CHAPTER 1
Principles and Application of Project Finance

ORIGINS AND HISTORY OF PROJECT FINANCE

Project finance is a highly versatile, if often misunderstood and misapplied, financing paradigm. There is no one single definition that succinctly captures project finance. Ostensibly, it is the long-term financing of infrastructure and industrial projects based upon the projected cash flows of the underlying project rather than the balance sheet of the project sponsors. Project finance refers to the financing of long asset life infrastructure, industrial and public assets, and services using non- or limited-recourse financing raised by an enterprise with a single line of business/finite asset life in accordance with contractual agreements.

Project finance is a tried and tested financial discipline that has been around for many centuries. The history and origins of project finance can be traced back to the 13th century when Italian banks financed a silver mine in Devon, England, with the loan repayment source being a lease over physical silver production from the mine. It has been used to finance maritime voyages to the new world in the 17th and 18th centuries with the merchant investors dividing the cargo spoils from returning ships. Project finance's application to infrastructure can be traced to the original construction of the Panama Canal and was key to financing wildcat upstream oil and gas investments in the early 19th century in the US along with the development of the North Sea oil fields in the 1970s and 1980s. The seminal market development that established the modern version of long-term contract-based project financing was the oil crisis in the US in the early 1970s. The fears and concerns over energy dependence forged the passage of the Public Utilities Regulatory Policy Act (PURPA) in the US in 1978. PURPA served to open the US electricity market to non-utility generators (NUGs) in an effort to increase energy supply, which heralded the origins of deregulation of the US electricity sector. PURPA essentially required vertically integrated monopoly utilities to purchase power from NUGs at their "avoided cost," which is the cost a utility would pay to generate power itself. This opened the energy market up to what became known globally as the Independent Power Producer (IPP) market and created the ability to raise project financing on the back of long-term power purchase agreements with creditworthy electricity purchaser utilities.

WHY SPONSORS USE PROJECT FINANCE

Project finance is both a financing and a governance structure. It is based on the notion that project risks are identified upfront, allocated to those best able to bear them, and mitigated such that the residual risks are acceptable to lenders. While project finance risk analysis and mitigation is not unique to this asset class, the process of contractual allocation of risk is unique to project finance. Project finance is sometimes referred to as "contract financing." The scope of the project along with the financing and security arrangements granted to lenders are set out in a comprehensive set of contractual documents entered into by the project company-and identified project risks are effectively allocated to those parties best able to bear them via these project contracts.

While there are many and varied reasons why project sponsors choose to use project financing versus on balance sheet corporate financing, according to Benjamin Esty it is to reduce capital markets imperfections or the net costs associated with the following:1

• Transaction Costs: Project finance deals generally take anywhere from 6 to 12 months to structure, negotiate, and execute the financing. The incremental legal, financial, and other costs associated with execution of the project financing can represent, on average, anywhere from 3% to 5% of total project costs. As such, transaction costs for project finance deals exceed comparable costs for corporate-financed deals.
• Asymmetric Information: Project finance capital providers to a greenfield infrastructure project-which is highly leveraged, thinly capitalized, and typically a single-asset special purpose company with no cash flows-require extra due diligence (independent consultants, insurance/legal advisors, and financial modeling), reporting, and controls (cash flow waterfall, financial and non-financial covenants, step-in rights, pledge of security/contracts, etc.). This reduces asymmetric information between lenders and owners/sponsors. The robust due diligence process that project finance lenders undertake also ensures that negative net present value (NPV) projects will not be undertaken as would be the case in corporate deals where project cash flows are co-mingled, fungible, and subject to cross-subsidizing between positive and negative NPV projects.
• Incentive/Agency Conflicts: Project finance helps reduce incentive/agency conflicts due to higher leverage/risk of default and assignment of most of the project cash flows toward servicing debt. This dissuades stakeholders (shareholders, governments, construction companies, operators, etc.) from cash flow diversion actions that would negatively affect the project. The high risk and high leverage typical of project finance deals would normally mean investors and creditors would require higher risk adjusted returns (as measured by the internal rate of return, or IRR) and a higher risk premium on debt, which in turn requires larger project cash flows and heightens the risk of stakeholder interference and adverse actions. The contract structuring and associated risk allocation, which is the essence of project finance, serves to mitigate and reduce risk and therefore reduce required project returns by investors and creditors, which in turn lowers incentive conflict.
• Financial Distress: Project finance reduces or eliminates project sponsor risk contamination as the legally independent special purpose vehicle (SPV) project borrower ensures the project debt is "off balance sheet" to the sponsor from an accounting treatment perspective. It is more difficult to achieve full "off credit risk" treatment as credit rating agencies typically take the view that the debt and the underlying project is an intrinsic and strategically core part part of the sponsor company's business operations. The sponsor would be viewed as never exercising its non-recourse rights ("walking away") should the project default. It is one of the main reasons integrated oil and gas majors such as Xon and Chevron typically do not use project financing unless they need to accommodate a financially weaker joint venture partner or are seeking to mitigate country risk. However, it is exactly why a company like US IPP Calpine Corp with 95% debt-to-equity and a sub-investment grade rating was able to successfully raise $5 billion in project finance loans to construct 25 new power generation plants in the early 2000s.

PROJECT FINANCE-ASSET CLASS PERFORMANCE

Source: Refinitiv 2019 Global Project Finance Review.

The global project finance market is relatively small-the total project finance loan market amounted to $297 billion in 2019-relative to the US leveraged loan market ($1.6 trillion) or the US capital markets ($3 trillion).2 That said, project finance is a critical lynchpin for catalyzing and crowding in other forms of private sector capital (insurance companies, pension funds, infrastructure funds, sovereign wealth funds, private equity, etc.) along with development financial institutions (DFIs) such as multilateral and bilateral development banks and export credit agencies.

Source: S&P Global Market Intelligence, Annual Global Project Finance Default and Recovery Study, 1980-2014 (S&P Global Market Intelligence, 2016).

Notwithstanding that project finance involves financing a thinly capitalized, high leveraged single asset with no cash flows and material construction risks, it has proven to be a resilient asset class able to withstand adverse, unexpected external events. A Standard & Poor's (S&P) 2016 study analyzed project finance default rates and recovery from 1980 to 2014.3 The study covered over 8,000 projects across all industries and geographies. The S&P study revealed that the project finance annual default rate peaked in 2002-03 at around 4.8%; however, since then the annual default rate has averaged 1.5% per annum compared to 1.8% annual average default rate for secured corporate lending. The 2002-03 peak in project finance defaults resulted from the following coterminous macroeconomic events:

• The 2001 Argentina sovereign debt default and currency devaluation, which negatively affected natural resource (mainly oil and gas) and power projects;
• The 2002 US energy crisis resulting from the bankruptcy of Enron (at the time the largest corporate bankruptcy in US history), which caused the US and European energy markets to decline, resulting in increased project defaults and the demise of the merchant power sector;
• The 2002 dot-com Internet asset bubble collapse, resulting in telecom corporate defaults (WorldCom, Global Crossing, etc.)

Source: S&P Global Market Intelligence, Annual Global Project Finance Default and Recovery Study, 1980-2014 (S&P Global Market Intelligence, 2016).

The S&P study found that the annual marginal default rate for the project...