The project company enters into contracts, such as a construction contract, a supply agreement, an operating and maintenance agreement and an off-take agreement, for development of the project. There can be many of these agreements in project finance deals, covering relationships (where relevant) between the project company and investors, governments or regulators, construction contractors, suppliers, the operator, customers and the financiers. These contracts improve risk management because they should allocate identified risk to the most appropriate participants. Described below are agreements on the concession period, financial completion, intercreditor agreements, construction, off-take, forward purchase and production payments and supply.
The concession, or licence, for the construction, maintenance and operation of the project is typically granted by the government to a special-purpose project company. This is particularly attractive to a government that wants to minimize the impact on its capital budget and to increase efficiency by using private sector management. Also, for developing countries, it helps promote foreign investment and the introduction of new technology.
An example of the importance of the concession is the Toll Highway Project in Latin America which secured the project debt under a concession agreement. In this project, the project company received a 20-year concession from the government to upgrade and maintain a major highway and the government retained title to the project’s principal assets. Lenders were not able to create a meaningful mortgage over the assets, but, on the basis of the concession, the International Finance Corporation (IFC) made a loan on various loan securities and provided a small equity investment (Ahmed and Xinghai, 1999, p. 61).
Sponsors require assurances from government on a range of issues that might affect the project, and that adequate compensation will be paid if the government acts to the
detriment of the project (e.g., through price regulation). The government is concerned that the concession company provides an adequate service, observes relevant safety and environmental protection standards, levies reasonable charges upon consumers, and maintenance and repairs are carried out. In a Build, Operate and Transfer (BOT) project, the condition of the asset on transfer is often specified in the contract.
A financial completion agreement has the major sponsors agree to provide funds if needed to meet debt service until the project achieves financial completion, which is when the debt has been repaid. After physical completion, if the company struggles to meet the conditions set for financial completion, project loans are then protected by sponsor obligations under the agreement to service loans until they are repaid.
Lenders typically enter into intercreditor agreements in order to regulate their relationship as creditors to the project company, to define the rules for the administration of their financial arrangements and, in the event of foreclosure, to share the collateral pledged in their favour. The basic purpose of these agreements is to prevent disputes among lenders that may jeopardize the interest of all creditors. The project company is not a part of an intercreditor agreement.
The construction contract is crucial, as construction costs are often around 80% of the total. The construction contract defines the duties, responsibilities and the scope of work for the parties (Turner, 1990). Any misunderstandings will affect the time and cost of the project and therefore influence the project finance package in terms of higher equity or debt needed or non-compliance of debt payment. Further, it is common to link the construction contract directly to the financial agreement; for example, the Athens Ringroad project had availability of the loans depend on the achievement of milestones in each section of the road (Esty, 2000). In this case, meeting the conditions of the construction contract is an essential part of the project finance package. A good construction contract lays the foundation of a successful project finance deal, because it helps attract potential investors and may also get a higher rating of the project, which has positive effects on the interest rates the project company is going to pay on its debts.
Often the project company enters into a long-term sale and purchase contract for project outputs, particularly in capital-intensive projects. By an off-take agreement, the off-taker agrees to buy from the project company a quantity of project output, for a set period of time and at pre-established prices. Consequently, an off-take agreement provides certainty that a project will generate sufficient cash flow to cover debt service and operating costs, and provide a reasonable return on investment. Although every project finance package has its own special features, the basic structure is that of a limited or non-recourse loan, repayable out of project cash flows with a forward purchase or a production payment agreement. Production payments are a method of financing that use the project’s product and/or sales proceeds as security. Debt is serviced from the production of the project, and the lender becomes entitled to all, or an agreed proportion, of the project’s production until the debt is repaid, together with the interest due. Usually the project company is required to re-purchase the product delivered to the lenders or sell it as agent for the lenders to realize cash. Under a forward purchase agreement, the lenders set up a special purpose vehicle to purchase agreed quantities of future production. The project company’s obligation is to deliver the product and to service the debt. The purchase contract requires the project company to either buy back the production or to sell it on to third parties as agents for the lenders.
The Star Petroleum project in Thailand provides an example of an off-take agreement: the foreign sponsor (a US-based petroleum company) owned 64% of the project and the local sponsor (a company owned by the Thai government) owned 36%. The total project cost was approximately US$1.7 billion, to which the World Bank’s financing arm, the International Finance Corporation (IFC) helped provide US$450 million in direct and syndicated loans. The project included a long-term take-or-pay agreement with the local sponsor and with a subsidiary of the foreign sponsor, covering 70% of the project’s output (Ahmed and Xinghai, 1999, p. 46). The off-take agreement committed the sponsors to purchasing enough of the project’s output to cover debt repayments.
The project company can have long-term supply agreements covering construction and operation of the project. Supply agreements lock in the availability and price of key supplies and generally have a term as long as that of the debt financing. The project company also may contract the operation, maintenance and management of the project to an operator, who carries most of the uninsured operating risks.