As discussed in section 2.4, project contracts are the main tools available to SPV and sponsors to manage project risks. A number of these contracts exist for managing both pre- completion and post completion risks. Corielli et al. (2010) identified four of these contracts as the most important. They include Engineering, Procurement and Construction agreement, Supply/raw material agreement, Operation and Management agreement, and off-take/sales agreement. The SPV, before approaching lenders, is expected to secure some form of contract or commitment with various counterparties regarding how the project risks will be managed. Together these contracts are called non-financial contracts (NFCs). Corielli et al., (2010) define NFCs as “contracts that generate cash inflows or outflows that affect the unlevered free cash flow of the SPV”.
As to whether these contracts are secured before approaching lenders or afterwards remain a debate in PF literature. While Corielli et al. (2010) and Gatti (2013) assume that these contracts have to be signed before lenders are approached; Blanche-Brude and Strange (2007) hold a different view. They believe that these contracts are only signed during or after negotiation with lenders. They indicate that lenders potentially influence the final terms of
these contracts and only agree on the financing details when they are happy with these contract terms.
In the thesis (Chapter 4), we adopt the argument of Blanche-Brude and Strange (2007) and assume that the signing of the NFCs goes hand-in-hand with the negotiation of the financing package. Specifically, we argue that finalising NFCs before approaching lenders is likely to make the financing stage onerous. This is because where lenders disagree with counterparties or feel aspects of project risks are not fully covered, sponsors will have to go back and renegotiate these contracts. As a result, we assume that a logical approach would be to sign these contracts after lenders have indicated their agreement to these terms.15
2.6.1 Engineering Procurement and Construction Contracts
EPC contracts are used to transfer project construction risks to the contractor counterparty. EPC contracts are written as turnkey agreements: where the contractor counterparty assumes all risks related to the engineering, procurement and construction of the project infrastructure. Thus, they effectively transfer all construction related risks from SPV and sponsors to the contractor counterparty. The SPV will require the EPC to provide performance guarantees on the technology used in the construction (also known as wrapping). Wrapping provides a form of assurance to lenders regarding the project’s construction technology. It certifies the contractor’s familiarity and confidence with the project’s construction technology. Also, there are minimum performance standard provision clauses that are usually the theoretical minimum performance level of the plant. For assuming these risks, the contractor
15 The overlap between securing NFCs counterparties and the financing package is likely to induce an
endogenous relationship between the NFCs terms and that of the financing package. If lenders significantly influence how these contracts are designed and/or who they are signed with, then one would expect the financing terms to reflect these biases. For instance, one option available to lenders is to request that sponsors take up responsibilities as NFC counterparties, if it is likely to align sponsors’ interest with project outcome. On the other hand, they can also require sponsors to relinquish such roles where they (lenders) infer conflict of interest. In Chapter 4 of the thesis, we examine these issues and thus assume that the involvement of lenders as project counterparties is non-random and likely to be determined by a number of pre-contract characteristics.
counterparty is compensated through regular fixed payment by the SPV (Gatti, 2008; Corielli et al., 2010).
There are instances, where the contractor only assumes the risk of construction risk but not engineering or procurement of material for setting up the infrastructure. In other words, the contractor counterparty’s liability, in this case, is limited to meeting pre-determined post- completion specification of the facility. Gatti (2013) notes that the proportion of construction risks that a contractor is willing to assume is influenced by the construction technology adopted, that is, whether it is proven or not. Where proven technology is adopted, contractor counterparty is likely to agree on a turnkey contract with the SPV. Where this is not possible, the SPV may either retain the risks or seek alternative means to manage them
Once the construction of the plant is completed, an independent engineer is required to perform initial tests on the commercial operating date. When this initial test reveals that the new facility meets the minimum performance standard, a provisional acceptance certificate (PAS) is issued. Next, a series of test runs is conducted over a period, to determine if the plant meets operational specifications. Where the plant does not meet the optimal (operational) level, the contractor is required to make a commitment, buy-down damage; which is the difference in revenue if the plant had operated at the optimal level and the minimum performance standard level. If the plant, however, meets the operational expectation, the final acceptance certificate is issued. After which the plant becomes formally operational and handed over to the SPV.
2.6.2 Supply contracts
The supply contract is signed to ensure raw material, and other critical inputs needed by the SPV to operate are available unconditionally. These agreements are usually drafted as a put-or-pay agreement, which imposes an obligation on the SPV to purchase from a supplier
(s) for the supply of inputs stipulated in the contract. In the same way, if the supplier fails to deliver the raw materials on time, the supplier is required to make alternative arrangements for the delivery of raw materials in specified quantity and quality. To ensure fairness, the price of the input is usually adjusted to the Market Price Index to ensure that there is sufficient economic interest for the supplier to fulfil contractual obligations. If the input needs transportation from to the SPV plant location, then sponsors would have to arrange for transportation, either as part of the supply contract or through a separate transportation agreement.
2.6.3 Operation and Management Contracts
Operation and Management contracts are signed to manage operational and management risks that could adversely affect the project. For the SPV to generate the requisite cash flow to pay its costs and investors, the SPV must ensure that the plants are running efficiently to guarantee project profitability and viability. In this regard, the O & M contracts are signed with experienced and reputable management firms. In return for managing a projects’ day-to- day operation, the O&M contractor must be compensated through payments directly from the SPV, which can be either a fixed-price contract or pass-through contract. In a fixed price contract, the operator takes up all costs relating to operational cost overrun. On the other hand, a pass-through contract pertains to fixed payment and performance related incentives, made to ensure the operator takes the necessary steps to reduce cost.
2.6.4 Off-take Contracts
Off-take agreements are contracts signed with the project counterparty to secure ready market for the project outputs. These contracts specify delivery of specified quantities of goods or services to the counterparty at a pre-agreed or market determined price (Gatti, 2013). The market price is often indexed to consider inflation. Off-take contracts can take
several forms, with the most common being take-or-pay, take-if-offered, and hell-or-high water. Under take-or-pay agreements, the counterparty is obligated make payment to the SPV, whether they take delivery of output or not. Cash payments for non-delivery are usually credited against future deliveries. However, this is conditional on the SPV fulfilling specific requirements related to pre-agreed quality and standard (Ruster, 1996). Take-if offered agreements requires the purchaser of the SPVs output to only pay for the output, only if the project delivers. Thus payment is only expected if the SPV delivers the output. Hell-or-High Water provides no opt-out clauses for the purchaser of the output. The project counterparty must pay the SPV in all circumstances, regardless of adverse conditions that might affect the purchaser’s ability to take deliveries (Finnerty, 2013).