. A wide context exists behind the project finance which includes the concept by which the financing for building of infrastructure and industrial projects has been executed. It includes the sources of fund that are brought by project sponsors as equity, project lenders syndicate of banks who provides loans to the project company. Project finance has been defined by, Vinter as "Financing the development or exploitation of a right, natural resource or other asset where the bulk of financing is not to be provided by any form of share capital and is to be repaid principally out of the revenues provided by the project". In project financing, banks provide finance for a single project or for a particular economic unit and take a large part of the risk in the success or failure of that project. They are the lenders and the project sponsors act as borrowers who also bring equity to the project. A project company is thus formed, a special purpose vehicle (SPV) for the construction of that project under that company, which provides the basis for the whole economic unit that is working for building up the infrastructural project.
According to Willie Tan, "Project finance is a form of financing a capital intensive project (such as an infrastructure project) on non-recourse or limited recourse basis through a special project vehicle (SVP)." The recourse for lenders is largely the revenues generated by the project for loan repayment with project assets as collateral .The limited recourse feature of project financing is more attractive to sponsors because it is off-balance sheet. Due to the risky nature of non-recourse finance, lenders require some form of contingent financial support from sponsors over and above their equity shares and third party guarantee. The government may be called to guarantee repayment and for providing limited contingency support if the borrower is a local public agency in the circumstances if the project is delayed and requires additional funding. In many cases, equity from a sponsor or few sponsors is insufficient because of large investment involved. Hence the equity must be supplemented by funds from other equity investors. On the debt side, lending is often syndicated under a lead bank or arranger to pool the funds and spread the risk among a few lenders.
A country's development is based upon the initiation of major and bigger projects such as power plant project, airport project, oil and gas projects. These are the basis in which the development of a country relies. Such major projects are accomplished by big budget or finance and needs plenty of time duration and resources. Present and future prospective are studied well before launching such major project. Major projects are greatly influenced by the jurisdiction of a country where the project is carried out. These projects should abide a defined legal authority of a government or a legal body. The legal and structural framework for the project finance has developed over time. There are three general sources: project finance legislation and regulations, developed by the host government; standard contractual and financing requirements developed by the private sector, and project finance standards established by multilateral institutions, such as the united nations commission on international trade law.
There are different structures of project finance arrangement according to different values, terms and parties variation. The main governing structure of project finance where the project company, source of finance and jurisdiction of the project are all different is the public private partnership scheme PPP or Public finance initiative (PFI).
Public Private Partnership (PPP)
Figure : figure for Project financing structure of PPP
This structure was developed following the fiscal crisis of 1980 in many countries. Governments sought to tap the large amount of funds, resources and expertise of the private sector.
Working Procedure of the PPP
PPP established a project contract between a public sector authority (government or a national body) and a private party (construction companies, agents). In such contract the private party provides a public service or project and considers substantial financial, technical and operational risk in the project. In this kind of project financing, the public agency or the host government identifies the necessity, duration and deadline, price and output service levels using key performance indicators. During such evaluation and feasibility study a board of consultants or agents may be appointed to help the public sector prepare information and facts for above.
In PPP there has been a provision where the site of the project is provided by the public agency and all the interested private parties are invited to join in the project. In general terms all the private parties are invited to bid for the project. Private parties provide bids with different prices and performance abilities. A Request for Qualification is used to pre-qualify bidders. After certain duration and after the closure of the bidding date all the shortlisted bidders are requested to present their proposed designs and bids based on the guidelines given in the Request for proposal or RFP to provide feedback and seek clarification. This helps the public agency to choose the right design and bid. If successful the private sector participants form an SPV of finance, build, operate and transfer the project after about certain years which is normally between 20 to 30 years only if appropriate.
The exact delivery of a project differs from project to project which depends upon the scale, location of the site and the futures prospectus of the project. The transfer may take effect by having the lease of a site for about 20 to 30 years. In the case of road project, the SPV may be able to cover the cost by imposing agreed tolls. For example the toll charged imposed on M6. There are various cases where the SPV may face deficit. In such cases the public agency may pay an annual fee. Sometimes there are the chances that the builder or the operator of the project. Here the private agency will take into consideration of the facility design and construction to minimize subsequent maintenance and operation cost.
Under PFI or PPP there are now eight new private prisons - with more in the pipeline, and major road schemes like the Thames crossing and the Birmingham relief road are being financed through PFI. The National Health Service (NHS) has probably seen the most new PFI activity recently. Six major PFI projects have been completed within the NHS, with a further 17 hospitals and other facilities under construction and a further 45 in the pipeline. It has been estimated that trade in public services could ultimately net the private sector an extra £30bn a year. However there are some drawbacks of PPP. According to a survey conducted for by Labour Research Department for the GMB union, the 'rent' for PFI projects in the health service alone will top £13bn. The union says profits for the companies involved will total between £1.5bn and £3.4bn over the next 30 years, about £5 a year for every tax payer in the country.
Parties within PPP
The government's objective should be on public interest when it allows the private sector to develop a project (whether or not in conjunction with it). The government will have concerns and motives to satisfy national interest making sure the project is completed to its specification on time. It also has the responsibility of bringing back the project into its ownership after the project has been completed by the private sector sponsor under the public-private partnership. Typically a joint venture consortium has been made in which there are private sponsor who facilitate the certain project. Under the BOT (build operate transfer) project finance model, concession is granted to the concession holder who is required to build the relevant project facilities or piece of infrastructure, operate them for a fixed period and at the end of such period transfer them back to the person who originally granted the concession. Therefore these types of project have definite life and form a part of the skill when the projects are put out to tender together with a financing package. This system insures that the lenders get repaid and the shareholders get a sufficient return on their investment before the concession terminates.
The other concern is to have adequate safeguards and assurances that the project will be operated properly and in the public interest to reduce or eliminate the need to use the government's own funds or borrowings. Although in certain type of projects government provide subsidy in order to make the project viable to limit undertakings given by the state but in certain type of projects it is essential e.g. to construct roads to a new airport. Another aspect of government is to transfer the ownership of the project to the other private sector entities if the original private sector sponsor failed to provide required level of service or run into financial difficulties. This step can also be taken to regain the control of the project into public ownership if the private sponsors completely failed or run into financial problems or difficulties.
The Private Sector Sponsors
These are the parties who sponsor the project where their role is to make the project viable to earn profits out of it by completing it on time. It is not generally the case that the project gets completed without having any risk in it. Project sponsors have to make a strategic approach to share the risk during the construction of the project and the burden of risk is distributed among the banks funding the project, the contractors, suppliers, off-taker, and host government. To carry out a project "off balance sheet", typically it refers to separate legal entities (separate companies of which parent holds less than 100% ownership) those entities were created to carry out project without having showing any borrowings from the lenders and financers of the parent company and the debts of the project.
Those private entities were mainly subsidiaries of the big company. It is most favourable to form a subsidiary or a special purpose vehicle by sponsor to carry out project. Because, it is easy to raise funds in the capital market for those subsidiaries as the investors were looking to invest in those particular type of subsidiary. But these off balance sheet financing could become a nightmare for the shareholders and lenders. As those, subsidiaries were made for earning wrongly not for the definite purpose of doing business. Because of that off balance sheet financing method those debt generally can't be seen on the accounts of those subsidiary companies and the parent company keep going on increasing funds from the capital market and the shares price is increasing. For example Collapse of Enron, which was a very big US established company and because of scandals it felled to ground. Enron established over 2000 subsidiary. And it was also financing many big projects in various countries including Dabhol Power Company based in India which is formed to manage the Dabhol power plant by Enron international in corporation with Bechtel Corporation and General electrical. Due to the political reasons project was failed. But Enron's directors were liable for its collapse and the accounting board who unseen the accounts of the company and the debts which were getting higher and higher, they just wanted to earn big money by wrong way and forged with the trust of shareholders. Ultimately, the result of their fraud and forged ways the company's landed in crash to the ground and making the economy down. Downfall of the Enron resulted in big economic crisis and affected the economies. That's why off balance sheet financing called to be curse for the shareholders and lenders at that time. Due to this it resulted in the big economic problems of that era. It could be said that often "off balance sheet" financing used in wrong way which is unfavourable for the risk bearers: shareholders and lenders, but the off balance sheet is effective and its advantage can still be achieved with a project company which is a true joint venture.
There are various types of lenders in a project. Construction lenders often comprise a syndicate of banks that provides short-term construction and land loans for commercial projects or long term loans for infrastructure projects. International agencies such as the World Bank, International Finance Corporation (IFC), European Investment Bank, and Asian development Bank (ADB) are often construction lenders in infrastructure projects. Permanent lenders are required in commercial property projects to "take-out" the short-term loan from the construction lender. The Permanent lender may comprise institutional investors such as Real Estate Investment Trusts (REITs) and insurance companies. These were the main finance provider in any big infrastructure project and their objective lies behind the risk they were taking in financing a project. As there were various risk involved in project and the bank also averse of that risk but only be able to assume measurable risk or measured risk by allocating various project risk analyst, bank provide loans to the project and taking a greater part in the risk of the project construction and its completion that's why bank should have its own objectives including earning profits from the project. As the bank is the main participant in project financing so it wanted to have control over the decisions of the project because they are funding greater part of project's cost.
Now from the discussion above we have come across various aspects of project financing including its meaning, First step in project financing, objectives of various project relating parties including Government, Sponsors and Lenders. Those were the parties which serve as the basis of project finance structuring. There were different type of structure used for main infrastructural projects including power projects and airport project. In this piece of work by discussing various elements that were originally used in financing power projects with the contrast of studying power project of Enron International, in India. The elements structuring, financing, risk segmentation, jurisdiction, contracts and causes of its failure have to be discussed and then bring about some conclusion.
Almost every country of the world respects the right of the private parties to bind them in a written contract. But different countries have different rules governing the contract formation, enforcement, and interpretation. The first question that must be answered: what law will govern the contract? In many contracts, a choice of New York or English law is preferable to the parties because both jurisdictions have well developed commercial law. In some countries, laws prohibit selection of any governing law other than the local law. These are typically justified on public policy or nationalistic grounds.
There are various main contracts involved in the project which are design contracts, construction contracts, and maintenance contract.
Contractors and consultants are involved in the engineering (design), procurement, and construction (EPC) of the facility. They include the main contractor, subcontractor, designers (engineers, architects, interior designer, and other specialists), project managers, cost engineers or quantity surveyors, and other professionals.
The engineering contract provides a project company with professional assistance in project design, bidding and review and administration of the work. Specifically it provides for the preparation of preliminary and general project design; preparation of specification; preparation of initial cost estimates; preparation, solicitation, and analysis of bids for work and supplies; preparation of detailed drawings for bidding purposes; review of detailed drawings produced by suppliers; scheduling of work; inspection and testing; and during the construction phase, administration of the construction contract for the project company.
It is not often used in a project financing. This is primarily because all project construction work, including engineering work, is included in a broad, turnkey construction contract in which the contractor is a single point of responsibility for all construction phases. The construction contract is between the project company and the contractor and sub contractor. Project managers are concerned with meeting the triple constraints of time, cost and quality. In trying to meet these objectives, they constantly have to coordinate and negotiate with other professionals over design, construction and quality issues.
The procurement contract provides for the orderly procurement of work and supplies for a project. The contract includes provisions that require the architect/engineer to establish bidding procedures for machinery, equipment, material, and supplies; to perform an economic analysis of the bids; to coordinate export licenses and other governmental authorizations necessary for the export and import of materials, supplies, machinery, and equipment to the project site; schedule and monitor delivery dates; make transportation arrangements for delivery of materials, supplies, machinery, and equipment to the project site; and coordinate financial matters, such as scheduling cash needs, reviewing invoices, and administration of accounting records. A separate procurement contract is not used often in project financing, for the same reasons that a separate engineering contract is not used. That is, all procurement work is included under the scope of turnkey construction contract, and funds are typically not available for procurement work until a financial closing occurs.
The construction contract is the contract that governs the complete construction of the project. As such, the contractor agrees in the construction contract to provide all construction related services, including construction supervision, labour and management, construction facilities, tools and supplies, site investigation, and field engineering. The construction contract between the project company and the contractor is the basis to provide a complete construction work on the prices which were mutually agreed for the delivery of the project within required deadline. Contractors want to be paid on time so that the credit chain to suppliers, workers, sub-contractors, and other bills is not broken. But there is a risk whether the work completes on time or not and even the contractor is uncertain about the future complexities that would arise in delaying the project. For avoiding such consequences project company gives attractive pricing options for bearing the risk by the contractor because risk can only be analysed by contractor. For this the amount of contract must be good enough to satisfy the contractor so that risk premium would be acceptable. Project Company can avoid the risk of an increased cost in construction work by providing this premium. By giving reward to the contractor the project company achieves the profitability in the construction work of the project and project would be completed on time. This is called structured project financing in which the project sponsor avoids certain risks in advance and save the risk premium paid by the lenders to various other contracting parties in the situations if the project is delayed.
The (engineering, procurement, and construction) contract combines the three stages of construction under one contract. It is sometimes called a fast track contract, in that it enables progress on a project to proceed on an overlapping basis, at a faster pace than if the three stages followed in series.
Consultant quantity surveyors or cost engineers fear mispricing from incorrect measurements, omissions, or using incorrect unit rates amid aggressive tender deadlines. For the responsibilities and effort in measuring to such detail, they wish fees could be higher as well as the architects of the project.
Engineers are more concerned with the civil, structural, mechanical, and electrical aspects of the facility. Professional liability, safety and being paid on time feature highly.
Sub contractors share the contractors concern over cash flow. They are often treated as if they are at the end of the value chain. If the project falters financially, they tend to be unhappy casualties. If contractors are not paid, sub contractors can expect to be squeezed.
The operation and maintenance contract between the SPV and the facility operator specifies the responsibilities of the operator (including staffing), takeover procedures from the contractor, the period of operation, the maintenance and repairs required, and fees. The operator is required to secure the necessary permits to operate the plant. Maintenance contract is mainly between the operator of the project who maintain it after its completion, and the final user of the facility that is government. These projects are called BOT projects (built, operate and transfer). The operator operates and maintains the facility after it has been built. In build-operate-transfer projects, the operator will transfer the facility to the owner after the operation contract expires.
There are variations such as the build operate-maintain-transfer-arrangement where the maintenance is the responsibility of sponsors and the build own operate structure where the facility is not transferred to the host government.
Project Financing for Power Projects
Enron was the biggest U.S. based company which has different financing activities in all the parts of the world as it was bigger equity investor of the mid nineties and the company going on expanding. It facilitates financing of projects in different parts of the world. It facilitates the power project in India in the year 1995, Maharashtra. By establishing Dabhol Power Company which is a subsidiary of Enron international for the generation of electricity and the purchaser of that electricity is Maharashtra state electricity board. With the combined effort of General electric company which provided the generating turbines and Bechtel Corporation which constructed physical plant, U.S. based companies. Here, above is the project financing structure for the power project and in contrast with the Dabhol power company it has to be understood. In that structure it could easily be seen that the Concessionaire consortium is formed which is financed through the sponsors who provide equity into the project company which is provided by the Enron international. As the domestic capital market was weak, that's why this subsidiary DPC is an unlimited liability Special purpose company (SPC) to domicile the project. Enron development corp. Bechtel enterprises Inc and GE capital which has signed a long term power purchase agreement (PPA) with the MSEB, a state owned enterprise. So it could be seen that Dabhol Power Company is an independent power producer or subsidiary of Enron international. And the off take purchaser of the electricity is (MSEB) which is state owned enterprise. It could be seen that the source of finance is from the equity investors of Enron international who were equity investors along with GE and Bechtel and in a company called Dabhol Power Company in Maharashtra state of India. These three group controlled DPC through chain of companies based in Mauritius in which 80 % of shares held by Enron whereas Bechtel and GE held 10% of shares in company DPC. DPC & MSEB who has a power purchase agreement (PPA). The PPA defines respective roles and obligations of DPC and MSEB under the tariff structure. The project has to be completed in two phase, phase 1 was ready by 1999 at a total cost of USD1.1 billion.
Lenders to DPC
Sources of funds available to the DPC include Bank Lending, Institutional Lenders, Export Credit agencies, International agencies. Lenders to DPC include foreign lenders- ABN AMRO, Standard Chartered, BNP Paribas, Calyon, CSFB, etc. This has approximate stake of USD 325 million. It also include domestic lenders- the largest being IDBI, ICICI, SBI, Canara Bank and IFCI, this has approximate of Rs. 62 billion.
There were Export credit agencies JBIC, US EXIM, Belgium OND with approximate stake of USD 480 million. Multinational export credit financing has become increasingly common but requires considerable coordination and extensive discussions with the various agencies involved. The type of credit can be supplier, buyer, or a specific credit with governmental participation. In some countries, e.g., the U.K. export credit involve, financing by banks with insurance provided by the export credit agency. In other, e.g. U.S. (Eximbank) and Australia (EFIC) Japan Exim this is either supplemented or substituted by direct lending by the export credit agency involved. As in the case of DPC this is involved.
Sources of funds also from the investment company called overseas private investment company (OPIC), USA which has approximate stake of USD 250 million.
The Contractual Framework for DPC
The contractual framework consist of power purchase agreement, EPC contract, O&M contract, Gas supply agreement, Government Guarantees, Loan agreements.
Power purchase agreement
The salient features of this agreement which is signed between DPC (Dabhol Power Company) and MSEB (Maharashtra state electricity board) are that DPC has the responsibility of designing, construction, maintenance of the power plant. DPC has construction contracts for the construction of the power plant and the designing of the construction work as well as the turnkey contracts with the contractor, in which risk is determined previously by the contractor in exchange of rewards by the company. For the supply of fuel to the power plant DPC entered into fuel supply contract with the supplier in consultation with the MSEB. The land for the construction of the power station, power to the plant, communication, water and the roads on the construction site were to be provided by MSEB and Government of Maharashtra (GOM). Transmission lines were to be build by the MSEB from the power station to MSEB grid. Power plant was to be available for the production of commercial power within 33 months otherwise if the project is delayed then DPC has to pay 14000 U.S. dollar per day to MSEB as penalties. As MSEB had to build the transmission lines, if it failed to do so then also there was an obligation to pay the decided payments of the generated electricity to the power company. Often the electricity could not be transmitted in the lines. And under those circumstances the construction cost will increased, for recovering the increased cost in construction delay the power tariff had to be adjusted.
The EPC (Engineering, procurement, and construction contract) contract combines the three stages of construction under one contract. That contract enables progress on a project to proceed on an overlapping basis, at a faster pace than if the three stages followed in series. There is an EPC contract between the DPC and the consortium of Bechtel and GE. According to this EPC contract the DPC and the consortium had to complete the project on time and deliver the project within definite period.
The operation and maintenance contract the Dabhol power company and the consortium of Bechtel and GE, was with the Alstom power company which acted as the facility operator then, who specifies the responsibilities of the operator (including staffing), takeover procedures from the contractor, the period of operation, the maintenance and repairs required, and fees.
Gas Supply Agreement
It was also an important contract between the Oman gas company and the Dabhol power company for the supply of Gas to the plant.
It may be called as sovereign guarantee which has required where the purchaser of the project output is a state agency. As in case of DPC, MSEB was government's agency that' why Government of Maharashtra has guaranteed duty of MSEB under the Power purchase agreement with the DPC, which has to be completed in two phase, that's why GOM has guaranteed for both the phases. Or in that case of DPC the Government of India has counter guaranteed, the Government of Maharashtra guarantee, for the first phase of construction period or completion. Because of the involvement of the international lending agencies the World Bank requires the counter guarantees from the sovereign to guarantee the state agency.
Loan agreement was between various lending parties including overseas and domestic lenders with the DPC including export credit agencies which also provided funds to the project.
PPP (Public Private Partnership) is the type of structure used in project financing for facilitating the building of infrastructure in a country. In which the project company is the sole creation of private sponsors as equity investors, sources of finance allocated by various financial lenders and off shore jurisdictionn applied to that project company. In the case of power financing structure where the source of finance is from foreign equity investor and the lending structure is too international lenders and the financing of the project by making a special purpose entity in different country, but operation of that entity is from the foreign country. So, that the jurisdiction also lies in the country where the entity is incorporated. Another thing is that it has shown that long term power purchase agreements could break down because of uncertainties over the short term and long term pricing of electricity.
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