LLM in Project Finance PPP - Risk Mitigation - Coursework Example

LLM IN PROJECT FINANCE PPP- RISK MITIGATION Introduction Globalisation has undeniably empowered private corporations and business personalities to grow their ventures as they now have the freedom of moving globally to seek business growth opportunities.1 It is therefore not surprising that when speaking of international relations in today’s political discourse multinational corporations are included as one of the major stakeholders that governments deal with.2 With the growing influence of the private sector in any economy, the issue of public private partnership (PPP) has become increasingly popular as governments through the public sector continue to partner the private sector for the fulfilment of national development agenda.3 For most governments executing major project investments such as power plant installation, they rely on PPP to get them done. As much as PPP has its own merits in easing the difficulty with which projects are executed, the issue of project financing remains a challenge especially with current volatility of markets. Because of the volatility of markets project finance and PPP lawyers have had difficulty securing finance for projects due to periods of uncertainty.4 Even in cases where project financing is successful, the issue of legal risk due to uncertainty on the market continues to become challenging for these lawyers. The essay there seeks to address ways in which the issue of uncertainty arising from legal risk can be handled by lawyers whiles recommending financial instruments that can be used to finance power plant for medium term of 7 to 10 years. Uncertainty from legal risk perspective Project finance and PPP lawyers are often faced with the challenge of uncertainty from legal risk perceptive when giving counsel on major international projects such as the installation of power plants. In this section, the dimension of legal structuring as reflected in legal and political risk are discussed with particular emphasis on developing countries. Dealing with legal and political risk The common notion within the global market is that private organisations that partner public institutions enjoy some level of legal and political protection. This notion is however refuted as it has been observed that depending on the political stability of a particular country, these partners could face several forms of legal and political risk when change of government takes place.5 It is therefore important for lawyers giving professional counsel to PPP clients to make them aware of what legal and political risks are and how these can be dealt with. Legal and political risk has been explained to be any changes in law or politics of a host country that presents an adverse impact on the project being taken place.6 Legal and political risks happen for various reasons and in different forms. For example change in government or sector ministers can lead to the cancelation of major projects. It is also possible that even if projects are not cancelled, their financing or overall government comment will be halted. There are also instances where new laws are made to favour political cronies, affecting ongoing PPP projects negatively. Ahead of accepting and major international projects on the principle of PPP, there some ways in which project managers and financers can deal with legal and political risks. Even in the course of the project, there are different ways in which legal and political risks that arise can be dealt with. The first of these is the use of political risk insurance provided by such internationally recognised bodies such as the Multilateral Investment Guarantee Agency (MIGA). As part of the World Bank Group, MIGA gives political risk insurance that comes under contracts of guarantee for both foreign equity and other related debt investments.7 MIGA identifies very specific political risk factors that most multilateral investments could be exposed to, including war, expropriation, currency transfer risk, and civil disturbances, and gives insurance coverage for any or all of these.8 Like with all other insurance policies, the political risk insurance ensures that partners in the PPP and the international project financing are adequately protected against any uncertainties so that if of the covered uncertainties happen. By protection, reference is being made to the fact that MIGA makes arrangements that guarantee investors of their investment capital in the event of uncertainties.9 Even more, there have been modifications to the mandate of MIGA which ensures that cover is given against breach of contract when the claimant is denied appropriate judicial or arbitral relief.10 Using stabilisation clauses have also become one of the commonest means by which legal practitioners have protected their clients against legal and political risks involving international projects through PPP.11 Stabilisation clauses are contractual protections that are incorporated in long term investment projects such as the installation of the power plant which is to take place in a period of 7 to 10 years between international investors and states.12 Right from the definition of stabilisation clause, it will be possible to appreciate its appropriateness for guarding against legal and political risks in PPP. First, stabilisation clauses deal with international investors and states whiles PPP involves private investors and government. Second, stabilisation clauses have been noted to be particularly useful in addressing changes in unstable markets. This is because when incorporated in the principal project documents, the stabilisation clauses insulate the project against any forms of adverse changes that occurs within the legal and fiscal environment.13 By implication, as much as the client using the stabilisation clause shall benefit from changes in legal environment of the host country, it shall also ensure that issues of economic instability are adequately protected from affecting the successful progress of the project. Using the stabilisation clause is indeed useful and relevant as freezing clauses for example can be used to ensure that changes to legislation due to any form of legal and political changes will not affect the contract signed.14 Once the stabilisation clause is breached, the right compensations must apply. The use of government undertakings is another popular means by which partners in PPP for international projects can be secured against legal and political risk. Through the use of government undertakings, even though the partnership between the private sector and the public sector takes place, the government or public sector is made to take possession of greater percentage of the share which is 51% or more.15 This procedure is used as legal and political risk mitigation as the fact that the government owns greater percentage of the project forces it to show greater commitment towards the success of the project. The use of government undertakings have however been criticised for its ineffectiveness for long term projects that may not be completed before there is change in government.16 This is because in most cases of changeover in government, there is the possibility that the new government may sell out its shares in the project to another private entity. In such a case, the initial private holder may have to get other means by which they can protect themselves against other forms of legal and political risks. It was against this backdrop that it has been recommended that careful selection of governing law of key project documents should be undertaken in general before accepting to partner any project with the public sector.17 The case of developing countries Even though legal and political risks can be common in all countries, there are studies that have showed greater levels of these risks in developing countries.18 In most studies that the concept of politically unsustainable states has been discussed, researchers have attempted to categorise the stability of countries based on various modalities. One such modality that is used by the Fund for Peace is the failed state index which ranks countries based on 12 major primary social, economic and political indicators.19 Out of the 12 indicators, 6 (50%) of them are political indicators. The 6 political indicators used under the failed stated index are state legitimacy, public service, human rights and rule of law, security device, factionalised elite, and external intervention. Because of the dominance of political indicators in the failed state index, the index has commonly been asserted as being ideal or appropriate for finding politically unsustainable countries in the world. Interestingly, the list of failed states provided by the highly acclaimed Fund for Peace in 2013 had so many developing countries in the top ranks, meaning that there are more developing countries than developed countries that can be considered as politically unstable.20 The general understanding that this indication gives is that international PPP projects that take place in developing countries come with higher legal and political risks for international investors. With the above noted, project finance and PPP lawyers have a responsibility of providing additional support assistance to clients investing in PPP in developing countries. Four major legal and political risk factors that are worse considering when investing in developing countries include legislative and regulatory systems, political security, economic security, and centralised infrastructure systems. Through the use of international law agencies, it should be possible to know the legislative and regulatory climate of the country as influenced by the systems in place in such countries. Where there are evidences of recurring injustice in the legal system, it will only be advisable to avoid such countries. Again, using metrics provided by institutions like the Fund for Peace, it is possible to quantify the extent of political security in almost all developing countries in the world. Where the rating for political security is low, it is advisable to avoid long term PPP investments since such countries require more political risk mitigation measures which sometimes come at additional cost to achieve.21 In terms of economic security, it has been advised of the relationship between economic hardship and political instability,22 meaning it is important that in thinking about reducing political risk, it will be necessary to select countries with better economic security. Structuring of financial instruments for the power plant financing Financial instrument dimension is one other dimension very necessary for addressing the issue of power plant financing in the medium term of 7 to 10 years. This is because after going through all the listed procedures above to ensure that political risks are avoided, there will have to successful financing of the projects before the international project can be successful. This section therefore looks at the expectations of rates being sustainable in the medium term, the impact of construction periods in leading to risk, and the types of financial instruments that can be used for the power plant. Sustainability of financial instrument rates A financial instrument can be identified as tradable asset in the form of either cash, evidence of ownership interest in a particular equity, or as a contractual right gained to receive cash to a different financial instrument.23 Financial instruments are therefore needed for the funding of international projects such as the power plant which is the focus of the current study. The use of financial instruments for such international projects is commonly preferred due to the legal security that comes with these when used as contracts in rising financial assets for a preferred entity.24 Because financial instruments are legal agreements rather with monetary value, they are always payable after a period of time. Because of this, legal aids helping with the project financing of PPP projects for clients have always been particular about issues of sustainability of the financial instrument rates. Since the funds secured will be paid after a given time frame, it is always important to ensure that the most appropriate selection of an instrument will be made so that when the payable period for the project comes, the eventual rate of increase in interests will not exceed the earnings from the project. For most modern day projects, comprehensive financing arrangement have been encountered to cover any increases in rates associated with interest rate risk, currency risk, and market risk.25 Impact of construction period on access to financial instrument selection Within the finance market, financial instruments can be categorised into asset classes based on the length or period of the project involved. In most cases, the asset class is either a long term debt or a short term debt. It has been argued that knowledge of the construction period of the project is very relevant in knowing the right type of financial instrument that will be relevant for the project.26 This caution is particularly significant as a lack of understanding or accuracy with the duration of a project can lead to the selection of wrong financial instruments that will not be able to adequately serve the need of the project such as the power plant installation. In order to avoid this problem, various durability models and modalities have been used by project managers and project finance officers in ensuring that the right calculations can be made to acquire the right form of financial instrument. For the current power plant which has been estimated to last for 7 to 10 years, it can be put under the general category of long term asset class since it is going to be over 1 year.27 For such long term debts, the type of instruments that have been recommended in literature vary, including securities, other cash, exchange traded derivatives, and over-the-counter (OTC) derivatives. For the power plant installation therefore, it is expected some of these types of financial instruments will be selected and used. Recommended financial instruments As it has been stated above, the installation of the power plant is to take place as a long term asset class, requiring the use of financial instruments that are securities, other cash, exchange-traded derivatives, or OTC derivatives. Among these types, three ideal financial instruments have been selected and discussed below. Investment lending Investment lending is now considered one of the most popular exchange-traded derivatives that functions in the manner of interest rate futures but with long term payable periods.28 Because of the international nature of the current project, the investment lending ought to be taken from a global perspective by the use of multilateral lending institutions that come with competitive interest and repayment rates. Based on the principles of most of these multilateral lending institutions such as the International Monetary Fund (IMF) and World Bank Group, reforms have been made to the use of investment lending as financial instruments such that this type of instrument is carried out as a policy-based lending with elements of performance-driven loans.29 Meanwhile, performance-based loans have been described as investment loans that are distributed in tranches based on the achievability of the project’s outcomes and the verification of the expenditure of the outcomes by the lending bank.30 There are two major reasons that make the use of investment lending appropriate for the current power project. In the first place, because banks do not give out the loans in full, they become less cautious of the possibility of credit risk, making it easier to secure financial instrument through performance-driven loans.31 Secondly, the project owner or implementing parties have lesser financial risk to deal with. This is because there are only chances that parts of the projects will fail instead of the whole project since the delivery of funds is done in bits. What is more, because only parts of the project may fail, the cost of recovery is always relatively lower for partners in the project.32 These advantages notwithstanding, it has always been recommended that there be the presence of derivatives used to hedge against risk in the lending context. This is because for major international projects like power installation, parts of the projects that may fail could cost very high. In the light of this, derivatives have been used for hedging against exposure to risk, as well as the hedging against exchange rate risk. Equity Financing Equity financing is one other type of exchange-traded derivative often traded in the form of equity futures. In principle however, equity financing is known to involve the sale of ownership interests in any form including shares of a stock to raise funds for a project.33 When used as financial instrument, equity financing comes with its own benefits and some isolated challenges. In the first place, based on the credibility of the private entity involved in the PPP, the ability to raise to funds through equity financing has been noted to be one of the fast track approaches to gearing funds.34 The reason for this assertion is that it is easy for the buying party in an equity financing to assess, forecast, or predict the viability of the shares being traded by the enterprise. This prediction or forecasting can easily be done by using such readily available sources of data such as the stock market. Again, even though the money raised through equity financing may be directed purposely for the power plant, it can be expected that the presence of the buying party in the enterprise can also lead to companywide competition which could be fostered well to represent financial growth for the company.35 Once this happens, it is easy to expect that the part of shares lost in the enterprise may be translated into cash that replaces company level activity that may be lost from the running of the company into the project. It has also been stated that unlike debt financing which involves funds directly borrowed by the project financiers, the paperwork and risk involved in equity financing is relatively lower.36 For example there are several types of risks such as credit risk and operational risk that are hardly applicable in equity financing.37 However, it remains important to be mindful of market risk and currency risk which could be incurred at whiles the funds are being used. As far as the demerits are concerned, the issue of lost of corporate ownership could be faced by the private entity in the PPP.38 Interest rate swaps Interest rate swap (IRS) is commonly considered as an innovative financial instrument considered as in most literature as a type of underutilised financial instrument.39 This is because there are several benefits and advantages that this type of financial instrument offers but its usage is hardly known or preferred in PPP projects. IRS is a type of OTC derivative used in financing long term projects or debts as a liquid financial derivative where the two parties involved in the financing agreement accept to exchange interest rate case flows calculated with the use of specified notional amount from a fixed rate.40 To many, IRS hardly generate sufficient starting point amount to start a project and thus a reason for not using it. There are however several advantages with IRS that cannot be overlooked with today’s market liquidity. For example even when using this instrument in developing countries or lesser known economic states, international investors can be assured of the backing of such global bodies as the International Swaps and Derivatives Association Inc. (ISDA) who provide framework for limiting most forms of risks associated with the use of this financing instrument.41 What is more, when IRS is used, it is the hedging bank employed as a third party that takes the risk of fluctuations in interest and exchange rates instead of the borrower.42 This means that the borrower who is likely to be a private entity gets a lot of guarantee against risk. Conclusion The paper has established and appreciated the opportunities that PPP present to both multinational investors and governments, as well as the risks involved in the successful implementation of PPP projects. The opportunities largely focused on the shared fund capitalisation benefits that both parties enjoy at the end of these international projects. For the private entity, the lump sum amounts they charge help in boasting the market capitation of their businesses whiles the governments are favoured from having to finance the projects single handed from the start. But for any of the parties to benefit from their opportunities, it is important any form forms of risk that can act as impediment for the successful execution and completion of the projects be identified and mitigated. More specific is legal and political risk as this form of risk has been noted to be very common with most countries, particularly developing countries. With globalisation and the growing opportunities in developing countries as emerging markets, it will be very difficult for an investor to avoid these countries entirely. It is against this backdrop that the need to mitigating the legal and political risk ahead of the investments is recommended. In terms of financial instruments, it has been realised that investment lending, equity and innovation loans are some of the most ideal means of guaranteeing finance for such medium term projects as the power plant that can take from 7 to 10 years to complete. 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