Historical Evolution of Project Finance and Market Segments

C H A P T E R

^u

2

The Market for Project Finance:

Applications and Sectors

Introduction

The focus of this chapter is the projectWnance market. Here we present:

1. The historical evolution of the sector and of market segments in an inter- national context, distinguishing between various macro areas at a global level 2. A detailed look at the European market and public–private partnerships

(PPPs)

The data presented here are taken from the Thomson One Banker databank, and they refer to loans granted for projectWnance transactions. Bond issues, which are speciWcally addressed in Section 6.11, are not included.

Section 2.1 focuses on the historical evolution of project Wnance worldwide;

Section 2.2 presents market data. Details on the European context and PPP initia- tives are given in Sections 2.2.1 and 2.2.2, respectively.

2.1 Historical Evolution of Project Finance

Funding was provided on the basis of the ability of producers to repay principal and interest through revenues from the sale of crude oil, often with long-term supply contracts serving as counterguarantees.

In the 1970s, project Wnance spread to Europe as well, again in the petroleum sector. It became theWnancing method used for extracting crude oVthe English coast.

Moreover, in the same decade, power production regulations were passed in the United States (PURPA—the Public Utility Regulatory Policy Act of 1978).

In doing so, Congress promoted energy production from alternative sources and required utilities to buy all electric output from qualiWed producers (IPPs, or inde- pendent power producers). From that point on, project Wnance began to see even wider application in the construction of power plants for traditional as well as alternative or renewable sources.

From a historical perspective, then, project Wnance came into use in well-deWned sectors having two particular characteristics:

1. A captive market, created by means of long-term contracts at preset prices signed by big,Wnancially solid buyers (oVtakers)

2. A low level of technological risk in plant construction

In these sectors, the role of project sponsor has always been taken on by large international contractors/developers and multinationals in the petroleum industry.

In the 1980s and 1990s, in contrast, the evolution of projectWnance followed two diVerent development trends. TheWrst involved exporting theWnancing technique to developing countries; this was promoted by the same developers. Since room in the market in their home countries was gradually diminishing, these entrepreneurs oVered project Wnance to governments in developing countries as a quick way to reach a decent level of basic infrastructure with a greater contribution of private capital. The support oVered by export credit agencies (see Chapter 6) in the home countries of contractors and multinationals played a key role in the process of developing the projectWnance technique.

The second trend in the project Wnance market emerged in those industrialized countries that initially tested the technique in more traditional sectors. In fact, these nations began to use projectWnance as an oV-balance-sheet technique for realizing:

. Projects with less (or less eVective) market risk coverage; examples can be found in sectors where there is no single large buyer, such as toll roads, leisure facilities, and city parking lots.

. Projects in which the public administration participates in promoting works for the public good. In many cases, such works cannot repay investment costs or cover operating expenses or debt service at market prices. This is why such projects have to be subsidized to some degree by public grants. In some countries (the UK is front-runner in Europe), project Wnance is very often applied when carrying out public works through a program called the Private Finance Initiative (PFI).

Figure 2-1 summarizes these points. Cell II refers to the best example project Wnance initiatives; in fact, this is where the technique originated. The two arrows pointing toward Cell I and Cell III indicate market trends that are under way. Note that Cell IV shows a risk combination that is not suited to projectWnancing. In fact, high uncertainty, an extremely rigid contract structure, and high Wnancial leverage 20 C H A P T E R ^u 2 The Market for Project Finance: Applications and Sectors

make it diYcult for management to respond quickly or to adapt to change. In these cases a corporateWnance loan is a more appropriate solution.

The matrix in Figure 2-1 is also signiWcant from another perspective: It enables us to pinpoint the sectors in which projectWnance is applied, depending on the capacity of the initiative to cover associated costs and investments with its cash inXows.

SpeciWcally, note that in the sectors listed in Cells II and I, the product in question can be sold at market prices on the basis of long-term contracts (take or pay agreements or oVtake agreements; see Chapter 3). For the projects in Cell III, on the other hand (with the exception of the hotel and leisure facilities and telecom), setting a market price that can generate adequate proWts for sponsors is usually complicated. These initiatives pertain to goods/services with major externalities (such as water system management or urban and social development of areas where roads are to be built) or to those associated with the needs of the general population that have costs that dramatically impact lower-income segments (health care, for example). In these situations, entrusting a project completely to the private sector could make it impossible for some people to exploit the service oVered through the realization of the initiative in question. This gives rise to the need for public funding in the form of contributions on works that can mitigate the investment costs for private sponsors and consequently the level of prices or fees paid by end users as well.

In this regard, a classiWcation is quite widely used among operators that draws a distinction between projectWnance initiatives that are fully self-Wnanced (i.e., project Wnance in the strict sense) and those that are partially self-Wnanced. For the former, the assessment is based on the soundness of the contractual framework and the counterparties. In the latter case, in addition to these factors, bankability depends a great deal on the level of public grants conferred.

• Industrial plants

• Mining

• Oil and gas

• Power generation In developed countries

Exposure to market and/or technological risk

Low High

I II

IV

• Industrial plants

• Mining

• Oil and gas

• Power generation In developing countries

• Toll roads

• Telecom

• Rail and infrastructure

• Hotel/leisure

• Water and sewerage

• PFI/PPP

In developed countries III

High

Exposure to country risk

Low

F I G U R E 2-1 Evolution of the Project Finance Market by Type of Market and Underlying Risks Source: Adaptation of Esty (2002a).

Historical Evolution of Project Finance and Market Segments 21