energy project finance

energy project finance

The Role of Project Finance in the Energy Sector

1. Introduction to Project Finance

At its core, project finance is unique because it relies on the project company’s assets and income stream, independent of the assets and liabilities of its sponsor(s). This is the bedrock principle underlying the theory of project finance, whereby the project is structured as a stand-alone contractually-based economic entity independent of the sponsor companies. Following from this, the sponsors are shielded to the extent possible from adverse changes in the project’s fortunes. In the event the project goes bad, it is the limited recourse nature of the financing source that is most attractive to the equity and debt providers that distinguishes project finance.

1.1. Definition Project finance refers to financing techniques which primarily rely on the project’s expected future cash flow to meet the anticipated cost of, and the risks associated with, a particular project. In simple terms, project finance is the process of raising money to fund an exceptional capital expenditure from and against the future cash flow of the project being financed.

In this book, we consider the development of a single new large-scale energy project and the associated project finance as a lens for analyzing the functioning and the role that project finance plays in the broader energy sector. The first part of the book is intended to provide the reader with a better understanding of project finance, and hence, justifies that explanation.

2. Project Finance Structures in the Energy Sector

Project finance is an ideal financing technique for large-scale and capital-intensive energy projects that are designed to be separated from other assets owned by a sponsor. Prima facie, project finance appears to be a complex mix of legal, financial, and technical arrangements. These arrangements are, in actuality, required to resolve a dilemma. The dilemma lies in the need of power developers to construct clean, new, and efficient plants, ensure their market acceptability, and reap profits from the project. The financiers, mostly banks and leasing companies, and host countries aim to place as much risk on the developer as possible due to strict preconditions for turning a project into a merchant plant (that is, a plant without power purchase agreement reliance). In project finance, a utility sees enough marketing benefits, therefore it turns to a project as its primary project agent. It has to make capital contributions and reduce the debt-equity ratio to a predetermined level. But the question remains as to what precisely a project really is, how it is to be handled and structured, and what critical success factors of the project need to be negotiated by the parties involved.

3. Risk Management and Mitigation Strategies in Energy Project Finance

The ultimate solution to such inefficiency would be to shift to the private sector the risks associated with such operations to the full extent that there are sufficient markets to handle such risks. However, owing to the structure of the evolving private energy market, it has remained difficult to place these risks with their most efficient bearers owing to the lack of capacity of the insurance and the reinsurance markets to absorb them. These risk factors are caused by underinvestment as a result of insufficient action by the government, especially in the care, maintenance, and expansion of existing energy assets, and in the reform of the inherited market operating architecture.

The need to attract capital to the energy sector is matched by its high-risk content. The private sector is not comfortable with the high degree of uncertainty that surrounds the energy sector and the investment environment. The reason why the private sector is averse to the high risks of the energy sector is that the sector is exposed to price and quantity risk, which in turn have an impact on the profitability of the investment project. Due to changes in the nature of the objectives of national hydrocarbon exploitation and the inefficiency in the management and operation of traditional energy sectors, both hydrocarbon exploration and the downstream operation of national energy sectors have become highly risky endeavors, even in relatively low-risk operating areas of the world.

4. Case Studies and Best Practices

The main author of this section is Florian Alburo. The contributing authors would like to acknowledge with gratitude the support and input from the members of the GEF Expert Network on Project Finance, and from UNDP and IRENA. As a case study of success in renewable energy financing, we selected a new US dollar 55 million geothermal power station being constructed in the Eastern Hol province of the Philippines. Controversy attached to the project, including agitation by church, farmer, and non-governmental organizations (NGOs), a protest march to Manila, and a postponement of scheduled loan approvals, caused serious problems for the national government and the local sponsors, Energy Development Corporation (EDC) and Compania Agricola de Ordiones.

This section focuses on a number of case studies and best practices for project preparation and effectively mobilizing and managing both domestic and international finance. It is divided into a number of sub-sections, namely: A practical guide for governments and developers of geothermal power projects (Section I); case studies focusing on mobilization of financing (Section II); on promoting bankability through risk mitigation (Section III); and on features of power purchase agreements from the perspective of potential equity and project financiers (Section IV). Then, these case studies lead to a number of summary best practices and next steps in developing other guidance and bridging advice with potential for replicating such experiences in terms of types of projects, instruments, sectors, and regions. Please note that the case studies are considered to be status updates based on the information available in these reports at the time of writing, and do not represent any further analysis or comment.

5. Future Trends and Innovations in Energy Project Finance

I. INTRODUCTION A. Terms of Reference and Methodology of the Study B. An Overview of Innovative Financial Structures for Use in the Project Finance Context II. RECENT EVOLUTION OF THE ROLE OF PROJECT FINANCE IN THE ENERGY SECTOR A. Project Finance Transactions: Key Factor to Promote Privately Financed Energy Investments B. Project Financing in Relation to the Growth of Renewable Energy Investments C. Exceptionally Large Financing Requirements for Prospective Energy Projects D. Projects with Different Degrees of Perceived Credit Risk E. The Multiplicity of Investors’ Motives When Engaging in Energy Project Financings

Project finance has become increasingly important in the promotion of privately financed investments in the energy sector. In the face of escalating global energy challenges (e.g. climate change, uncertainty about energy supply security, and concerns for pollution), the surge in project financing in the energy sector has become increasingly important. During the last ten years, the upward trend in project financing has meant that the amounts of money at stake in this context are now truly massive. Yet, the dramatic trends observed in project finance transactions are not confined to increases in the overall volumes of money agreed. Indeed, on the contrary, what really sets these transactions apart from others is that much of the money involved in these deals comes from different sources such as pension funds, venture capital, private equity, hedge funds, family offices, real estate funding, etc.