3.2 Risk Allocation with Contracts Stipulated by the SPV
3.2.4 Allocation of Market Risk
Market risk coverage is crucial in project finance. This is because a reduction or cancellation of market risk allows the SPV to lock in the first line of cash flows or to reduce its volatility (and consequently the risk of a cash shortage).
F I G U R E 3-6 Structure of a Fixed-Price Maintenance Contract
F I G U R E 3-7 Structure of a Pass-Through Maintenance Contract
Risk Allocation with Contracts Stipulated by the SPV 49
However, this coverage is not always possible. It is simpler if there is a single buyer of the good or service (the offtaker), but it becomes impossible when dealing with a retail market. For example, it is much easier to draw up long-term sales contracts with an industrial buyer or a utility, as occurs in the power sector. However, the situation becomes more complicated in the transportation sector (roads, tunnels, parking lots, etc.) or when dealing with building hotels or leisure facilities. In these fields, the variability of tourist or traffic flows can never be completely eliminated.
Only minor remedies can be put in place by sponsors.
. They can conduct sensitivity analyses to estimate users’ reactions to a (poten- tially substantial) fee reduction (always within a defined range of probability).
. They can attempt to limit demand fluctuations by drawing up contracts that ensure minimum use of the structure. An example might be contracts assigning some parking spaces to a specific counterparty; another example is the hotel and leisure sector, where tour operators can contract for guaranteed room avail- ability in certain periods of the year for the business segment.
. They can force the public administration to guarantee a minimum level of revenues where there is a variable market. In this case, although it is improper to talk about offtaking agreements, the public administration can act as a wholesale buyer, reducing the level of market risk otherwise borne by project sponsors. Two examples related to the transportation sector and the hospital/
health care services sector are discussed in Section 3.2.4.3.
3.2.4.1 Offtake Agreements
When the SPV sells goods or services to a single large counterparty, offtake agree- ments represent a very useful tool for structuring a project finance transaction.
In fact, by mitigating market risk, such agreements decrease the volatility of future cash flows from operations, which are the basis of lenders’ assessments as to the sustainability of the deal.
Offtake agreements are long-term contracts in which one counterparty (usually an SPV) commits to delivering certain volumes/quantities of a good or service. The other, called the offtaker, agrees to pay predefined sums of money or a set fee for a certain period of time in exchange for a good/service from the SPV. The price the offtaker pays is indexed to parameters that track trends in the rate of inflation for production prices and consumer prices.
The most common types of offtake agreements are set up on a take-or-pay basis.
Figure 3-8 illustrates the functioning of such an agreement. The offtaker commits to buying a good or service produced by the SPV and is obligated to pay even if it does not actually take a good or service. This latter is true, however, only if the SPV is able to supply the good in question, i.e., only if the SPV’s production output is available for delivery.
In contrast, as the lower part of Figure 3-8 shows, if output is unavailable, it is the SPV that commits to providing an alternative source for the product or service and must compensate for the greater costs incurred by the offtaker if and when the case may be. In this way, a take-or-pay duplicates a put-or-pay contract, discussed earlier in Section 3.2.2.
Offtake contracts take various names, depending on the sector in question and the business conducted by the SPV; these agreements have been used the longest in the power sector (see Section 3.2.4.2). In the telecom sector, for example, there are IRU 50 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
contracts (indefeasible rights of use), which refer to the exclusive right to use a specific portion of the capacity of a communications cable for a set period of time. In exchange for this right, the beneficiary company (generally a service pro- vider) pays fixed periodic sums to the owner of the network (often the SPV). Another example is in the shipping industry, where we find time charter contracts (which usually run from five to fifteen years). This tool enables ship owners to finance investment initiatives while employing a limited amount of their own financial resources. With a time charter, a third party (often a service company) pays a rental fee to the SPV, which is usually the owner of a fleet of ships, for the use of these vessels. In this way, the SPV curtails its market risk, e.g., finding no renters and leaving its fleet anchored in port.
3.2.4.2 Offtake Contracts in the Power Sector
The power sector is certainly the investment area in which such agreements have evolved the furthest and for the longest time. Today, in fact, various types of contract frameworks can satisfy the needs of the counterparties involved in an investment initiative while respecting the principle of correct risk allocation among project participants. The contract structures to which we refer are the following:
. PPA (power purchase agreement)
. tolling (based on a tolling agreement)
Power Purchase Agreement Structure: The contract model for distributing electrical power known as the PPA was the first to be used on a wide scale in the United States
F I G U R E 3-8 Structure of Take-or-Pay Contracts
Risk Allocation with Contracts Stipulated by the SPV 51
and various European countries to develop construction projects for private power plants. This contract structure is based on long-term agreements between private investors and a public counterparty or an entity linked to the public administration that essentially poses no credit risk.
With a PPA, the SPV undersigns contracts in two directions:
1. A fuel supply agreement (FSA) to ensure fuel supply and mitigate supply risk 2. A power purchase agreement (PPA), a supply contract for the long-term sale of all power generated by the plant to one or more wholesalers (offtakers) to mitigate the risk of selling energy output
Specifically, the PPA contract establishes that the project company will make a certain amount of electric power available daily; the offtaker, in turn, is obligated both to make a minimum purchase and to pay a fee, part of which is fixed and part variable.
The fixed component, also known as the capacity charge, serves to cover fixed costs of the plant, the return on investments of the sponsors, and debt service. The variable component, which can also be called the energy charge or energy fee, is indexed to the actual electric power produced; it goes to meeting both fuel costs and variable operation and maintenance (O&M) costs. Basically, every increment in fuel prices should translate into an increase in the electricity rate paid by the buyer (pass- through). Normally, the method for revising this rate is established at the outset and is linked to the revision mechanism for fuel costs. The rate is calculated by using the following equation:
PPA rate ¼ Cf þEf where:
Cf ¼Capacity fee¼fixed costsþdebt serviceþsponsor reimbursement Ef¼Energy fee¼fuelþvariable O&M costs
Figure 3-9 illustrates how the PPA rate is determined.
In the energy sector, the PPA contract is the keystone for project finance initia- tives. In this context, lenders’ main concern should be to verify that the contract
Total revenuefromenergysale (PPA)
CAPACITY CHARGE ENERGY CHARGE
Dividends to shareholders
Fixed costs (fixed O&M costs and other fixed costs) Debt service
Fuel costs
Variable operating costs Variable O&M costs
F I G U R E 3-9 Determination of the PPA Rate
52 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
extends to the entire tenor of the loan and on the assessment of the offtaker creditworthiness. Specifically, banks focus on escape clauses that buyers reserve for themselves. In addition, banks tend to make buyers accept contract provisions allowing for an adequate amount of time to devise solutions that would prevent withdrawal from the contract.
There are two basic PPA contracts, the American model and the British model.
In the first, federal and state authorities grant power producers the exclusive right to supply and distribute energy in a given area. As for power generation, this right is limited: Utilities can buy the energy generated by independent producers only if this power is cheaper than what they produce themselves.
In the UK, on the other hand, power producers sell their output on an energy exchange (the Power Pool), which then transmits this power to local distributors who buy from the same exchange. The Power Pool is run by the National Grid Company (NGC); producers offer energy to this company on the basis of set prices, specifying if the plant is operational or in standby. The NGC takes responsibility for periodically compiling a classification of power plants, based primarily on the bid price but also on the plant’s capacity to respond rapidly to NGC demand and on its geographical location. Energy demand is conveyed to the NGC through regional electric com- panies (RECs), who base the purchase prices they offer on local needs. In the British model, producers do not know exactly what price they will receive for the power they supply. The same is true for the RECs, which do not know ahead of time what price they will pay for electric power supply. Therefore, this is a market model in which prices depend on supply meeting demand.
This uncertainty is dealt with by means of a mechanism known as acontract on differencesbetween the independent producer and the REC. In this agreement, the parties set up a hedging fund on the basis of a strike price. If the price paid by the REC to the Pool exceeds the strike price, then the producer refunds the REC; if instead this price falls below the strike price, it is the REC who pays the difference to the producer. In reality, the contract on differences is an exact replica of the PPA contract in the American model.3
Tolling Structures: PPAs have gradually been replaced by other types of contract models. An example istolling,which enables the energy producer (usually an SPV or an independent power producer—IPP) to generate sufficient cash flows to repay initial investments. At the same time, this setup allows for more efficient and rational risk allocation. Tolling contracts were first invented and developed in the petrochemical industry, in particular in the crude oil refining sector.
In the electric power sector, in contrast, tolling has been used in countries that first liberalized domestic markets for electricity and gas: the United States and the UK and later Spain and Italy.
This type of contract has basically evolved from the need for fuel suppliers to allocate risk in an innovative way while preserving the project’s ability to raise capital on a nonrecourse basis. The base contract that typifies a tolling structure is called
3. A contract for differences is similar to a hedging contract between the SPV and a hedging counterparty.
With hedging, an agreement is drawn up between the two parties for the sale of a commodity at a set price for a given period of time. At the same time, a lower bound and an upper bound are set to limit price variations for the commodity. If on the settlement date the price is between the lower and upper bounds, the SPV sells the product on the open market. If instead the price goes below the lower bound (above the upper bound), the SPV has the right to sell the commodity at the lower bound price to the hedging counterparty (and vice versa, the hedging counterparty has the right to buy at the upper bound price).
Risk Allocation with Contracts Stipulated by the SPV 53
a tolling agreement. According to this accord, on one hand a wholesale customer, called the toller, supplies fuel as a ‘‘free issue good’’ to the project company’s plant and gives this company orders for converting the quantity of fuel delivered into energy. In exchange for services offered, the SPV, on the other hand, has the right to receive a tolling fee. Figure 3-10 shows the functioning of a standard tolling agreement.
The unique features of a tolling structure can be summarized as follows.
. All market risks, especially those relating to supply and the sales price of electric power, are taken on by the toller, who sets up agreements directly for fuel supply and transportation and for sale of electric power.
. The project company, in exchange for the tolling fee paid by the toller, offers its production capacity and provides the service of converting fuel into electricity.
. Only operating risk is taken on by the SPV.
. The project company can rely on readily predictable and constant cash flows for the duration of the tolling agreement, regardless of the fluctuations in the power market or in the price of fuel used to produce electricity.
The tolling fee paid by the toller to the project company for services rendered is one way to guarantee this final condition.
There are generally two approaches to building a tolling fee: financial and industrial. In both cases, per-unit fixed costs and variable costs of operations are taken as components of the fee, for they are essential to the functioning of the plant.
The difference between the two calculation methods is the remuneration of factors taken into consideration: financial resources, loan capital, and equity in the financial approach, investment capital in the industrial approach.
According to the financial approach, the tolling fee can easily be compared to the capacity charge described earlier in relation to PPA structures. In fact, this fee is meant to cover fixed costs of the plant, return on investments for sponsors, and debt service.
Following the industrial approach, in contrast, the tolling fee is seen as a source for remunerating the capital invested in the project. In addition to covering fixed costs of
F I G U R E 3-10 Functioning of the Tolling Agreement
54 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
operations, the fee includes amortization for goods tied up in the investment initiative as well as the return on capital invested requested by lending institutions.
In some cases a variable-cost item may be factored into the tolling fee, which is indexed to contracted thermal efficiency criteria (heat rate adjustment). Nonetheless, the key component of the variable fee of a PPA—fuel costs—is absent, because fuel is supplied directly by the toller. The amount due is calculated by applying the follow- ing equations, depending on whether the financial or the industrial approach is used.
Financial Approach:
Tolling fee¼DsþRsþFocþVoc where:
Ds¼Debt service
Rs¼Remuneration of sponsors Foc¼Fixed operating costs Voc¼Variable operating costs Industrial Approach:
Tolling fee¼AmþRciþFocþVoc where:
Am¼Amortization
Rci¼Remuneration of investment capital Foc¼Fixed operating costs
Voc¼Variable operating costs
Figures 3-11 and 3-12 show the structure of the tolling fee in the financial approach and the industrial approach, respectively.
This type of contract makes it possible to maximize the financial leverage of the SPV, since one of the cornerstones of project finance is fully actualized: Risk is allocated to players who, in each specific case, are in the best position to control it.
Lastly, it should be emphasized that in tolling structures, risks are taken on primarily by the toller. For this reason, the toller must demonstrate to lenders sufficient technical/professional skills to handle both supplying fuel and selling electric power while maintaining a high credit standing for the entire tenor of the loan.
Take-and-Pay Contracts (Merchant Plants): In recent years, project finance ventures in the power sector have been structured much more aggressively as far as the risk assessed and allocated among various participants in the investment initiative. This trend can be attributed to a series of conditions that have emerged on the financial markets in the past few years. Examples are a high level of available liquidity, a growing tendency for commercial banks to assume greater risks in order to win market share while thwarting competitors, and high oil prices, which have allowed energy and oil companies to boost their profit margins.
Risk Allocation with Contracts Stipulated by the SPV 55
Among the financial models adopted in this context, which is characterized by intense speculation on financial markets, we find themerchant structure. Within this framework, the project company does not enter into any long-term contract guaran- teeing fuel supply within a set price bracket or the sale of electricity generated by the plant. In fact, the offtaker pays for only what it actually buys (take and pay).
As a result, the SPV’s cash flows are exposed to operating risks, inherent in the ability to produce electric power efficiently and economically, supply risk, and market risk, i.e., the level of liquidity and volatility of the electric power market throughout the life of the project.
With merchant structures, in fact, fuel suppliers are forced to accept a consider- able share of the price risk of electricity, leaving most of remuneration to the power producers. This particularly aggressive type of structure is called merchant square.
It is distinctive both because there is no fuel supply agreement (FSA) to cover against supply risk or power purchase agreement (PPA) to cover against market risk in a strict sense. In this way, the SPV buys fuel and sells electric output daily and is completely exposed to market risk on both fronts.
Nonetheless, in practice, exposure to fuel supply risk is lower and is normally mitigated by implementing an FSA. Moreover, fuel sellers are often forced to accept price indexing for fuel that is linked to the actual sales price of electric power on regulated markets.
Total tollingfee
Dividends to shareholders (RS)
Fixed costs (fixed O&M costs and other fixed costs) (FOC)
Debt service (DS) Variable operating costs
(fuel excluded)
F I G U R E 3-11 Structure of the Tolling Fee in the Financial Approach
Total tollingfee
Remuneration of invested capital (RCI) Fixed costs (fixed O&M costs and other fixed costs)
(FOC) Amortization (AM) Variable operating costs
(fuel excluded)
F I G U R E 3-12 Structure of the Tolling Fee in the Industrial Approach
56 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
3.2.4.3 Offtake Agreements in PPP initiatives
Sponsors of projects falling in the PPP category often ask the public administration to cover at least a part of the market risk related to such initiatives. A PPP, in fact, is a way to transfer most of the risks of providing services to a retail public of end users to private parties, leaving the public sector only the role of director and supervisor of service provision to taxpayers. For this reason, it seems natural to ask the public administration for some form of subsidy in order to improve the attractiveness for the private sector and project profitability for sponsors.
Such subsidies are very similar to a take-or-pay agreement. They generally involve the payment of tariffs when the usage of the facility built by the SPV is below a certain predefined level or tariffs with a minimum floor amount that compensates the private sector for the availability of a given facility, regardless of the number of users.
An example of the first type is the shadow toll system used in transportation facilities;
the second type can be found in hospital and health care services.
Offtaking Contracts in the Transportation Sector—The Shadow Toll System: The shadow toll system is used in the context of building toll roads and upgrading preexisting roads. This contract mechanism facilitates awarding concessions for segments of roadways—either BOT or its variant, DBFO (design, build, finance, and operate)—to private operators. With this contract, the public administration pays an annual toll to the private concession holder based on the volume of traffic on the road and the service levels. The wordshadowrefers to the fact that the end user does not actually pay a toll to the operator; in fact, there are no tollgates for collecting money. The final cost of road construction is factored into the national budget and so is paid for by citizens through taxes.
The private concession holder pledges to raise capital to carry out the project and for a set time period has the right to collect shadow tolls (usually for around 30 years). This revenue allows the concession holder to recover the costs of upgrading or building the road and to earn a reasonable return on capital invested. When the concession expires, payments stop and the road is turned over to the public admin- istration, which pays no additional fee to the concession holder.
During the term of the concession, the concession awarder pays the holder on the basis of the number of vehicles that travel on the road. Payments are based on a banding system linked to the use of the roadway. In the UK, a rather common formula is for potential concession holders to make an offer based on multiple banding, where every band covers a different project cost profile (see Figure 3-13).
Band 1 is used to cover fixed O&M costs and senior debt service. Band 2 serves to cover variable management and O&M costs and to service the subordinate debt.
Lastly, Band 3 is normally earmarked for paying out dividends. For traffic volumes above a given level (Band 4), as decided by the public administration and the concession holder, no shadow tolls are paid. As a result, there is a cap on costs for the public administration and revenue for sponsors.
There are several advantages to the shadow toll system.
. Incentives for the concession holder:Given that payments to this company are based on traffic volumes and service quality, it is in the concession holder’s best interest to complete the road construction quickly and to avoid construction delays or inefficient management of the infrastructure.
. Limitation of traffic risk: This facilitates private partners in the search for financing for building new roads or upgrading existing ones. Moreover, a
Risk Allocation with Contracts Stipulated by the SPV 57