Project Finance Deals and Governmental Support - Essay Example

?Project Finance Deals Usually Require Some Form of Governmental Support. What Governmental or Legislature Actions Create Better Environment for Project Finance? Table of Contents Introduction 3 The Complex Structure of Project Finance 5 The Associated Risks 8 Critical Analysis of Government Support 16 Conclusion 21 References 23 Introduction In simple terms ‘Project Finance’ can be referred to the raising of funds in order to finance a project requiring huge amount of capital in terms of investment1. The rising of funds can be based on non-recourse or a partial recourse. The financed amount or the return on investment (ROI) of the project largely depends on the cash flow obtained from the project2. From a general perspective, it is quite apparent that project finance is a complex subject and quantifies on various attributes related to the financing of a project. It can be well depicted from the definition provided by Benjamin C. Esty, which states that “Project finance involves the creation of a legally independent project company financed with equity from one or more sponsoring firms and non-recourse debt for the purpose of investing in a capital asset”3. Project financing include various features which in turn develops the entire process to be complex and multifaceted. Few of the major characteristics involved in project financing relates to the nature of the contract among the project company and the parties who are financially responsible for the completion of the project. Project financing also involves the legal agreement between the financially accountable parties and the project company, focussed on the availability of cash to assist the operational expenditures and fulfil the requirements of debt services in any circumstances. Another major attribute of project financing is that the process includes a legal consent from the involved parties which intends to secure the process of the project financially in case of any defaults arising even after the completion of the project. Thus, the process involves various risks in form of credit and commercial threats4. The basic features identifiable from the above provided description and definitions of project financing imply that it is a legal process and requires strong and effective regulatory interventions in its course to reduce the risks involved. This signifies the role of government to be quite significant in structuring the legislative actions concerned with minimisation of risks involved in project financing. However, in project financing, not only the regulatory frameworks, but other macro-economic factors also play crucial roles which can be controlled by governmental support. Based on this thought, the paper will intend to recognise and critically evaluate the governmental measures that can effectively support project financing in the modern day context. The Complex Structure of Project Finance With a general point of view, it can be stated that project finance intends to create an entity which is based on a special-purpose and aimed at the achievement of a particular goal, unlike any other commercial institution. For instance, an entity created with the aim to develop a power plant or a petrochemical unit or a toll road or even railways and operate it with the sole purpose for serving the state5. Thus, it is quite apparent that the purpose of project finances is predominantly broad which involves multiple facets and disciplines for its achievement. It is in this context that the structure of project finances are divided into two broad disciplines, i.e. the development of the project and finance. Both the disciplines are termed to be quite significant. The progress of the project deals with the functions performed by corporate players entitled to develop the project. Similarly, the finance discipline concentrates on the funding of the project representing the relationship between the financial lenders and the project development6. According to the experts, project financing is a complex process which involves multiple players and influencing factors active in the macro and the micro environment of the project company. The multifaceted nature of project finance also develops the structure to be complex7. The parties involved in the process can be identified as the sponsors, the borrowers, the financial advisers, the lenders, and the technical adviser, lawyers, equity investors and Export Credit Agencies (ECA) to name some. Notably, the lenders can be identified as the bank which is engaged with arranging and negotiating the term sheets and other documentations. The managers, the facility agent, technical banks, account banks, insurance banks and the security trustee can also be identified as the lenders of the project finance8. Along with the aforementioned players, the structure of project finance also involves Special Purpose Vehicle (SPV). It is recognised as an entity responsible for the completion of the project and is also signified as the project company9. In the international project finances and in the national project finances as well, the role played by governments and the legislatures are termed to be the most crucial in comparison to other players. Evidences in the modern era have revealed that governmental funds are necessary for the project finance and most of the projects entirely depend upon these kinds of funding or financial supports. However, the project finances, irrespective of their level of dependence on the governmental funding have to operate as a Public Private Partnership (PPP). The prime responsibilities of governments in project financing include providing an approval to the plan10. In order to simplify the structure of project finance, it is often divided into two dimensions by the experts, i.e. the commercial structure of the project and its financial structure. The commercial structure deals with the managerial functions, such as obtainment of approvals considering the governmental supports. On the similar context, the financial structure deals with the aspects related to financing e.g. the contractual issues between the lenders and borrowers engaged in the project finance. Thereby, the financial structure of a project depends on the legislative actions which are again controlled by the government and thus has to depend on the governmental support. As stated by Hoffman (2008), both the structures depend on each other to a great extent. Studies based on this context have revealed that financial structure of a project supports its commercial structure and vice-versa. In other words, both the structural dimensions of project finance are inter-depended11. With reference to the above discussion, it can be stated that project finance possesses a complex structure. It involves various aspects from legal to managerial and financial issues. Among the essential elements, governmental support is termed to be the most crucial. It is due to the fact that governmental interventions reduce the various risks associated with the process of project financing12. The Associated Risks It is of no doubt that project financing is a complex process and also possess a multifaceted structure which involves the participation of numerous players, e.g. the lenders, lawyers, banks and others. Even in terms of disciplines, the structure of project financing proves to be compound in nature. It is due to this reason that various risks are identified to be associated with the process of project financing. To be precise, the structure of project financing relates to the regulatory environment of the host and the home country. It also relates to the technological, environmental, geographical and other related factors which have the potential to influence the completion of the project. Thereby, the risks associated with project finance can be identified as the financial risks, regulatory risks, environmental risks and risks in terms of faulty governance system13. From a general point of view, the basic risks associated with project financing can be recognised as the completion risk, technological risk, financial risk, currency risk, political risk, and environmental risk14. The completion risk can be further divided into two phases, i.e. the pre-completion phase and the post-completion process. The pre-completion risks are identified as the risks involved in planning the entire process with due consideration provided to the aspects of time involved and sustainability. These kinds of risk may cause delay in the completion, deficient performance in the completion which in turn will lead to a faulty completion or even non-completion of the project. With deficient planning in the pre-completion phase, the project can also witness cost swamps. On the similar context, the post-completion risks involve the operational deficiencies occurring after the completion of the project15. In the modern day phenomenon it has been witnessed that most of the projects involve technologies which are freshly developed and thus possess various characteristics which tend to be unidentified by the parties engaged in the process. The un-identified of the characteristics lead to the technological risks which can cause post-completion deficiencies. Project finances deal with huge projects which involve a large amount of resources and are also not easily available. Due to the fact projects are often witnessed to suffer the risks arising from low availability of raw-materials. Project finances are also stated to be affected by economic risks to a large extent. For instance, due to a decrease in the price of the product supplied by the project, e.g. electricity, the cash flow can be hampered which in turn can cause financial risks to the project. Interest rate risks also involve in the financial risks faced by projects during the completion and even after the completion. In international project financing, currency rates also influence the operational and financial risks16. Environmental risks resemble the demographic and geographic factors which can hamper the project financing. For instance, a toll road being constructed in an earthquake prone area can cause risk to the completion and successful operation of the project financed. Along with the aforementioned risks, political risks also play a major role in influencing the project financing. Political and regulatory environment in a country is recorded to be fluctuating continuously. Evidences have revealed that a change in the government can lead to a major risk to the project financing. For instance, Strom Thurmond National Defence Authorisation Act, signed by the US president in the year 1998 was recorded to witness political risks due to the deficient U.S. export controls which caused hindrance in the project completion17. To be simplified, the risks associated with project finances in the modern day context is categorised as the market risks and the credit risks. Market risks are identified as the risks faced by the project in its pre-completion phases as well as in its post-completion period. The examples of market risks include currency fluctuations, interest rate risks, environmental and regulatory risks along with the political obstacles18. Credit risks relate to the challenges faced by the project financiers in terms of improper cash flows. This can be caused by the insufficient amount of finances and also due to the ineffective operations to generate adequate cash in order to repay the financial borrowings. Both credit and market risks have been referred to as interrelated. It is in this context that governmental interventions play an important role in controlling these issues which would be discussed further19. Diagrammatic Representation of the Structure of Project Finance20 Role of Government in Minimising the Risks The importance of project financing through public and private collaborations is growing rapidly in the modern day phenomenon. It is because of the fact that services provided by the public sectors considering the overall welfare of the nation are observed to be ineffective in most economies which are believed to be enhanced by the participation of private sectors. With this concern, governments in various countries are focussing on project financing as PPPs21. This develops the structure of project finance to be complex. Notably, the hybrid structure of project finance and raises numerous risks and governmental interventions are expected to reduce the effects caused by these risks. Experts have categorised the risks associated with project financing in various disciplines based on its financial and non-financial nature. However, studies have revealed that the risks are pragmatically interlinked22. For instance, environmental risks are stated to be non-financial risks or market risks. But it has a considerable impact on the financial risks which are also categorised as credit risks. To be illustrated, in an earthquake prone region the lenders may prove to be reluctant in financing the project of toll road construction resulting in scarcity of funds. Furthermore, the allocation of financial resources can be affected by the changes in regulatory frameworks, such as in the case of petrochemical unit construction which demands due consideration to the aspects of labour security and the environmental protection. It is in this context that governmental interventions can lessen the effect caused by the risks both in financial and non-financial terms23. The structure of project financing signifies governmental inclusion to be one of the most crucial facets. It is due to the reason that most of the project finances in the modern era tend to be PPPs which include significant participation of the public sector. In other words, the structure of project finances is observed to be hybrid in nature. Moreover, it is increasingly being concentrated on the PPPs with an intention to divide the risk guarantees faced by the project finances. For instance, in most of the cases it has been witnessed that private financiers undertake the risks associated with the construction of the project which can also be categorised as the operating risks. On the similar context, the public financiers are observed to undertake market risks related to the project24. From a general point of view, it is quite apparent that governments can influence the political risks significantly and thus secure the completion and operation of the projects financed to a certain extent. Governments can also play an impressive role in mitigating market risks, such as the risks associated with project financing in terms of faulty legal agreements, and ineffective EXIM (Export Import) policies which can obstruct the completion of the project financed. Governmental interventions can also play a major role in minimising risks associated with environmental hazards. Furthermore, interest rate risks, currency fluctuations and other similar risks can also be reduced by effective governmental involvements25. The role played by governments in supporting project finances can be defined as a financier, co-sponsor and a contributor of non-financial securities. To be specific, governments play a role of financier and a co-sponsor by supporting the project finances together with the private collaborations. For example, governments often supply a proportion of the total equity and loan capital which facilitates the funding of project finances. Host governments has also bee observed to provide guarantees on various terms which supports the project finances against political risks, environmental risks, and other non-controllable risks26. Furthermore, governments have also been recorded to supply raw materials to the project under the supervision of public sponsors which minimises the raw material risks along with the risk of cost overruns. Governments also act as one of the sole customers of the products and/or services produced in the projects constructed. For instance, in power supply plant engaged in producing electricity, it is the local government which acts as the sole customer and thus reduces the risk of insufficient cash flow. Other risks, such as fluctuations in tax rates, interest rates, currency valuation and others can also be minimised by the effective participation of governments in PPPs. To be mentioned, governments often provide fiscal incentives to the project finances in terms of tax exemptions, fixed interest rate facilities and others27. Governments’ participation in the development of a legal agreement between the parties involved in the project finance also plays a crucial role. For instance in the case of international project finances, the legal agreements between the supplier of raw materials and the sponsors need to consider the rules mentioned in the EXIM policies of the countries. Governmental support in simplifying the process can stimulate the process of completion and mitigate numerous risks associated with the project finance, such as delay in the completion, scarcity of resources, reduction in the overall operations costs and others28. Critical Analysis of Government Support In the modern day phenomenon, the significance of the role played by governments in supporting project finance is apparently recognisable. It not only stimulates the construction and the operations of project finances, but also reduces the consequences of various risks associated with the process. However, in the pragmatic concern, the role of governments in supporting the project finances have been criticised by experts over the past few decades29. Mody (1996) states that government interventions in project finances, have often been misunderstood on the basis of the procurement system of subsidies earned by the government from the project financed. However, in the realistic venture, government interventions have been concerned on the infrastructural and operational risks with the sole intention to reduce the risks and facilitate the project finance. Recurring subsidies earned by the government do not include in the role of government30. It is in this context that analysts and authors have often suggested the government to procure its subsidies earned from the project finances, in supporting the operations of the plant. For instance, revenue earned by the government from road tax, vehicle tax, sewerage services, electricity charges and others should be utilised in stimulating the operations of the plant rather than being accumulated with other subsidies earned by the government31. But due to the fact that governmental role do not signify the procurement of subsidies as a supportive measure to the infrastructural development of the plant, governments somewhat proves to be ineffective in stimulating the services provided by the plants. Due to this reason the government also fails to reduce the operational risks in a significant manner which evidently raises issues regarding the role of government in supporting project finances. Therefore, it is quite evident that governmental policies which direct the internal operations of the government also have a considerable effect on the supportive role played by the government in relation to project financing. An example of such governmental issues can be identified in the European context. The railways in Europe were operated according to the governmental policies of the 19th century with only few transitions to the overall constitution and were solely governed by the public sector. After the First World War, private railway construction companies started entering the sector but at the condition to render services below the average cost as mentioned by the governmental policies and the legal agreements. But over the years, it caused increasing debts and diminished contribution to the GDP of the economies until the later 1990s. This forced the European government to restructure the policies leading to the cut in costs, allocation of finances and increase in the freight charges32. Therefore, it is quite apparent that governmental policies strongly affect the performance of the plants constructed influencing the risks associated with the construction and operations as well. However, the sovereignty of governments on supporting project finance also depends on the external factors which in turn conversely affect the role of governments in this context. To be illustrated, due to the recent economic down-turn in 2008-09, the American government suffered from diminished bank profits and other crises. Subsequently, the government decided to mitigate the tax incentives on the projects related to clean technology which in turn discouraged the private financial institutions to invest in the sector. Along with the clean technology sector, other capital intensive sectors also faced similar challenges with diminished amount of financial investments due to the changes in the political and economical environment. This signifies that market risks, especially risks such as, inflation are uncontrollable by the government. In other words, government can not minimise all the risks and ensure the attainment of the goal determined in project finance33. These attempts put forward by the government in various instances, undoubtedly raises questions based on the criticality of the role played by government in supporting the project finances. However, there are also several illustrations which augment the significance of the governmental support in the modern era. For instance, the UK government had been recorded considering few reforms in the constitutional policies in order to regulate the operations of PPPs. In the year 2003, the UK government initiated to standardise the legal agreements or concession contracts considered in the Private Finance Initiative (PFI) deals. In this regard, the insurance terms had been tightened in terms of the price to cover, the term period and the availability of the insurance facilities. Thus, the initiative proves that governmental interventions also influence insurance risks in the market. However, as there are various types of players involved in the process and also because the agreement is likely to differ from one deal to another, it is almost impossible to have a fully standardised concession for all types of project finances34. Another significant trend identifiable in the UK context was the ‘batching’ initiative. The UK government had attempted to categorise the project finances according to the amount invested or required. The sole purpose behind this initiative is to reduce the limitations of the process to financially close the dealing which can be identified in terms of complexity, time consumption and operational costs. Moreover, the government had also initiated to refinance the projects in the post-completion phase to boost up the performance of the plants35. However, these reforms are likely to raise numerous risks. The governmental initiatives to restructure project finance initiatives in the country is likely to have a considerable effect on the structural risks which can be identified as complexity, unsystematic influences and others, although, for a short-term period. It also raises the regulatory risks caused standardisation and ‘batching’. Therefore, it can be stated that the government should evaluate the consequences of the initiatives during the restricting of the policies related to project finances. Furthermore, it can be stated that governmental interventions play a crucial role in mitigating the risks associated with project finance. But governmental policies also get influenced by the risks active in the external environment. At times, even the government initiatives can influence the risk factors, rather than minimising the effects. As stated by Klein (1996), “....government, through the tax system, cannot really do better than private financial markets at funding infrastructure projects”. Hence, it can be stated that although the role played by governments are quite crucial for the effectivity of project finance, it is not strongly dependable in the modern phenomenon36. Conclusion Project finance is one of the complex and increasingly important facets of industrial and social development. Since its evolution in the industrial sector, project finance has continuously broadened its parameters in terms of its structure and aim as well. Subsequently, the concept has emerged to be multifaceted involving multiple parties as financiers, borrowers, customers, and others. Another significant characteristic of project finance in the modern day phenomenon is its participation in economic growth as PPPs which perpetually involve the public sector as the most crucial constituent of its structure. Notably, governments have been witnessed to support project finance in various terms from regulatory support to the mitigation of credit and market risks. For instance, simplifying legal procedures to instigate a project; minimise interest rate and currency risks; supporting the cash flows by acting as both lenders and customers37. However, in the pragmatic manner, governmental support have been criticised by various analysts and experts. It is worth mentioning that governments in UK, US and other countries have been witnessed to adopt various measures in order to support project financing in the countries, such as tax incentives, long-term loan facilities, lower interest rates and others. Governmental initiatives also included the customisation and standardisation of legal frameworks to reduce the operational risks and pre-completion risks of project finance. These initiatives significantly supported project finances, but also raised few other limitations in terms of complexity, demanding execution, and others38. Therefore, governments should adopt measures which will significantly minimise the risks faced by project financiers, but raise minimum and less effective risks subsequently. Considering the above mentioned facts, it can be stated that governments should focus on restructuring the regulatory frameworks according to the type of projects. For instance, a standardised regulatory framework can be developed to structure the toll road construction projects, while the construction of power plants can be regulated by another framework. To be precise, depending on the characteristic of projects, different regulatory frameworks should be developed which will not only simplify the process, but also minimise the risk of cost overruns and raw-material risks. Furthermore, the obtainment of sufficient finances in terms of loans and capital should also be supported by the government to a major proportion. In this regard, government should furthermore consider the liberty of private financiers without hampering their interests and securing the sustainability of the project simultaneously. Conclusively, the structure of project finance has emerged to be quite complex and any reform exercised in this context shall prove to be time consuming and expensive for the government. 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