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Introduction to Infrastructure

Financing Large Scale Projects
Corporate Finance V/S Project Finance

Equity Debt

Corporate Finance V/S Project Finance

Equity Corporate Finance Project Finance

Debt 1/3 2/3
Equity 2/3 1/3

Equity Debt Equity Debt Equity Debt

Project 1 Project 2 Project 3

• Each Project is a SPV

– Has its own set of Financers, CFs, Risk.
Major potion of the equity is given by
2-3 sponsors
Isn’t this counter

Then how is it
possible for
Take to raise
Active large
Sponsors debt?
related to Passive Investors
Technology, Fuel,
the projectetc.

Corporate Finance Project Finance
• Which is more risky or uncertain: financing
Contractual Agreements
it have
is non
lenders 2/3limited
or and
corporations or financing projects?
Equity 2/3 1/3
Historical Annual Project Finance
Default Rates 2001-10
Who should go for Project Finance
1. Capital investment projects that are capable
of functioning as independent economic units
2. Can be completed without undue uncertainty
3. When completed will be worth more than the
cost to complete
Project CFs go to project
Projects have finite life
lenders and sponsors
Which project specific characteristics
should be considered
1. Credit requirements of lenders- profitability of the
project and indirect credit facility that would be
provided (viz. by suppliers)
2. How is the project tax shield being shared between
capital providers
3. Impact of project on the agreements governing the
sponsor’s existing debt obligation
4. Regulatory requirements that the project must satisfy
Decommissioning or environmental restoration
5. Accounting treatment
liabilities.of project
So the liabilities
BV of the asset and
cost may also
include the decommissioning cost for purpose of
contractual agreements depreciation
Why Project Finance
• Traditional School of thought: Shah and Thakor (1987) very large, high
risk projects.
• Chen, Kensinger and Martin (1989) PF is used even in medium size
low risk projects such as cogeneration facilities.
• Chemmanur and John (1996) explain the need for PF on the basis of
its benefits of corporate control
Desire for control
How Project Finance Creates Value?
Low High
Agency Costs

Low Increasing ITS High

Availability of Internal Resources

Low High
Comprehensive Contractual Agreement
an d Construction
Agreement Fixed or variable
Output Dedication:(with a threshold and acap)
Contractor Tolling Contract: Co.Supplier
May selldedicates
to the most
Design, portion Supplier
of output supply
generated from a specific
profitable client but has to pay a availability
Service definition,
Equipment, Interruptiblesource
gas as
– low cost but can be
charge to the projectcoal
etc.) interupted

Debt to equity
What if someone wants to
Government Project Company
License Concession period (SPV)
Who getshow
to sit
a company
on the
will be ownedboard
and managed
Can a investor be fired

Off take Agreements:

- Take Customer
or pay Availability period during which the
Power Purchase Agreement borrower is expected to pay a
Long Term sales commitment fee
Details such as how long, how Repayment Clause, Key ratios,
much, at what price etc. dividends, representations, warranties
History of project Finance
Devon Mines in
However, they did not
• In 1299- England and
take care of the mine
and hence the contract
Is this long term or
was terminated after a
short term
year of ops
The lender could take
Italian as much unrefined
Merchant ore as it could extract
Bankers during that year

Such agreements are called Production Payment

Project Life Cycle

Viability Construction Operation
What is financial Closure?
Financial Closure and Contractual agreement? (EPC,
Where is most of thepower purchase,
investment fuelhappening???
CAPEX supply etc.)

Who invests in the Development phase???

Financial closure
Structure Highlights

• Independent, single purpose company formed to build and

operate the project.
• Extensive contracting
– As many as 15 parties in up to 1000 contracts.
– Contracts govern inputs, off take, construction and operation.
– Government contracts/concessions: one off or operate-transfer.
– Ancillary contracts include financial hedges, insurance for Force
Majeure, etc.
Structure Highlights

• Highly concentrated equity and debt ownership

– One to three equity sponsors.
– Syndicate of banks and/or financial institutions provide credit.
– Governing Board comprised of mainly affiliated directors from
sponsoring firms.
• Extremely high debt levels
– Mean debt of 70% and as high as nearly 100%.
– Balance of capital provided by sponsors in the form of equity or quasi
equity (subordinated debt).
– Debt is non-recourse to the sponsors.
– Debt service depends exclusively on project revenues.
– Has higher spreads than corporate debt.
Comparison with Other Vehicles
Financing vehicle Similarity Dis-similarity

Secured debt Collaterized with a Recourse to

specific asset corporate assets

Subsidiary debt Possible recourse to

corporate balance

Asset backed Collaterized and non- Hold financial, not

securities recourse single purpose
industrial asset

LBO / MBO High debt levels No corporate sponsor

Venture backed Concentrated equity Lower debt levels;

companies ownership managers are equity
Disadvantages of Project Financing
• Often takes longer to structure than equivalent size
corporate finance.
• Higher transaction costs due to creation of an
independent entity. Can be up to 60bp
• Project debt is substantially more expensive (50-400
basis points) due to its non-recourse nature.
• Extensive contracting restricts managerial decision
• Project finance requires greater disclosure of
proprietary information and strategic deals.
Motivations: Agency Costs
Problems: Structural solutions:
• High levels of free • Concentrated equity ownership provides
cash flow. critical monitoring.
Possible • Bank loans provide credit monitoring.
managerial • Separate ownership: single cash flow stream,
mismanagement easier monitoring.
through wasteful
expenditures and • Senior bank debt disgorges cash in early years.
sub-optimal They also act as “trip wires” for managers.
Motivations: Agency Costs
Problems: Structural Solutions:
• Opportunistic • Vertical integration is effective in precluding
behavior by trading opportunistic behavior but not at sharing
risk (discussed later). Also, opportunities for
partners: hold up.
vertical integration may be absent.
Ex-ante reduction in
• Long term contracts such as supply and off
expected returns.
take contracts: these are more effective
mechanisms than spot market transactions
and long term relationships.
Motivations: Agency Costs
Problems: Structural Solutions:
• Opportunistic • Joint ownership with related parties to share
behavior by trading asset control and cash flow rights. This way
counterparty incentives are aligned.
partners: hold up.
Ex-ante reduction • Due to high debt level, appropriation of firm
value by a partner results in costly default
in expected
and transfer of ownership.
Motivations: Agency Costs
• Opportunistic Structural Solutions:
behavior by host • Since company is stand alone, acts
governments: of expropriation against it are highly
expropriation. visible to the world which detracts
Either direct future investors.
through asset
seizure or • High leverage forces disgorging of
creeping through excess cash leaving less on the table
increased to be expropriated.
tax/royalty. Ex-
ante increase in
risk and required
Motivations: Agency Costs
• Opportunistic Structural Solutions:
behavior by host • High leverage also reduces
governments: accounting profits thereby reducing
expropriation. local opposition to the company.
Either direct
through asset • Multilateral lenders’ involvement
seizure or detracts governments from
creeping through expropriating since these agencies
increased are development lenders and
tax/royalty. Ex- lenders of last resort. However
ante increase in these agencies only lend to stand
risk and required alone projects.
Motivations: Agency Costs
Problems: Structural Solutions:
• Debt/Equity holder • “Cash flow waterfall” reduces managerial
conflict in distribution discretion and thus potential conflicts in
of cash flows, re-
investment and distribution and re-investment.
restructuring during • Given the nature of projects, investment
distress. opportunities are few and thus investment
distortions/conflicts are negligible.
• Strong debt covenants allow both
equity/debt holders to better monitor
Motivations: Agency Costs
Problems: Structural Solutions:
• Debt/Equity holder • To facilitate restructuring, concentrated
conflict in distribution debt ownership is preferred, i.e. bank
of cash flows, re- loans vs. bonds. Also less classes of
investment and debtors are preferred for speedy
resolution. Usually subordinated debt is
restructuring during
provided by sponsors: quasi equity.
Motivations: Debt Overhang
• Under investment in
Structural Solutions:
Positive NPV projects at the
sponsor firm due to limited
• Non recourse debt in an
corporate debt capacity. independent entity
Equity is not a valid option
due to agency or tax
allocates returns to new
reasons. Fresh debt is capital providers without
limited by pre-existing debt
covenants. any claims on the
sponsor’s balance sheet.
Preserves corporate debt
The underinvestment problem
Firm faces the following outcomes with equal probability of either state
of nature
Boom Recession Expected
Value 5000 2400 3700
Debt 4000 - 3200
Equity 1000 - 500

There is a positive NPV project with a value of 1700 after investing 1000. Will Debt holders
provide capital?
Boom Recession Expected
Value 6700 4100 5400
Debt 4000 Why does this happen?
4000 4000
Equity 2700 100 1400

Will Equity providers invest?

Motivations: Risk Contamination

Problems: Structural Solutions:

• A high risk project can • Project financed investment exposes the
potentially drag a corporation to losses only to the extent of
healthy corporation its equity commitment, thereby reducing
into distress. Short of its distress costs.
actual failure, the risky • Through project financing, sponsors can
project can increase share project risk with other sponsors.
cash flow volatility and Pooling of capital reduces each provider’s
reduce firm value. distress cost due to the relatively smaller
Conversely, a failing size of the investment and therefore the
corporation can drag a overall distress costs are reduced. This is
healthy project along an illustration of how structuring can
with it. enhance overall firm value. That,
contradicting the MM Proposition.
Motivations: Risk Mitigation
• Completion and operational risk can be mitigated
through extensive contracting. This will reduce cash
flow volatility, increase firm value and increase debt
• Project size: very large projects can potentially
destroy the company and thus induce managerial
risk aversion. Project Finance can cure this (similar to
the risk contamination motivation).
Motivations: Other

• Tax: An independent company can avail of tax holidays.

• Location: Large projects in emerging markets cannot be
financed by local equity due to supply constraints. Investment
specific equity from foreign investors is either hard to get or
expensive. Debt is the only option and project finance is the
optimal structure.
• Heterogeneous partners:
– Financially weak partner needs project finance to participate.
– It bears the cost of providing the project with the benefits of project
– The bigger partner if using corporate finance can be seen as free-
– The bigger partner is better equipped to negotiate terms with banks
than the smaller partner and hence has to participate in project
Alternative Approach to Risk
Risk Solution

Completion Risk Contractual guarantees from manufacturer,

selecting vendors of repute.
Price Risk hedging

Resource Risk Keeping adequate cushion in assessment.

Operating Risk Making provisions, insurance.

Environmental Risk Insurance

Technology Risk Expert evaluation and retention accounts.

Alternative Approach to Risk
Political and • Externalizing the project company by forming it abroad
Sovereign Risk or using external law or jurisdiction
• External accounts for proceeds
• Political risk insurance (Expensive)
• Export Credit Guarantees
• Contractual sharing of political risk between lenders and
external project sponsors
• Government or regulatory undertaking to cover policies
on taxes, royalties, prices, monopolies, etc
• External guarantees or quasi guarantees
Interest Rate Risk Swaps and Hedging
Insolvency Risk Credit Strength of Sponsor, Competence of management,
good corporate governance
Currency Risk Hedging
Sources of Capital-1
Banks Private Placement Public Issue

Tenure Medium (5-7 Medium to LT(7-

LT(10 -15years)
years) Typically
10 insurance
years) cos. In
indian context. O.w.
pension funds , university
endowments etc.
Interest Rate Floating Fixed Fixed

Highest but
services such High to
as dem esti, medium
viability etc.
Sources of Capital-2 International
Credit Markets
• Cheaper capital from investors used to long term
investments. But due to unfamiliarity with doing
business in the economy would like:
– ToVendor
establish economic
Credit (Vendor has better viability beyond
understanding doubt
of the project
But Vendor is not a banker so refinance)
– Protection against competition
– Borrower/Sponsor’s track record
EXIM Bank of the Equipment Supplier country
– Attractiveness of currency, Inflation
– Political, Economic and Policy Stability
Multilateral Donor Agencies (WB, IFC, ADB, AfDB)

Bi lateral Donor Agencies AusAid, USAID, DFID (UK)

Clause for procurement
Sources of Capital-3 VGF
• If all capital private, then tariffs may be
discriminatory and the larger objective of welfare
may be lost. Hence, the State inorder to make
services non discriminatory and accessible may
provide funds for the project.
– Provided to the lowest bid asking for capital (subsidy)
subject to a max of 20% of the total project cost
– Another 20% possible through the respective ministry
Sources of Project Finance
Refinance (Hard, Soft)
But As the Project Progresses…Risk
Initially is more
comes expensive!!!
uncertainty is So…
Dividend Debt

Equity Debt Market

Financing Choice: Equity vs. Debt
• Reasons for high debt:

– Agency costs of equity (managerial discretion,

expropriation, etc.) are high.

– Agency costs of debt (debt overhang, risk shifting) are low

due to less investment opportunities.

– Debt provides a governance mechanism.

Financing Choice: Sequencing
• Starting with equity: eliminate risk shifting, debt overhang
and probability of distress (creditors’ requirement).

• Add insider debt (Quasi equity) before debt: reduces cost of

information asymmetry.

• Large chunks vs. incremental debt: lower overall transaction

costs. May result in negative arbitrage.
Oil and Gas resource auctions in India
Revenue sharing contracts
1. Developed will have
economies (US,toUK)
follow athe oil and
revenue gas that
they will share with
arrangement and the
2. Developing at different
economies levels
production. follow
They also
to indicate the revenue that
CAG criticised this they will share at different
tendency price levels. Coal Bed
Oil and Gas
cost went up from Methane
2.4 b$ to 8.5 b$
Needs close scrutiny of
costs since there is
The contractor first Contractor Pays Production
an agreed
incentive to overbook or
Sharing Industry is opposed to the shift to PLP
recovers cost and then PLP safeguards the amount to
government govtLinked
gold plate and reflect
Contract because they feelscrutiny
it disincentivises high
shares profits 1.
Too much
case risk Panel
cost has
of aexploration
windfall arising as in
on the
from PSC is
price PLP
surge for
of output.
costs through transfer such as deepwater
upon as aboth
surprise bybecause:
geological contractor
find.contractor earns
pricing that do not reflect exploration.more and the govt.
true economic activity
Revenues too are in line
with production
KG Basin Scam
This makes the entire bidding
• CAG report cites violation of PSC: process a laughing stock
because it was on the basis of
– Gold Plating as shown earlier.. Their justification,
profit shares, now with theit was
capex, one can minimise profits
necessary for capacity doubling to increase the capex
from 2.4 to 5.2 bn $. And later to 8.5 b $
• High price of gas
– A EGoM set in 2007 under chairmanship of Pranab
Mukherjee has allowed $4.2 per MBTU to RIL. They had
ealier agreed to $2.34
Aroundand also
the same separately
time, ONGC was (as a result of
being paid, $1.8 per MBTU
sibling rivalry) accepted that the production cos was
Kochi Metro

Remaining Rs.
1336 crore should
Agency Francaise de be raised by SG
Development (AFD) and CG Canara
Rs. 1170 crore
subordinate loan @ 10.8%
Rs. 1,525 crore loand at KMRL (Rs. 5537 for 20 years with a
2% for 25 years with a Crore) moratorium of seven years
moratorium of five years

SG and CGSponsor
Rs. 753 crore each
Contractual Systems in
developing Petroleum Assets
Three Dominant Systems
1. Concession/Licensing Agreements
2. Joint Venture Agreements
3. Production Sharing Agreements
Concession or Licensing Agreement
Concession or License Agreement
• Government gives concession to a operator (exclusive
rights) to Explore, Develop, Sell and Export Oil or other
minerals from a specific area for a defined period.
• Advantage:
– Concessions are less complicated as compared to a JV or PSA
– It is best for home government because the entire financial
risk is borne by the bidder.
• However there are two issues
– Loss of time in bidding
– May not attract the best bidder who is financially strong and
technically competent.
• Disadvantage
– No knowledge of potential (of the reserve) in other words
incomplete information can hurt either party... But never
Questions to Government
• Were tender terms made public?
• Length of the Concession
• How many people bid
• What has the successful bidder agreed to pay
• Who was the external advisor
• How long is the work program and how much will
the bidder invest
• What is the revenue share agreement between the
Central Government and the Local Government
Questions to Companies
How much will be paid for the concession and to
Criteria for choosing the local sub contractor
Joint Venture Agreement
Joint Venture
National Oil
Companies Pure JV: All Costs/Risks Shared

R Partner ship between NoC and IoC

I Risks and Costs are shared between the two
S E.g.: Nigeria,Typical
Northwest shelf (Australia) andthrough
Russia Disadvantage:
JV: Government carried
K Govt. Is a
exploration phase
equal partner
S to litigations
H Env. Etc.
A Needs a good
R Full Carry JV: Government carried through understanding
I exploration and development Pre Nuptial
N Agreement

Former Soviet Union Type JV: Government

International carried through rehabilitation and
Oil development until cash flows start
Questions to Government
• What is the exact purpose of the JV?
– Is it for exploration, development, operation
• What will each party contribute?
– Cash, Knowhow, Management
• What will each party receive?
• What is the responsibility of each party?
– Operation, sales, government coordination
• How long will the JV remain in existence?
• What are the agreements that constitute the JV?
– Establishment Agreement: Codifies the JVs governance provisions
– Operating Agreement: Codifies how oil field ops are to be managd
• How is the JV going to be terminated
– Under what circumstances can one party unilaterally terminate
• What was the JV format chosen?
• What is the government receiving for taking this risk?
Production Share Agreement
Production Sharing Agreement
– Started in 1960 in Indonesia
– State retains ownership
• Would negotiate a profit sharing agreement
– Prominent in Central Asia
– Work commitment
– Bonus Payment
• Host Government often earns a signup bonus
– Royalties Grey areas
depending on
• Will the company pay royalty once production beins
– Recovery of Production Cost
• Current operating expense, expenses for materials consumed
in the year, capex
• Advantages to Host Gov
– Financing and operating risk remains with the private oil co. The only
loss is the cost of negotiation (fee paid to advisors)
– If PSA is well drafted then on non compliance, Govt can terminate the
existing contract and invite a new private firm
• Complexity of PSA would depend on the soundness of the legal
Soundness of legal

Complexity of PSA
• If PSA is enacted into a law, then it provides security to pvt oil cos.
As a result, gov, surrenders its right to adopt new laws and
regulations in public interest if it adversely affects their interest.
• Conversely, leaving the PSA flexible is not the greatest for the local
government because it lays stress on having access to technical,
financial, commercial and legal expertise.
Questions about PSA
• Was there a competitive bid
• What types of payments will the government
receive? (Bonus etc.)
• What other payments will the companies make?
• Are companies obliged to invest in local
communities (hospital, school etc.)?
– Will the govt. Give tax concessions?
– Is the commitment to be deducted from taxes or open a
credit line against tax obligation?
• How is the profit going to be shared?
• How is the cost of environmental damage to be
Regulatory Pricing Mechanism: Regulation
•Regulation of public utilities has traditionally been
justified on ground of public interest and natural
monopoly characteristics(Priest, 1993)
•Types of regulation
•Dominant form of regulation is public (Blundell and
Robinson, 1999)
•Some view regulation as a temporary phenomenon till
effective deregulation involving competing private firms
are introduced.
Incentive based regulation as a dominant
alternative to RoR or Cost of Service Regulation
• Main obj of incentive regulate is to promote efficiency
improvement by rewarding good performance relative to some pre
defined benchmark.
• Approaches to incentive based regulation
– Rate of Return Regulation
– Price Cap Regulation
– Cap on Total Revenue
– Cap on Average Revenue
– Combination of the two
– Weighted Avg Price Cap
– Earning Share Regulation
• As a first step Benchmarking
• Comparison of Actual performance against a reference or
benchmark performance
Rate of Return Regulation
An estimate of cost (opex, capex, tax, dep) and
demand associated with a recent historic ‘test’ year
for providing a set of services in that year
Set of products or services to be supplied is
Given the volumes the expected aggregate cost of
supply is estimated and a consultatively agreed
upon fair rate of return is added.
Find the per unit service price
Dis/advantages of RoR
• Close alignment between price and cost
• Safer for the contractor and hence easy to attract
Some of the ways in which the industry has addressed these
issues are by:
(i) Value of the RAB is determined on basis of efficiency costs
• Issues
(ii)Extending the length of the control period
–(iii)Disallowing operating
If Regulator has limitedcosts which areabout
information assessed to be
the supplier’s
costs or
– Unable to confidently audit the operators actually costs
– Known problem of Gold Plating
• RoR is best suited to regulated sectors where limited cost
or productivity efficiency gains are possible
• Additionally eco setting where the regulator is able to
obtain sufficiently accurate and detailed information about
costs and future consumer demand, RoR, in principle
allows the regulator to set efficient tariffs.
• However, RoR would not work where:
– (i) Existing suppliers (benchmarks) are not fully efficient
– (ii) where the industry is ‘dynamic’ viz. Rapid demand or
technological change
• Maximum allowable average price (revenue) path
for a set of relevant services for a specified period
– This price path is independent of the ‘actual cost’ of
providing this service.
– 1+RPI-X
Average price is set so as to be independent of the
controllable costs of the supplier for a significant
period of time
Types of PCR
• Cap on total Revenue: Revenue earned is constant
and is independent of the fluctuations in the
quantity supplied.
– Who bears the risk of demand volatility? Consumers
– When demand is falling prices will ______________?
• Operator has a perverse incentive to:
– Reduce volume of sale
– Degrade quality of services
– To Reduce consumption supplier may set prices above
marginal cost on the most elastic services
Types of PCR
• Cap on Average Revenue: Allowable average revenue
per each unit of output is capped.
Note: Actual revenue earned on each unit is not capped
– Who bears the risk of demand volatility? Supplier
• If dem lower than expected? Part of FC not recovered
• If dem is higher than expected? Higher Profits
• Supplier therefore has incentive to expand demand beyond
what is forecast.
• Increase the quality of service offered to high demand
• Price the service to encourage greater usage by high
demand customers.
X-Factor for the first control period
in IGIA Delhi
Types of Benchmarking
• Frontier Based Benchmarking
• Mean and Average Benchmarking
• International Benchmarking
Frontier based benchmarking
• Estimate the efficient performance frontier from
best practices in the industry from within a
sample of firms.
Efficient frontier is the benchmark against which
the performance of individual firms is measured
– Frontier Based Benchmarking-Data Envelopment
Analysis (DEA)
– Mean and Average benchmarking - Corrected
Ordinary Least Square (COLS)
– Stochastic Frontier Analysis (SFA)
Data Envelopment Analysis
• DEA does not require specification of production or
cost function
• Allows calculation of allocative and technical
• Technical efficienyc can further be decomposed into
scale, and pure technical efficiencies.
• Can be used in conjunction with Malmquist indices
Efficiency Benchmarking using DEA- Input
Variables - Genco
• Opex (Rs/Unit)
• Number of Full time employees
• Hydro power capacity (% and MW)
• Thermal power capacity (% and MW)
Corrected OLS
• Instead of looking at frontier functions this method
estimates effieicenty measures based on mean or
average performance (production or cost function).
• The actual peformance of the firm can be compared
to the estimated pefromance by plugging their
inpur output and evniromental data into the
estimated (coefficients) function.
Aim of Power Sector Reforms
To Achieve allocative and internal efficiency through
competition, privatization and price mechanism
(Vicekrs and Yarrow, 1988)
What are the possible reforms?
• Introduction of competition in generation
• Design of Organised power markets
• Unbundling of Generation, transmission,
distribution and supply (retail)
• Ownership reforms or privatization of existing
What are the reforms generally taking
• First acceptance of price mechanism
• Competition in generation and supply
• T&D generally kept as natural monopoly
Geographic Distribution of
Project Finance
Sector wise distribution of PF
PF by source of funding
Top deals in EMEA
Top Deals in Americas
Top Deals in Asia and Pacific
Top Deals in Europe
Break up of use of PF in Social
Conventional V/S Renewable
energy by value
Global players in PF
Global Book Runners