FINANCING DEVELOPMENT

Project Finance - Background

Traditionally, financing for large projects in developing countries was channeled primarily through states. States borrowed money to finance the project, retained ownership of the project once it was completed, and operated the facilities themselves. However, a shift away from this model has been underway for several decades. Cash crunches, caused in part by high debt loads, reduced the ability of states to borrow sufficient funds to finance needed infrastructure. Additionally, some commentators believe governments wished to distance themselves from projects that garnered negative publicity because of alleged human rights and/or environmental abuses. Pressure from international organizations and foreign governments to liberalize and privatize economic activities may have also contributed to reductions in state involvement in various sectors of the economy. Whatever the reasons, private actors now play a significant role in sponsoring and operating of infrastructure projects. The preferred method of financing is known as project finance.

Project finance involves financing provided with recourse to the assets associated with a specific project rather than the sponsor’s entire pool of assets. A key feature of this method of financing is that the project assets are owned and operated by a separate legal entity - the project company - that is owned and controlled by the sponsors. The other key feature is that financing is provided to the project company rather than the sponsors. This structure prevents the financiers from having recourse to the assets of the sponsors, except to the extent that the sponsors provide guarantees of the project company's obligations. Financing can be obtained from either financial institutions - including quasi-public institutions such as the International Financial Corporation (part of the World Bank Group) and the European Bank for Reconstruction and Development - or the capital markets. It is also conventional to take out insurance on the project to cover various contingencies, including those known as 'political risk.'

The project company is also the entity that enters into contracts with suppliers and customers. In cases where the viability of the project depends upon access to a crucial input or upon the revenues from a particular customer the project company typically enters into some sort of long-term contract. These contracts, together with the agreements governing the construction and operation of the project, usually require a considerable amount of time and money to negotiate.

Project Finance Graphic

Economic advantages of project finance vs alternative methods of financing

Project finance resembles but is distinguishable from either secured borrowing or securitization:

Making a secured loan to the sponsor secured by the project assets would normally give lenders recourse to sponsors’ assets in addition to project assets in the event of default. At the same time, depending on applicable insolvency laws, a secured lender's claim over the project assets may be subordinated to the claims of other creditors of the sponsor.
Securitization of the financial assets generated by a project does not give financiers recourse against the project's non-financial assets.

The transaction costs of project financing compared to secured lending, and possibly even securitization, are relatively high. However, there are several offsetting benefits:

Limited recourse helps to minimize conflicts with the sponsor’s existing creditors. More specifically:
- Giving project lenders priority over the assets of the project helps them to avoid concerns about sharing the benefits of the project with the sponsors’ other creditors. Without this priority, project lenders have inadequate incentives to provide financing lest other lenders recover the project’s assets in the event of default.
- Limiting the project lenders' recourse to assets of the sponsor gives the sponsor's existing creditors reason to permit the financing without fear of dilution.
- Limiting the project lenders' recourse to the assets of the sponsor makes other financiers willing to extend financing to the sponsor without fear of dilution.
- In the event of default, limiting the number of creditors interested in any given pool of assets can reduce the time and expense of negotiating a restructuring.
Segregating assets may make them easier to monitor and value. If a venture was undertaken as an operation of the sponsors without creating an external legal entity, it would be much more difficult to differentiate between the sponsor’s operations and those associated with the venture.

Many projects involve large free cash flows, making them vulnerable to managerial misappropriation. Project company governance structures can be tailored to limit managerial discretion.
- Project company capital structures can be structured with high leverage to force managers to disgorge free cash flows.
- The number of investors (shareholders and creditors) can be limited to discourage investors from free-riding on one anothers' monitoring efforts.
- Compensation schemes within the project company can be tailored to provide project-specific incentive structures. This is arguably easier to accomplish if the project company is an independent entity rather than a division of a sponsor.

Segregating project assets may make expropriation more visible and thereby reduce political risk associated with a project. A foreign government may find it easier to expropriate a relatively small part of a large transnational corporation than to simply expropriate an entire company. Additionally, high leverage reduces expropriation risk by a) reducing reported profits and b) making expropriation more likely to trigger responses by external investors, who may have relatively significant amounts of political leverage.

What types of projects are financed through project finance?

Project finance is typically used for projects in infrastructure and extractive industries, including:

Mines
Water and sewage systems
Power plants
Energy transmission systems
Pipelines
Roads
Railways
Airports
Ports

Social, economic and political impacts on the host society

Many large projects promote the economic development of the host country by providing employment, profits and technology transfer for local suppliers, tax revenue for the state, and, in some cases, additional goods or services for local customers.

However, the operation of projects that make use of project financing may also have adverse effects in the host society. For instance, many of the projects listed above can result in environmental pollution or displacement of residents. In addition, where the project creates a monopoly over the production of locally-consumed goods or services, such as electricity, water or transportation, local consumers may be prejudiced by exploitative pricing policies.

Projects that generate revenues from overseas can also be associated with adverse economic or political effects within the host state.

Economic effects:
- If the project causes a large boost in exports, the result may be that the host nation’s currency will appreciate in value. Generally, an appreciation of this sort makes a nation’s other exports less competitive, as foreign buyers essentially must pay a higher price for them.
- By driving up prices of non-traded goods – e.g. housing - resource industries can make other industries such as manufacturing uncompetitive. This can be problematic if manufacturing is more likely to contribute to growth than other industries.
- Governments can take proactive steps to reduce these effects (known as the 'Dutch Disease'), such as investing certain amounts of money overseas so as to avoid driving up either the currency or the price level and thereby crowding out non-resource exports.
Political effects:

The more access a state has to cashflows from export-oriented projects the less dependent it is on tax revenues or foreign financiers. This makes governments less accountable to external constituencies and can undermine their incentives to govern soundly.
Actors' efforts to win control of lucrative projects, either directly or by obtaining control of the project sponsors, can be wasteful and even destructive.

States sometimes respond to these concerns by adopting special laws that govern how revenues from projects are to be spent. This strategy is particularly common among oil-producing countries. Usually the proceeds from projects are put into special funds that serve specific purposes, such as investing in education or simply to serve as reserve for a future time when revenues are inadequate.

The international community has responded to these concerns by promoting transparency in financial transactions between states that host lucrative export-oriented projects and foreign companies. For instance, the Publish What You Pay coalition of over 300 NGOs worldwide calls for the mandatory disclosure of the payments made by oil, gas and mining companies’ to all governments for the extraction of natural resources. The coalition also calls on resource-rich developing country governments to publish full details on revenues. Advocates of the movement argue that transparency will place pressure on governments to use the revenues from projects to more effectively promote economic growth. The World Bank has endorsed this strategy by adopting its Extractive Industries Transparency Initiative.

Role of the project agreements

The project documents serve to allocate risks amongst the parties involved the transaction. From a commercial perspective, the most important risks are the following:

Completion risk
Operating risk (mismanagement)
Resource risk (availability of inputs)
Market risk/currency risk (value of outputs)
Political risk (state actions that affect revenues)

Role of background law

The social, economic, and political implications of projects are influenced by a variety of bodies of law.

Host state regulation of foreign investment
- Countries have laws that limit foreign investment in various sectors or only permit it at the discretion of government officials.
- Many states are subject to international obligations that limit their ability to regulate foreign investment. The sources of those obligations include:
  - Agreement on Trade-Related Investment Measures (TRIMs)
  - The General Agreement on Trade in Services (GATS)
  - Bilateral Investment Treaties (BITs) and regional agreements such as the North American Free Trade Agreement (NAFTA)
- Many multilateral organizations discourage countries from adopting restrictions on foreign investment.

Self-imposed policies of financiers
- Many lenders require the projects they support to meet social and environmental standards that are independent of any binding legal obligations. A significant number of private project finance lenders have endorsed the Equator Principles, which commit them to ensure that the projects they support meet social and environmental standards set by the International Finance Corporation to guide its own operations.
- Methods of enforcing these obligations vary. For instance, some of the multilateral financial institutions have established ombudsmen or quasi-judicial bodies charged with overseeing compliance with their operational policies.

Contract law
- Concerns include:
  - Enforceability of stipulated damages clauses.
  - Enforceability of choice of law, choice of forum and arbitration clauses.
  - Enforceability of obligations in the hands of assignees.
  - Recognition of foreign judgments and arbitral wards.
  - Speed, integrity and efficacy of local enforcement of judgments.
Law of secured transactions
- Concerns include:
  - Onerous registration or search requirements.
    - Can inhibit taking collateral over floating assets such as cash, inventory or small items of equipment.
  - Limitations on effective scope of collateral, such as failure to extend security interests automatically to proceeds.
  - Involuntary subordination to other creditors.
  - Absence of right to repossess collateral.
  - Delay in exercise of right to repossess or sell collateral.
    - Repossession may require a prior judicial hearing either in all cases or in bankruptcy.
    - Sale may be conducted by public official with onerous notification requirements.
Domestic laws that affect the value of the project to its investors and sponsors
- Projects typically implicate a broad range of domestic laws of general application, including:
  - Immigration laws
    - Many projects will require professionals with specific technical skills to be on site. Often such labor cannot be supplied domestically and must be brought in from elsewhere.
  - Environmental and safety laws
  - Tax laws
  - Currency controls
- Changes in these laws, or outright physical expropriation, can seriously impair the value of the project to investors and sponsors.
  - Projects are often designed to minimize the host state's incentive to take such action. Staging the investment, withholding critical technology, or involving actors such as official creditors or political risk insurers who can threaten to cut off future dealings with the state are all ways of creating disincentives to expropriate.
- Sponsors and financiers of large projects often obtain agreements that require the host state to exempt them from specified domestic laws or to provide compensation for changes in the law. (Provisions designed to insulate foreign investors from the effects of changes in the law are sometimes referred to as stabilization clauses.)
- International legal obligations such as customary international law and the provisions of Bilateral Investment Treaties (BITs) limit host states' ability to expropriate the assets of foreign investors or otherwise treat them unfairly, including by reneging on agreements designed to insulate them from the effects of domestic law.
- Many commentators are concerned that these sorts of international obligations place undue restrictions on host states' ability to adopt socially beneficial laws.