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Types of project risks You On Here » Types of project risks

Of course, every project is different and it is not possible to compile an exhaustive list of risks or to rank them in order of priority. What is a major risk for one project may be quite minor for another. In a vacuum, one can just discuss the risks that are common to most projects and possible avenues for minimizing them. However, it is helpful to categories the risks according to the phases of the project within which they may arise: (1) the design and construction phase; (2) the operation phase; or (3) either phase. It is useful to divide the project in this way when looking at risks because the nature and the allocation of risks usually change between the construction phase and the operation phase.

1. Construction phase risk - Completion risk

Completion risk allocation is a vital part of the risk allocation of any project. This phase carries the greatest risk for the financier. Construction carries the danger that the project will not be completed on time, on budget or at all because of technical, labor, and other construction difficulties. Such delays or cost increases may delay loan repayments and cause interest and debt to accumulate. They may also jeopardize contracts for the sale of the project's output and supply contacts for raw materials.

Commonly employed mechanisms for minimizing completion risk before lending takes place include: (a) obtaining completion guarantees requiring the sponsors to pay all debts and liquidated damages if completion does not occur by the required date; (b) ensuring that sponsors have a significant financial interest in the success of the project so that they remain committed to it by insisting that sponsors inject equity into the project; (c) requiring the project to be developed under fixed-price, fixed- time turnkey contracts by reputable and financially sound contractors whose performance is secured by performance bonds or guaranteed by third parties; and (d) obtaining independent experts' reports on the design and construction of the project. Completion risk is managed during the loan period by methods such as making
pre-completion phase drawdown’s of further funds conditional on certificates being issued by independent experts to confirm that the construction is progressing as planned.

2. Operation phase risk - Resource / reserve risk
This is the risk that for a mining project, rail project, power station or toll road there are inadequate inputs that can be processed or serviced to produce an adequate return. For example, this is the risk that there are insufficient reserves for a mine, passengers for a railway, fuel for a power station or vehicles for a toll road.

Such resource risks are usually minimized by: (a) experts' reports as to the existence of the inputs (e.g. detailed reservoir and engineering reports which classify and quantify the reserves for a mining project) or estimates of public users of the project based on surveys and other empirical evidence (e.g. the number of passengers who will use a railway); (b) requiring long term supply contracts for inputs to be entered into as protection against shortages or price fluctuations (e.g. fuel supply agreements for a power station); (c) obtaining guarantees that there will be a minimum level of inputs (e.g. from a government that a certain number of vehicles will use a toll road); and (d) "take or pay" off-take contacts which require the purchaser to make minimum payments even if the product cannot be delivered.

Operating risk
These are general risks that may affect the cash-flow of the project by increasing the operating costs or affecting the project's capacity to continue to generate the quantity and quality of the planned output over the life of the project. Operating risks include, for example, the level of experience and resources of the operator, inefficiencies in operations or shortages in the supply of skilled labor. The usual way for minimizing operating risks before lending takes place is to require the project to be operated by a reputable and financially sound operator whose performance is secured by performance bonds. Operating risks are managed during the loan period by requiring the provision of detailed reports on the operations of the project and by controlling cash-flows by requiring the proceeds of the sale of product to be paid into a tightly regulated proceeds account to ensure that funds are used for approved operating costs only.

Market / off-take risk
Obviously, the loan can only be repaid if the product that is generated can be turned into cash. Market risk is the risk that a buyer cannot be found for the product at a price sufficient to provide adequate cash-flow to service the debt. The best mechanism for minimizing market risk before lending takes place is an acceptable forward sales contact entered into with a financially sound purchaser.

3. Risks common to both construction and operational phases
Participant / credit risk
These are the risks associated with the sponsors or the borrowers themselves. The question is whether they have sufficient resources to manage the construction and operation of the project and to efficiently resolve any problems which may arise. Of course, credit risk is also important for the sponsors' completion guarantees.

To minimize these risks, the financiers need to satisfy themselves that the participants in the project have the necessary human resources, experience in past projects of this nature and are financially strong (e.g. so that they can inject funds into an ailing project to save it).

Technical risk
This is the risk of technical difficulties in the construction and operation of the project's plant and equipment, including latent defects. Financiers usually minimize this risk by preferring tried and tested technologies to new unproven technologies. Technical risk is also minimized before lending takes place by obtaining experts reports as to the proposed technology. Technical risks are managed during the loan period by requiring a maintenance retention account to be maintained to receive a proportion of cash-flows to cover future maintenance expenditure.

Currency risk
Currency risks include the risks that: (a) a depreciation in loan currencies may increase the costs of construction where significant construction items are sourced offshore; or (b) a depreciation in the revenue currencies may cause a cash-flow problem in the operating phase. Mechanisms for minimizing resource include: (a) matching the currencies of the sales contracts with the currencies of supply contracts as far as possible; (b) denominating the loan in the most relevant foreign currency; and (c) requiring suitable foreign currency hedging contracts to be entered into.

Regulatory / approvals risk
These are risks that government licenses and approvals required to construct or operate the project will not be issued (or will only be issued subject to onerous conditions), or that the project will be subject to excessive taxation, royalty payments, or rigid requirements as to local supply or distribution. Such risks may be reduced by obtaining legal opinions confirming compliance with applicable laws and ensuring that any necessary approvals are a condition precedent to the
drawdown of funds.

Political risk
This is the danger of political or financial instability in the host country caused by events such as insurrections, strikes, suspension of foreign exchange, creeping expropriation and outright nationalization. It also includes the risk that a government may be able to avoid its contractual obligations through sovereign immunity doctrines. Common mechanisms for minimizing political risk include: (a) requiring host country agreements and assurances that project will not be interfered with; (b) obtaining legal opinions as to the applicable laws and the enforceability of contracts with government entities; (c) requiring political risk insurance to be obtained from bodies which provide such insurance (traditionally government agencies); (d) involving financiers from a number of different countries, national export credit agencies and multilateral lending institutions such as a development bank; and (e) establishing accounts in stable countries for the receipt of sale proceeds from purchasers.

Force majeure risk
This is the risk of events which render the construction or operation of the project impossible, either temporarily (e.g. minor floods) or permanently (e.g. complete destruction by fire). Mechanisms for minimizing such risks include: (a) conducting due diligence as to the possibility of the relevant risks; (b) allocating such risks to other parties as far as possible (e.g. to the builder under the construction contract); and (c) requiring adequate insurances which note the financiers' interests to be put in place.

Conclusion
This paper only gives a brief overview of the common risks and methods of risk minimization employed by financiers in project finance transactions. As stated previously, each project financing is different. Each project gives rise to its own unique risks and hence poses its own unique challenges. In every case, the parties - and those advising them - need to act creatively to meet those challenges and to effectively and efficiently minimize the risks embodied in the project in order to ensure that the project financing will be a success.

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