James J. Hobin, Marsh Inc.
Depending on what consultants’ assessments you believe, there are roughly 660 GW of electric power capacity in various stages of planning and development throughout the world at this time. To EPC contractors and equipment providers, that’s great news. It means plenty of work for the foreseeable future, assuming the demand for new power sources continues.
The not so good news, however, is the fact that funding for these projects is not a bottomless well and, in fact, is not as available as it was a year ago. This dilemma is due in part to the overall credit crunch currently being experienced in the capital markets, which is making lenders and investors more cautious about where to park funds, along with the fact that many of these facilities will function as merchant plants.
Moreover, in many cases, these facilities are being financed on a non-recourse basis with no parental guarantees. Since lenders generally do not take equity positions in these financing arrangements, their upside is limited to the spread between the loan interest they charge and that of a theoretical risk-free investment such as a 10-year U.S. Treasury Bond (4.9 percent at press time) or London Interbank Offered Rate (LIBOR). When one considers that the term of most non-recourse financing for power plants is often 20 years, it is no wonder that lenders closely scrutinize each prospective deal and try to eliminate all risk from the project.
The words “on time,” “within budget,” and “to specification” are not just part of a project’s mission statement to a lender, they represent the key ingredients that will make the difference between a productive loan or a disastrous experience for the loan officer who inks the deal.
With the cost of a typical 450 MW gas plant now at $270 million to $300 million, anything the loan officer can do to assure that all three conditions are met will make him more comfortable with the deal and hence more apt to offer favorable lending terms to the sponsor.
This being the case, what can one do to assure that the pro-forma economic analysis presented by the project sponsor becomes a reality? One answer is to bring in a well-heeled third party with a gold-plated balance sheet to take out as much of the risk from the project as possible. This is often referred to as “credit enhancement” and, if done effectively, can result in lower lending rates.
Many project sponsors now use insurance to accomplish this objective. A comprehensive insurance policy has been developed to address the traditional risks associated with any construction project, as well as specific targeted risks that could derail the project during critical junctures. Taking potential “Achilles Heel(s)” out of a project makes it more bankable in the eyes of prospective lenders and can provide the remedy needed to close the deal.
For example, working with the global insurance market, Marsh Inc., a risk and insurance services firm, has developed an insurance program, known as Consolidated Project Insurance (CPI), to address this need.
CPI acts as a platform that addresses project risk on a holistic basis. It responds not only to risks associated with property, general liability, and boiler and machinery events, but can also cover more challenging risks. These include: political risk, force majeure, liquidated damages, cost overruns, delay in start-up (not necessarily tied to a physical events), protection against power price spikes when the plant is tripped or operating at reduced power, mitigating costs to get a delayed project back on schedule, and ensuring debt service coverage ratios are maintained. In addition, systems performance coverage can be provided if the project doesn’t perform as predicted, and residual value insurance is available to guarantee lenders that if the project fails, the value of certain collateralized assets will not fall below a given level. CPI also can be structured to include hedges against the price of fuel, credit wraps and contingent capital, along with other applications.
Because each project has unique economic characteristics, effective risk strategies often call for a team of experienced risk professionals with backgrounds in project finance, law, and engineering, who can work with sponsors and their lenders, on project due diligence, financial and technical risk assessment, as well as risk mitigation and transfer.
With respect to specific solutions, CPI is just one tool in the project “tool box.” The ability to choose and apply the right tools for the job is as important as the tools themselves.
The CFO of a company that recently completed a major infrastructure project in Brazil said, “In my 20 years of experience dealing with undertakings of this type, this was the first time insurance has ever paid for itself.” In this case, it did more than just pay for itself-it saved the sponsor tens of millions of dollars due to the lower financing costs afforded the project.
Hobin is the financial products leader and senior client advisor for the Marsh Global Power Practice. He works with clients, insurance markets and capital markets on matters relating to hedging of commodity price and market risk, project finance credit enhancements, weather risk and energy trading risk management. He may be contacted at 860-723-5650 or e-mail, JamesJ.Hobin@marsh.com.