31 March 2022

Project Finance: Identification, Allocation And Mitigation Of Risk Factors

SimmonsCooper Partners


SimmonsCooper Partners (“SCP”) is a full service law firm in Nigeria with offices in Lagos and Abuja. SCP is one of Nigeria’s leading practices for transactions relating to all aspects of competition law, commercial litigation, regulatory compliance, project finance and energy. Our team has gained extensive experience in advising both local and international clients.
This is because there is a direct relationship between recourse and the sponsor's balance sheet, debt to assets ratio, and risk.
Nigeria Finance and Banking
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Project finance is generally used to refer to a non-recourse or limited recourse financing structure in which debt, equity, and credit enhancement are combined for the construction and operation, or refinancing, of a particular facility in a capital-intensive industry, in which lenders base credit appraisals on the projected revenues from the operation of the facility, rather than the general assets or the credit of the sponsor of the facility, and rely on the assets of the facility, including any revenue-producing contracts and other cash flow generated by the facility, as collateral for the debt.1 Simply put, project finance enables governments to finance infrastructure by using "other people's money".2

Project finance, a major mechanism for financing large-scale and capital-intensive projects, is being widely used especially developing countries in industries of electric power (e.g. Indonesian and Pakistan power stations); road projects (e.g. the Lekki Toll Road Concession in Lagos, Nigeria); telecommunication project (e.g Mexico); mining and natural resources; petroleum and petrochemicals; infrastructure and other sectors. Project finance could be non-recourse or limited recourse. 'Recourse' generally is an important factor in project finance. This is because there is a direct relationship between recourse and the sponsor's balance sheet, debt to assets ratio, and risk. The sponsor's risk rises as the amount of recourse increases.

The non-recourse project finance is founded upon the success of the project rather than the asset of the project sponsor. The credit appraisal of the non-recourse project finance lender is therefore based on the underlying cash flow from the revenue – producing project contracts, independent of the non-project assets of the project sponsor. Because the debt is non-recourse, the project sponsor has no direct legal obligation to repay the project debt or make interest payments if the project cash flows prove inadequate to service the debt.3 Put differently, the 'non- recourse' structure envisages a situation whereby the project sponsor cannot be liable for any debt which may accrue from the failure of the project.

In practise, the non-recourse is uncommon. This is because, since project finance is basically risk identification and allocation based, lenders and the host-government require a form of guarantee from the project sponsor. This will obviously include an assumption of certain project risks.

The limited form of project financing is common. Unlike the non-recourse project financing, a limited degree of liability is attached to the project sponsor under the limited recourse project financing. For example, if the lenders perceive that a substantial risk exits during the construction phase of a project, they could require that the project sponsor infuse additional equity if the risk actually materializes.4 The lender would have recourse to the project sponsor's assets until the risk subsides or construction is complete.


The bidding process is a means by which the host-government (e.g., the Federal Government of Nigeria or a State Government) implores a private-sector or project company to undertake a project in its country. A bidding program is competitive process undertaken by a government that allows for the efficient selection of a provider of goods or services in a transparent manner, based on the selection criteria formulated by the government, for the purpose of selecting a low-cost provider best capable of project completion and operation. The selection criteria can be a simple, market-based price, or it can make use of complicated formula that places differing weight on such considerations as experience, financial strength, non-financial resources and price.

The bidding process is meritorious for several reasons. A bid process increases competition among potential providers of the goods or services, minimises the cost of the solicited good and services, and fosters public support and credibility for the project by avoiding the perception of corruption. In developing countries, the bidding process also helps government leaders overcome public resistance to previously free or subsidized infrastructure that will now be provided by the private sector.5 As such, because the public bidding process passes through defined criteria and decision-making process and a qualified project company selected, it reduces potential political risk or criticism.

After a project sponsor/company has been appointed by the host-country, the first stage of such development is the negotiation of a letter of intent or memorandum of understanding with the host government. Generally, the substance of a letter of intent or memorandum of understanding varies depending of the nature of the project. After a memorandum of understanding has been finalised, a concession agreement is entered into between the host-government and the project sponsor. Concession agreements usually constitute a quasi-monopoly in favour of the project company.

Further to the grant of relevant permits, an implementation agreement6 is prepared and executed by the host-government and the project sponsor. The implementation agreement is an effort to mitigate risk factors and thereby encourage developmental projects, capital-investment economy, and debt in an uncertain environment. The implementation agreement mitigates at an early stage certain risks and uncertainties inherent in project finance including: political risks such as expropriation; currency questions; permits and licenses issues; tax benefits and incentives; public unrest and insurrection etc.


Basically, the agreement between the parties will specify the type of mechanism for the infrastructure development. For this purpose, however, we shall consider the build-own-transfer ("BOT") structure. The BOT is one of the most typical structures for infrastructure development in developing countries where the host government under this structure, provides a concession (a right to build and operate the project) to the project sponsor, which agrees to build and operate the project for a definite period. After the expiration of the operation period, the project sponsor either transfers the project to the host-government or renegotiate for an extended operation period. BOT projects are beneficial to host-governments seeking to achieve a variety of goals. The primary goal is the ability of the host-government to facilitate a developmental project without the input of government's finance.


Risk is an inherent component of any project finance. Risk has been defined as ''uncertainty in regard to cost, loss, or damage.''7 Uncertainty is the important aspect of risk and project finance abhors it. In project finance, the project participants are exposed to diverse risk factors. A major cause of project failures in project finance is the inappropriate allocation of risks to the various parties in the project.8 Because a project financing is non-recourse to the project sponsor, financial responsibility for the various risks in a project financing must be allocated to parties that will assume recourse liability and that possess adequate credit to accept the risk allocated. In project finance, risks are allocated to the parties best able to manage them. In other words, identification, assessment and risk allocation is vital in project financing. Risks in project finance come in different phases and categories. For the purpose of this article, however, we shall briefly consider the following risks namely, development risk; design and construction risk; start-up risk; operating risk; financial risk; political risk and force majeure risk.


Development risks are risks that occur during the initial phase of the project development. Development risks are primarily risks to the project sponsors and the development loan lenders. Risks during this stage include failure to obtain permits or other governmental approvals; public opposition to the project; and weaknesses in the business framework of the deal (in the vernacular, ''the deal doesn't make sense''). Although, risks are very high during the developmental stage of the project, however, there are high possibilities of potential and positive rewards.


These are risks that manifest during the design and construction stage of the developmental project. Here, we are concerned with the project not being able to get under way as originally planned or entailing unexpected delays or cost.9 As construction moves forward, new risks arise and other subsides. Design development and construction risks are primarily risks to the project sponsors and the construction loan lender, although each project participant is concerned with whether the project will be constructed on time for the price upon which project financial projections are based. It is important to note that interruptions in the construction stage of the project, for instance, will eventually result into delay in completion and revenue flow. This will obviously prejudice the repayment of the loans and debt invested in development of the project. Delay in project may be caused by several factors but poor interface coordination and late design changes are the most common factors.10

The construction risk is the necessity of a change in the work that is not contemplated in the construction price. Such risks which may occur during this stage of the project include; price changes caused by inflation or fluctuation of currency; shortage of raw materials; design changes occasioned by policy change; construction delays etc. Typically, if a project is unsuccessful during the construction phase, the project assets will not likely be of sufficient value to repay the construction loan.


Start-up of a project is the most important risk-shifting phase of a project finance because achievement of the performance guarantees through performance tests signals the end of the contractor risk period and the beginning of the risk period for the operator and the project company. At start-up, permanent lenders and equity investors, including the sponsors, require the contractor to prove that the project can operate at a level of performance necessary to service debt and pay the operating costs. Prolonged project start-up time may result in significant underestimation of initial start-up cost. Labour and raw material shortages; inflation, inaccurate engineering and design studies, large operating deficits, increase start-up cost risk.


These are risks that arise after the project is accepted or is in preliminary operation. Each operating risk affects whether the project will perform at projected levels, thereby producing sufficient funds to cover debt service and operating costs and provide a return on equity invested. Operating risks are exemplified by a decrease in the availability of raw materials or fuel or a decrease in demand for the output of the project. Other operating risks may include, low productivity due to market forces, inflation; changes in currency exchange rate; technical problems; supply risks, political risks, policy changes; failure to meet engineering specifications; management inefficiencies etc. Risks during this stage are borne by the project company and permanent loan lenders. If a project is unsuccessful during the early years of project operation, the assets of the project will not likely be of sufficient value to repay the project loans, and the project sponsors will not have received the equity return for which they helped. With the passage of time, however, the potential loss decreases as project debt is amortised and investment returns are achieved. In the early years of operation, however, risk mitigation and allocation techniques, such as take-and-pay, off-take contracts, fixed price fuel and raw material supply contracts, and political risk insurance, are important.


Financial risks constitute a major risk factor in project finance. Financial risks such as fluctuations in exchange and interest rates, volatility in world prices, inflation and the imposition of new tariffs will also figure high on the lenders' list of concerns.11 Fluctuations in the exchange rate can affect net cash flow of the project throughout both the construction and the operation stages. In much the same way as with the exchange rate, inflation can affect the balance sheet item to the extent of jeopardizing the equity base. In order to protect it, constant vigilance and adjustment is needed in the composition of assets and liabilities. The inclusion in the project package of hedging facilities such as currency and interest rate swaps and futures contracts can assist in this respect. In addition, the way in which capital and interest payments are to be made on the loan, and the percentage of revenues that is to be allocated directly to the lenders, can be linked to statistics such as movements in prices and inflation rates.


Another risk encountered by project sponsors, foreign investors, and lenders in developing countries is political risk. This risk is based on the concern of likelihood of sudden change in government which may adversely affect the continuity of the project development. Political risks entail some unexpected government intervention causing default of obligation or significantly the returns expected by the suppliers of fund. Failure to comply with contractual agreements; expropriations;12 changes in law and regulations; price control and exchange restrictions are potential political risks. The Dabhol Power Project13 in India is another project that suffered political risk.

Assurances by the host-government that it will not expropriate or nationalise the projects, together, if possible, with central bank undertakings to ensure the continuing availability of foreign exchange, are often important items.


"Force majeure" is the term used generally to refer to an event beyond the control of a party claiming that the event has occurred, including acts of God, fire, flood, earthquakes, pandemics war, and strikes. The party who will bear the risk is always a subject of negotiation, and often is determined to be the party best able to control (by, for example, obtaining insurance) each particular force majeure risk. (Scott Hoffman, 2008).


Risks in project finance are essentially identified and allocated to the project participant best able to assume and manage those risks. Several mitigation tools or techniques are adopted. However, we shall consider some of these mitigation tools from the viewpoint of the risk period or phase.


During the construction phase of project finance, three (3) main groups of instruments are used to mitigate risk namely, Contractual arrangements and associated guarantees; Contingency funds and lines of credit; and Private insurance. (Jeff Ruster, 1996).

  • Contractual Arrangements: Contractual arrangements, including guarantees, are common risk mitigation instruments used during the construction period of a project. It offers a broad range of possibilities for allocating risks among the several project participants. In a project finance construction contract, construction risks are allocated between the project sponsors and the contractor. In other words, the construction contract, for example, assigns responsibilities to the project sponsor and the construction companies for engineering, procurement, performance testing, obtaining permits and insurance, provision of required services (water, electricity, fuel), and relief under force majeure The contractor may be responsible only for bringing a project to mechanical completion according to the owner's design and specifications, transferring to the project sponsors responsibility for start-up and testing. Under an engineering, procurement, and construction contract, however, the contractor accepts full responsibility for delivering a fully operational facility on a date certain and fixed-price basis. If the contractor fails to meet its obligations, it may be required to pay compensation to the project sponsors, often in the form of liquidated damages.
  • Contingency funds and Lines of Credit: Lenders are often concerned about the risk of cost overrun when the construction costs exceed the original estimates owing to factors such as inflation and materials shortages, and when drawdowns from loans cannot match the payments to contractors.14 A risk-mitigation tool used to mitigate the cost overrun risk is the construction budget contingency reserve fund. This fund is a line item in the construction budget, supported with loan or equity commitments, to pay cost overrun during the construction period. (Scott Hoffman, 2008). Contingency funds can be used to cover all types of cost overruns or earmarked for specific contingencies. In addition to, or in the absence of, such instruments, contingent lines of subordinate debt may be provided by third-party contractors, standby letters of credit, or sponsor guarantees. (Jeff Ruster, 1996). Standby letters of credit provide security in the event of non-performance of the underlying agreement, and it may be used in place of performance bonds.
  • Insurance: A project is generally covered by several types of insurance. Construction risk insurance protects against property damage and is effective from the commencement of procurement to transportation to the project site through completion of construction and performance testing. Risks covered include pandemics, acts of God and standard perils (fire, lightning). Others may include employer's liability, architect errors and omissions, and force majeure insurance, which can cover losses due to strikes, contractor insolvency, and delays in obtaining permits (Jeff Ruster, 1996).


The instruments most used to mitigate risk during the operating period are contractual arrangements; contingency reserves; cash traps; insurance; and risk compensation devices.

  • Contractual Arrangements: Contractual arrangements to manage risks are the most common risk mitigation tool used during the project's operation phase. Take-or-pay,15 take-and-pay,16 put-or-pay17 and pass-through18 structures are used to assure revenue streams to the project sponsors or company. In a project finance, where the take-or-pay contract represents the sole revenue source, the payments required under the contract be sufficient to enable the project sponsor to pay debt service payments, and operation Because the contract is effective over a long term, typically at least the term of the project debt, the price is subject to escalation for such variables as inflation. (Scott Hoffman, 2008, p. 250-251).
  • Contingency Reserves: During the operation phase, contingency reserve accounts can be used to mitigate the risk that insufficient revenue will be available to pay operating costs, planned and extraordinary equipment overhauls, and debt service. These can take the form of operating cost reserve accounts, overhaul reserve accounts, and debt service reserve accounts respectively. They can also be unfunded, provided backup credit support exists to provide the funds if needed, such as through a letter of credit. (Hoffman)
  • Cash Traps: This is a risk mitigation technique that is sometimes used to balance the competing concerns of owner and lender. Under this technique, profit can be distributed to project sponsors as longs as a negotiated debt service coverage test is satisfied or other conditions are met. If not, all excess cash not needed for project operation or debt service is held (trapped) in a collateral account. The funds on deposit in this account can be applied by the project lender for debt service, and ultimately debt prepayment, if project difficulties are not resolved. (Hoffman, 2008). In the same vein, sometimes a project can meet its debt service obligations, but not with the cash flow margins that lenders had Cash traps can be used to ensure that lenders continue to receive timely payments. (Ruster, 1996).
  • Insurance: Coverage for the operating period typically includes property insurance with extensions available for loss of revenue from machinery breakdown and for business interruption from property damage. Third-party general liability insurance might include coverage for workers' compensation, automobiles, and pollution clean-up.
  • Risk Compensation Devices: Sometimes investors and contractual participants assume certain risks in return for an opportunity to share in the project's upside potential. Tracking accounts are often used to compensate input suppliers or off-takers for offering fixed price agreements, which shield project sponsors from market risk. (Ruster, 1996).


Political risk can be mitigated in several ways. The project can be structured to capture hard currency revenue streams offshore, thereby reducing currency transfer and convertibility risk.

Also, the involvement in a project by a multilateral financial institution, such as the International Finance Corporation (IFC), African Development Bank (AfDB) can reduce host-government interference with a project's ability to repay private sector debt. (S. Hoffman, 2008). Another viable means of mitigating such risks is by political risk insurance policy.

Political risk insurance can offset large potential losses.19

For instance, the Multilateral Investment Guarantee Agency (MIGA), an affiliate of the World Bank, is an insurance/guarantee provider. Political risk insurance from a commercial company is another means to mitigate risks of expropriation, movement lockdowns, instability, war, insurrection, revolution, civil disturbances, and breach of undertaking by host-government.


Another risk-mitigation instrument is by foreign-exchange undertaking. Basically, loans made available for projects in developing countries are generally in hard currency. Investment returns should therefore be in hard currency to mitigate the currency risk. One of the major problems in infrastructure projects in developing countries is that they do not generate income in hard currency. Thus, remittance guarantees are necessary to enable the project sponsors to remit freely all the project revenues. Guarantees of foreign-exchange convertibility and availability should also be obtained from the host government to reassure the lenders and investors. (McCarthy, 1991). However, where the loan is generated locally, this protection may be needless.

All said, project financing is a veritable developmental tool adopted by countries of the world to finance capital-intensive projects. Whilst project finance is best known for its complexity and diverse risks inherent in its use, a proper identification, assessment, and allocation of these risks are key to achieving a successful developmental project.


1 Scott L. Hoffman, The Law and Business of International Project Finance. 3rd ed., p. 17-18, 2008.

2 Roger McCormick, PROJECT FINANCE IN CENTRAL AND EASTERN EUROPE; Journal of International Banking and Financial Law, 1 January 1998.

3 S. Hoffman, p. 4-5. For further explanatory notes, See, e.g JOHN T. AND JOHN K. OPTIMALITY OF PROJECT FINANCING: THEORY AND EMPIRICAL IMPLICATIONS IN FINANCE AND ACCOUNTING. Review of Quantitative Finance and Accounting 1991;1:51–74. ''Pure'', zero recourse, project financing provides an important category of off-balance sheet-financing for the sponsoring firm because the project is legally distinct from the sponsor, does not appear on its balance sheet, and does not affect the sponsor's debt to assets ratio. Project creditors have no recourse to the cash flows from other assets of the sponsoring entity.

4 S. Hoffman, at p. 5.

5 Clive Harris et al., Infrastructure Projects- A Review of Cancelled Private Projects, PUBLIC POLICY FOR THE PRIVATE SECTOR, WORLD BANK NOTE NO. 252 (JAN. 2003).

6 ''An implementation agreement is a contract between a project sponsor and a host government that addresses the financial and political elements necessary in project financing that are absent, or at least unpredictable, in the host country''

7 C. Hardy, RISK AND RISK-BEARING 1 (1923).


9 Henrique Ghersi and Jaime Sabal, AN INTRODUCTION TO PROJECT FINANCE IN EMERGING MARKETS, p. 9 (2006).

10 In the Channel Tunnel project, for instance, the delay was due to late changes in the signalling system specification and the shuffle design. Out of the seven (7) years construction contract, a delay of one (1) year resulted. Because build-operate-transfer (BOT) projects (a form of project financing) rely on the income generated from the operation to service their debts, the rolled-up interest from a delayed project can be substantial and can seriously affect the project's profitability. At one time, financiers of the channel tunnel were reluctant to commit further loans when the delay resulted into substantial cost increase.


12 In a nutshell, expropriation is the taking of a project by the state, whether for public purposes or otherwise. See Jeffery Barratt, EXPROPRIATION: INVESTMENT PROTECTION AND MITIGATING THE RISKS; Journal of International Banking and Financial Law, 349, 1 June (2010).

13 Jyoti P. Gupta and Anil K. Sravat, DEVELOPMENT AND PROJECT FINANCING OF PRIVATE POWER PROJECTS IN DEVELOPING COUNTRIES; A CASE STUDY OF INDIA, International Journal of Project Management, Vol. 16 No. 2, pp. 99-105 (1998).

The Dabhol Power Project was being financed when Maharashtra State was controlled by the Congress Party, which encouraged private investment in India's infrastructure. Soon after the financing was completed, the political control changed to Bharatiya Janata Party (BJP). Soon after gaining political control, Bharatiya Janata Party announced that it would cease construction on the project and abandon the portions already under construction. Eventually, the project company was forced to renegotiate the project power sales agreement.

14 S. McCarthy and R. Tiong, FINANCIAL AND CONTRACTUAL ASPECTS OF BUILD-OPERATE-TRANSFER PROJECTS, International Journal of Project Management, p. 225 Vol. 9 No. 4 (November 1991).

15 A take-or-pay is the term generally used to refer to a contractual obligation between a buyer and seller in which the buyer agrees to make payments on certain dates to the seller in return for available deliveries of goods and services at specified price. The payment obligation of the buyer is unconditional. Thus, even if no goods or services are delivered, the payment obligation exists). See generally Scott L. Hoffman, 2008 p. 250.

16 A take-and-pay contract is similar to the take-or-pay contract except that the buyer is only obligated to pay if the product or service is actually delivered. Thus, a take-and-pay contract does not contain an unconditional obligation.

17 Put-or-pay contracts provide for a secure supply of project feed stocks or raw materials. If the supplier is unable to provide the inputs, it agrees to indemnify the project company for excess costs incurred in securing the inputs from third parties or, if third-party supply is unavailable, for revenue losses due to the project's resulting inability to comply with its off-take arrangements. See generally (Jeff Ruster, 1996).

18 Pass-through structures often link the off-take and input agreements to shield investors from adverse changes in the prices of project inputs or outputs.

19 See, Jeannet, J.P and Hennessey H.D. (1992, 1995), GLOBAL MARKETING STRATEGIES, Houghton- Mifflin, Boston.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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