project finance energy

project finance energy

The Role of Project Finance in the Energy Sector

1. Introduction to Project Finance

They also have inherent uncertainties that relate to unconventional exploration risk, as well as the highly volatile behavior of markets. All these aforementioned characteristics of the energy markets make it difficult to arrange the finances of a project using the traditional corporate finance approach. The project financing method (in which lenders see themselves as equivalent to equity owners) has been adopted since the beginning of the twentieth century. Over 50% of all new investments in the U.S. energy sector are conducted through this financing method. The bulk of this money comes from secondary lenders in the project mode. Lenders receive interest and principal according to a fixed schedule of payments, and they can exert control if the project goes awry. They are not equity holders even if things go well. Except for constrained cost and time overruns, outsized returns go mostly to the equity holders. Project financing begins with the structuring of the project, generally with the formulation of a business plan which explains how the technical, economic, and financial outcomes of the project align with each other, becomes in place before seeking finance.

The energy sector is the single most important sector of the economy and is generally characterized as one that acts as a catalyst for growth and development. The problems and issues germane to the energy sector are unique in nature and are further compounded by the economics of the high investment-cost working environment, the embedded technology, as well as the resource uncertainty. These problems call for other unique ways of arranging and managing the financing complexities of the sector. Hence, project financing – a financing instrument that helps structure and manage the finances of a project to meet the conflicting needs of the various project interests and stakeholders over different stages of the project – is an appropriate choice. The arguments for and management of the risks inherent in the energy sector mostly revolve around technical and economical solutions found in the financial markets. The economics, peculiar problems, and the unique relationships with the financial markets indicate that the case of project financing for the energy sector deserves to be addressed separately. Energy sector projects are characterized by a long investment window that may range from ten to forty years.

2. Project Finance Structures in the Energy Sector

In a typical project finance structure, the primary source of repayment for lenders comes from the cash flows generated by the project rather than from parent company guarantees. The independently financed nature of these projects requires that each project finances separately. Also contributing to project finance’s uniqueness is the inclusion of the project in the decision-making, building, and concentrating phases of the project’s life cycle. Given that most of the political and economic risks of the construction phase are considered unacceptable without providing for proportional compensation in terms of high debt margins.

Project finance structures in the energy sector have traditionally had high front-end commitments on behalf of project sponsors and project company’s financiers. However, the value of financial engineering does have significant value and subsequently has been utilized by the industry. New financing trends, in particular the increased use of capital market financing of energy-related projects and the public-private partnership structure, now offer developers the flexibility to match the form of financing with the risk profile of the project. In this chapter, we review the traditional and innovative project finance structures used to finance capital-intensive projects in the energy sector.

3. Risk Management and Mitigation in Energy Project Finance

Risk management in the context of project finance starts with stakeholder management. A project finance analysis typically will include a description of the main parties to the transaction, the incentives that motivate them, and the basis for the allocation among the parties of the numerous risks that are intrinsic to large, long-term investments. This analysis yields an understanding of the delicate balance among different stakeholders’ willingness, diligence, and ability to manage different project risks. It also sheds light on institutions and contractual arrangements that have been developed to manage, share, and reallocate some of the risks the sponsors are unable or unwilling ultimately to bear.

Risk management is central to project finance. It seeks to identify, assess, and mitigate the variety of risks that arise from the long-term, capital-intensive nature of large projects. Efficient risk management is an essential ingredient in the successful execution of projects such as those in energy, which can absorb billions of dollars in investment over a multiyear period before production commences.

4. Case Studies and Success Stories in Energy Project Finance

The projects leveraged substantial official credit resources while being promoted by private sponsors in Malaysia, Argentina, and Kazakhstan. The case of the Itaipu project is particularly interesting because it was implemented under a unique legal and historical situation with neighboring countries (Brazil and Argentina). The Ust-Kamenogorsk district heating rehabilitation project exhibits an interesting investor dividend through the provision of early returns through the development of self-liquidating rehab of economically targeted district heating activities in a larger privatization of a historic predominantly nuclear city heating system operation.

This section presents three case examples of energy projects for which we have considerable detail: the Haina Combined Cycle Power Plant, the Itaipu Binational Hydropower Plant project, and the Ust-Kamenogorsk District Heating Rehabilitation Project. These projects illustrate both the difficulties and benefits of project finance, the process involved, and how risks are allocated. In the case of the Haina Combined Cycle Power Plant, we will provide two alternative closing structures that demonstrate the flexibility and diversity of capital sources that are possible with a project where significant preliminary work, including the negotiation of fuel supply, long-term debt coverage, power purchase, and concession agreements, has been undertaken.