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New Zealand Engineering 1999 March Law Project Finance Can Increase Engineering Risk Changing roles Project financing structures, used throughout the world for the financing of major infrastructure projects, place added pressure on professional engineers. Generally, engineers may find that they are pressured into accepting risks under relevant project documents that they would not otherwise be expected to accept, at least to the same degree. In the modern competitive environment for the supply of engineering services, these pressures may be significant. Over the past decade, project financing has been particularly prevalent in regions with a high demand for infrastructure but limited access to development capital, such as Southeast Asia, Eastern Europe and Latin America. In recent years it has been used in New Zealand to fund the construction of various projects, including power stations and waste water facilities. Project financing transactions are complex and, typically, involve many participants. For this reason their success depends principally on two things: multidisciplinary cooperation between project participants (lenders, project developers, equity participants and project contractors) and the appropriate allocation and sharing of risk among those project participants. Changing Roles Essentially, project financing is the non-recourse or limited recourse financing of a project, for example, the construction and operation of a power station. Lenders rely for security principally on the specific assets of the project, including contracts relating to the construction, operation and maintenance of the project and contracts from which the project generates revenue. The lenders have no or limited recourse to the assets of the developer and other equity participants if there is a default in the repayment of the project loan. In the purest form of project finance, they will look exclusively to the future revenue generated by the project for the repayment of the loan. As with project developers and equity participants, the project finance lenders are directly and financially interested in the timely and proper completion of construction of the project and its operational performance. Under other traditional financing techniques, the lenders will be concerned principally to ensure both that the developer has sufficient revenue to repay its loans as they fall due and sufficient assets to enable the loans to be recovered in the event of any default. Lenders are not as concerned with the success of the developer’s activities, rather they are concerned to mitigate the risk profile of these activities. To some extent, the interests of the lender and the developer will diverge and conflict. However, under project financing the lenders have a vested interest in ensuring the successful completion of the relevant project, so that the project will generate sufficient revenue to repay the loans. Lenders are inherently concerned with the success of the developer’s activities. The incentives of the borrower and the lender are therefore, to some extent, aligned. Project finance, therefore, may be perceived as a mechanism for achieving greater cooperation between lenders and developers in respect of a project. Cooperation by all participants in the project is essential to the success of project financing. Risk allocation Because the lenders are inherently concerned with the success of the project and its ability to generate revenue to repay the loan, they will seek to ensure that their project risk is minimised and allocated to other parties. As a result, the lenders will carefully analyse the project contracts and the parties to those contracts to determine the risk profile. The lenders will also wish to define, to some degree, the content of future contracts and, in some cases, retain a right of final approval for them. The project contracts will generally seek to allocate and spread risk on the basis of specialisation. As a general rule, the participant most capable of controlling a given risk is the participant who should accept that risk. For example, the EPC contractor may be liable to pay liquidated damages for failure to complete construction of a facility within an agreed time frame or failure of the facility to meet contracted operating characteristics. Similarly, the operator of the facility will be penalised should the facility not be operated to meet contracted performance targets. The lenders’ concern to allocate risk to other parties has negative and positive implications for engineers. Engineering pressure Professional engineers play a central and key role in any project financing. This is no surprise given that, essentially, the underlying project is a large-scale, complex engineering enterprise. The professional engineer is instrumental in ensuring the timely and successful completion of the project. The common objectives of lenders and project developers to successfully complete the project and to spread and allocate project risk define the engineer’s role and create pressures for the engineer in a number of ways. The dependence of the lenders and the developers upon the expertise of the professional engineer results in the close supervision by the lenders, developers and their advisers (including other engineers) of the engineer’s activities in order for them to be comfortable that the project will proceed smoothly to completion, on time and within cost, and that the project will meet performance expectations. The lenders will want assurances as to the reliability of the professional engineer, based, for example, on previous performance and experience, and may require evidence of the creditworthiness of the engineer (including the nature of any professional indemnity insurance). The increased reliance by a greater number of parties on the credentials and performance of the professional engineer and the desire to spread risk can result in an expectation that the engineer will assume greater risk than in other projects. The engineer may be expected to bear more risk, in terms of liquidated damages and performance guarantees, than might be the case with projects financed in other ways. These risks may be balanced with performance bonuses, giving incentives to engineers that align with the risks to the developer and the lenders. Risks may also be managed to a degree by the engineer spreading risk to third parties, for example, the manufacturer or the supplier of materials. It is important that the professional engineer, as with any party to a project financing, does not accept risk that cannot be controlled or that is out of balance with the return should that risk not materialise. Project financings that feature such imbalances are inherently risky as they threaten multi-disciplinary cooperation and invite further unacceptable risk taking. On the positive side for professional engineers, project financing tends to utilise more engineering expertise than traditional financing structures. The lenders, project developers, equity participants and contractors may all have their own independent engineers involved in the review and negotiation of contracts in order to better understand and negotiate the proper allocation of risk. As a result, project financing structures often utilise the skills of more engineers than lawyers. For most readers of this article, that is probably justification enough for opting for this form of financing structure! Chris Gordon is a partner in the Wellington
office of law firm, Bell Gully Buddle Weir. |
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