International project financing is a funding model that allows companies to obtain loans for large-scale projects. It’s commonly used in infrastructure projects such as roads, airports, power stations, and oil and gas. While international project financing provides incredible opportunities, it also carries a unique set of hazards due to the complex nature of these ventures. These risks can arise from internal and external factors like changes in local laws, government policies, or global market conditions.
Here, we discuss major risks in international project financing.
Operating Risks in International Project Financing
As noted under Certainty of Revenue Stream, the project’s financial model and assumptions are based on projected operational costs. If operating costs rise, lenders may seek protection to ensure it does not negatively impact the revenue stream.
For example, fuel costs are a significant operational expense in power generation projects, while energy costs are crucial in International project financing related to water treatment plants. Some costs can be locked in, to some extent, through hedging, futures contracts, and input agreements. On the other hand, costs that are not hedged may pose risks, and lenders may want to ensure that these risks are minimized.
Another key cost in operations will be the cost of workers, often assumed to be affected by wage inflation using indexes like the retail price index. It is vital to ensure that the index covers increases in the expenses incurred by the project.
Construction Cost Risk
Every project company aims to complete construction within the allocated budget. Unfortunately, that’s not very common, while building expense overruns are. Construction cost overruns also pose a serious risk to the project’s profitability and success. This risk stems from several factors that must be considered because aspects that cause construction cost overruns can ruin the project. Some of the most common reasons for building cost hazards are:
- Inflation can lead to an increase in the costs of commodities and building materials.
- A shortage of workers can cause construction labor costs to increase.
- An unqualified contractor can cause extensive change orders.
- A poorly written construction contract may result in significant cost overruns for the project company.
- An inexperienced project sponsor is frequently inclined to set their budget too strictly to make a deal work.
- The project location can potentially lead to material and labor shortages or increase transportation costs to unsustainable levels.
- Natural disasters can cause a rise in construction materials expenses.
Sponsor Risk
The project sponsor is typically a consortium of entrepreneurs who serve as the driving force behind the project. The project sponsor is often an entrepreneur who lacks the funds necessary to complete the project. In other situations, the sponsor may possess the required capital but is unwilling to bet the parent company’s balance sheet on a high-risk project.
The primary risks with sponsors are based on their experience, management ability, international and local agency connections, and equity contribution. Investors and lenders can reduce these risks by closely examining the sponsor’s history with similar International project financing transactions.
Political and Regulatory Risk
Expanding the project finance market into developing countries has raised concerns about political risk. Key risks may include government cancellation of projects, changes to contract terms, failure to fulfil obligations, political or regulatory risks, and failure to implement agreed-upon tariff increases.
The government may take some risks regarding compensation for unilateral termination in project agreements. However, not all political dangers will likely be borne by the government. Commercial lenders may be prepared to assume some political risk. In some nations, the perceived political risk hinders or even prevents financing projects that may otherwise be feasible.
Since the commercial insurance market can only absorb a limited degree of true political risk, many project sponsors have turned to multilateral or export credit agencies.
