International Conference in the Built Environment in the 21st Century (ICiBE2006)

EFFICIENT RISK ALLOCATION IN PROJECT FINANCE: ANALYSIS OF

LITERATURE REVIEW1

Zulhabri Ismail and Johan Victor Torrance Abdullah

Department of Construction Management
Faculty of Architecture, Planning & Surveying, Universiti Teknologi MARA
E-mail: zulhabri@salam.uitm.edu.my

ABSTRACT

Project finance is one of the most effective alternatives to finance large construction projects due to off
balance sheet and limited / non recourse project financing machinery. However, the “lenders” which
are the most important entities in this structure will ensure the success of the project by way of efficient
risk allocation scenarios and all necessary safeguards have been affirmed before agreeing to provide
debt and the project can be started. The reason behind is to ensure the success and revenues can be
generated.

This paper highlights and analyses points of view and suggestions by project finance experts from the
various countries (i.e. UK, USA and Australia) that had experience with such project procurement
method to get overview and general knowledge in relation to project finance. The study showed that
almost all commentators and practitioners agreed that in any situation efficient risk allocation scenarios
are one of the solutions that can minimise the risk of unperforming projects. This can be seen from the
report done by the UK government when a large percentage of projects executed were able to be
delivered within the time stated and as per quality and cost required.

Keywords: Literature review, lenders, project finance, PFI/PPP & BOT, risk allocation.

INTRODUCTION

Didkovskiy (2003) and Karpova (2003) enlighten that project finance often becomes
the most viable alternative to financing important infrastructure development needs
particularly because of the public sector “off-balance sheet financing” and “limited or
non-recourse project financing” mechanism. Under this arrangement, the financing of
the project will largely derive from debt by the project finance lenders [lenders]
normally 60% - 80% and equity from shareholders normally 20% - 40%. For the
lenders, risk in financing infrastructure projects is crucial, as most projects are capital
intensive and have long construction and payback periods i.e. 20 – 30 years or more
(Bruce, 2004). Therefore, the lenders will make sure the success of the project by way
of ensuring efficient risk allocation scenarios.

It has been suggested that the profile of lenders in project finance can differ from
project to project. It may include a combination of private sector commercial lenders
[banks] together with export credit agencies and bilateral and multilateral finance
organisations (Delmon, 2005 and Banani, 2003). Scriven (1995) clarifies that each
lender’s detailed requirements can differ greatly depending on the nature,
arrangement and jurisdiction of the project (Mallesons, 2003). In this paper it is
assumed that the term “lenders” is referring to the said entities in general and in the
same project or at least in the same type within the same jurisdiction. Therefore, it is

1
This paper was presented in the International Conference in the Built Environment in the 21st Century
(ICiBE2006) Renaissance Kuala Lumpur Hotel, Kuala Lumpur, Malaysia. 13-15 June 2006.

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beyond the scope of this paper to discuss each type of lender’s appetite in different
types of construction projects across different jurisdictions.

This paper aims to discuss what are typical efficient risk allocation scenarios accepted
by most lenders in project finance, at the same time demonstrates the lenders risk
averse attitude if such scenarios are “dramatically different” and to show whether
such attitude is compatible with such efficient risk allocation and it is beyond the
scope of this paper to discuss the whole structure of risk management system. For the
purpose of this paper, the “risk allocation scenarios” in question will merely refer to
risk allocation structures of infrastructure projects in general, particularly under UK
PFI/PPP and BOT arrangements. The research method was purely based on the
literature review and the data collection will be done in near future depending on
availability of target group and case studies.

RISK ALLOCATION IN PROJECT FINANCE

Gerrard (2001) clarifies that there are not many differences between PFI/PPP and
BOT. PFI/PPP itself draws from BOT and other almost similar forms i.e. BOOT and
DBFO. The central theme of PFI/PPP is delivery of services and not payment for
assets by way of “Unitary Charge” by public sector. Whereas under BOT arrangement
Delmon (2005) states that the SPV operates the project for the whole concession
period, receiving revenues in exchange for operation of the project obtained from
single off-taker i.e. the government.

Project finance in the context of PFI/PPP and BOT projects involve the financing of a
project through limited or non-recourse Special Purpose Vehicle [SPV] which is
created as the bearer of the debt. The SPV will be responsible [via project agreement]
to the “whole life” of the project including building, financing, maintaining and
operating the asset. As one of the most important entities in project financing, lenders
will have influence on risk allocation and ensure that the SPV will sub-contract the
construction and operation of the facility ensuring that no residual risk remains with
the SPV, Capper (2005) affirms that the “residual risks” in question are either
transferred to the subcontractor or remain with the public sector.

As stated earlier, the financing of the project is a mixture of equity and a large amount
of debt from lenders and also insurance in respect of insurable risks borne by the SPV.
Therefore, the lenders will be keen to ensure the successful of the project by way of
efficient risk allocation in order for them to get repayment of debt through the project
revenues. Delmon (2005) suggests that “efficient contractual arrangement with
appropriate risk allocation structure will be the deciding factor for the bankability of
the project and whether the lenders will go with the project financing of the
development”. Whereas, Mallesons (2003) argues that due to lenders’ requirements
which may vary from project to project and jurisdiction to jurisdiction, it cannot be
said that absolute certainty of risk allocation will definitely be bankable although it
can usually be stated which allocation will not be bankable, even so Pirani (1999)
states that “major projects look more viable when risks are spread broadly”. Penrose
and Rigby (2001) suggest that appropriate risk allocation in bankability assessment is
crucial in order to foresee and ensure the success of the project and determine
certainty in timely debt payments. But in any situation efficient risk allocation is
crucial in any situation to minimise the risk of unperformed project.

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It is understood that “most lenders” will not be in the operation, construction or even
administration of the project (Mills, 1996). Therefore, they will be hesitant to accept
risk allocations which are unfamiliar, uncertain or even different from other project
finance lenders. If so, they will make sure that appropriate safeguards are on board i.e.
appropriate cover ratio; higher equity investment in order to ensure greater ownership
by the shareholders, hence ensure the success of the project; better insurance
coverage; more thorough assessment on bankability to ensure that those risks will be
borne to the party “best able to manage”; protection via contractual provisions and its
security documentation and its rights in relation to the project should the project fail
(Scriven, 1995).

The lenders view risk differently than other project participants, they will not feel safe
and comfortable with both technical and commercial risks as will other project
participants, particularly if the lenders in question provide a large percentage of
funding, hence take significant portion of the project risk. However, Capper (1995)
suggests that proper risk allocation / management will not remove all risk from
projects, merely to ensure that risks are managed most efficiently by way of
contractual documents after the risks have been identified. Whereas, Barber (1989)
urges that the framework or contract “should be compatible with the realities of
construction and of nature”, therefore thorough analysis is required prior to allocating
that risk efficiently to any particular party.

As stated earlier, lenders are extremely careful to manage and accept risk allocation
scenarios. They will definitely restrict some type of risks they might take and ensure
the majority of risks are transferred and allocated to project participants efficiently.
The amount and type of risks the lenders are willing to take is heavily market driven
and is commonly considered within the concept of bankability of the project. In
assessing bankability the viability of the project will be assessed, Delmon (2005)
suggests that the viability of the project will concentrate on four main areas: financial,
legal, economic and technical, thus all the risks associate with these areas need to be
allocated and mitigated efficiently. Moreover, Karpova (2003) emphasises that all the
said factors require thorough and extensive assessments prior to commencing the
project. This shows that “lenders risk averse attitude” is enshrined even at the very
beginning stage! Henchie (2002) suggests that even during negotiation stage where
the lenders will not be present, but still its presence will be felt, this confirms Pausch
(2003) view when he said that “lenders risk averse is compatible with all debt
contracts”. For instance, in Australia, any project under the department of defence,
the contractor / SPV is required to include the risk allocation table in the Request for
Tender in order to ensure that all risks are identified and allocated efficiently.

To determine bankability and viability particularly under a BOT arrangement,

Delmon (2005) points out that financial review will consider financial position of the
project to ensure that the revenues received will be sufficient for the various needs of
the project; legal review will consider the legal and tax system in that country; the
economic review will involve whether the local economy can support the project.
Nicklisch (2003) suggests that the economic viability depends on the extent to which
the planned cash flow can be assured in the framework, thus ensure project revenues;
and the technical review will look at the design and equipment to be used and whether
this has in the past demonstrated sufficient reliability and performance capacity to
satisfy the requirements of a project. In order to “avoid new risk” on board, Delmon
(2005) suggests that the lenders prefer not to finance projects with new or unfamiliar

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risks which has not been accepted by them [or other lenders] for instance using new
method or untested new technology. Therefore, it can be concluded that bankability is
one way to determine efficient risk allocation scenarios and the lenders will be
hesitant to accept different or new risk than those normally accepted by other project
lenders.

EFFICIENT RISK ALLOCATION AND COMPATIBILITY

Some commentators emphasis that efficient risk allocation scenarios relate to project
performance, for instance the UK government (OGC) suggests that risk allocation is
the “process of apportioning individual risks relating to projects and service delivery
to the party best placed to manage each risk”. Whereas, Chapman et al. (1995)
consider that “efficient risk allocation is crucial in order to enhance project
performance by way of reducing costs, time and improved quality of the completed
works”. Delmon (2005) considers that “efficient allocation of risk will generally
result in a more successful and profitable project and will benefit each of the parties
involved”. Even so, efficient risk allocation is practically difficult to achieve due to
certain risks inherent in infrastructure projects proved particularly difficult to
effectively allocate. For instance Barber (1989) suggests that variable ground
condition on a tunnelling project cannot be quantified with sufficient certainty having
regard to the limited profit margin involved, but still the lenders will do whatsoever to
allocate and manage it efficiently.

In order to ensure efficient risk allocation scenarios, Abrahamson (2005) suggests that
“risk should be placed on insurers or other professional gamblers where practicable;
otherwise it should be placed on whoever gains the main economic benefit of running
it; that is, on to one who carelessly or wilfully creates it, or can best control the
events that may lead to it occurring or best manage it when it does occur”. Thus, it
can be said that efficient risk allocation refers to allocation of risk between parties that
will have incentive, be best equipped to manage and minimise that risk, if not it will
be inefficient, as a result the lenders will be hesitant to accept it.

However, Delmon (2005) suggests that there is situation where the lenders are
unwilling to permit the particular party to bear a particular risk in order to allocate it
to more “financially significant entities” even if this allocation is expensive and
inefficient. He confirms that “one lender is willing to accept…risk allocation in a
given project, other lenders will be expected to accept”. Therefore, that caption made
clear that the particular lender will be hesitant to accept “dramatically” different risk
allocation from other project finance lenders in the same project.

Ashley et al. (1995) suggest that six questions need to be answered to ensure efficient
risk allocation: who can control the occurrence of a risk?; who wants to be in a
position over the circumstances related to the risk?; who can manage the risk for the
least cost?; is the relevant party able to manage the risk, does it have the relevant
resources and is it in a position to manage the risk?; can the relevant party bear the
consequences of the risk?; is there an interrelationship between the relevant risk and
other project risks?; and will that party be motivated to manage the risk in the most
efficient and effective manner?. Therefore, the writer agree with Coggen (1995) when
he expressed that “in order to ensure compatibility with efficient risk allocation
scenarios, the lenders will make sure that answers for all these questions are certain
and again particular risk will be assigned to the party best able to control it”.

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According to a survey done by Grandjean (1999), lenders averse attitude on risk

allocation is not incompatible to the success of project. He urges that lenders will
ensure that management of risk follows a pragmatic path i.e. on the past experiences
and they willing to go to great extent to identify, understand and manage risks, in the
absence of precedent, again the risk is allocated on the principle that “the party best
able to control it undertakes it”. He notes that lenders “agreed that risk allocation is a
subject of many debates but insisted that deals must rest on sound principles”,
therefore, lenders attitude is actually compatible with efficient risk allocation
principles.

In the context of PFI/PPP and BOT arrangements [see Figure 1 below], one can say
that efficient risk allocation scenarios are one of its major principles. This can be seen
where a SPV will be established and the lenders will ensure that those “whole life
project risks” are efficiently allocated and shared with other project entities by way of
the contractual arrangements (Capper, 1995) i.e. to construction contractor, service
providers. The contractor / service providers will normally pass the risks either wholly
or partially down the line to their sub-contractors, thus, the risks are generally spread
over the entire project structure and shared among the project participants and
allocated to the parties who can “best control and manage the risks”. Therefore, if
there is any inefficiency in the risk allocation structure in question, for instance where
the lenders believe that the risk is allocated to someone not able to manage it
efficiently or they think that risk allocation in question is different from what is
normally being accepted by most lenders, they will be hesitant to accept it. Delmon
(2005) suggests that inefficiency in risk allocation scenarios can be seen in a
construction context for instance ground condition risk may be relevant to ground
works contractor, as a result it will be inefficient if this ground works contractor to
bear surface risk where it has no control over it. Another obvious scenario is where
operation and maintenance risks are borne mainly by the construction contractor
instead of the facilities management operator. Therefore, it seems quite clear that
lenders risk averse attitude in this context is compatible with efficient risk allocation.

Another example of efficient risk allocation under UK PFI/PPP is in relation to

payment mechanism i.e. “Unitary Charge” where the key concept of services is “no
service - no payment” and “poor service – reduced payment” (Handley, 2004) risks
are expected to incentivise all private sector participants to work together in order to
deliver the required services on time, within cost and as per quality since the risk of
delay completion, overrun and maintenance are allocated to them. Thus, it places
pressure on them to manage the risks more efficiently (UK NAO, 2003). Therefore, it
can be said that such incentivising as a result of efficient risk allocation scenario
evidenced that the lenders risk attitude is compatible with efficient risk allocation.
Bear in mind that if risk allocation in question is inefficient or lenders in doubt with
different risk allocation [if any], the project will not be started at the first place.

TYPICAL RISK ALLOCATION SCENARIOS ACCEPTED BY MOST

PROJECT FINANCE LENDERS

From the lenders point of view, there are five categories of risks that need to be
considered and allocated in PFI/PPP projects: construction risk, which is related to
design problems, cost overruns and delays; financial risk, which is related to interest
rates, exchange rates, and other factors affecting financing costs; performance risk
which is related to the availability of an asset and the continuity and quality of service

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provision; demand risk which is related to the ongoing need for services and residual
value risk which is related to the future market price of an asset (IMF, 2004).

Whereas under BOT arrangement, the Mizuho Financial Group highlights that there
are at least eight risks that need to be considered, managed and allocated efficiently:
country risk; construction risk; technology risk; fuel/input supply risk; off take risk;
operation and maintenance risk; interest rate/FX risk; and environmental and social
risk. In order to ensure efficient risk allocation, Mizuho (2004) highlights that risks in
question should be allocated as in Figure 1 below. Efficient risk allocation scenarios
can be seen where the lenders in general or Mizuho in particular will ensure that each
participant will take risk that is within its control by way of contractual arrangement,
for instance Contractor and Engineer will take construction and technology risks via
construction agreement and engineering procurement; fuel or input supplier will take
fuel or input risk via fuel or input agreement; country and political risk will be
mitigated by way of guarantee or insurance and so forth.

Figure 1 is the typical risk allocation structure in most of project finance transactions
which is accepted by most project finance lenders; therefore in order to avoid any
incompatibility and inefficiency the lenders will be hesitant to accept dramatically
different structure of risk allocation than in Figure 1 below, the main reason for this is
to “avoid unexpected and unwelcome surprises” that will effect the project in general
and its revenue in particular (ACEC & AGCA, 1998).

Engineer / Contractor Fuel or input Off taker Operator

Supplier

Construction Risk Off take Risk Operation &

Technology Risk Fuel or input Risk Maintenance

Engineering Procurement Fuel or input Off take Agreement Operation &

Construction Agreement Supply Agreement Maintenance
Agreement

Project Company /
SPV

Equity / Debt Debt Guarantee / Insurance

Remaining Project Risks Country / Political Risk

Foreign Developer / Sponsor Foreign Financial Institution Multilateral Export Credit

Agency

Figure 1: typical risk allocation structure in most of project finance transactions

Gerrard (2001) elucidates that under PFI/PPP arrangement, positive results for
efficient risk allocation are evidenced where it has been reported that most PFI/PPP
projects are completed ahead of schedule and within budget. In the UK, 78% of PFI
projects executed in 2003 were reported with no construction cost increase after

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contract award, thus no increase to the public sector’s payments, if any, it had been
borne by the private sector compared with conventional procurement where 73% of
the projects had run over budget. In addition, over 81% of authorities said that “value
for money” of their PFI/PPP was satisfactory or better and 50% said that the value for
money for their PFI projects was good or excellent (UK NAO, 2003). Despite that,
not all projects are suitable for PFI/PPP arrangement, some parties still in doubt
whether risk allocation and management in PFI/PPP arrangement is efficient enough
(UK NAO, 2004) e.g. London Underground (Lonergan, 2004), but still as a result of
efficient risk allocation structure large percentage of PFI/PPP deals are able to give
better “value for money” and enhance a large percentage of project performance.
Therefore, lenders’ attitude is hesitant to accept different structure of risk allocation
accepted by other lenders is compatible with efficient risk allocation.

CONCLUSION

This paper shows that the lenders attitude is hesitant to accept risk allocation
scenarios that are dramatically different from those accepted by other project finance
lenders actually compatible with efficient risk allocation. If so, they will make sure
that all necessary safeguards will be demanded, the main reason is most lenders will
not be rigorously involved with the project, therefore efficient risk allocation via
contractual arrangement is crucial to foresee and ensure the success of the project,
hence will ensure certainty and timely debt payments. Bankability assessment is a
means to determine and to assess success on the project and efficient risk allocation
scenarios. In the course of bankability assessment, new risks and improper risk
allocation will be highlighted; this will effect lenders decision whether to go on with
the project, lenders will be hesitant to accept new risks, improper risk allocation
scenarios or even dramatically different risk allocation scenarios in a given project
where other lenders will hesitance to accept the same position. The lenders will give
their consent to go on with the project once they are comfortable with risk allocation
scenarios that will ensure the project success and debt payments. Even so, this “too
cautious” attitude does not create an obstacle to the success of the project but on the
other hand, it is one of the factors that contribute to the success of the project. For
instance, “incentivising” as a result of risk allocation in PFI/PPP projects places
pressure on the project participants to manage the risks more efficiently, as a result, a
large percentage of PFI/PPP projects have been completed on schedule. Whereas, in
BOT projects, “back to back risk allocation” will assign risk to the party best able to
control and manage it efficiently, bear in mind that if risk allocation in question is
inefficient and improper or lenders are in doubt with dramatically different risk
allocation than accepted by other lenders, most probably the project will not be
executed. Therefore, lenders attitude is compatible with efficient risk allocation.

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