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Economics, Law, and Institutions in Asia Pacific

Takao Higuchi

Natural Resource
and PPP
Infrastructure
Projects and Project
Finance
Business Theories and Taxonomies

123
Economics, Law, and Institutions in Asia Pacific

Series Editor
Makoto Yano (Professor of Economics, Kyoto University, Japan; President
and Chief Research Officer, Research Institute of Economy, Trade and Industry
(RIETI), Japan)

Editorial Board Members


Reiko Aoki (Commissioner, Japan Fair Trade Commission, Japan)
Youngsub Chun (Professor of Economics, Seoul National University, Republic
of Korea)
Avinash K. Dixit (John J. F. Sherrerd ‘52 University Professor of Economics,
Emeritus, Princeton University, United States)
Masahisa Fujita (Fellow, The Japan Academy, Japan)
Takashi Kamihigashi (Director and Professor, Center for Computational Social
Science (CCSS), Kobe University, Japan)
Masahiro Kawai (Project Professor, Graduate School of Public Policy, The
University of Tokyo, Japan)
Chang-fa Lo (Honourable Justice, The Constitutional Court, Taipei, Taiwan)
Mitsuo Matsushita (Professor Emeritus, The University of Tokyo, Japan)
Kazuo Nishimura (Professor, Research Institute for Economics and Business
Administration (RIEB) and Interfaculty Initiative in the Social Sciences (IISS),
Kobe University, Japan; Member, The Japan Academy, Japan)
Akira Okada (Professor of Economics, Institute of Economic Research, Kyoto
University, Japan)
Shiro Yabushita (Professor Emeritus, Waseda University, Japan)
Naoyuki Yoshino (Dean, Asian Development Bank Institute, Japan; Professor
Emeritus, Keio University, Japan)
The Asia Pacific region is expected to steadily enhance its economic and political
presence in the world during the twenty-first century. At the same time, many
serious economic and political issues remain unresolved in the region. To further
academic enquiry and enhance readers’ understanding about this vibrant region, the
present series, Economics, Law, and Institutions in Asia Pacific, aims to present
cutting-edge research on the Asia Pacific region and its relationship with the rest of
the world. For countries in this region to achieve robust economic growth, it is of
foremost importance that they improve the quality of their markets, as history
shows that healthy economic growth cannot be achieved without high-quality
markets. High-quality markets can be established and maintained only under a
well-designed set of rules and laws, without which competition will not flourish.
Based on these principles, this series places a special focus on economic, business,
legal, and institutional issues geared towards the healthy development of Asia
Pacific markets. The series considers book proposals for scientific research, either
theoretical or empirical, that is related to the theme of improving market quality and
has policy implications for the Asia Pacific region. The types of books that will be
considered for publication include research monographs as well as relevant
proceedings. The series show-cases work by Asia-Pacific based researchers but also
encourages the work of social scientists not limited to the Asia Pacific region. Each
proposal will be subject to evaluation by the editorial board and experts in the field.

More information about this series at http://www.springer.com/series/13451


Takao Higuchi

Natural Resource and PPP


Infrastructure Projects
and Project Finance
Business Theories and Taxonomies
Takao Higuchi
Attorney-at-Law
Nagashima Ohno & Tsunematu
Tokyo, Japan

ISSN 2199-8620     ISSN 2199-8639 (electronic)


Economics, Law, and Institutions in Asia Pacific
ISBN 978-981-13-2214-3    ISBN 978-981-13-2215-0 (eBook)
https://doi.org/10.1007/978-981-13-2215-0

Library of Congress Control Number: 2018958316

© Springer Nature Singapore Pte Ltd. 2019


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Preface

This book is the English version my book Fundamental Theories of Natural


Resource and Infrastructure PPP/Project Finance, which was published in Japanese
by Kinzai Institute for Financial Affairs, Inc. (Ippan Shadan Houjin Kinyu Zaisei
Jijyo Kenkyukai) in 2014. Although the English and Japanese versions of this book
generally address the same topics, they do differ in certain respects. The Japanese
version deals with certain topics that are particular only to Japan and thus are not
mentioned in this book. Furthermore, the English version contains certain topics
that reflect relevant developments that are not mentioned in the Japanese version
published in 2014.
Public–private partnership (PPP) is now a common arrangement implemented
throughout the world, but for each person involved in such projects, the definition of
PPP is different. In addition, PPP is not the sole arrangement by which private com-
panies provide public services. For certain infrastructure projects involving the pro-
vision of public service, deregulated privatization might be preferable over PPP.1 In
this book, I have categorized some types of PPP projects to which several well-­
established business theories for PPP are applied. I believe that only PPP projects
that fall within such categories should be considered true PPP projects, but this is a
matter of definition. However, the reader should understand at least that if PPP is
defined more broadly, the abovementioned well-established business theories for
PPP would apply only to specific types of PPP projects and not all PPP projects.
To clearly comprehend the foregoing, we need to understand the fundamental
business theories that create the foundation for actual projects or project finance
structures. This book clarifies such fundamental business theories that underpin
those projects and project finance transactions. Particularly, it is critical for persons
in the public sector with responsibility over PPP to have a firm understanding of the
business methods and strategies used by the private sector in implementing PPP
projects.

1
 See Engel E., Fischer R., and Galetovic A. The Economics of Public–Private Partnerships: A
Basic Guide. Cambridge University Press, 2014, pp 72–76.

v
vi Preface

Also, both (i) natural resource projects and infrastructure PPP projects and (ii)
project finance are covered equally, and the relationship between them is explained
in this book.
In this book, I do not provide a detailed explanation of natural resource projects.
The structure of these projects may differ depending on the type of natural resource
involved in the relevant project and also the particularities of such projects. However,
I believe that the fundamental business theories for many natural resource projects
and project finance financing for such projects are basically the same as those for
infrastructure PPP projects and project finance financing for those projects.
Finally, I wish to express my sincere gratitude to Mr. Paul M. Iguchi, my col-
league at our firm, Nagashima Ohno & Tsunematsu, as well as to Babel Transmedia
Center K.K. and Mr. Yoki Nakajima. They provided me with much advice and many
suggestions in preparing the English language version of this book.

Tokyo, Japan Takao Higuchi


June 2018
Contents

1 Introduction and Basic Understandings Regarding NRI-PPP


Projects and Project Finance������������������������������������������������������������������    1
1 Introduction����������������������������������������������������������������������������������������   1
2 Major Steps in NRI-PPP Projects and Project Finance
and Structure of This Book ����������������������������������������������������������������   4
3 Parties Concerned ������������������������������������������������������������������������������   5
3.1 Host Country/Off-taker ����������������������������������������������������������   6
3.2 Sponsor (Shareholder)������������������������������������������������������������   7
3.3 Project Company��������������������������������������������������������������������   8
3.4 O&M Operator������������������������������������������������������������������������   8
3.5 EPC Contractor ����������������������������������������������������������������������   9
3.6 Senior Lender��������������������������������������������������������������������������   9
3.7 Independent Consultant/Independent Engineer����������������������  10
4 Contractual Relationships ������������������������������������������������������������������  11
4.1 Project Agreements ����������������������������������������������������������������  11
4.2 Financing Agreements������������������������������������������������������������  15
5 Two Illustrative Cases ������������������������������������������������������������������������  17
Reference ����������������������������������������������������������������������������������������������������  19
2 Business Theories of NRI-PPP Projects������������������������������������������������   21
1 Nature of NRI–PPP Projects��������������������������������������������������������������  21
1.1 Build–Operate–Transfer (“BOT”) Project������������������������������  21
1.2 Difference Between Build–Lease–Transfer (“BLT”)
Projects and BOT Projects������������������������������������������������������  22
1.3 Relationship Between BOT and PFI/PPP ������������������������������  23
1.4 Relationship Between PFI and PPP����������������������������������������  24
1.5 PPP Projects that Involve Only the Provision of Goods
and/or Services Without the Aspect of Design
and Construction of Facilities ������������������������������������������������  25
1.6 Design–Build–Operate (DBO) Project ����������������������������������  26
1.7 Accommodation PFI ��������������������������������������������������������������  27

vii
viii Contents

2 Reasons NRI–PPP Projects Are Used������������������������������������������������  28


2.1 Source of “Wealth” in NRI–PPP Projects������������������������������  28
2.2 Indicators to Measure the Benefits for the Host Country/
Off-taker����������������������������������������������������������������������������������  29
2.3 Indicators to Measure Benefits for Sponsors��������������������������  34
3 The Essence of an NRI-PPP Project ��������������������������������������������������  35
3.1 Reasons an SPC Is Used in an NRI-PPP Project��������������������  35
3.2 True Reason the Project Company, an SPC, Is Used
in an NRI-­PPP Project – “Investment” by Private
Business Entities in an NRI-PPP Project��������������������������������  39
4 Characteristics of an NRI–PPP Project����������������������������������������������  48
4.1 Operation Is the Essential Chapter of an NRI-PPP
Project ������������������������������������������������������������������������������������  49
4.2 Principle of Owner–Operator��������������������������������������������������  50
4.3 Conflict of Interests Between Sponsors and EPC
Contractors������������������������������������������������������������������������������  50
4.4 Principle of Single Business in One Project,
and the Project Company’s Status as being an SPC ��������������  52
4.5 Back-to-Back Provision, Pass-through of Risks,
and the Project Company as being a Paper Company������������  53
4.6 Principle of Single Point Responsibility��������������������������������  55
4.7 The “Sponsor/O&M Operator” Is the Key Player
in an NRI-PPP Project������������������������������������������������������������  59
4.8 Design/Construction Period and Operation Period����������������  64
4.9 Two Types of NRI-PPP Projects ��������������������������������������������  66
4.10 Fixing of the Project During the Project Period���������������������  69
4.11 Project Company Lacks Cash–Paying
Capability by Nature ��������������������������������������������������������������  71
4.12 Difficulties and Sustainability of an NRI–PPP Project����������  72
5 Characteristics of Key Project Agreements����������������������������������������  73
5.1 Characteristics of the Concession Agreement/Off-Take
Agreement/PPP Agreement����������������������������������������������������  73
5.2 Characteristics of an O&M Agreement����������������������������������  97
5.3 Characteristics of an EPC Contract����������������������������������������  98
References���������������������������������������������������������������������������������������������������� 100
3 Business Theories of Project Finance����������������������������������������������������  103
1 Fundamentals of Project Finance�������������������������������������������������������� 103
1.1 Definition of Project Finance�������������������������������������������������� 103
1.2 Difference Between Project Finance and Aircraft
Finance that Uses a Finance Lease ���������������������������������������� 104
1.3 Difference Between Project Finance and Securitization�������� 105
1.4 Difference Between the Project and the Asset������������������������ 105
2 Reason Project Finance Is Used���������������������������������������������������������� 106
2.1 Source of “Wealth” in Project Finance ���������������������������������� 106
Contents ix

2.2 Advantages of Project Finance for the Sponsor���������������������� 107


2.3 Advantage of Project Finance for the Senior Lender�������������� 116
2.4 Limitations/Disadvantages of Project Finance
for the Sponsor������������������������������������������������������������������������ 116
2.5 Limitation of Project Finance for the Senior Lender�������������� 119
2.6 Benefits and Limitation of Project Finance
for the Host Country/Off–Taker���������������������������������������������� 120
3 The Essence of Project Finance���������������������������������������������������������� 123
3.1 Financing that Depends on the Sponsor’s Business
Performance Capability���������������������������������������������������������� 123
3.2 Long–Term Business Finance������������������������������������������������ 124
3.3 Review of the Project by the Senior Lender �������������������������� 125
3.4 Monitoring by the Senior Lender�������������������������������������������� 130
4 Characteristics of Project Finance������������������������������������������������������ 131
4.1 Debt-Equity Ratio ������������������������������������������������������������������ 132
4.2 Waterfall Provisions���������������������������������������������������������������� 134
4.3 Cash Flow Structure���������������������������������������������������������������� 142
5 Characteristics of the Key Financing Agreements������������������������������ 157
5.1 Financial Completion and Completion Guarantee������������������ 158
5.2 Sponsor Support���������������������������������������������������������������������� 162
5.3 Security Package�������������������������������������������������������������������� 163
5.4 Security Interests in Project Finance�������������������������������������� 164
5.5 Direct Agreement and the Right to Step–In���������������������������� 171
References���������������������������������������������������������������������������������������������������� 180

Index������������������������������������������������������������������������������������������������������������������  181
About the Author

Takao Higuchi is a partner at Nagashima Ohno & Tsunematsu (http://www.noandt.


com/en/index.html), a Japanese law firm. He has more than 29 years of experience
in project finance, corporate finance, and banking, with a particular focus on infra-
structure and energy projects and public  private partnership (PPP) and PFI
transactions.
Mr. Higuchi graduated with an LLB from the University of Tokyo in 1987 and
with an LLM from Columbia Law School in 1995. He was admitted to the bar in
Japan in 1989 and in New York in 1996. He worked at Milbank, Tweed, Hadley &
McCloy LLP in New York (1995–1996) and Linklaters & Paines in London (1996–
1997) as a visiting attorney. He also worked exclusively for the Project Finance
Department of The Export–Import Bank of Japan in Tokyo (1997–1999). Further,
since 2010, he has served as a part-time instructor (hijokin koshi) at the Graduate
School of Management, Kyoto University.

xi
Chapter 1
Introduction and Basic Understandings
Regarding NRI-PPP Projects and Project
Finance

Abstract  Achieving an optimum result in a natural resource project, infrastructure


PPP project or project finance transaction requires a clear understanding of the busi-
ness theories underlying these arrangements and the particular business consider-
ations for the relevant project. This chapter prepares the reader for the subsequent
discussion addressing these theories and considerations by presenting certain basic
understandings regarding (i) the major steps in a natural resource project, infrastruc-
ture PPP project or project finance transaction from the perspectives of the main
parties involved, and (ii) the major parties and contractual relationships in such proj-
ects and transactions. Finally, two illustrative cases are presented to aid the reader in
understanding the relevant theories discussed in Chaps. 2 and 3 of this book.

1  Introduction

Natural resource projects and infrastructure PPP projects (collectively, NRI-PPP


Projects) along with project finance have long been used to achieve business-related
objectives. As for the origins of these types of arrangements, various explanations
have been put forth.1 The use of NRI-PPP Projects and project finance has grown
steadily since the 1970s particularly in the natural resource sectors of oil, liquefied
natural gas (“LNG”) and mining, as well as the manufacturing sector such as the
petrochemical industry which produces raw materials and products from crude oil
and natural gas. Further, since the 1980s, the adoption of NRI-PPP Projects and
project finance has expanded to the infrastructure sector, including projects involv-
ing power generation (which are considered to have had the greatest impact in the
development of this trend), railways, roads, airports, ports, water supply, waste
treatment, and communications. In the early 1990s Japan deregulated its electricity
market. As a consequence of deregulation, electricity production businesses

1
 See Kaga R. (2007) The Practice of Project Finance. Kinzai Institute for Finacial Affairs, Inc.
Shadan Houjin Kinyu Zaisei Jijyo Kenkyukai, Tokyo, Japan, pages 60-70 (written in the Japanese
language)

© Springer Nature Singapore Pte Ltd. 2019 1


T. Higuchi, Natural Resource and PPP Infrastructure Projects and Project
Finance, Economics, Law, and Institutions in Asia Pacific,
https://doi.org/10.1007/978-981-13-2215-0_1
2 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

operated by independent power producers (“IPP”), with Japan’s power companies


serving as off-takers, emerged, and NRI-PPP Projects and project finance were
adopted for the establishment of those businesses. Even today in Japan, IPP busi-
nesses involving power generation through renewable energy sources, particularly
wind and solar, are prevalent and NRI-PPP Projects and project finance continue to
serve an important function in the establishment of these businesses.
In England in 1992, private finance initiative (“PFI”) was originally imple-
mented under the administration of Prime Minister John Major of the UK
Conservative Party. Then, under the administration of Prime Minister Tony Blair of
the UK Labor Party, PFI was enhanced into the public-private partnership (“PPP”)
arrangement. The use of NRI-PPP Projects and project finance expanded to hospi-
tals and prisons with the private sector assuming responsibility for full or part of the
operations of such institutions – an arrangement that had never occurred until then
in England and most other countries. Geographically, NRI-PPP Projects and project
finance expanded beyond the borders of the UK and into other developed countries,
and on September 24, 1999, Japan enacted legislation addressing PFI in Japan: the
Act on Promotion of Private Finance Initiative (the “PFI Act”).
Since being admitted to the practice of law in Japan in 1989, the author has been
involved in hundreds of NRI-PPP Projects and project finance transactions, including
overseas projects, concerning various sectors and has participated in countless dis-
cussion with clients and negotiations with counsel for counterparties. During such
discussions and negotiations, one important concern that always needs to be
addressed is the congruence between the theories underlying NRI-PPP Projects/proj-
ect finance and the business-related considerations of the project’s stakeholders. In
particular, the parties must consider how to structure the relevant NRI-PPP Project/
project finance transaction to accommodate the particularities of the project within
these theories. Instead of engaging in superfluous arguments over the acceptability of
certain provisions, competent legal counsel must offer creative solutions based on
knowledge gained from previous NRI-PPP Projects and project finance transactions.
In this sense, all relevant stakeholders, not just the lawyers, should consider and offer
creative solutions to challenging issues that arise and those are capable of doing so
will be highly regarded by all involved. Project finance is often referred to as being
“tailor-made” because each transaction is specially tailored to accommodate the par-
ticularity of the project and address unique issues that inevitably arise.2
Until the late 1990s, NRI-PPP Projects and project finance transactions could
have been characterized as “club deals” since only “members” of a group of quali-
fied individuals (i.e., experts with a good grasp of the theories underlying NRI-PPP
Projects and project finance) had the ability to move projects forward. For example,
in departments of financial institutions specializing in project finance, individuals
handling project finance transactions developed an in-depth understanding of the
theories underlying NRI-PPP Projects and project finance through “on-the-job train-
ing” (i.e., practical experience and knowledge gained through involvement in numer-
ous NRI-PPP Projects and project finance transactions). Through such training,

 Id. at page 9.
2
1 Introduction 3

these individuals came to understand the basic principles of project finance (such as
the precept that the credit rating of a Project Company will never surpass the credit
ratings of the Sponsors  - a point discussed in Chap. 2, Sect. 4.7.4). However, no
textbook taught such important underlying principles and theories regarding NRI-
PPP Projects and project finance. As for legal practitioners, at that time only a lim-
ited number of lawyers at a few major UK law firms and US law firms engaged in
these types of international projects and were competent in these areas.
Since the mid-1990s, the number of NRI-PPP Projects and project finance trans-
actions increased remarkably. This trend seems to have accelerated particularly
since PFI came into existence in the UK. Regrettably, however, the number of indi-
viduals who understood the underlying theories of NRI-PPP Projects and project
finance failed to increase in proportion to this expansion. As a matter of fact, cases
where NRI-PPP Projects and project finance transactions proceeded without a
proper understanding by those involved of the underlying theories increased, and in
some situations in Japan projects proceeded based on the concept of securitization
because of similarities in NRI-PPP Projects/project finance and securitization struc-
tures. However, once the aforementioned principle of “the credit rating of a Project
Company will never surpass the credit ratings of the Sponsors” is understood, it
becomes apparent that project finance differs completely in essence from securitiza-
tion since, in practice, securitization is a means to make the creditworthiness of a
special purpose company (SPC) (i.e., the Project Company) greater than that of its
originator. In securitization, various techniques are employed to prevent the bank-
ruptcy of the SPC; whereas, in project finance, the focus is on understanding what
countermeasures should be taken once the SPC goes bankrupt, with the occurrence
of bankruptcy as a given factor. As for these countermeasures, I will address them
in Chap. 3, Sect. 5.5.2.6.
Specialized books on NRI-PPP Projects and project finance currently exist in the
market. These books explain the roles of the parties involved, expound on issues
likely to arise in actual projects, and describe how to determine the economic effi-
ciency of a project. However, no book currently exists in Japan that describes from
the outset the underlying “theory” of NRI-PPP Projects or the underlying “theory”
of project finance. Even among literature on this subject written in English, such
topic is infrequently, if ever, addressed. Accordingly, in this book I address the the-
ory of NRI-PPP Projects in Chap. 2, and the theory of project finance in Chap. 3. In
doing so, I have tried to provide as clear an explanation as possible for the benefit of
readers who may not be familiar with these types of structures and concepts,
although I have assumed that readers will have at least a basic knowledge of finance.
Also, as the author is a lawyer, some readers may expect this book to contain techni-
cal explanations focused on legal concepts and principles and contractual provi-
sions. However, in this book, I have attempted to limit such types of explanations to
the minimum required to properly describe the theory of NRI-PPP Projects and the
theory of project finance.
4 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

2  M
 ajor Steps in NRI-PPP Projects and Project Finance
and Structure of This Book

In general, the major steps in NRI-PPP Projects and project finance transactions are
listed below in the order they arise or occur
• From the perspective of the Host Country/Off-taker:
• Planning of the NRI-PPP Project
• Selection of advisors
• Preparation of the bid documents
• Determination of the bidding procedures
• Determination of the pre-qualifications
• Review of the bid proposal documents
• Determination of the successful bidder
• Negotiation and execution of the Concession/Off-take/PPP Agreement with
the successful bidder
• Negotiation and execution of a Direct Agreement with the Senior Lender
• Monitoring of the project
• Effectuation of transactions upon termination of the Concession/Off-take/
PPP Agreement
• From the perspectives of private sector businesses:
• Search for an appropriate NRI-PPP Project
• Consideration of its ability to participate in a specific NRI-PPP Project
• Organize consortium of private sector business operators and conclude a con-
sortium agreement
• Preparation and submission of bid documents and proposal documents
• Discussions with the Senior Lender regarding project finance
• Negotiation and execution of the Concession/Off-take/PPP Agreement with
the Host Country/Off-taker after successful bid selection
• Negotiation and execution of various Project Agreements
• Negotiation and execution of various Financing Agreements with the Senior
Lender
• Performance of obligations prior to project completion
• Performance of obligations in relation to operation and maintenance of the
NRI-PPP Project
• Effectuation of transactions upon termination of the Concession/Off-take/
PPP Agreement
• From the perspective of the senior lender:
• Preliminary consultation with private sector business operators regarding the
project and review of information regarding the project
• Submission of a letter of intent
• Further review of information regarding the project
3  Parties Concerned 5

• Performance of syndicated loan related arrangements


• Preparation and submission of an information memorandum
• Review and negotiation of various Project Agreements including the
Concession/Off-take/PPP Agreement
• Term sheet preparation and negotiation
• Negotiation and execution of various Financing Agreements
• Confirm satisfaction of all conditions precedent to the first loan
disbursement
• Certification of financial completion
• Monitoring of the project
Explaining the major steps of NRI-PPP Projects and project finance chronologi-
cally with attention to practical aspects may enhance the reader’s understanding, espe-
cially those who are unfamiliar with NRI-PPP Projects and project finance. However,
as the focus of this book is to explain the underlying theories of NRI-PPP Projects and
project finance, a chronological explanation approach has not been taken.
In addition, to gain an understanding of the theories underlying NRI-PPP Projects
and project finance, it is important to properly understand the key role players and
their relationships to each other. Therefore, before addressing the “Theories” in
Chaps. 2 and 3, I discuss the “Parties Concerned” in Sect. 3 and “Contractual
Relationships” in Sect. 4 of this chapter, respectively. Additionally, to support your
understanding of the underlying “theories,” I discuss two illustrative cases in Sect.
5 of this chapter. Although some may think supplementing explanations with exam-
ples from specific cases may aid the reader’s understanding of theories underlying
NRI-PPP Projects and project finance, in this book I avoid taking such approach
since it may lead to memorization of superfluous information. These theories cannot
be understood in their true sense just by reading textbooks addressing NRI-PPP
Projects and project finance. To master the theories underlying NRI-PPP Projects
and project finance, an understanding gained through practical experience and “on-­
the-­job training” is truly required. Therefore, readers are encouraged to thoroughly
study the theories addressed in this book by participation in actual NRI-PPP Projects
and project finance transactions. By doing so the reader will truly being to under-
stand how such theories are related to a project and to each other.

3  Parties Concerned

In explaining the underlying theories of NRI-PPP Projects and project finance, I


begin by discussing certain enterprises and entities that are involved in NRI-PPP
Projects and project finance transactions and refer to these enterprises and entities
as the “parties concerned.” However, in this chapter I will cover only those parties
concerned that are required to explain the theories of NRI-PPP Projects and project
finance. Thus, for example, in project finance transactions, a syndicated loan struc-
ture with multiple lenders is generally adopted, and for such structure, various
6 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

agents and trustees are involved. Also, arrangers and financial advisors play impor-
tant roles at the stage of planning and effecting the financing arrangement. In addi-
tion, from the viewpoint of risk sharing, the roles of insurance companies and swap
providers become important in practice. However, as the involvement of, and roles
played by, such agents, trustees, arrangers, financial advisors, insurance companies
and swap providers do not directly relate to the theories underlying NRI-PPP
Projects and project finance, these role players are not taken up in this book. Also,
in some NRI-PPP Projects, raw materials/fuel suppliers which provide raw materi-
als and fuel required for the operation of NRI-PPP Projects, play important roles. In
the case of independent power producer projects, for example, raw materials/fuel
suppliers provide coal or natural gas which is the fuel used for power generation,
and in oil refining/petrochemical projects, raw materials/fuel suppliers provide
crude oil for refinement or conversion into petrochemical products. However, as a
grasp of the roles served by raw materials/fuel suppliers is not critical for an under-
standing of the underlying theories of NRI-PPP Projects and project finance, expla-
nations of such role players and their roles are not discussed in this book.

3.1  Host Country/Off-taker

I begin with the Host Country which is the authority, usually of a national govern-
ment but sometimes of a local government, which gives permission for the opera-
tion of NRI-PPP Projects by private businesses. In emerging countries, the Host
Country is generally an authority of the national government in light of certain
concerns regarding the risks associated with local governments. In NRI-PPP
Projects, the national government that gives the permission mentioned above is
often referred to as the Host Country. Specifically, the Host Country is the contract-
ing governmental authority which enters into the Concession/Off-take/PPP
Agreement (i.e., the agreement which stipulates the terms and conditions of the
contemplated project, as discussed in Sect. 4.1.1 of this chapter) with the Project
Company (discussed in Sect. 3.3 of this chapter). On occasion, the contracting gov-
ernmental authority for the Concession/Off-take/PPP Agreement may be an admin-
istrative entity (e.g., the relevant power authority) and not the Host Country.
However, even under this arrangement, the national government itself, and not the
administrative entity which entered into the Concession/Off-take/PPP Agreement,
is called the Host Country. It should be noted, however, that in situations where an
administrative entity, rather than the Host Country, becomes the contracting party to
the Concession/Off-take/PPP Agreement, the Host Country sometimes provides
support by guaranteeing the administrative entity’s payment or performance obliga-
tions or by issuing a letter of support to the Project Company or to the Senior
Lenders (as discussed below in Sect. 3.6 of this chapter), pledging to support the
project contemplated by the subject Concession/Off-take/PPP Agreement.3

 Id. at page 21.


3
3  Parties Concerned 7

The word “off-taker,” which may be unfamiliar to many, is a technical term used
in NRI-PPP Projects. Concession/Off-take/PPP Agreements are categorized broadly
into two types: those for which the Project Company assumes market (demand)
risks, and those for which the Project Company does not assume such risks (I will
discuss this point in Chap. 2, Sect. 4.9). In projects where the Project Company does
not assume market risks, the Project Company itself provides all of the deliverables
and services required under the relevant Concession/Off-take/PPP Agreement to the
Host Country/administrative entity. Because the Host Country/administrative entity
receives (i.e., “takes”) these deliverables and services, they are called “off-takers,”
and the agreement for this type of arrangement is called an “off-take agreement.”
On the other hand, particularly with respect to certain natural resource projects,
the Host Country may only grant certain approvals and licenses required for the
development of a project (e.g., a concession, or a license to engage in the relevant
business) to the Project Company, without concluding a Concession/Off-take/PPP
Agreement. Also, there are cases where an off-take agreement is not executed by the
Host Country/administrative entity, but instead by a private sector business entity. I
will discuss this point later in Sect. 4.1.1 of this chapter.

3.2  Sponsor (Shareholder)

Generally, the word “sponsor” is used fairly broadly, and in some cases merely
refers to a provider of capital or supporter. In NRI-PPP Projects, however, the term
“Sponsor” refers to those who provide all or part of the capital required to pay for
the project costs (I will discuss this in Chap. 2, Sect. 4.8.1) of NRI-PPP Projects, as
well as who substantially own and operate the NRI-PPP Projects through the Project
Company. In this sense, a Sponsor and O&M Operator (which is discussed later in
d) are basically the same legal entity. This is called the “Principle of Owner-­
Operator.” (This principle is discussed later in Chap. 2, Sect. 4.2) However, there are
cases where a Sponsor is not involved with the operations of the project, and in
those situations the amount of equity in the Project Company held by such Sponsor
(as a percentage of the total equity in the Project Company) will never, and should
never, represent the majority interest. In addition, the ways in which capital contri-
butions are made by Sponsors to the Project Company include equity investment
and subordinated loans.4 Because of this, Sponsors are sometimes called
­shareholders. Yet, Sponsors may invest directly in the Project Company, or for tax
reasons they may invest indirectly through their 100% subsidiaries. In the latter
case, however, it should be noted that those 100% subsidiaries may not be consid-
ered the Sponsors themselves. Essentially, those companies which provide capital
to projects and are involved in their operations are considered to be Sponsors.

4
 In addition to the equity investment, the granting of a subordinated loan (sometimes referred to sim-
ply as a “sub-loan”) also exists as a way of effectuating capital contribution. The foregoing also applies
in the following sections where I refer to a Sponsor’s contribution. As for the reason why a subordi-
nated loan is used instead of equity investment, I will discuss that point later in Chap. 3, Sect. 4.3.1.
8 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

3.3  Project Company

A Project Company is the counterparty to the Host Country/Off-taker in a Concession/


Off-take/PPP Agreement. It is also the borrower of the loan issued through the proj-
ect finance transaction. As discussed in Sect. 3.2 of this chapter, direct and indirect
shareholders of a Project Company are generally considered to be Sponsors. From
the viewpoint of legal rights and obligations under a Concession/Off-take/PPP
Agreement, the entity principally responsible for the execution of the project is the
Project Company as the counterparty to the Host Country/Off-taker, not the Sponsor.
Also, the entity responsible for repaying the loan made by the Senior Lenders under
the project finance transaction is generally the Project Company, not the Sponsors.
As for the reasons why the contracting party of the Concession/Off-take/PPP
Agreement is the Project Company and not the Sponsors, I will discuss such topic later
in Chaps. 2 and 3. In addition, as the party primarily responsible for the project (i.e., the
counterparty to the Host Country/Off-taker under the Concession/Off-take/PPP
Agreement), it is the Project Company which enters into the O&M Agreement (dis-
cussed later in Sect. 4.1.2 of this chapter) and the EPC Contract (discussed later in Sect.
4.1.3 of this chapter) with the O&M Operator and the EPC Contractor (discussed later
in Sect. 3.5 of this chapter), respectively. Therefore, those who actually execute the
project-related works, services and operations are the O&M Operator and EPC
Contractor. In this sense, the Project Company is substantially a paper company except
for the fact that it owns the assets related to the project and is the contracting party for
various project-related contracts. I will discuss this point later in Chap. 2, Sect. 4.5.2.
Also, the Project Company is a special purpose company (SPC). Because the
Project Company is established solely for the purpose of conducting necessary
operations in regard to the subject project, it is truly a “special purpose” company. I
will discuss this point later in Chap. 2, Sect. 4.4.2.
As for the legal form of the Project Company, it is usually formed as a limited
liability company (LLC) or a partnership for tax reasons. I will discuss this point in
Chap. 2, Sect. 3.2.4.

3.4  O&M Operator

“O&M Operator” is a technical term that is specifically used in project finance, and
is not commonly used in relation to other general types of business. O&M is an
acronym for “operation and maintenance,” and the term “O&M Operator” refers to
the legal entity responsible for the operation and maintenance of a project. In private
finance initiative (PFI) projects in Japan, operations and maintenance responsibili-
ties typically are assumed by different legal entities and most of the PFI projects in
Japan are accommodation projects (hakomono) which do not involve operations.
Contrastingly, in typical project finance transactions, both the operations and main-
tenance of a project are required to be performed by a single entity (i.e., the O&M
Operator) in view of the principle of “Single-Point Responsibility.” I will discuss
3  Parties Concerned 9

this point in Chap. 2, Sect. 4.6.1. As I discussed in Sect. 3.2 of this chapter, the
Sponsor (or one of the Sponsors) typically serves as the O&M Operator.
Also, there are occasions when a local subsidiary of the Sponsor will assume the
role of O&M Operator, and the Sponsor guarantees the performance of such O&M
Operator’s contractual obligations.

3.5  EPC Contractor

“EPC Contractor” is a technical term mainly used in relation to NRI-PPP Projects


and project finance and not frequently used in relation to other general types of busi-
ness. However, this term may be used in relation to certain projects other than NRI-­
PPP Projects, such as an EPC project whose single objective is the completion of
the construction of a certain facility. EPC is an acronym for “engineering, procure-
ment and construction.” As will be discussed in Sect. 4.1.3 of this chapter, an EPC
Contractor is obligated not just to construct a facility, but to complete the whole
project. The works required for the completion of a project typically include not just
the construction of the facilities, but also the design of facilities and the procure-
ment of the required equipment for the project. Incidentally, in most Japanese PFI
projects, design/construction of the facilities and procurement of the required equip-
ment for the project are performed by separate entities. However, in typical NRI-­
PPP Projects and project finance transactions, all of the works necessary for the
completion of the Project are required to be performed by a single entity (i.e., the
EPC Contractor) in keeping with the principle of “Single-Point Responsibility.” I
will discuss this point in Chap. 2, Sect. 4.6.2.
In other jurisdictions, there are cases where a local subsidiary of the primary
EPC Contractor assumes the role of EPC Contractor, and the primary EPC
Contractor guarantees the performance of the EPC Contractor’s (i.e., such local
subsidiary’s) contractual obligations in relation to the relevant project. Also, for tax
reasons, works are sometimes divided into overseas works and domestic works with
separate “local” EPC Contractors having responsibility for the works in their
respective jurisdictions, and hence separate EPC Contracts are signed. EPC
­
Contracts involving overseas works are called “Offshore EPC Contracts,” and EPC
Contracts involving domestic works are typically called “Onshore EPC Contracts,”
and to integrate these two contracts a “Coordination Contract” is separately entered
into. I will further discuss this point in Chap. 2, Sect. 4.6.2.

3.6  Senior Lender

The Senior Lender, which is a technical term mainly used in relation to project
finance, means the lender of the loans in a project finance transaction. The borrower
is, as I discussed in Sect. 3.3 of this chapter, the Project Company. As discussed in
Sect. 3.2 of this chapter, in a project finance transaction the Sponsor lends funds to
10 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

the Project Company through subordinated loans; thus, loans provided through proj-
ect finance are called Senior Loans based on their preferential status in comparison
to the subordinated loans. Thus, the lender of a Senior Loan is called a Senior Lender.

3.7  Independent Consultant/Independent Engineer

In textbooks written on NRI-PPP Projects and project finance, the Independent


Consultant/Engineer is often described as having a supporting role. However, an
Independent Consultant plays an important role, not just from a practical viewpoint
but also theoretically. The role of an Independent Consultant can be described
broadly as an advisor to the Senior Lenders on technical issues relating to the proj-
ect, and on issues and matters relating to the EPC Contractor and the O&M Operator
during (i) the structuring stage of the project finance transaction and (ii) the moni-
toring stage after the project finance Senior Loans have been made.
Even though the monitoring function of the Senior Lender is addressed generally
in Japanese legal articles addressing PFI, most of those articles do not identify spe-
cifically the scope of the monitoring, nor describe specifically how the Senior
Lenders are to conduct the monitoring. The Senior Lenders are to monitor not just
the financial figures of the borrower/Project Company, but also technical matters
related to the project. I will discuss this point later in Chap. 3, Sect. 2.6.4. It would
be impossible for the Senior Lenders, which do not possess expertise in the relevant
technical matters, to correctly identify issues regarding such technical matters, con-
duct proper evaluations, and make requisite decisions based on such information
and without such expertise. Thus, it is crucial for the Senior Lenders to receive
advice on such technical matters from Independent Consultants in order for them to
competently perform the monitoring required for project finance transactions.
Incidentally, an Independent Consultant who advises the Senior Lenders on techni-
cal matters in relation to a project finance transaction is supposed to remain ­independent
and neutral as indicated by the description “independent” consultant. In that sense, it
is necessary for the Senior Lenders and the Sponsor (and the Project Company) to
reach agreement on the selection of the Independent Consultant. Also, in project
finance, issues periodically arise which result in a conflict of opinions or interests as
between the Sponsors (and the Project Company) on one hand and the Senior Lenders
on the other. When these issues are technical in nature, and will not affect repayment
of the Senior Loans, they are often left to be decided by the Independent Consultant
whose opinion is binding on both the Senior Lenders and the Sponsors (and Project
Company). In this respect (i.e., to serve as an arrangement for alternative dispute reso-
lution (ADR)), the existence of the Independent Consultant is critical.
Depending on the project, various consultants other than the technical consultant
may be required such as consultants to advise on tax/accounting issues, consultants
to advise on environmental issues, market consultants when market risks exist,
insurance consultants in projects where complex insurance coverage is required,
and coal consultants where the project is a coal-fueled IPP project and the coal for
4  Contractual Relationships 11

such project is to be supplied by private businesses. However, whether or not these


consultants are truly neutral and independent may depend on the relevant project.

4  Contractual Relationships

It is also important to gain a full understanding of the relationships between the


relevant parties, primarily those involved in NRI-PPP Projects and project finance
transactions. For this, I next examine the kinds of contracts entered into between the
relevant parties in NRI-PPP Projects and project finance transactions.
The relevant contracts involved in NRI-PPP Projects and project finance can be
broadly classified as either “Project Agreements” or “Financing Agreements.” Project
Agreements and Financing Agreements have various meanings depending on the
type of financing involved. Thus, it is necessary to understand the specific meanings
of such terms in relation to NRI-PPP Projects and project finance. As a general dis-
tinction, Project Agreements are the agreements that are required for NRI-PPP
Projects, and Financing Agreements are the agreements required for project finance.
In practice, as a general rule, agreements to which the Senior Lenders (or the parties
serving as lenders of the Senior Loans) are contracting parties are Financing
Agreements, and contracts to which the Senior Lenders (or the parties serving as
lenders of the Senior Loans) are not contracting parties are Project Agreements. I will
first discuss Project Agreements and then move to Financing Agreements.

4.1  Project Agreements

4.1.1  Concession Agreement/Off-take Agreement/PPP Agreement

A Concession/Off-take/PPP Agreement is the agreement, entered into between the


Host Country/Off-taker and the Project Company, which sets out the framework of
the NRI-PPP Project. The Concession/Off-take/PPP Agreement stipulates, among
other things, the Project Company’s obligations to the Host Country/Off-taker (i) to
complete the project in accordance with the specified requirements, and (ii) to oper-
ate the project in accordance with the specified requirements. In some cases, the
Concession/Off-take/PPP Agreement also stipulates the Off-taker’s obligation to
pay the specified “consideration” to the Project Company upon its receipt of the
deliverables and/or services to be provided by the Project Company under such
Concession/Off-take/PPP Agreement. I will discuss the meaning of this “consider-
ation” in Chap. 2, Sect. 5.1.2.
It should be noted that there are cases, especially in relation to natural resource
projects, where the Host Country only grants its approval and a license (or a conces-
sion) to the Project Company, and the Host Country/administrative entity does not
execute a Concession/Off-take/PPP Agreement. In these cases, an Off-take
12 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

Agreement may be executed by a private business entity instead of the Host Country/
administrative entity as the counterparty to the Project Company. For example, in
LNG projects and petroleum refining and petrochemical projects, private businesses
serving as off-takers become contractually obligated to purchase liquefied natural
gas (LNG) and petroleum products produced through such projects.
As discussed above, in certain cases, especially cases involving natural resources
projects, the Host Country will grant the Project Company a license to operate the
project without entering into a contract obligating the Project Company to operate
the project. This type of natural resource project is essentially a Market-Risk-­Taking-
Type project, which I will discuss later in Chap. 2, Sect. 4.9. In this arrangement, the
Project Company receives consideration from the party to whom the final end prod-
ucts or services are ultimately provided. It may be possible for the Host Country to
select this alternative arrangement type as a way to have certain public services pro-
vided by private entities. Natural resource projects have an affinity for this approach,
which essentially results in a “B-to-B” (business-to-business) project. However,
when this approach is considered for an infrastructure PPP project which is a
“B-to-C” (business-to-consumer) project, a careful study should be made to deter-
mine whether it would be appropriate as a way of providing the relevant public ser-
vices. Also, consideration should be given to, among other things, whether the
Project Company should have full discretion over the setting of prices for the end
products or services to be provided under the arrangement; it should be noted that
having the consumers (i.e., general public) to whom the end products or services are
to be provided as a public service in a Market-Risk-Taking -Type Infrastructure PPP
Project pay consideration to the Project Company is similar in nature to a tax, even
though, as the beneficiary of such public service, they may be legally obligated to pay
such consideration. I will discuss this point later in Chap. 2, Sect. 5.1.2.

4.1.2  O&M Agreement

An O&M Agreement is an agreement entered into between the Project Company


and the O&M Operator. As I will discuss later in Chap. 2, Sect. 4.8, the project
period stipulated in the Concession/Off-take/PPP Agreement can be broadly divided
into (i) the “design/construction period” which is the period ending upon the com-
pletion of the project, and (ii) the “operation period” which covers the duration of
the operation of the project after completion of the project. The Concession/Off-­
take/PPP Agreement will stipulate that the Project Company’s obligation during this
operation period is to operate the project. To fulfill this obligation, the Project
Company will enter into an O&M Agreement with an O&M Operator whereby the
O&M Operator basically assumes the Project Company’s responsibility to operate
the project in accordance with the Concession/Off-take/PPP Agreement. The O&M
Agreement specifies the obligations of the O&M Operator, owed to the Project
Company, to operate the project in accordance with the required standards stipu-
lated in the Concession/Off-take/PPP Agreement.
4  Contractual Relationships 13

Additionally, the obligation of the Project Company to pay “consideration” to


the O&M Operator in return for the services provided by the O&M Operator in
operating the project is stipulated in the O&M Agreement. I will discuss the mean-
ing of this “consideration” in Chap. 2, Sect. 5.2.
Further, as was discussed in Sect. 3.4 of this chapter, in cases where the Sponsor’s
local subsidiary assumes the role of the O&M Operator and the Sponsor guarantees
the contractual obligations of the said O&M Operator, it follows that an O&M guar-
antee agreement will be executed by the Sponsor as guarantor along with the O&M
Agreement.

4.1.3  EPC Contract

During the design/construction phase of a project, the Concession/Off-take/PPP


Agreement obligates the Project Company to complete all works related to that
phase of the project. To fulfill this obligation, the Project Company enters into an
EPC Contract with the EPC Contractor. The EPC Contract stipulates the EPC
Contractor’s obligation to complete all works related to the design/construction
phase of the project to the required specifications stipulated in the Concession/Off-­
take/PPP Agreement. Thus, it can be said that the objective of the EPC Contract is
to facilitate the completion of the project. By executing the EPC Contract, the EPC
Contractor assumes full responsibility for completion of all works related to this
phase of the project.
Completion of the project in accordance with the requirements stipulated in the
Concession/Off-take/PPP Agreement naturally involves the design and construction
of the facilities and the delivery of the relevant equipment to the project. However,
from a legal perspective, the responsibility to complete all works related to a project
cannot be divided, and should be understood as a single responsibility to fulfill all
obligations required to complete the project. In an EPC Contract, terms such as
“date-certain,” “fixed price,” “lump-sum,” and “full turn-key” are frequently used to
describe certain aspects of the contractual arrangement. These terms can be under-
stood to have the following meanings: (i) completion of the project is to occur by a
certain fixed date; (ii) the total amount of consideration to be paid upon the comple-
tion of the project is predetermined and fixed and must be paid as a lump-sum pay-
ment; and (iii) the project must be “full turn-key.” The term “full turn-key” means
that the project is to be fully completed and ready to commence operations by the
turning of a single key, so to speak. In other words, no additional work needs to be
performed by the Project Company to start the operation of the project. Completion
of these obligations becomes the responsibility of the EPC Contractor under the
EPC Contract.
Additionally, under the EPC Contract the Project Company becomes obligated to
pay the agreed amount to the EPC Contractor as “consideration” for the services to
be performed under the EPC Contract. I will discuss the meaning of this “consider-
ation” in Chap. 2, Sect. 5.3.1.
14 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

Further, regarding the EPC works previously discussed in Sect. 3.5 of this chap-
ter, when the works are classified into two types (i.e., overseas works and domestic
works), there should exist an Offshore EPC Contract, an Onshore EPC Contract,
and a coordination agreement among the Project Company, the Offshore EPC
Contractor and the Onshore EPC Contractor to coordinate the works to be per-
formed under the Offshore EPC Contract and the Onshore EPC Contract.

4.1.4  Sponsor’s Subordinated Loan Agreement

The Sponsor’s Subordinated Loan Agreement is an agreement entered into between


the Project Company and the Sponsor to set forth the terms and conditions of the
subordinated loan to be made by the Sponsor to the Project Company, which I dis-
cussed in Sect. 3.2 of this chapter. Being a “loan” agreement, the Sponsor’s
Subordinated Loan Agreement is often misunderstood as being part of the Financing
Agreements. However, it is not included in the Financing Agreements as it is not
related to the project finance transaction. The Sponsor’s Subordinated Loan
Agreement is a contract that relates directly to the project, and thus, it belongs to the
category of the Project Agreements. Additionally, it should be pointed out that the
Sponsor’s Subordinated Loan Agreements may be referred to by different names
depending on the specific projects; for example, it may be called “subordinated loan
agreement” or “shareholder loan agreement.”

4.1.5  Project Management Services Agreement

The Project Management Services Agreement is an agreement entered into between


the Project Company and the Sponsor (or if there are more than one sponsor, some
of the Sponsors); however, it is seldom covered in Japanese textbooks on NRI-PPP
Projects or project finance. As I discussed in Sect. 3.3 of this chapter, a Project
Company is substantially a “paper company” and thus even though it has formally
appointed officers and directors, it does not have any employees in a substantial
sense. On the other hand, the Project Company needs to carry out certain minimum
actions required of a company. For example, it needs to prepare minutes and various
documents related to its shareholders’ meetings and board of directors’ meetings. It
also needs to perform various actions related to the various Project Agreements or
Financing Agreements. In practice, the Sponsor (or one or more of the Sponsors)
performs these actions on behalf of the Project Company, and the obligations of the
Sponsor(s) to perform these actions on behalf of the Project Company are stipulated
in the Project Management Services Agreement. It should be noted that essentially,
as I will discuss later in Chap. 2, Sect. 4.3, the interests of the Sponsor(s) (i.e., the
owner(s) of the Project Company) are in conflict with those of the EPC Contractor.
For example, whether the approval of the EPC Contractor confirming that the proj-
ect is completed, should be given or not is a critically important matter which results
in a conflict of interest between the Sponsors (who are the owners of the Project
Company) and the senior lenders on one side, and the EPC Contractor on the other.
4  Contractual Relationships 15

Also, although cost over-runs up to certain threshold are to be borne by the Project
Company under the EPC Contract, when the requirement to obtain prior approval
for such over-run costs is not strictly observed, the incurrence of such costs may
have a negative impact on the cash flow of the Project Company, and thus creates,
potentially, another conflict of interest between the EPC Contractor and the Project
Company. In light of the foregoing, the Sponsors need to take stringent positions
vis-à-vis the EPC Contractor, on behalf of the Project Company.
Additionally, the Project Management Services Agreement may be referred to by
a different name depending on the specific project.

4.2  Financing Agreements

4.2.1  Senior Loan Agreement

The Senior Loan Agreement is an agreement entered into between the Senior Lender
and the Project Company, which provides for the making of the senior loan by the
Senior Lender to the Project Company for the financing of the project. The Senior Loan
Agreement may be referred to by a different name depending on the specific project.

4.2.2  Sponsor Support Agreement

The Sponsor Support Agreement is an agreement entered into between the Senior
Lender and the Sponsor (as well as the Project Company in some cases), in which
the Sponsor’s obligation to the Senior Lender to provide a certain level of support in
relation to the project is stipulated. In project finance related to an NRI-PPP Project,
the words “limited recourse” are inserted before the words “project finance” in strict
cases. In a project finance transaction, the Sponsor borrows moneys through the
Project Company. Thus, although from a practical perspective, the borrower is the
Sponsor, from a legal perspective, the borrower is the Project Company, not the
Sponsor. Consequently, by differentiating the Project Company, a separate legal
entity, from itself, the Sponsor is able to assume a “non-recourse” position. Thus, it
follows that the creditor/senior lender does not have the right to pursue an enforce-
ment action against the assets of the Sponsor to collect amounts legally owed by the
Project Company. However, in regard to “limited recourse” project finance, in cer-
tain cases the creditor/senior lender does have the right to pursue an enforcement
action against the assets of the Sponsor who is the de facto debtor in financing
provided in relation to a project. Actually, in these cases, it follows that the Sponsor
bears some obligations with respect to the senior loan. In some cases, the Sponsor
asserts that it assumes a “non-recourse” position and thus has no obligations with
respect to the senior loan made under the project finance transaction. However, this
assertion is based on an incorrect understanding of project finance practices in rela-
tion to NRI-PPP Projects. The “certain cases” mentioned above differ depending on
16 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

the specific NRI-PPP Project; however, a commonality among all such projects is
the maintenance of investment ratios by the Sponsors to the Project Company. This
is an obligation of the Sponsors to the Senior Lender, which is required based on the
Principle of Owner/Operator. Thus, in certain cases project finance in relation to
NRI-PPP Projects will not occur without the Sponsors’ bearing some obligations
with respect to the senior loans, and this is the reason why the words “limited
recourse” is attached in strict cases before the words “project finance” in relation to
NRI-PPP Projects. Additionally, in certain cases a “Sponsor Support Agreement”
which stipulates the obligations of the Sponsors in relation to the senior loan, is
executed. I will discuss this form of sponsor support in Chap. 3, Sect. 5.2.

4.2.3  Security Agreement

“Security Agreements” (sometimes referred to as “Security Documents”) are a set


of agreements, notices and approvals that are executed or issued in relation to the
granting of the security interests, which includes the requisite documents, notices
and approvals to establish perfection. The objective of granting security interests in
relation to the financing of the project will be discussed later in Chap. 3, Sect. 5.4.
Security interests are roughly classified as follows: (i) security interests granted in
relation to the assets that comprise the project, which are owned by the Project
Company (including the Project Agreements and the rights therein), and (ii) security
interests granted in relation to (a) the shares and other equity interests issued by the
Project Company and held by the Sponsors, and (b) receivables arising from the
subordinated loans. As to the former, a Security Agreement is executed between the
Senior Lender and the Project Company, and as to the latter, a Security Agreement
is executed between the Senior Lender and the Sponsor (and the Project Company).

4.2.4  Direct Agreement

“Direct Agreement” is also a technical term used in relation to project finance. It is


an agreement executed between each of the Project Company’s counterparties to the
Project Agreements (specifically, the Host Country/Off-taker, the O&M Operator,
the EPC Contractor, etc.) and the Senior Lender, as well as the Project Company in
some cases. The primary objectives for concluding the Direct Agreement are: 1)
effectuating perfection of the security interests granted in relation to the relevant
Project Agreement (and the Project Company’s rights therein), and 2) securing of
the “step-in” rights of the Senior Lender. As for the step-in rights, I will discuss such
rights in Chap. 3, Sect. 5.5.2. The Direct Agreement may be referred to by a differ-
ent name depending on the specific project. A Direct Agreement was previously
referred to as an “Acknowledgment and Consent Agreement.” However, the term
“Direct Agreement” has become the commonly accepted name for such agreement
ever since “Direct Agreement” as a technical term was first used in relation to PFI
in England. I will discuss Direct Agreements in Chap. 3, Sect. 5.5.
5  Two Illustrative Cases 17

4.2.5  Consulting Agreement

“Consulting Agreement” is an agreement among the Independent Consultant, the


Senior Lender and the Project Company, which establishes the obligation of the
Independent Consultant to provide consulting services to the Senior Lender as dis-
cussed in Sect. 3.7 of this chapter. The Independent Consultant’s compensation for
providing the relevant consulting services is to be paid by the Project Company.
The Consulting Agreement may be referred to by a different name depending on
the specific project, and this agreement is not always included in the Financing
Agreements.

5  Two Illustrative Cases

To explain the theory of NRI-PPP Projects and the theory of project finance, it is
beneficial to consider specific cases. NRI-PPP Projects can be classified generally
into two groups: 1) those in which the Project Company assumes market risks, and
2) those in which the Project Company does not assume market risks. I will discuss
these two groups further in Chap. 2, Sect. 4.9. In this book I will consider NRI-PPP
Projects classified in each of these two groups.
• Illustrative Case where the Project Company assumes market risks (Case 1)
As an illustrative case where the Project Company assumes market risks (herein-
after called “case 1”), I consider an offshore oilfield development project. I make
the following assumptions in regard to this offshore oilfield development project:
• A concession agreement is entered into between a Host Country (“A”) and a
Project Company (“B”), and such agreement provides that B will have the right
to develop the offshore oilfield and sell the crude oil extracted from said
oilfield.
• B’s Sponsor and O&M Operator is an oil development and marketing company
(“C”).
• The EPC Contractor is an engineering and construction company (“D”).
• The crude oil extracted from the offshore oilfield is sold in the spot market.
(Thus, it follows that the market risks in regard to whether said crude oil can be
sold or not, and if sold at what prices, are assumed by the Project Company.)
• The Senior Lender is a financial institution (“E”).
• The Independent Consultant is a consulting company (“F”).
The contractual relationships of the parties concerned are shown in Fig.  1.1.
Italicized text denotes the Project Agreements, and underlined text denotes the
Financing Agreements.
• Illustrative Case where the Project Company does not assume market risks (Case 2)
18 1  Introduction and Basic Understandings Regarding NRI-PPP Projects and Project…

EPC Contractor D Sponsor and O&M


Operator C
EPC Contract
O&M Agreement, Project
Direct Equity Investment
Sponsor’s Management Services
Agreement
Subordinated Loan Agreement
Concession Agreement
(Concessions Granted )
Agreement

Host Country A Project Company B


Payment of
Direct Consideration Senior Loan Agreement,
Agreement Security Agreement
Independent Consultant F
Crude Oil Purchasers
in the Spot Market Consulting Agreement
Senior Lender E

Sponsor Support Agreement,


Security Agreement, Direct
Agreement

Fig. 1.1  Case 1 (Offshore Oilfield Development Project)

As an illustrative case where the Project Company does not assume market risks
(hereinafter called “case 2”), I consider an IPP project. I make the following assump-
tions in regard to this IPP project:
• A power purchase agreement (“PPA”) is entered into between a state-owned
power corporation (Off-taker) (“X”) and the Project Company (“Y”), pursuant to
which X and Y agree that Y is to complete and operate a natural gas-fueled power
plant, and sell the power generated from such power plant to X over the span of
15 years.
• Under the PPA, Y is to receive consideration from X based on a so-called “take-­
or-­pay” (to be discussed in Chap. 2, Sect. 4.9.3), on the condition that said power
plant has the performance capability stipulated in the PPA. (Therefore, it follows
that the Project Company did not assume any market risks in regard to whether
the generated power can be sold or not). It should be noted that the state-owned
power corporation, X, bears the obligation to supply natural gas to the power
plant, and in practice, X would supply the natural gas to Y through a state-owned
natural gas supplier.
• Y’s Sponsor and O&M Operator is an independent power producer (“Z”).
• The EPC Contractor is an engineering and construction company (“W”).
• The Senior Lender is a financial institution (“V”).
• The Independent Consultant is a consulting company (“U”).
Reference 19

EPC Contractor W Sponsor and O&M


Operator Z
EPC Contract
O&M Agreement, Project
Direct Equity Investment
Sponsor’s Management Services
Agreement
Subordinated Loan Agreement
Payment of Consideration Agreement

Off-taker X PPA Project Company Y


Sells Power
Direct Senior Loan Agreement,
Agreement Security Agreement
Independent Consultant U

Consulting Agreement
Senior Lender V

Sponsor Support Agreement,


Security Agreement, Direct
Agreement

Fig. 1.2  Case 2 (Independent Power Producer Project)

The contractual relationships of the parties concerned are shown in Fig. 1.2.


Italicized text denotes Project Agreements, and underlined text denotes Financing
Agreements.

Reference

Kaga, R. (2007). The practice of project finance. General Incorporated Association (Kinyu-Zaisei-­
Jijyo Kenkyukai): Tokyo.
Chapter 2
Business Theories of NRI-PPP Projects

Abstract  In this chapter, I focus primarily on NRI-PPP Projects and discuss,


among other things, the nature, qualities and types of NRI-PPP Projects, their key
elements and characteristics, as well as the main considerations of the major parties
(e.g., the Host Country/Off-takers and Sponsors) including risk-taking by such par-
ties and the principle of Single Point of Responsibility. This chapter also addresses
certain challenges and concerns in relation to NRI-PPP Projects and identifies cer-
tain matters that should be considered by the major parties at various stages of a
project. Finally, I discuss key project agreements, in particular the Concessions/
Off-take/PPP Agreement, and address key elements and considerations such as risks
and risk sharing.

1  Nature of NRI–PPP Projects

1.1  Build–Operate–Transfer (“BOT”) Project

To understand the theories underlying NRI-PPP Projects, I need first to comprehend


what types of projects should be considered NRI-PPP Projects, especially with
respect to project finance. That is to say, there are various types of projects in the
world (e.g., real estate development projects, support projects, etc). However, it is
obvious that not all projects involve project finance. Thus, I first need to have a clear
understanding of the types of projects that are the subject of project finance.
From this point of view, it can be said that NRI-PPP Projects mainly refer to so-­
called BOT Projects.1 The acronym “BOT”, which is a technical term used in

1
 In NRI-PPP Project, appellations that use acronyms consisting of the initial letters of the relevant
words are used to describe the nature of the project; they include BOT, BOO (Build-Own-Operate)
and BLT (to be discussed in Sect.1.2 of this chapter). BOO differs from BOT in that the ownership
of the facilities is not transferred to the Host Country/Off-taker at the end of the project. Although,
the number of BOO projects may be relatively small compared to BOT, BOO Projects are a type
of NRI-PPP Project which becomes the subject of Project Finance.

© Springer Nature Singapore Pte Ltd. 2019 21


T. Higuchi, Natural Resource and PPP Infrastructure Projects and Project
Finance, Economics, Law, and Institutions in Asia Pacific,
https://doi.org/10.1007/978-981-13-2215-0_2
22 2  Business Theories of NRI-PPP Projects

­ RI-­PPP Project and project finance, stands for “Build-Operate-Transfer.” Various


N
types of projects exist, not only in the natural resources sector, but also in relation to
infrastructure including projects relating to electricity generation, water, communi-
cation, railways, roads, airports, and ports. Included among these projects are EPC
Projects whose only aim is the completion (i.e., the design, procurement, construc-
tion and commissioning) of the project facilities. However, these EPC Projects are
not projects that should become the subject of project finance. The term BOT Project
generally refers to projects that are intended to “Build” and “Operate” the project,
and thereafter “Transfer” the facilities that comprise the project to the Host Country/
Off-taker upon the termination of the BOT Project agreement. Incidentally, I will
discuss the reasons for transferring the facilities that comprise the project at the
termination of the BOT Project agreement, in Sect. 5.1.4 of this chapter.
The operation of the project is the intrinsic purpose of a BOT Project. This opera-
tion would involve the selling of crude oil in illustrative Case 1 and the selling of
electricity in illustrative Case 2, described in Chap. 1, Sect. 5. The sole purpose of
an EPC Project is the completion of the project facilities, and in this respect it fun-
damentally differs from a BOT Project in that operation (which is the intrinsic pur-
pose of a BOT Project) is not within the scope of an EPC Project.
Thus, initially I will discuss the reasons why an NRI-PPP Project is used in Sect.
2 of this chapter, where I will discuss why BOT-type NRI-PPP Projects are adopted.
Thereafter in Sects. 3 and 4 of this chapter, I will discuss the essence of an NRI-PPP
Project and the characteristics of an NRI-PPP Project, respectively. Finally, I will
discuss the characteristics of key project agreements in Sect. 5 of this chapter.

1.2  D
 ifference Between Build–Lease–Transfer (“BLT”)
Projects and BOT Projects

Projects that are suitable for project finance include BLT Projects in addition to
BOT Projects. “BLT”, an acronym for the “Build-Lease-Transfer”, is another tech-
nical term used in infrastructure PPP projects and project finance. A BLT Project
refers to a project whose objective is to complete (Build) the project, lease (Lease)

Also, although the letter “B” (which refers to “Build”) is used to describe new construction
projects, the letter “R” (which refers to “Rehabilitate”) may be used to describe refurbishment
projects. Further, because the aspect of “Design” is included in the scope of the project, not just
“Building”, the letters “DB” (which refers to “Design-Build”) are sometimes used. Although it is
the personal impression of the author, these terms may not be used in a strictly unified way within
this industry. For example, “B” (Building) of “BOT” usually becomes the subject of the EPC
Contract, and thus, “D” (Design) should naturally be included when one refers to “B.” In this
sense, necessity to use the letters “DB” for matters characterized as “B” is somewhat in question.
Some specialized books just list these appellations without considering these matters appropri-
ately. In any event, when using these appellations, it is critical to have a clear consciousness about
the meanings of these letters and whether they are appropriate in the substantial sense considering
the words they represent and the scope of the particular project. In this book, we use “B” with the
view that it includes the meaning of “D.”
1  Nature of NRI–PPP Projects 23

the project to the Host Country or other administrative entity that is the contracting
governmental authority of the Concession/Off-take/PPP Agreement, and transfer
(Transfer) the facilities that comprise the project to the subject Host Country or
other administrative entity upon termination of the BLT Project agreement. The dif-
ference between BLT and BOT is that, whereas Operation of the Project is imple-
mented by the Project Company in BOT, Operation of the Project is implemented
by the subject Host Country or other administrative entity in BLT, and thus the
Project Company’s role is limited to performing a so-called leasing operation.
An example exemplifying this difference is the case of Mexico’s power genera-
tion project. When Mexico introduced infrastructure PPP in relation to a power
generation project in the 1990s, it first implemented a BLT Project, and after that, it
came to implement a BOT Project. It can be inferred that Mexico’s decision to pro-
ceed in this manner was partly due to the fact that a BLT Project was easier for the
Host Country because the Host Country could avoid having to perform certain tasks
such as evaluation of the company to serve as operator of the project. As illustrated
above, the implementation of a BLT Project at the initial stage of an infrastructure
PPP project may have significant benefits. However, as will be discussed in Sect.
3.2.3 of this chapter, the essence of an NRI-PPP Project lies in assigning the task of
operation to a private business entity. Consequently, the originally conceived ideal
form of NRI-PPP Projects that should be the subject of project finance is the BOT
Project. To support this, the only substantial benefit to be gained by a private busi-
ness entity in a BLT Project seems to be tax-related. In that sense, even if nominal
Value For Money (VFM) (to be discussed in Sect. 2.2.1 of this chapter) is generated
(becomes higher), in light of the reduced tax revenue implementing a BLT Project
would not make sense from the perspective of a Host Country. From this point of
view, the extent of benefit to be gained by implementing a BLT Project from the
perspective of the Host Country must be evaluated carefully.

1.3  Relationship Between BOT and PFI/PPP

Various explanations have been offered globally as well as domestically to explain the
relationship between BOT Projects and PFI/PPP Projects. In this regard, understand-
ing the essence of both types of projects is critical. BOT is an acronym for Build-
Operate-Transfer as I discussed in Sect. 1.1 of this chapter, and its name generally
identifies the types of work or actions to be implemented by the Project Company.
Regarding project types, as I discussed in Sect. 1.2 of this chapter, there exists BLT in
addition to BOT.  On the other hand, PFI and PPP typically refer to project types
involving the contracting to the private business entities of services or work that has
been provided or done up to that point by a public entity, as evidenced by the involve-
ment of the Host Country/Off-taker. In other words, in BOT Projects, the party which
is equivalent to a Host Country/Off-taker should not necessarily be a public entity, and
a private business entity could take the position of the Host Country/Off-taker (For
instance, in IPPs during the period of deregulation of Japan’s electricity sector in the
24 2  Business Theories of NRI-PPP Projects

early 1990s, or in regard to wind-power generation plants and mega solar power plants
that benefit from Japan’s feed-in tariff scheme for renewable energy created under
Japan’s Act on Special Measures for the Procurement of Renewable Energy by
Operators of Electric Utilities which took effect on July 1, 2012, Japan’s regulated
electric power companies which are all private business entities, are the Off-takers). In
this sense, BOT and PFI/PPP are not dissimilar, but are compatible concepts that rep-
resent the same thing considered possibly from different perspectives.

1.4  Relationship Between PFI and PPP

The terms PFI and PPP have been assigned various meanings and no universally
accepted definitions exist. If I reflect back on the origins of these terms which I
discussed in Sect. 1, Chap. 1, you will recall that PFI was born in the United
Kingdom in 1992 under the Conservative Party, and then it developed into PPP
under the Labor Party. The author’s personal impression considering this history is
that at the time PFI was viewed politically as putting too much emphasis on compe-
tition, and to mitigate that image PPP came into use; thus these two terms essen-
tially refer to the same thing. As mentioned above, the view that PFI and PPP were
born in the United Kingdom in the 1990s still seems to exist. However, the current
prevailing global view is that projects involving the operation of public infrastruc-
ture financed by private funds, which existed before the birth of PFI, should be
included in the category of PPP; and thus, from that perspective, the PPP structure
is recognized as having been in existence before the birth of PFI in the United
Kingdom.
However, as for the meaning of PPP, the definition on page 4 of IMF Working
Paper (WP/09/144) seems to be the most appropriate: “[a] PPP is an arrangement
in which the private sector participates in the supply of assets and services tradi-
tionally provided by the government.”.2 In this definition, the provision of goods
and/or services by the private sector, which to that point had been provided by the
public sector, is clearly advocated. The project types primarily contemplated in this
definition are those where the private business entities manage the operation of proj-
ects which, to that point, had been managed by the Host Country/Off-taker. In this
sense, PPP is essentially the same as privatization. However, in this definition, no
mention is made of private finance (the “PF” in PFI). In this regard, the provision of
just goods and/or services (which does not include the aspect of design and con-
struction of facilities financed by private funds; this point is discussed in Sect. 3.2.3
of this chapter) is also included in the definition of PPP. Projects like market testing
in Japan performed by contracted private business entities are also included in PPP
under the wording of this definition. From this viewpoint, PPP is broader in scope

2
 Burger P., Tyson J., Karpowicz I. and Delgado Coelho M. (2009) The Effects of the Financial
Crisis on Public-Private Partnerships. IMF Working Paper (WP/09/144). http://www.imf.org/
external/pubs/ft/wp/2009/wp09144.pdf
1  Nature of NRI–PPP Projects 25

than PFI. However, because page 4 of the above-cited IMF Working Paper, regard-
ing the definition of PPPs, also provides: “[t]he private partner(s) is usually respon-
sible for both the construction and operational phases of the project,” it can be said
that the essence of PPP lies in the fact that it includes the design and construction of
facilities, and that private funds are used for that purpose.
Also, page 4 of the publication Public-Private Partnerships, Government
Guarantees, and Fiscal Risk, provides: “[a] PPP has been defined as ‘the transfer
to the private sector of investment projects that traditionally have been executed or
financed by the public sector’”.3 Additionally, this publication comments on the
other two characteristics of PPP, stating: “first, there is an emphasis on service pro-
vision and investment by the private Sector; and, second, significant risk is trans-
ferred from the government to the private Sector.” Further, it explains that the typical
type of PPP is DBFO (Design-Build-Finance-Operate). From this comment as well,
it can be said that the essence of PPP lies in the fact it includes the design and con-
struction of facilities, for which the private funding is to be used, and thus, PPP is
essentially the same as PFI.
Incidentally, in Japan there are cases where PPP Projects, which are not PFI in the
sense discussed above, are also called PFI. Further, projects, that are not PFI or PPP
in the sense discussed above, are also implemented as projects based on PFI Act.

1.5  P
 PP Projects that Involve Only the Provision of Goods
and/or Services Without the Aspect of Design
and Construction of Facilities

As discussed in Sect. 1.4 of this chapter, although projects that concern only the
offering of goods and/or services without the aspect of design and construction of
facilities are included in PPP by definition, their roles in relation to PPP can be
characterized as merely a supporting role. Yet, being in supporting roles does not
preclude them from being implemented. What should be noted is that projects cat-
egorized as PPP are based on different theories. While PPP that includes the design
and construction of facilities by private equity investment (PFI) are funded with
“investments” made by the private business entities as I will discuss in Sect. 3.2 of
this chapter, PPP that concerns only the offering of goods and/or services without
the design and construction of facilities does not incur capital expenditure (expen-
ditures for fixed assets such as land and buildings) in principle, and thus “invest-
ments” by the private business entities are not involved. This means that various
questions as to the differences between projects that concern only the offering of
goods and/or services without the design and construction of facilities and PPP

3
 Cangiano M., Anderson B., Alier M., Petrie M. and Hemming R. (2006) Public-Private
Partnerships, Government Guarantees, and Fiscal Risk. IMF Special Issues. https://www.imf.org/
en/Publications/IMF-Special-Issues/Issues/2016/12/31/Public-Private-Partnerships-Government-
Guarantees-and-Fiscal-Risk-18587
26 2  Business Theories of NRI-PPP Projects

(PFI) projects that include the design and construction of facilities for which fund-
ing from private equity investments is required, arise, to wit: (i) is an SPC used or
not? (ii) can it be the subject of Project Finance? and (iii) how are profits of the
private business entities measured? To the best knowledge of the author, no Japanese
literature on this topic has explained the difference of the corresponding theories by,
for example, addressing the questions mentioned above, and none has discussed the
differences between PPP (PFI) Projects that include, in their scope, the design and
construction of facilities with funding from private equity investment, and PPP
Projects that do not include the design and construction of facilities. In this respect,
careful consideration is required regarding what theories are to apply in the imple-
mentation of PPP that concerns only the offering of goods and/or services without
including the design and construction of facilities.

1.6  Design–Build–Operate (DBO) Project

In Japan, particularly in relation to waste treatment projects, there exists a type of


project where a private business entity implements the design and construction of
facilities, transfers ownership of such facilities to a local government entity at the
completion of the project, and receives consideration for completion of the project
in one lump sum at the time of the ownership transfer. Thereafter, the private busi-
ness entity is contracted by the local government to perform the operation and main-
tenance of the facility, and implements the operation and maintenance of the subject
facilities. In Japan, this type of project is called DBO (Design-Build-Operate)
Project. In a DBO Project, “investments” by private business entities are not
involved, and thus, questions as to the differences between DBO Projects and PPP
(PFI) Projects that include the design and construction of facilities by use of private
equity investments, arise, to wit: (i) is an SPC used or not? (ii) can it be the subject
of Project Finance? and (iii) how are profits of the private business entities mea-
sured? Also, as DBO Projects do not involve “investments” by the private business
entities, careful consideration is needed as to whether VFM is generated (becomes
higher) or not in a DBO Project.4

4
 It seems that a major reason why DBO Projects are used in Japan instead of PFI is that the financ-
ing cost through the issuance of local government bonds is lower than the financing cost of
PFI.  However, the reason the interest rates of Japanese local government bonds are lower is
because they are substantially guaranteed by the Japanese Government; in that sense, the prefer-
ence of DBO Projects over PFI in Japan might result from the particularities of Japan. As we will
elaborate in Sect. 4.7.2 in this chapter, the most important discriminating factor between a success-
ful NRI-PPP Project and an unsuccessful one is the business performance capability of the Sponsor
and the O&M Operator. Because of this, the Host Country/Off-taker positions the Project as an
integrated one under the Concession/Off-take/PPP Agreement, and lets the Project Company,
whose shareholders are the Sponsor and the O&M Operator, implement the Project. On the other
hand, in DBO Projects in Japan, as for the design and construction aspects, the local government
enters into a Design Work Contract and a Construction Contract with a Design Firm and a
Construction Company, respectively, and enters into an Operation Work Contract with the Project
1  Nature of NRI–PPP Projects 27

1.7  Accommodation PFI

In regard to PFI in Japan, the so-called hakomono (Accommodation) PFI is most


prevalent. In the Accommodation PFI, only the design/construction and mainte-
nance of facilities are the subject of PFI, and operation of the facilities is not the
subject of PFI. In this respect, it should be noted that maintenance of facilities is not
considered operation of facilities. Accommodation PFI is also called BTO (Build-­
Transfer-­Operate) Project. However, while the “O” of BTO stands for operation,
and since operation is not an aspect of Accommodation PFI, Accommodation PFI
should not be referred to as BTO, but rather only BT. In this sense, most of the PFIs
in Japan are not substantially PFI or PPP. Conversely, even if the operation aspect is
partially included in PFI, it would violate the Principle of Single Point Responsibility
in relation to PFI projects, which I will discuss in Sect. 4.4 of this chapter, and thus
it would result in an inappropriate project being referred to as PFI.
Incidentally, a counterargument may be expected based on the fact that
Accommodation PFI also exists in the United Kingdom. I will engage in an evalua-
tion of PFI in the United Kingdom in Sect. 2.2.3 of this chapter.

Company only with regard to the operations. However, this arrangement does not constitute a
contractual relationship whereby the Project is subcontracted to a private business as an integrated
project by depending on the business performance capability of the Sponsor and the O&M
Operator. In a DBO Project in Japan, the local government enters into master agreements with the
Sponsors and subcontractors which are to perform various types of work delegated by the Project
Company; hence a counter-argument may be made that through these Master Agreements, the
Project is implemented by a private business entity as an integrated project. However, the subject
master agreements usually stipulate that each constituent company of the private business entity
enters into a contract after the whole operation was divided into design, construction, operation,
and maintenance as a “division of roles”. Additionally, it should be noted that this division of roles
is intended to allow each role to be conducted in parallel, which, in turn, contradicts, as we will
discuss in Sect. 4.7.1 of this chapter, the notion that a DBO Project is dependent on the business
performance capability of the Sponsor and the O&M Operator, and that the Sponsor and the O&M
Operator supervises the whole Project. Yet still another counter-argument may arise that even in
PFI, the Project Company enters into an EPC Contract with the EPC Contractor and an O&M
Agreement with the O&M Operator; thus both are positioned to perform their duties in parallel.
However, the reason an O&M Agreement is signed is to cover the costs related to the O&M work.
As we will discuss in Sect. 5.2 of this chapter, profit from the O&M work is not included in the
O&M work fee. The profit for the O&M Operator is paid in the form of dividends from the Project
Company to its shareholders. Therefore, any argument claiming that the O&M Agreement and the
EPC Contract are performed in parallel is not appropriate. The EPC Contractor is required to be
positioned as the subcontractor of the Sponsor and the O&M Operator which has the business
performance capability to supervise the whole Project.
28 2  Business Theories of NRI-PPP Projects

2  Reasons NRI–PPP Projects Are Used

2.1  Source of “Wealth” in NRI–PPP Projects

The reasons NRI-PPP Projects are used are, naturally, because they offer benefits to
both the Host Country/Off-taker and the private business entities. If a system were
to be beneficial to only one side, such a system would be considered unreasonable
and could not be established as a system in practice. Then, the discussion focuses on
what are the sources that generate this benefit (hereinafter referred to as “Wealth”).
As for the source of “Wealth”, the following two principles are generally
observed:
(1) Regarding a specific risk, the party who is most knowledgeable about, and thus
is in the best position to control it, can take on this specific risk at the lowest cost.
(2) Because of the competition mechanism, private business entities can provide ser-
vices more efficiently (less expensively) than their public entity counterparts.
Above-listed two principles may mean the same thing depending on the perspec-
tive. Stated simply and concisely, as for the risks the private business entities can
control, a project can be completed at lower cost, when the risks are taken by the
private business entities. The success or failure of specific NRI-PPP Project depends
on the existence of sufficient “Wealth” and the ability of this “Wealth” to be divided
appropriately between the Host Country/Off-taker and the private business entities.
Accordingly, as indicators to judge whether this “Wealth” exists, and whether
appropriate allocations have been made, I will discuss the “indicators to measure the
benefits to the Host Country/Off-taker” in Sect. 2.2 of this chapter, and the “indica-
tors to measure the benefits to the Sponsor” in Sect. 2.3 of this chapter.
Additionally, whether the above-mentioned two principles are truly correct
should be addressed from the perspective of economics, and also it should be sub-
stantiated statistically. In that sense, this is a subject far beyond the capability of the
author, who is not an economist, to discuss.
The above-mentioned Public-Private Partnerships, Government Guarantees,
and Fiscal Risk publication also states at page 5, regarding the difference between
conventional public works and PPP, that there is “[a] belief that giving the private
sector responsibility for designing, building, financing, and operating an asset leads
to increased efficiency in service delivery”; that is to say, it identifies, as the reason
for PPP’s adoption, the fact that public service can be efficiently provided when
DBFO (Design-Build-Finance-Operate) project is subcontracted to private busi-
nesses, and it goes as far as saying that it is “a belief.”5 However, empirically speak-
ing, these reasons seem to be considered to be correct by many people.

5
 Cangiano M., Anderson B., Alier M., Petrie M. and Hemming R. (2006) Public-Private
Partnerships, Government Guarantees, and Fiscal Risk. IMF Special Issues. page 5. https://www.
imf.org/en/Publications/IMF-Special-Issues/Issues/2016/12/31/Public-Private-Partnerships-Government-
Guarantees-and-Fiscal-Risk-18587
2  Reasons NRI–PPP Projects Are Used 29

Consequently, from the viewpoint of this source of “Wealth”, when a Sponsor is


a public legal entity, some doubts may arise regarding its business performance
capability. On the other hand, as I will discuss in Sect. 4.7.2 of this chapter, the busi-
ness performance capability of a Sponsor and an O&M Operator is reviewed in
relation to an NRI-PPP Project, and it should be noted that a Host Country/Off-taker
cannot give a high evaluation to such a Sponsor, as a general rule. Also, it should be
noted that the Senior Lender in a Project Finance transaction cannot provide project
financing to such a Sponsor as a general rule.

2.2  I ndicators to Measure the Benefits for the Host Country/


Off-taker
2.2.1  Value For Money (VFM)

The benefit for the Host Country/Off-taker, especially in relation to PPP in advanced
countries, is the existence (increase) of the Value For Money (“VFM”). Plainly
speaking, PPP costs less than implementation of a conventional public works project.
The reason for this is that, as a matter of course, the existence of “Wealth”, which I
discussed in Sect. 2.1 of this chapter. As for VFM, the present value of the total finan-
cial burden throughout the Project Period when the project is implemented as a con-
ventional public works project (Public Sector Comparator; PSC), and the present
value of the total financial burden throughout the Project Period when the project is
implemented by PPP (Life Cycle Cost; LCC) are calculated. Specific calculation
methods of these values are beyond the scope of matters covered by this book.
However, substantial discretion exists in regard to the measurement of VFM. As
a result, in a situation where the implementation of a PPP Project has been deter-
mined, there arises a risk that the implementation decision is made arbitrarily. This
consequently would leave nothing but excessive financial burden on the Host
Country/Off-taker, thus it should not be done from the viewpoint of the Host
Country’s best interest because the financial burden would ultimately be borne by
the citizens of that country in the form of a tax. As I will discuss in iii, VFM has not
generated much support in the United Kingdom reportedly. In this sense, how to
measure VFM becomes important in practice. Particularly, regarding whether quan-
titative judgment can really be made in practice, or whether only qualitative judg-
ment is possible, the author expects more extensive discussion to occur.
Strictly speaking, increase of value per currency unit means the increase of VFM,
thus, if the value increases through added value, VFM increases. However, the point
is, whether the addition of value is truly needed by the Host Country/Off-taker, or
not. Minimum requirements for a Host Country/Off-taker are defined as the
“Required Level” in the bidding documents of a Project. Accordingly, whether a
value exceeding the Required Level is truly needed by the Host Country/Off-taker,
30 2  Business Theories of NRI-PPP Projects

or ultimately by the national government of the Host Country is a matter that neces-
sitates separate, careful review.6

2.2.2  Additionality

In addition, in NRI-PPP Projects in developing countries, discussions on VFM itself


may not have been so active, in the first place. This may be because the operations
of the subject projects contribute extensively to the economic development of the
relevant countries, and thus benefits beyond what can be measured by VFM may

6
 In PFI in Japan, evaluation that puts higher value on elements other than price has generally been
said to be acceptable. The author does not intend to insist that the value-added consideration is not
required without exception. However, being capable of making a clear determination in specific
projects is hard thing to achieve; including who will make the determination objectively based on
what standards to decide whether the added-value part is truly necessary. One business model
which has been successful in Japan so far seems to be “increasing the added value and selling it
high in light of that increased added value”. However, in NRI-PPP Projects in the developing
countries where the Host Country/Off-taker is unable to bear significant financial burden, carefully
verification is needed to determine whether the concept that “evaluation that places higher value on
elements other than price is acceptable” really holds true. The subject value-added part may turn
out to be just a “luxury” for the Host Country/Off-taker. Incidentally, in regard to PFI in the United
Kingdom, at least in early days, it is reported that bidding competitions were basically evaluated
on price alone, and only when there was no substantial difference in price, factors other than price
became the subject of review.
As we will discuss in Sect. 4.1 of this chapter, the essence of an NRI-PPP Project is its opera-
tion, and the qualities of the goods and/or services to be provided by the subject operation are
defined by the required level. Consequently, as long as the subject required level is satisfied, in
order for VFM to be generated (increased) essentially, the extent to which the prices of the goods
and/or services that the Project Company is to provide to the Host Country/Off-taker becomes
cheaper is important. Whatever added value the facilities may have, whether value exists or not is
determined by the Sponsor’s operational perspective, and ultimately, the value should be reflected
in the prices of the goods and/or services the Project Company provides to the Host Country/Off-
taker. There may be an argument that factors such as safety should be evaluated; however, such
factors other than prices are essentially determined by the required level to be established in the
bidding by the Host Country/Off-taker, and should be addressed by appropriately establishing the
required level.
In relation to this, PFI is often referred to as “performance criteria” in Japan. This derives, as
we will discuss in Sect. 5.1.2.2 of this chapter, from the fact that true PFI sets operation as its
objective. When performance criteria is adopted in Accommodation PFI, a risk may arise that the
required level becomes vague, thus, making it not necessarily objectively reviewable on the one
hand, and on the other hand, the outcome sometimes does not meet the intention of the public side
which actually is to perform the operation using the subject PFI constructed facility. Thus, ulti-
mately, the quality of the goods and/or services to be provided by the operation is the most impor-
tant consideration; in performance criteria, whether the goods and/or services provided by the
operation meets the required level is important. In other words, careful consideration should be
given in determining whether the output satisfies the required level, whether added value beyond
the required level is needed by the Host Country/Off-taker, and who will judge objectively its
necessity when needed. The most easy-to-understand example is case 2. When performance capa-
bility to provide a certain level of electric power is assured, added value beyond that capability is
not usually assumed.
2  Reasons NRI–PPP Projects Are Used 31

exist for the Host Country. Yet, benefits beyond what can be measured by VFM are
sometimes very difficult to quantify objectively. Thus, introducing such factors irre-
sponsibly to NRI-PPP Projects will only interest a segment of the private business
entities, and ultimately result in the imposition of a valueless burden on the relevant
country. This must not be allowed to occur, particularly in developed nations.
Relating to this subject, some have advocated that a benefit to the Host Country/
Off-taker in developing countries that implements an NRI-PPP Project is the so-­
called “Additionality.”7 In an NRI-PPP Project, it costs a lot of money (Cash-outs
are made) during the design/construction stage of the facilities, and in the long-term
operation stage thereafter, sales are recorded (Cash-ins are made) gradually.
Accordingly, bridging the gap financially between the two stages is required. On the
other hand, in developing countries, when the governments try to raise funds to sup-
port public investments, issuance of public debt that relies on future tax revenues
and other means cannot be expected (a limitation on liquidity exists). Therefore,
projects may exist in which it is assumed that the Host Country/Off-taker cannot
raise the necessary funds. For this reason, there is a benefit in adopting an NRI-PPP
Project and relying indirectly on the fund-raising capacity of private businesses.
This is called “Additionality” in the sense that when there is a limitation on the
fund-raising capacity of public entities, an NRI-PPP Project brings about additional
fund-raising capacity beyond the existing limitation. This concept of “Additionality”
itself seems to be legitimate. The issue is whether a Host Country/Off-taker can
really ensure the funds in the future required to repay the debt incurred in relation
to the raised funds, including through profits of the private business entities and
loans from financial institutions. For example, in illustrative Case 2 described in
Chap. 1, Sect. 5, Off-taker X sells the purchased Power to the corporations and
nationals of that nation. Off-taker X needs to sell the purchased Power at prices that
will enable it to ensure receipt of the funds necessary for the repayment, however,
the issue is whether it can really sell the Power at such prices. If Off-taker X cannot
sell the Power at such prices, payment must be ultimately made using the Off-taker
X’s own funds or Host Country’s funds. In that sense, the simple fact that the Host
Country lacks sufficient funds differs from Additionality, and it should be noted that
without ensuring substantial funds for repayment, implementing an NRI-PPP
Project is not viable.8

7
 See e.g., Winch G., Onishi M. and Schmidt S. (2011) Taking Stock of PPP and PFI Around the
World. ACCA workshop at p.12. http://www.accaglobal.com/content/dam/acca/global/PDF-
technical/public-sector/rr-126-001.pdf
8
 In the case of infrastructure investments in emerging and developing countries, the subject invest-
ments are made in US dollars in practice. Accordingly, returns on the subject investments need to
be paid in US dollars. For this reason, ensuring there are sufficient funds in US dollars for the
payment of the subject returns in cases of infrastructure investments in emerging and developing
countries becomes important. On the other hand, the amount of US dollar funds that emerging and
developing countries can use to pay to foreign countries is limited. Therefore, emerging and devel-
oping countries cannot commit themselves unlimitedly to NRI-PPP Projects that are the subject of
infrastructure investments. Recently, infrastructure investment in African countries has become a
hot topic; however, careful review should be made including whether collection of funds in US
32 2  Business Theories of NRI-PPP Projects

2.2.3  E
 conomic Stimulus Effect in Lieu of the Public Finance
and the Off–Balance Issue in the Public Balance Sheet

In relation to above-discussed subject, as a benefit to the Host Country/Off-taker


that adopts an infrastructure PPP project, whether the NRI-PPP Project can function
as an economic stimulus in lieu of public finance is sometimes discussed. This issue
was discussed at an International Conference on the Development of Public
Infrastructure that utilizes Public Private Partnerships, held in October 2009  in
Seoul, Korea, under the framework of Asia Europe Meeting (ASEM), to which the
author was one of the participants. The conclusion reached at that conference was
that “implementing PPP with economic stimulus as its primary objective is
inappropriate.”
Further in relation to this subject, it is sometimes advocated that an infrastructure
PPP project should be introduced to take advantage of the off-balance benefit in
regard to the balance sheet of the Host Country/Off-taker, and that the public sector
side should incorporate private management techniques more actively. Putting aside
whether or not the public sector side should incorporate private management tech-
niques more actively, the conclusion at the above ASEM International Meeting was
that the Host Country/Off-taker should handle the future payment burden related to
PPP as substantially an on-balance treatment, and implement the debt management.
Aside from the situation where accounting standards formally require off-balance
sheet treatment, as long as the Host Country/Off-taker has a substantial obligation
to pay the PPP debt in the future, PPP being used for the purpose of off-balancing
the debt of a Host Country/Off-taker from the balance sheet of the subject Host
Country/Off-taker, will invite, as a result, the risk of eventually imposing a valueless
burden on the national.9
Even in the United Kingdom, which is a birthplace of the terms PFI and PPP,
considerable Accommodation PFIs exist within PFI and PPP. In PFI in the United
Kingdom, many projects reportedly have not generated VFM (or VFM has been
low).10 Despite this, it appears that PFIs have been used from the viewpoint of eco-

dollars is really possible. Conversely, in order to develop the infrastructure of emerging and devel-
oping countries, those emerging and developing countries need to have sufficient funds denomi-
nated in US dollars, and in return, they need to receive US dollar funds through activities such as
exporting their products overseas. Also, each of the emerging and developing countries prioritizes
its needed infrastructure within the range of its paying ability to make return payment in US dol-
lars. Additionally, when making investments in emerging and developing countries as pure private
sector type investments, there is an inherent risk in arranging for the payment of returns in US
dollars which is not limited to infrastructure investments (the so-called foreign exchange trading
risk including concerns arising from legal regulations as well as regulations in practice).
9
 As for the matters discussed at the ASEM International Conference, please refer to Public and
Private Partnership (PPP) Infrastructures under Global Financial Crisis-Observation on ASEM
Infrastructure PPP Conference, page 14 of the 1207th issue of International Finance, which was
co-authored by Masaaki Anma and the author (2009).
10
 See Armitstead L. (2012) UK taxpayers ‘rarely’ benefit from public-private partnerships, claims
study. The Telegraph. http://www.telegraph.co.uk/finance/newsbySector/constructionandprop-
erty/9196524/UK-taxpayers-rarely-benefit-from-public-private-partnerships-claims-study.html;
2  Reasons NRI–PPP Projects Are Used 33

nomic stimulus, and the viewpoint of off-balancing the debt of a Host Country/
Off-taker on the public sector side. In recent years, this point has become an issue
in the United Kingdom,11 and the popularity of PFI and PPP seems to have rapidly
diminished. It is truly regrettable that PFI and PPP, which are extremely beneficial
to the national when their contents are correctly understood and used, have been
implemented without a proper understanding of their true essence.

2.2.4  “ Private Money Is Used Because National and Local Governments


Lack Financial Resources” Is Essentially a Mistaken Concept

In relation to the above-discussed Sect. 2.2.3 of this chapter, and regarding infra-
structure PPP projects, it is often mentioned that private funds are used because
national and local governments lack money. However, this is a way of thinking that
does not understand the difference between National and local governments’ money
is fiscal money that serves its purpose once it is expended. On the other hand, private
money does not serve its purpose once payment of such money is made. Private
money is used for investment or financing purposes. When the private sector pays
money, the money has to be paid back to the private sector together with profit. Funds
for payment are, as I will discuss in Sect. 4.9.1 and Sect. 4.9.2 of this chapter, pro-
vided as payments of consideration by the recipients of goods and/or services in the
case of a Market Risk-Taking Type Infrastructure PPP Project, and payments of con-
sideration by an Off-taker in the case of Availability Fee Payment Type Infrastructure
PPP Project, which I will discuss in Sect. 4.9.2 of this chapter. The funds used for
payment of consideration by an Off-taker are the money of national and local govern-
ments. In this sense, it should be noted that the concept of “private money is used
because national and local governments lack financial resources” is essentially mis-
taken especially in the case of Availability Fee Payment Type Infrastructure PPP
Project. In the case of Availability Fee Payment Type Infrastructure PPP Project,
reducing the cost burden percentage of the national and local governments from
100% to 90% may be possible, but making it to zero is impossible.
In addition, funds for payments in Market Risk-Taking Type Infrastructure PPP
Projects are for payments of consideration by the recipients of goods and/or ser-
vices. In this type of project, reducing the cost burden of national and local govern-
ments from 100% to zero may be possible. However, as I will discuss in Sect. 5.1.1.3
of this chapter, it is a common knowledge that, in general, a Market Risk-Taking
Type Infrastructure PPP Project is difficult to implement. In this sense, the prudent
judgment of each of the Host Country, the private businesses involved, and the

Fawcett G. (2012) Public private partnerships: the record isn’t great. The Guardian. http://www.
guardian.co.uk/public-leaders-network/blog/2012/apr/11/public-private-partnerships-the-record-
isnt-great
11
 See Treasury  - 17th Report Private Finance Initiative (2011) United Kingdom, House of
Commons Report. http://www.publications.parliament.uk/pa/cm201012/cmselect/
cmtreasy/1146/114602.htm
34 2  Business Theories of NRI-PPP Projects

senior lenders is required when considering implementation of a Market Risk-­


Taking Type Infrastructure PPP Project. In addition, a national or local government
will incur monetary payment obligations with respect to the risks assumed by such
national or local government. Should an infrastructure PPP project be initiated
based on the perception that “national and local governments lack financial
resources,” distortions based on the “lack of financial resources of the national and
local governments” arise in various aspects such as risk sharing and, as a result,
good results are seldom expected.

2.3  Indicators to Measure Benefits for Sponsors

The indicator to measure benefits for Sponsors is the Internal Rate of Return on
Equity (“Equity-IRR or EIRR”). Because this Equity-IRR is, along with the Internal
Rate of Return on Project/Investment (“Project-IRR or PIRR”) or simply Internal
Rate of Return (“IRR”), more appropriately explained in relation to the leverage
effect of project finance, I will discuss it in Chap. 3, Sect. 2.2. Whether or not
Equity-IRR is at an appropriate level from the viewpoint of the Sponsor’s business
becomes important. No matter how much VFM is generated for the Host Country/
Off-taker, if Equity-IRR is too low, there will be no benefit in implementing the
project for the Sponsor which is a commercial enterprise. As I discussed in Sect. 2.1
of this chapter, the existence of sufficient Wealth is important also for Sponsors.
What should be noted here is that Equity-IRR is an indicator measuring “invest-
ment” efficiency. Also, in Equity-IRR, the subject investment efficiency is shown as
a percentage calculated based on the investment made by the Sponsors into the
Project Company. Thus benefits gained by the Sponsors (i.e., private commercial
enterprises) will appear directly as the Project Company’s profit against the invest-
ments made by the Sponsors. Conversely, the EPC Contractor’s profit, which is
included in the EPC fee it receives, is not a direct benefit from the perspective of the
Sponsors in an NRI-PPP Project. I will discuss this point in Sect. 4 of this chapter.
Additionally, the concept of “Equity-IRR needs to be at an appropriate level
from the viewpoint of Sponsor’s business,” which is not well understood particularly
by the Host Country/Off-taker, requires explanation. From the Sponsors’ perspec-
tive, realizing a minimum level of profit is not acceptable. As I will discuss in Chap.
3, Sect. 2.2.1.3, an indicator of a Sponsor’s final profit, expressed as a percentage, is
the rate obtained by deducting from the Equity-IRR the interest rate of the financing
costs related to the subject Sponsor’s investment. For example, if Equity-IRR is
10% and the interest rate of the financing costs related to subject Sponsor’s invest-
ment is 4%, the subject Sponsor’s final profit, expressed as a percentage, is calcu-
lated as 6%. Accordingly, Equity-IRR needs to be at least higher than the interest
rate of the financing costs related to the investment of the subject Sponsor. Further,
even when Equity-IRR is higher than the interest rate of the financing costs related
to subject Sponsor’s investment, if the Equity-IRR is significantly low, it would
mean that the Project Company is not utilizing the funds effectively for the works to
be performed in relation to the project, and consequently, the value of the subject
3  The Essence of an NRI-PPP Project 35

Sponsor’s investment would diminish even if the subject Sponsor achieves some
level of profit. In other words, shareholders of a Sponsor might be better off dispos-
ing of the asset and receiving the cash, and thereafter investing such cash in busi-
nesses that generate higher returns. Thus, in relation to a Sponsor’s investment,
Equity-IRR must be at a level at which the Sponsor can make an appropriate level
of profit. From this viewpoint, each Sponsor must decide whether to participate in
an NRI-PPP Project based on its determination that the investment will or will not
achieve an acceptable Equity-IRR. Additionally, Equity-IRR‘s essential nature in
relation to a Sponsor’s investment becomes critical in understanding risk-sharing in
relation to force majeure events, etc. which I will discuss in Sect. 5.1.1.1 of this
chapter, and the effect of a change in the performance criteria of a NRI-PPP Project
during of the project period, which I will discuss in Sect. 4.10 of this chapter.
Regarding PFI and PPP in Japan, the ability to capitalize on the capabilities of
private businesses and the vitality of the private sector is cited as a reason for using
private business entities. However, this is nothing more than meaningless rhetoric that
shows a lack of understanding of the essence of PFI and PPP. The essential element of
a NRI-PPP Project is “investment” by private business entities, as reflected in the
phrase “Overseas Infrastructure Investment.” In regard to this element, the operating
company’s involvement as Sponsor and investment in a Project Company, and the
ability of the project to make a profit through its operation, are necessary prerequi-
sites. Facilities needed for the operation are designed and constructed for the purpose
of conducting the operation, and thus, the design and construction of facilities are
measures, not the project’s primary objective. In the next Sect. 3 of this chapter, I will
discuss the essence of an NRI-PPP Project in the context of this “investment”.

3  The Essence of an NRI-PPP Project

3.1  Reasons an SPC Is Used in an NRI-PPP Project

In NRI-PPP Projects, the contracting party that enters into the Concession/Off-take/
PPP Agreement with the Host Country/Off-taker is not a Sponsor but the Project
Company, an SPC. Why is the Project Company, an SPC, the contracting party to
the Concession/Off-take/PPP Agreement rather than the Sponsor? I analyze this
question in the subchapters below.

3.1.1  I s a Project Company Used Because Multiple Sponsors


may Be Involved?

As to this question, because multiple Sponsors are usually involved in an NRI-PPP


Project, in order to implement a project under a Concession/Off-take/PPP
Agreement, a joint venture agreement is entered into among all Sponsors, and the
joint venture company, a newly formed SPC, implements the project. This can be
considered a reason why the Project Company is the contracting party to the
36 2  Business Theories of NRI-PPP Projects

Concession/Off-take/PPP Agreement rather than the Sponsor. However, if this is the


reason, then from the Host Country/Off-taker’s perspective, the counterparty to the
Concession/Off-take/PPP Agreement (i.e., the joint venture company) in general
would have a lower credit rating than the Sponsors. As I will discuss in Sect. 4.7.4
of this chapter, a Project Company that is an SPC can never have a higher credit
rating than the Sponsors. Thus, if this were the only reason, the Host Country/Off-­
taker’s interest would be impaired unless the debt owed by the Project Company
under the Concession/Off-take/PPP Agreement to the Host Country/Off-taker is
guaranteed by the Sponsors or by the subcontractors to which the project-related
work is to be assigned by the Project Company. On the other hand, such guarantees
are not made in an NRI-PPP Project, and it has been explained that such guarantees
should not be made. For example, the publication by the HM Treasury of the United
Kingdom, Standardisation of PFI Contracts Version 4 provides at Sect. 4.4.1 as fol-
lows: “In traditional procurement, the Authority may expect to obtain parent com-
pany guarantees from the parent companies to the Contractor and/or the
Sub-contractors (in particular, the Construction Sub-Contractor) to support the
obligation to deliver the Service on time. This is not, however, normally appropriate
in PFI Contracts and should not be a pre-condition to acceptance of a tenderer’s
bid.”12 Accordingly, the existence of multiple Sponsors does not provide support for
the use of a Project Company, an SPC.

3.1.2  Is Project Finance the Reason for Using a Project Company?

In addition, from the viewpoint of project finance, the fact that the borrower must be
a Project Company, an SPC, is sometimes cited as the reason an SPC is used in an
NRI-PPP Project. However, as I will discuss in Chap. 3, Sect. 2.2 and 2.4, project
finance has merits and demerits from the viewpoint of a Sponsor. Thus, Sponsors do
not always choose to fundraise through project finance. Also, as I will discuss in
Chap. 3, Sect. 2.4.2, not all Sponsors are qualified to raise funds through project
finance. In this sense, the use of project finance would not serve as the reason for the
use of the Project Company, an SPC.

3.1.3  I s Bankruptcy Remoteness of the Project Company, an SPC,


from the Sponsors the Reason?

If the Sponsor is directly responsible for a project, continuation of the project


becomes impossible in the event that the Sponsor becomes bankrupt. This concept
of bankruptcy remoteness from Sponsors is sometimes cited as the reason an SPC is
used in an NRI-PPP Project. Certainly, the situation where a highly public

 Standardisation of PFI Contracts Version 4 (2007) HM Treasury of the United Kingdom. p. 29.
12

https://ppp.worldbank.org/public-private-partnership/sites/ppp.worldbank.org/files/documents/
UK_Standardisation%20of%20PFI%20Contracts%20(ver4.2007).pdf
3  The Essence of an NRI-PPP Project 37

infrastructure PPP project becomes inexecutable due to the profitability deteriora-


tion of a business that has nothing to do with the Project should be avoided as much
as possible. In this respect, separating the infrastructure PPP project from the
Sponsors (as legal entities) may have some rationale. However, from the viewpoint
of the Host Country/Off-taker, the essential countermeasure in the event the coun-
terparty to a Concession/Off-take/PPP Agreement falls into bankruptcy is, as I will
discuss in Chap. 3, Sect. 5.5.2.7, to terminate the Concession/Off-take/PPP
Agreement and to conclude a new Concession/Off-take/PPP Agreement with a new
private business entity. The Senior Lender’s rights to step-in, which I will discuss in
Chap. 3, Sect. 5.5.2, is an important countermeasure in practice; however, from the
viewpoint of the Host Country/Off-taker, it is no more than a passive countermea-
sure in the sense that the Host Country/ Off-taker relies on the judgment and action
of the Senior Lender. Therefore, bankruptcy remoteness from the Sponsors does not
serve as the reason for the use of the Project Company, an SPC. In addition, as I will
discuss in Sect. 4.2 in this chapter, judging from the Principle of Owner-Operator,
when a Sponsor goes bankrupt, the operations of an NRI-PPP Project will not be
implemented, and consequently, the business of the Project Company, an SPC, will
also go bankrupt unless effective countermeasures are implemented. Further, as I
will discuss in Sect. 4.7.4 of this chapter, the credit rating of the Project Company,
an SPC, will not be higher than those of the Sponsors, in the first place. Thus, it is
unlikely that a Host Country/Off-taker would choose a Project Company as its
counterparty to a Concession/Off-take/PPP Agreement based on a concern regard-
ing the possibility of the bankruptcy of the Sponsors. Because a Project Company
would have a lower credit rating than the Sponsors, its probability of bankruptcy is
higher than those of Sponsors. Should the Project’s operations-related costs exceed
expectations, and if the contracting party to the Concession/Off-take/PPP Agreement
is the Sponsor and assuming such Sponsor’s credit rating is sufficiently high, such
Sponsor would likely be able to absorb the increase in operational costs to allow the
Project’s operations to be carried out in accordance with the Concession/Off-take/
PPP Agreement. However, as I will discuss in Sect. 4.11 of this chapter, an SPC
would lack the funds to cover any such cost overruns. If bankruptcy remoteness is
the reason, as I discussed in Sect. 3.1.1 of this chapter, unless the debt owed by the
Project Company to the Host Country/Off-taker under the Concession/Off-take/PPP
Agreement is guaranteed by the Sponsors, the interest of the Host Country/Off-­
taker will be impaired.
Bankruptcy remoteness from the Sponsors’ perspective is a securitization issue.
However, different from securitization, in an NRI-PPP Project the Project Company,
an SPC, is the company that actually implements the project, and thus there is an
inherent possibility that the Project Company may become bankrupt. It should be
noted that anyone who claims that an NRI-PPP Project can be analogous to securi-
tization does not understand the essential difference between them.
That is to say, the subject of securitization is the asset, not an operation. In secu-
ritization, cash flow generated by the asset itself becomes an issue, and because the
downside risks in relation to cash flow are low (i.e., volatility of the cash flow is
low), the absence of any risk of bankruptcy is a precondition of securitization.
38 2  Business Theories of NRI-PPP Projects

Conversely, if the downside risks of the cash flow are not low, securitization will not
be realized; hence great care is taken to ensure that the SPC will not fall into bank-
ruptcy. Also, for this reason, the need to isolate the SPC from the risk of bankruptcy
of the originator arises. Further, in securitization, as the asset is transferred from the
originator to the SPC, a “true sale” of the asset is also required. In addition, because
the cash flow generated by the asset itself varies depending on the good or poor
performance of the asset management company, various factors should be consid-
ered in regard to the downside risks of the cash flow. On the other hand, in an NRI-­
PPP Project, cash flow generated by the operation of the project is dependent upon
the Sponsor’s business performance capability, and any cash flow generated by the
project itself that is not affected by the business performance abilities of the Sponsor
does not become an issue. Also, essentially, a downside risk in regard to cash flow
from the Project’s operations always exists (i.e., cash flow volatility is high), and
therefore the Project Company always has the potential to go bankrupt. Further,
when the Sponsor goes bankrupt, the project’s operations will not be performed.
Accordingly, in an NRI-PPP Project, although concerns regarding bankruptcy
remoteness in terms of securitization are not applicable, countermeasures to address
the possible bankruptcy of the Project Company are considered in light of the
Project Company’s potential for bankruptcy. I will discuss these countermeasures in
Chap. 3, Sect. 5.5.2.6. Also I will discuss the difference between operations and
assets in Chap. 3, Sect. 1.4.

3.1.4  I s Monitoring of the NRI–PPP Project the Reason for Using


a Project Company?

From the viewpoint of monitoring of an NRI-PPP Project (or the transparency of an


NRI-PPP Project), the use of a Project Company, which is a separate legal entity
from the Sponsor, is sometimes cited as being necessary. However, if the monitoring
is regarding a technical aspect of the project, there may not necessarily be the need
to choose the Project Company, an SPC, as the contracting party of the Concession/
Off-take/PPP Agreement. Alternatively, if it is financial monitoring of the NRI-PPP
Project, there may be some basis for selecting the Project Company as the contract-
ing party of the Concession/Off-take/PPP Agreement. However, in regard to PFI
project finance practice in Japan, for example, because all project-related risks are
transferred from the Project Company to its subcontractors retained for the project,
financial issues would not impact the financial statements of the Project Company.
Also, if this is the reason, as I discussed in Sect. 3.1.1 of this chapter, unless the debt
owed by the Project Company to the Host Country/Off-taker under the Concession/
Off-take/PPP Agreement is guaranteed by the Sponsor, the interest of the Host
Country/Off-taker would be impaired. In that sense, the viewpoint of monitoring an
NRI-PPP Project (or the transparency of an NRI-PPP Project) is not the essential
reason, though it may be an incidental reason, the Project Company, an SPC, is used
in an NRI-PPP Project.
3  The Essence of an NRI-PPP Project 39

3.2  T
 rue Reason the Project Company, an SPC, Is Used
in an NRI-PPP Project – “Investment” by Private Business
Entities in an NRI-PPP Project

The reason the Project Company, an SPC, is used in an NRI-PPP Project is because
“investments” are made by private business entities. “Investment” in general terms
has various meanings and is used to refer to, among other things, a stock investment
or an investment in one-self. However, “investment” in relation to an NRI-PPP
Project has a somewhat more specialized meaning as discussed below.

3.2.1  Contribution of Money by Sponsors

As an “investment”, a contribution of money is essential. The parties who contribute


money are, as a matter of course, the Sponsors, and this contribution of money is imple-
mented through equity investments made by the Sponsors to the Project Company.

3.2.2  Projects Are Implemented for the Benefit of Sponsors.

Money contributed by the Sponsors needs to result in a positive financial return ulti-
mately. In a typical investment arrangement, there exists the possibility of realizing a
positive financial return based on an increase in the share price of the object of the
investment. However, “investment” in an NRI-PPP Project differs from such a capi-
tal gain approach. A project is implemented using money contributed by the Sponsors,
and thereafter the project generates income from which Sponsors gain financial
returns. In other words, benefiting from the income gained through the operation of
the project is the essence of the investment in an NRI-PPP Project. Accordingly,
profit of private business entities involved in an NRI-PPP Project is realized ulti-
mately in the form of profit provided to the Sponsors, and this profit takes the form
of dividends, etc. as a positive financial return for the equity investment.13

3.2.3  P
 urpose for the Use of Funds Contributed by Sponsors. – Essence
of the Project Is Operation

A project is operated with money contributed by the Sponsors, then the project gen-
erates cash and from such cash inflow a profit is earned. As long as this arrangement
is implemented, the project must generate profit over a long period of time to some

13
 Strictly speaking, from the viewpoint of cash flow, money paid to the Sponsors includes not only
the dividends of profit, but also repayments of invested capitals. In this sense, particularly from the
viewpoint of tax, the nature of the Sponsor’s profit and the money actually paid to the Sponsor
must be recognized after distinguishing the profit from the repayment of invested capital. Also,
when a subordinated loan is used, payments of interest and principal of each such subordinated
loan are included in the cash flow. We will discuss these topics in Chap. 3, Sect. 4.3.
40 2  Business Theories of NRI-PPP Projects

extent. Consequently, the operation (including the management of such operation)


becomes the essence of the project, and, the money contributed by the Sponsors is
used to pay for the design and construction costs of the facilities (capital expendi-
tures) and other related costs necessary to conduct the operation. Costs related to
operation itself are financed with cash generated through the operation.
Additionally, the subject facilities are normally large in scale, and therefore pro-
curing all of the facilities through leasing is not practical. However, when the facili-
ties are small in scale, procurement through leasing is conceivable. However, when
the facilities are procured through leasing, the design and construction costs cannot
be expensed as initial costs. This, in turn, means the method of investment cannot
be employed in the first place. Also, if the ownership of the facilities cannot be
transferred to the Host Country/Off-taker at the conclusion of the project works
under the Concession/Off-take/PPP Agreement, it will not constitute a BOT Project.
Because of these concerns, it should be noted that if a leasing arrangement is used
to procure major parts of the facilities, there is a possibility that the project may lack
factors essential for an NRI-PPP Project.

3.2.4  Limited Liability in the “Investment”

The aspect of limited liability in relation to an “investment” is an important topic


which does not receive significant coverage in existing textbooks on NRI-PPP
Projects or project finance. The essence lies in the fact that in NRI-PPP Projects and
project finance, private business entities can invest a certain amount of capital and
take the risk of not recovering such capital, but they cannot take on risk that would
potentially result in unlimited liability (i.e., liability beyond the invested amount). A
reasonable Sponsor would not be able to assume such a risk of unlimited liability,
and the Equity-IRR calculated based on the invested amount might become unjusti-
fiable in the first place. In that sense, the Sponsor’s obligation in regard to the invest-
ment is, first of all, to assume limited liability, regardless of whether project finance
is implemented in relation to the NRI-PPP Project. Ensuring this limited liability
legally is the true reason the Project Company, an SPC, is employed. In this sense,
the employment of the Project Company, an SPC, is essentially for the benefit of the
Sponsors, not for the Host Country/Off-taker. I will discuss the specifics of this
obligation of the Sponsor in regard to the investment, in Sect. 3.2.6 of this chapter.
For this reason, a corporation is usually employed as the legal entity form of the
Project Company. However, if limited liability of the owners of the Project Company
can be realized, the form of the Project Company needs not be limited to a corpora-
tion. From the viewpoint of preferred tax treatment for the Project Company and other
reasons,14 the use of a limited liability company (“LLC”) is also an alternative. Also,

14
 In the case of corporations, corporations cannot pay dividends as profits to their shareholders
(“dividend of surplus” under Japanese law) unless amounts to be paid as dividends (“distributable
amount” under Japanese law) exist. However, from the viewpoint of project finance, under the cash
flow structure, if money exists that can be paid to the shareholders in accordance with the relevant
3  The Essence of an NRI-PPP Project 41

before the legal form of a limited liability company was introduced, limited partner-
ships were used. In regard to limited partnerships, each of the Sponsors becomes a
limited partner who has limited liability, and the position of the general partner who
bears unlimited liability is assumed by a Sponsor-owned corporation, a paper com-
pany, and thus through this arrangement substantial limited liability can be realized.
Additionally, in this book, for the convenience of explanation, I assume as a
premise that the Sponsor’s investment is made through an equity investment.
However, it should be noted that this does not mean that the form of the Project
Company is limited to corporation.

3.2.5  A
 dequacy of the Host Country/Off–taker’s Execution of a Master
Agreement with Sponsors and Subcontractors Retained to Perform
Work Assigned by the Project Company

In an NRI-PPP Project in Japan, the Host Country/Off-taker often executes a master


agreement with the Sponsors and subcontractors retained to perform work assigned
by the Project Company, prior to signing the Concession/Off-take/PPP Agreement
with the Project Company. This may sometimes become necessary from the view-
point of legal compliance in relation to a bidding procedure. However, it should be
noted that if the Sponsors and subcontractors retained to perform work assigned by
the Project Company bear the obligation to substantially guarantee the debt of the
Project Company under Concession/Off-take/PPP Agreement, that arrangement
will be against the essential nature of an NRI-PPP Project. As I discussed in Sect.
3.1.1 of this chapter, in an NRI-PPP Project, it is unacceptable for the Project
Company to receive guarantees (including substantial guarantees) from Sponsors
and subcontractors retained to perform work assigned by the Project Company.

3.2.6  R
 isks Under the Concession/Off–Take/PPP Agreements Are
Transferred to Private Companies

In an NRI-PPP Project, whether or various risks will be transferred to private busi-


ness entities under the Concession/Off-take/PPP Agreement becomes an issue.
What should be noted here is that even if certain risks are transferred to private busi-
ness entities, because the extent of liability that may be incurred by private business
entities is limited as discussed in (iv), unlimited financial risk will not be assumed
by the private business entities. In this sense, private business entities, particularly
Sponsors, will not take on risk that may ultimately result in their bankruptcy. A Host

payment waterfall scheme, even when there is no dividend amount available as reflected on the
corporation’s balance sheet, the subject money can be used in a pay out to Sponsors, who are the
shareholders of the corporation. Therefore, to avoid this limitation restricting payments to the divi-
dend amount available, a legal entity form other than a corporation is sometimes chosen for the
Project Company. Regarding this point, please refer to Chap. 3, Sect. 4.3.
42 2  Business Theories of NRI-PPP Projects

Country/Off-taker only has rights legally that are provided under the Concession/
Off-take/PPP Agreement (that is to say, it may seek recourse against the Project
Company, an SPC, only to the extent of its creditworthiness which, in turn, is lim-
ited by the limited liability of its shareholder, a private business entity) to which the
Host Country/Off-taker is a contracting party. In other words, risks that may result
in liability beyond the relevant liability exposure limitations are to be borne by the
Host Country/Off-taker. I will elaborate on this point a bit more specifically.
Though I will discuss the details of the risks in Sect. 5.1.1.2 of this chapter, first
of all, it should be noted that the risks in an NRI-PPP Project can be broadly classi-
fied into two categories: (A) risks related to aspects of the project, and (B) risks that
may prevent fulfillment of the Project Company’s obligations, or risks that may
result in additional costs being incurred by the Project Company related to the ful-
fillment of the subject obligation. As for category (A), if private business entities
cannot take on these risks, a project’s viability as an NRI-PPP Project becomes an
issue in the first place, and as for category (B), assuming that a private business
entity can take on the risks related to a certain operation under category (A), regard-
ing the risk that an issue may arise that significantly affects the subject work, which
of the Host Country/Off-taker and private business entities is to bear such risk
becomes an issue. For example, whether private businesses can take on operational
risks falls under category (A), and assuming private business entities can take on
such operational risks, the risk that such private business entities cannot conduct the
project’s operations due to the occurrence of a force majeure event, etc. falls under
category (B). This “transfer of risks under the Concession/Off-take/PPP Agreement
to private business entities” becomes an issue when, under category (A), private
business entities are able to take on risks related to aspects of the project.
If I take an example of operational risk in an Availability Fee Payment Type NRI-­
PPP Project, this risk issue can be classified broadly into two categories: (1) fi
­ nancial
relationships of private business entities against the Host Country/Off-taker, and (2)
bearing of internal costs among the private business entities.
I discuss these two categories below.

3.2.6.1  Financial Relationships of Private Business Entities Against the Host


Country/Off-Taker

As I will detail in Sect. 5.1.3 of this chapter, if a specific required level of availabil-
ity stipulated in the Concession/Off-take/PPP Agreement is not achieved or main-
tained during the operational period due to a reason attributable to the Project
Company (i.e., a situation where the Project Company is unable to provide goods
and/or services required under the Concession/Off-take/PPP Agreement), the
Project Company will have failed to perform an obligation under the Concession/
Off-take/PPP Agreement. Under general principles of Japan’s civil law, the Project
Company bears an obligation to compensate the Host Country/Off-taker for dam-
ages suffered by the Host Country/Off-taker due to the nonperformance by the
Project Company of such obligation.
3  The Essence of an NRI-PPP Project 43

However, even if the Project Company should become legally liable to the Host
Country/Off-taker for such damages, basically, it would not have funds to compen-
sate the Host Country/Off-taker for such damages. In this sense, the Project
Company is a “money-lacking company”, as I will discuss in Sect. 4.11 of this
chapter. Thus, although the Concession/Off-take/PPP Agreement stipulates that the
Project Company is obligated to pay such damages, such provision might have no
real effectiveness. Accordingly, even if private business entities should take on oper-
ational risks, this does not mean that they take on risks which may result in them
having to pay additionally a specific amount of money to the Host Country/Off-­
taker. For instance, the way the Project Company takes on operational risks in an
Availability Fee Payment Type Project is, basically, by reducing the Availability
Fee, which I will discuss in Sect. 4.9.2 of this chapter. That is to say, reduction of
the Availability Fee means that private business entities cannot receive the amount
of money that was agreed originally between private business entities and the Host
Country/Off-taker.
The above rule applies when the Availability Fee Payment Type NRI-PPP Project
and its Concession/Off-take/PPP Agreement are terminated due to reasons attribut-
able to the Project Company. In other words, when the Concession/Off-take/PPP
Agreement is terminated during the operational period due to reasons attributable to
the Project Company, the Project Company is liable for the damages the Host
Country/Off-taker suffers due to its termination under typical breach of contract
principles. The Project Company, however, does not bear such liability for damages
in an Availability Fee Payment Type NRI-PPP Project. The extent of liability the
Project Company may actually bear is a reduction by a certain percentage (e.g.,
30%) of the purchase price of the facilities related to the Project (typically, the pres-
ent value of the unpaid Availability Fee) which the Host Country/Off-taker pays to
the Project Company at the termination of the Concession/Off-take/PPP Agreement.
This is also structured as a reduction of the Availability Fee, that is to say, private
business entities simply would not receive the amount of money that was agreed to
originally between such private business entities and the Host Country/Off-taker.
What has been discussed so far relates to operational risks during the operation
period; however, it also applies to the project’s completion risks during the design/
construction period. When the Project Company, during the design/construction
period, cannot complete the project in accordance with the Concession/Off-take/
PPP Agreement due to a reason attributable to the Project Company, even if the
Project Company is obligated to pay damages under the Concession/Off-take/PPP
Agreement, such obligation to pay damages has no substantial effectiveness.
Accordingly, in these situations, a typical NRI-PPP Concession/Off-take/PPP
Agreement grants the Host Country/Off-taker the right to terminate the Concession/
Off-take/PPP Agreement, while imposing an obligation on the Project Company to
pay a specific amount of damages when the Concession/Off-take/PPP Agreement is
terminated due to reasons attributable to the Project Company. Further, as a credit
enhancement measure to ensure fulfillment of such obligation to pay a specific
amount of damages under the Concession/Off-take/PPP Agreement, the Project
Company is obligated to provide to the Host Country/Off-taker payment guarantees
44 2  Business Theories of NRI-PPP Projects

by banks such as a standby L/C or bond at the time of the signing of the Concession/
Off-take/PPP Agreement. With this measure, the amount obtained by adding the
amount of the payment guarantee by the bank to the amount of the investment
becomes the upper limit of the liability exposure for the Sponsor.15
On the other hand, it can be said that imposing an obligation on the Project
Company beyond the aforementioned limited liability threshold is possible by
imposing obligations on the O&M Operator and the EPC Contractor by way of the
O&M Agreement and EPC Contract. However, it should be noted that the Host
Country/Off-taker is not a contracting party to the O&M Agreement or the EPC
Contract, and thus it cannot, or should not, exercise control over the O&M
Agreements or EPC Contracts.
In regard to NRI-PPP Projects, cases exist where the Host Country/Off-taker has
tried to get involved in determining the terms and conditions of an O&M Agreement
or an EPC Contract. One reason for this may be the Host Country/Off-taker’s antici-
pation of the possible situation where members of the assembly of the Host Country
might assert that the government must monitor and control all aspects of the NRI-­
PPP Project. However, it should be noted that this is against the essence of NRI-PPP
Projects which subcontract the performance of the projects to the private sector, and
thus any such assertion made by such members of the assembly go against the
essence of NRI-PPP Projects. Conversely, if terms adverse to the Host Country/Off-­
taker are stipulated in the O&M Agreement or EPC Contract, and if the Host Country/
Off-taker is made aware of such terms in advance, there is a risk that a court may
order that the Host Country/Off-taker must accept such adverse terms. In this sense,
the involvement of the Host Country/Off-taker in relation to an O&M Agreement or
EPC Contract is reflective of the saying “all to lose and nothing to gain.”
With respect to this point, Sect. 4.4.2 of the publication by the HM Treasury of
the United Kingdom, Standardisation of PFI Contracts Version 4, explains as fol-
lows: “[r]ather, the necessary comfort and protection for the Authority can be pro-
vided through the Project Documents, the use of collateral warranties and or direct
agreements between the Subcontracts and the Authority (see Sections 24.5
(Financiers’ Security) and 29 (Authority Step-In)). Further discussion of this issue
takes place in Section 24 (Indemnities, Guarantees and Contractual Claims).”16
However, as I discussed, the Host Country/Off-taker cannot or should not get
involved in determining the terms of the Project Agreements. Also, although the
Senior Lender is involved in determining the terms of the Project Agreements from
the viewpoint of project finance, as I will discuss in Chap. 3, Sect. 3.3.3, the Senior
Lender’s assumption of a certain part of the Sponsor’s operational risks is essential
in project finance. Therefore, the Senior Lender will not be able to assert in the

15
 Additionally, in some projects, instead of relying on the creditworthiness of the Sponsor, the
Senior Lender is asked to provide the subject payment guarantee. The essence of the relevant issue
is the debt-to-equity ratio, where the issue is the extent of the risk borne by the Sponsor.
16
 Standardisation of PFI Contracts Version 4 (2007) HM Treasury of the United Kingdom. p.
https://ppp.worldbank.org/public-private-partnership/sites/ppp.worldbank.org/files/documents/
UK_Standardisation%20of%20PFI%20Contracts%20(ver4.2007).pdf
3  The Essence of an NRI-PPP Project 45

O&M Agreement and the EPC Contract that the O&M Operator and the EPC
Contractor are to take on an unlimited liability obligation. Also, as I discussed in
Sect. 3.1.2 of this chapter, financing may not always be achieved through project
finance. In this sense, it should be noted that, even though the interest of the Host
Country/Off-taker is protected through the Project Agreements, it is not protected
completely, nor is it protected always. In other words, protecting the interest of the
Host Country/Off-taker completely is not a requirement.
In addition, in the case where the Availability Fee is reduced, the dividends, etc.
that the Project Company expects to pay to the Sponsors will be reduced to account
for such reduction. Also, as I will discuss in Sect. 4.2 of this chapter, the Sponsor
and the O&M Operator are basically the same legal entity from the Principle of
Owner-Operator. Therefore, among the operational risks, the risk of (1) “financial
relationships of private business entities against the Host Country/Off-taker” is ulti-
mately taken by the Sponsor and the O&M Operator in the sense that dividends, etc.
that the Project Company expects to pay to the Sponsors will be reduced. In other
words, as for this risk of (1) “financial relationships of private business entities
against the Host Country/Off-taker,” ultimately, it is borne by the private business
entities, but only to the extent there exists risk that financial returns based on the
invested amount by the Sponsor (and the O&M Operator) will not be collected, and
thus, the liability exposure of the private business entities is limited.

3.2.6.2  Bearing of Internal Costs Among the Private Business Entities

Another risk issue that arises in relation to operational risk is the risk that, in the
course of the operation of the NRI-PPP Project, additional costs related to O&M work
are incurred in an amount larger than originally planned. This risk occurs when the
specific level of availability stipulated in the Concession/Off-take/PPP Agreement is
not achieved or maintained by the Project Company for reasons attributable to the
Project Company. Further, even when a Project Company has achieved and main-
tained the specific level of availability stipulated in the Concession/Off-­take/PPP
Agreement (e.g., goods and/or services stipulated in the Concession/Off-­take/PPP
Agreement are ready to be provided), and thus non-performance under the Concession/
Off-take/PPP Agreement attributable to the Project Company has not occurred, and
accordingly, the issue of financial relationships of private business entities against the
Host Country/Off-taker does not exist, there may be a situation, in the course of the
operation of the NRI-PPP Project, where the incurred cost relating to O&M work is
larger than originally planned. In other words, this is a risk that exists regardless of
whether the specific level of availability stipulated in the Concession/Off-take/PPP
Agreement is achieved and maintained or not, based on a reason attributable to the
Project Company. Also, the operational activities under the Concession/Off-take/PPP
Agreement are performed by the O&M Operator based on the O&M Agreement.
Accordingly, the cost increase actually occurs at the level of the O&M Operator, not
at the level of the Project Company. In such situation, who is to bear the cost increase
which occurs at the level of the O&M Operator becomes an issue.
46 2  Business Theories of NRI-PPP Projects

When the reason for the cost increase is not attributable to the Project Company,
such as the occurrence of force majeure events, etc., the above-stated risk (2)
applies, and the increase should be borne by the Host Country/Off-taker under the
Concession/Off-take/PPP Agreement; and therefore, the O&M Operator can receive
the necessary funds for such costs, which are borne by the Host Country/Off-taker,
through the Project Company.
In risk (1) where private business entities can take on the risks, this risk becomes
an issue when the cost increase is attributable to the Project Company (actually, the
O&M Operator). In this case, as a matter of course, the Host Country/Off-taker does
not bear the cost increase under the Concession/Off-take/PPP Agreement. As a
result, only two choices remain: (x) the O&M Operator bears the increase and does
not pass on the charge to the Project Company, or (y) the O&M Operator passes on
the charge to the Project Company.
If this is an issue related to EPC work, instead of operational work, as I discussed
in Chap. 1, Sect. 4.1.3, since the EPC fee is a fixed amount, the EPC Contractor
would bear the increased costs and would not pass on the charge to the Project
Company. With respect to this arrangement, the risk of bearing such costs assumed
by the private business entities, along with all other risks associated with the com-
pletion of the project, are transferred to the EPC Contractor. I will discuss this point
in Sect. 5.3.1 of this chapter.
In PFI in Japan, costs related to O&M work are under the control of the O&M
Operators, and for this reason it is sometimes argued that the O&M fee should be set
as a fixed amount like the EPC fee, and accordingly alternative (x) above should be
selected. Also, the O&M Operators themselves sometimes accept alternative (x) since
those costs are controllable by them. However, O&M work, unlike EPC work, is
intended to be performed over a long term that surpasses 10 years, and thus it is essen-
tially impossible, even for the O&M Operators themselves, to control completely the
total O&M work-related costs that will be incurred during the contracted period. In
this sense, it is not reasonable to expect that the O&M Operators will keep implement-
ing the O&M work “in the red” (i.e., at a loss) for a period of more than 10 years.
In this case, however, as I discussed before, the Host Country/Off-taker does not bear
the increased costs, and there is, in fact, no one else who will bear the increased costs.
This means that the revenue of the Project Company will not increase by that amount.
Consequently, the Project Company’s source of funds for payments to the O&M
Operator for the increased amount must come from dividends, etc. that are originally
intended to be paid to the Sponsors. In this sense, alternative (y) is to be selected.
However, as I will discuss in Sect. 4.2 of this chapter, from the Principle of
Owner-Operator, the Sponsor and the Owner-Operator are basically the same legal
entity in the first place.
Accordingly, alternative (y) just changes the description of the payment to the
Sponsor and the O&M Operator from dividends, etc. to the increased cost amount
related to the O&M work.
And because the dividends, etc. amount payable to the Sponsor has an upper
limit naturally, when the increased cost amount related to O&M work exceeds the
dividends, etc. amount (i.e., the amount to be paid as profit, etc. to the Sponsor), for
3  The Essence of an NRI-PPP Project 47

the Sponsor and the O&M Operator to keep on implementing the O&M work means
for them to incur increasing losses. If either the Sponsor or O&M Operator was to
be the contracting party to the Concession/Off-take/PPP Agreement, it might be
obligated to the Host Country/Off-taker under the Concession/Off-take/PPP
Agreement to bear the increased cost related to the O&M work.17 The contracting
party to the Concession/Off-take/PPP Agreement, however, is the Project Company,
not the Sponsor or the O&M Operator, in reality. And, also in regard to the O&M
work, the Sponsor/ O&M Operator will not be required to perform the O&M work
and bear, without limitation, the cost increases related to the O&M work.18
Additionally, as I discussed in (1) the Host Country/Off-taker cannot control the
terms and conditions of the O&M Agreement, nor should it control them. When
these are considered together, I can conclude that neither the Sponsor/O&M
Operator nor the Project Company will perform the O&M work and be obligated to
incur unlimited costs relating to the O&M work. In other words, and also regarding
the risk of (2) “bearing of internal costs among the private business entities,” private
business entities will bear risk in the form of reduced dividends, etc. payable to the
Sponsor/O&M Operator, and thus the liability exposure of the private business enti-
ties is limited.
Conversely, when the Project Company continues to record losses for a certain
period (e.g., 3 years), in order for the project to be terminated smoothly, situations
such as the initiation of a bankruptcy proceeding due to a breach or the complete
failure by the Project Company to fulfill its obligations under the Concession/Off-­
take/PPP Agreement, should be avoided. From this viewpoint, particularly in regard
to the Market Risk-Taking Type NRI-PPP Project, it should be noted that it is more
reasonable to recognize that the Project Company should have a termination right
under the Concession/Off-take/PPP Agreement. Additionally, the obligations the
Project Company bears in regard to the termination of the Concession/Off-take/PPP
Agreement are, as a matter of course, basically the same as the case where the Host
Country/Off-taker terminates the Concession/Off-take/PPP Agreement due to rea-
sons attributable to the Project Company.
Incidentally, considering the interest of the Host Country/Off-taker, some may
take the view that establishing a liability cap for the private business entities is inap-
propriate. However, the structure described above in which private funds are
invested in an NRI-PPP Project is essentially limited liability, and because of this

17
 However, under typical contracts between private business entities, because liability for damages
in the case of non-performance has an upper limit, if the increased cost exceeds the upper limit of
liability for damages, incentives for continuing the O&M Operation will disappear. In that sense,
it should be noted that even if the Sponsor/O&M Operator becomes a contracting party of the
Concession/Off-take/PPP Agreement, the increased costs relating to the O&M Operation to be
borne by the Sponsor/O&M Operator should have an upper limit.
18
 As mentioned in the above comment, if the upper limit of liability for damages in the case of
non-performance by the O&M Operator is stipulated in the O&M Agreement, and if the increased
cost exceeds the upper limit of liability for damages, the O&M Operator’s incentives for continu-
ing the O&M Operation will disappear, and in this sense, the bearing of increased cost related to
the O&M Operation by the O&M Operator has an upper limit.
48 2  Business Theories of NRI-PPP Projects

limited liability, VFM is generated. If setting an upper limit on the monetary amount
of the liability of private business entities is inappropriate, then using an NRI-PPP
Project structure based on the premise of long-term cost fixing becomes impractical
in the first place. Also, it is very common in general (i.e., in cases other than NRI-­
PPP Projects) for monetary upper limits to be stipulated in the contracts between
private business entities. As long as the NRI-PPP Project is an approach that intro-
duces these private transactional practices for the provision of public services, the
Host Country/Off-taker needs to accept the method of setting an upper limit of lia-
bility in private transactions as part of the total package.19
In addition, in both of the above-mentioned risks of (1) and (2), even if the
Sponsors should accept unlimited liability, the liability would return to the Host
Country/Off-taker when the Sponsors go bankrupt. Only Sponsors with no concern
for downside risk, and thus low creditworthiness and high potential for bankruptcy,
would assume unlimited risks. Should Sponsors with high potential for bankruptcy
take on any risks under the Concession/Off-take/PPP Agreement, it does not mean
that the risks will be transferred to the Sponsors in a substantial sense. Some may
say that the Host Country/Off-taker should emphasize the point that the Sponsor is
to bear complete responsibility, in its explanation to the national; however, that
alone does not provide any benefit to the national essentially. The Host Country/
Off-taker should understand that, rather than imposing unlimited responsibility on a
Sponsor with low creditworthiness, as I will discuss in Sect. 4.7.2 of this chapter,
selecting a Sponsor with high creditworthiness and high business performance
capability will bring more benefits to the Host Country/Off-taker and the national.
Additionally, the payment of increased costs relating to O&M work by the
Project Company to the O&M Operator also relates to the interests of the Senior
Lenders in project finance. I will discuss this point in Chap. 3, Sect. 4.3.3.1.

4  Characteristics of an NRI–PPP Project

As I discussed in Chap. 3, an NRI-PPP Project means a project where the Sponsors


make investments to the Project Company, the Project Company completes the proj-
ect using the invested capital and money procured by project finance, the Project
Company operates the project after its completion, and then the Sponsors receive
the profit from the subject operation from the Project Company. In this chapter, I
will discuss the characteristics of an NRI-PPP Project.

19
 Additionally, it is a matter of course that limited liability should be separately considered for the
case of damages to a third party. Even in transactions between private business entities, the upper
limit amount of tort liability in relation to the third party claims is never established between the
parties who carry out the transaction; and even if it should be set, it is obvious that it has no effect
on the third party. However, it is sometimes argued that the Sponsor may not incur tort liability in
regard to third parties because an SPC is employed. But there are many cases in this world where
private business entities conduct business through their subsidiaries, and, at least, this is not an
issue inherent to an NRI-PPP Project.
4  Characteristics of an NRI–PPP Project 49

4.1  Operation Is the Essential Chapter of an NRI-PPP Project

As I discussed in Sect. 3.2.3 of this chapter, the essential part of an NRI-PPP Project
is the operation (including the management of the operation). In an NRI-PPP
Project, decreasing of the lifecycle cost, which is the total sum of the costs related
to the design/construction of the facilities (i.e., costs related to Project Completion)
and operation (including the maintenance cost related to operation), becomes an
issue. However, the part of the lifecycle cost that usually results in the greatest profit
are costs related to operation. In pursuit of this profit, private business entities com-
pete fiercely in the project bidding process presided over by the Host Country/Off-­
taker. Although, traditionally, especially in Japan, an infrastructure project is
equated with the design and construction business, the provision of goods and/or
services is, in fact, the essence of an infrastructure project – such as the supply of
electricity in a power business and the operation of trains in a railway business – and
design and construction is no more than a precondition to the provision of goods
and/or services. Greater recognition should be given to the fact that the essence of
an infrastructure project is the operation (i.e., the provision of goods and/or ser-
vices), and thus the operation of an NRI-PPP Project is to be implemented by a
private business entity.
Additionally, in PFI in Japan, some projects exist where a private business entity
completes the facility, etc., and, part of such completed works is used by national or
local governments, and the remainder parts are used by private business entities.
Also, under the PFI Act of Japan as amended on June 11, 2011, rental housing,
ships, aircrafts, artificial satellites, etc. also became the subject of PFI. The objective
in some of these cases includes offsetting and thus lowering the usage fees of the
facilities used by the Host Country/Off-taker by with the profits earned by private
business entities through the effective utilization of the remainder parts. There is no
problem with private business entities’ utilization of the remainder parts of the
assets owned by the Host Country/Off-taker in itself (therefore, effective utilization
should not be discouraged). However, what should be understood here is that such
projects are not PFI or PPP. Such projects, in the first place, do not use the concept
discussed in Sect. 2.1 of this chapter (i.e., as to a specific risk, the party who is most
knowledgeable about, and thus is in the best position to control it, can take on such
specific risk at the lowest cost). In that sense, the theory on which an NRI-PPP
Project is based cannot be applied to such projects, and in these projects, the criteria
to judge whether to employ an SPC or not, whether such projects can be considered
as the object of project finance, or how to measure the profits of private business
entities are different from those of an NRI-PPP Project. It should be clearly realized
that structuring projects without these understandings will result in inappropriate
projects. In the first place, the author considers that such projects are exceptional
projects; that is to say, private business entities will earn satisfying profits by utiliz-
ing the remainder parts, and at the same time, such profits will be sufficient to lower
the usage fees of the facilities used by the Host Country/Off-taker. Further, when
one SPC is employed by regarding (i) the project related to the Host Country/Off-­
50 2  Business Theories of NRI-PPP Projects

taker’s use of the facilities and (ii) the project related to the private business entities’
utilization of the remainder parts of the facilities, as one project, if the latter project
goes bankrupt, the former project may also go bankrupt, and hence a risk exists in
such cases. It is obvious that structures like these are not appropriate.

4.2  Principle of Owner–Operator

Profits in an NRI-PPP Project are ultimately realized in the form of the profits of the
Sponsors. Profits of the Sponsors take the form of dividends, etc. issued in relation
to the invested capital. Accordingly, the O&M Operator who is qualified to share in
the profits related to the operation becomes the shareholder of the Project Company
to receive the profits related to the subject operation. In this way, the shareholder of
the Project Company, an SPC, must be the O&M Operator; and this is called the
Principle of Owner-Operator which is a technical term used in relation to NRI-PPP
Projects and project finance. The fact that the holder of the shares of the Project
Company is the O&M Operator is a logical consequence of the concept that, from
the viewpoint of the source of Wealth, regarding a specific risk, the party who is
most knowledgeable about, and thus is in the best position to control it, can take on
this specific risk at the lowest cost, which I discussed in Sect. 2.1 of this chapter.
Incidentally, the O&M Operator receives, besides dividends, etc., the O&M fees
from the Project Company which is the “consideration” for implementing the oper-
ation including maintenance in accordance with the O&M Agreement. Sometimes,
whether or not profits are included in this consideration becomes an issue. However,
from the viewpoint of project finance, within this consideration, only actual costs
related to the operation including maintenance should be included, and profits
should not be included. I will discuss this point in Sect. 5.2 of this chapter.

4.3  C
 onflict of Interests Between Sponsors and EPC
Contractors

Conversely, from the viewpoint of the Sponsor, the interests of the Sponsor and the
EPC Contractor are in conflict. First of all, in regard to the bidding for a project
which is conducted by the Host Country/Off-taker, the extent to which the lifecycle
cost can be kept lower than levels stipulated in other proposals is the most critical
factor in determining the successful bidder for the project. Thus, determining how
to keep the profits of the EPC Contractor lower becomes important. As a matter of
course, since the EPC Contractor is not allowed to conduct the EPC work without
earning sufficient profits, the principle of competition works there, and as a result,
prices agreeable to both the Sponsor and the EPC Contractor are determined
eventually.
4  Characteristics of an NRI–PPP Project 51

In addition, approval as to Project Completion becomes critical to the Sponsors,


let alone to the Senior Lenders, since the completion risk of the project is imposed
on the EPC Contractor, and accordingly, it is a matter in which the interests of the
Sponsor and the EPC Contractor are in conflict. Incidentally, although cost overruns
to a certain extent are absorbed by the Project Company even in an EPC Contract,
when the process of certification of cost overruns is not strictly followed, it will
adversely affect the cash flow of the Project Company. Thus, also in this respect, the
interests of the Sponsor and the EPC Contractor are in conflict.20
Additionally, an NRI-PPP Project is a project where operation plays a central
role, and, from this viewpoint, the EPC Contractor is positioned like a supporting
player. However, this does not mean that the EPC Contractor is not allowed to earn
a profit from the NRI-PPP Project. As discussed before, if the principle of
­competition works appropriately, the EPC Contractor can earn an appropriate level
of profit. If the EPC Contractor cannot make a profit in regard to an NRI-PPP
Project, it is not because of the EPC Contractor’s position within the project, but
because of the existence of such factors as excessive competition that hinders the
appropriate function of the principle of competition. Essentially, this is not an issue
that can be resolved by the choice of one type of format in which the project is to be
implemented over another (e.g., traditional format or NRI-PPP Project format).
Conversely, it is sometimes asserted that in order for the EPC Contractor to make
a profit, the shifting of the operational role of the NRI-PPP Project to another private
business entity is necessary. However, the O&M Operator does not become involved
with the operation to make the EPC Contractor profitable. It should be noted that
this is also an assertion that puts the cart before the horse.
Incidentally, a misconception exists among some Host Countries/Off-takers and
private business entities that if the EPC Contractor becomes a shareholder of the
Project Company, an SPC, it will have a positive influence in regard to the NRI-PPP
Project. And even though this way of thinking is considered rather mainstream in
regard to PFI in Japan, it is nothing but an illusion. In the first place, if the EPC
Contractor was to become a shareholder of the Project Company, an SPC, it would
mean that the EPC Contractor would take on operational risks. This, in turn, would
mean that the EPC Contractor, which is not familiar with operational risks, would
take on the operational risks, which would not contribute to the reduction of life-
cycle cost (rather, the cost would increase).21 Incidentally, there may be a counter-­
argument which claims that it is conceivable for the EPC Contractor to become a
shareholder of the Project Company, an SPC, and recognize profits from the EPC
work through dividends. However, because the O&M Operator is also a shareholder
of the Project Company, an SPC, profits from the EPC work will become distribut-

20
 Regarding this point, please refer to Overseas Operation of Infrastructure Business and Issues
for Japanese Corporations (Vol. 71, No. 6, page 16 of Transportation and Economy) by Satoru
Madono (2011) (written in the Japanese language).
21
 In regard to Accommodation PFI in Japan, in most of cases the investors are the EPC Contractors.
However, invested capital is considered “wasted money,” and thus the invested capital is not used
efficiently.
52 2  Business Theories of NRI-PPP Projects

able as dividends to O&M Operator, which is not appropriate. Incidentally, the use
of tracking stock or class share may be theoretically conceivable; however, the
author considers that practical reasons to justify this approach do not exist.
Further, in regard to actual projects, some NRI-PPP Projects may suffer from
negative effects. For example, in PFI in Japan, the board members of the Project
Company are usually dispatched from the construction company and operation
company involved in the project. In this situation, however, it should be noted that
there exists the risk, in regard to the approval as to Project Completion, that an
appropriate judgment will not be made because the interests of the EPC Contractor
and the Project Company are in conflict. It should also be noted that this is not a
desirable situation, not only for the Sponsors and the EPC Contractor, but also for
the Host Country/Off-taker.

4.4  P
 rinciple of Single Business in One Project,
and the Project Company’s Status as being an SPC
4.4.1  Principle of Single Business in One Project

The Principle of Single Business in One Project provides that each NRI-PPP Project
should be devoted to only one business. Profits in an NRI-PPP Project are recog-
nized ultimately in the form of dividends, etc. paid to the Sponsors. If multiple busi-
nesses are to be operated in a single NRI-PPP Project under one Concession/
Off-take/PPP Agreement, and each of those businesses is separately operated by a
different O&M Operator, what will happen? The profitability of each business
would be different, and the timing of profit realization may be different for each
business. However, because those profits are realized in the form of dividends, etc.
corresponding to the investment made by the Sponsors/O&M Operators to the
Project Company, the differences in profitability and timing of profit recognition
cannot be reflected in a profitability projection format. Here, a counter-argument
may arise claiming that this issue can be resolved by having each O&M Operator
enter into a separate O&M Agreement with the Project Company, and realizing
profit in the form of an O&M fee. However, as I discussed in Sect. 4.2 of this chap-
ter, profits should not be included in an O&M fee at least from the viewpoint of
project finance. Further, use of tracking stock may be considered. However, tracking
stock cannot provide any remuneration to the tracking stock holder when the Project
Company goes bankrupt. If the Project Company goes bankrupt due to the failure of
one business, the O&M Operators of businesses that are doing well must take on
risks incurred by the failed business. This is contrary to the concept that “regarding
a specific risk, the party who is most knowledgeable about, and thus is in the best
position to control it, can take on this specific risk at the lowest cost.” Another con-
ceivable option may be for all of the O&M Operators to agree in advance to prepare
for the failure of one of the businesses to be operated in the project by agreeing to
bear the obligations of the failed business in order to compensate for any damages
that are incurred by the O&M Operator of the failed business. However, not only is
4  Characteristics of an NRI–PPP Project 53

this contrary to the concept of limited liability of the Sponsors, but also bearing such
mutual obligations under a risk-return relationship may have no rationality from the
viewpoint of business.
In PFI in Japan, it is not infrequent to see cases where “the Principle of Single
business in One Project” is interpreted to mean the Project Company, an SPC,
agrees to enter into a certain multi-business PFI arrangement, and hence, more than
one business is to be undertaken in one PFI project, and the party who is subcon-
tracted by the Project Company to perform each of the businesses of such project
operates such business. However, it should be noted this is against “the Principle of
Single business in One Project” in the true sense of such principle.

4.4.2  Project Company’s Status as Being an SPC

For the same reason stated in Sect. 4.4.1 of this chapter, the Project Company must
be a special purpose company (SPC) that engages only in the business of the subject
NRI-PPP Project. If the Project Company engages in a business other than that of
the NRI-PPP Project, given the risk that profitability of the Project Company’s other
business may deteriorate, the possibility of the Project Company’s bankruptcy arises
even when profitability of the NRI-PPP Project has not deteriorated. This means
that the public service to be provided through an NRI-PPP Project with high public
interest would not be provided due to a reason that has nothing to do with the NRI-­
PPP Project, and as such, this arrangement is something the Host Country/Off-taker
would find difficult to accept. Also, the Senior Lenders of the project finance take
on business risks based upon their judgment of the Sponsors’ business performance
capability in relation to the NRI-PPP Project. Accordingly, the Project Company’s
possible bankruptcy due to the failure of the businesses other than that of the
Sponsor’s NRI-PPP Project, on which the Senior Lenders have made judgments as
to whether to take on a business risk or not, is something that would be deemed
hardly acceptable even for the Senior Lenders.

4.5  B
 ack-to-Back Provision, Pass-through of Risks,
and the Project Company as being a Paper Company
4.5.1  Back to Back Provision and Pass-Through of Risks

The Project Company subcontracts third parties to perform each of its obligations
under the Concession/Off-take/PPP Agreement, and therefore, matters to be imple-
mented by the Project Company itself do not exist. The reason for this is, consider-
ing the EPC work for instance, that the completion risk of the Project needs to be
borne by the EPC Contractor. Just as the Project Company’s obligation to complete
the project is stipulated in the Concession/Off-take/PPP Agreement, the EPC
Contractor’s obligation to complete the engineering, procurement and construction
aspect of the project is stipulated in the EPC Contract, and such obligations must be
54 2  Business Theories of NRI-PPP Projects

performed to enable the Project Company to fulfill its obligation to complete the
Project under the Concession/Off-take/PPP Agreement. In this way, stipulating the
obligations of the subcontractors assigned to perform specific aspects of the project
in separate agreements, including the EPC Contract, entered into between such sub-
contractors and the Project Company so as to ensure the fulfillment of the Project
Company’s obligation under the Concession/Off-take/PPP Agreement, is called a
“Back-to-Back Provisions”. This concept also applies to the O&M Agreement
related to the O&M work.
As for “Back-to-Back Provisions” in relation to the EPC Contract, though the
Senior Lender of project finance may also demand such, it is required from the
viewpoint of the interests of the Sponsors of the NRI-PPP Project regardless of the
existence of project finance, as the Sponsors impose the risk of completion of the
whole project onto the EPC Contractor. On the other hand, as for “Back-to-Back
Provisions” in the O&M Agreement, as the Sponsor is also the O&M Operator any
risk that is not covered under “Back-to-Back Provisions” will still be assumed by
the Sponsor. In accordance with the Principle of Owner-Operator, from the view-
point of the Sponsor, it is not necessarily required to stipulate “Back-to-Back
Provisions” in the O&M Agreement. However, from the viewpoint of the Senior
Lender of project finance, the Senior Lender cannot take on the risk of not having
obligations related to the O&M work under the Concession/Off-take/PPP Agreement
assigned to the O&M Operator. In that sense, making the provisions in the O&M
Agreement “Back-to-Back” is required essentially from the viewpoint of the inter-
ests of the Senior Lender of project finance.
A concept similar to “Back-to-Back Provisions” is called “Pass-through of
Risks.” “Pass-through of Risks” means risks related to a project are transferred from
one contracting party of a project agreement to another contracting party of another
project agreement. Transfers of risks the Project Company bears under the
Concession/Off-take/PPP Agreement to the EPC Contractor or the O&M Operator
through the EPC Contract or O&M Agreement may be the most easy-to-understand
example representing this concept. However, in practice, this concept seems to be
used in transferring certain risks borne by the Project Company in its execution of
the project to the Host Country/Off-taker. For example, in case (2), the obligation to
supply natural gas to Project Company Y is borne by Off-taker X. Now let’s assume
that this supply obligation in actuality is borne by a national gas supplier instead of
Off-taker X, and that the risk of gas prices is borne by Off-taker X. In this case,
Project Company Y signs a gas supply contract with the national gas supplier and
pays the relevant amount based on such gas price to the national gas supplier. The
risks related to gas prices include the risk of unit price change, the timing risk (i.e.,
Project Company Y must have received the relevant cash amount from Off-taker X
before it actually pays the amount owned for the supplied gas to the national gas
supplier), and the foreign exchange risk (when the payment currency of Project
Company Y to the national gas supplier is different from the payment currency of
Off-taker X to Project Company Y). Whether or not Off-taker X bears these risks
appropriately in the Concession/Off-take/PPP Agreement becomes an issue of
whether these risks have been passed through or not.
4  Characteristics of an NRI–PPP Project 55

4.5.2  The Project Company as Being a Paper Company

The Project Company subcontracts third parties to perform all of its obligations
under the Concession/Off-take/PPP Agreement, and thus there are no matters for
which the Project Company itself is to execute. In other words, as I discussed in
Sect. 4.5.1 of this chapter, from the viewpoint of the Senior Lender in project
finance, not only the EPC work but all of the obligations related to the O&M work
under the Concession/Off-take/PPP Agreement must be imposed on the O&M
Operator (Please refer to Sect. 3.2.6 of this chapter, for specifics regarding the O&M
Operator). Accordingly, the Project Company, an SPC, itself should not execute any
work and should assume the sole responsibility of assigning all of its obligations
under the Concession/Off-take/PPP Agreement to third party subcontractors except
for matters required under applicable corporate law to be performed by the Project
Company such as mandatory obligations to be fulfilled by its board of directors. In
this sense, particularly from the viewpoint of project finance, the Project Company
is required to be a paper company.
However, even when the Project Company is established as a paper company, it
will need to perform various actions such as the preparation of financial statements
and documents related to its shareholders’ meetings and board of directors meet-
ings, and the fulfillment of obligations under various Project Agreements and
Financing Agreements. For this reason, the Project Management Services
Agreement, which I discussed in Chap. 1, Sect. 4.1.5, is signed, and the Sponsors
(or some of them) perform these actions on behalf of the Project Company.
Furthermore, there are several actual projects where the Project Company, by hiring
its own employees, fulfills some of its operational obligations under the Concession/
Off-take/PPP Agreement. Further discussion regarding the appropriateness of such
arrangement might be necessary, particularly when comparing it to the deregulated
privatization arrangement.

4.6  Principle of Single Point Responsibility

4.6.1  Principle of Single Point Responsibility in O&M Work

Related to the Principle of Single Business in One Project, from the viewpoint of
project finance and NRI-PPP Projects, there exists a principle called “Single Point
Responsibility, or Single Responsibility.” For example, regarding the operation of
the project during the operation period, which I will discuss in Sect. 4.8.2 of this
chapter, when issues related to subject operation arise, sometimes it is unclear
whether the issue arises because the operation itself had problems, or the operation
went wrong because of problems related to the maintenance of the project’s facili-
ties. In this situation, if the Project Company signs separate subcontracts for the
operation and maintenance of the facilities with an operation subcontractor and a
maintenance subcontractor, the risk of not being able to hold either subcontractor
56 2  Business Theories of NRI-PPP Projects

liable arises. This does not lead to an appropriate transfer of operational risks includ-
ing maintenance to private business entities. From this viewpoint, the operation and
maintenance are collectively subcontracted to one O&M Operator (or multiple
O&M Operators who are to bear joint and several liability), and hence, the risks of
the operation and maintenance are to be borne by the O&M Operator(s), and the
O&M Operator(s) is/are to be held jointly and severally liable regardless of which
of the operation or the maintenance has incurred the problems. The principle that
focuses the responsibility to single point is, exactly, this Principle of Single Point
Responsibility. In an NRI-PPP Project, from the viewpoint of this Principle of
Single Point Responsibility, the combination of “O&M”, which is seldom employed
in ordinary projects, is employed.
Additionally, even if the O&M Operator is responsible for both operation and
maintenance under the O&M Agreement, if the Project Company must substantiate
specifically where in the operation and maintenance the violation occurred in order
to hold the O&M Operator liable for the violation of its duty, the Project Company
will not be able to hold the O&M Operator liable for the violation when it is not
clear which of the operation or the maintenance actually had the relevant problems.
From this viewpoint, it should be noted that, depending on the governing law of the
O&M Agreement, if the Project Company can demonstrate that a violation occurred
regarding the operation, the Project Company will not be required to substantiate
specifically where in relation to the operation and maintenance the violation
occurred. This principle needs to be stipulated in the O&M Agreement.
Incidentally, if the Principle of Single Business in One Project is considered together
with the Principle of Single Point Responsibility, the contract that exists in relation to
the operation and maintenance in a NRI-PPP Project is just the O&M Agreement.
However, when the Sponsor’s local subsidiary company takes the role of the
O&M Operator, and the Sponsor itself guarantees the contractual obligations of the
subject O&M Operator, which I discussed in Chap. 1, Sect. 4.1.2, it follows that an
O&M Guarantee Agreement where the Sponsor is a contracting party is executed,
along with the O&M Agreement where the O&M Operator is a contracting party.

4.6.2  Principle of Single Point Responsibility in EPC Work

The Principle of Single Point Responsibility is applicable not only to O&M work
during the operation period, but also to EPC work during the design/construction
period, which I will discuss in Sect. 4.8.1 of this chapter. In other words, for exam-
ple, when the project does not reach completion, its cause is sometimes unclear
(e.g., whether the problems resulting in the non-completion were caused by the
design or by construction). If the Project Company signs separate subcontracting
contracts or general contracts with a design company and a construction company
regarding the design and construction, there arises the risk that the Project Company
may not be able to hold either party liable for any failure. This means the project’s
completion risk has not been appropriately transferred to private businesses. From
this viewpoint, the Project Company assigns both the design and construction
responsibilities to the EPC Contractor, and regardless of the cause of the
4  Characteristics of an NRI–PPP Project 57

problems – whether in the design or construction phase – the completion risk of the
project is to be borne by the EPC Contractor. In an NRI-PPP Project, based on this
Principle of Single Point Responsibility, the technique called “EPC”, which is also
seldom employed in normal projects, is employed. Incidentally, if the Principle of
Single Business in One Project is considered together with the Principle of Single
Point Responsibility, the contract that exists relating to the EPC work in a NRI-PPP
Project is just the EPC Contract. However, regarding the EPC work I discussed in
Chap. 1, Sect. 4.1.3, if it is classified into overseas works and domestic works from
the view point of local operators, there exists an Offshore EPC Contract, an Onshore
EPC Contract, and a Coordination Contract. When the EPC work is separated into
two separate contracts (i.e., an Offshore EPC Contract and an Onshore EPC
Contract), and in the case problems arise in relation to the EPC work, there arises
the risk that both EPC contractor counterparties to the two EPC Contracts may be
partly responsible for the problem, which, in turn, will end up being contrary to the
Principle of Single Point Responsibility. The contract to be signed to minimize this
risk is called a Coordination Contract.
Additionally, just like the O&M Agreement I discussed in Sect. 4.6.1 of this chap-
ter, even if the EPC Contractor is responsible for both the design and construction
work under the EPC Contract, if the Project Company must substantiate specifically
where in the design and construction work a violation occurred to hold the EPC
Contractor liable for the violation, the Project Company will not be able to hold the
EPC Contractor liable for the violation when it is not clear in which of the design or
construction works the problem actually arose. From this viewpoint, it should be
noted that, depending on the governing law of the EPC Contract, if the Project
Company can demonstrate that a failure to meet the required performance criteria
regarding the design and construction occurred, the Project Company will not be
required to substantiate specifically where in relation to the design and construction
the violation occurred. The above principle needs to be stipulated in the EPC Contract.
Also, in PFI in Japan, a design firm and a construction company sign separate
subcontracting contracts with the Project Company, an SPC, and if any problems
arise in the EPC work, it is assumed that especially the construction company, in
view of the public sector nature of the project, addresses how to deal with the prob-
lems regardless of whether it has actually assumed such responsibility in the con-
tract. If the construction company does not regard the design firm as being responsible
for the problem, no other issue arises. However, if the construction company tries to
hold the design firm responsible for the problem, because of the absence of a contrac-
tual relationship between the construction company and the design firm, the con-
struction company will find itself powerless in enforcing the contractual obligations
of the design firm. As the design firm has signed a design work subcontracting con-
tract with the Project Company, having the Project Company hold the design firm
responsible for the problem is conceivable; however, unless the construction com-
pany is the major shareholder of the Project Company, it is not likely that the Project
Company will take such action. If the construction company is to bear responsibility
regardless of the existence of actual contractual responsibility, it should bear respon-
sibility by becoming the EPC Contractor from the beginning, and as the EPC
Contractor, sign the design work subcontracting ­contract with the design firm by
58 2  Business Theories of NRI-PPP Projects

positioning the design firm as its subcontractor. This would enable it to directly
enforce the contractual obligation of the design firm and become sufficiently profit-
able as the EPC Contractor. Conversely, if the construction company does not accept
responsibility for dealing with the problems, with recognition that it does not bear
any contractual obligation to do so, as I discussed before, there emerges a risk of not
being able to hold either the design firm or the construction company responsible,
which, in turn, invites an undesirable situation for the O&M Operator, the Senior
Lender, and furthermore, for the Host Country/Off-taker.

4.6.3  D
 ifference of Bases where Single Point Responsibilities Are
Required in O&M Work and EPC Work

Strictly speaking, as for Single Point Responsibility in relation to the EPC work,
though it is required by the Senior Lender of project finance, from the viewpoint of
imposing risk of completion of the project on the EPC Contractor, it is required
from the viewpoint of the interests of the Sponsors of the NRI-PPP Project regard-
less of the presence of project finance. On the other hand, as for Single Point
Responsibility in relation to the O&M work, from the viewpoint of the Sponsor, as
it is also the O&M Operator, when the maintenance work is subcontracted to a third
party, the O&M Operator signs a maintenance subcontracting contract with such
third party. In that sense, the risks are taken on by the O&M Operator who will be
responsible in situations where it is unclear whether the issue arises because the
operation itself had problems or the operation suffered because of problems related
to the maintenance of the project facilities. Consequently, if I consider the fact that
the shareholder of the Project Company, an SPC, is the O&M Operator, from the
viewpoint of the Sponsor, it is not unreasonable for the Project Company to sign a
maintenance agreement with a third party. However, from the viewpoint of the
Senior Lender of project finance, it cannot take the risk of not establishing the
responsible party as either the operation provider or maintenance provider. In this
sense, Single Point Responsibility in relation to the O&M work is essentially
required from the viewpoint of the interest of the Senior Lender of project finance.
This explanation is substantially the same as that given in regard to the “Back-to-­
Back Provisions,” which I discussed in Sect. 4.5.1 of this chapter.

4.6.4  O
 ther Businesses Where Application of the Principle of Single Point
Responsibility Is Required

Besides O&M work and EPC work, another service where the Principle of Single
Point Responsibility is applicable is the supply of coal in an IPP (Independent Power
Producer) project. The coal supplier needs to bear not only the obligation to supply the
coal to the Project Company, but also the obligation to transport (marine transport
usually) the coal from the coal mine, and deliver the coal at the site of the project.
From this viewpoint, a coal supplier signs a Fuel Supply and Transportation Agreement
(FSTA), and hence bears responsibility for both supply and t­ransportation/delivery.
4  Characteristics of an NRI–PPP Project 59

4.7  T
 he “Sponsor/O&M Operator” Is the Key Player
in an NRI-PPP Project
4.7.1  T
 he Sponsor/O&M Operator’s Oversight of the Whole NRI-PPP
Project

Based on the matters addressed above, particularly the Principle of Owner-Operator


and the Principle of Single Point Responsibility, it can be concluded that the key
player of an NRI-PPP Project is the Sponsor/O&M Operator. The design and con-
struction of the facilities are also implemented as part of the Sponsor/O&M
Operator’s duty to efficiently operate the NRI-PPP Project in accordance with the
performance criteria stipulated in the Concession/Off-take/PPP Agreement. If I
take, as an example, a project that involves the operation of a swimming pool,
assuming the project is a purely private business and an advanced facility is to be
designed and constructed, the design and construction of this advanced facility is
not going to be implemented if there is a concern that attractiveness of the pool to
potential customers would be weak from the viewpoint of the operation of the
swimming pool. Also, irrespective of how advanced the design and construction
method of the facility may be, if the completed facility poses a risk of harm to the
users of the swimming pool, this advanced design and construction method will not
be adopted. As mentioned above, the Sponsor/O&M Operator supervises the whole
project, including the design and construction of the facility, not just its operation
and maintenance. The operating company considers how to design and construct the
facility from an operational viewpoint of the project, and decides on which design
firm and construction company to retain, after comprehensively considering various
relevant factors such as the design capability or construction capability and price
proposals of the design firm and the construction company.22 An NRI-PPP Project
takes advantage of not only the operating capability of a private operating company
for the operation of a project implemented by a Host Country/Off-taker, but also the
business performance capability of the Sponsor/O&M Operator, who supervises the
whole Project, for the offering of public services.
In PFI in Japan, the prevailing practice is for each of the design firm, construc-
tion company, operating company, and maintenance company to sign a service
agreement, subcontract, etc. with the Project Company, an SPC, concurrently, and
each of these companies is to bear responsibility within the range of its own subcon-
tracted activities. However, under this system, no single company supervises the
whole project and bears responsibility for ensuring the appropriate operation of the
project. For instance, when issues in terms of design or construction arise, the ten-
dency is for the operating company or maintenance supplier to regard them as issues
to be addressed by the design firm or construction company, and not to make a
special effort to try to resolve such issues. In this situation, the business ­performance
capability of a private business entity has not been introduced into the offering of

 This point is more specifically explained in Issues of Japanese PFI when compared to Overseas
22

by Masaaki Anma (2008), page 90 of the 1195th issue of International Finance. (written in the
Japanese language)
60 2  Business Theories of NRI-PPP Projects

public services at all. The Project Company that manages the whole project should
play the most important role, and earn profits in proportion to its efforts. Current PFI
in Japan may be described best as responsibility sharing amongst the relevant par-
ties with each focusing on its own specialized field. However, in fact, this situation
is no better than having multiple subcontracts, and thus the attainable profits are
limited, and there exists the risk that such arrangement may result in a defective
project because of the absence of one party with responsibility to supervise the
whole project and who is to bear responsibility for the whole project.

4.7.2  I mportance of the Sponsor/O&M Operator’s Business Performance


Capability

The point that the NRI-PPP Project’s key player is the O&M Operator means, with-
out exaggeration, that the success or failure of the NRI-PPP Project depends on the
business performance capability (including the management capability) of the
O&M Operator. In the first place, a Sponsor/O&M Operator with high business
performance capability will not participate in an NRI-PPP Project with low eco-
nomic efficiency or an NRI-PPP Project where the risk sharing between the public
and private sectors is inappropriate. Also, a preferable Sponsor/O&M Operator with
high business performance capability would choose an appropriate EPC Contractor
for the execution of the NRI-PPP Project. A preferable Sponsor/O&M Operator
with high business performance capability would also grasp appropriately the risks
involved in an NRI-PPP Project, and take the appropriate risk management mea-
sures to the greatest extent possible. Conversely, the Sponsor/O&M Operator would,
if it fails in the NRI-PPP Project, not only be unable to recoup its investment, but
also jeopardize its reputation in the market. For these reasons, a preferable Sponsor/
O&M Operator with high business performance capability would avoid the possi-
bility of failure of the NRI-PPP Project, which, in turn, will contribute to its detailed
evaluation of the NRI-PPP Project, and will contribute to the achievement of the
public-interest objectives envisioned by the NRI-PPP Project.
In other words, not all NRI-PPP Projects slated for bidding in the world are eco-
nomically efficient or appropriate in terms of risk sharing between the public and
private sectors. To achieve a successful NRI-PPP Project, having eyes that see the
essence of the project is exactly what is required of the Sponsors.
Also, the importance of the business performance capability of the Sponsor/
O&M Operator also means the Sponsor/O&M Operator needs to remain in exis-
tence throughout the project period. Accordingly, even though extremely high
creditworthiness may not be required, relatively high creditworthiness is required of
the Sponsor/O&M Operator.
An NRI-PPP Project is financed through project finance in most of the cases.
Financial institutions that provide financing through project finance have experts who
analyze the projects. Just as some financial institutions are excellent in structuring
project financing for power generation projects, there are different experts for each
relevant field. This means that, even within NRI-PPP Projects, different and broad
4  Characteristics of an NRI–PPP Project 61

knowledge, experiences and know-how are required in the relevant fields. Regarding
NRI-PPP Projects, the risks taken by financial institutions and private business entities
are basically the same. In that sense, private business entities must have the same
capability to conduct risk analysis as experts at project finance units in financial insti-
tutions. This is applicable, not only to the risks related to the project, but also to the
risks related to the macroeconomic management system of the Host Country.
Therefore, private business entities and financial institutions alike “need to have
much interest in the macroeconomic management systems of developing countries,”
and “need to pay sufficient attention to the profitability of the subject project, legiti-
macy of economic development, political background and environmental issues,
including the confirmation of actual demand, and having acceptance readiness in
place such as the relevant infrastructure, and to review the risks that are unseen from
the provisions of the contract.”23 As I will discuss in Sect. 4.12 of this chapter, an
NRI-PPP Project needs to be a project with high sustainability that has the support
of the nation including the adequacy of the price; hence, private business entities
with the ability to identify qualified projects can be successful in NRI-PPP Projects,
and with the fostering of trust through their success, they will obtain a high evalua-
tion from both the Host Country/Off-taker and the financial institutions involved in
NRI-PPP Projects that follow.

4.7.3  Principle of Proven Technology

In relation to the above subject, there exists a principle that the technology employed
in an NRI-PPP Project must be a proven technology, that is, an established technol-
ogy. In other words, for the Sponsor/O&M Operator to persuade a third party of its
ability to successfully carry out the project, it needs to show that the technology
employed in relation to the project has already been successful in other projects.
Consequently, the technology employed in an NRI-PPP Project must be an estab-
lished technology, not a new technology. Conversely, projects that cannot be oper-
ated with established technologies are not suitable to be an NRI-PPP Project
basically. Incidentally, technologies in this context include not only technologies
related to operation and maintenance, but also technologies related to EPC.
The third party in this context refers to the Host Country/Off-taker who selects
the Sponsors, and the Senior Lenders who grant the project finance.

4.7.4  Rating of an NRI-PPP Project

The fact that the success or failure of an NRI-PPP Project depends on the business
performance capability of the O&M Operator means that an NRI-PPP Project will
not be executed if the Sponsor/O&M Operator goes bankrupt. In that sense, the

 Anma M. (1998) Mechanism and Risk of Project Finance. International Finance (Dec. 1998);
23

page 30. written in the Japanese language)


62 2  Business Theories of NRI-PPP Projects

rating of an NRI-PPP Project will never become higher than that of its Sponsor/
O&M Operator. As I discussed in Sect. 4.7.3 of this chapter, although a high rating
such as AAA will not be required of the Sponsor/O&M Operator, creditworthiness
that reasonably eliminates the risk of bankruptcy is required during the project
period of the Concession/Off-take/PPP Agreement.
Additionally, it is sometimes argued that because assuming the credit risk of the
borrower (i.e., the Sponsor) is not a viable option and a loan cannot be granted under
corporate finance, financing through project finance is used as an alternative. However,
if the credit risk of the borrower (Sponsor) cannot be accepted, as I have previously
discussed, the possibility that financing through project finance will not be a viable
option is high in the first place. In that sense, it should be noted that the argument that
project finance works as an alternative to corporate finance does not reflect a proper
understanding of the essence of an NRI-PPP Project and project finance.

4.7.5  Project Period of an NRI–PPP Project

The period commencing from the day the Concession/Off-take/PPP Agreement for
an NRI-PPP Project is signed to the day the operation of the NRI-PPP Project ends
is called the “Project Period”; and this Project Period is, as I will discuss in Sect. 4.8
of this chapter, composed of the design/construction period and the operation
period. Here, the issue is the length of the Project Period. In some NRI-PPP Projects,
the Project Period is sometimes over 30 years. The reason for this may be because
the VFM will not be generated (will not increase) unless the Project Period is set for
such a long term. Also, in a project where a “concession” is granted, a lengthy
Project Period may be set to maximize the consideration the Host Country/Off-taker
can receive at the time the subject concession is granted. However, the success or
failure of an NRI-PPP Project depends on the business performance capability of
the Sponsor/O&M Operator. On the other hand, who will be able to guarantee that
the Sponsor/O&M Operator will survive for over 30 years, with its creditworthiness
and business performance capability maintained? The period of government bonds
is usually 20  years. It seems that the creditworthiness and business performance
capability of private business entities beyond 20 years cannot be appropriately pre-
dicted by anyone. In that sense, in an NRI-PPP Project, the Project Period will
inevitably have an upper limit. Conversely, as for an NRI-PPP Project in which the
Project Period is set beyond its appropriate limit, the Host Country/Off-taker needs
to review carefully the feasibility of the project.

4.7.6  M
 atters to Be Reviewed by the Host Country/Off-Taker During
the Bidding Stage of an NRI-PPP Project

As I discussed in Sects. 4.7.1 and 4.7.2 of this chapter, the most important factors in
an NRI-PPP Project include the business performance capability and creditworthi-
ness of the Sponsor/O&M Operator. Various matters are reviewed in the bidding
4  Characteristics of an NRI–PPP Project 63

stage, and it is no exaggeration to say that the most important matters in this review
process are the Sponsor/ O&M Operator’s business performance capability and
creditworthiness. Also, it can be reasonably said that the business performance
capability of the Sponsor/O&M Operator, a private business entity, is ultimately
most appropriately demonstrated by its track record of past successes and failures in
the same or similar projects. Additionally, as the technology to be employed in the
NRI-PPP Project needs to be a proven technology, to verify the satisfaction of this
requirement, a review of the track record of the Sponsor/O&M Operator’s past suc-
cesses and failures in the same or similar projects becomes important ultimately.
Incidentally, on page 53 of Edward Yescombe’s Principles of Project Finance, as
matters of Pre-qualification review (Called “PQ” in practice in Japan), the following
matters are listed24:
• technical capacity to carry out the project:
• experience of the personnel to be involved;
• experiencer performance with similar projects;
• financial capacity25 to carry out the project.
As mentioned above, the Sponsor/O&M Operator’s business performance capa-
bility including its track record of past successes and failures in the same or similar
projects, and whether the technology is proven or not, are reviewed in the pre-­
qualification review. What should be noted here is the fact that the business perfor-
mance capability of the Sponsor/O&M Operator is included in the pre-qualification
review matters. In this stage, setting the required review criteria high enough so that

24
 Yescombe E. (2014) Principles of Project Finance. second edn. Academic Press, London,
page 53.
25
 As a matter of course, from the viewpoint of the feasibility of the project, financial capacity to
carry out the project is a matter to be reviewed by the Host Country/Off-taker at the bidding stage
of the NRI-PPP Project. Aside from the case where a project is to be financed100% by the bidder’s
own funds, when a project is to be financed with funds from financial institutions it is important for
the bidder to obtain documents from the subject financial institutions confirming their intention to
lend the funds for the project, and to confirm the likelihood that such funds will be actually
procured.
Before financial institutions actually sign loan agreements in general, they must go through
internal review and approval procedures. To complete the internal review and approval procedures
during the stage of bidding pre-qualification, review is impossible from a practical point of view.
Therefore, because completing the review and approval procedures is one of the pre-conditions for
signing the loan agreement, and rejection in the review and approval procedures is possible, there
exists a risk that the lending intention certificates do not certify anything at all as they substantially
depend upon the subsequent loan approval/disapproval determination of the financial institutions.
Consequently, the acceptability of the lending intention certificates depends on the extent of the
certification provide by the financial institutions.
Further, in the case of project finance, as we will discuss in Chap. 3, Sect. 2.5, not all financial
institutions are capable of granting project finance for an NRI-PPP Project in any field. Financial
institutions are required to have sufficient experience in project finance in the subject matter of the
relevant NRI-PPP Project, and to truly understand the project finance arrangement. In that sense,
this is not a perfunctory screening that requires only the preparation of a document called the lend-
ing intention certificate. The Host Country/Off-taker also needs to sufficiently understand this point.
64 2  Business Theories of NRI-PPP Projects

superior Sponsors/O&M Operators are selected, and then letting the candidates
selected in the pre-qualification review compete amongst themselves mainly in
regard to the proposed bid prices, is important from the viewpoint of making the
NRI-PPP Project successful. Conversely, NRI-PPP Projects for which superior
Sponsors/O&M Operators do not submit bid proposals are projects without rational-
ity in regard to profitability and risk sharing. It should be noted that to continue such
NRI-PPP Projects only for the convenience of the Host Country/Off-taker does not
contribute to the welfare of the national ultimately. From the viewpoint of the Host
Country/Off-taker, placing a NRI-PPP Project with high public interest in the hands
of Sponsors who make speculative investments is not allowed in the first place.
Additionally, as I will discuss in Chap. 3, Sect. 3.3.1, in the review to decide
whether project finance can be granted or not, the lenders of project finance should
conduct a review with a focus on the business performance capability and credit-
worthiness of the Sponsor/O&M Operator.

4.8  Design/Construction Period and Operation Period

When an NRI-PPP Project is viewed as a timeline, it is broadly separated into the


design/construction period and the operation period.

4.8.1  Design/Construction Period

An NRI-PPP Project is a project that implements operation, and the time period to
perform the design and construction of the facilities for the operation is referred to
as the “Design/Construction Period.” The Design/Construction Period, in the usual
case, is several years at the longest. In stricter terms, the point in time when a project
is constructed and operational is called “Project Completion” in technical terms
used in relation to NRI-PPP Projects and project finance. The period up to Project
Completion is called the Design/Construction Period. As Project Completion means
to have taken the project from its very beginnings to the state where the project is
operational from the stipulated operational completion date (as I discussed in Chap.
1, Sect. 4.1.3, this means to have operations starts with a turn of a key (the start of
operation becomes possible)), to achieve Project Completion requires advance
study, etc. of land, etc. which precedes the stage of design and construction. In addi-
tion, not only the construction of the buildings, but tasks to make the facilities oper-
ational such as delivery and installment of equipment are included. Further, not only
completing the facilities physically and mechanically (This is called Physical/
Mechanical Completion), but also confirming that the facilities are equipped and
have the planned capability through the implementation of various tests, training of
personnel who are to conduct the operation of facilities, and securing of spare parts
are included. This is called Operational Completion. As indicated by the above
explanation, what the Project Company implements during the Design/Construction
Period is not limited to the design and construction of facilities.
4  Characteristics of an NRI–PPP Project 65

Additionally, the Project Company allows the EPC Contractor to undertake full
responsibility for this Operational Completion, thereby, imposing completion risk
on the EPC Contractor. I will elaborate on this in Sect. 5.3.1 of this chapter.
Incidentally, in addition to this Physical/Mechanical Completion and Operational
Completion, from the viewpoint of project finance, a project completion exists in
relation to the Senior Lender. To fulfill this project completion, besides Physical/
Mechanical Completion and Operational Completion, such matters as insurance for
the operation must be secured, and the project must have realized the planned cash
flow at certain operation period milestones. This is called Financial Completion. I
will discuss this point in Chap. 3, Sect. 5.1.
The costs to be incurred by the Project Company in relation to the project com-
pletion during this Design/Construction Period are called the “Project Costs.” The
majority of the Project Costs is the amount designated as the EPC payment to the
EPC Contractor under the EPC Contract. Other Project Costs include the establish-
ment cost of the Project Company and outsourcing fees payable to various consul-
tants. Money received through capital investments and from subordinated loans
from the Sponsor as well as the loan proceeds from the Senior Loan of the project
finance are used to pay the Project Costs.

4.8.2  Operation Period

This is a period for the operation (and the maintenance related to the operation) of
the NRI-PPP Project. When the Project Company subtracts, from the revenue earned
through the project’s operation, the operation costs such as taxes and public dues,
etc. and the O&M fee, and further subtracts the amounts required for repayment of
the principal amount and accrued interest thereon of the Senior Loan of the project
finance, the remainder is the profit from the operation. The Project Company earns
profits solely through the operation of the project.

4.8.3  Cash Flows from the Viewpoint of Time Series

A diagram depicting the cash-in to the Project Company and cash-out from the
Project Company during the Design/Construction Period and the Operation Period
is shown in Fig. 2.1. Incidentally, for the sake of convenience, it is assumed that
operation costs are limited to taxes and public dues, etc. and O&M fees.
As can be seen from this diagram, the EPC Contractor receives payment of the
EPC fees at a relatively early phase of the Project Completion, and hence earns
profits. On the other hand, the Sponsor earns profits during the Operation Period of
more than 10 years after the Project Completion. It should be noted here that there
exist differences in viewpoints in regard to the risks arising from the difference in
timing of the profit realization in relation to the project.26

 Further, both the advisers for the Host Country/Off-taker and the financial advisers for the proj-
26

ect finance will receive their commissions at the time of the signing the Concession/Off-take/PPP
66 2  Business Theories of NRI-PPP Projects

<Cash-in>
Consideration from users
(Case 1)
Capital Investment/ Subordinated Loan Consideration from Off-taker
Senior Loan of the Project Finance
(Case 2)

<Cash-out> Project Company


Taxes and public dues, etc.
O&M fee
EPC Fee Repayment of principal and interest of
Other Project Costs the Senior Loan of the Project Finance
Dividends, etc. related to equity
investments and subordinated loans

Design/Construction Period Project Completion Operation Period


(Usually one year to several years) (Usually more than 10 years)

Project Period

Fig. 2.1  Cash flow of the Project Company

Incidentally, as for the NRI-PPP Project’s nature of being a project based on the
premise of a cash flow structure, I will discuss this point in Chap. 3, Sect.4.3.

4.9  Two Types of NRI-PPP Projects

NRI-PPP Projects are broadly classified into the following two project types depend-
ing on whether the Project Company is willing to take on the market (demand) risk
or not: “Market Risk-Taking Type” and “Availability Fee Payment Type.”

4.9.1  Market Risk–Taking Type NRI–PPP Project

Market Risk-Taking Type describes a project in which the Project Company actu-
ally provides goods and/or services, and receives consideration from the parties
who receive the goods and/or services. Illustrative Case 1 described in Chap. 1,
Sect. 5 corresponds to this project type. That is to say, Project Company B takes on

Agreement or the project finance contract, and thus, they will not take on the risks related to the
Project Completion or operation that follow. Regarding this point, please refer to page 15 of the
above-cited article Overseas Operation of Infrastructure Business and Issues for the Japanese
Corporations by Satoru Madono.
4  Characteristics of an NRI–PPP Project 67

the risk that the crude oil will sell or not, including the risks associated with deter-
mining whether the crude oil exists or not in the first place, whether it can be
extracted through drilling, and whether the crude oil can be sold at the expected
prices. Also, the revenue of Project Company B is cash revenue based on the sale of
the crude oil at the applicable spot price.

4.9.2  Availability Fee Payment Type NRI-PPP Project

Availability Fee Payment Type can be described as a project which, upon the
achievement and maintenance of a certain available condition stipulated under the
required level, obligates the Off-taker to pay the “full amount” to the Project
Company; and when such available condition is not achieved and maintained, the
payment to the Project Company is reduced by the proportion of the shortage (i.e.,
the percentage by which the value stipulated in the required level was not achieved
and maintained in relation to such condition). Illustrative Case 2 described in Chap.
1, Sect. 5 corresponds to this project type.
In the Availability Fee Payment Type, the payment from the Off-taker to the
Project Company is composed mainly of (A) the Availability Fee (the Capacity Fee)
and (B) the Usage Fee. The Availability Fee is consideration to be paid depending
on whether the project has achieved and maintained a certain available condition or
not.
On the other hand, the Usage Fee is consideration paid in proportion to the
amount of goods and/or services related to the project actually received. This point
can be illustrated by referring to Case 2. When Project Company Y is in a condition
to be able to generate the amount of electricity stipulated in the electric power pur-
chase agreement, Off-taker X will pay the full amount of the Availability Fee to
Project Company Y, and when Project Company Y is not in a condition to be able to
generate the amount of electricity stipulated in the electric power purchase agree-
ment for any reason attributable to Project Company Y, the Availability Fee is
reduced in proportion to the shortage amount and the stipulated ratio in the electric
power purchase agreement. Additionally, the Usage Fee is paid in proportion to the
amount of electricity actually generated and purchased by Off-taker X from Project
Company Y.
As the Availability Fee is paid regardless of the amount of electricity actually
sold, it basically covers the fixed costs (the Project Costs and fixed cost related to
the operation, ordinarily). On the other hand, the Usage Fee covers the variable
costs directly related to the power generation of the sold electricity. With the expla-
nations of the structures given, if I again consider Case 2, even if Off-taker X does
not purchase electricity from Project Company Y, as long as the Availability Fee is
paid in full, Project Company Y could be profitable, but the situation will never
occur where Project Company Y cannot cover the fixed costs. In this sense, Project
Company Y is not taking on the risk that Off-taker X may or may not purchase the
electricity, that is to say, the market risk. Incidentally, the source of funds for the
repayment of the Senior Loan of the project finance is basically the Availability Fee.
68 2  Business Theories of NRI-PPP Projects

4.9.3  Take or Pay

Incidentally, some people may question whether it is inappropriate for the Off-taker
to bear the obligation to pay the Availability Fee in spite of not receiving the specific
goods and/or services. However, payment of consideration without receipt of spe-
cific goods and/or services exists in our daily lives today such as the obligation to
pay a basic charge in order to place a call by telephone. Thus, paying the Availability
Fee itself should not be considered unreasonable at all.
First of all, there exists the technical term of “Take or Pay” in regard to NRI-PPP
Projects. This means the minimum purchase amount of the purchaser for each period
is agreed, and the purchaser has the option of “purchasing or paying.” In other words,
when purchasing during the current term, the purchaser pays the price, but the pur-
chaser can choose not to purchase during the term on the condition that the purchaser
pays the price equivalent to the minimum purchase amount. Conversely, the pur-
chaser has the obligation to pay the minimum purchase amount regardless of whether
the purchase is actually made or not. Incidentally, there is a case where the purchaser
has the option of purchasing during a certain term that follows the current term even
if the purchaser does not purchase during the current term.
Some people may feel a sense of incongruity in regard to the concept of paying
without purchasing. That sense is understandable if it is an ordinary sale and pur-
chase contract. However, this purchase and sale is a special purchase and sale where
the seller completes facilities that produce specific products for sale to specific pur-
chasers, and then sells them. This method is a method developed for an NRI-PPP
Project, particularly in regard to LNG. In an LNG project, huge liquefied natural gas
production facilities are needed, and for that, a huge amount of capital investment is
required. A seller of liquefied natural gas will not undertake a liquefied natural gas
project unless it is assured that it can sell sufficient quantities of liquefied natural gas
to recover the huge capital investment. On the other hand, if it is possible to sell liq-
uefied natural gas in the market in quantities and at prices that will allow for the
recovery of the huge capital investment, the seller of liquefied natural gas may be
able to take on the market risk associated with the sale of liquefied natural gas.
However, there has been no such a market for natural gas thus far. On the other hand,
if it is possible for a purchaser to purchase the liquefied natural gas in quantities and
at a price that would surely enable the recovery of the huge capital investment (of
course, this is made possible only when it is possible for the purchaser to implement
a business, such as gas supply or electric power generation business, which uses
liquefied natural gas purchased in sufficient quantities and at an acceptable price), it
will become possible for the purchaser, by making a commitment to the seller that it
will purchase liquefied natural gas in quantities and at a price that would surely
enable the recovery of the huge capital investment, to enable the seller to conduct the
liquefied natural gas project and to purchase liquefied natural gas from the seller.
Take or Pay means the commitment made by the purchaser to the seller to pur-
chase liquefied natural gas in quantities and at a price that would ensure the recoup
of the huge capital investment, and it is also a concept that was structured from the
viewpoint of finance.
4  Characteristics of an NRI–PPP Project 69

That is to say, the purchaser of liquefied natural gas does not need the agreed
quantity to be delivered all at once, but, usually, it will purchase the agreed quantity
over a relatively long period of time. On the other hand, as for the recovery of the
huge capital investment, most of the huge facility cost is financed by a loan; and
accordingly, the subject loan is to be repaid over the long term. Because the timing
and amount of each payment in the loan’s schedule of repayment are predetermined
from the beginning, the seller of liquefied natural gas must receive proceeds from
sales of liquefied natural gas at times and in amounts that will allow the seller to
meet the payment deadlines in the loan repayment schedule. On the other hand,
considering the situation of the purchaser of liquefied natural gas, the required
amounts of liquefied natural gas may possibly vary depending on the circumstances
at each individual period of time. However, if this variation is reflected directly in
the sales amounts, the proceeds may fall short of the amount required to cover a
payment installment of the loan for a specific period. Accordingly, with the repay-
ment of the loan in mind (adding the factor of financing), the parties agree to level
the sales proceeds to be paid by the purchaser of liquefied natural gas over a period
of time by setting the minimum purchase amount regardless of the actual purchase
amount, and this arrangement is called Take or Pay.

4.9.4  Differences Between Take or Pay and Availability Fee

In a simple form of Take or Pay, the purchaser bears the obligation to pay sales
proceeds in predetermined consistent minimum purchase amounts regardless of the
ability of the sellers to provide the subject goods and/or services. However, in Case
2 for example, the Availability Fee (This is equivalent to the payment of sales pro-
ceeds in predetermined consistent minimum purchase amounts. Sales proceeds cor-
responding to the actual sales amount is included in the Usage Fee.) is not paid in
full when the project is not in an available condition. Accordingly, particularly in
infrastructure PPP projects, it should be noted that, in this sense, it is not a simple
Take or Pay arrangement.

4.10  Fixing of the Project During the Project Period

When a private business entity determines whether to participate in a certain NRI-­


PPP Project or not, as a matter of course, it determines ultimately whether it can
make profits after taking on the risks associated with the subject NRI-PPP Project.
Accordingly, as I discussed in Sect. 4.7.5 of this chapter, it is not appropriate to set
an overly long Project Period from this viewpoint. Further, what will happen if the
performance criteria of the project changes in the middle of the Project Period? Then
the private business entity needs to review whether it can still make a profit after tak-
ing on the risks associated with the project after the subject change. Furthermore, the
profits in this context need to meet the profit level that can justify the Equity-IRR of
70 2  Business Theories of NRI-PPP Projects

the subject private business entity. As I discussed in Sect. 2.3 of this chapter, the
indicator to measure the benefit for the Sponsor is Equity-IRR, and this rate impacts
the value of the project to the Sponsor. Consequently, although a Sponsor may be
able to take on the risk of a drop in Equity-IRR due to reasons attributable to the
Sponsor, it cannot take on the risk of a drop in Equity-IRR due to reasons not attribut-
able to the Sponsor, particularly in a long-term project like an NRI-PPP Project.
Therefore, it should be noted that an NRI-PPP Project where the performance
criteria of a project can be changed in the middle of the Project Period without the
consent of the Project Company (the Sponsor) is at least one example of a project in
which any reasonable private business entity would not participate. That is to say,
the terms of a Concession/Off-take/PPP Agreement needs to be unchangeable with-
out the approval of the Project Company (the Sponsor) which it may grant or with-
hold in its free discretion (a provision to that effect should be stipulated in the
Concession/Off-take/PPP Agreement). Further, as I will discuss in Chap. 3, Sect.
3.3, the Senior Lender of Project Finance reviews, with the contents of the specific
NRI-PPP Project as a premise, whether a Sponsor is capable of implementing the
project appropriately or not, and only when the Senior Lender determines that the
Sponsor can implement the project appropriately, will it decide to grant financing
through project finance. That is to say, changing the performance criteria of the
project in the middle of the Project Period is contrary to the premise that enables the
granting of financing through project finance. Therefore, also from the viewpoint of
project finance, changing the performance criteria of the project in the middle of the
Project Period without at least the approval of the Senior Lender should not be
allowed. For the above reason, it must somehow be agreed that the Concession/Off-­
take/PPP Agreement cannot be changed without the approval of the Senior Lender
which it may grant or withhold in its free discretion.
In addition, in practice, when the performance criteria of a project are changed in
the middle of the Project Period, it is not easy at all to determine the consideration
under the Concession/Off-take/PPP Agreement appropriately. I will discuss this
subject in Sect. 5.1.2.3 of this chapter.
Furthermore, information technology (IT) or information and communications
technology (ICT) is an integral part of many projects. However, innovations in IT
and ICT make IT/ICT adopted for a certain project out-of-date within a few years or
sooner. Thus, it might be impractical to describe the IT or ICT requirements in the
performance criteria for a project, and the establishment of fixed performance crite-
ria might not be possible in the case of projects that involve IT or ICT. Consequently,
a regulated privatization arrangement might be more appropriate for such types of
project. Further discussion with respect to this issue might be necessary to consider
the implications when a project involves IT or ICT.
4  Characteristics of an NRI–PPP Project 71

4.11  P
 roject Company Lacks Cash–Paying Capability
by Nature

First of all, being different from ordinary business companies, the Project Company
is, even if it bears an unplanned monetary payment obligation, basically a company
that does not have any debt-paying resources. That is to say, although cash that
flows into the Project Company during the design/construction period includes
invested capital and money financed through project finance, those funds are used to
pay the Project Costs; therefore, the Project Company has no money left as cash
except for the reserve funds. Also, when funds are raised through project finance,
security interests are granted in favor of the Senior Lender on the assets obtained by
paying the Project Costs. Further, the inflow of money to the Project Company dur-
ing the operation period is limited to the payment from the Host Country/Off-taker,
etc. in principle. This money, except for the profit portion for the Sponsor, is also
used for cash payments necessary for the operation of the project. In that sense, even
if unplanned cash payment obligations are legally imposed on the Project Company,
basically, there would be no resources to pay such unplanned cash payment obliga-
tions except for the profit portion designated for the Sponsor. In this sense, the
Project Company is a company that lacks cash-paying capability by nature, and no
matter how the Project Company may be obligated to make payment, for example,
if the Concession/Off-take/PPP Agreement stipulates that the Project Company is
required to pay damages, such stipulation would have no effectiveness. In that
sense, risk sharing in the form of compensation for damages which occurs in ordi-
nary transactions does not work with an NRI-PPP Project. Also, even if risks usu-
ally borne by private business entities in ordinary transactions are imposed on the
Project Company, it has no financial resources to bear those risks. For example, in
PFI in Japan, more than a small number of projects stipulate in the relevant agree-
ments that increased costs incurred by the Project Company due to changes in laws
aimed at regulating the matters directly related to the subject PFI including design
works, construction works, operation and maintenance, etc. of the subject PFI facili-
ties are to be borne by the Host Country/Off-taker, but increased costs incurred by
the Project Company due to other changes in laws are to be borne by the Project
Company. However, whatever the changes in laws might be, or regardless of whether
or not the changes in laws aim at regulating the matters directly related to the sub-
ject PFI, no financial resources exist for the Project Company to bear the originally
unplanned, increased costs. Conversely, in ordinary transactions, because there exist
risks of incurring increased costs, fixing the price for a long period of time is not
possible. In this sense, it should be noted that PFI that imposes in principle such
change-of-law risks on private business entities does not understand the essence of
an NRI-PPP Project.
72 2  Business Theories of NRI-PPP Projects

4.12  Difficulties and Sustainability of an NRI–PPP Project

Recently in Japan, NRI-PPP Projects, particularly infrastructure PPP projects, have


received a lot of attention; many private business entities have shown genuine inter-
est in regard to participation in infrastructure PPP projects, and the creation of infra-
structure funds have made headlines in newspapers. Among the stories being
reported, more than a few have given the impression that infrastructure PPP projects
are easy to accomplish and relatively anyone can participate in them.
However, the essence of an NRI-PPP Project is in carrying out the operation.
Moreover, the success or failure of an NRI-PPP Project depends on its Sponsor’s busi-
ness performance capability. If a project ends up in failure, invested money will not be
recovered. Also, the repayment amount under the Senior Loan of the project finance
will not be collected. In that sense, both the Sponsor and the Senior Lender are required
to have the capability to properly and fully assess the profitability of the projects.
Further, the funds for repayment of an investment particularly in infrastructure
PPP project will come from, as I discussed in Sects. 4.9.1 and 4.9.2 of this chapter,
the consideration to be paid by those who received goods and/or services in a Market
Risk-Taking Type Infrastructure PPP Project, and the consideration to be paid by
the Off-taker in an Availability Fee Payment Type Infrastructure PPP Project. Funds
for the consideration to be paid by the Off-taker ultimately come from the national
and local governments, that is to say they are generated through taxes, etc. Also,
because the goods and/or services provided in an infrastructure PPP project are
generally related to traditional public services, consideration from those who receive
such goods and/or services in a Market Risk-Taking Type Infrastructure PPP Project
often has a characteristic similar to taxes. In that sense, an infrastructure PPP project
is a project with high political risk. Accordingly, as I will discuss in Sect. 5.1.1.6 of
this chapter, in determining the profitability of a project, private business entities
also need to judge the political risks involved in relation to an infrastructure PPP
project, and for that purpose, private business entities need to judge whether or not
the subject infrastructure PPP project really contributes to the benefit of the national
and is supported by the national including the monetary amount of the consider-
ation; that is to say whether or not the sustainability of the project is high. Also, for
this purpose, as I discussed in Sect. 4.7.2 of this chapter, private business entities
need to perform a risk analysis considering, among other risks, the risks related to
the macroeconomic management system of the Host Country.
For instance, with respect to renewable energy power generation projects par-
ticularly in some developed countries, FIT (feed-in tariff) systems are adopted. The
idea that FIT is a system intended to prevent global warming through the promotion
of the use of renewable energy, the cost of which is to be borne by the national
broadly and narrowly, would appear to gain support by the national of most devel-
oped countries. However, the point is whether or not the FIT system is a system
through which “the cost is to be borne by the national broadly and narrowly.” The
specific meaning of “the cost is to be borne by the national broadly and narrowly”
is that each national bears the cost progressively depending on his/her means. If this
5  Characteristics of Key Project Agreements 73

is the case, whether or not the FIT system, in which the cost is to be borne by the
national depending on the usage amount of electricity, is really supported by the
national should be sufficiently examined. If it is judged that there is no objective
rationality to the FIT system, to what extent private business entities that have
invested in projects under FIT system should be protected (by the national burden)
will become the subject of pervasive discussion widely.
In relation to this, to protect cross-border investments by private business enti-
ties, bilateral investment treaties between nations exist. Private investments that
should be protected under these treaties should be limited to investments that have
been made to establish projects that benefit the national.
Further, the Sponsors need to review and examine various considerations, factors
and matters regarding each NRI-PPP Project, and then judge whether to invest or
not in the subject NRI-PPP Project. In that sense, to invest or not in an NRI-PPP
Project is essentially decided by a bottom-up approach. Conversely, if investment in
an NRI-PPP Project is made by a top-down approach (that is to say, the decision to
invest in an NRI-PPP Project is made at the very beginning), such an investment
will inevitably fail, and such cases periodically exist.

5  Characteristics of Key Project Agreements

5.1  Characteristics of the Concession Agreement/Off-Take


Agreement/PPP Agreement

As I discussed in Chap. 1, Sect. 4.1.1, the Concession/Off-take/PPP Agreement is a


contract that stipulates the performance criteria of the NRI-PPP Project and the
obligations of the Project Company to the Host Country/Off-taker to complete the
project according to the mandatory performance criteria and to operate the project
in accordance with the mandatory performance criteria. I will discuss the following
subjects in this subchapter along with other subjects related to the Concession/Off-­
take/PPP Agreement: risk sharing; consideration under the Concession/Off-take/
PPP Agreement; the Project Company’s way of taking on risks in an Availability-­
Fee -Payment Type Project; and reasons to transfer the project-related facilities to
the Host Country/Off-taker at the conclusion of the project.

5.1.1  Risk Sharing

5.1.1.1  Basic Concept of Risk Sharing

In an NRI-PPP Project, regarding the various risks that arise in relation to a project,
whether a risk should be borne by the Host Country or the Project Company becomes
an issue. Specific examples of these risks include: funding risk, market risk, land
74 2  Business Theories of NRI-PPP Projects

acquisition risk, completion risk, operation risk, change-of-law risk, force majeure
risk,27 and political risk.28 In regard to risk sharing, the following explanation is some-
times offered: The determination of which of the Host Country or the Project Company
is to take on the risks depends on the characteristics of the relevant parties and the
specific project. However, this explanation is misleading. As for which of the Host
Country/Off-taker and the Project Company should take on the risks, a basic concept
exists, and, essentially, it is determined univocally by following this basic concept.
The basic concept of this risk sharing is, as I discussed in Sect. 2.1 of this chap-
ter, as follows: regarding a specific risk, the party who is most knowledgeable about,
and thus is in the best position to control it, can take on this specific risk at the low-
est cost. However, what should be noted here is that this basic concept only means
that risks which can be controlled by private business entities should be borne by the
private business entities. As an example, in relation to an NRI-PPP Project, some-
times the assertion is made that because a change-of-law risk or force majeure risk
cannot be controlled by the public side, private business entities should take on
those risks. However, a change-of-law risk or force majeure risk cannot be con-
trolled by private business entities, either. As for these risks, because neither private
business entities nor the public side can control them, the determination of which
side should take on those risks becomes an issue. The change-of-law risk and force
majeure risk are risks that are borne by the public side when the projects are imple-
mented as traditional public works. In that sense, they are essentially risks inherent
in a project, and therefore, except for cases where VFM is generated (becomes
higher) when they are transferred to private business entities, those risks should be
borne by the public side. Also, even if private business entities take on the subject
risks, VFM is not generated (does not become higher) as long as private business
entities cannot control them. Should private business entities take on the change-of-­
law risk or force majeure risk, it would only result in a higher amount of consider-
ation (i.e., an increase proportionate to such risk) to be paid under the Concession/
Off-take/PPP Agreement. In response to this point, there may be a counter-argument
that even if VFM is not generated (does not become higher), no loss would be
incurred by the public side when private business entities take on the subject risks.
However, the issue is whether the assertion that no loss would be incurred by the
public side is really true.
Under a Concession/Off-take/PPP Agreement, without consideration of all other
contractual conditions, the contracting party who takes on risks will be disadvan-
taged, and the contracting party who does not take on such risks will be advantaged.
Therefore, there exists a premise that, without consideration of all other contractual

27
 As for the force majeure risk, it will differ depending on the country (the difference is especially
noticeable when comparing common law countries to continental (civil) law countries) and how
force majeure is defined in that country. We will discuss this point in Sect. 5.1.1.5 of this chapter.
28
 For additional information regarding these risks, please refer to the earlier referenced Practice of
Project Finance by Ryuichi Kaga (2007), pages 72–93, and Mechanism and Funding of
International Infrastructure Project (Chuo Keizaisha) by Ryuichi Kaga (2010), pages 45–46. (both
written in the Japanese language)
5  Characteristics of Key Project Agreements 75

conditions, the assumption by the Project Company of risk is advantageous for the
Host Country/Off-taker. However, the issue of consideration in regard to a contract
is finally decided after taking all contractual conditions into account. Regarding a
certain risk, if the Project Company takes on that risk, the amount of consideration
the Host Country/Off-taker is to pay to the Project Company increases proportion-
ate to the risk assumed by the Project Company. In that sense, the situation where
“all other contractual conditions are not taken into consideration” does not exist,
and hence it cannot be simply assumed that the contracting party who does not take
on the risks is benefitted.
Additionally, when private business entities take on at least the change-of-law
risk or the force majeure risk, not only are they unable to calculate the proper
amount of the consideration rationally (thus, they take on the risks conservatively
by including in their calculation a buffer amount), but they determine the consider-
ation amount by adding a margin to account for the risk taken, based on their own
past business experiences as private business entities essentially. Accordingly, if a
change-of-law risk or a force majeure risk is imposed on the private business enti-
ties, it is more likely than not that less VFM will be generated (becomes lower). In
this sense, it must be understood that imposing these risks on private business enti-
ties will increase the burden on the public eventually and incur the risk of using
additional taxpayer money unnecessarily.29
Also, as I discussed in Sect. 2.3 of this chapter, the indicator to measure the ben-
efit for the Sponsor is Equity-IRR, and this rate will influence the value of the
Sponsor. Consequently, the Sponsor may be able to take on the risk of a lowered
Equity-IRR due to reasons attributable to the Sponsor, but, particularly in a long-­
term project like an NRI-PPP Project, the Sponsor cannot take on the risk of a low-
ered Equity-IRR due to reasons not attributable to the Sponsor. Also from this
viewpoint, change-of-law risk and force majeure risk are risks that should be borne
by the Host Country/Off-taker.
In view of this basic concept of risk-sharing in an NRI-PPP Project, risks to be
borne by private business entities can be limited to operation risk, completion risk,
funding risk, and market risk in the case of a Market Risk-Taking Type, and the

29
 Similar issues also arise sometimes in transactions between purely private business entities. For
example, under a loan agreement, should a cost increase be incurred by the lender in relation to the
execution or maintenance of a loan, it is a firm practice that the borrower is to bear the increased
cost. This does not mean that because the lender is in a dominant position, the lender imposes the
risk on the borrower. This is because if the increased cost is to be borne by the lender, not only is the
lender unable to calculate the amount of the consideration to account for the risk rationally (thus, the
lender takes a buffer and takes on the risks conservatively), but also the lender would need to deter-
mine the spread by adding the return for taking on the risk (it should be noted that the party which
gains profits directly from the granting of the loan is the lender, and it is a lender who adds the
return). In Japan, arguments sometimes arise from the borrower that there is no reason for the bor-
rower to bear the increased costs, or the borrower should be given the option to choose between
bearing the increased costs and making a prepayment in lieu of having to bear the increased costs.
However, this is an assertion that does not understand that spread, a consideration, is determined
within a total transaction including the bearing of increased costs, or through the cost transfer
method in risk sharing, thus, it should be noted that there is no rationality to this assertion.
76 2  Business Theories of NRI-PPP Projects

other risks are those that should be borne by the Host Country/Off-taker.30
Incidentally, as a matter of course, in a specific NRI-PPP Project, if a private busi-
ness entity judges that it cannot take on the operation risk, completion risk, funding
risk, or market risk in the case of a Market Risk-Taking Type NRI-PPP Project, the
private business will not take part in such project in the first place.
Risks that should be assessed from the viewpoint of an NRI-PPP Project and
project finance are included in sponsor risk. This is a risk as to whether or not the
Sponsor has the adequate business performance capability. This risk, as I will discuss
in Chap. 3, Sect. 3.3.1, becomes an issue from the viewpoint of whether the Senior
Lender can take on this risk primarily in project finance. However, sponsor risk could
also become an issue between the Host Country/Off-taker and the Project Company.
Also, as the Project Company is owned substantially by the Sponsor, it means sub-
stantially that it is essentially impossible for the Project Company to bear the sponsor
risk. In that sense, the sponsor risk must be borne by the Host Country/Off-taker.
Accordingly, as I discussed in Sect. 4.7.2 of this chapter, the Host Country/Off-taker
should carefully examine this point at the bidding stage of the NRI-PPP Project.

5.1.1.2  Types of Risks

The various risks can be broadly classified into two types: (A) risks related to the
specifics of the project, and (B) regarding the obligation to be fulfilled by the Project
Company under the Concession/Off-take/PPP Agreement, risks that hinder the ful-
fillment of such obligation by the Project Company or the risk additional costs will
be incurred by the Project Company in relation to the fulfillment of such obligation.
(A) Risks related to the Specifics of the Project.
Market risk, land acquisition risk, completion risk, operation risk, etc. are included
in (A). As for (A), for example, regarding completion risk and operation risk, if the
Project Company cannot take on these risks, implementation of the Project in the
form of an NRI-PPP Project becomes impossible in the first place. Additionally,
regarding market risk, if the Project Company can take on this risk, it becomes a
Market Risk-Taking Type as I discussed in Sect. 4.9.1 of this chapter, and if the
Project Company cannot take on this risk, it becomes an Availability Fee Payment

30
 As for other risks, if additional costs that can be covered by insurance exist, they can be posi-
tioned as the risks to be assumed by private business entities to that extent. However, whether the
subject insurance is available in the market is a matter the Host Country/Off-taker should confirm
before the bidding of the project. Additionally, for example, in the case a plant is damaged by a
force majeure event, if the costs related to repairing the subject plant can be covered by insurance,
the subject costs can be positioned as the risk of private business entities. However, the amount
equivalent to the Availability Fee during the period required for the subject repair cannot be cov-
ered by insurance (profit compensation insurance may exist, but it is expensive even if it exists, and
will only push up the Availability Fee at the bidding stage to account for that amount); accordingly,
the Availability Fee needs to be paid in full, and it should never be reduced as the risk borne by
private business entities.
5  Characteristics of Key Project Agreements 77

Type as discussed in Sect. 4.9.2 of this chapter. In the first place, these risks lead to
the issue of whether the project can be implemented in the form of an NRI-PPP
Project and, if so, in what form of an NRI-PPP Project it can be implemented.
Additionally, as for (A), when risks appear in the case where the Project Company
does not take on the subject risks, solutions are sometimes realized by the Host
Country/Off-taker’s providing funds to pay for damages or losses in compensation.
For example, as for the acquisition risk of the land on which the project is to be
implemented, if the Project Company can take on that risk, it becomes the obliga-
tion of the Project Company under the Concession/Off-take/PPP Agreement, and if
the Project Company cannot take on that risk, it does not become the obligation of
the Project Company under the Concession/Off-take/PPP Agreement.
The issue that comes up next relates to the ways in which the Host Country/Off-­
taker bears the risk when the Host Country/Off-taker is to bear the land acquisition
risk. One way is to execute the Concession/Off-take/PPP Agreement after the Host
Country/Off-taker acquires the subject land (in this case, the Host Country/Off-­taker
should provide a representation and warranty under the Concession/Off-take/PPP
Agreement that no discrepancy regarding the ownership of the subject land exists
that would hinder the Project Company when it performs the NRI-PPP Project, and
should covenant that no such discrepancy will arise in the future. Another way could
be for the Host Country/Off-taker to bear an obligation under the Concession/Off-
take/PPP Agreement to acquire and maintain the ownership, etc. of the subject land
in a way that would prevent the existence of any discrepancy that may become a
hindrance to the Project Company in its performance of the NRI-­PPP Project.
Considering the situation where the Host Country/Off-taker violates such repre-
sentation, warranty, covenant or obligation and, as a consequence, provides damages
or loss compensation to the Project Company, the issue arises as to whether or not the
lost profits of the Project Company should be included in such damages and loss
compensation. In the situation where the Host Country/Off-taker could not acquire
the land due to any force majeure reason, perhaps there is rationality to the idea that
the lost profits of the Project Company should not be the subject of such damages or
loss compensation. However, in a situation where a representation or warranty proves
not to be true, or the Host Country/Off-taker violates its covenant or obligation due
to a reason attributable to itself, as a general theory, it would be rational to include the
lost profits of the Project Company in the damages and loss compensation payable to
the Project Company, in light of the necessity to maintain Equity-IRR. In this regard,
please note that Equity-IRR is calculated using the discount rate and the net present
value from all cash flows from the project. This means that a delay in the payment of
money, from the perspective of the equity-holder, might decrease the present value of
such payment which would result in a decrease of Equity-IRR.
Additionally, as for the issue of whether or not private business entities can take
on the acquisition risk of the land where the project is to be implemented, in the
situation where multiple plots of land suitable for the project exist, and they can be
acquired through the open market, private business entities can control the risks, and
then the Project Company would naturally be able to take on the subject risk. In
such situation, the Project Company bears the land acquisition obligation under the
78 2  Business Theories of NRI-PPP Projects

Concession/Off-take/PPP Agreement. On the other hand, in situations where oppo-


sition by residents exists or there are parties who are using the land, etc., those are
risks that are uncontrollable by private business entities, and thus it becomes impos-
sible to impose the land acquisition risk on the Project Company. In this situation,
the Host Country/Off-taker takes on the acquisition risk of the subject land.
Incidentally, in ordinary NRI-PPP Projects, such situation where private business
entities can acquire the land suitable for the project under the market mechanism
would seem to be very unlikely.
Additionally, sometimes an assertion is made that as both contracting parties
should be treated equally, if there is an upper limit to the obligation of the Project
Company, there should be an upper limit to the obligation of the Host Country/Off-­
taker. However, because contracting parties have different roles and risks to be borne
in relation to the transaction contemplated by the contract, it is a matter of course that
the nature of the obligations to be borne by the subject contracting parties is different.
It should be noted that neglecting to consider the different roles of the contracting
parties in the subject contract and insisting on equality does not reflect a proper
understanding of the essence of the contract, and there is no rationality to it.
(B) Regarding the obligations to be fulfilled by the Project Company under the
Concession/Off-take/PPP Agreement, risks that hinder the fulfillment of such
obligations by the Project Company or the risk that additional costs will be
incurred by the Project Company in relation to the fulfillment of such
obligations.
Change-of-law risk and force majeure risk, etc. are included in (B). Even when
private business entities take on the risk of (A) (for example, operation risk), private
business entities do not take on operation risk in every case. For instance, in a case
where the Project Company is unable to implement the operation of the project due
to the occurrence of a force majeure event, this risk is, as I discussed in (1), taken by
the Host Country/Off-taker. In this sense, to think of risk (A) and risk (B) in parallel
is not appropriate.
This risk becomes an issue in two cases. For the first case, consider the situation
in an Availability Fee Payment Type NRI-PPP Project, where, regarding the obliga-
tion to be fulfilled by the Project Company under the Concession/Off-take/PPP
Agreement, the fulfillment of the subject obligation becomes impossible due to the
occurrence of the subject risk event. In this situation, how to treat the contractual
obligation of the Host Country/Off-taker (especially, the consideration payment obli-
gation), as the counterparty of the Concession/Off-take/PPP Agreement, becomes an
issue similar to risk sharing. The basic remedy in an Availability Fee Payment Type
NRI-PPP Project is that the Host Country/Off-taker’s consideration payment obliga-
tion under the Concession/Off-take/PPP Agreement will not expire at least regarding
the Availability Fee, and when the right of termination of the Concession/Off-take/
PPP Agreement is granted to each party of the Concession/Off-take/PPP Agreement,
and when the Concession/Off-take/PPP Agreement is terminated, the Host Country/
Off-taker will compensate all of the losses that are incurred by the Project Company.
In this case, the losses that occur to the Project Company are basically unrecovered
5  Characteristics of Key Project Agreements 79

fixed costs. Also, these fixed costs are, as I discussed in Sect. 4.9.2 of this chapter,
recovered in the form of the Availability Fee in Availability Fee Payment Type NRI-
PPP Project. Consequently, as a method for the loss compensation, the Host Country/
Off-taker purchases the facilities of the project (if the completion of the project is the
objective, the output of the facilities at that point in time), and the purchase price
(calculated to the present value) becomes an outstanding Availability Fee (if the com-
pletion of the project is the objective, the actual costs and expenses incurred and paid
by the Project Company until, and related to the Concession/Off-take/PPP Agreement
termination). In this sense, when the fulfillment of the obligation under the
Concession/Off-take/PPP Agreement becomes impossible due to reasons such as
change-of-law risk or force majeure risk, etc., the Availability Fee payment obliga-
tion of the Host Country/Off-­taker under the Concession/Off-take/PPP Agreement,
as the counterparty under the Concession/Off-take/PPP Agreement, does not expire
substantially. If these basic measures of an NRI-PPP Project contradict with a con-
cept similar to risk sharing under the civil law of the host country, provisions that are
consistent with the basic theories of NRI-PPP Projects need to be stipulated in the
Concession/Off-take/PPP Agreement.
Regarding this point, in the case where the Concession/Off-take/PPP Agreement
is terminated before the completion of the project due to the occurrence of a change-­
of-­law risk or a force majeure risk, although an idea to pay the “market value of the
existing facilities” as consideration is sometimes proposed, this is not appropriate.
First of all, costs incurred by the Project Company before the termination of the
Concession/Off-take/PPP Agreement are not limited to construction costs, but
rather design costs and other Project Costs also exist. As long as the Project
Company does not take on the market risk, the Host Country/Off-taker needs to
compensate the Project Company for these design costs and other Project Costs.
Further, in the case where output does not exist at all due to a natural disaster, for
example, if the market value is zero because of the nonexistence of output, the Host
Country/Off-taker will not take on the risk. In this sense, “purchase” price does not
mean “market value” of the output. Essentially, “purchase” is no more than an expe-
dient way for the Host Country/Off-taker to take on risks (that is to say, the Host
Country/Off-taker compensates the Project Company for the actually borne
expenses before the termination of the Concession/Off-take/PPP Agreement and
related to the termination of the Concession/Off-take/PPP Agreement). Some par-
ties may assert that paying more than the “market value” of the output is not appro-
priate because it lacks consideration. However, how much to pay to the Project
Company in the event the Concession/Off-take/PPP Agreement is terminated due to
the occurrence of change-of-law or a force majeure event is determined in the risk-­
sharing structure of the overall Concession/Off-take/PPP Agreement, and, in that
sense, consideration should be judged considering all aspects of the project.
Focusing solely on the output at the time of the Concession/Off-take/PPP
Agreement’s termination and asserting that the compensation lacks consideration
has no rationality in itself.
80 2  Business Theories of NRI-PPP Projects

The second case where this risk becomes an issue is at what timing additional
costs31are incurred by the Project Company, although it should be noted that the
subject risk will not prevent the Project Company from fulfilling its obligations
under the Concession/Off-take/PPP Agreement. This risk also is to be taken, as I
discussed in (1), by the Host Country/Off-taker.
The issue in this case is at what timing the Host Country/Off-taker should make
its payment for the additional costs to the Project Company. As I discussed in Sect.
4.11 of this chapter, the Project Company lacks cash-paying capability by its nature,
and thus funding for any payment of costs the Project Company needs to make basi-
cally comes only from funds received from the Host Country/Off-taker. For this
reason, before the Project Company can actually make payment on the subject addi-
tional costs, the Host Country/Off-taker needs to transfer funds sufficient to cover
the subject additional costs to the Project Company. Otherwise, the Project Company
will be forced to borrow funds through a bridge loan to cover the deficit between the
time when the Project Company actually pays the subject additional costs and the
time when the Host Country/Off-taker provide funds to cover the subject additional
costs to the Project Company. Although in practice, funding through a subordinated
loan provided by the Sponsor is assumed in many cases, at least the funding costs
are to be incurred by the Project Company, and in this case, the Host Country/Off-­
taker needs to bear the subject funding costs. That is to say, when the Host Country/
Off-taker is unable to pay the subject additional costs timely to the Project Company,
the burden of the Host Country/Off-taker will increase by that amount. From the
standpoint of the Host Country/Off-taker, it may not be able to pay the subject
­additional costs without taking appropriate budgetary measures. However, budget-
ary measures are no more than internal procedures of the Host Country/Off-taker. In
that sense, it must be carefully reviewed whether the Host Country/Off-taker’s ben-
efit by not timely paying the subject additional costs to the Project Company really
exists in light of the subject funding costs.

5.1.1.3  Market Risks

As I discussed in Sect. 4.9 of this chapter, NRI-PPP Projects are broadly classified into
two types based on whether private business entities take on market risks: that is, the
Market Risk-Taking Type and the Availability Fee Payment Type. In cases where pri-
vate business entities do not take on market risks, if the private business entities main-
tain the situation where goods and/or services to be provided under the Concession/

31
 Additionally, in PFI in Japan, in cases where additional costs are incurred by the Host Country/
Off-taker (not by the Project Company) due to a change-of-law risk or force majeure risk, it is
sometimes asserted that part of these costs should be borne by the Project Company. However, this
risk is the one that is borne by the Host Country/Off-taker when it implements the traditional pub-
lic works. If this risk is imposed on private business entities, the result will be less generation of
VFM (a reduction of VFM), and thus no benefits can be enjoyed by private business entities or the
Host Country/Off-taker. Accordingly, additional costs arising from a change-of-law risk or force
majeure risk should be borne 100% by the Host Country/Off-taker.
5  Characteristics of Key Project Agreements 81

Off-take/PPP Agreement are, in fact, provided, they can receive the full amount of the
so-called Availability Fee from the Host Country/Off-taker. On the other hand, in
cases where private business entities take on market risks, the consideration to be paid
for such goods and/or services are paid ordinarily by the parties who actually receive
the goods and/or services, and not by the Host Country/Off-taker.
What is important to note is the common sense realization that Market Risk-­
Taking Type NRI-PPP Projects are generally difficult to implement due to the market
risk from the perspective of private businesses. Particularly, identifying the factors
influencing market risk is not easy, and, in that sense, even considering the risk that
goods and/or services may not sell due to a force majeure event, private business
entities must take on such risk.32 This is a fact that cannot be learned when Market
Risk-Taking Type projects and projects where private business entities do not take on
market risks are discussed in parallel in textbooks. On the other hand, unless some-
thing like a shadow toll33 is collected, as described before, payment from the Host
Country/Off-taker will not be received in a Market Risk-Taking Type NRI-PPP
Project. This sounds very attractive in the implementation of an infrastructure project
by a Host Country/Off-taker who cannot financially afford taking on such risk. In
fact, it is often the case that advisors to a Host Country/Off-taker will recommend
this arrangement for an NRI-PPP Project. Of course, the author has no intention of
characterizing all Market Risk-Taking Type NRI-PPP Projects as unreasonable.
However, it is true that there are more than a few cases of Market Risk-Taking Type
NRI-PPP Projects ending in failure. In the first place, it is ­generally difficult to accu-
rately predict objectively how much demand will exist over the long term.
Generally speaking, among infrastructure PPP projects, those that can take on
market risks are in areas where the economy is expanding and in regions where the
population is increasing. Incidentally, in the early years of PFI in the United
Kingdom there was a project seeking to connect central London to its suburbs by
tram; and in this case, there existed an agreement not to set up other transportation
systems that connected central London to the subject suburbs. As in this case, unless
specific arrangements positioning the infrastructure PPP project to succeed are
established, private business entities cannot determine whether or not they can take
on the relevant market risks.
Recently in Japan and other jurisdictions, with the introduction of so-called
“concessions” there have been increased discussions on the introduction of a Market
Risk-Taking Type Infrastructure PPP Project including “airport PFI” (i.e., operation
of airport facilities through PFI concessions). However, in those discussions, the
common sense point that Market Risk-Taking Type NRI-PPP Projects are generally

32
 Incidentally, it should be noted that the risk of not selling goods and/or services due to the facili-
ties being rendered unusable physically or functionally due to a force majeure event, would not be
a market risk.
33
 In an expressway project, for instance, ordinarily tolls are collected from the users of the express-
way. However, in some cases, tolls are not collected from the users and instead, the Host Country
pays the tolls in accordance with the traffic volume. This toll paid by the Host Country is called a
shadow toll.
82 2  Business Theories of NRI-PPP Projects

difficult to implement due to the market risk from the perspective of private business
entities does not seem to be understood sufficiently. Also, in the case of airport PFI
in Japan, as a precondition to implementing a project in the form of PFI, the govern-
ment must first decide on the airport’s position in relation to travel within Japan and/
or Asia (Is it to be positioned as a hub? What specific measures will the government
take if the airport is positioned as hub? What arrangements are to be considered and
implemented as between the central and local governments?). Without this determi-
nation, private business entities cannot make a reasonable judgment on whether or
not to take on the market risks, and they will not elect to participate in such an
infrastructure PPP project.34
Further to the above point, consider the global financial crisis which occurred in
2008, and which created numerous problems and issues for NRI-PPP Projects in
existence at the time. The global financial crisis was described as an exceptional
event having an occurrence probability of once in every 100 years. However, his-
torical records show us that significant financial crises actually occur on a more
frequent basis. In Asia, the Asian financial crisis occurred in June 1997, about ten
years before the 2008 global financial crisis. On the other hand, the Project Period
of an NRI-PPP Project is ordinarily more than 10 years. In this sense, it may be
reasonable to think that a major financial crisis will occur once during the Project
Period of an NRI-PPP Project. Accordingly, along with the need to conservatively
estimate the demand for the relevant goods or services to be provided, private busi-
ness entities should consider in advance stipulating in the Concession/Off-take/PPP
Agreement the support to be provided by the Host Country/Off-taker upon the
occurrence of an exceptional event.

5.1.1.4  Ways for Private Business Entities to Deal with Risks and Completion


Risk

As discussed in Sect. 5.1.1.2 (A) of this chapter, in an NRI-PPP Project, completion


risk should be taken on by private business entities, and if private business entities
cannot take on the completion risk, the relevant project cannot be implemented as
an NRI-PPP Project. Also, as I discussed in Sect. 5.1.1.2 (B) of this chapter, even
though completion risk is to be taken on by private business entities, change-of-law
risk and force majeure risk, etc. are to be taken on by the Host Country/Off-taker. In
light of the foregoing, the following issue arises: Considering that certain risks are
to be borne by the private business entities, when a project fails to be completed due
to reasons attributable to the private business entities, what actions should be taken
by the Host Country/Off-taker? Also, a related issue arises regarding the approaches
that should be taken by private business entities to deal with completion risk.

 One case that illustrates the importance of the positioning of the airport and issues that will arise
34

when political risks actually occur is the Manila International Airport Terminal 3 Project in the
Philippines. For information regarding this case, please refer to above-cited Mechanism and
Funding of International Infrastructure Project by Ryuichi Kaga, pages 273–276. (written in the
Japanese language)
5  Characteristics of Key Project Agreements 83

For instance, in illustrative Case 2 described in Chap. 1, Sect. 5, the completion


risk in relation to a 1000 megawatt (“MW”) natural gas-fueled power plant is taken
on by Project Company Y. If the project is not completed due to a deficiency of just
1  MW, and if the Off-taker is allowed to terminate the Concession/Off-take/PPP
Agreement on the basis that the underperformance of the plant is attributable to
Project Company Y, what measures should Project Company Y take to deal with the
completion risk? A reasonable Project Company (or an EPC Contractor who bears
the subject completion risk under an EPC Contract) would deal with this comple-
tion risk by providing for a buffer, that is to say, by setting as the goal the comple-
tion of a power plant that has a relatively higher power generation capacity (rather
than specifying the power generation capacity as 1000 MW).
In taking this measure to address completion risk, the cost for completion
increases to account for the buffer, and the consideration to be paid by the Host
Country/Off-taker (the party which actually receives the goods and/or services) to
the Project Company will ultimately be increased to account for that buffer, and
VFM will not be generated (become lower) to account for that buffer.
If the failure to achieve the 1000 MW target power output capacity by 1 MW
prevents the Host Country/Off-taker from achieving its public-side objectives, a
reasonable basis may exist for the Host Country/Off-taker’s termination of the
Concession/Off-take/PPP Agreement based on such failure. However, in the real
world, the situation where the Host Country/Off-taker’s public-side objectives can-
not be achieved due to the 1 MW underperformance is not conceivable. If the above
situation was to occur, as an alternative to termination the Host Country/Off-taker
might acknowledge completion if a certain reduced performance threshold (95% of
the 1000 MW power generation capacity, for example) is fulfilled (resulting in the
inability of the Host Country/Off-taker to terminate the Concession/Off-take/PPP
Agreement), and the Availability Fee would be reduced to account for the
­underperformance of the plant’s power generation capacity. If the Host Country/
Off-taker is willing to accept such approach to deal with this completion risk issue,
there is no need for the Project Company (or EPC Contractor) to set, as a buffer, the
goal of completing a power plant that has a power generation capacity relatively
higher than 1000 MW. Rather, the goal from the beginning can be to complete a
power plant with a power generation capacity of 1000 MW, and VFM can be main-
tained for that amount (not be lowered).
As illustrated above, even among the areas where private business entities are
supposed to take on risks, depending on the ways private business entities deal with
the risks, there exist areas where the Host Country/Off-taker can add value to facili-
tate their efforts. Also, it should be noted that this ultimately will have greater ben-
efits to the Host Country/Off-taker than to the private business entities.

5.1.1.5  Force Majeure Risk

As discussed in Sect. 5.1.1.1 of this chapter, because of the possibility that VFM is
not generated (becomes lower) when a force majeure risk is taken on by private
business entities, a force majeure risk is, in theory, a risk that should be taken on by
84 2  Business Theories of NRI-PPP Projects

the Host Country/Off-taker. On the other hand, subject to the practices in the rele-
vant jurisdiction, it is explained that force majeure events in certain circumstances
can be controlled by private business entities; thus, in such circumstances, private
business entities should take on the force majeure risk.
For example, in the publication by the HM Treasury of the United Kingdom,
Standardisation of PFI Contracts Version 4, events that could be characterized as
force majeure events are classified and described either as a “Force Majeure Event”
or a “Relief Event.”35 And in the case of a Force Majeure Event, the Concession/
Off-take/PPP Agreement basically is terminated, and additional costs incurred to
private business entities due to the occurrence of subject event is to be borne by the
Host Country/Off-taker. On the other hand, in the case of a Relief Event, it is stated
that although private business entities are released from their obligations under the
Concession/Off-take/PPP Agreement, as for the additional costs incurred by private
business entities due to the subject event, they are to be borne by the private business
entities since the subject risk of incurring such costs is deemed to be controllable by
the private business entities.
On the other hand, in some continental (civil) law countries, a force majeure
event could be defined as any event the occurrence of which (a) will result in a
default based on the failure to meet a certain legal obligation,36 and (b) was not
caused by the debtor nor the creditor of the subject debt. If this is the case, on the
one hand, whether a private business entity is exempted or not from its obligation
under a Concession/Off-take/PPP Agreement is judged solely by the occurrence or
nonoccurrence of a force majeure event. On the other hand, in the case where the
event will not result in a default by a private business entity but additional costs are
incurred as a consequence of such event, whether a force majeure event, which is an
event conceived in relation to a default, will have occurred or not will require a
separate examination.
As discussed above, because the concept of force majeure event varies depend-
ing on the civil law of the Host Country, how to address a force majeure event in
each country will require a separate examination.

5.1.1.6  Political Risk

Although various risks arise in relation to an NRI-PPP Project, one risk that requires
special attention, particularly in emerging and developing countries, is political risk.
Political risk encompasses various kinds of risk including political violence risk,
breach of contract risk, license revocation risk, foreign exchange transaction risk,

35
 Standardisation of PFI Contracts Version 4 (2007) HM Treasury of the United Kingdom. https://
ppp.worldbank.org/public-private-partnership/sites/ppp.worldbank.org/files/documents/UK_
Standardisation%20of%20PFI%20Contracts%20(ver4.2007).pdf
36
 The inclusion of such event as a force majeure event is one factor considered when determining
whether the debtor is liable for default or is exempt from the fulfillment of its obligations upon the
occurrence of such event.
5  Characteristics of Key Project Agreements 85

and change-of-law risk. Also, the severity of these risks varies depending on various
factors including the stage of development of the Host Country’s political infra-
structure. Political risk is, as a matter of course, beyond the control of private busi-
ness entities, and thus it is a risk to be borne by the Host Country/Off-taker.
Also under the Concession/Off-take/PPP Agreement, political risk should be
stipulated as a risk to be borne by the Host Country/Off-taker. However, the fact that
the Concession/Off-take/PPP Agreement stipulates political risk is to be borne by
the Host Country/Off-taker does not mean private business entities can be indiffer-
ent to political risks. Also, some political risks cannot be shared through a stipula-
tion in the Concession/Off-take/PPP Agreement in the first place. For example, in a
case where the Host Country/Off-taker breaches the Concession/Off-take/PPP
Agreement, although the Project Company will ultimately try to enforce its rights in
a court proceeding, it is conceivable that a situation may arise where the filing of a
lawsuit itself could be difficult in practice. In addition, a fair trial cannot always be
expected in the judicial system of the Host Country. Should a trial in a third country
or arbitration be taken as the agreed dispute resolution measure, when it comes to
enforcement of the court’s judgment or arbitral award, if the assets of the Host
Country/Off-taker exist only in the Host Country, enforcement by the courts of the
Host Country becomes necessary, and fair enforcement of such judgment or award
cannot always be expected.
One extremely effective means of mitigating political risk is to involve the Export
Credit Agency (ECA)37 or a Multilateral Development Bank (MDB)38in the NRI-­
PPP Project (when the Host Country/Off-taker does not comply with the Concession/
Off-take/PPP Agreement, the ECA or MDB becomes unable to collect certain
receivables which becomes an international issue, and this serves as a mitigating
measure against political risk). However, this alone is not sufficient. Assessing
whether ongoing, individual and specific NRI-PPP Projects are truly and objec-
tively beneficial to the national of the Host Country becomes important. During a
Project Period that extends beyond 10 years, it is natural to expect that the project
will face challenges including various crises. In these situations, the Host Country
must prioritize the projects within its limited resources, and if the Host Country is
truly concerned for the welfare of its people it will prioritize continuation of those
projects that have high public interest and contribute to the well-being of the
national. No matter how clearly it is stipulated under the Concession/Off-take/PPP

37
 “Export Credit Agency” (ECA) refers to official financial institutions of each country which are
established with the objective of promoting overseas exports and imports and investments.
Although only “Export” is included in its name, its function is not limited to the promotion of
exports. Export-Import Bank of the United States (Ex-im Bank) in the US, and Japan Bank of
International Cooperation (JBIC) and Incorporated Administrative Agency, Nippon Export and
Investment Insurance (NEXI) in Japan, are examples of ECA.
38
 “Multilateral Development Bank” (MDB) refers to international financial institutions established
by multiple countries that provide lending with the objective of development. International Bank
for Reconstruction and Development (IBRD) and International Finance Corporation (IFC) that
belong to the World Bank, Asian Development Bank (ADB), and European Bank for Reconstruction
and Development (EBRD) are examples of MDB.
86 2  Business Theories of NRI-PPP Projects

Agreement that the Host Country/Off-taker is obligated to make payment, goods


and/or services that are not truly used by the national will never get the support of
the national of the Host Country. As I discussed in Sect. 4.7.2 of this chapter, the
Sponsor needs to examine sufficiently such legitimacy of the NRI-PPP Project in
the Host Country, and conversely, unless private business entities are able to exam-
ine and evaluate such matters, they will most likely fail if they participate in an
NRI-PPP Project.
In PFI in Japan, there seems to be a view that considerations that relate to the
public sector in nature are something that should be considered by the public side,
and that private business entities need only to be concerned about matters stipulated
in the Concession/Off-take/PPP Agreement and can be indifferent to these public
sector-related considerations. This way of thinking seems to be focused on the con-
struction work that occurs during the construction period of a Project. However, the
operation period of an NRI-PPP Project extends beyond 10  years, and therefore,
O&M Operators cannot be indifferent to these public sector-related considerations.
In fact, in PFI in Japan over the past decade, political risks have existed, and there has
been a case where a PFI Project was not implemented due solely to the replacement
of a municipal chief. When political risks become apparent, no matter how clearly
the relevant terms may be stipulated in the Concession/Off-take/PPP Agreement, it
seems unlikely that all of the losses incurred to private business ­entities can be borne
by the public side. In that sense, instead of judging that a project is of high public
interest simply because the subject of the project is a hospital, for example, private
business entities also need to judge whether the objective of the project is to provide
goods and/or services that are objectively and truly needed by the national.

5.1.2  Consideration Under the Concession/Off-take/PPP Agreement

5.1.2.1  Consideration in the Case of Market Risk-Taking Type NRI-PPP


Project

As I discussed in Sect. 4.1 of this chapter, NRI-PPP Projects are broadly classified
into the Market Risk-Taking Type and the Availability Fee Payment Type. In the
case of Market Risk-Taking Type NRI-PPP Project, the Project Company receives
consideration from the parties who were provided the goods and/or services. This
consideration is included in the conditions of the offer tendered by the Project
Company in the bidding stage of the NRI-PPP Project, and it is considered that this
consideration condition is to be applied throughout the Project Period.
Additionally, as I discussed in Chap. 1, Sect. 4.1.1, a project that grants a “con-
cession” is a Market Risk-Taking Type. Assuming the concession is granted for a
fee, and if acceptance of the amount of the fee is a condition for the concession
award, the amount of the concession granting fee is reflected in the consideration
the Project Company receives from those who are provided goods and/or services.
Thus, it needs to be noted that, depending on the amount of concession granting fee,
there exists a risk that those who are provided goods and/or services may be forced
5  Characteristics of Key Project Agreements 87

to bear a burden beyond the value of such goods and/or services?. Further, when
both the amount of the concession granting fee and the amount of consideration
received from those who are provided the relevant goods and/or services become
the condition for the bid tender, is it really possible to establish standards that review
both reasonably? From this viewpoint, when a project involving a concession is
proposed as an NRI-PPP Project, careful consideration of the various implications
and factors becomes necessary.

5.1.2.2  Consideration in the Case of an Availability Fee Payment Type NRI–


PPP Project

As I discussed in Sect. 4.9 of this chapter, in an Availability Fee Payment Type NRI-­
PPP Project, when a certain available condition stipulated under the required level
is achieved and maintained, the Off-taker pays the “full amount” to the Project
Company, and when such an available condition is not achieved and maintained,
payment to the Project Company is reduced by the proportion of the shortage (i.e.,
the percentage by which the value stipulated in the required level was not achieved
and maintained in relation to such condition). The payment from the Off-taker to the
Project Company is composed broadly of (A) an Availability Fee (Capacity Fee)
and (B) a Usage Fee. Availability Fee is a consideration that may or may not be paid
depending on whether the project is in an available status or not, and Usage Fee is a
consideration that is paid according to the actual amount used. Availability Fee is
paid regardless of the amount of goods and/or services actually provided, and as
fixed costs are covered by this fee, the Project Company consequently does not take
on market risk.
In an Availability Fee Payment Type NRI-PPP Project, when a certain available
condition stipulated under the required level is not achieved and maintained due to
a reason attributable to the Project Company, payment of the Availability Fee is
reduced by the proportion of the shortage (i.e., the percentage by which the value
stipulated in the required level was not achieved and maintained in relation to such
condition). Accordingly, whether a certain available condition stipulated under the
required level is achieved and maintained or not becomes an important point; and
for this purpose, the certain available condition stipulated under the subject required
level must be something that can be evaluated objectively. Additionally, because an
NRI-PPP Project is a project that focuses on operation, a certain available condition
stipulated under the required level that is required in operation becomes the subject
of the objective evaluation. In relation to this objective evaluation, there is a need for
a quantifiable evaluation and this is performed through the establishment of perfor-
mance criteria that will show whether a certain available condition stipulated under
the required level is achieved and maintained. Conversely, when only the mainte-
nance of a project is the subject of an NRI-PPP Project, to objectively quantify and
evaluate whether a certain available condition stipulated under the required level
regarding the maintenance of the project is achieved and maintained or not may be
difficult both from a theoretical and practical perspective.
88 2  Business Theories of NRI-PPP Projects

Additionally, in an NRI-PPP Project, private business entities take on the opera-


tion risk. What this means is, when a certain available condition stipulated under the
required level is not achieved and maintained, the Project Company takes on the
operation risk. In practice, this appears as a reduction of the Availability Fee in an
amount proportionate to the percentage by which the subject required level is
unachieved. This point will be discussed in Sect. 5.1.3.1 of this chapter.

5.1.2.3  Special Characteristics of the Consideration under the Concession/


Off–Take/PPP Agreement in an Availability Fee Payment Type NRI–PPP
Project

As I discussed in Sect. 4.10 of this chapter, in an NRI-PPP Project, the project is


fixed during the Project Period, and a change in the performance criteria of the proj-
ect in the middle of the Project Period will never occur. In relation to this, assuming
the project is changed during the Project Period of an NRI-PPP Project, disagree-
ments sometimes arise regarding how the consideration under the Concession/Off-­
take/PPP Agreement should be amended. In the first place, changing the project itself
during the Project Period is not appropriate, and thus the argument itself on how to
appropriately change the consideration under Concession/Off-take/PPP Agreement
is not appropriate. However, what the author wants to emphasize here is that the
specific details of the actual arguments on the appropriateness of changing the con-
sideration under the Concession/Off-take/PPP Agreement indicate a lack of under-
standing of the special characteristics of the consideration under the Concession/
Off-take/PPP Agreement in an Availability Fee Payment Type NRI-PPP Project, and
accordingly, a lack of understanding of the essence of an NRI-PPP Project.
First of all, what will occur when there is a quantitative increase or decrease
related to the project? For example, in the case where the consideration under a
Concession/Off-take/PPP Agreement has been determined based on the labor costs
of two workers, a 20% increase of the workload does not necessarily lead to a 20%
increase of the labor costs. When three full-time workers are needed to meet the
increased workload, the increase in labor costs will amount to 50%.
Further, when the project under the Concession/Off-take/PPP Agreement increases
qualitatively, what should be the appropriate way to determine the consideration
under the Concession/Off-take/PPP Agreement? Although some may argue that it is
determined based on an evaluation of similar cases, each Sponsor has its own price
range that it can justify in the first place. Because consideration should be determined
exactly by comparing VFM and Equity-IRR, consideration in similar cases can never
serve as an objective standard. Further, when the subject similar cases do not involve
an NRI-PPP Project, the special characteristics of consideration under a Concession/
Off-take/PPP Agreement in an NRI-PPP Project are not reflected, and thus, also from
this viewpoint, consideration of similar cases cannot be substituted for an objective
standard. Because consideration under a Concession/Off-take/PPP Agreement in an
NRI-PPP Project can be justified only by factors considered in the process of the
competitive bidding at the stage of Sponsor selection, justifying consideration by any
other means can never be supported theoretically.
5  Characteristics of Key Project Agreements 89

For example, in the case of an Availability Fee Payment Type NRI-PPP Project,
some may argue that it is appropriate to determine the consideration of a modified
project based on the consideration of similar projects as the standard. This argument
may not be perceived as irrational from the perspective of someone unfamiliar with
the essence of NRI-PPP Projects. However, it is wrong on several levels. First of all,
the consideration under the Concession/Off-take/PPP Agreement varies depending
on the specific aspects of a project (including the types and qualities of the appli-
cable risks), and whether the consideration can be justified varies depending on the
Sponsors. Conversely, because the consideration varies depending on the Sponsors,
VFM is generated (becomes higher). Consequently, in the first place, consideration
in similar projects cannot be the standard on which an objective and appropriate
judgment is based.
Further, in the case of an Availability Fee Payment Type NRI-PPP Project, con-
sideration under the Concession/Off-take/PPP Agreement cannot be changed in
principle during the Project Period. Specifically, the consideration is fixed during
the period that surpasses 10  years. On the other hand, in ordinary projects,
­consideration is never fixed for such a long period of time. For example, even if
conditions other than consideration are stipulated in a master agreement, negotia-
tions to revise the consideration are implemented every year or every several years
(Conversely, if an agreement on the consideration is not reached, the subject project
is terminated at that point.). This is because consideration varies depending on fac-
tors beyond the control of the parities to the project, such as market condition, level
of prices, and changes in laws. In ordinary projects, private business entities will
respond to these risks by changing the consideration, by terminating the project, or
by switching to other projects. However, in an NRI-PPP Project, private business
entities fix the consideration for a long period, and during that period, they do not
have the freedom to quit the project, or the freedom to start other projects; in other
words, they are in a situation where both of their hands and feet have been tied up.
In this sense, I cannot discuss NRI-PPP Projects in the same context as projects
where ordinary private business entities do not have their hands and feet bound.
Conversely, the reason private business entities can fix the consideration for a long
period is because they bear only the risks that the private business entities can con-
trol and do not bear other risks. In that sense consideration under a Concession/
Off-take/PPP Agreement in the case of an Availability Fee Payment Type NRI-PPP
Project has special characteristics different from the consideration in other ordinary
projects. Accordingly, there is no rationality in using the consideration in a similar
project which is not an NRI-PPP Project as a standard when considering changing
the consideration under a Concession/Off-take/PPP Agreement.
90 2  Business Theories of NRI-PPP Projects

5.1.3  A
 Project Company’s Way of Taking on Risks in an Availability Fee
Payment Type Project

5.1.3.1  Way of Taking on Operation Risk During the Operation Period

As I discussed in Sect. 3.2.6 of this chapter, operation risk appears specifically as


the issues of “financial relationship of private business entities against the Host
Country/Off-taker” and “cost sharing within the organization of private business
entities.” Of these, I will elaborate first on “financial relationship of private business
entities against the Host Country/Off-taker.”
Regarding the operation to be performed during the operation period, the inabil-
ity of a Project Company to achieve or maintain a certain available condition (i.e.,
the situation where the Project Company is unable to fulfill its obligation to provide
goods and/or services pursuant to the Concession/Off-take/PPP Agreement) stipu-
lated under the required level of the Concession/Off-take/PPP Agreement due to a
reason attributable to the Project Company is a default by the Project Company
under the Concession/Off-take/PPP Agreement. Under the general principles of
civil law, the Project Company is obligated to compensate the Host Country/Off-­
taker for its damages sustained based on the default of the Project Company. For
example, in illustrative Case 2 described in Chap. 1, Sect. 5, if Project Company Y
is, due to a reason attributable to Project Company Y, unable to generate the
stipulated amount of electricity under the power purchase agreement, Project
­
Company Y becomes obligated to compensate Off-taker X for the damages sus-
tained by it and resulting from such default. Then, the relationship between Project
Company Y’s liability for Off-taker X’s damages and a reduction of the Availability
Fee, which I discussed in Sect. 5.1.2.2 of this chapter, becomes an issue.
To begin with, if the Project Company is to incur both this liability for damages
and a reduction of the Availability Fee (which I discussed in Sect. 5.1.2.2 of this
chapter), what will happen? If the Project Company bears at least such liability for
damages, then because the Host Country/Off-taker suffers no loss beyond such
damages, whether the further reduction of the Availability Fee has rationality
becomes highly questionable. In this regard, there may be a counter-argument that
the reduction of the Availability Fee should be considered liquidated damages, and
thus, if there exist damages beyond the amount of this “liquidated damages,” the
Project Company should be liable for such excess damages. However, in the first
place, where is the rationality in setting such liquidated damages?
As I discussed in Sect. 4.11 of this chapter, because the Project Company is a
company that lacks cash-paying capability, regardless of what may be stipulated in
the Concession/Off-take/PPP Agreement to impose an obligation on the Project
Company to pay damages, such provision would be ineffective. This is also con-
cluded from the perspective of limited liability in relation to the “investment,” which
is the essence of an NRI-PPP Project, as discussed in Sect. 3.2.4 of this chapter. The
risk taken by private business entities in an NRI-PPP Project is the risk of not being
able to recover the invested money, and because the invested money is used for the
payment of the Project Cost, private business entities will never take on the opera-
tion risk in order to recover such money.
5  Characteristics of Key Project Agreements 91

Based on this lack of cash-paying resources and the viewpoint of objectifying


and quantifying the operation risk, the way a Project Company takes on the opera-
tion risk in an Availability Fee Payment Type NRI-PPP Project is essentially limited
to the reduction of the Availability Fee.
As for this lack of cash-paying resources, there may be a counter-argument that
the Project Company’s Availability Fee claim against the Host Country/Off-taker
after the reduction of the Availability Fee, and the Host Country/Off-taker’s dam-
ages claim against the Project Company can be offset, and, to that extent, cash-­
paying resources exist. However, if above argument is valid, there is no need to use
the technique of objectifying and quantifying the operation risk by the reduction of
the Availability Fee. Conversely, by the use of the technique of objectifying and
quantifying the operation risk, private business entities can preserve the Availability
Fee after taking the relationship between risk and return into consideration; hence
VFM is to be generated (increases).
The above discussion also holds true in a situation where an Availability Fee
Payment Type NRI-PPP Project is terminated due to a reason attributable to the
Project Company or to an issue related to the Project Company. That is to say, when
the Concession/Off-take/PPP Agreement is terminated due to a reason attributable
to the Project Company or to an issue related to the Project Company, generally,
losses incurred by the Host Country/Off-taker due to the subject termination are
compensated by the Project Company; however, the Project Company does not pos-
sess the money to compensate such losses, and as a result, objectifying and quanti-
fying operation risk cannot be achieved. To address this, operation risk is imposed
on the Project Company in an Availability Fee Payment Type Project in the form of
a deduction of a certain percentage (e.g., 30%) of the purchase price of the facilities
related to the project (in the ordinary case, the present value of the unpaid Availability
Fee), which is later paid by the Host Country/Off-taker to the Project Company at
the termination of Concession/Off-take/PPP Agreement.
Incidentally, although there may be a counter-argument that the Project
Company’s liability for damages under the Concession/Off-take/PPP Agreement
can be borne by the O&M Operator under the O&M Agreement, as I discussed in
Sect. 3.2.6 of this chapter, this argument runs counter to the essence of an NRI-PPP
Project. Also, under civil law, there may be a counter-argument that if there is liabil-
ity based on a breach by the Project Company, the Project Company is obligated to
compensate the Host Country/Off-taker for damages that were actually sustained.
However, as I discussed in Sect. 3.2.6 of this chapter, the provisions of the
Concession/Off-take/PPP Agreement should be consistent with the principles
underlying an NRI-PPP Project pursuant to the principle of freedom of contract.
The next topic, in the context of the operation risk, is “cost sharing within the
organization of private business entities.” Here, as I discussed in Sect. 3.2.6.2 of this
chapter, the risk that O&M costs will exceed levels originally planned due to rea-
sons attributable to the Project Company (in substance, the O&M Operator) becomes
an issue. Also, the subject additional costs are actually incurred by the O&M
Operator, and the Project Company bears responsibility to pay for substantially all
of such additional costs. However, the Project Company has no source of funds to
pay for such additional costs except for the dividends, etc. to be paid to the Sponsor.
92 2  Business Theories of NRI-PPP Projects

As the Sponsor and the O&M Operator are basically the same entity from the
Principle of Owner-Operator, eventually, what occurs is only a change of payment
accounts (i.e., from payment to the Sponsor as a payment of dividends, etc. to a pay-
ment to the O&M Operator for the additional costs related to O&M work).

5.1.3.2  Way of Taking on Completion Risk During the Design/Construction


Period

Completion risk of the project also appears specifically as an issue concerning


“financial relationship of private business entities against the Host Country/Off-­
taker” and “cost sharing within the organization of private business entities.” The
author elaborates first on the issue of “financial relationship of private business enti-
ties against the Host Country/Off-taker.”
The inability to complete the project as stipulated in the required level for rea-
sons attributable to the Project Company constitutes a default by the Project
Company under the Concession/Off-take/PPP Agreement. However, since the
Project Company lacks financial resources, simply imposing a damages compensa-
tion obligation on the Project Company in this case would be ineffective. Also, as
with the case involving operation risk, the technique of objectifying and quantifying
is taken also in relation to completion risk. With this technique, private business
entities can calculate the Availability Fee after taking the risk-return relationship
into consideration; hence, VFM is generated (increases).
Based on the above, in cases where the project is not completed by a certain
deadline due to reasons attributable to the Project Company and the Host Country/
Off-taker terminates the Concession/Off-take/PPP Agreement, the Project
Company’s obligation is generally stipulated in the Concession/Off-take/PPP
Agreement as the payment of a specified amount of liquidated damages; and the
Host Country/Off-taker ensures payment of the subject liquidated damages by
obtaining a guaranteed bank payment commitment such as a standby L/C or bonds
in an amount that matches the amount of subject liquidated damages. Generally, the
Sponsor provides the guaranteed bank payment commitment of the subject bank to
the Host Country/Off-taker by using its creditworthiness. Accordingly, for the
Sponsor, the provision of the guaranteed bank payment commitment of the subject
bank means an additional cost, and thus the amount needs to be appropriate based
on the relevant market conditions. Otherwise, this cost will be reflected inevitably
in the amount of the Availability Fee, and when it is unreasonably high, VFM is not
generated (becomes lower), which leads to a risk which is unfavorable to the
national. Incidentally, as payment of the subject liquidated damages is necessitated
due to reasons attributable to the EPC Contractor, the Project Company passes
through this risk to the EPC Contractor, and in cases where the Project Company
pays the subject liquidated damages to the Host Country/Off-taker, it imposes a
burden on the EPC Contractor to compensate the Project Company in an amount
that matches the subject liquidated damages paid by the Project Company. Also,
while the Project Company imposes this reimbursement obligation in regard to the
5  Characteristics of Key Project Agreements 93

subject liquidated damages on the EPC Contractor, at the same time the Host
Country/Off-taker makes a demand for the guaranteed bank payment commitment,
such as the standby L/C and bonds, in an amount that matches the amount of the
subject liquidated damages. This is because, as I discussed in Sect. 3.2.6.2 of this
chapter, the Project Company cannot rely on the EPC Contractor to fulfill the sub-
ject payment obligation imposed under the EPC Contract. Conversely, the practice
itself of demanding a guaranteed bank payment commitment such as a standby L/C
or bond is the outcome of the Host Country/Off-taker’s inability to rely on the ful-
fillment of obligations provided under the EPC Contract or O&M Agreement.
Additionally, regardless of whether or not the project ultimately cannot be com-
pleted as stipulated under the required level due to reasons attributable to the Project
Company, there exists a risk that the project will not be completed by the comple-
tion date stipulated under the Concession/Off-take/PPP Agreement due to reasons
attributable to the Project Company. In this case also, from the viewpoint of objec-
tifying and quantifying the risk, the obligation of the Project Company to pay the
Host Country/Off-taker liquidated damages is stipulated in the Concession/Off-­
take/PPP Agreement, and at the same time, the amount of liquidated damages per
each day of delay (i.e., each day after the scheduled completion date that the project
remains uncompleted) is stipulated, and thus the amount of liquidated damages is
specifically calculated based on the actual number of the days of delay. Also,
because the payment of liquidated damages due to the subject completion delay is
necessitated by reasons attributable to the EPC Contractor, the Project Company
passes this risk through to the EPC Contractor; and when the Project Company pays
the liquidated damages to the Host Country/Off-taker, the Project Company makes
a demand on the subject EPC Contractor to compensate the Project Company in an
amount that matches the amount of the subject liquidated damages. The obligation
requiring the EPC Contractor to so compensate the Project Company is provided for
in the EPC Contract. Incidentally, in general, it seems that the Host Country/Off-­
taker will not obtain a guaranteed bank payment commitment, such as a standby
L/C or bond, in an amount that matches the amount of liquidated damages in situa-
tions involving a completion delay.
Further, as I discussed in Sect.5.1.1.4 of this chapter, there exists a risk that an
Availability Fee will be reduced proportionately in cases where performance of the
project has failed to meet the originally planned levels, and completion of the proj-
ect with alternative or reduced performance levels has been approved. This is also
an issue concerning “financial relationship of private business entities against the
Host Country/Off-taker” related to the completion risk of the project. This risk is
also a risk borne by the EPC Contractor. If this risk event occurs, as I will discuss in
Sect. 5.3.2 of this chapter, it is dealt with through the payment of liquidated dam-
ages by the EPC Contractor to the Project Company.
The next topic to be addressed is “cost sharing within the organization of private
business entities” related to the completion risk of the project. Regarding this point,
just as in the case of the operation risk, the risk becomes an issue when costs incurred
in the performance of the EPC work exceed originally planned limits due to reasons
attributable to the Project Company (the EPC Contractor, substantially), and, in
94 2  Business Theories of NRI-PPP Projects

actuality, the amount of the subject cost exceedance is incurred by the EPC
Contractor. However, different from the case of operation risk, as I discussed in
Chap. 1, Sect. 4.1.3, since the EPC fee is a fixed amount, the EPC Contractor
absorbs the amount of the subject cost exceedance and does not pass it on to the
Project Company. In this regard, the financial aspect of completion risk is imposed
on the EPC Contractor. I will discuss this point in Sect. 5.3.1 of this chapter.
In addition, as for “cost sharing within the organization of private business enti-
ties” in regard to the completion risk of the project, a different risk exists from the
case of “cost sharing within the organization of private business entities” in regard
to the operation risk. The subject risk concerns the situation where, although a cer-
tain performance standard (which is included in the basic performance criteria
under the EPC Contract) under the Concession/Off-take/PPP Agreement has been
achieved, in the effort to achieve such performance standard costs incurred in rela-
tion to O&M work exceeded originally planned limits. As I will discuss in Sect.
5.3.2 of this chapter, using illustrative Case 2 described in Chap. 1, Sect. 5, the typi-
cal case can be explained as follows. Although performance by Project Company Y
has been achieved in regard to the 1000 MW natural gas-fueled power plant, the
required amount of natural gas (fuel quantity for heat generation) to support the
subject performance is greater than expected. This risk is also included in ­completion
risk, and thus should be taken by the EPC Contractor. The specific way of taking
responsibility for this situation is, as I will discuss in Sect. 5.3.2 of this chapter, the
payment of liquidated damages by the EPC Contractor to the Project Company.

5.1.4  R
 easons to Transfer the Project–Related Facilities to the Host
Country/Off–Taker at the Conclusion of the Project

In a BOT project, the Host Country/Off-taker’s obligation to take over the project’s
facilities by a transfer of such facilities upon the conclusion of the project is stipu-
lated in the Concession/Off-take/PPP Agreement. The subject transfer is usually
carried out without any additional consideration being paid when the conclusion of
the project coincides with the conclusion of the Project Period. A question then
arises as to why the project-related facilities are to be transferred to the Host
Country/Off-taker upon the conclusion of the project.
The presumed reasoning can be explained as follows: (i) the objective of the sub-
ject project is to provide goods and/or services which the Host Country/Off-­taker is
originally responsible to provide; (ii) the Host Country/Off-taker usually needs to
continue providing the subject goods and/or services after the conclusion of the sub-
ject project; and thus (iii) the facilities related to the subject project are transferred to
the Host Country/Off-taker to allow the Host Country/Off-taker (or its third-party
contractor) to continue providing the subject goods and/or services. As a matter of
course, it is conceivable that the term of subject Concession/Off-take/PPP Agreement
would be extended upon or prior to the conclusion of its original term, and the same
private business entity would continue providing the subject goods and/or services
pursuant to such renewed Concession/Off-take/PPP Agreement. However, whether
5  Characteristics of Key Project Agreements 95

or not the subject renewal arrangement is entered into depends on whether an agree-
ment relating to the subject renewal between the Host Country/Off-taker and the
private business entity is made or not, and since there exists a possibility that such
agreement will not be made, the premise at the execution of the Concession/Off-take/
PPP Agreement is that the Concession/Off-take/PPP Agreement will not be renewed.
On the other hand, should ownership of the facilities related to the project be retained
by the private business entity (i.e., if the facilities are not transferred to the Host
Country/Off-taker), it cannot be assumed that the subject private business entity
would continue providing the subject goods and/or services, and usually it is not
conceivable to covert the subject facilities for another use other than the subject pro-
vision of goods and/or services. In that sense, even if the private business entity
retains ownership of the facilities, they would be of no use to such private business
entity, and rather it is more likely the case that the private business entity would end
up incurring the risk of bearing unwanted responsibility in relation to such facilities.
Consequently, the private business entity would choose to demolish the subject facil-
ities, and then it would naturally include the cost for such demolition in the consid-
eration of the Concession/Off-take/PPP Agreement. As a result, the overall cost of
the project would unnecessarily become higher, which would not be appropriate at
all from the viewpoint of the Host Country/Off-taker.
Additionally, in the case where the Concession/Off-take/PPP Agreement is ter-
minated in the middle of the operation period due to a reason attributable to the
Project Company, whether or not the Host Country/Off-taker chooses to accept a
transfer of the subject facilities becomes an issue. If the Host Country/Off-taker
does not take over the facilities by transfer, what would happen? As a matter of
course, payment of any nature by the Host Country/Off-taker to the Project Company
is not assumed. Then, there would be no other choice for the Project Company but
to maintain ownership of the subject facilities. On the other hand, continued provi-
sion of the goods and/or services related to the subject facilities by the private busi-
ness entity cannot be assumed, and converting the facilities for another use other
than for the provision of the subject goods and/or services usually would not be
conceivable. Then, the private business entity would not be able to recover the mon-
etary amount equivalent to the gross amount of the unpaid Availability Fee at that
time. This would mean the private business entity would bear a substantially large
financial risk. If the private business entity is to bear such a large financial risk,
consideration in an amount that matches such risk should become necessary, and
consequently, the Availability Fee would increase by that amount, and VFM possi-
bly would not be generated (would not become higher).
In relation to this point, even in the case where the Concession/Off-take/PPP
Agreement is terminated in the middle of the operation period due to a reason attrib-
utable to the Project Company, whether or not the Host Country/Off-taker should be
obligated to receive the facilities related to the project becomes an issue. Incidentally,
even when this obligation is not stipulated as an “obligation” in the Concession/
Off-take/PPP Agreement, it should be stipulated as a “right.” And, in cases of both
rights and obligation, the consideration for the transfer typically would be, as was
discussed in Sect. 5.1.3.1 of this chapter, the amount of money that represents the
96 2  Business Theories of NRI-PPP Projects

present value of the unpaid Availability Fee discounted by a certain percentage (e.g.,
30%). As for this point, some Concession/Off-take/PPP Agreements stipulate it as a
right, and some as an obligation. Whether to stipulate it as the obligation or a right
is a fairly difficult issue. However, if it is stipulated as the obligation of the Host
Country/Off-taker, a contradictory issue will arise in that the Host Country/Off-­
taker will be required to bear such obligation to receive the facilities related to the
project in spite of the fact that the termination of the Concession/Off-take/PPP
Agreement is due to a reason attributable to the Project Company. Further, in the
case where the Senior Lender provides the Senior Loan of the project finance only
in an amount that matches the present value of the unpaid Availability Fee dis-
counted by a certain percentage (e.g., 30%), even in the situation where the Senior
Lender should be the most responsible for having taken on the risk (i.e., the risk of
termination of the Concession/Off-take/PPP Agreement due to a reason attributable
to the Project Company), the Senior Loan of the project finance would need to be
repaid in full. This means, specifically, that the subject loan is not project finance
that takes on project risk, but nothing more than a collateralized corporate loan that
depends on the paying capability of the Host Country/Off-taker. It should be noted
that, in this case, such benefit of project finance regarding the restoration of the
project by a new Sponsor does not exist at all.
Incidentally, in PFI in Japan, in cases where there exist defects in the facilities at
the time of the Concession/Off-take/PPP Agreement’s termination, some
Concession/Off-take/PPP Agreements concerning PFI include an obligation requir-
ing such defects to be cured before transfer of the facilities is performed. However,
if goods and/or services are satisfactorily provided according to the required level,
the Project Company should not be required to bear further obligations. Also, even
if the subject obligation should be imposed on the Project Company, the source of
funds to fulfill that obligation (or the source of funds to compensate the Host
Country/Off-taker for its damages in the case of a breach of the subject obligation)
is basically limited to the Availability Fee. If this obligation arises after the full
amount of the Availability Fee has been paid to the Project Company, since the
amounts received from such payment are subsequently paid out by the Project
Company to financial institutions, subcontractors that have performed work assigned
by the Project Company, and the Sponsors, there would be no funds left to fulfill the
subject obligation and thus the subject obligation will end up being ineffective.
Also, should payment of the last installment of the Availability Fee not be made, and
if the costs to cure the defects exceed the amount of the last installment of the
Availability Fee, again, the curing of the defects cannot be expected. In the first
place, should any obligation be imposed on the Project Company under the
Concession/Off-take/PPP Agreement, the source of funds to fulfill such obligation
is limited to the Availability Fee, and thus transactions under a Concession/Off-take/
PPP Agreement concerning PFI are essentially different from ordinary transactions.
Accordingly, stipulating substantially meaningless obligations like this in the
Concession/Off-take/PPP Agreement will most likely impose unnecessary risks on
the Sponsor on the one hand, and on the other hand, it will mislead the national who
have limited technical knowledge regarding PFI, and thus it should be noted that it
is inappropriate from the perspective of the national’s interest.
5  Characteristics of Key Project Agreements 97

5.2  Characteristics of an O&M Agreement

As I discussed in Chap. 1, Sect. 4.1.2, an O&M Agreement is the contract pursuant


to which the O&M Operator is to operate the project for the Project Company as
stipulated in the Concession/Off-take/PPP Agreement. In the O&M Agreement, the
obligation of the O&M Operator to the Project Company to operate the project in
accordance with the required level stipulated in the Concession/Off-take/PPP
Agreement is defined. Here I will discuss the O&M Fee, which is the “consider-
ation” for implementing the operation in accordance with the O&M Agreement.
A subcontracting fee in an ordinary subcontracting agreement includes the profit
the subcontractor is to gain as well as the costs to be incurred by the subcontractor in
relation to the operation. However, in the case of project finance, the Sponsors are to
receive their profits after the amounts to be paid under the Senior Loan of the project
finance (i.e., the principal amount of the loan and all accrued interest) are paid. The
provisions describing how this arrangement is to be realized are called waterfall pro-
visions, which will discuss in Chap. 3, Sect. 4.2. The receipt of profits by the Sponsors
before the payment of the principal and accrued interest of the Senior Loan of the
project finance (referred to as the “Equity Leakage”) is made, is prohibited.
As I will discuss in Chap. 3, Sect. 4.2, under waterfall provisions, money received
by the Project Company during the operation period is to be paid out in accordance
with the following broadly described prioritization order: (1) taxes and public dues,
etc., O&M fee, (2) principal and interest of the Senior Loan of the project finance,
and (3) dividends to the Sponsors, etc. The fact that the payment priority ranking of
“dividends to the Sponsors” is lower than that of “principal and interest of the Senior
Loan of the project finance” exactly embodies the arrangement that Sponsors are to
receive profits after the principal and interest of the Senior Loan of the project
finance are paid.
Additionally, as discussed in Sect. 4.1 of this chapter, since the essence of an
NRI-PPP Project is the operation, and, as I discussed in Sect. 3.2.2 of this chapter,
the profits of private business entities in an NRI-PPP Project are paid ultimately in
the form of dividends, etc., the profits from the operation are paid in the form of
dividends, etc. to the Sponsors. On the other hand, profits included in the O&M fee
are exactly these profits from the operation. The payment priority ranking of O&M
fee under waterfall provisions is set as (1). Therefore, if profits are included in the
O&M fee, it would mean that payment of profits from the operation has a higher
payment priority ranking than payment of the principal and interest of the Senior
Loan of the project finance, which constitutes the Equity Leakage. As I discussed in
Sect. 4.2 of this chapter, this issue arises from the Principle of Owner-Operator; that
is to say, the Sponsor and the O&M Operator, which is the contractor under the
O&M Agreement, are the same entity. Consequently, as I discussed in Sect. 4.4.1 of
this chapter, profits should not be included in the O&M fee.
Incidentally, the expenses included in the O&M fee are included in the payment
having a priority status of (1), and thus payment of such expenses should have prior-
ity over payment of the principal and interest of the Senior Loan of the project
finance. I will discuss this point in Chap. 3, Sect. 4.2.2.
98 2  Business Theories of NRI-PPP Projects

Additionally, in some NRI-PPP Projects, the profit portion of the O&M fee is
positioned as a subordinated O&M fee and ranked between (2) “the principal and
interest of the Senior Loan of the project finance,” and (3) “dividends to the
Sponsors,” in terms of payment priority.39,40

5.3  Characteristics of an EPC Contract

As I discussed in Chap. 1, Sect. 4.1.3, EPC Contract is the contract pursuant to


which the EPC Contractor is to complete the engineering, procurement and con-
struction of the project as stipulated in the Concession/Off-take/PPP Agreement, on
behalf of the Project Company. It is also the contract where the EPC Contractor’s
obligation to the Project Company to complete the project in accordance with the
required level is stipulated under the Concession/Off-take/PPP Agreement. Strictly
speaking, the EPC Contract is the contract pursuant to which the EPC Contractor
undertakes full responsibility for the operational completion (the status where the
project becomes operational as of the stipulated operational completion date) of the
project for the Project Company, and additional matters that are not stipulated in the
Concession/Off-take/PPP Agreement which are to be completed. Here, I will dis-
cuss the consideration for the EPC work and liquidated damages to be assessed
based on the failure to achieve required performance standards, which are matters
ordinarily stipulated in the EPC Contract.

5.3.1  Consideration for the EPC Work

As I discussed in Chap. 1, Sect. 4.1.3, consideration for the EPC work is a fixed
amount. What this means is that the EPC Contractor absorbs whatever additional
costs are incurred in relation to the EPC work and does not charge them to the
Project Company. With this arrangement, the risk of “cost sharing within the orga-
nization of private business entities” related to completion risk of the project is
imposed on the EPC Contractor. The significant difference between the costs related
to EPC work and that of O&M work is that unlike EPC work, O&M work is to be

39
 In practice, it is not easy to distinguish clearly what parts of an O&M fee are expenses to be
incurred by the O&M Operator, and what parts are profits from the operation. A practical solution
for this may ultimately be to rely on the judgment of an independent consultant.
40
 Although it is a small point, as we will discuss in Chap. 3, Sect. 4.2.5 “dividends to the Sponsors,
etc.,” whether such can be paid or not requires a determination as to whether the requirements for
payment of dividends, etc. have been fulfilled. Although, the requirements for payment of divi-
dends, etc. are relevant to waterfall provisions, in view of the risk that the subject NRI-PPP Project
may not be operated appropriately in the future and consequently payment of principal and interest
of the Senior Loan of the project finance may not be made because the subordinated O&M fee is
substantially the dividends, etc. payable to the Sponsors, payment of such fee may well be condi-
tioned upon the satisfaction of such requirements for payment of dividends, etc.
5  Characteristics of Key Project Agreements 99

conducted over a long period of time (over 10  years), and thus it is essentially
impossible even for the O&M Operator itself to estimate or control completely the
costs related to O&M work during that period.

5.3.2  L
 iquidated Damages Related to the Failure to Achieve the Required
Performance Criteria

As I discussed in Sect. 5.1.1.4 of this chapter, the failure to achieve required perfor-
mance standards under the Concession/Off-take/PPP Agreement (which is included
in the basic performance criteria under the EPC Contract), may not be a termination
event, but rather an Availability Fee reduction event. In illustrative Case 2 described
in Chap. 1, Sect. 5, failure to achieve required performance standards is reflected by
Project Company Y’s failure to achieve the 1000 MW target power output capacity
for the natural gas-fueled power plant. Incidentally, in Case 2, there is also a situa-
tion where, although Project Company Y failed to achieve the 1000  MW target
power output capacity for the natural gas-fueled power plant, the required amount
of natural gas (i.e., the quantity of fuel for power generation) to support the actual
level of the power plant’s performance is greater than expected (such fuel quantity
is included in the basic performance criteria under the EPC Contract). This is com-
pletion risk (the former being the issue of “financial relationship of private business
entities against the Host Country/Off-taker,” and the latter being the issue of “inter-
nal cost-sharing within the private business entities”), and is borne by the EPC
Contractor under the EPC Contract. The issue is how liability is to be assumed by
the EPC Contractor in relation to this risk.
If I look at this issue from the viewpoint of project finance, when the Availability
Fee is reduced, since the numerical value of the numerator of DSCR (in practice, it
is a notional DSCR, and I will discuss this in Chap. 3, Sect. 4.3.3.1) decreases (cash-­
inflow to the Project Company decreases), DSCR decreases. Also, when the amount
of natural gas (i.e., the quantity of fuel for power generation) is greater than expected,
similarly, the numerical value of the numerator of DSCR decreases (because of the
increase of operational costs) which leads to the decrease of DSCR.
As a result of the foregoing, at least from the standpoint of the Senior Lender, the
risk of non-repayment of principal and Interest of the Senior Loan of the project
finance increases. To avoid this risk, DSCR needs to be returned as much as possible
to the originally-planned numerical value. One way to achieve this is by proportion-
ately reducing the numerical value of denominator. Also, in practice it can be
achieved by reducing the principal and interest of the Senior Loan of the project
finance, and for this purpose, prepayment of the principal and interest of the Senior
Loan of the project finance for the required amount will suffice.
From this viewpoint, the EPC Contractor needs to pay the Project Company
money in an amount that matches the monetary amount of the prepayment of the
principal and interest of the Senior Loan of the project finance required to reduce
DSCR to the original level. Accordingly, the payment is made in the form of liqui-
dated damages payable under the EPC Contract. As a matter of course, the EPC
100 2  Business Theories of NRI-PPP Projects

Contractor’s payment of money to the Project Company related to the failure to


achieve required performance standards in the form of the subject liquidated dam-
ages constitutes a forced prepayment event under the priority loan agreement, and
the subject monetary amount paid by the EPC Contractor as liquidated damages
becomes the funding source for the prepayment of principal and interest of the sub-
ject Senior Loan of the project finance. Incidentally, the monetary amount of liqui-
dated damages related to the failure to achieve required performance standards is,
from the viewpoint of this purpose, not a predetermined specified amount, but an
amount represented as the mathematical expression based on the quantum by which
each requirement has not been satisfied (represented as a percentage) in relation to
the non-achievement of the required performance standard. Also, the EPC Contractor
will judge whether or not it can bear the liability for the subject liquidated damages
(including the determination of the upper limit amount of such liquidated damages),
taking into consideration the monetary amount of the profit related to the subject
EPC work it is to receive.

References

Anma, M. (1998). Mechanism and risk of project finance. International Resources (Kokusai
Shigen), Issue 288, 23–30.
Anma, Masaaki (2008). Issues of Japanese PFI when compared to overseas. International Finance
(Kokusai Kin-yu). Issue 1195, 90–96.
Anma, Masaaki, & Higuchi, Takao (2009). Public and private partnership (PPP) infrastructures
under global financial crisis-observation on ASEM infrastructure PPP conference. International
Finance (Kokusai Kin-yu). Issue 1207, 14–20.
Armitstead, L. (2012). UK taxpayers ‘rarely’ benefit from public-private partnerships, claims
study. The Telegraph. 11 April. http://www.telegraph.co.uk/finance/newsbySector/construc-
tionandproperty/9196524/UK-taxpayers-rarely-benefit-from-public-private-partnerships-
claims-study.html.
Burger, P., Tyson, J., Karpowicz, I., & Delgado Coelho, M. (2009). The effects of the financial
crisis on public-private partnerships. IMF working paper (WP/09/144). http://www.imf.org/
external/pubs/ft/wp/2009/wp09144.pdf
Cangiano, M., Anderson, B., Alier, M., Petrie, M., & Hemming, R. (2006). Public-­private
partnerships, government guarantees, and fiscal risk. IMF Special Issues. https://
www.imf.org/en/Publications/IMF-Special-Issues/Issues/2016/12/31/Public-Private-
Partnerships-Government-Guarantees-and-Fiscal-Risk-18587
Fawcett, G. (2012). Public private partnerships: The record isn’t great. The Guardian,
11 April. http://www.guardian.co.uk/public-leaders-network/blog/2012/apr/11/
public-private-partnerships-the-record-isnt-great.
HM Treasury of the United Kingdom. (2007). Standardisation of PFI contracts version 4. https://
ppp.worldbank.org/public-private-partnership/sites/ppp.worldbank.org/files/documents/UK_
Standardisation%20of%20PFI%20Contracts%20(ver4.2007).pdf
Kaga, R. (2007). Practice of project finance.
Kaga, R. (2010). Mechanism and funding of international infrastructure project. Tokyo: Chuo
Keizaisha.
Madono, S. (2011). Overseas operation of infrastructure business and issues for Japanese corpora-
tions. Transportation and Economy (Un-yu to Keizai), 71(6), 16.
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United Kingdom, House of Commons. (2011). Treasury  - Seventeenth report. Private


Finance Initiative. 18 July.http://www.publications.parliament.uk/pa/cm201012/cmselect/
cmtreasy/1146/114602.htm
Winch, G., Onishi, M., & Schmidt, S. (2011). Taking stock of PPP and PFI around the world.
ACCA workshop at p.  12. http://www.accaglobal.com/content/dam/acca/global/PDF-
technical/public-sector/rr-126-001.pdf
Yescombe, E. (2014). Principles of project finance (2nd ed.). London: Academic.
Chapter 3
Business Theories of Project Finance

Abstract  With a background understanding of NRI-PPP Projects discussed in


Chap. 2, in this chapter I move on to examine project finance. To understand the
business theories of project finance, I go over fundamental understandings regard-
ing project finance and the “pros and cons” of entering into a project finance trans-
action from the perspectives of the major parties (i.e., the Sponsor, the Senior
Lender and the Host Country/Off-taker). My discussion of project finance deepens
to address its essence and particular characteristics including a Debt-Equity Ratio,
waterfall provisions and cash flow structure. Finally, I end by analyzing important
characteristics of the Security Package established by the key financing agreements
including security interests and step-in right.

1  Fundamentals of Project Finance

1.1  Definition of Project Finance

As I discussed in Chap. 1, Sect. 4.2, project finance is a lending arrangement where


(i) the Project Company, an SPC, is the borrower, and (ii) the Sponsor, which is, in
substance, the project’s main operating body, in principle does not bear liability for
the subject lending; it is a transaction where the Sponsor’s liability in relation to the
subject lending is limited to exceptional cases.
With respect to the definition of project finance, various attempts at presenting a
suitable definition exist. For example, one notable definition is as follows: “[i]t is
financing where (1) a specified project is the subject for the financing; (2) the pri-
mary source of funds for the repayment is in principle the cash flow from the subject
project; and (3) the collateral is limited to the assets of the subject project.”1 This
definition itself is correct. However, to define project finance in a way that describes
its fundamentals without inclusion of unnecessary or omission of necessary infor-

 See Kaga R. (2007) The Practice of Project Finance. page 5.


1

© Springer Nature Singapore Pte Ltd. 2019 103


T. Higuchi, Natural Resource and PPP Infrastructure Projects and Project
Finance, Economics, Law, and Institutions in Asia Pacific,
https://doi.org/10.1007/978-981-13-2215-0_3
104 3  Business Theories of Project Finance

mation, so that it can be understood by non-experts, at least without any e­ xplanation,


is substantially impossible. In particular, this form of financing that depends on the
subject project’s cash flow also involves structured finance and the securitization. In
order to understand project finance, it is important to understand the similarities and
the differences between these other types of financing and project finance.

1.2  D
 ifference Between Project Finance and Aircraft Finance
that Uses a Finance Lease

For example, in the case of aircraft finance that uses a finance lease (this is ordinarily
viewed as a type of “structured finance”), the lender lends to an SPC, and the source
of funds for the incremental repayments of the subject loan is in principle the lease
payments paid by the aircraft company to the SPC based on a finance lease contract
entered into between the SPC and the aircraft company. Because it is structured so that
each lease payment obligation arises upon the occurrence of a condition that matches
the repayment condition of the subject lending, the contract is referred to as a “finance”
lease. From the viewpoint of the lender, because the lending is repaid in principle if
the lease payments are made, even if the lender takes on the creditworthiness risk of
the aircraft company, all other risks are not taken on by the lender in principle.
If a specified aircraft (or the leasing of the subject aircraft) falls under the descrip-
tion of “specified project” because the primary source of funds for the repayment
depends on the cash flow from the subject project, which are the lease payments,
and the “collateral” is limited to the subject aircraft,2 etc., the aircraft finance that
uses a finance lease also falls under the definition of project finance. Surely, in some
cases, aircraft finance that uses a finance lease is called project finance. However,
ordinarily, aircraft finance that uses a finance lease is not called project finance. This
is because the aircraft (or the leasing of the subject aircraft) does not fall under the
classification of “specified project”.
As I discussed in Chap. 2, the NRI-PPP Project that becomes the subject of proj-
ect finance is a project highly dependent upon the success of the project’s opera-
tions, and the success or failure of the project’s operations largely depends on the
business performance capability of the Sponsor. In that sense, projects that become
the subject of project finance are projects where the cash flow of the project varies
depending on the business performance capability of the Sponsor (i.e., projects
where the volatility of the project cash flow, which is directly related to the Sponsor’s

2
 In the case of aircraft finance that uses a finance lease, security interests are granted on the insur-
ance claim right and the deposit refund claim right, in addition to the aircraft. In light of this fact,
in the case of aircraft finance that uses a finance lease, there may be a counter-argument that “col-
lateral is not limited to the asset of the subject project.” However, in the case of project finance,
security interests are also granted on the insurance claim right and the deposit refund claim right,
etc. In this sense, from the viewpoint of security interests, it needs to be noted that the insurance
claim right and the deposit refund claim right are also included in the classification of “asset” as it
is referred to here.
1  Fundamentals of Project Finance 105

business performance capability, is high). Because the volatility of the cash flow is
high, the Principle of Owner-Operator, which I discussed in Chap. 2, Sect. 4.2, and
the Principle of Single Point Responsibility, which I discussed in Chap. 2, Sect. 4.6,
apply, and various mechanisms including the waterfall provisions in project finance
which I will discuss in Sect. 4.2 of this chapter are required. On the other hand, in
regard to the aircraft (or the leasing of the subject aircraft), except for the creditwor-
thiness risk of the aircraft operating company, the predetermined amounts of lease
payments at the determined times are paid, and thus not much variance exists in the
amount of the cash flow (i.e., volatility is low). In that sense, a specified aircraft (or
the leasing of the subject aircraft) does not fall under classification of “specified
project” with a high cash flow volatility, and thus aircraft finance that uses a finance
lease is not considered project finance, ordinarily.

1.3  Difference Between Project Finance and Securitization

In the case of securitization, a financial institution lends to an SPC capital that is


required when the SPC purchases the asset from the originator. The source of funds for
repayment for the subject loan is, in principle, the revenue generated from the subject
asset. If the subject asset should fall under the classification of “specified project”
because the “primary source of funds for the repayment” depends on the “cash flow
from the subject project” (i.e., the revenue resulting from the operation of the subject
asset), the securitization also would possibility be considered part of the project finance.
However, as I discussed in Chap. 2, Sect. 3.1.3, the cash flow that results from the
subject asset, in terms of securitization, has low volatility. Conversely, an asset with
high cash flow volatility does not become the subject of securitization, for practical
and theoretical reasons. In that sense, in terms of securitization, assets with high
cash flow volatility do not fall under the classification of “specified project”; and
thus, the securitization is not considered project finance.

1.4  Difference Between the Project and the Asset

As discussed above, from the viewpoint of financing, the cash flow generated from
the asset itself becomes the primary issue, essentially, and if the volatility of the cash
flow is low, financing that depends on the subject cash flow becomes possible. If the
volatility of the cash flow generated from the subject asset is high, and assuming
such volatility cannot be controlled by any of the parties, then at least debt financing
(i.e., financing where the ability to perform repayment is a precondition) that depends
on the subject cash flow (at least, in cases where the debt amount would surpass the
aggregate cash flow that would be generated in the worst case scenario) will become
impossible. Also, prevention of bankruptcy is a premise for using an SPC, and there-
fore, various tactics are used to prevent the SPC from going bankrupt. Accordingly,
106 3  Business Theories of Project Finance

the need to protect the SPC in the event of bankruptcy of the originator also arises.
In this connection, in securitization, because the asset is transferred from the origina-
tor to the SPC, the “true sale” of the subject assets must also be confirmed.
In contrast to this, the project essentially generates the cash flow as a single inte-
grated business separate from the assets that comprise the project. Some projects
may generate equivalent cash flows regardless of the management in charge.
Nevertheless, it remains the essence of project finance that the success or failure of
a project is dependent upon the business performance capability of those who oper-
ate the subject project. In a project, if the volatility of the cash flow generated from
the project is high, it is directly related to the business performance capability of
those who operate the project. In that sense, the Project Company has the potential
to go bankrupt. Also, when the Sponsor goes bankrupt, the project will not be per-
formed, and thus the Project Company also will go bankrupt. Therefore, in project
finance, among the various tactics implemented to prevent the Project Company
from going bankrupt, a ban on bankruptcy filings by the Project Company and/or
the Sponsor is the ultimate tactic possible. In Project Finance, the establishment of
bankruptcy remoteness in regard to the SPC against the originator, which is stan-
dard in the case of the securitization, will not be undertaken either. Further, because
the assets of the Project Company are newly-obtained assets in principle (i.e., not
assets acquired from the Sponsor), the issue of “true sale” of assets does not arise.
Instead, in project finance, on the premise that the Project Company has the poten-
tial to file for bankruptcy, countermeasures to address the possible bankruptcy of the
Project Company are taken in advance. Regarding the subject countermeasures in
project finance, I will discuss those in Sect. 5.5.2.6 of this chapter.
As explained above, when considered from the viewpoint of financing, the asset
and the project differ completely in essence. Although cash flows generated from
the asset and the project are similar in that both facilitate lending to the SPC (i.e.,
the cash flows are the source of funds for repayment in regard to aircraft finance that
uses a finance lease or securitization, and project finance), the essence of these cash
flows are completely different.
Thus, through this chapter, first, in Sect. 2, I discuss why project finance is used in
the chapter entitled “Reason Project Finance is Used.” Next, in Sects. 3 and 4, I dis-
cuss “Essence of Project Finance” and “Characteristics of Project Finance,” respec-
tively. Finally, in Sect. 5, I discuss “Characteristics of Key Financing Agreements.”

2  Reason Project Finance Is Used

2.1  Source of “Wealth” in Project Finance

Similar to the discussion in Chap. 2, Sect. 2.1, explaining that an NRI-PPP Project
is used because of the advantages for both the Host Country/Off-taker and the
Sponsor, the reason project finance is used is because of the advantages for both the
2  Reason Project Finance Is Used 107

Sponsor and the Senior Lender. The source of wealth in project finance is ultimately
the same as in an NRI-PPP Project, which I discussed in Chap. 2, Sect. 2.1. Rather,
due to the increase of the Equity-IRR of the Sponsor through project finance, which
I will discuss in Sect. 2.2 of this chapter, simply put, the Project Company has the
potential to be able to provide goods and/or services to the Host Country/Off-taker
or its citizens at a cheaper price than the case where financing through project
finance is not employed; and thus the use of project finance indirectly benefits the
Host Country/Off-taker. That is to say with financing through project finance, the
percentage of wealth that is realized by the Sponsor of the NRI-PPP Project becomes
larger, and part of the increased benefits can be passed on to the Host Country/Off-­
taker (and, if the case allows, to those who perform contracted work assigned from
the Project Company including the EPC Contractor, etc.).
Next, I will discuss the “Advantages of Project Finance for the Sponsor” in Sect.
2.2 of this chapter, and the “Advantages of Project Finance for the Senior Lender”
in Sect. 2.3 of this chapter. Additionally, as project finance has both advantages and
disadvantages together with limitations, I will discuss “Limitations/Disadvantages
of Project Finance for the Sponsor” in Sect. 2.4 of this chapter, and “Limitations of
Project Finance for the Senior Lender” in Sect. 2.5 of this chapter, and finally
“Advantages and Limitations of Project Finance for the Host Country/Off-taker” in
Sect. 2.6 of this chapter.

2.2  Advantages of Project Finance for the Sponsor

2.2.1  I mprovement of the Sponsor’s Equity-IRR Through Project


Finance

It is no exaggeration to say that the advantage of project finance for the Sponsor
comes down to the improvement of the Sponsor’s Equity-IRR due to the leverage
effect of project finance. The indicator to measure the advantage for the Sponsor is,
as I discussed in Chap. 2, Sect. 2.3, the Internal Rate of Return on Equity (“Equity-­
IRR” or “EIRR”). Next, I will thoroughly explain Equity-IRR; however, in order to
explain Equity-IRR, I need to discuss first the profitability (economic efficiency) of
the project as well as the internal rate of return and the net present value.

2.2.1.1  P
 rofitability (Economic Efficiency) of the Project As Well as Internal
Rate of Return and Net Present Value

In a project in which investments by private business entities are made, the profit-
ability (economic efficiency) of the project itself becomes an initial issue. In such a
project, to put it plainly, profitability is measured by the extent of the cash return on
the capital invested. In a project involving investments by private business entities,
it is understood that profitability of such project is measured by using the internal
108 3  Business Theories of Project Finance

rate of return (“Internal Rate of Return on Project,” “Project–IRR” or “PIRR,” or


simply “Internal Rate of Return” or “IRR”). Incidentally, because the Project
Company in an NRI-PPP Project is only engaged in the subject project, the profit-
ability of the project means, in principle, the profitability of the Project Company.
In the case of a project, such as an NRI-PPP Project, that extends over a long period
of time, in considering its profitability, the timing of the cash-in (i.e., money that comes
into the project) and the timing of the cash-out (i.e., money that goes out of the project),
with respect to the capital invested in the subject project, become important. Therefore,
the profitability of the project needs to be evaluated after determining the present val-
ues of the cash-in and the cash-out amounts. For this evaluation, the so-called DCF
(discounted cash flow) method is employed. What is important in the evaluation of the
investment is the net present value (“NPV”) of the project calculated by using this DCF
method. NPV of the project is expressed by the following equation:
NPV = present value of the cash inflow of the project - present value of the cash
outflow of the project.
What should be noted here are the meanings of “cash inflow of the project” and
“cash outflow of the project” in the equation above. As can be seen from Fig. 2.1 “Cash
flow of the Project Company” presented in Chap. 2, Sect. 4.8.3, the cash that comes
into the Project Company is broadly classified as funds from the following sources:
• in regard to the design/construction period:
• invested capital / subordinated loan; and
• Senior Loan of the project finance; and
• in regard to the operation period:
• consideration from the users / consideration from the Off-taker.
And, the cash that goes out of the Project Company is broadly classified as pay-
ments concerning:
• in regard to the design/construction period:
• project costs; and
• in regard to the operation period:
• taxes and public dues, etc.;
• O&M fee;
• repayment of principal and interest of the Senior Loan of the project finance;
and
• dividends, etc. related to the equity investments and subordinated loan.
Here, in order to simplify the discussion, I assume that the full amount of the
investment is funded by the invested capital from the Sponsor. Based on this assump-
tion, the cash that comes into the Project Company is broadly classified as:
• in regard to the design/construction period:
• the invested capital; and
2  Reason Project Finance Is Used 109

• regard to the operation period:


• consideration from the users / consideration from the Off-taker.
And, the cash that goes out of the Project Company is broadly classified as pay-
ments concerning:
• in regard to the design/construction period:
• project costs; and
• in regard to the operation period:
• taxes and public dues, etc.;
• O&M fee; and
• dividends, etc. related to the equity investments and subordinated loan.
Considering the foregoing, because the “cash inflow of the project” in the above-­
presented equation for calculating NPV is the indicator to measure the investment
efficiency against the invested capital amount, here, it means the invested capital
during the design/construction period which is the full amount of the investment.
Likewise, because the “cash outflow of the project” in the above-presented equation
for calculating NPV is the return on the investment, it means the dividends, etc.
related to the equity investments and subordinated loan during the operation period.
As can be seen from the above-presented equation, the NPV of the project varies
depending on the discount rate used to determine the present value of future cash
flows in the calculation of the NPV. Then, using the DCF method, the equation for
calculating the NPV of the project is created first; further, the discount rate that
makes the NPV equal to zero (i.e., the discount rate that makes the NPV of the cash
inflow of the project equal to the NPV of the cash outflow of the project) is calcu-
lated. This discount rate that makes the NPV equal to zero becomes the Internal
Rate of Return, that is, the Project-IRR.3 This Project-IRR becomes an indicator that
shows what percentage of profit will be generated out of the invested capital. If
asked to provide a very simplified explanation that could be readily understood, the
author would state that, conceptually, Project-IRR is equivalent to the interest rate
by which interest accrues on amounts deposited into one’s bank account (although,
different from such interest, Project-IRR does not always generate a return with the
passage of time).

2.2.1.2  T
 he Relationship Between Project-IRR and Equity-IRR As Well
as the Leverage Effect of Project Finance

As discussed above, profitability of a project is measured by Project-IRR, and profit-


ability of the Sponsor (not of the project) is measured by Equity-IRR. Next, I will
discuss the relationship between Project-IRR and the Sponsor’s profitability. Here, to
simplify my discussion, the author presents the following “Project-X” as an example:

 See Kaga, R. (2007) The Practice of Project Finance. page 136.


3
110 3  Business Theories of Project Finance

Project-X: A project that is able to generate a return of \11 billion after 1 year of
operation, and which is capitalized with a total investment of \10 billion (it is
assumed that taxes and transaction costs are not to be incurred).
Also, in order to simplify the explanation, I use numerical values to represent the
Return on Investment (“ROI”) and the Return on Equity (“ROE”), neither of which
is converted into its present value amount. ROI corresponds to Project-IRR, and
ROE corresponds to Equity-IRR.
• The case where the full amount of the \10 billion investment is funded by equity
investment (Case A)
Investment in the amount of \10 billion is required for the capitalization of
Project-X; whereas, in the case where the full amount of the investment is funded
by equity investment, ROI and ROE in Project-X are calculated as described below.
First, because ROI is the percentage of the profit against the overall investment,
ROI would be the percentage of the aggregate \1 billion profit against the overall
investment; and thus, ROI in this scenario of Project-X is 10%. Then, since ROE is
the percentage of the profit against the invested capital, in the Project-X example,
ROE would be the percentage of the aggregate \1 billion profit against the overall
investment; and thus, ROE in this scenario of Project-X is 10%, which is the same
with ROI. That is to say, in this scenario of Project-X:
ROE = ROI = 10/100 = 10%.
Figure 3.1 illustrates this relationship.
• The case where, regarding the \10 billion investment, \8 billion is funded through
a loan which provides for an interest rate of 9%, and remaining \2 billion is
funded by equity investment (Case B)
Regarding the \10 billion required as the investment for Project-X, in the case
where \8 billion is funded by proceeds from the Senior Loan of the project finance,

10%

ROI=ROE 10%

\10 Billion
Equity Investment

Fig. 3.1  ROI and ROE in the case where the full amount of the ¥10 billion Investment is funded
through equity investment
2  Reason Project Finance Is Used 111

and remaining \2 billion is funded by equity investment, ROI and ROE in this sce-
nario of Project-X are calculated as follows:
First, because ROI is a percentage of the profit against the overall investment,
whether the investment is in the form of equity investment or in the form of loan
proceeds does not make difference to ROI. Therefore, ROI would be the percentage
of the \1 billion profit against the \10 billion investment (which is the sum of the \2
billion equity investment and the \8 billion loan proceeds); and consequently, ROI
in this scenario of Project-X is 10%.
Regardless of whether this investment takes the form of an equity investment or
loan proceeds, ROI or the Project-IRR would not be affected. This is a conclusion
drawn from the Modigliani–Miller theorem (i.e., under certain presumed conditions
such as the absence of taxes, the market value of a company will not be affected by
its capital structure).
Next, let’s see what will happen to ROE. Because ROE is the percentage calcu-
lated by comparing the profit against the equity investment, the numerical value of
the denominator becomes \2 billion, which is the amount of the equity investment.
On the other hand, as for the amount of the profit, in the case where \8 billion is
funded with the equity investment, a profit of \0.8 billion is generated, which is a
10% rate of return on the \8 billion equity investment. However, as the interest rate
in case B is 9%, the profit on the \8 billion is as much as \0.72 billion. The difference
between \0.8 billion and \0.72 billion, which is \0.08 billion, is not profit attributable
to the Senior Loan (of \8 billion) in the project finance, but a profit on the \2 billion
of equity investment. Consequently, the profit on such \2 billion is the sum of \0.2
billion (i.e., 10% of \2 billion, representing the ROI) and \0.08 billion (i.e., the trans-
ferred profit from the \8 billion proceeds from the Senior Loan in the project
finance), which is \0.28 billion in total.
Therefore, ROE equals 14%, which is the percentage of \0.28 billion against \2
billion.
That is to say, ROE = 0.28/2 = 14%.
Figure 3.2 illustrates this relationship.
As discussed above, in the case where project finance is used, the absolute
amount of the profit the Sponsor receives is reduced from \1 billion to \0.28 billion.
However, because the original amount of the equity investment changes from \10
billion to \2 billion, in terms of the rate of return, it increases from 10% to 14%.
Conversely, if \10 billion is available, instead of investing \10 billion in one project,
investing in five projects, each with a rate of return of 10% by using project finance
would be preferable in terms of investment efficiency.
In this way, when project finance is employed, Equity-IRR, which is the indica-
tor to measure the benefit for the Sponsor, increases. This is called the “leverage
effect” of project finance.
Incidentally, in addition to project finance, does this “leverage effect” also occur
in relation to corporate finance? If I assume that the Project Company is an SPC in
an NRI-PPP Project, in corporate finance where the Project Company is assumed to
be the borrower, the provision of financing to the Project Company would be practi-
cally impossible from the viewpoint of its creditworthiness, in the first place. Thus,
112 3  Business Theories of Project Finance

%
ROE 14%

ROI 10%

Interest 9%
Rate

\2 billion \8 billion
Equity Investment Senior Loan of the Project
Finance

Fig. 3.2  ROI and ROE in the case where project finance is used

the only remaining option conceivable is the provision of corporate financing, with
the Project Company as the borrower and the Sponsor as a guarantor. Based on the
creditworthiness of the Sponsor, such provision of corporate financing might be
possible. Also, in the aforementioned case, the structure reflected on the balance
sheet of the Project Company would be the same as shown in the Case B above.
Therefore, it appears that the leverage effect also exists in this case. However, cor-
porate financing with the Project Company as the borrower and the Sponsor as a
guarantor is, from the viewpoint of the Sponsor’s creditworthiness upon which the
Senior Lender depends, economically the same as the situation where the Senior
Lender provides a loan for the full amount of the investment to the Sponsor and the
Sponsor uses the proceeds from such loan to make the equity investment in the
Project Company. In other words, the Sponsor is using its creditworthiness to
achieve the full amount of the invested capital, which, in essence, is the same as in
Case A above. Accordingly, in the case of corporate finance, this leverage effect
does not provide the same economic benefit.
Figure 3.3 illustrates this relationship.

2.2.1.3  The Ultimate Profitability of the Sponsor

Finally, for the Sponsor to make an equity investment, the Sponsor itself needs to
obtain financing for the capital (cash) to be used for the equity investment. As a mat-
ter of course, the Sponsor will incur financing-related costs for the subject equity
investment. Accordingly, the indicator of the Sponsor’s ultimate profitability is the
interest rate gained by subtracting from the Equity-IRR, the interest rate to be
applied in relation to the financing cost related to the subject Sponsor’s investment.
If I represent this as an equation, it is shown as follows:
Senior Lender Senior Lender

Guarantee \8 billion Loan


\8 billion Loan
2  Reason Project Finance Is Used

Sponsor Sponsor

Same from the viewpoint of
\2 billion \10 billion
Sponsor’s creditworthiness
Equity Equity
Investment upon which the Senior Investment
Lender depends

Project Company Project Company

Fig. 3.3  Relationships from the viewpoint of the sponsor’s creditworthiness in the case of corporate finance
113
114 3  Business Theories of Project Finance

The Indicator of the Sponsor’s Ultimate Profitability = X -- Y.


X = Profitability of the Equity Investment (Capital) = Equity-IRR.
Y = Financing Cost of the Equity Investment (Capital) = Actual Financing Cost
or the Internal Benchmark Interest Rate.
Figure 3.4 illustrates this relationship from the viewpoint of the balance sheets of
the Sponsor and the Project Company (It is assumed that only one Sponsor exists).

2.2.2  L
 imited Legal Liability of the Sponsor with Respect to the Loan
Obligation, and the Off–Balancing of the Loan Obligation
from the Balance Sheet

In connection with the improvement of the Sponsor’s Equity-IRR due to the lever-
age effect of project finance, in the case of project finance, regarding the loan obli-
gation related to the project, the Sponsor does not bear legal liability against the
Senior Lender in principle, other than the legal liability arising from the Sponsor
Support Agreement. Thus, the Sponsor can benefit by keeping the loan obligation
off of its balance sheet.
First, because the borrower in project finance is not the Sponsor but the Project
Company, the project finance-related loan obligation is listed in the liabilities sec-
tion of the non-consolidated balance sheet of the Project Company. Also, because
the Sponsor does not guarantee the subject loan obligation except for the Completion
Guarantee (I will discuss Completion Guarantee in Sect. 5.1.3 of this chapter, no
note on the existence of any guarantee is included in the Sponsor’s non-consolidated
balance sheet. Therefore, the Sponsor can elect to “off balance sheet” or not reflect

Balance Sheet--Project Company Balance Sheet--Sponsor

Assets Liabilities Assets Liabilities

Y = Financing
X = Equity-IRR Investment Financing Y
Cost of Capital

Equity (Net Assets


in Japan) X = Equity-IRR

Equity (Net Assets


in Japan)
Note: X and Y refer to interest rates indicating,
respectively, (i) the profitability of the equity
investment (capital) and (ii) the financing cost of the
equity investment (capital); they do not refer to actual
figures of capital, investment or financing in the
balance sheet.

Fig. 3.4  Ultimate profitability of the sponsor


2  Reason Project Finance Is Used 115

the loan obligation related to the project on the Sponsor’s non-consolidated balance
sheet. However, with respect to this, the following two points need to be noted.
First, the Sponsor will not legally guarantee the project finance-related loan obli-
gation, except for the Completion Guarantee. However, the Sponsor is obligated to
the Senior Lender to provide various support with respect to the project. These
obligations are to be stipulated in the Sponsor Support Agreement which I discussed
in Chap. 1, Sect. 4.2.2. In the case where these support obligations are substantially
equivalent to guarantee obligations, the question of whether a note on the existence
of the guarantee should be inserted in the Sponsor’s non-consolidated balance sheet
requires confirmation from the viewpoint of accounting. For example, as I will dis-
cuss in Sect. 5.1.3 of this chapter, in project finance, an arrangement that is eco-
nomically identical to the Completion Guarantee, involves the case where the
Sponsor bears an uncapped obligation to the Senior Lender to provide to the Project
Company with the capital required for the completion of the project. The reason the
Completion Guarantee takes this form seems to be because, despite being a guaran-
tee in substance, no note regarding the existence of such guarantee is mentioned in
the Sponsor’s non-consolidated balance sheet. However, in the case where the
Project Company goes bankrupt, despite the amount of capital contribution the
Sponsor will have provided to the Project Company, the project finance loan will not
have been repaid. In order to provide the same assurances as the Completion
Guarantee from the perspective of economic effect, the Sponsor must agree to pay
directly to the Senior Lender the unpaid balance of the project finance loan in the
case where the Project Company goes bankrupt. Regarding whether, even under this
arrangement, a note on the existence of the Sponsor’s “guarantee” needs not to be
mentioned in the Sponsor’s non-consolidated balance sheet, the author considers
that a careful review needs to be made from the viewpoint of accounting.
Secondly, regarding the project finance-related loan obligation, the possibility of
off-balance sheeting such loan obligation from the Sponsor’s consolidated balance
sheet (as opposed to the Sponsor’s non-consolidated balance sheet) becomes an
issue. If I acknowledge the Principle of Owner-Operator, which I discussed in Chap.
2, Sect. 4.2, the Sponsor needs to be the major shareholder of the Project Company.
Then, the Project Company ordinarily becomes a consolidated subsidiary of the
Sponsor, and consequently, there arises a possibility that the project finance-related
loan obligation will need to be listed as a liability on the consolidated balance sheet
of the Sponsor. However, if this is the case, there is a potential likelihood that the
benefit to the Sponsor in using project finance will decrease remarkably.
Incidentally, even in the case where the Project Company’s project finance-­
related loan obligation is listed as a liability on the consolidated balance sheet of the
Sponsor, from the viewpoint of the credit rating of the Sponsor, by explaining to the
rating agency that such loan obligation is entirely the obligation of the Project
Company because such loan is a project finance loan, there is a possibility that such
point may be taken into consideration by such rating agency in its determination of
the Sponsor’s credit rating.
116 3  Business Theories of Project Finance

2.3  Advantage of Project Finance for the Senior Lender

The advantage of project finance for the Senior Lender is the realization of higher
returns by taking more risks than it could otherwise take as a financial institution.
Ordinarily, the spread of a project finance loan is considerably higher than 100 basis
points (i.e., 1%). This is to say, in general terms, a spread of a considerably higher
interest rate than that applied in ordinary corporate finance. In that sense, the Senior
Lender of project finance stands to gain higher returns than it would in ordinary
corporate finance by taking greater risks than in the case of the ordinary corporate
finance. In this regard, the Senior Loan of the project finance is sometimes described
as being “high risk/high return” or “moderate risk/moderate return.” However, the
Senior Loan of the project finance is essentially a loan, and is different from equity
investment. Even if the Senior Lender of project finance may take more risks than
in ordinary corporate finance, if there is a substantial risk that the Senior Loan of the
project finance may not be repaid, the making of such loan will not be possible. In
that sense, the level of high risk/high return, or moderate risk/moderate return in
regard to Senior Loan of the project finance, when compared to the case of equity
investment where there is the risk of no return or the possibility of tenfold return,
will not be viewed as excessively high.

2.4  L
 imitations/Disadvantages of Project Finance
for the Sponsor

The primary limitations and disadvantages of project finance for the Sponsor,
include the following five points.

2.4.1  Restriction on Projects that Qualify for Project Finance

An NRI-PPP Project that can become the subject of project finance is, as I discussed
in Chap. 2, Sect. 1.1, usually a BOT Project. It is exactly the type of project where
the operations of the project determine the success of the project. Therefore, an NRI-
PPP Project which is not dependent on the project’s operations for its success does
not become the subject of project finance in the first place, with certain exceptions
such as BLT Projects. This is one of the limitations of project finance for the Sponsor.
Further, although an ordinary Sponsor typically will not become involved in a
project that is expected to have low profitability in the first place, there may be cases
where the Sponsor participates in a low profitability project for various reasons.
However, from the viewpoint of the Senior Lender, the expected profitability of a
project must be to the extent that justifies project finance. Therefore, it is very likely
that a project that is not expected to have high profitability will not become the
subject of project finance.
2  Reason Project Finance Is Used 117

2.4.2  Restriction on Sponsors that Qualify for Project Finance

Not all Sponsors are qualified to engage in project finance. As I discussed in Chap.
2, Sect. 1.1, in an NRI-PPP Project, from the viewpoint of the Host Country/Off-­
taker, the Sponsor and O&M Operator’s high business performance capability
related to the subject NRI-PPP Project is required. This is also a requirement in
regard to project finance. For example, what would be the result if an automobile
company with an AAA credit rating should become the Sponsor of an IPP project?
No matter how high the Sponsor’s credit rating is, unless its business performance
capability in regard to the IPP project is high, the subject Sponsor will be unable to
realize the benefit from the project finance related to such IPP project.
Also, because project finance is financing that depends on the business perfor-
mance capability of the Sponsor, the existence of the subject Sponsor during the
project period becomes important. For example, in the case of an NRI-PPP Project
with a project period of 20 years, surely, there is no company in the world that can
guarantee its existence for 20 years. Therefore, an extremely high creditworthiness
is not required of the Sponsor. However, a reasonable assurance of the Sponsor’s
existence for 20 years is required, and unless it is a Sponsor with a certain degree of
creditworthiness, benefitting from project finance is not possible.
Incidentally, it is sometimes asserted that where lending by corporate finance is
not possible due to the creditworthiness of a Sponsor, the provision of financing
through project finance should be made. However, the Sponsor’s creditworthiness is
also important in terms of project finance; therefore, it needs to be noted that this is
an assertion that does not understand the essence of project finance.

2.4.3  Limitation on the Technologies Available

As I discussed in Chap. 2, Sect. 4.7.3, for the Sponsor to demonstrate to the Senior
Lender that it has the capability to successfully complete the project, the Sponsor
needs to show that the technology to be used in the subject project is a proven tech-
nology that has already been successful when applied in other projects. Some
Sponsors may hope to implement an NRI-PPP Project using an innovative technol-
ogy. However, unless the subject innovative technology is a proven technology, a
third party cannot judge whether the project using the subject innovative technology
will be successful. In that sense, unless the technology the Sponsor uses is a proven
technology, the Sponsor will not be able to reap the benefits of project finance. This
is also one of the limitations of project finance.

2.4.4  Cost and Time Involved in Project Finance

In project finance, the Senior Lender analyzes and assesses the profitability of an
NRI-PPP Project. The Senior Lender also analyzes and assesses various risks
involved in the subject project. In an NRI-PPP Project, various risks emerge for
118 3  Business Theories of Project Finance

each project, and thus project finance cannot be commoditized. As I discussed in


Chap. 1, Chap. 1, project finance is tailor-made financing.
In these analyses and assessments, as I discussed in Chap. 1, Sect. 3.7 the Senior
Lender receives advice from various experts including consultants on technology, tax
and accounting issues, environmental issues, insurance, etc. These consultants ulti-
mately prepare reports, and the total amount of fees of these consultants is by no means
a small amount. Also, in the case of project finance, although ordinarily the scheme
will include a syndicated loan, because the arrangements made by the arrangers of
syndicated loans are quite diverse, arrangement fees to be incurred are substantially
higher than fees incurred in corporate finance transactions. Further, the documentation
of the various contractual relationships involves preparation of numerous contracts,
which then requires professional advice to be obtained from law firms. The legal fees
charged by such law firms also can be a large sum. These fees and compensation,
depending on the project, can amount to more than US$10 million in total.
Further, it takes a considerable number of days to conduct these analyses and
assessments. If I include the time required for contract negotiations in a project
finance transaction, in some cases, it can take more than a year from the time the
Sponsor begins communicating with financial institutions regarding the financing to
be provided by project finance to the time the project finance contract is executed.
As mentioned above, in the case of project finance, in comparison to corporate
finance, a much higher amount of costs is to be incurred, and far more days are to
be taken. The author considers that, in practice, unless the project is an NRI-PPP
Project that exceeds US$100 million in terms of project costs, from the viewpoint
of the cost and the time, project finance may not be a suitable option for the financ-
ing of such project. Incidentally, as I discussed in Sect. 2.3 of this chapter, the
spreads of project finance loans are, when compared to the spreads of corporate
finance loans, considerably higher in relative terms. From that perspective, the bor-
rowing cost itself becomes higher for the Sponsor.
These project finance cost-related concerns are to be considered together with the
advantages of project finance, which is a point I discussed in Sect. 2.2 of this chapter.
Whether or not the Sponsor can accept these costs is ultimately decided in this con-
text, and only when, after comparing the costs against the advantages, the Sponsor still
stands to gain a sufficient benefit, will the project finance transaction be undertaken.

2.4.5  C
 ontrol by the Senior Lender in Regard to the Project Company’s
Business Performance

Project finance is financing that depends on the Sponsor’s business performance


capability, and thus it is not appropriate for the Senior Lender to impose excessive
restrictions that affect the business decisions of the Project Company. However, in
project finance, because the Senior Lender takes on the business risks of the project,
with respect to matters that adversely affect the cash flow of the project substantially
(and thereby adversely affect the potential for repayment of the project finance loan
substantially), the Senior Lender’s approvals are required. To this extent,
2  Reason Project Finance Is Used 119

restrictions are imposed on the business decisions of the Project Company. For
example, in the case where O&M costs are likely to increase, if the Project Company
has complete freedom to increase the O&M fee to be paid to the O&M Operator,
such fee increase will have a substantial adverse effect on the potential for repay-
ment of the project finance loan, and thus, the Senior Lender needs to impose a
certain restriction to limit the Project Company’s ability to increase such fee.
Incidentally, in practice, if variations are within a certain range, a mechanism to
resolve issues, such as adopting the opinion of an independent consultant which I
discussed in Chap. 1, Sect. 3.7, may be adopted.

2.5  Limitation of Project Finance for the Senior Lender

Project finance is not a type of financing that can be arranged by any financial insti-
tution. As the Senior Lender is to assume the business risks of the project, it must
have the capability to properly assess whether the risks of the business should be
assumed. This is qualitatively different from the borrower’s creditworthiness risk in
corporate finance. As for the business-related risks, various risks exist depending on
the type of the business. Even among similar types of NRI-PPP Projects, the busi-
ness risks associated with each project are considerably different, such as the differ-
ences between risks associated with the offshore oilfield development project in
illustrative case 1 (described in Chap. 1, Sect. 5 and the IPP project in illustrative
case 2 (described in Chap. 1, Sect. 5. Accordingly, financial institutions establish
specialized departments for project finance, and each comes to have specialized
knowledge in certain business fields. Also, the Senior Lender needs to develop an
internal review system to assess the various business risks. In other words, it is not
the case that any financial institution can arrange project finance financing in regard
to any field to which an NRI-PPP Project relates. On one hand, if a financial institu-
tion can arrange project finance financing for a particular NRI-PPP Project, that will
differentiate the subject financial institution in the sense that it has comparative
strength in the specialized field (i.e., the field to which the NRI-PPP Project relates);
and consequently such financial institution will have a high reputation in the field of
finance. However, on the other hand, in view of the fact that not all financial institu-
tions can arrange project finance financing, there is a limitation on project finance
that may be undertaken by the Senior Lender.
Conversely, if a financial institution with inferior assessment ability undertakes
project finance, there is a risk that the project for which such project financing is
granted will have lower sustainability, which then increases the risk that undertak-
ing such project may have adverse consequences from the perspective of the nation-
als of the Host Country.
120 3  Business Theories of Project Finance

2.6  B
 enefits and Limitation of Project Finance for the Host
Country/Off–Taker

The Host Country/Off-taker is not a direct party to a project finance transaction.


Therefore, the Host Country/Off-taker is not a direct recipient of the benefits of
project finance. However, there is the possibility that the Host Country/Off-taker
may receive benefits indirectly from project finance. The following five points are
among the major benefits that the Host Country/Off-taker may possibly receive
indirectly from project finance.

2.6.1  Improvement of VFM

As I discussed in Sect. 2.2.1 of this chapter, the Sponsor’s Equity-IRR improves by


engaging in project finance. If the Sponsor should transfer a portion of its increased
Wealth to the Host Country/Off-taker, what would happen? The Sponsor’s Equity-­
IRR would not be improved by that amount. However, this transfer of a portion of the
Sponsor’s increased Wealth would result in a reduction by the Project Company in the
prices of the goods and/or services it provides to the Host Country/Off-taker by that
amount, and thus, this leads to the improvement of VFM. Because of this, the Host
Country/Off-taker would possibly enjoy benefits from project finance indirectly.
However, the Host Country/Off-taker is not in a position to force the Sponsor to
transfer any portion of its increased Wealth. The best that the Host Country/Off-­
taker can do is to review the proposed prices of the goods and/or services to be
provided to the Host Country/Off-taker at the stage of the bidding. Whether or not
such increased Wealth is transferred, and to what extent in the case where it is trans-
ferred, is ultimately determined by the Sponsor-selection competitive bid process
arranged by the Host Country/Off-taker; and the criteria for the determination
include (a) whether the Sponsor, from a business perspective, can accept the numer-
ical value of the Equity-IRR, and (b) whether the contemplated profitability of the
project is acceptable to the Senior Lender of project finance (If the prices of the
goods and/or services to be provided to the Host Country/Off-taker decrease, the
profitability of the project decreases by that amount). In this regard, in practice,
proper implementation of the Sponsor-selection competitive bid process by the Host
Country/Off-taker is critical (the bid process should result in competing bids from
multiple consortia).

2.6.2  Screening Function of an NRI–PPP Project

A Host Country/Off-taker contemplates various NRI-PPP Projects. Included among


them are projects with low-profitability or projects that do not contribute to the
benefit of the nationals of the subject Host Country/Off-taker. Low-profitability
projects have a higher risk of failure, whereas, on the other hand, NRI-PPP Projects
2  Reason Project Finance Is Used 121

generally have a high public interest factor. For this reason, from the viewpoint of
the Host Country/Off-taker, the situation where an NRI-PPP Project is unsuccessful
must be avoided as much as possible. If the expected profitability is low, instead of
using a structure that employs private investment, the Host Country/Off-taker
should implement the subject project as the principal operating body on its own in
the first place. Conversely, even among projects with a potential for high profitabil-
ity, projects that do not contribute to the welfare of the nationals of the subject Host
Country/Off-taker (or projects that impose an excessive burden on the nationals)
also exist. Unless it is a project that brings benefit to the nationals and is supported
by the nationals, that is, a project with a high potential for sustainability no matter
how high the potential for profitability of the project may be, there is a risk that the
Host Country/Off-taker will not make payments as stipulated under the Concession/
Off-take/PPP Agreement.
The Senior Lender cannot arrange project financing for a low-profitability proj-
ect or a project with low potential public benefit and low probability for sustain-
ability. Therefore, conversely, if project finance financing is provided for an
NRI-PPP Project, it means that the subject NRI-PPP Project is regarded as a project
having both high profitability potential and high potential for public benefit as well
as high probability for sustainability. In this way, project finance has a screening
function in regard to NRI-PPP Projects, and this function contributes to the welfare
of the nationals of the Host Country/Off-taker.

2.6.3  Function to Screen the Sponsors

An NRI-PPP Project is a project, the success or failure of which depends on the


business performance capability of the Sponsor. Therefore, the Host Country/Off-­
taker should review the business performance capability of the Sponsor in the
Sponsor-selection competitive bid process. However, the business performance
capability of the Sponsor is also reviewed by the Senior Lender because if the NRI-­
PPP Project should be implemented improperly, the Senior Loan of the project
finance will not be repaid. In this way, only Sponsors with high business perfor-
mance capability are qualified to enjoy the benefits that can be gained through proj-
ect finance, and this Sponsor-screening function of project finance contributes to the
success of an NRI-PPP Project with a high potential for public benefit.

2.6.4  Monitoring Function of an NRI–PPP Project

As I will discuss in Sect. 3.3 of this chapter, before entering into the project finance-­
related contracts, the Senior Lender reviews the project and analyzes and assesses
various aspects of the project. Further, as I will discuss in Sect. 3.4 of this chapter,
after making the Senior Loan of the project finance, the Senior Lender monitors the
project to determine whether the subject project is running as planned, and if not,
why not and the solutions to any problems/issues that arise. This monitoring is not
122 3  Business Theories of Project Finance

limited simply to the monitoring of the financial matters of the Project Company,
but also includes the monitoring of the technical matters required in the course of
implementing the project.
Although the Host Country/Off-taker should monitor (either on its own or
through a third-party contractor) whether the project is running as planned after the
Concession/Off-take/PPP Agreement is entered into, monitoring of the project
should also be performed by the Senior Lender to confirm the appropriate imple-
mentation of the NRI-PPP Project. In this regard, the Senior Lender plays an impor-
tant role in contributing to the success of the NRI-PPP Project.

2.6.5  Project Revitalizing Function

In the case where the Project Company is not able to implement the project in accor-
dance with the Concession/Off-take/PPP Agreement due to reasons attributable to
the Project Company (therefore, the Project Company is not able to fulfill its obliga-
tions under the Concession/Off-take/PPP Agreement due to reasons attributable to
the Project Company), what countermeasures should the Host Country/Off-taker
take to address such failure? First of all, because the provision of goods and/or ser-
vices which are the subject of the subject Concession/Off-take/PPP Agreement has
a high public interest factor, the subject goods and/or services need to be continu-
ously provided at least during the Project Period under the subject Concession/Off-­
take/PPP Agreement. Accordingly, in the event the Project Company fails to supply
the subject goods and/or services in accordance with the terms of the Concession/
Off-take/PPP Agreement, the countermeasure to be taken by the subject Host
Country/Off-taker, as I will discuss in Sect. 5.5.2.7 of this chapter, is ultimately
termination of the Concession/Off-take/PPP Agreement based on the Project
Company’s breach of contract; then, after selecting a new Sponsor, the subject Host
Country/Off-taker will enter into a separate Concession/Off-take/PPP Agreement
with the new Sponsor’s Project Company. Once the subject Concession/Off-take/
PPP Agreement is terminated, the Host Country/Off-taker needs to take certain
steps including taking ownership of the facilities, etc. of the NRI-PPP Project, and
then transferring ownership of such facilities, etc. to the new Sponsor’s Project
Company. These procedures, including the selection of the new Sponsor, will incur
considerable time and costs.
However, under project finance, the Senior Lender has the right to Step-in.
Although I will discuss this right to Step-in in Sect. 5.5.2 of this chapter, one of the
aspects of this right is that the Senior Lender is able to replace the Sponsor. The
success or failure of the NRI-PPP Project depends on the business performance
capability of the Sponsor. If the Project Company cannot fulfill its obligations under
the Concession/Off-take/PPP Agreement due to reasons attributable to the Project
Company, it means the Sponsor does not have the business performance capability
as originally assumed. If such is the case, in order to revitalize the subject project,
the Sponsor needs to be replaced with a company that has the requisite business
performance capability. This right of the Senior Lender to implement the replace-
ment of the Sponsor is one of the aspects of the right to Step-in.
3  The Essence of Project Finance 123

From the perspective of the Host Country/Off-taker, it may have some apprehen-
sion regarding the Senior Lender’s replacement of the Sponsor with a new Sponsor
who may or may not have the requisite business performance capability (therefore,
it would be unknown to the Host Country/Off-taker whether the new Sponsor has
the ability to conduct a project, having a high public interest factor and involving the
provision of goods and/or services, in accordance with the Concession/Off-take/
PPP Agreement). However, the Senior Lender would not be blindly picking any
company to serve as the new Sponsor. Unless the project is revitalized, the Senior
Loan of the project finance will not be repaid. Therefore, the Senior Lender will
search for a company with a high business performance capability whose
­performance will allow the Senior Loan of the project finance to be repaid, and
invite a company with such qualifications to take on the role of the Sponsor for such
project. In that sense, the interests of the Host Country/Off-taker and the Senior
Lender are aligned, and the Host Country/Off-taker will allow the Senior Lender of
project finance to take steps to have the project revitalized without itself taking any
procedures such as enforcing its right to terminate the Concession/Off-take/PPP
Agreement, etc. which would incur time and costs. Additionally, the limitations that
may apply with respect to the new Sponsor can be stipulated in the Direct Agreement,
which I will discuss in Sect. 5.5.2.5 of this chapter.
As discussed above, the Host Country/Off-taker can receive various benefits indi-
rectly from project finance. However, particularly regarding the various functions I
discussed in Sects. 2.6.2 through 2.6.5 of this chapter, the Senior Lender does not
exercise these functions with the benefit of the public as its primary concern. The
Senior Lender exercises these functions essentially to facilitate the repayment of the
Senior Loan of the project finance. In that sense, these functions are derived purely
from the Senior Lender’s concerns for its own business interest, and the contributions
and benefits to the interests of nationals of the Host Country/Off-taker are nothing
more than a secondary effect. The financial institutions are not exercising these func-
tions for any social responsibility-related purpose or reason. However, it is not the
case that project finance implemented by any financial institutions will include all of
these functions. As I discussed in Sect. 2.5 of this chapter, only those project finance
transactions implemented by financial institutions that have expertise and experience
in project finance will include all of these functions. In that sense, it needs to be noted
that not all Senior Lenders that claim to provide project financing have the capability
to carry out the obligations and responsibilities mentioned above properly.

3  The Essence of Project Finance

3.1  F
 inancing that Depends on the Sponsor’s Business
Performance Capability

As I discussed in Chap. 2, Sect. 4.1, an NRI-PPP Project that becomes the subject of
project finance is a project that is highly dependent upon the success of the project’s
operations (including the management of such operations), and the success or failure
124 3  Business Theories of Project Finance

of a project depends on the business performance capability (including management


capability) of the Sponsor and O&M Operator. From this perspective, a project that
becomes the subject of project finance is a project where the amount of cash flow
varies depending on the business performance capability of the Sponsor (a project
where the volatility of the project’s cash flow, which is directly related to the business
performance capability of the Sponsor, is high). In addition, because the existence of
the Sponsor and O&M Operator during the Project Period is a precondition to the
project’s success, the Sponsor’s creditworthiness is required to be at a certain level.
Also, project finance is financing that depends on the business performance capa-
bility of the Sponsor. The reason the Senior Loan of the project finance is made and
repaid without the requirement of a Sponsor’s guarantee is because in project finance
a sufficient amount of the project’s cash flow that enables repayment of the Senior
Loan is generated due to the high business performance capability of the Sponsor.
Further, although the Sponsor recovers a return from an NRI-PPP Project in the
form of a return on the equity investment, for the Sponsor to recover this return in
project finance, a mechanism must be implemented which allows the principal and
interest of the Senior Loan to be repaid in advance. This mechanism is the waterfall
provisions, which I will discuss in Sect. 4.2 of this chapter.

3.2  Long–Term Business Finance

First, it should be noted that loans by financial institutions have a characteristic


known as “the depth of the pocket” which is peculiar to banking. That is to say, if,
in the case of corporate bonds, an event of default should occur with respect to the
corporate bond debt, in practice, there is a considerable likelihood that the debt
would be accelerated. However, in the case of a loan from a financial institution,
even when an event of default occurs with respect to the loan debt, it does not neces-
sarily immediately lead to the acceleration of the borrower’s payment obligation. A
financial institution would take into consideration the nature of the problem (i.e., the
default event) and the various factors regarding the borrower (debtor), and then
decide whether or not accelerating the borrower’s payment obligation would be the
better option from its perspective. Conversely, financial institutions try, using their
best efforts and various methods within their acceptable range of tolerance, to reha-
bilitate the borrower, until they finally conclude that repayment of the loans cannot
be expected. Hence, the events of default are relatively narrowly defined in relation
to corporate bonds, and relatively broadly defined in relation to loans.4
In the case of project finance by financial institutions, this “depth of the pocket”
of the banking becomes even more important. Project finance loans extend ordinar-

4
 This “depth of the pocket” in banking also appears in other situations, such as, for example, in a
situation where financing through the corporate bond market is not possible due to insufficient
creditworthiness of a corporation, financing through a loan made by a financial institution is
possible.
3  The Essence of Project Finance 125

ily for periods exceeding 10 years. During the term of a project finance loan, various
problems occur in relation to the subject project. The Senior Lender must address
these various problems together with the Sponsor. In that sense, the essence of proj-
ect finance, from a financial perspective, is to provide long-term business financing
that supports the Project Company’s long-term project operations.
The author also has dealt with various problems that have arisen during the oper-
ation periods of projects. The lesson learned by the author from these cases is that
to calmly analyze and address the problem events is important even if those events
would be astonishing in an ordinary situation. In addition, with respect to typically-­
occurring events such as changes in the laws and regulations, it is critical to deter-
mine and document the risk sharing arrangement in the contract in advance. The
author also has had many experiences addressing risk sharing arrangements relating
to certain issues that are determined and addressed in the relevant contracts 10 years
before the occurrences of the subject issues. Particularly, it would not be an over-
statement to say that changes in the laws and regulations relating to environmental
issues are certain to occur during a project’s operation period of about 20  years.
Even if it is stipulated in the contract that the parties are to amicably resolve such
issues through discussions when they occur, in reality, when the issues actually
occur, the issues will not be resolved easily. Although these points may not particu-
larly conform to the thinking of the parties involved in the transaction at the time of
the relevant contract’s execution, without considering these matters, understanding
risk-sharing arrangements, and taking proper steps to address potential problem
situations in advance, you would not be able to implement an NRI-PPP Project and
project finance properly. Incidentally, most of these issues are matters that basically
can be resolved reasonably if examined based on the business theories of NRI-PPP
Projects and project finance.

3.3  Review of the Project by the Senior Lender

Both the Senior Lender and the Sponsor base the success or failure of an NRI-PPP
Project on the cash flow generated by such NRI-PPP Project. From this perspective,
with the exception of the review performed by the Senior Lender in regard to the
Sponsor selection, the subject matters the Senior Lender assesses in judging whether
or not to arrange project financing for an NRI-PPP Project are basically the same as
the subject matters the Sponsor assesses in judging whether or not to invest in the
subject NRI-PPP Project. Additionally, this review contributes to the screening
functions of the NRI-PPP Project and the Sponsor which are among the indirect
benefits of project finance for the Host Country/Off-taker, which I discussed in
Sects. 2.6.2 and 2.6.3 of this chapter.
The key points the Senior Lender reviews and considers when deciding whether
or not to arrange project financing in regard to an NRI-PPP Project are as follows:
126 3  Business Theories of Project Finance

3.3.1  S
 ponsor’s Business Performance Capability and Creditworthiness
As Well as the Technologies Used

Because project finance is financing that depends on the Sponsor’s business perfor-
mance capability, the assessment of the Sponsor’s business performance capability
is critical. Additionally, accompanying this, the Sponsor’s creditworthiness is also
an important factor. Incidentally, the business performance capability to which I
refer here includes, as I discussed in Chap. 2, Sect. 4.7.1, not only the Sponsor’s
capabilities in relation to the operation and the maintenance of the subject project,
but also the business performance capability in the sense of overseeing the overall
project.
Also, the technologies used by the Sponsor in an NRI-PPP Project with respect
to the project’s operation and the maintenance are assessed based on whether they
are appropriate to ensure the profitability of the subject NRI-PPP Project.
Incidentally, the Senior Lender is typically a financial institution and not an
expert in regard to the NRI-PPP Project. From this reason, the Senior Lender obtains
advice from an Independent Consultant, which I discussed in Chap. 1, Sect. 3.7, and
assesses the Sponsor’s business performance capability and technologies.
Further, in the case where there are two or more Sponsors acting as a consortium,
the roles of the Sponsors and their ability to work together effectively also become
the subject of the assessment.
And in these assessments, as I discussed in Chap. 2, Sect. 4.7.6, including con-
sideration as to whether the technologies to be used in the subject NRI-PPP Project
are proven technologies or not, the assessment of past cases of success or failures of
the same or similar projects becomes important ultimately.

3.3.2  Economic Efficiency (Profitability) of the Project

Based on the project plan with respect to the project developed by the Sponsor, the
Senior Lender assesses the economic efficiency of the project. The Sponsor’s ability
to gain sufficient profit from the subject NRI-PPP Project becomes an important
incentive for the Sponsor’s implementation of the project. In this regard, cash flow
models of the project are developed, and they are analyzed to determine whether the
Sponsor can gain sufficient profit even after factoring shortcomings in regard to the
underlying preconditions of the subject cash flow models. This is called the sensitiv-
ity analysis of the cash flow.
Further, the Senior Lender will judge the appropriate indicators such as DSCR
and LLCR through this sensitivity analysis of the cash flow in order to minimize the
risk of default in the repayment of the project finance loan. Regarding DSCR and
LLCR, I will discuss them in Sect. 4.3.3 of this chapter. Also, the Senior Lender will
need to negotiate the appropriate Debt Equity Ratio with the Sponsor, which I will
discuss in Sect. 4.1 of this chapter.
3  The Essence of Project Finance 127

3.3.3  Various Risks Involved in an NRI-PPP Project

The Senior Lender, like the Sponsor, identifies the various risks involved in the
subject NRI-PPP Project and examines them; these risks include market risk, land
acquisition risk, completion risk, operation risk, risk of changes in laws and regula-
tions, force majeure risk, and political risk, amongst others. Specifically, the Senior
Lender considers the following: regarding the aforementioned risks, whether or not
the level of risk to be borne by the Host Country/Off-taker is appropriate; regarding
risks borne by private business entities, whether or not the Senior Lender is able to
take those risks; in the case where the level of risk to be borne by the Host Country/
Off-taker is not appropriate, or the Senior Lender is not able to take risks that are
borne by private business entities, whether some type of support, particularly sup-
port by the Sponsor, should be demanded in order to reduce such risks to a level that
is acceptable to the Senior Lender. Incidentally, as I discussed in Chap. 2, Sect.
5.1.1.1, from the basic concept of risk sharing in an NRI-PPP Project, the risks to be
borne by private business entities can be limited to operation risk, completion risk,
financing risk and market risk in the Market Risk-Taking Type (discussed below),
and other risks are risks to be borne by the Host Country/Off-taker. If I base my
discussion on this concept, the risks possibly taken by the Senior Lender will be
operation risk, completion risk and market risk in the Market Risk-Taking Type.
Here, I will discuss completion risk and market risk.

3.3.3.1  Completion Risk

As I discussed in Chap. 2, Sect. 4.8.1, there are three types of completion in relation
to Project Completion: the Physical/Mechanical Completion, the Operational
Completion, and the Financial Completion. In project finance, Financial Completion
becomes an issue, which I will discuss in Sect. 5.1 of this chapter. Here, I will dis-
cuss the risk that Operational Completion may not be accomplished.
As I discussed in Chap. 2, Sect. 5.3, under the EPC Contract, the Project Company
allows the EPC Contractor to undertake comprehensively the project’s Operational
Completion (to make the operation workable from today), and allows the EPC
Contractor to bear the completion risk from the Principle of Single Point
Responsibility, which I discussed in Chap. 2, Sect. 4.6. Therefore, the Senior Lender
reviews the EPC Contractor’s ability to achieve Operational Completion, and the
appropriateness, from the viewpoint of the project’s operations, of the EPC tech-
nologies to be used in the subject NRI-PPP Project.
And similar to what I explained in regard to the Sponsor’s business performance
capability and the technologies to be used, which I discussed in Sect. 3.3.1 of this
chapter, the Senior Lender assesses, with advice from the Independent Consultant,
which I discussed in Chap. 1, Sect. 3.7, the EPC Contractor’s ability to achieve
128 3  Business Theories of Project Finance

Operational Completion, and the technologies to be used in the subject NRI-PPP


Project. Thus, proper review of past cases of success or failures in regard to the
same or similar projects, including whether or not the technologies to be used in the
subject NRI-PPP Project are proven technologies, becomes important ultimately.
Additionally, regarding the point where the completion risk becomes the subject
of the review even in the case where the Sponsor provides the completion guarantee,
I will discuss such point in Sect. 5.1.3 of this chapter.

3.3.3.2  Market Risk

As I discussed in Chap. 2, Sect. 4.1, NRI-PPP Projects are broadly classified into
two types: the Market Risk-Taking Type NRI-PPP Projects and the Availability Fee
Payment Type NRI-PPP Projects. Also, as I discussed in Chap. 2, Sect. 5.1.1.3, it is
common knowledge that Market Risk-Taking Type NRI-PPP Projects are generally
more difficult to execute than Availability Fee Payment Type NRI-PPP Projects.
In the case of Market Risk-Taking Type NRI-PPP Projects, operation risk
includes market risk. Identifying the cause of market risk is not easy, and private
business entities must take on the market risk including the case where goods and/
or services do not sell due to the occurrence of force majeure events. In that sense,
the Project Company must take on the market risk even when it is not attributable to
a particular cause.
From this reason, an entity that contemplates becoming the Sponsor of a Market
Risk-Taking Type NRI-PPP Project will only actually become the Sponsor of such
Market Risk-Taking Type NRI-PPP Project when it judges that the goods and/or
services are sure to sell. This is because the Sponsor will invest a considerable
amount of money into the subject NRI-PPP Project, and when the goods and/or
services produced through such project do not sell, the Sponsor cannot recover its
investment.
NRI-PPP Projects are not the subject of highly speculative investments. On the
other hand, because an NRI-PPP Project is a project having a high public interest
factor, the Host Country/Off-taker must avoid, to the greatest extent possible, the
situation where the subject project is to be terminated midway through the project
period.
Additionally, the fact that the Senior Lender grants project financing to a Market
Risk-Taking Type NRI-PPP Project means the Senior Lender also assumes the mar-
ket risk. That is to say, in the case where goods and/or services produced through
such project do not sell, the Senior Lender takes on the risk of all or part of the
Senior Loan of project finance not being repaid. In this sense, unless it is a Sponsor
with a track record of success in the same or similar projects in the past, it would be
impossible for the Sponsor to be granted project financing on the Market Risk-­
Taking Type NRI-PPP Project. Project finance is, in essence, a loan, with the repay-
ment of which being a prerequisite, and it is by no means a speculative investment.
3  The Essence of Project Finance 129

3.3.4  Sustainability of an NRI-PPP Project

As I discussed in Chap. 2, Sect. 4.7.2, unless the sustainability of the subject NRI-­
PPP Project is high, no matter what is stipulated in the Concession/Off-take/PPP
Agreement, for a private business entity, the subject project will be a project with
high risk, and in that sense, with a high potential to end in failure. From this per-
spective, not only the private business entity but also the Senior Lender “needs to
pay a great deal of interest in the macro-economic management system in the devel-
oping countries,” and, “including the confirmation of the actual demands and the
review of whether the acceptance mechanism such as the related infrastructures are
in place, the Senior Lender needs to pay attention to the economic efficiency of the
subject project, legitimacy in the economic development, the political background
and the environmental issues, etc., hence, needs to review the risks unseen on the
face of the contract.”5
For example, in the IPP Project in case 2 mentioned above, let’s assume an IPP
Project that is extremely attractive, in an economic sense, to a private business
entity, exists. However, what would be the consequence if a power transmission
network, that is required to transmit the power generated by the IPP Project to large
cities, has not been developed? Such IPP project would not be beneficial to the
nationals of the Host Country after all, and the risk that nationals of the Host Country
would not support the project in view of its failure to provide a benefit would be
realized.
As discussed above, in project finance, various matters are reviewed and exam-
ined; however, if a fundamental aspect of an NRI-PPP Project is to be changed in
the middle of the project period, the premise for conducting these reviews and
examinations would be lost. Therefore, ensuring that no part of the NRI-PPP Project
will be changed during the Project Period becomes a premise for granting project
finance.
Further, similar to the case where the Sponsor determines whether or not to
invest in an NRI-PPP Project which I discussed in Chap. 2, Sect. 4.12, in project
finance, after reviewing and examining various matters in relation to a particular
project, the Senior Lender determines whether or not it is able to grant project
financing for such project. In that sense, whether or not to grant project finance is
determined essentially by applying the bottom-up approach. Conversely, if the deci-
sion to grant project finance is made without proper review and examination of such
matters in advance, it is most likely that such project will fail, and such cases exist
in the real world in no small numbers.

 Anma M. (1998) Mechanism and Risk of Project Finance. International Finance. page 30


5
130 3  Business Theories of Project Finance

3.4  Monitoring by the Senior Lender

As I discussed in Sect. 3.3 of this chapter, the Senior Lender thoroughly reviews the
project before entering into the contract for project finance, and makes analysis and
assessment with respect to various matters regarding the subject project. Likewise,
in the case of corporate finance, the lender will review the creditworthiness of the
borrower before entering into the contract for corporate financing. The procedure
for conducting the preliminary review in regard to project finance is, though certain
review items may vary, basically the same as the procedure for conducting a pre-
liminary review in regard to corporate finance.
In corporate finance transactions, the lender will monitor the creditworthiness of
the borrower after the execution of the loan. Specifically, the lender will review the
financial statements of the borrower, and, if in the case of corporate financing where
the subject funds serve as capital for a specific project, the progress of the subject
project is to be monitored. Additionally, under the contract for corporate financing,
financial covenants which obligate the borrower to maintain the amount of capital
and the amount of profits at certain levels, are stipulated, and thus, monitoring pur-
suant to the provisions of the contract is also implemented. Incidentally, though it is
a matter of course, the lender will stipulate financial covenants into the contract for
corporate financing mainly with the objective of encouraging the borrower to make
efforts to rectify the business and the company in the case where the borrower vio-
lates any of such financial covenants; and the lender would take steps to force the
borrower to forfeit the benefit of time (i.e., the lender would exercise its right to
accelerate the loan payment obligation) based on the occurrence of an event of
default caused by the subject violation only when the lender judges that the bor-
rower would no longer be able to rectify the subject business or the company.
Similarly, in the case of project finance, the Senior Lender conducts monitoring
with respect to the borrower or the project itself even after it executes the Senior
Loan. The Senior Lender continues to monitor the project regarding such points as
whether the subject project is being implemented as planned; and if the subject
project is not being implemented as planned, it will investigate the reasons for such
as well as the possible solutions to rectify the situation. This monitoring is not lim-
ited simply to the monitoring of financial matters related to the Project Company,
but it also includes the monitoring of technical matters that arise in the course of
implementing the project. Also, because project finance is financing that depends on
the Sponsor’s business performance capability, monitoring with respect to the
Sponsor’s financial situation is also required. Further, in the case where issues arise,
similar to the case in corporate finance, the Senior Lender will make its best efforts
and consider various approaches to revitalize the project within its abilities as a
financial institution until it finally judges that the successful revitalization of the
project by the Sponsor would be impossible to achieve. This is, as I discussed in
Sect. 3.2 of this chapter, the “depth of the pocket” unique to banking. Conversely,
4  Characteristics of Project Finance 131

only certain of the professional financial institutions involved in project financing


are actually qualified to grant project financing.6
In connection with this point, with respect to the monitoring of technical matters
in particular, it is beyond the judgmental skill of the Senior Lender alone. This func-
tion cannot be fulfilled without the advice from the Independent Consultant, whom
I discussed in Chap. 1, Sect. 3.7. Also from this viewpoint, the involvement of expe-
rienced and appropriate Independent Consultant is important for the Senior Lender
of project finance, and indirectly for the Host Country/Off-taker.
Additionally, in Japan, the Senior Lender and the Host Country/Off-taker are
considered to be involved in the monitoring of technical matters related to the oper-
ation of the project and financial matters in regard to the Project Company. However,
their involvement with the monitoring of financial matters related to the Sponsor is
rarely mentioned. In this regard, it needs to be noted that further discussions in
Japan on this point needs to take place. Particularly in regard to PFI in Japan, as I
will discuss later, there exists a mechanism that transfers all of the risks related to
the project, with the exception of risks taken by the nationals and the local govern-
ments, to the Sponsor or the parties who are subcontracted by the Project Company
to perform certain work; hence, leaving no risks to be assumed by the Project
Company is believed to be favorable. In this regard it is generally understood that if
issues arise in relation to the project, such issues will not affect the financial condi-
tion of the Project Company. Notwithstanding the existence of this mechanism, it
should be noted that whether issues in relation to a project will arise or not cannot
be predetermined in the first place. Also, in one actual case in which the Sponsor
assumed certain risks relating to the subject project, all of the issues came to be real-
ized at once due to the sudden bankruptcy of such Sponsor. Thus, even with this
mechanism in existence, because of their unpredictable nature, issues cannot be
identified at an early stage of a project and preventative measures cannot be
implemented.

4  Characteristics of Project Finance

As I discussed in sect. 3 of this chapter, the essence of project finance resides in the
fact that it is long-term financing that depends on the business performance capabil-
ity of the Sponsor, and that the operation risk of the project is taken by the Senior
Lender. Thus, I now discuss the characteristics of project finance.

6
 Under an NRI-PPP Project, financing through the issuance of project bonds is sometimes under-
taken. Failure to consider the issuance of project bonds as a possible cost-effective financing option
is not appropriate. However, separate reviews would need to be made to judge what types of NRI-
PPP Projects are appropriate for financing through project bonds. Also, it needs to be noted that
“depth of the pocket” is not applicable in relation to bonds. Further, although the topic of infra-
structure funds is gaining attention recently, sufficient discussions regarding what specific roles
infrastructure funds can play within the overall NRI-PPP Project landscape needs to take place.
132 3  Business Theories of Project Finance

4.1  Debt-Equity Ratio

4.1.1  The Meaning of Debt-Equity Ratio

As I discussed in Sect. 3.2 of this chapter, the essence of project finance is that it is
long-term financing, and the proceeds from the Senior Loan in the project finance
are used to pay the project costs of the subject NRI-PPP Project. Accordingly, in a
case involving project finance, the project costs are financed by the equity invest-
ment (in the Project Company) and the Senior Loan of the project finance. Then,
determining the ratio or measure of the relationship between the Senior Loan and
the equity investment becomes an issue. This ratio between the Senior Loan and the
equity investment is referred to as the “debt-to-equity ratio” (Debt-Equity Ratio).
As I discussed in Sect. 2.2.1.2 of this chapter, due to the leverage effect of project
finance, the higher the ratio of the Senior Loan to the equity investment in the
financing of project costs is, the further the Sponsor’s Equity-IRR improves, and
consequently the advantages enjoyed by the Sponsor increases. On the other hand,
the higher the ratio of the Senior Loan to the equity investment in the financing of
the project costs is, the smaller DSCR becomes (This is because the value of the
denominator in DSCR becomes larger while the value of the numerator does not
change), as I will discuss in c, iii, (1), and consequently, the disadvantage to the
Senior Lender increases. In addition, in the absence of an equity investment of some
amount by the Sponsor, the Sponsor’s actual damages would be minimal even if the
Sponsor should abandon the project, which could lead to a moral dilemma for the
Sponsor. Accordingly, a certain amount of money subject to capital risk needs to be
invested by the Sponsor. After these factors are considered together, ultimately, the
Sponsor and the Senior Lender reach an agreement on a Debt-Equity Ratio that
presents a satisfactory Equity-IRR and DSCR to both the Sponsor and the Senior
Lender. Incidentally, if an Equity-IRR and a DSCR that are reasonably satisfactory
to both the Sponsor and the Senior Lender do not exist, that means the subject NRI-­
PPP Project does not have economic efficiency in the first place.
Debt-Equity Ratio varies depending on the nature of the subject NRI-PPP Project
and the situation of the country where the subject project is located. In the author’s
opinion, in the case of an IPP Project, the ratio of the Senior Loan to the equity
investment (in this regard, equity includes the subordinated loan) could be within
the range of 7:3 to 7.5:2.5.

4.1.2  The Period when Debt–Equity Ratio Consideration Is Required

Debt-Equity Ratio involves finding the appropriate ratio between the Senior Loan
and the equity investment to finance the project costs. Therefore, Debt-Equity Ratio
arises as an issue in the design/construction period during which the project costs
are paid out. That is to say, during the design/construction period, the Senior Lender
and the Sponsor need to assume the risks of the project in accordance with Debt-
Equity Ratio; thus, the Senior Loan and the equity investment are actually executed
4  Characteristics of Project Finance 133

and paid in amounts that are consistent with Debt-Equity Ratio (i.e., Debt-­Equity
Ratio needs to be maintained in regard to the payment made by the Senior Lender
and the Sponsor). This concept is called the “equity pro rata.” In practice, in advance
of the execution of the Senior Loan, a condition precedent is stipulated requiring
that an equity investment in an amount that corresponds to the executable amount of
the Senior Loan must have been made by the Sponsor before the execution date of
the subject Senior Loan.

4.1.3  The Equity Last

From the perspective of the Sponsor, in terms of timing, the later the equity invest-
ment payment is made, the lower the present value of the cash payment to the
Project Company for that amount becomes, and this results in an improvement of
the Equity-IRR for that amount. On the other hand, if the Sponsor provides the
Completion Guarantee with respect to the Senior Loan, the Senior Lender will not
assume the risks of the project during the design/construction period. Then, in such
case, the Senior Loan and the equity investment do not necessarily need to be actu-
ally executed and paid in, respectively, in accordance with Debt-Equity Ratio. From
this reasoning, in the case where the Sponsor provides the Completion Guarantee
with respect to the Senior Loan, the following payment order becomes possible.
That is to say, the initial equity investment by the Sponsor is limited to the minimum
required under applicable corporate law of the jurisdiction where the Project
Company is established; subsequently, the full amount of the Senior Loan is issued;
and thereafter, the rest of the equity investment is made (Accordingly, the Equity-­
IRR is improved for that amount; however, considering the fact that a Completion
Guarantee is provided, whether this Equity-IRR can be justified is a subject for a
separate discussion.). Making the equity investment at the end as described above is
called the “equity last.”

4.1.4  N
 o Rationale Exists for Maintaining Debt-Equity Ratio During the
Operation Period

The Senior Lender sometimes requires that Debt-Equity Ratio must be maintained
even during the operation period, i.e., the loan repayment period for the Senior
Loan. However, this is also a mistake that specifically arises from the Senior
Lender’s misunderstanding that the subordinated loan has the same status as the
bank loan.
As I will discuss in Sect. 3.3.2 of this chapter, the dividends payable in relation
to the equity investment, the repayment of the equity investment, the interest on the
subordinated loan, and the principal of the subordinated loan, are merely “pipelines”
(i.e., different means to effect payment) to flow the cash from the Project Company
to the Sponsor. What matters most to the Senior Lender in this regard is that it is able
to identify the monetary amounts to be paid to the Sponsor in accordance with the
134 3  Business Theories of Project Finance

waterfall provisions, and the dividends, etc. payment requirement that indicates
whether the dividends, in fact, are to be paid to the Sponsor. If the monetary amounts
to be paid to the Sponsor can be identified by these two criteria, such monetary
amounts should then be paid to the Sponsor using one or more of the aforemen-
tioned “pipelines”. Even if there may be some discretion for determining the order
of the various payment “pipelines” to be used in view of tax and other consider-
ations, there is no rationale in prioritizing the pipelines or designating which of the
pipelines are to be used or not from the viewpoint of protecting the benefit/interest
of the Senior Lender. Conversely, even if Debt-Equity Ratio is required to be main-
tained during the operation period, there would be no increase in the sources of
funds for repayment of the Senior Loan, in regard to the Project Company, and there
would be no increase in the possibility of repayment of the Senior Loan.
Maintaining Debt-Equity Ratio during the operation period is essentially a con-
cept that applies to corporate finance, and thus, whether or not to require maintenance
of Debt-Equity Ratio during the operation period is a touchstone to judge whether or
not one understands the essence of project finance, i.e., the cash flow structure.

4.2  Waterfall Provisions

4.2.1  Elements of Waterfall Provisions

Waterfall provisions are stipulated in Senior Loan agreements, etc. The purpose of
waterfall provisions is to enable the Senior Lender to designate the cash flow, during
the operation period of the project, into different bank accounts opened to receive
funds for each payment purpose, and to manage the subject bank accounts.7 Under
waterfall provisions, the following bank accounts are typically opened:
(1) A revenue account, into which the cash payable to the Project Company during
the operation period is transferred;
(2) The O&M fee, etc. payment account, into which the cash to pay taxes and pub-
lic dues, etc. and the O&M fees is transferred from the revenue account8;
(3) The Senior Loan repayment account, into which the cash to repay the principal
and interest of the Senior Loan of the project finance is transferred from the
revenue account;
(4) The dividends, etc. payment reserve account, into which the cash to pay the
dividends, etc. is transferred from the revenue account and held in reserve until
payment into the dividends, etc. payment account; and.

7
 Theoretically speaking, managing the cash flow by using just one bank account and designating
each payment purpose is not impossible. However, under waterfall provisions, managing the cash
flow by classifying payments to be made into separate bank accounts is more convenient and
understandable to anyone.
8
 In some cases, the taxes and public dues, etc. payment account and the O&M fee payment account
are separated.
4  Characteristics of Project Finance 135

(5) The dividends, etc. payment account, into which the cash to actually pay the
dividends, etc. is transferred from the dividend payment reserve account.9
As I discussed in Sect. 2.2.1.1 of this chapter, the cash that goes out of the Project
Company during the operation period includes amounts for payments of taxes and
public dues, etc., the O&M fee, principal and interest of the Senior Loan of the
project finance, and dividends, etc. related to the equity investments and the subor-
dinated loans. If all of these payment obligations cannot be fulfilled with the cash
amount expected to be generated by the Project Company, which payment obliga-
tions should be given priority? Prioritizing these payment obligations is the objec-
tive of the waterfall provisions.
If I list these payment items in terms of the priority ranking, the order would be
as follows: (1) taxes and public dues, etc., the O&M fee; (2) principal and interest
of the Senior Loan of the project finance; and (3) dividends related to the equity
investments and amounts owed under the subordinated loans. Under the waterfall
provisions, the cash in the revenue account, which will have been transferred as a
payment to the Project Company during the operation period, is transferred to the
following accounts for the subject payments in the order corresponding to the above
priority ranking: (1) the O&M fee, etc. payment account, (2) the Senior Loan repay-
ment account, and (3) the dividend, etc. payment reserve account; and subsequently,
from the subject payment accounts, the amounts to be paid for the following are
paid out: (1) taxes and public dues, etc., the O&M fee, (2) principal and interest of
the Senior Loan of the project finance, and (3) dividends related to the equity invest-
ments and amounts owed under the subordinated loans. Incidentally, to be more
precise, in regard to (3) dividends related to the equity investments and amounts
owed under the subordinated loans, the cash is transferred first to the dividend pay-
ment, etc. reserve account, and then transferred to the dividend, etc. payment
account, and thereafter, the dividends related to the equity investments and amounts
owed under the subordinated loans are paid out. I will discuss the reason for this in
Sect. 4.2.6 of this chapter.
Now, I will discuss why the cash is paid out in accordance with the priority
scheme set out in the waterfall provisions.

9
 In practice, depending on the project, in addition to these accounts, there exist other accounts such
as a taxes and public dues, etc. payment reserve account, a large-scale repair reserve account, a
reserve account that is used to maintain sufficient amounts of cash in preparation for the occur-
rence of a large payment at a specific time, a senior loan repayment reserve account, and an opera-
tion cost reserve account; all of these are reserve accounts that prepare for possible situations
where the cash in the O&M Fee, etc. payment account and the Senior Loan repayment account
alone are insufficient to meet debt repayment obligations as they become due. In practice, these are
important accounts; however, because they do not relate directly to the business theories of project
finance, they are not addressed herein.
136 3  Business Theories of Project Finance

4.2.2  P
 ayment Priority Status as Between (1) Taxes and Public Dues, etc.,
and the O&M Fee, and (2) the Principal and Interest of the Senior
Loan of the Project Finance

Let us first address the payment priority status as between (1) taxes and public dues,
etc., and the O&M fee, and (2) principal and interest of the Senior Loans of the
project finance. What is important to note here is that the source of funds for repay-
ment of the Senior Loan of the project finance is payments of consideration from
users of the services provided through the subject project or the payments of consid-
eration from the Off-taker during the operation period. That is to say, in the case
where the Project Company does not achieve the required level under the Concession/
Off-take/PPP Agreement due to reasons attributable to the Project Company, or in
the case where the Host Country/Off-taker terminates the Concession/Off-take/PPP
Agreement, the contemplated payments of consideration from users or contem-
plated payments from the Off-taker will not be made; and thus, there arises a pos-
sibility that the full amount of the funds necessary for the repayment of the Senior
Loan of the project finance will not be available (This is the operation risk taken by
the Senior Lender.).
Conversely, because the full amount of the principal and interest of the Senior
Loan of the project finance will not be repaid to the Senior Lender in the case where
the Host Country/Off-taker terminates the Concession/Off-take/PPP Agreement due
to reasons attributable to the Project Company, the Senior Lender needs to take steps
to ensure that the project will continue (e.g., ensure that taxes and public dues, etc.
are timely paid, as well as the O&M fee which is necessary for the continuation of
the services to be provided by the O&M Operator) to avoid the termination by the
Host Country/Off-taker, and concurrently, to revitalize the project, even if repayment
of the Senior Loan of the project finance is to be postponed. If in the case where the
project is revitalized, the payments of consideration from the users and the payments
of consideration from the Off-taker during the operation period occur as originally
contemplated, and from such payments, the Senior Lender is able to receive suffi-
cient funds for the repayment of the Senior Loan of the project finance, including any
additional amounts to be paid due to the postponement, termination of the Concession/
Off-take/PPP Agreement by the Host Country/Off-taker can be avoided. Accordingly,
(1) taxes and public dues, etc. and the O&M fee have a higher payment priority status
than (2) principal and interest of the Senior Loan of the project finance.
It is a cardinal rule in corporate finance that if there is even a little amount of cash
available to repay the loan, such cash is to be applied towards the repayment of the
loan. However, for example, in the case where there is a principal amount of \1 bil-
lion to be paid under the Senior Loan of the project finance, if \ten million desig-
nated for the payment of the O&M fee is instead applied towards the repayment of
the principal amount of the Senior Loan of the project finance, the O&M Operator
thereafter would not perform the contracted O&M work, which could lead to the
termination of the Concession/Off-take/PPP Agreement by the Host Country/Off-­
taker, and eventually, the Senior Lender would face the possibility of not being able
to recover the \990 million remaining principal balance owed under the Senior
4  Characteristics of Project Finance 137

Loan. Rather than this unfavorable result, if in the alternative the \ten million is paid
to the O&M Operator in satisfaction of the outstanding O&M fee and the project
proceeds as contemplated, there is a reasonable likelihood that the \1 billion princi-
pal amount under the Senior Loan of the project finance ultimately will be repaid in
full. In the case where there is even a small amount of cash available to be applied
toward the repayment of the loan, to spend such cash for such purpose could have a
rather adverse result in the case of project finance.
Incidentally, if a termination-causing event arises due to factors attributable to
the Project Company, because the O&M Operator is ultimately responsible for the
occurrence of such event, there may be an argument that the O&M Operator may
not refuse to perform the O&M works even if it does not receive payment of the
O&M fee. However, as I discussed in Chap. 2, Sect. 5.2, the O&M fee covers only
the cost of the O&M works, and does not include the profit. Because the O&M
Operator is the Sponsor, the costs of the O&M works to be borne by the O&M
Operator will not be unlimited as that would go against the principle of the Sponsor’s
limited liability, which I discussed in Chap. 2, Sect. 3.2.6.2.

4.2.3  P
 ayment Priority Status as Between (2) the Principal and Interest
of the Senior Loan of the Project Finance, and (3) the Dividend, etc.
Related to the Equity and Amounts Owed Under the Subordinated
Loan

Secondly, the payment priority status as between (2) principal and interest of the
Senior Loan of the project finance, and (3) dividend, etc. related to the equity invest-
ments and amounts owed under the subordinated loan needs to be addressed.
In project finance, one of the reasons the Sponsor’s guarantee is not required is
that, notwithstanding the fact that the Sponsor will gain a profit if the project’s
operation goes well, the repayment of the Senior Loan of the project finance is com-
pleted before the Sponsor obtains such profit. Additionally, because of this arrange-
ment, the payment priority status of (2) principal and interest of the Senior Loan of
the project finance is higher than (3) dividend, etc. related to the equity investments
and amounts owed under the Subordinated Loan.
If the Sponsor pays a substantial amount of money subject to capital risk to the
Project Company in the form of an equity investment, and its Equity-IRR is reason-
ably high, even though the Sponsor takes on the risk that its equity investment may
not be recovered ultimately, the Sponsor will use its best efforts to cause such equity
investment to be returned. Further, if the Sponsor can operate the project as planned,
it should be able to obtain a sufficient return. Therefore, if the Sponsor has a high
business performance capability, it should operate the project profitably to the great-
est extent possible, and should be able to respond promptly to any problems that
may arise in relation to the project. Based on the high business performance capabil-
ity of the Sponsor and with the waterfall provisions in place, the Senior Loan can be
repaid, and a guarantee by the Sponsor is not required.
Figure 3.5 illustrates the aforementioned waterfall provisions.
138

Project Company

Cash in Cash out

Payments of
consideration from
Revenue
users and
Account
payments of
consideration from
the Off-taker O&M Subcontracting
Payment of taxes and
Fee, Etc. Payment public dues, etc. / O&M
Account fees

Payment of principal and


Senior Loan
Repayment Account interest of the Senior Loan
Satisfaction of
of the project finance
Requirements of
Dividends, Etc.
Dividend, Etc. Dividend, Etc.
Payment Payment of
Payment Reserve
Account Account dividends, etc.

Fig. 3.5  Flow of cash under the waterfall provisions


3  Business Theories of Project Finance
4  Characteristics of Project Finance 139

4.2.4  T
 he Payment Order Under the Waterfall Provisions Is Applied
for Each Designated Payment Period

Taxes and public dues, etc. are usually paid on a per annum basis, and the O&M fees
are paid on a periodic basis. Therefore, it is unrealistic to expect that the repayment
of the Senior Loan is to commence only after all taxes and public dues, etc. and the
O&M fees are paid in full. Also, if the payment of dividends, etc. related to the
equity investments and amounts owed under the subordinated loan is to be made
only after the Senior Loan is repaid in full, the leverage effect in relation to such
payment will weaken, the timing of the Sponsor’s actual receipt of such payment
will be delayed, the present value of the cash-out from the Project Company will
become lower by that amount, and the Equity-IRR will be reduced. This result is
undesirable not just for the Sponsor, but for the Senior Lender as well.
For this reason, the payment orders under the waterfall provisions are applied peri-
odically. In the case of the Availability Fee Payment Type NRI-PPP Project, the sub-
ject period is set so that payment of the Availability Fee is made once in that period.
Also, the repayment date of the principal and interest of the Senior Loan is determined
so that the repayment obligation arises once in the subject period. In practice, the
subject period will be one-half year (6 months) or one-quarter of a year (3 months).
Additionally, although this is a rather technical issue applicable in practice and
not considered in relation to the business theory, in the case where the subject period
is set at 6 months (from April 1 through September 30, for example), in actual prac-
tice in regard to waterfall provisions, usually the cash equivalent amount of the
O&M fee10 that is scheduled to be paid each month within that subject period is
transferred on the first day of each such month from the revenue account into the
O&M fee, etc. payment account, to the extent sufficient cash balance exists in the
revenue account on such first day of each such month. And, on the first day of the
last month within the subject period, as for the cash balance that exists in the reve-
nue account as of that date, the cash equivalent amount of the O&M fee scheduled
to be paid in that month is transferred first to the O&M fee, etc. payment account,
and then the cash amount equivalent to the principal and interest of the Senior Loan
scheduled to be paid in that month is transferred to the Senior Loan payment
account; and subsequently, the balance of the revenue account is transferred to the
dividend payment reserve account.
Therefore, ideally, it is best if payment of the Availability Fee is executed semi-­
annually on April 1 (and the amount paid on April 1 is included into the cash b­ alance
that exists in the revenue account on April 1), and the repayment date of the princi-
pal and interest of the Senior Loan is set for any day within September. Under this
arrangement, in the calculation of DSCR, which I will discuss later in Sect. 3.3.1 of
this chapter, the certain period, which is the premise of the subject DSCR, can be set

10
 Incidentally, because the taxes and public dues, etc. are usually paid once in a year, it is not
appropriate to transfer the full amount of the taxes and public dues, etc. of 1 year in any 1 month.
Instead, transfer in a planned manner using the taxes and public dues payment reserve account, etc.
is required.
140 3  Business Theories of Project Finance

from April 1 to September 30, and the combined amount of the Availability Fee
Payment amount on April 1 and the payment amount of the O&M fee from April 1
through September 30, can be used as the numerator value, and, further, the repay-
ment amount of the principal and interest of the Senior Loan of September can be
used as the denominator value.
However, for example, in the case where the Availability Fee is to be paid semi-­
annually, say, on April 5 and October 5, the funds for the payment of the April O&M
fee will be derived, not from the payment of the Availability Fee in the period that
includes the April 5 payment date, but from the payment of the Availability Fee that
was made on October 5 of the previous period. As mentioned above, in the calcula-
tion of DSCR in a specific period, there is a possibility that the cash-in within a
specific period will not necessarily be the funds for the cash-out of that period.
Because various payments are made regularly, calculation issues may not arise so
often. However, in the case where payments are not made regularly or the cost for a
large scale periodic repair is incurred, strictly, under the definition of DSCR, it is
required that these are stipulated to match the total amount of cash flow.

4.2.5  Requirements of Dividend, etc

Cash transferred from the revenue account to the dividend payment reserve account
cannot be received by the Sponsor “unconditionally” from the Project Company as
dividends, etc. because, as I discussed in Sect. 4.2.4 of this chapter, the payment
orders under waterfall provisions are applied for each period. However, there exists
a risk that the project may not be operated as planned at the time the cash is to be
transferred from the revenue account to the dividend payment reserve account, and
thus, the payments of consideration from the users of services provided through the
subject project and the payments of consideration from the Off-taker may be reduced
to such an extent that repayment of the principal and interest of the Senior Loan
cannot be made when such obligation falls due. In these cases, the Sponsor is not
allowed to participate in the profits from the project, and revitalization of the project
is required. In consideration of the foregoing, the terms under which the Sponsor is
to receive dividends, etc. from the Project Company need to be clearly stipulated.
The reference date to judge whether these requirements are satisfied or not is
usually the Senior Loan principal and interest payment date; that is to say, when the
cash is transferred from the revenue account to the dividend payment reserve
account, it is subsequently transferred to the Senior Loan principal and interest
repayment account, and the principal and interest of the subject Senior Loan is
expected to be paid with this transferred cash on that date. Additionally, among the
requirements to pay dividend, etc., the following requirements, which are common
to all projects, exist (The following assumes that payment orders under the waterfall
provisions are applied every 6 months.):
( 1) the financial completion has been achieved;
(2) no event of default or potential event of default under the Senior Loan Agreement
has occurred;
4  Characteristics of Project Finance 141

(3) the projected DSCRs for both the 6-month period that includes the subject
Senior Loan principal and interest payment date and the following 6-month
period are over a certain stipulated value; and.
(4) the historical DSCRs for the two consecutive 6-month periods that immediately
precede the 6-month period that includes the subject Senior Loan principal and
interest payment date are over a certain stipulated value.
As for requirement (1), I will discuss this requirement in Sect. 5.1.2.2 of this
chapter. If an event of default or potential event of default under the Senior Loan
Agreement has occurred, it evidently means that the project has not been operated
as planned; and thus requirement (2) must naturally be included in the requirements.
As for the reasons requirements (3) and (4) are included in the requirements, I will
discuss such in Sect. 4.3.3.1.2 of this chapter. What should be noted here is that the
historical DSCRs for the two consecutive 6-month periods are required. That is to
say, the requirement for these two ratios assumes that the two payments of principal
and interest of the Senior Loan have already been made without any cash flow prob-
lems. To make this clear, there is also the case where the two prior payments of
principal and interest of the Senior Loan are stipulated separately as a requirement
for the dividend, etc. payment.
Additionally, as a practical point it is important to determine whether or not the
calculation basis for determining the DSCRs stipulated in requirements (3) and (4)
can be prepared timely on the subject Senior Loan principal and interest payment
date, which is the reference date to judge whether these requirements are satisfied
or not. If the above preparations cannot be made timely, the timing of the actual
payment of dividends, etc. to the Sponsor will be delayed correspondingly.

4.2.6  R
 eason the Dividends Reserve Account and the Dividends Payment
Account Are Opened Separately

If I continue to consider the example described in Sect. 4.2.5 of this chapter, the date
on which the cash is transferred from the revenue account to the dividends reserve
account is September 1. On the other hand, the date on which the dividend require-
ments are determined is September 20. Until September 20, the cash that exists in
the dividends reserve account must be under the control of the Senior Lender.
Therefore, security interests must be granted over amounts held in the dividends
reserve account in favor of the Senior Lender. Regarding the reasons security inter-
ests are granted in project finance, I will discuss such in Sect. 5.4 of this chapter. On
the other hand, when the dividends, etc. requirements are satisfied on September 20,
the cash that exists in the dividends reserve account needs to be made freely avail-
ably for use by the Sponsor. For this reason, the subject cash needs to be transferred
to the dividends payment account to which security interests in favor of the Senior
Lender are not granted. This is the reason the dividends reserve account and the divi-
dends payment account are opened separately. Incidentally, some may argue that
instead of transferring the cash on September 1 from the revenue account to the divi-
dends reserve account, the cash may well be transferred directly to the dividends
142 3  Business Theories of Project Finance

payment account on September 20 when the dividends, etc. requirements are satis-
fied (and thus, the dividends reserve account is not necessary). However, if there
should be a deposit made into the revenue account between September 2 and
September 20, what should happen? As a matter of course, even if the subject deposit
satisfies the dividends, etc. requirements on September 20, it cannot be transferred
to the dividends payment account on September 20. In this respect, the existence of
transferable cash and non-transferable cash in one account goes against the objective
of the waterfall provisions, which is to manage the cash flow during the operation
period by classifying amounts into separate bank accounts designated for each pay-
ment purpose.
Additionally, if the dividends, etc. requirements are not satisfied on September
20, the cash existing in the dividends payment reserve account is transferred to the
revenue account and becomes funds for payments to be made in the following period.

4.3  Cash Flow Structure

As I discussed in Sect.1.1, project finance is financing where the primary funds for
the repayment depend, in principle, on the cash flow of the subject project. The term
“cash flow” has many meanings, and the applicable meaning varies depending on
the context in which it is used.
For example, when one measures the value of a corporation, consideration may be
given to its cash flow. In such case, it is explained that the value of a corporation, from
the perspective of the subject project, is the sum of the present value amounts of all
cash flows generated by the project. That is to say, in regard to such explanation, the
future cash flows to be generated by the project are predicted, then, they are converted
to their present value amounts and totaled to determine the value of the project. In this
case, the so-called “indirect method” of cash flow reporting is mostly used, and in this
method, with the information contained in the company’s income statement as a ref-
erence, non-cash factors, etc. are added back to the net income before taxes to develop
the cash flow statement. EBITDA (Earnings before Interest, Taxes, Depreciation and
Amortization) is also an indicator to measure the cash flow based on this concept.
However, the cash flow in project finance differs somewhat from this indirect
method of cash flow reporting. For example, in the case of the indirect method of
cash flow reporting, non-cash factors do not seem to be excluded completely. On the
other hand, in the cash flow in project finance, considering a case where there exists
debt which is obligated to be paid on March 20, if the funds for such payment are
deposited with the Project Company prior to March 20, the Project Company can
pay the subject debt obligation. However, if the funds for such payment are to be
deposited after March 20 (say on March 25), the Project Company cannot timely pay
the subject debt obligation. In measuring the business value of a corporation, consid-
eration of the timing of such payment may not be necessary. In the cash flow in
project finance, however, the timing of payments like the one in the aforementioned
scenario also becomes an important factor; non-cash factors need to be eliminated
completely to grasp the actual inflow and outflow of cash by the “direct method” of
4  Characteristics of Project Finance 143

cash flow. As far as the author is aware, the economic efficiency in overseas project
finance transactions seems to be substantiated by the direct method of cash flow.
This is basically consistent with the practice of a profitable company that checks
daily inflow and outflow of cash to avoid the situation where it is short of funds.
The adoption of this cash flow structure can be said to be the most important
characteristic of project finance. Next, I will explain what characteristics of project
finance exist due to this cash flow structure.

4.3.1  Grant of the Subordinated Loan by the Sponsor (Shareholder)

As I discussed in Chap. 1, Sect. 3.2, footnote 4, etc., in addition to the Sponsor’s


equity investment, the provision of funds by the Sponsor to the Project Company is
made through the granting of a subordinated loan. In practice, the portion that exceeds
the minimum capitalization amount required for the Project Company under the appli-
cable corporate law of the jurisdiction where it is established, is provided through the
grant of a subordinated loan. As a general principle, from the viewpoint of payment
order, creditors of the Project Company are better protected when the Project Company
acquires financing through an equity investment rather than a loan. However, this does
not become an issue in project finance. Then, the issue of why a subordinated loan is
used instead of equity investment arises. There are two main reasons why a subordi-
nated loan is used instead of equity investment, and these are explained below.

4.3.1.1  T
 he First Reason for Using the Subordinated Loan: Benefit Under
the Tax Law

The first reason a subordinated loan is used instead of equity investment in project
finance is that, in a cross-border project where the Project Company and the Sponsor
are located in different countries, the interest rate of the withholding tax on interest
payments is lower than the interest rate of the withholding tax on dividend payments.
Because of this difference, the Sponsor can receive more when it receives cash in the
form of interest from the Project Company than if it receives cash in the form of divi-
dends. Also, although this is not specifically limited to cross-border projects, the
following point also can be cited as a reason: the interest is deductible in the taxable
income calculation of the Project Company, whereas dividends are not. However,
regarding this point, the issue of so-called “thin capitalization” may arise.

4.3.1.2  T
 he Second Reason for Using the Subordinated Loan: Avoidance
of the Local Dividend Stopper

The second reason a subordinated loan is used instead of equity investment is the
fact that dividends can only be paid if there is distributable income under the appli-
cable corporate law of the jurisdiction where the Project Company is established
(The technical term in project finance for this requirement regulating dividend
144 3  Business Theories of Project Finance

distribution is “Local Dividend Stopper”); however, under the cash flow structure,
there exists the case where the cash can be payable to the Sponsor without the exis-
tence of this distributable income under applicable corporate law (i.e., a case where
cash can be transferred to the dividend payment account under the waterfall provi-
sions). To enable this payment to the Sponsor to be made, a subordinated loan instead
of equity investment is used, and under the payment classification of principal and
interest of the subordinated loan, this distributable cash to the Sponsor is paid out.
Probably, this second reason, rather than the first reason, will be a more substantial
reason a subordinated loan instead of equity investment is used in project finance.
Consider the case where 100% of the investment to the Project Company by the
Sponsor is made through equity investment, and the distributable income under the
applicable corporate law is zero. This case is illustrated in Fig. 3.6.
In this case, even if the cash shown in the shaded portion in the asset section in
Fig. 3.6 should exist, payment of a dividend to the Sponsor is not possible. Also, I
assume, for example, that the repayment date of the debt (shown as the diagonal
lines in the liability section) is 10 years after the investment is made. Then, for the
repayment which is to occur 10 years after the investment is made, in the asset sec-
tion, the asset that corresponds to the subject debt cannot be used, and the subject
asset may possibly even be cash.
However, if the cash equivalent to the debt shown in the liability section as the
shaded portion, should flow into the Project Company over such 10 years without
fail, there is no substantial reason to keep the cash shown as the shaded portion in
the Project Company at such point in time. Then, to enable the payment of the cash
shown as the shaded portion to the Sponsor at such point in time, investment in the
form of a subordinated loan is used over equity investment, and the payment of such

Assets Liabilities

Cash Repayment Obligation


Occurs after 10 Years

Equity (Net Assets in Japan)

Distributable Income is zero.

Fig. 3.6  Cash indicated on the balance sheet of the project company in the case where 100% of
the sponsor’s investment to the project company is made through equity investment
4  Characteristics of Project Finance 145

Assets Liabilities

Cash Repayment Obligation


Occurs after 10 Years

Subordinated Loan
Substantial
Repayment Equity
Equity (Net Assets in Japan)
Distributable Income is zero.

Fig. 3.7  Cash indicated on the balance sheet of the project company in the case where the spon-
sor’s investments to the project company are made through both an equity investment and a subor-
dinated loan

cash to the Sponsor is realized in the form of payment of the principal and interest
of the subordinated loan to the Sponsor.
Of course, since the payment is in the form of principal and interest of the sub-
ordinated loan, even without the existence of the distributable income under appli-
cable corporate law, the Project Company can make the subject payment to the
Sponsor.11 Figure 3.7 illustrates this point.
Additionally, some may argue that the Project Company should not make a pay-
ment to the Sponsor until the Project Company has distributable income under the
applicable corporation law of the jurisdiction where it is established. However,
although it goes without saying, the sooner the Sponsor receives the subject pay-
ment from the Project Company, the higher the present value amount of the subject
payment will be, and the higher the Equity-IRR becomes for that amount.
Accordingly, it needs to be noted that if the subject payment cannot be made until
the Project Company has distributable income under the applicable corporation law,
the subsequent decline of the Equity-IRR will eventually be a disadvantage to the
Host Country/Off-taker.

11
 Existence of the distributable income means there exists profit in the Project Company, which, in
turn, means a tax will be levied on the Project Company, and, as a consequence, the cash payable
to the Sponsor will decrease by the amount of the tax. In view of the fact that the indicator to mea-
sure the investment efficiency of the Sponsor is the Equity-IRR, if the monetary amount of the
cash-in to the Project Company does not change, maximizing the cash payable to the Sponsor will
improve the Equity-IRR, and the Sponsor will gain a higher return. Therefore, under the cash flow
structure, the Sponsor is recommended to manage the Project Company in a way not to generate
profit to the extent permitted under applicable tax law.
146 3  Business Theories of Project Finance

4.3.1.3  T
 he Characteristics of Project Finance from the Viewpoint
of a Comparison with Corporate Finance

Speaking in general terms, corporate finance is financing based on figures that are
evaluated in financial statements that consist mainly of the company’s balance
sheets, and project finance can be described as financing based on the actual figures
reported through the direct method of cash flow reporting. This can be exemplified
by the following comparison: under a corporate finance loan contract certain finan-
cial covenants by the borrower, including covenants to maintain certain specified
levels of capital and profit, are sometimes stipulated, whereas, under a project
finance loan contract, financial covenants that regulate such capital amount and
profit amount are never stipulated.
As discussed above, under the cash flow structure, issuance of a deficit “divi-
dend” is substantially possible (of course, the legal nature of this “dividend” is not
a dividend to shareholders under applicable corporate law). On the other hand, even
corporations with surpluses (including those which do not receive funds through
project finance) go bankrupt if they fall short of funds. In that sense, an aspect simi-
lar to non-Euclidean geometry exists in the world of cash flow structures, which is
a little bit different from the world of financial statements that consist mainly of
balance sheets.12

4.3.1.4  The Subordinated Loan as an Equity Equivalent

As addressed above, the Sponsor’s subordinated loan is, in substance, an equity


investment, and the investment is made in the legal form of a subordinated loan for
the reasons discussed in Sect. 4.3.1.1 and 4.3.1.2 of this chapter. In this sense, the
Sponsor’s subordinated loan is called an “Equity Equivalent.” Based on the forego-
ing, the following can be stated.

12
 Because a corporation may go bankrupt even though it initially has a surplus of capital, as a
requirement to commence a bankruptcy proceeding, in addition to having excessive liabilities, a
suspension of payment by the debtor is required. Incidentally, in regard to a borrower of financing
through project finance (that is to say, the Project Company), even when it incurs an excessive
amount of liabilities, there are cases where there is an abundance of cash flow as planned. In such
cases, it would be natural to think that the mere existence of excessive liabilities does not satisfy
the requirement for commencement of a bankruptcy proceeding. This essentially holds true in situ-
ations involving a normal business corporation which incurs excessive liabilities on a temporary
basis, where the requirement for excessive liabilities to commence a bankruptcy proceeding will
not be satisfied. Likewise, although the satisfaction of the requirement for commencement of a
bankruptcy proceeding is sometimes stipulated as an event of default under the Senior Loan
Agreement, it should be stipulated that a case like this will not constitute an event of default.
4  Characteristics of Project Finance 147

Treatment of the Subordinated Loan in the Calculation of Equity-IRR


In the calculation of Equity-IRR, the subordinated loan is treated as equity. This is
because the payment of the principal and interest of the subordinated loan is sub-
stantially the same as an equity investment and it includes the characteristic of profit
to be received by the Sponsor.
In other words, the equity investment and the subordinated loan are “pipelines”
to pay cash to the Sponsor, and in the cash flow structure, these types of “pipeline”
are not questioned. Incidentally, there may be an argument that only equity invest-
ment should be used from the viewpoint of allowing the Sponsor to maintain control
over the management of the Project Company. However, management control is
determined essentially by the percentage of the Project Company’s equity held by
the Sponsor, not by the amount of the equity investment. Therefore, in practice, the
amount of the equity investment is often limited to the minimum capitalization
amount required under the applicable corporate law of the jurisdiction where the
Project Company is established.

Irrationality of the Host Country/Off–taker’s Setting the Minimum


Capitalization Threshold of the Project Company
There are cases where the Host Country/Off-taker sets the amount of the minimum
capitalization of the Project Company in an NRI-PPP Project. However, this is not
appropriate because, in the first place, the determination of the ratio between the
amount of equity investment and the amount of the Senior Loan, i.e., the funds with
which the project costs are to be paid, must be solely the responsibility of the
Sponsor, which must have absolute discretion when making such determination, in
view of the Sponsor’s relationship vis-à-vis the Host Country/Off-taker. Therefore,
any arrangement where the Host Country/Off-taker sets the amount of the minimum
capitalization of the Project Company in an NRI-PPP Project is irrational. Further,
as I discussed in Sect. 4.3.1.4.1 of this chapter, regarding the investments to be made
by the Sponsor, the amount of its equity investment basically needs to be no more
than the minimum capitalization amount required under the applicable corporate
law of the jurisdiction where the Project Company is established. Also from this
viewpoint, there is no rationale for the Host Country/Off-taker to set the minimum
capitalization amount of the Project Company in an NRI-PPP Project.
In this regard, depending on the applicable corporate law of the jurisdiction
where the Project Company is established, in cases where the invested capital
exceeds a certain amount, the subject corporation may be obligated to conduct an
audit, etc. Then, there may be an argument that, in order to impose this legal obliga-
tion to conduct an audit, etc. on the Project Company under the applicable corporate
law, the minimum capitalization amount of the Project Company needs to be set
above such legal threshold amount. However, if there is a need to impose such obli-
gation on the Project Company, it is sufficient to stipulate it as an obligation of the
Project Company under the Concession/Off-take/PPP Agreement. As I discussed in
Sect. 4.3.1.2 of this chapter, if the minimum capitalization amount of the Project
148 3  Business Theories of Project Finance

Company is set, the timing of the payment from the Project Company to the Sponsor
will be delayed correspondingly, and the Equity-IRR will decline, eventually result-
ing in a disadvantageous situation for the Host Country/Off-taker.

The Equity Investment Ratio and the Subordinated Loan Contribution Ratio


of Each Sponsor should Be the Same
As I have mentioned repeatedly thus far, the NRI-PPP Project and Project Finance
depend on the business performance capability of the Sponsor. In the case where
multiple Sponsors are involved, it would be rational for the Sponsors to have control
over the Project Company’s management and to earn profits in proportion to the
business performance capability of each Sponsor. In that case, regarding both the
equity investment that represents management control and profits and the subordi-
nated loan that represents profits, having the equity interest percentage of each of
the Sponsors be the same would be rational. Also, further to this reasoning, the
Senior Lender as well as the Host Country/Off-taker need to make not only the
equity interest percentage, but also the subordinated loan contribution percentage of
each Sponsor the subject of their review.

The Subordinated Loan and the Senior Loan of the Project Finance, a Bank


Loan, Differ in Essence
Sometimes, there exist Sponsors who consider a subordinated loan and a bank loan
(i.e., a loan by a financial institution which constitutes a debt to the borrower) to be
identical. As I will discuss in Sect. 5.4 of this chapter, in project finance, security
interests are granted on the assets of the Project Company in order to secure pay-
ment of the Senior Loan receivables (i.e., the principal and interest to be paid under
the Senior Loan). Partly because of this, some Sponsors request that second priority
security interests on the assets of the Project Company be granted in order to secure
payment of the subordinated loan receivables (i.e., the principal and interest to be
paid under the subordinated loan).
However, the subordinated loan is not a bank loan. The claim to the subordinated
loan receivables is essentially the same as the “claim” for dividends, etc. (to which
the Sponsor is entitled to receive) based on equity investment. The granting of secu-
rity interests on the assets of the Project Company for the purpose of securing the
Sponsor’s “claim” for dividends (to which it is entitled to receive) based on the
Sponsor’s equity investment and the granting of a right of recourse, will never occur.
Thus, the granting of security interests on the assets of the Project Company to
secure payment of the subordinated loan receivables should never occur.
In addition, as I will discuss in Sect. 5.4 of this chapter, the objective of granting
security interests in project finance is not to directly collect the receivables by the
foreclosure of the subject security interests, but to replace the Sponsor and to trans-
fer the project to a new Sponsor when the subject Sponsor cannot perform the proj-
ect as planned. On the other hand, it is unlikely that the Sponsor would grant the
security interests based on this underlying objective (i.e., the objective to transfer
4  Characteristics of Project Finance 149

the project to another Sponsor once it is established that the current Sponsor is inca-
pable of performing the project as planned). In light of the foregoing, there is no
rational basis for the granting of security interests on the assets of the Project
Company since the true objective is not to secure the payment of the subordinated
loan receivables. The way of thinking described above (i.e., the granting of security
interests to collect receivables upon foreclosure) is essentially reflective of corpo-
rate finance, not project finance.

Granting of Security Interests on the Subordinated Loan Debts


Conversely, as I will discuss in Sect. 5.4 of this chapter, in project finance, security
interests are granted even on the Sponsor’s equity investment to secure payment of
the Senior Loan receivables. In addition, because the subordinated loan is equiva-
lent to equity, security interests are granted even on the Sponsor’s subordinated loan
receivables to secure payment of the Senior Loan receivables.
In this regard, there are some Sponsors which insist on granting security interests
only on the Sponsor’s equity investment, and not on the subordinated loan receiv-
ables; therefore, in the case where the Sponsor cannot perform the project as
planned, only the former Sponsor’s equity investment will be transferred to the new
Sponsor, and the former Sponsor would retain its right to payment under the subor-
dinated loan. However, what would be the consequence if only the former Sponsor’s
equity investment is transferred to the new Sponsor? When the new Sponsor revital-
izes the project through its own efforts, the profits generated through such effort will
become the source of the subordinated loan payment. That is to say, profits earned
through the revitalization of the subject project will be paid to the former Sponsor
who failed in its performance of the project. If this is the case, no new Sponsor
would willingly revitalize the project. The subordinated loan is a “pipeline” in
essence to pay the receivable under such loan to its holder. This “pipeline” needs to
be transferred to the new Sponsor, and accordingly, security interests need to be
granted also on the Sponsor’s subordinated loan receivables to secure the payment
of the Senior Loan receivables.

Treatment of the Subordinated Loan Under the Waterfall Provisions Is the Same


as that of the Equity Investment
As I discussed in Sect. 2.2.1.1 of this chapter, the cash that goes out of the Project
Company during the operation period includes payments of taxes and public dues,
etc., the O&M fee, principal and interest of the Senior Loan of the project finance,
and dividends, etc. related to the equity investments and amounts owed under the
subordinated loan. Additionally, as I discussed in Sect. 4.2.1 of this chapterthe pay-
ment order under the waterfall provisions is consistent with this order. Regarding the
payment of dividends, etc. related to the equity investments and amounts owed
under the subordinated loan, as I discussed in Sect. 4.2.5 of this chapter the
Requirement of Dividends, etc. is stipulated, and only after the subject Requirement
of Dividends, etc. is satisfied will the payment of dividends related to the equity
150 3  Business Theories of Project Finance

investments and amounts owed under the subordinated loan be made. Conversely, if
the subject Requirement of Dividends, etc., is not satisfied, the payment of dividends
related to the equity investments and amounts owed under the subordinated loan will
not be made.
In this regard, there are cases where the Sponsor will insist that satisfaction of the
Requirement of Dividends, etc., is not required for the payment of amounts owed
under the subordinated loan to be made; however, because the subordinated loan is
in the nature of an equity equivalent, there is no rationale for treating it differently
from the payment of the equity investment.

The Subordinated Loan Is a “Relatively Subordinated Debt”


Finally, it needs to be noted that the Sponsor’s subordinated loan is a so-called “rela-
tively subordinated debt.” In regard to subordinated debts, there exist “absolutely
subordinated debts” and “relatively subordinated debts.”
An absolutely subordinated debt means that upon the debtor of the subordinated
debt becoming legally insolvent, payment priority in regard to such debt is subordi-
nated to all regular debts in the subject insolvency proceeding, and thus such subor-
dinated debt is to be paid only after all other regular debts are paid in full. The
absolutely subordinated debt is a type of subordinated debt that is used mainly when
a financial institution becomes the debtor because the financial institution can treat
it as equity under BIS (Bank for International Settlements) regulations.
In contrast, relatively subordinated debt means that upon the debtor of such debt
becoming legally insolvent, the payment priority in regard to such debt is subordi-
nated only to certain specified debts (i.e., priority debts) in the subject insolvency
proceeding. Except for this arrangement, the payment priority status of the rela-
tively subordinated debt is the same as other regular debts. Accordingly, in the situ-
ation where the debtor of the subordinated debt becomes legally insolvent, the
relatively subordinated debt is given the same payment priority status as all other
regular debts in the subject insolvency proceeding. As mentioned above, the rela-
tively subordinated debt is not subordinated to all other regular debts. It is only
subordinated to certain priority debts pursuant to an agreement between the
creditor(s) of the priority debt(s) and the creditor (and the debtor) of the subordi-
nated debt. To effect such payment priority arrangement, the party that represents
both the creditor(s) of priority debt(s) and the creditor of the subordinated debt
receives a payment from the debtor, and then, distributes such payment amount in
accordance with the subject payment priority arrangement.
e priority debt in project finance is, as a matter of course, the Senior Loan debt.
Additionally, according to the waterfall provisions (i.e., a contractual payment arrange-
ment agreed between the parties), which I discussed in Sect. 4.2.3 of this chapter, pay-
ments are made in accordance with this relationship of priority and subordination.
The reasons subordinated loans are used in project finance are, first, for the ben-
efits under the applicable tax laws and to avoid the local dividend stopper, which I
discussed in Sects. 4.3.1.1 and 4.3.1.2 of this chapter. Also from the Senior Lender’s
perspective, realization of the relationship of priority and subordination based on
the waterfall provisions is sufficient, and further subordination of the subordinated
loan is unnecessary.
4  Characteristics of Project Finance 151

In regard to the above perspective, there may be an argument that even from the
standpoint of the Senior Lender, there is no disadvantage in opting for absolute
subordination. However, as I will discuss in Sect. 5.4 of this chapter, the security
interests on the subordinated loan receivables in favor of the Sponsor are granted in
favor of the Senior Lender. If the project is not performed properly, and ultimately
a new Sponsor cannot be found, the Senior Lender will need to undertake a corpo-
rate finance-based debt collection proceeding. In the case where the Project
Company goes bankrupt, if the subordinated loan is a relatively subordinated debt,
the claim for payment of the subordinated loan will have the same payment priority
status as that of regular debts in the subject insolvency proceedings, and there exists
a possibility that payment in full may not be made. In such case, the Senior Lender
can foreclose on the security interests granted on the subordinated loan debts, and
the payment in regard to the subject subordinated loan receivables can be used to
repay the Senior Loan. However, if the subordinate loan is configured as an abso-
lutely subordinated debt, payment in regard to such a subordinated loan will not be
made, and the Senior Lender will become unable to receive payment of amounts
owed under the Senior Loan, which it might have received if it had been configured
as a relatively subordinated debt. That is to say, from the Senior Lender’s perspec-
tive, making it an absolutely subordinated debt could possibly result in disadvan-
tages to the Senior Lender.

4.3.2  T
 he Description of the Cash Payment to the Sponsor Does Not
Matter

The legal description of the cash payment from the Project Company to the Sponsor
can be any of the following: dividends on the equity investment, redemption of the
equity investment, interest on the subordinated loan, and repayment of the principal
of the subordinated loan. However, in the calculation of Equity-IRR, the numerical
value of the Equity-IRR does not change based on the legal description of the cash
payment to the Sponsor (except for changes relating to differences in tax). Also, as
to the Requirement of Dividends, etc. in relation to the equity investment and the
subordinated loan, which I discussed in Sect. 4.2.5 of this chapter the subject
requirements which are to be satisfied prior to payment of dividends, etc. do not
change based on the legal description of the cash payment to the Sponsor. This
means that, in regard to the payment from the Project Company to the Sponsor
under the cash flow structure in project finance, only the fact that the payment of
cash is to occur or occurred matters. Accordingly, under the cash flow structure in
project finance, dividends on the equity investment, redemption of the equity invest-
ment, interest on the subordinated loan, and repayment of the principal of the sub-
ordinated loan are, in essence, no more than the “pipelines” to pay the subject cash
from the Project Company to the Sponsor. Conversely, under the cash flow structure
in project finance, timing and monetary amount in regard to the payments to be
made via the subject pipelines are matters to be determined by the Sponsor in its
sole discretion.
152 3  Business Theories of Project Finance

However, in the real world, tax issues may possibly arise depending on which
“pipelines” are to be used. The Sponsor is to determine which “pipelines” to use,
considering also potential tax issues.

4.3.3  DSCR, LLCR and PLCR

As I discussed in Sect.4.3.1.3 of this chapter, in project finance transactions, the


lender cannot rely on the amount of the capitalization or the amount of the profits,
which are reflected as numerical values in the financial statements of the borrower;
that is to say, these numerical values cannot become the indicators of the borrower’s
creditworthiness (i.e., borrower’s repayment capacity). If this is the case, on what
alternatives do they rely?
As I discussed using the two figures in Sect. 4.3.1 of this chapter, if the cash
equivalent to the debt shown in the liability section as the shaded portion, flows into
the Project Company over such 10 years without fail, there is no substantial reason
to keep the cash shown as the shaded portion in the Project Company at such point
in time. Consequently, the issue becomes whether or not the cash equivalent to the
debt shown in the liability section as the shaded portion, will flow into the Project
Company over such 10 years without fail. If I take the Senior Loan as an example,
the issue is whether or not the payments to be made under the Senior Loan will flow
into the Project Company before the repayment date without fail. The indicators to
judge whether or not such payments will flow into the Project Company are the
Debt Service Coverage Ratio (DSCR, sometimes called “the principal and interest
repayment coverage ratio”) and the Loan Life Coverage Ratio (LLCR). That is to
say, these indicators show the paying capacity of the borrower in project finance.
Next, I will discuss these two ratios.

4.3.3.1  DSCR

DSCR is an indicator to show the quantity of funds available to pay the principal
and interest of the Senior Loan during a specified period of time against the princi-
pal and interest of the subject Senior Loan to be paid within such specified period
(this period is the interval between the payment dates of the principal and interest of
the Senior Loan - typically 6 months or 3 months - and usually matches the period
of one-half year or one quarter year). If I express DSCR as an equation, it would be
as stipulated below. Incidentally, the funds available to pay the principal and interest
of the Senior Loan are called the “cash available for debt service”.
DSCR  =  The total cash flow amount in a certain specified period of time
before the payment of the principal and interest of the Senior Loan) / amount
of principal and interest of the Senior Loan to be repaid in such specified
period of time.
What should be noted here is the description of the numerator in the DSCR equa-
tion: the “total cash flow amount in a certain specified period of time before the
payment of the principal and interest of the Senior Loan.” Although the term “cash
4  Characteristics of Project Finance 153

flow” can have many meanings, here it is defined as follows: the monetary amount
after deducting the payment amount of the taxes and public dues, etc. and the O&M
fee to be paid during the specified time period from the cash paid into the Project
Company during such time period (that is to say, the cash that flows into the Project
Company during the operation period equals, basically, the payments of consider-
ation from the users and the payment of consideration from the off-takers. Note that
the execution of the Senior Loan occurs during the operation period.)
Cash flow in a certain period before the payment of principal and interest =
Cash amount that flows into the Project Company during the subject period -
(payment amount of taxes and public dues, etc. during the period + payment
amount of O&M fee during the period).
The cash flow in a certain period before the payment of the principal and interest
should be, roughly speaking, equivalent to the sum of (x) the amount of the payment
of principal and interest of the Senior Loan in the project finance for the subject
period and (y) the payment amount of the dividends, etc. on the equity investment
and the amounts owed under subordinated loan. The reasons why the payment
amount of the taxes and public dues, etc. and the payment amount of the O&M fee
are subtracted from the cash amount that flows into the Project Company are, as I
discussed in Sect. 2.2.1 of this chapter such arrangement is consistent with the order
of payment in regard to (1) taxes and public dues, etc. and the O&M fee and (2) the
principal and interest of the Senior Loans of the project finance, and (ii) the Senior
Lender needs to allow the project itself to continue in order to avoid termination by
the Host Country/Off-taker, and to rectify the project, even if the repayment of the
Senior Loan of the project finance is postponed.
The larger the numerical value of this DSCR, the greater the possibility that the
principal and interest of the Senior Loan will be paid, and this principle holds true
even in the situation where the amount of the cash flow that actually comes into the
Project Company is smaller than expected, or the situation where the actual O&M
fee is larger than forecasted (i.e., where the Project Company does not perform as
well as expected).
DSCR is used in the following ways:

(A) Determination of the Conditions of Financing during the Cash Flow


Sensitivity Analysis Stage
During the cash flow sensitivity analysis stage of the project review performed by
the Senior Lender, which I discussed in Sect.3.3.2 of this chapter, the Senior Lender
first calculates DSCR for each of the designated payment periods during the loan
term of the Senior Loan. As a matter of course, if DSCR is less than 1.0 for a certain
period, the repayment of the principal and interest of the Senior Loan for that period
cannot be expected. Ordinarily, the cash that flows into the Project Company, the
amount of the payment of the principal and interest of the Senior Loan, and the
amount of the O&M fee for such period will be the same monetary amount install-
ments. However, payments of taxes and public dues, etc. often are to be made at
specified times in a year. Also, in the case of a major project overhaul, the O&M fee
may become exorbitant. When these events occur, the value of the numerator of the
154 3  Business Theories of Project Finance

DSCR equation becomes smaller, and consequently, the numerical value of DSCR
becomes smaller. In this regard, to prepare for these payments, the Project Company
needs to set aside money in the reserve accounts, or adjust the repayment amount of
the principal of the Senior Loan. In particular, the day-to-day cash flow becomes
important. Additionally, in the case where money set aside in the reserve accounts
is used for the payment of the taxes and public dues, etc. or for the payment of the
O&M fee, in the calculation of DSCR it would be rational to prevent the numerical
value of DSCR from becoming smaller, in addition to preventing the value of the
numerator from becoming smaller.
Further, if DSCR’s numerical value is slightly above 1.0, it is still too low. In the
sensitivity analysis of the cash flow, it is typically determined that the DSCR value
based on the estimated cash flow needs to sufficiently exceed 1.0; otherwise, just a
slightly poor performance by the Sponsor in the operation of the project may make
repayment of the Senior Loan impossible. To address this concern, a buffer to a
certain extent is required.
Specific numerical values of DSCR that should be ideal vary depending on fac-
tors such as the nature of the subject NRI-PPP Project, the situation of the country
where the subject project is located, etc. The author considers, in the case of an IPP
Project where PPA exists, that the numerical value of DSCR, based on the expected
cash flow, could be around 1.3.
Incidentally, the portion of the DSCR value above 1.0 is the cash that serves as the
source of payment of the dividends, etc. related to the equity investment and the
amounts owed under the subordinated loan. The source of payment of the dividends,
etc. related to the equity investment and the amounts owed under the subordinated
loan serves as a backup to the source of payment of the principal and interest of the
Senior Loan. From this perspective, gaining sufficient profits to allow for the payment
of the dividends, etc. related to the equity investment and the amounts owed under the
subordinated loan (that is to say, the achievement of high economic efficiency in
regard to the project) is important also from the Senior Lender’s perspective.

(B) The Requirements of Dividends, etc. under the Waterfall Provisions


As I discussed in Sect. 4.2.5 of this chapter, in the payment of the dividends, etc.
related to the equity investment and the amounts owed under the subordinated loan
under the waterfall provisions, the Requirements of Dividends, etc. are stipulated,
and only after the subject Requirements of Dividends, etc. are satisfied will the pay-
ments of dividends, etc. related to equity investment and amounts owed under the
subordinated loan be made. The purpose of stipulating the subject Requirements of
Dividends, etc. is, as I discussed in Sect. 4.2.5 of this chapter, to prevent the Sponsor
from obtaining the profits generated by the project when the subject Requirements of
Dividends, etc. are not satisfied since, based on such failure, it can be assumed that
the project is not being operated profitably or will not be operated profitably in the
near future. Also, in project finance transactions, keeping the numerical value of
DSCR within a certain range is included in the subject Requirements of Dividends,
etc. As a matter of course, the DSCR value range stipulated in the Requirements of
4  Characteristics of Project Finance 155

Dividends, etc. is lower than the numerical value originally assumed during the stage
of the sensitivity analysis of the cash flow, and higher than the numerical value trig-
gering an event of default, as to which I will discuss in Sect. 4.3.3.1.3 of this
chapter.
Further, there are two types of DSCR: projected DSCR that uses projections of
future cash flow in its calculations, and historical DSCR that uses historical cash flow
data in its calculations. In projected DSCR, the conditions of the cash flow that will
occur in the future are projected, and DSCR is calculated based on such projections.
Contrastingly, historical DSCR is DSCR that is calculated based on historical cash flow
data, and in this calculation the projections applied in projected DSCR are not used.
In the Requirement of Dividends, etc. under the waterfall provisions, in most
cases, both projected DSCR and historical DSCR are used. Ordinarily, achieving a
certain numerical value which takes into consideration projected DSCR and histori-
cal DSCR for 1 year becomes a Requirement of Dividends, etc. under the waterfall
provisions. The length of the period related to DSCR corresponds to the period from
the payment date of the principal and interest of the Senior Loan to the next pay-
ment date of the principal and interest. If payments of the principal and interest of
the Senior Loan are to occur every 6  months, the length of the period related to
DSCR becomes 6 months. Accordingly, as for DSCR in regard to the Requirement
of Dividends, etc. under the waterfall provisions, projected DSCR uses two future
periods of DSCR, and historical DSCR uses two past periods of DSCR.

(C) Events of Default


Further, in most of the cases, the failure of DSCR to meet a certain numerical value
threshold constitutes an event of default under the Senior Loan Agreement.
Incidentally, DSCR in this case is projected DSCR which is lower than the numeri-
cal value of DSCR in the Requirement of Dividends, etc. under the waterfall provi-
sions, and the numerical value threshold which must be met or exceeded is 1.0.
The reason historical DSCR is not usually used to determine whether an event of
default occurs is as follows. If historical DSCR is below 1.0, it means the Project
Company could not pay the full amount of the principal and interest of the matured
portion of the Senior Loan in the past. Failure to timely pay the principal and inter-
est of the Senior Loan is itself an event of default, and thus to stipulate that an event
of default will occur based on the historical DSCR’s failure to meet the stipulated
threshold value would be redundant. Also, if historical DSCR is above 1.0, it means
the Project Company paid the full amount of the principal and interest of the matured
portion of the Senior Loan in the past. If the Project Company paid the full amount
of the principal and interest of the matured portion of the Senior Loan in the past, an
event of default may not arise depending on the project.
On the other hand, as to projected DSCR, in cases where the numerical value of
projected DSCR is slightly above 1.0 (not to mention cases where such value is 1.0
or lower), the project is not being operated appropriately, and thus, for the Senior
Lender, there exists a substantial risk that the full amount of the principal and ­interest
of the Senior Loan will not be paid in the near future. If that is the case, the situation
156 3  Business Theories of Project Finance

requires the Senior Lender to exercise its right to Step-in at that point of time, which
I will discuss in Sect.5.5.2 of this chapter, and replace the Sponsor, and to undertake
to rectify the project (In exercising the right to Step-in to replace the Sponsor, as I
will discuss in Sect.5.5.2 of this chapter, if doing so takes the form of a foreclosure
of security interests in favor of the Senior Lender, the payment obligations of the
Senior Loans will be accelerated.).

4.3.3.2  LLCR

While DSCR assumes a certain period as a precondition, LLCR (Loan Life Coverage
Ratio) is an indicator to show the net present value of the available source (i.e., cash
flow) for repayment of the principal of the Senior Loan against the principal amount
of the subject Senior Loan, over the whole loan period, and it is calculated by con-
verting the money available for repayment of the principal and interest of the Senior
Loan into its present value. It should be noted that interest of the Senior Loan is not
considered when determining LLCR.
If I express it in equation, it is shown as follows.
LLCR = present value of the sum of the cash flows before the payment of the
principal and interest of the Senior Loan / the total balance of the principal of the
Senior Loan.
Similar to DSCR, the larger the LLCR’s numeric value is, even in situations
where the actual cash amount that flows into the Project Company is less than pro-
jected, or where the actual O&M fee is higher than projected (i.e., where the Project
Company does not perform as well as expected), the higher the probability of repay-
ment of the Senior Loan. Incidentally, while DSCR assumes a certain period as the
period of calculation, LLCR assumes the remaining balance of the loan period at the
time of calculating LLCR as the period of calculation. In that sense, LLCR is sel-
dom considered in relation to the Requirement of Dividends, etc. under the waterfall
provisions, and seldom serves as a basis for an event of default. LLCR is a value that
is reviewed during the stage of the sensitivity analysis of the cash flow to examine
mainly the economic efficiency of the project and the repayment probability in
regard to the Senior Loan over the whole loan period. Incidentally, LLCR is calcu-
lated either just before the commencement of the project, or any time during the
Project Period by using the present value of the sum of the cash flows before the
payment of the principal and interest of the Senior Loan, and the remaining unpaid
principal amount of the Senior Loan, both as of the time of such calculation. Also,
the value of the numerator of the LLCR equation is the net present value of the sum
of the cash flows (i.e., the present value of the total amount projected to be gener-
ated from the cash flows during the loan period) before the payments of the princi-
pal and interest of the Senior Loan.
In addition, in the case of a Market Risk-Taking Type NRI-PPP Project, there is
a possibility that benefits will arise. If the quantity of goods and/or services sold
exceeds expectations, LLCR calculated at that point of time should be fairly high
(and consequently, the Sponsor can receive greater dividends, etc. than expected
5  Characteristics of the Key Financing Agreements 157

based on the excess profits achieved). On the other hand, a Market Risk-Taking
Type NRI-PPP Project is a project whose cash flow is highly volatile. Consequently,
as a counter-measure to address the future downside risk, in the case where LLCR
calculated in the middle of the loan period shows a numerical value above a certain
level, it is conceivable to appropriate funds acquired through the cash flow during
the initial lucrative period for the early repayment of the Senior Loan. Depending on
the NRI-PPP Project and the terms of the Senior Loan Agreement, LLCR may be
used to determine when a compulsory prepayment event (i.e., an event compelling
the Project Company to prepay amounts under the Senior Loan) occurs.

4.3.3.3  PLCR

Similar to LLCR, there is an indicator called the Project Life Coverage Ratio (PLCR).
To understand PLCR, consider the scenario where the operation period of a certain
NRI-PPP Project is 20 years. Under this scenario, in order to hedge the cash flow
risk, ordinarily the repayment period (tenor) is set in such a way that allows repay-
ment of the principal of the Senior Loan a few years before the completion of the
operation period. By taking this approach, even if a situation arises where the full
amount of the principal of the Senior Loan is not repaid on the originally-­planned
final repayment date, the balance of the unpaid principal can be expected to be repaid
with the cash flow that occurs during the operation period of the remaining few years.
The cash flow that occurs during this operation period, not the loan period, becomes
the source of funds for such repayment. That is to say, when the numerator in the
LLCR equation is replaced with the present value amount of the sum of the cash flow
(before the payment of the principal and interest of the Senior Loan) that occurs dur-
ing the operation period, not the loan period, the value becomes PLCR. PLCR is an
indicator that shows the probability that the full amount of the principal will be ulti-
mately repaid, in the case where the repayment of the principal of the Senior Loan is
not made as planned. PLCR is mainly used in the determination of the conditions of
the financing during the stage of the sensitivity analysis of the cash flow.

5  Characteristics of the Key Financing Agreements

Project finance textbooks often include assertions claiming, for example, that condi-
tions precedent, representations and warranties, covenants and events of default are
stipulated in the Senior Loan Agreements, or, that an offshore escrow account is used
in project finance for projects in emerging and developing countries, etc. These are
certainly facts that must be understood to gain an understanding of project finance.
However, conditions precedent, representations and warranties, covenants and
events of default are also stipulated in loan agreements for corporate finance. Also,
in project finance for projects in developed countries, an offshore escrow account is
not used. In the first place, except for procedural provisions and general provisions,
158 3  Business Theories of Project Finance

the provisions of a loan agreement are intended basically to protect the interest of
the lender. The interest of the lender means, in the case where an event, etc. occurs
that negatively impacts the creditworthiness of the borrower, to exempt the lender
from the lending obligations if such occurrence is before the execution of the loan,
and to enable the lender to seek the immediate repayment of the loan if such occur-
rence happens after the loan is executed. Conditions precedent to the disbursement
of the loan are stipulated in the Senior Loan Agreement to exempt the lender from
the lending obligation when such conditions are not met. Also, events of default are
stipulated in the Senior Loan Agreement to accelerate the loan and to enable the
lender to seek an immediate repayment of the loan if any of the default event occurs.
Further, the truthfulness and the accuracy of the borrower’s representations and
warranties in the Senior Loan Agreement become a condition precedent to the dis-
bursement of the loan, and the failure of any representation or warranty to be entirely
truthful and accurate becomes an event of default under the Senior Loan Agreement.
Also, the borrower’s non-violation of any of its covenants in the Senior Loan
Agreement becomes a condition precedent to the disbursement of the loan, and the
borrower’s violation of any of such covenants becomes an event of default under the
Senior Loan Agreement. Provision protecting the interest of the lender are also
­stipulated in loan agreements for structured finance; that is to say, these are the com-
mon stipulations in loan agreements.
Those who are in charge of projects for which project financing is provided need
to understand the stipulations, including provisions protecting the interest of the
lender, that are commonly included in loan agreements. In that sense, ideally, those
who are in charge of such projects should have extensive experience in corporate
finance, particularly, extensive knowledge of syndicated loan agreements.
The objective of this book is to expound on the business theories of project
finance. Therefore, these stipulations that are common to loan agreements are not
the subject of explanation herein. Also, in principle, the mechanisms that are used
only in project finance financing for projects in developing countries will not be
discussed in this book. In the following sections, the characteristics of the key
financing agreements typical, generally, to project finance are explained. Incidentally,
although the waterfall provisions are also characteristic of the key financing agree-
ments typical to project finance, because I have already discussed that subject in
Sect. 4.2 of this chapter it is excluded from the explanations below.

5.1  Financial Completion and Completion Guarantee

In an NRI-PPP Project and project finance, there are three concepts of the term
“completion.” They are Physical/Mechanical Completion, Operational Completion,
and Financial Completion. Regarding Physical/Mechanical Completion and
Operational Completion, I addressed them in Chap. 2, Sect. 4.8.1 of this chapter. I
will discuss Financial Completion here.
5  Characteristics of the Key Financing Agreements 159

5.1.1  Requirements of Financial Completion

For Financial Completion to be achieved, in addition to the achievement of


Operational Completion, the following requirements need to be satisfied.
• (1) The operation of the project has been commenced.
• (2) Depending on the nature of the project, the project has been operated for a
certain period (which excludes the trial operation for Financial Completion), and
the cash flow has been generated as planned.
• (3) Unpaid project costs do not exist.
• (4) Licensing, etc. for the operation have been obtained.
• (5) Insurance for the operation has been obtained.
• (6) Funding requirements have been satisfied by transfer of funds into the reserve
account.13
• (7) No event of default or potential event of default under the Senior Loan
Agreement has occurred.
Incidentally, for example, if the borrower’s obligation to obtain licenses, etc. for
the operation by a specific time is stipulated under the Senior Loan Agreement,
because failure to fulfill this obligation would become an event of default under the
Senior Loan Agreement, it may not be separately stipulated other than as an event
of default under the Senior Loan Agreement. This is also true in relation to the
requirement that insurance for the operation is properly obtained.
As a matter of course, the matters addressed by these requirements are not by
nature matters to be implemented by the EPC Contractor under the EPC Contract
except for Operational Completion. However, they are important provisions from
the viewpoint of the repayment of the Senior Loan. For this reason, separately from
Operational Completion, Financial Completion is stipulated in the Senior Loan
Agreement. Next, the purpose for addressing Financial Completion in the Financing
Agreements needs to be addressed.

13
 Incidentally, if the funds in the Senior Loan repayment reserve account are included in the proj-
ect costs, as a matter of course, the fact that the funding requirements are to be fulfilled with funds
held in the Senior Loan repayment reserve account is included in the requirements for the Financial
Completion. However, in regard to the subject funding requirements, the debt portion of the Debt-
Equity Ratio is financed by the Senior Loan. Considering that the requirement for transfer of funds
into the Senior Loan repayment reserve account is fulfilled for the purpose of securing the repay-
ment of the Senior Loan, the fact that an additional amount of the Senior Loan is disbursed in order
for the Senior Lender to secure the repayment of the Senior Loan is a bit curious. Ideally, the fund-
ing requirements in regard to the Senior Loan repayment reserve account should be fulfilled by the
cash paid to the Project Company during the operation period. Incidentally, the fact that funding
requirements are to be satisfied with funds in the Senior Loan repayment reserve account cannot
necessarily be one of the requirements for Financial Completion. In addition, in the case where the
funding requirements in regard to the Senior Loan repayment reserve account are to be satisfied
with the cash to be paid to the Project Company during the operation period, the payment of divi-
dends, etc. to the Sponsor will be delayed to the extent such funds are not available for the payment
of dividends, etc. Although the Sponsor would prefer to receive the dividends, etc. earlier, in regard
to the subject funding requirements, the Sponsor must also make an additional equity investment
for the equity portion of Debt-Equity Ratio. As a loss and gain issue, whether or not it is advanta-
geous for the Sponsor eventually is also a matter that should be examined.
160 3  Business Theories of Project Finance

5.1.2  Objectives for Stipulating Financial Completion

5.1.2.1  F
 ailure to Achieve Financial Completion Becomes an Event
of Default

Under the Senior Loan Agreement for the financing of a project in project finance,
the borrower is obligated to achieve Financial Completion by a specific date. This
means that, unless the borrower achieves Financial Completion by the specified
date, an event of default arises under the Senior Loan Agreement due to the bor-
rower’s failure to fulfill the subject obligation. This is because the failure of the
Sponsor to achieve Financial Completion by the specified date calls into question
the Sponsor’s business performance capability. Incidentally, for Financial
Completion, Operational Completion must be achieved, as a matter of course. In
that sense, the Sponsor must select an EPC Contractor that can conduct the EPC
work appropriately, and whether or not the Sponsor can select a capable EPC
Contractor is also reflective of the Sponsor’s business performance capability.

5.1.2.2  A
 chievement of Financial Completion Prior to Sponsor’s Receipt
of Dividends, etc

remains a concern from the viewpoint of repayment of the Senior Loan, receipt by the
Sponsor of dividends, etc. before the achievement of Financial Completion becomes
an absolutely impossibility. As I discussed in Sect. 4.2.5 in this chapter, the achieve-
ment of Financial Completion is included in the Requirements of Dividends, etc.

5.1.2.3  The Condition Subsequent to the Completion Guarantee

As I will discuss in Sect. 5.1.3 of this chapter, depending on the project for which
project financing will be granted, there are cases where the Sponsor provides a
Completion Guarantee. Also, once Financial Completion is achieved, this
Completion Guarantee becomes void and ineffective. For this reason, Financial
Completion is stipulated as a condition subsequent to the Completion Guarantee.

5.1.3  Completion Guarantee

The term Completion Guarantee means the Sponsor guarantees the liabilities of the
Project Company under the Financing Agreements until Financial Completion is
achieved. Incidentally, in Japan, there are some who believe that Completion Guarantee
means the Sponsor bears the continuing obligation to the Senior Lender to contribute
the cash required for the completion of the project until the project is completed.
However, the “guarantee” in Completion Guarantee indicates that it is a guaranty.
Specifically, the Sponsor, essentially, guarantees satisfaction of the liabilities of the
5  Characteristics of the Key Financing Agreements 161

Project Company under the Financing Agreements. But, as I discussed in Sect. 2.2.2
of this chapter, there is a mechanism that has the same economic effect as Completion
Guarantee, which is the case where the Sponsor bears the continuing obligation to the
Senior Lender to contribute an unlimited amount of cash, as required, for the comple-
tion of the project until the project is completed. However, it needs to be noted that the
issues I discussed in Sect. 2.2.2 of this chapter relate to this obligation.
Also, the completion in this context means the Financial Completion I discussed
in Sect. 5.1.2.3 of this chapter. If I speak in legal terms, Completion Guarantee
means the guarantee of the liabilities of the Project Company under the Financing
Agreements by the Sponsor, with the Financial Completion stipulated as a condition
subsequent. Incidentally, as a matter of course, in a project where Completion
Guarantee is required, if the Sponsor’s credit risk is unacceptable, it means the proj-
ect cannot be financed by project finance, in the first place.
In addition, it should be noted that the fact that the Sponsor provides Completion
Guarantee does not mean that the Senior Lender has not accepted the completion
risk. For example, even in the case where Operational Completion has been
achieved, a latent defect in the facility that was not realized during the period of
Operational Completion may subsequently be discovered. The EPC Contractor is
liable for such latent defect based on its warranty against defects under the EPC
Contract. However, the period during which the EPC Contractor bears liability
under such warranty is limited, and even if the cost to repair such defect may be
covered under such warranty of the EPC Contractor, the Project Company’s lost
earnings due to its inability to operate because of the existence of such defect may
not necessarily be included.14
Additionally, although not related directly to the business theories of project
finance, there exists a concept called “Political Risk Carve-out” in connection with
the Completion Guarantee. It means that, in the case where the Senior Lender is an
Export Credit Agency (“ECA”) or a Multilateral Development Bank (“MDB”),
because the assumption of political risk is provided as one of the objectives of an
ECA or MDB, in the case where Financial Completion is not achieved due to the
existence of a political risk, the Sponsor’s Completion Guarantee obligation should
be exempted. This exemption of the Sponsor’s Completion Guarantee obligation in
the case of an unachieved Financial Completion due to the existence of a political
risk is called the Political Risk Carve-out. Incidentally, it should be noted that this
Political Risk Carve-out assumes that Completion Guarantee means that the Sponsor
guarantees the liabilities of the Project Company under the Financing Agreements
until Financial Completion.

 Incidentally, on page 122 of the above-cited Practice of Project Finance, Mr. Kaga argues that
14

“although obtaining the Completion Guarantee leads to securing the receivables conservation mea-
sures of the lender, because the Completion Guarantee itself does not technically guarantee the
completion, the Completion Guarantee should essentially be recognized as the reinforcing means
under the security package.”
162 3  Business Theories of Project Finance

5.2  Sponsor Support

The project finance in an NRI-PPP Project is project finance with limited recourse.
In principle, the Sponsor does not bear the legal liability with respect to the repay-
ment of the Senior Loan. However, since it is limited recourse, it does not mean that
the Sponsor bears no liability at all regarding the subject liability. As I discussed in
Chap. 1, Sect. 4.2.2, the Sponsor bears some obligations regarding the Senior Loan
in certain cases. Also, the contract that stipulates its obligations is the Sponsor
Support Agreement.
The Sponsor’s obligations that are common to any project include, for example,
the Sponsor’s obligation to the Project Company to maintain the investment ratio.
This is a necessary obligation of the Sponsor to the Senior Lender under the Principle
of Owner-Operator which I discussed in Chap. 2, Sect. 4.2 of this chapter. Also, as
I will discuss in Sect. 5.4 of this chapter, although security interests are granted on
the equity and receivables under the subordinated loan which the Sponsor holds, the
Sponsor also bears the obligation not to infringe on the subject security interests.
Also, since the validity of the Financing Agreements entered into by the Sponsor is
the premise for project finance transactions, representations and warranties of the
Sponsor with respect to the validity of the Sponsor’s internal authorizations and the
Sponsor’s obligations under the Financing Agreements are also required.
However, when it comes to imposing a direct financial obligation on the Sponsor,
because it becomes an exception to the principle that the Sponsor does not bear legal
obligation with respect to the repayment of the Senior Loan, a rational reason for the
imposition of such direct financial obligation on the Sponsor is required. For exam-
ple, a case is conceivable where the risk that originally should have been borne by
the Host Country/Off-taker is to be borne by the Project Company under the
Concession/Off-take/PPP Agreement. Although there is a question regarding the
Sponsor’s involvement with such an NRI-PPP Project in the first place, if the
Sponsor goes so far as to take the risk to be involved with the subject project, the
Sponsor cannot let the subject risk be borne by the Senior Lender. If this risk
becomes realized, the Sponsor itself becomes liable for the repayment of the Senior
Loan.
As another example, in a plant project where a certain technology is used, the
past history of plants that used the same technology will indicate where such other
plants had frequently incurred problems a few years after their completion. In such
a case, as for the source of funding to cover the costs to resolve the subject problem,
one alternative could be to impose such funding contribution obligation on the
Sponsor, in the form of an additional subordinated loan to the Project Company,
with an upper limit predetermined depending on the project.
As yet another example, in the case where an insured event occurs, if the insur-
ance benefit is paid to the Project Company before the Project Company pays the
costs incurred by the subject event, no issue arises. However, if, under the ­conditions
5  Characteristics of the Key Financing Agreements 163

of the insurance contract, the insurance firm is not obligated to pay the insurance
benefit until the Project Company pays the subject costs, etc., the financing gap
needs to be covered. This also can be met by imposing on the Sponsor the obligation
to issue an additional subordinated loan to the Project Company. However, in this
case, if the insurance proceeds are to be paid to the Project Company, the subject
subordinated loan should be repaid preferentially to the Sponsor with funds received
as the subject insurance proceeds.

5.3  Security Package

Security Package is a terminology specific to project finance. Although the tendency


is to consider it refers to security interests because the term includes the word “secu-
rity,” it is a concept that is broader than legal security interest and a personal guar-
antee combined.
In its review of a project, the Senior Lender conducts analyses of the project’s
economic efficiency and risks. In such review, as for the various risks, whether the
subject risks are taken by those who ought to take those risks becomes an issue.
Also, the risks that remain with the Project Company are limited to only those that
are inherent to the Project Company. The Project Company’s operation risk is
exactly one of those risks. To that extent, the risk of the Senior Loan not being
repaid exists. From these viewpoints and in regard to the Senior Loan, various credit
enhancement measures are taken. The set of credit enhancement measures taken
with respect to a project is called a Security Package. In project finance, the Senior
Lender is to construct a Security Package ultimately in accordance with its analysis
of risk sharing based on its review of the project.
The credit enhancement measures included in a Security Package specifically
include the following, most of which have already been addressed in this book:
• (1) The EPC Contractor’s obligation to pay liquidated damages;
• (2) The Sponsor’s obligations under a Sponsor Support Agreement;
• (3) The Completion Guarantee by the Sponsor;
• (4) Debt-Equity Ratio;
• (5) DSCR, LLCR and PLCR;
• (6) The repayment period of the Senior Loan;
• (7) Waterfall provisions;
• (8) Insurance/Derivatives;
• (9) The support letter by the Host Country, etc.;
• (10) The involvement of an ECA and an MDB;
• The review by an independent consultant; and
• (12) Various Security Interests.
164 3  Business Theories of Project Finance

5.4  Security Interests in Project Finance

Although it has been said security interests are not granted in project finance, such
understanding is incorrect. Rather, in project finance security interests are granted
more comprehensively than in corporate finance. In project finance there are cases
where the security interests are sometimes granted even on the assets whose value
is uncertain. The assets that become the collateral include not only the real estate
and personal property constituting the project assets, but also the Project Agreements
which include the Concession/Off-take/PPP Agreement. In addition, insurance
claims and other claims as well as various accounts that are opened in accordance
with the waterfall provisions are also included (except for the dividends payment
account). Further, security interests are granted also on the equity interests/invest-
ments and subordinated loan receivables that the Sponsor holds.
Then, the reasons why security interests are granted in project finance should be
considered. Among such reasons, there exist two types: the passive (or defensive)
reason and the active reason. Next, I will discuss these two types.15

5.4.1  R
 easons Security Interests Are Granted in Project Finance –
The Passive (Defensive) Reason

The passive (defensive) reason why security interests are granted in project finance
is, from the viewpoint of protecting the project cash flows which are the subject of
project finance, to prevent the Project Company’s assets and the Sponsor’s equity
interests/investments and subordinated loan receivables from being disposed of by
the Project Company or the Sponsor, or being foreclosed upon by third parties.
Project finance is financing that depends on the project’s cash flow. Thus, if the
assets that generate such cash flow are disposed of or lost, the subject cash flow can-
not be maintained. The Project Company is a special purpose company devoted only
to the subject project, in the first place. Therefore, the assets of the Project Company
are limited to those assets that generate the cash flow in the subject project.
Accordingly, security interests are granted on every asset held by the subject Project
Company. In this case, even if certain assets have less property value, if they are
indispensable assets from the viewpoint of generating the subject cash flow, and if
alternative assets are not easily procured, security interests need to be granted on the
subject assets from the viewpoint of maintaining the cash flow.
Incidentally, the dissipation and the loss of the cash flow-generating assets
includes, in addition to the disposal of the project assets by the Project Company,
foreclosures on the Project Company’s assets by third-party creditors of the Project
Company. If security interests have been granted on the subject assets, because the
Project Company’s third party creditors cannot expect to achieve debt collection by
the seizure of the subject assets substantially, they will not have incentive to conduct
a foreclosure proceeding, etc.

 For supporting documents with the same purport, see Vinter, G. and Price, G. (2006) Project
15

Finance, Third Edition. Sweet & Maxwell U.K. Pages 247–250.


5  Characteristics of the Key Financing Agreements 165

In addition, security interests are granted not only on the assets of the Project
Company, but also on the equity interest/investments and subordinated loan receiv-
ables held by the Sponsor, and this is because, from the principle of Owner-Operator
which I discussed in Chap. 2, Sect.4.2, there exists the risk of not being able to
maintain the cash flow when the Sponsor is replaced.

5.4.2  R
 easons Security Interests Are Granted in Project Finance –
The Active Reason

The active reason why security interests are granted in project finance can be
explained as follows. In project finance, in the case where cash flow from a project
is not realized because the project is not going well, and thus payments of the prin-
cipal and interest under the Senior Loan are not made as scheduled, the Sponsor and
O&M Operator bear responsibility due to their failure to achieve the planned results
for the project. Therefore, in such cases, the Sponsor is replaced with a new Sponsor
to rectify the project, and once the project is successfully rectified the planned cash
flow is achieved and the payment of the principal and interest under the Senior Loan
is made possible. There are two ways to replace the Sponsor, which are as follows:
(1) to have the equity interest/investments and subordinated loan receivables held
by the former Sponsor transferred to the new Sponsor, and (2) to have all of the
assets of the former Project Company transferred to the new Project Company
owned by the new Sponsor. These transfers to replace the Sponsor may need to be
carried against the will of the former Sponsor or the former Project Company. For
this reason, security interests are granted on every asset held by the former Project
Company and on the equity interest/investments and subordinated loan receivables
held by the former Sponsor, and, by means of foreclosure of such security interests,
the equity interest/investments and subordinated loan receivables held by the former
Sponsor can be transferred to the new Sponsor, and the entire assets of the former
Project Company can be transferred to the new Project Company owned by the new
Sponsor, compulsorily even against the will of the former Sponsor or the former
Project Company. This is the active reason security interests are granted in project
finance.
These two ways are illustrated in Fig. 3.8.
Incidentally, in the case where the Sponsor is to be replaced by way of foreclo-
sure of security interests, it is sufficient to use one of the two aforementioned ways
(i.e., (1) transferring the equity interest/investments and subordinated loan receiv-
ables held by the former Sponsor to the new Sponsor, or (2) transferring the entire
assets of the former Project Company to the new Project Company owned by the
new Sponsor); executing both methods is not necessary. This right of the Senior
Lender to replace the Sponsor is one of the rights to Step-in the Senior Lender has
in project finance. As to the Senior Lender’s right to Step-in, I will discuss that topic
in Sect.5.5.2 of this chapter.
As discussed above, in project finance, in the case where the planned cash flow
is not generated because the project is not going well, and thus, payments of princi-
pal and interest under the Senior Loan are not made as planned, the project will be
166

Replacement by way of foreclosure of security interests on the Sponsor’s equity interests/investments


and subordinated loan receivables
Former Sponsor New Sponsor

Equity
Subordinated Loan

Project Company

Replacement by way of foreclosure of security interests on the Project Company’s assets

Former Sponsor New Sponsor

Assets

Former Project Company New Project Company

Project Agreements
(including Concession/Off-take
/PPP Agreement)
Counterparties to Project Contracts
(including Host Country/Off-taker)

Fig. 3.8  Replacement of the sponsor by way of foreclosure of security interests


3  Business Theories of Project Finance
5  Characteristics of the Key Financing Agreements 167

transferred to a new Sponsor or to the Project Company owned by the new Sponsor.
Consequently, the project is revitalized by the new Sponsor, and if successful, the
Senior Lender will receive payments of principal and interest under the Senior Loan
from the cash flow generated by the revitalized project. Accordingly, in contrast to
the granting of security interests in corporate finance, the consideration that can be
generated through the foreclosure of the secured collateral is not of primary ­concern,
and the foreclosure of security interests is not the final step in the credit collection
of amounts owed under the Senior Loan.
In this way, project finance has a project-revitalization function, and this also
provides benefits indirectly to the Host Country/Off-taker.
Incidentally, although this point may be a bit technical, in the case where the
project’s assets are transferred from the former Project Company to the new Project
Company, the question of whether liabilities related to the Senior Loan remain with
the former Project Company, the borrower, or transfer to the new Project Company,
arises. Regarding this issue, the author has never heard of an actual case where a
project’s assets have been transferred to the new Project Company through the
above-described method. However, in practice, it seems that the amount equivalent
to the unpaid balance owed under the Senior Loan at the time of the foreclosure of
security interests is loaned by the Senior Lender to the new Project Company
through a loan issued in the new project finance arrangement, and the principal from
such loan is used by the new Project Company to repay the balance owed under the
Senior Loan from the former project finance arrangement, as consideration at the
time of the foreclosure of the security interests.

5.4.3  A
 dvantages and Disadvantages of (1) the Transfer of the Equity
Interests/Investments and Subordinated Loan Debts Held by the
Former Sponsor to the New Sponsor, and (2) the Transfer
of the Former Project Company’s Entire Assets to the New Project
Company Owned by the New Sponsor

Next, in the case where the Senior Lender forecloses on the security interests, it
must select one of the following transfer arrangements: (1) the transfer of the equity
interest/investments and subordinated loan receivables held by the former Sponsor
to the new Sponsor, and (2) the transfer of the former Project Company’s entire
assets to the new Project Company owned by the new Sponsor.
Of course, the first proposed arrangement (i.e., (1) the transfer of the equity inter-
est/investments and subordinated loan receivables held by the former Sponsor to the
new Sponsor) is the simpler procedure. However, in that arrangement, the corporate
entity of the Project Company remains unchanged. If such a Project Company will
have incurred an additional debt obligation, the new Sponsor will be prevented from
receiving a profit from the project until such debt obligation is paid-off, and this will
reduce the new Sponsor’s incentive to revitalize the project to the extent of such
debt obligation. Further, there is a possibility that the Senior Lender will not be able
to find anyone willing to become the new sponsor in the first place. In this situation,
168 3  Business Theories of Project Finance

the project would not be revitalized and payment of amounts owed under the Senior
Loan would not be made; and this result would be undesirable for both the Senior
Lender and, indirectly, the Host Country/Off-taker.
Based on the foregoing, the second arrangement (i.e., (2) the transfer of the for-
mer Project Company’s entire assets to the new Project Company owned by the new
Sponsor) needs to be secured. Incidentally, in this case, security interests on various
types of collateral will need to be foreclosed, and the procedures become more
complicated accordingly. Also, a new Project Company needs to be established.
Further, depending on the project, the new Project Company may need to newly
obtain the required licenses, authorizations and permits (and, as a matter of course,
there exists the risk that it may not be able to obtain all of the required licenses, etc.).

5.4.4  Timing of the Granting of the Security Interests

Considering the passive (defensive) and active reasons why security interests are
granted in project finance, every security interest needs to be granted before the
initial drawdown of the Senior Loan.16 As for future assets (including the receiv-
ables held by the Project Company as well as the Sponsor’s equity interest/invest-
ments and subordinated loan receivables), security interests on such future assets
need to be granted before the initial drawdown of the Senior Loan in a way that
allows for perfection depending on the security interests to be granted.
However, there may be cases involving particular projects where security inter-
ests may not be granted before the initial drawdown of the Senior Loan; for exam-
ple, the case where the O&M Agreement is not entered into by the date of the initial
drawdown of the Senior Loan. Also, there is the possibility that the insurance con-
tracts required for the operational stage may not be entered into by the date of the
initial drawdown of the Senior Loan. Further, an example arises based on the fact
that under Japanese law, a building is considered a separate real estate asset from the
land upon which it is located. Ordinarily, on the date of the initial drawdown of the
Senior Loan, a building related to a project will not yet have been constructed, and
therefore, the security interest on the subject building to be constructed cannot be
granted on such date. These security interests need to be granted ultimately by no
later than the Financial Completion, and under the Senior Loan Agreement, the
granting of the subject security interest is to be stipulated as the obligation of the
Project Company.
Regarding the granting of these security interests, whether such stipulation in the
Senior Loan Agreement obligating the Project Company to grant the subject secu-

16
 Strictly speaking, in practice, receivables in regard to the agent fee and/or receivables in regard
to swap providers that may be claimed against the Project Company, may possibly be generated
before the initial drawdown of the Senior Loan. Being similar to the receivables under the Senior
Loan, these receivables are also receivables that should be secured by security interests. It is also
conceivable that security interests in regard to these receivables may be granted before the initial
drawdown of the Senior Loan. In practice, this will ultimately be an issue to be determined on a
project by project basis.
5  Characteristics of the Key Financing Agreements 169

rity interests is sufficient or not becomes an issue. If the Project Company breaches
the subject obligation, such breach will constitute an event of default under the
Senior Loan Agreement. Accordingly, the Senior Lender can accelerate the payment
obligation under the Senior Loan, and can foreclose on its security interests.
However, in this case, security interests are not granted on all of the assets constitut-
ing the project, and therefore all of the assets that constitute the project cannot be
transferred to a new Sponsor or the new Project Company of the New Sponsor. If
this situation arises, project finance becomes unworkable. To address this concern,
an arrangement such as conditioning the Sponsor’s support under the Sponsor
Support Agreement on the granting of the subject security interest, etc. is required.

5.4.5  Procedures to Foreclose the Security Interests

Next, from the viewpoint of project finance, the procedures to be followed to fore-
close on the security interests need to be determined. This point has been listed, in
a project finance transaction of a Host Country, as one of the items to be investigated
in the legal due diligence investigation of the subject Host Country, before the grant-
ing of project financing in regard to the subject project.
Normally, proceeds from the project assets (particularly real estate assets) are
realized through the foreclosure of security interests over such assets, and, ulti-
mately, the sale of such assets through an auction procedure conducted by the court.
However, this does not secure the transfer of such project assets to the new Project
Company established by the new Sponsor, and thus the active reason for the grant-
ing of security interests in project finance, which I discussed in Sect. 5.4.2 of this
chapter, cannot be achieved. From this viewpoint, the ability to perform a foreclo-
sure procedure without having to go through the judicial process, in regard to the
security interests over the project assets, is required in project finance.

5.4.6  Granting of Security Interests on the Project Agreements

In project finance, security interests are granted on all of the Project Agreements.
This is because the Project Agreements are also assets of the Project Company that
are indispensable for the project’s cash flow. As I discussed in Sect. 2.1 of this chap-
ter, the benefits of project finance also extend to the parties that enter into the Project
Agreements with the Project Company (specifically, the Host Country/Off-taker,
the O&M Operator, the EPC Contractor, etc.; such parties are hereinafter collec-
tively referred to as the “Project Parties” for the sake of convenience). Accordingly,
the subject Project Parties need to perform certain stipulated acts required with
respect to the granting of security interests on the Project Agreements to a reason-
able extent.
The procedure for granting security interests on the Project Agreements varies
depending on the governing law of the subject Project Agreements and the law
applicable to the security interests.
170 3  Business Theories of Project Finance

Depending on the individual project, security interests may be granted only on


the receivables and the rights of the former Project Company under the Project
Agreements. However, in such cases, even if the security interests are foreclosed
upon, only the receivables and the rights under the Project Agreements are trans-
ferred to the new Project Company, and the obligations and the debts of the former
Project Company under the Project Agreements remain with the former Project
Company. Regarding whether or not the new Project Company can revitalize the
project under this arrangement, a careful examination is required. Depending on the
particular project, a treatment equivalent to the novation of the Project Agreements
under UK law may be required.
Although the concept of contractual status as a party does not exist under com-
mon law, under civil law, the concept of contractual status as a party exists in certain
respects. If the governing law of the Project Agreements is the law of a civil law
jurisdiction and the concept of contractual status as a party exists, the procedure by
which the contractual status as a party of the former Project Company is transferred
to the new Project Company becomes an issue. Legal issues including whether
security interests can be granted in regard to the contractual status as a party of the
Project Company under the governing laws of the Project Agreements, must be
addressed in the due diligence investigation before entering into the Project
Agreements.
Incidentally, in the case where security interests are granted on the Project
Agreements, the entity to which the Project Company’s rights, obligations and con-
tractual status as a party under the Project Agreements are to be transferred is
unknown to the Project Parties (i.e., the counterparties to the subject Project
Agreements) at the time the subject security interests are granted. Further, because
there could be cases where the former Project Company is in breach of its obliga-
tions under the subject Project Agreements at the time of the foreclosure of security
interests, the resulting influence of such breach in regard to the rights of and the
receivables owed to the Project Parties under the subject Project Agreements against
the former Project Company, also arouses our interest. I will discuss these issues in
Sect. 5.5.2.5 of this chapter.
Further, security interests are also granted on the O&M Agreement. For the pas-
sive (defensive) reason for the granting of security interests in project finance, this
granting of security interests is required. However, regarding the granting of secu-
rity interests on the O&M Agreement, the active reason for granting security inter-
ests in project finance is mostly not applicable. This is because the cases where the
Senior Lender forecloses on security interests are cases where the Senior Lender
has given up on the former Sponsor. Accordingly, the Senior Lender also will have
chosen to terminate the O&M Operator which is the former Sponsor, and thus there
is no need to transfer the O&M Agreement to the new Project Company. Incidentally,
based on this reason, the contents of the Direct Agreement concerning the O&M
Agreement will be different from the contents of other Direct Agreements.
5  Characteristics of the Key Financing Agreements 171

5.4.7  G
 ranting of Security Interests on the Concession/Off–Take/PPP
Agreements

Depending on the laws of the relevant Host Country, from the view point of the
administrative laws (particularly, accounting laws related to the execution of con-
tracts), there are cases where the execution of contracts by the Host Country/Off-­
taker, in principle, must be through a bid procedure. And, for this reason, there are
cases where the transfer of a Concession/Off-take/PPP Agreement to the new
Project Company is prohibited under the relevant administrative law because of the
absence of a bid procedure. In this case, the granting of project finance financing for
a project of the subject Host Country becomes impossible, in the first place. On the
other hand, in the case where financing by project finance is possible, such will also
benefit the Host Country/Off-taker. Therefore, if the Host Countries expect invest-
ments from foreign countries, they need to implement legal systems that will enable
this. For example, in Mexico, to facilitate foreign investments into IPP Projects,
they enacted a special law addressing administrative requirements with respect to
IPP Projects in this regard.
In addition, in general, what is required of the Host Country/Off-takers in the
case where they enter into contracts is procedural fairness from the viewpoint of the
subject administrative regulations. The bid procedure is used to ensure this proce-
dural fairness. On the other hand, in the case where the Host Country/Off-taker
enters into contracts, undergoing a bid procedure is not required in 100% of the
cases, and it seems that exceptions exist normally. Also, in such exceptional cases,
a bid procedure is not always required as long as the fairness of the procedure is
realized. If that is the case, this transfer of the Concession/Off-take/PPP Agreement
to the new Project Company is not likely to violate any procedural fairness require-
ment. If this is the case, it would be reasonable to say that this transfer of the
Concession/Off-take/PPP Agreement to the new Project Company will not violate
the subject administrative regulation as well.

5.5  Direct Agreement and the Right to Step–In

As I discussed in Chap. 1, Sect. 4.2.4, “Direct Agreement” is a technical term used


in project finance. A Direct Agreement is an agreement entered into by each of the
Project Parties with the Senior Lender, and with the Project Company if appropriate.
The primary objectives for entering into Direct Agreements are: (1) effectuation of
perfection with respect to security interests granted on the subject Project Agreement
(or on the Project Company’s rights under the subject Project Agreement), and (2)
securing the Senior Lender’s right to Step-in. Next, I will discuss these two objec-
tives, as well as the right to Step-in of the Senior Lender and the right to Step-in of
the Host Country/Off-taker. Finally, I will discuss other matters stipulated in a
Direct Agreement.
172 3  Business Theories of Project Finance

Additionally, as I discussed in Sect. 2.1 of this chapter, project finance also pro-
vides benefits to the Project Parties. Therefore, each Project Party needs to enter into
a Direct Agreement, the provisions of which are reasonable for such Project Party.

5.5.1  E
 ffectuation of Perfection with Respect to the Security Interests
Granted on the Project Agreements (or on the Project Company’s
Rights under the Project Agreements)

Perfection needs to be effectuated in regard to the security interests granted on the


Project Agreements (or on the Project Company’s rights under the Project
Agreements). Although the procedure for perfection is determined by the law
(including international private law) applicable to the subject security interests, nor-
mally it will be effectuated by obtaining approval, with respect to the subject secu-
rity interests, from the relevant counterparty (i.e., the relevant Project Party) to the
subject Project Agreements. Further, even in the case where the obtaining such
approval does not effectuate perfection of the security interests, such approval of the
subject security interests in relation to the subject Project Agreements will be
important from the viewpoint of confirming the understandings of the subject
Project Parties in regard to the Senior Lender’s right to Step-in in project finance. In
this regard, such approval of the security interests in relation to the Project
Agreements is normally stipulated in the Direct Agreement.
Incidentally, under the Project Agreements, in the case where the Project
Company grants security interests on the subject Project Agreements (or on the
Project Company’ rights under the Project Agreements), there are cases where
obtaining the prior approval of the Project Parties related to the subject Project
Agreements is required. Depending on the law applicable to the security interests,
this approval under the subject Project Agreement is different from the approval for
the perfection of the security interests. Particularly because the approval under the
subject Project Agreement needs to be a prior approval (i.e., it must be obtained
before the granting of security interests), whether both of these approvals can be
stipulated in the Direct Agreement, including consideration of the timing for enter-
ing into the Direct Agreement and for entering into the security agreement, needs to
be examined.
Additionally, there are cases where some Host Country/Off-takers request the
disclosure of the terms and conditions of the security agreement and the Senior
Loan Agreements. However, similar to the cases addressing the Host Country/Off-­
taker’s involvement in regard to the terms and conditions of the O&M Agreement or
the EPC Contract, which I discussed in Part 2, Sect. 3.2.6 of this chapter, (1), there
would be nothing to gain and everything to lose for the Host Country/Off-taker. If
the Host Country/Off-taker understands NRI-PPP Projects and project finance, it
would not request such disclosures. Rather, there are cases where the Host Country/
Off-taker requests that a stipulation be included in the Direct Agreement that con-
firms the understanding that the Host Country/Off-taker makes no representation or
warranty regarding the effectiveness of the grants of security interests.
5  Characteristics of the Key Financing Agreements 173

5.5.2  Right to Step-in

The right to Step-in is also a technical term specific to project finance. As for the
Senior Lender’s right to Step-in, the following two types exist.

5.5.2.1  (1) The Right to Step-In (1)

This right to Step-in is the right that allows the Senior Lender to fulfill the obliga-
tions of the Project Company under the Project Agreements in place of the Project
Company (on behalf of the Project Company). The Senior Lender literally steps into
(intervenes) the position of the Project Company and assumes the rights and obliga-
tions of the Project Company. In regard to this right to Step-in (1), in contrast to the
right to Step-in (2) to be discussed below, the Project Agreements are not transferred
to the new Sponsor’s new Project Company. The objective of this right to Step-in is
to undertake to rectify the project, with the Sponsor and the Project Company
remaining as they are at the time of the Step-in.
Because the Senior Lender does not have the technical capability to fulfill the
Project Company’s obligation under the subject Project Agreements, the actual
tasks are undertaken by appointed parties with the requisite capabilities.
The Senior Lender’s capacity to fulfill the obligations of the Project Company
under the Project Agreements in place of the Project Company (on behalf of the
Project Company) is to be stipulated in the Direct Agreement. Incidentally, this right
to Step-in (1) is exercised in cases where the Project Company has breached an
obligation under the Project Agreements and such default is due to reasons attribut-
able to the Project Company. In order to cure the subject default, the Senior Lender
exercises the right to Step-in (1).

5.5.2.2  (2) The Right to Step-In (2)

This right to Step-in is the right of the Senior Lender to replace the Sponsor (the
right to be able to replace the former Sponsor with the new Sponsor) to undertake
the revitalization of the project. As I discussed in Sect. 5.4 of this chapter, this right
to Step-in (2) involves the granting of security interests on the assets held by the
Project Company and the equity interest/investments and subordinated loan receiv-
ables held by the Sponsor.
The Project Parties’ approval of the granting the subject security interests in
favor of the Senior Lender is stipulated in the Direct Agreements. That is to say, it
is included in the approval discussed in Sect. 5.5.1 of this chapter.
174 3  Business Theories of Project Finance

5.5.2.3  (3) The Cure Period for the Senior Lender

Ordinarily, when a project is not going well, the Project Company will be in breach
of its obligations under the Project Agreements based on the reasons attributable to
the Project Company. In this case, normally, the Project Company is required to
cure such default within a certain cure period, and if the subject default is not cured
by the end of such cure period, the counterparties to the subject Project Agreements
(i.e., the Project Parties) will have the right to terminate the subject Project
Agreements. If the Project Parties exercise such termination right, the project will
be terminated. If the project is terminated, the Senior Lender’s right to Step-in will
become meaningless. Accordingly, in order for the Senior Lender to exercise the
right to Step-in and undertake to revitalize the project, the subject Project Agreements
cannot be terminated, and the project must not be terminated.
From this viewpoint, in addition to the Project Company’s cure period to cure the
defaults under the Project Agreements, the Direct Agreement provides for a certain
separate cure period, granted to the Senior Lender, during which the Project Parties
are not permitted to terminate the subject Project Agreements. Incidentally, depend-
ing on the nature of the subject default, the cure period granted to the Senior Lender
may have a substantial duration such as, for example, in the case where the blades
of a turbine are damaged in an IPP Project, the subject cure period may be as long
as 6 months to allow for the change of the subject blades. If this cure period granted
to the Senior Lender is short, the Senior Lender will lose the incentive to exercise
the right to Step-in, which, ultimately, will not be beneficial for the Project Parties,
especially the Host Country/Off-taker.
Incidentally, the Senior Lender needs to make reasonable efforts to achieve the
requisite cure during the subject cure period. If the Senior Lender fails to use its
reasonable best efforts in this regard, it would be reasonable for the subject cure
period to end and for the Project Parties to be permitted to exercise their rights to
terminate the subject Project Agreements.

5.5.2.4  ( 4) Default under the Project Agreements Is Not a Mandatory


Requirement for the Exercise of the Right to Step–In (2)

In the case where the Senior Lender forecloses on its security interests by exercising
the right to Step-in (2), in practice, the most likely scenario is that a default under
the Project Agreements based on the reasons attributable to the Project Company
has occurred. However, even in the case where there is no such default based on the
reasons attributable to the Project Company under the Project Agreements, there are
situations where the Senior Lender needs to exercise the right to Step-in (2). For
example, consider the case where the O&M Operator performs all required O&M
work satisfactorily such that the Project Company’s obligations under the
Concession/Off-take/PPP Agreement are fulfilled; however, the costs incurred in
relation to the O&M work turn out to be substantially higher than originally planned.
In this case, there is no default by the Project Company under the ­Concession/
5  Characteristics of the Key Financing Agreements 175

Off-take/PPP Agreement. However, as I discussed in Chap. 2, Sect. 3.2.6.2 of this


chapter, since the funds to be used to pay for the additional costs related to the O&M
work are essentially the Sponsor’s profits from the project, when substantial addi-
tional costs are incurred, payments of amounts owed under the Senior Loan cannot
be made. Also in cases like this, the Senior Lender needs to replace the Sponsor in
order to revitalize the project.
From the standpoint of the Host Country/Off-taker, it may be somewhat opposed
to the replacement of the Sponsor in the absence of the Project Company’s default
under the Concession/Off-take/PPP Agreement. However, in such cases, because of
the strong possibility that a default under the Concession/Off-take/PPP Agreement
will occur in the future if the status quo is maintained, the replacement of the
Sponsor (which would prevent such default from occurring) will also be beneficial
to the Host Country/Off-taker.

5.5.2.5  ( 5) Requests from the Project Parties Related to the Project


Agreements

Because the essence of security interests is the right to foreclose on the security
interests to seize the collateral, the approvals by the Project Parties to the granting
of the security interests over the Project Agreements to which such Project Parties
are the parties in favor of the Senior Lender naturally includes their approval to the
foreclosure of such security interests and seizure of their rights, interests and posi-
tion under and in relation to such Project Agreements, or it should be deemed to
include such approval. If the foreclosure of security interests is a matter that needs
separate approval by the Project Parties, and consequently this right to Step-in (2) is
lost, then project finance will lose its foundation.
However, as I discussed in Sect. 4.4 of this chapter, the party to whom the rights,
obligations and contractual position of the Project Company under the Project
Agreements are to be transferred is unknown to the Project Parties at the time the
security interests are granted. Further, because there could be cases where the for-
mer Project Company is in breach of its obligations under the subject Project
Agreements at the time of the foreclosure of security interests, the resulting influ-
ence of such breach in regard to the rights of and the receivables owed to the Project
Parties under the subject Project Agreements against the former Project Company,
also arouses our interest. From these viewpoints, the Project Parties may have ratio-
nal reasons to attach certain conditions to the foreclosure of the subject security
interests. For example, with respect to the new Sponsor, it is likely that the Project
Parties may require that such a new Sponsor has a sufficiently high business perfor-
mance capability, viewed objectively. However, the Senior Lender clearly is aware
that the position of the new Sponsor cannot be filled by any party. The Senior Lender
expects the project to be revitalized properly such that the amounts owed under the
Senior Loan can be paid with the cash flow generated from the revitalized project.
From that perspective, the Senior Lender will select, to the greatest extent possible,
the party with the highest business performance capability to serve as the new
176 3  Business Theories of Project Finance

Sponsor. Accordingly, whether or not the Project Parties need to make the adequate
qualifications of the new Sponsor (i.e., the requirement that the new Sponsor has a
sufficiently high business performance capability, viewed objectively) the condition
to the foreclosure of the security interests under the Direct Agreement, should be
sufficiently examined.
If, despite the existence of a capable potential new Sponsor, there is a risk that the
Senior Lender may not select such party as the new Sponsor, such Senior Lender is
essentially inferior in its ability to perform project finance. If this is the case, in the
case where the Project Party is the Host Country/Off-taker, and there is a problem
with the business performance capability of the Sponsor that has been granted project
financing for the relevant project from such Senior Lender, then, ultimately, the selec-
tion of such Sponsor as the successful bidder for the project is the essential problem.
Further, in the case where the Project Agreement is an EPC Contract, if the
Senior Lender exercises the right to Step-in (2), it can be assumed that a default
under the EPC Contract, attributable to the Project Company, has occurred. Also,
the Project Company’s obligation under the EPC Contract is mainly the EPC fee
payment obligation. In the case where the Senior Lender exercises the right to
Step-in (2) and replaces the Sponsor, because the objective for exercising such right
to Step-in (2) is to rectify the project, there will be no rationale for demanding the
EPC Contractor to continue fulfilling the obligations under the EPC Contract with
the EPC fee being unpaid. In that sense, in the case where the Senior Lender exer-
cises the right to Step-in (2), it is possible that the Senior Lender makes payment of
the outstanding EPC fee by the new Project Company a requirement.
Further, in the case where the Project Agreement is a Concession/Off-take/PPP
Agreement, if the Senior Lender exercises the right to Step-in (2), it can be assumed
that a default under the Concession/Off-take/PPP Agreement, attributable to the
Project Company, has occurred. Similar to the case involving the EPC Contract,
there could be cases where the Host Country/Off-taker insists that the Senior
Lender’s assurance to cure the subject default is to be made a requirement for the
Senior Lender’s exercise of the right to Step-in (2). However, in the case of the
Concession/Off-take/PPP Agreement, in contrast to the case of the EPC Contract,
the obligation which the Project Company has breached under the Concession/Off-­
take/PPP Agreement is the obligation to implement the project, not a monetary pay-
ment obligation (Additionally, as I discussed in Chap. 2, Sect. 5.1.3, the monetary
payment obligations the Project Company bears under the Concession/Off-take/PPP
Agreement should be limited to the bank payment guarantee demanded by the Host
Country/Off-taker under the Concession/Off-take/PPP Agreement, or to payment
obligations that are to be satisfied at the time of the termination of the Concession/
Off-take/PPP Agreement by the reduction of the unpaid Availability Fee. Further, it
needs to be noted that there is no rationale for imposition of any other monetary
payment obligations). Then, the breach of the obligation to implement the subject
project is to be cured through the revitalization of the project by the new Sponsor;
however, nobody can foresee whether or not the new Sponsor will be 100% success-
ful in revitalizing the project. Therefore, there is no rationality in ­forcing the Senior
Lender to give an assurance that the project will be revitalized ultimately.
5  Characteristics of the Key Financing Agreements 177

5.5.2.6  ( 6) The Countermeasures in the Case where the Bankruptcy/


Rehabilitation Proceedings Are Commenced with Respect
to the Project Company

In the case where bankruptcy/rehabilitation proceedings are commenced with


respect to the Project Company,17 what effects will such proceedings have on the
Senior Lender’s ability to exercise its right to Step-in (2)? For example, the right to
foreclose on the security interests granted on the project assets may possibly be
restricted. Also, in the case where only receivables under the Project Agreements
are the subject of security interests, there is a risk that the Project Agreements them-
selves may be terminated by the Project Company or by the trustee of the Project
Company as executory bilateral contracts. In this regard, the Senior Lender’s right
to Step-in (2) will lose its effectiveness.
In cases like this, the new Sponsor establishes a new Project Company, and the
Project Parties reach an agreement with the Senior Lender regarding the execution
of new Project Agreements between the Project Parties and the subject new Project
Company. With this arrangement, the absence of the effectiveness of the Senior
Lender’s right to Step-in (2) is addressed. This obligation of the Project Parties to
execute new Project Agreements with the subject new Project Company is to be
stipulated in the Direct Agreement (It should be noted that this obligation is an obli-
gation that will be binding on the Project Company vis-a-vis the Senior Lender.).
Incidentally, the contents of the new Project Agreements will have to be substan-
tially identical to the contents of the old Project Agreements. Also, the status and
handling of the former Project Company’s default under the old Project Agreements
will have to be addressed in the new Project Agreements. Additionally, with respect
to the new Sponsor, requirements that are basically the same as the requirements
relating to the exercise of the right to Step-in (2), which I discussed in (5), will be

17
 Incidentally, the author considers that whether or not a rehabilitation proceeding (i.e., a proceed-
ing based on Chapter 11 of the Bankruptcy Code in the U.S. or the Corporate Rehabilitation Law
of Japan and the Civil Rehabilitation Law of Japan) is appropriate for the Project Company, is a
matter worthy of discussion. These corporate rehabilitation proceedings are legal court proceed-
ings, the objective of which is to basically treat the claims of the creditors of the debtor seeking
rehabilitation equally, and to attempt to recover as much of their debt as possible, and to promote
the rehabilitation of the debtor. On the other hand, the Senior Lender’s right to Step-in (2) also has
as its objective the regeneration of the Project Company, and in its execution of such right, the
receivables of the Project Parties are basically protected. The Senior Lender’s right to Step-in (2)
is, so to speak, a fair rehabilitation proceeding that is conducted out of court. If this is the case, the
court should respect this form of fair rehabilitation proceeding that was developed by private busi-
ness entities and that does not depend on a court proceeding, as long as the Senior Lender has the
will to exercise the right to Step-in (2). In regard to allegations that serve as the basis for com-
mencement of a rehabilitation court proceeding filed by the Project Company, the Sponsor (share-
holder) or any of the Project Parties, the court may find that they are insufficient (aside from the
reasoning for commencement of such proceeding). However, the author considers that in regard to
allegations that serve as the basis for commencement of a rehabilitation court proceeding filed by
a pure third party (for example, a creditor with a damages claim based on the tort committed by the
Project Company), a determination by the court to make such application ineffective might be dif-
ficult to achieve.
178 3  Business Theories of Project Finance

applicable. Also, to cure the former Project Company’s default under the old Project
Agreements, requirements that are basically the same as the requirements relating to
the exercise of the right to Step-in (2), which I discussed in (5), will be applicable.18

5.5.2.7  (7) The Right to Step-In of the Host Country/Off-Taker

For the sake of convenience, I now address the Host Country/Off-taker’s right to
Step-in. The right of the Host Country/Off-taker to Step-in allows the Host Country/
Off-taker to fulfill the Project Company’s obligation under the Concession/Off-take/
PPP Agreement in place of the Project Company (on behalf of the Project Company).
In this case, the Project Agreements are not transferred to the new Sponsor’s new
Project Company.
In the first place, acknowledgment of the Host Country/Off-taker’s right to
Step-in is important because a risk arises that the public service to be provided under
the Concession/Off-take/PPP Agreement may become unavailable to the nationals
in the event the Project Company defaults on its obligations under the Concession/
Off-take/PPP Agreement. The Host Country/Off-taker exercises this right to Step-in
to avoid this consequence temporarily. This right is equivalent to the right to Step-in
(1) in the case of the Senior Lender, and the affected Project Agreement is limited to
the Concession/Off-take/PPP Agreement. This right to Step-in of the Host Country/
Off-taker is to be stipulated in the Concession/Off-take/PPP Agreement.
Incidentally, the right to Step-in of the Host Country/Off-taker can only tempo-
rarily cure the Project Company’s default under the Concession/Off-take/PPP
Agreement. The remedy to be taken by the Host Country/Off-taker when the subject
default is definite is to terminate the Concession/Off-take/PPP Agreement entered
into between the Host Country/Off-taker and the former Project Company, and to
enter into a new Concession/Off-take/PPP Agreement with the new Project Company
established by the new Sponsor. Therefore, the right equivalent to the right to Step-in
(2) in the case of the Senior Lender is not required.19

5.5.3  O
 bligations of the Project Parties to the Senior Lender to Comply
with the Obligations Under the Project Agreements

The Senior Lender makes the Senior Loan of the project finance on the premise that
the Project Parties, particularly the Host Country/Off-taker, will comply with their
obligations under the subject Project Agreements. Therefore, if the Project Parties

18
 This countermeasure to be implemented in the event of the Project Company’s bankruptcy exists
in relation to the Project Agreements, but does not exist in relation to the other assets. In this
respect, the essential countermeasure to be implemented is to replace the Sponsor before the com-
mencement of bankruptcy of the Project Company.
19
 Incidentally, in some PFI/DBO projects in Japan, the granting of security interests on the equity
of the Project Company in favor of the Host Country/Off-taker is required. However, as there is no
rationality for this, it should be noted that this is a requirement that reflects a lack of understanding
in regard to the essence of PFI or DBO.
5  Characteristics of the Key Financing Agreements 179

breach their obligations under the subject Project Agreements, the premise for the
issuance of the Senior Loan of the project finance is lost. Of course, this risk cannot
be passed on to the Sponsor. For this reason, under the Direct Agreement, the Project
Parties covenant to comply with their obligations under the subject Project
Agreements. This obligation of the Project Parties is an obligation to the Senior
Lender. Accordingly, if the Project Parties breach their obligations under the subject
Project Agreements, in addition to their liability to the Project Company under the
subject Project Agreements based on such default, they become liable to the Senior
Lender based on their default under the Direct Agreement. This liability of the
Project Parties to the Senior Lender based on the default under the Direct Agreement
is a liability to pay monetary compensation damages. However, because the dam-
ages to be incurred by the Senior Lender will be the outstanding uncollected
amounts under the Senior Loan, the amount of the damage will be the monetary
amount equal to total outstanding uncollected amounts under the Senior Loan.
Regarding whether or not the Project Parties are to incur liability to pay the mone-
tary amount equal to the total of the outstanding uncollected amounts under the
Senior Loan as the damages incurred by the Senior Lender caused by the default
under the Direct Agreement, although the answer will depend on the governing law
of the Direct Agreement, generally speaking, that possibility is unlikely. However,
to definitely state that the Project Parties will not bear the subject liability at all
times would be impossible. In project finance, it appears, so to speak, that legally
uncertain conditions like this have become meaningful as the product of the com-
promise between the Project Parties and the Senior Lender.
Incidentally, in PFI in Japan, the Senior Lender is occasionally required to pledge
to the national and local governments, etc. its commitment to comply with the obli-
gations under the Financing Agreements. However, the financing in an NRI-PPP
Project is a matter to be performed by the Sponsor as its responsibility in the first
place; the attempt by the national and local governments, etc. to impose obligations
on the Senior Lender, the Sponsor and the Project Company in matters of financing
is against the essence of NRI-PPP Projects. Also, in the case where the Senior
Lender violates the terms of the Financing Agreements, even if the Project Company
or the Sponsor should incur damages as a result of such violation, the national and
local governments, etc. will never incur damages worthy of the protection they seek
to impose. The protection of the national and local governments, etc. is limited
essentially to the liquidated damages that are to be assessed upon the termination of
the Concession/Off-take/PPP Agreement, as stipulated in the Concession/Off-take/
PPP Agreement, and payment is secured by the payment guarantee issued by the
bank or will be effected by the reduction of the Availability Fee.
Although one party to a contract occasionally demands the same rights as those
possessed by the other party to such contract, the rights possessed by parties to a
contract will vary depending on the nature of the contract. Thus, it should be noted
that a demand, for the sake of formality, by one party to a contract for the same
rights possessed by the other party to the contract is an assertion that reflects such
party’s lack of understanding of the essence of such contract.
180 3  Business Theories of Project Finance

References

Anma, M. (1998). Mechanism and risk of project finance. International Finance (Kokusai Kin-yu),
(Dec. issue), 30.
Kaga, R. (2007). The practice of project finance. Kinzai Institute for Financial Affairs, Inc. (Shadan
Houjin Kinyu Zaisei Jijyo Kenkyukai): Tokyo.
Vinter, G., & Price, G. (2006). Project finance (3rd ed.). London: Sweet & Maxwell.
Index

A Design/construction period, 64, 65


Acknowledgment and consent agreement, 16 Direct agreement, 16, 171–179
Additionality, 30 Discounted cash flow (DCF), 108
Aircraft finance, 104, 105
Asset, 105, 106
Availability fee, 69, 79, 87 E
Availability fee payment type NRI-PPP EPC contract, 13, 98–100
projects, 67, 78, 128 EPC contractor, 9
EPC project, 22
Equity-IRR, 77, 107–109, 120, 147
B Equity-IRR/EIRR, 34
Back to back provision, 53–55 Equity leakage, 97
Bank for international settlements (BIS), 150 Export credit agency (ECA), 85, 161
Bankruptcy remoteness, 36–37
Build-lease-transfer (BLT) project, 22
Build-operate-transfer (BOT) project, 21, 23 F
Business performance capability, 60, 61, 123 Feed-in tariff (FIT), 72
Finance lease, 104, 105
Financial completion, 65, 158–163
C Financing agreements, 15–17, 157, 158
Capacity fee, 87 Fixing of the project, 69, 70
Cash flow structure, 142–157 Force majeure risk, 74, 83–84
Changes in laws, 71 Fuel supply and transportation agreement
Completion guarantee, 158–163 (FSTA), 58
Completion risk, 92–94, 127 Function to screen the sponsors, 121
Concession agreement, 11, 12, 73–96
Consulting agreement, 17
Cure period, 174 H
Historical DSCR, 155
Host country, 6, 7
D
DBO project, 26
Debt-equity ratio, 132–134 I
Debt service coverage ratio (DSCR), 99, 126, Independent consultant, 10
152–157 Independent engineer, 10

© Springer Nature Singapore Pte Ltd. 2019 181


T. Higuchi, Natural Resource and PPP Infrastructure Projects and Project
Finance, Economics, Law, and Institutions in Asia Pacific,
https://doi.org/10.1007/978-981-13-2215-0
182 Index

Independent power producers (IPP), 1 Principle of single point responsibility, 55–58


Internal rate of return (IRR), 34, 107 Private finance initiative (PFI), 2, 23–25
Investment, 39–48 Project, 105, 106
Project agreements, 11, 12
Project company, 8
L Project completion, 49, 51
Leverage effect, 109–112 Projected DSCR, 155
Lifecycle cost, 49 Project finance, 9, 103
Limited liability, 40, 41 Project-IRR, 108
Liquidated damages, 99–100 Project-IRR/PIRR, 34
Loan life coverage ratio (LLCR), 126, Project life coverage ratio (PLCR), 152–157
152–157 Project management services agreement, 14,
Local dividend stopper, 143–145 15, 55
Project period, 62
Project revitalizing function, 122, 123, 167
M Proven technology, 117
Market risk, 80, 128 Public sector comparator (PSC), 29
Market risk-taking type NRI-PPP projects, 66, Public-private partnership (PPP), 2, 23–25
81, 128
Monitoring, 38, 130, 131
Monitoring function of an NRI-PPP project, R
121, 122 Rating, 61
Multilateral development bank (MDB), 161 Return on equity (ROE), 110
Return on investment (ROI), 110
Revitalization, 130, 173
N Rights to step-in, 165, 171–179
Net present value (NPV), 108 Risk sharing, 73–86

O S
Off-balancing, 114, 115 Screening function of an NRI-PPP project,
Off-take agreement, 11, 12, 73–96 120, 121
Off-taker, 6, 7 Securitization, 105
O&M agreement, 12, 13, 97 Security agreement, 16
O&M operator, 8, 124 Security interests, 164–171
Operation, 39, 40, 49 Security package, 163
Operational completion, 64 Senior lender, 9
Operation period, 64, 65 Senior loan agreement, 15
Operation risk, 90, 91 Shareholder, 7
Special purpose company (SPC), 8, 35–38, 53
Sponsor, 7, 124
P Sponsor support, 162, 163
Paper company, 53–55 Sponsor’s subordinated loan agreement, 14
Passive (Defensive) reason, 164 Sponsor support agreement, 15, 16
Pass-through of risks, 53–55 Subordinated loan, 143–151
Physical/mechanical completion, 64 Sustainability, 72, 73, 129
PIRR, 108
Political risk, 84
Political risk carve-out, 161 T
PPP agreement, 11, 12, 73–96 Take or pay, 68, 69
Principle of owner-operator, 50 Thin capitalization, 143
Principle of proven technology, 61
Principle of single business, 52, 53
Index 183

U W
Usage fee, 87 Waterfall provisions, 124, 134–142, 158

V
Value for money (VFM), 29, 120