Energy sectors Project finance ( in the  is driving innovation and the green transition, providing reliable power generation and gradually reducing the carbon footprint of the global economy.

Project finance schemes are enabling an increasing number of companies to switch to renewable energy sources such as wind farms, photovoltaic plants, biogas power plants and others.

At the same time, access to high financial leverage facilitates the implementation of large conventional energy projects as a bridge to a sustainable future, including the modernization of coal-fired thermal power plants, the construction of gas-fired combined cycle thermal power plants and other facilities.

It is becoming increasingly difficult for companies specializing in energy projects to implement capital-intensive projects without a high share of equity capital, especially against the backdrop of increasingly tight regulation in the banking sector.

Innovative project finance mechanisms, long-term investment loans, mezzanine capital, reliable loan guarantees and comprehensive consulting support allow our clients to implement large energy projects with 90% debt financing.

Contact CP Finance UK Finance to find out more.

Project finance in the renewable energy sector

Project finance refers to a method of raising long-term debt financing for large projects through financial engineering tools based on loans provided against the future cash flow generated by the project.

A distinctive feature of project finance is the participation of the SPV (special purpose vehicle), which is engaged in attracting the resources necessary for the implementation of the investment project, ensures its construction and makes payments on loans issued to energy sectors project finance  from the funds received through energy generation.

Securing the return of borrowed funds attracted to finance an investment project is the cash flow generated by the project. In addition, assets created during the implementation of the RES project can be provided as collateral. In other words, PF schemes do not require sponsors to provide their assets to ensure the return of received borrowed funds at the initial stage of the investment stage of the project. This makes project finance a fairly risky tool for capital providers.

Project finance in renewable energy is characterized by the following features:

• Comprehensive analysis of projects.
• Rational sharing of risks between project stakeholders.
• High requirements for the margin of safety of projects.
• Tender approach to the selection of suppliers and contractors.
• Complex contract structure of RES projects.
• Strict monitoring and control at all stages.

An important aspect of the implementation of energy projects, in addition to technology development, is the diversification of financing sources, in particular, the issuance of various types of securities.

The evolution of the financial market over the past decades has led to an increase in interest and the formation of a high demand for project finance bonds, opening up wide opportunities for financing renewable energy projects.

It has become profitable for commercial banks to refinance long-term investment loans in the bond market through the additional issuance of PF bonds or securitization.

At a certain point, the assets of the renewable energy sectors project finance had one of the highest potentials for securitization.

Starting around 2015, financial market participants began to actively use green bonds, which allowed energy companies to finance renewable energy assets by issuing bonds, the proceeds of which are directed to projects or activities with environmental goals. The growth in renewable energy funding has had a positive impact on the construction of photovoltaic power plants, offshore wind farms and other environmentally friendly energy projects in Europe and beyond.

Solar power plants

For project finance, solar energy projects are more suitable than wind generation projects, which are considered more technically complex and risky.

The commissioning of new photovoltaic power plants creates significant potential for the issuance of project finance bonds in the field of solar generation around the world. The specificity of solar energy technologies is such that continued investment in this sector is accompanied by a significant reduction in the cost of technologies and an increase in the competitiveness of the energy produced due to economies of scale.

Skyrocketing prices for natural gas, fuel oil and coal, caused by geopolitical tensions on the European continent in 2021-2022, are also boosting investor interest in energy sectors project finance.

It is one of the most well-studied and predictable sources of energy, making entire industries independent of fossil fuels.

Thanks to changes in the fossil fuel market and active support from governments, energy sectors project finance  has become very attractive.

Compared to other renewable energy facilities, solar energy projects are the most typical from an engineering point of view, since the technologies and equipment used in the construction of solar power plants are largely identical in projects implemented around the world. Low risk and predictable performance are some of the reasons why project finance models are extremely widespread in the construction of solar power plants.

Today, there are dozens of large solar power plants of various types around the world built using project finance.

Among them we can mention Benban Solar Park (Egypt), Noor Power Plant (Morocco) and others. Major financial institutions and companies such as Acciona Energy are actively involved in the development of innovative solar projects, making an invaluable contribution to the energy transition.

Wind farms

Project finance, being one of the priority tools for stimulating economic growth, allows the implementation of large-scale wind projects such as the construction of offshore wind farms.

The latter, having enormous development potential, are considered as one of the main sources of green energy for coastal regions, in particular for European consumers near the North Sea and the Baltic Seas. This is confirmed by the achievements of Germany, Denmark, Poland and other countries.

In Germany, using the project finance tool, the Nordsee ONE and Butendiek wind park projects were successfully implemented.

For their implementation, independent companies were established, the purpose of which was the development, financing, construction and operation of wind farms.

For example, Nordsee One GmbH was established for the Nordsee ONE park, while Western Power Distribution became the co-owner, operator and developer of the Butendiek wind farm.

International experience shows that global climate issues and rising fossil fuel prices are leading to an increase in project finance activity in the wind energy industry, especially in Europe and North America. The trend towards increased use of project finance schemes in the EU can be largely attributed to government programs, in particular targeted efforts to attract investment in renewable energy sources.

These government efforts are complemented by leading wind turbine manufacturers such as Siemens Gamesa and Vestas, who are investing hundreds of millions of euros to improve equipment capacity, reliability and reliability.

Hydropower plants

The top ten countries in terms of installed hydropower capacity remain unchanged over a long period of time.

China, Brazil, Canada, USA, Russia, India, Norway, Turkey, Japan and France remain the leaders, together accounting for more than two-thirds of the world’s installed capacity. These are countries that, due to the abundance of water resources, are able to develop hydropower projects on a sufficient scale and with high economic efficiency.

However, there are fewer and fewer suitable sites for new HPPs, which, along with tightening technical requirements, increases the cost of engineering and construction of such facilities.

Due to financial and technical reasons, hydropower is inferior in terms of investment attractiveness to other sources of renewable energy, especially solar and wind energy. This has a negative impact on the investment in the industry.

Between 2015 and 2019, the global average annual growth in installed hydropower capacity was 2.1%, which is considered a very modest figure. The need for increased funding for hydropower projects is felt almost everywhere, from greenfield projects to capital-intensive modernization of existing HPPs.

Energy sectors project finance has traditionally played a critical role in this sector due to the huge initial costs and long payback periods of such projects.

Few companies, even in partnership with government organizations, are willing to bear such costs without external support.

The cost of building a hydropower plant varies widely, depending on the specific location and natural conditions, the technology used and the scale of the project.

Previously, such facilities could build about 500,000 euros per 1 MW of installed capacity, but now the construction of hydroelectric power plants in hard-to-reach river sections in compliance with the strictest environmental requirements can easily exceed 4 million euros per 1 MW of installed capacity.

The establishment of a special purpose vehicle, isolation of project assets from its initiators, high financial leverage and rational distribution of project risks create the most favorable conditions for attracting financing for the construction of hydropower plants in the current environment.

Project finance in the conventional energy sector

Thermal power plants at the initial stage of construction are generally considered to be a cheaper solution compared to energy sectors project finance of similar installed capacity.

However, the exorbitant prices of natural, gas and coal make these plants quite costly to operate, so the cost of electricity produced can rise substantially during times when fossil fuel supplies are scarce. As a controversial energy source with an uncertain future, conventional energy facilities are now considered risky investments, which explains the difficulty of financing such projects.

Since thermal power plants are directly dependent on the availability of fossil fuels, in many cases these facilities are built near energy sources such as coal fields, liquefied natural gas terminals, large pipelines, refineries, and so on. Usually these are very large projects with an installed capacity of 1 to 3 GW or more, consisting of several multi-megawatt power units and a developed infrastructure.

The cost of such facilities can run into many hundreds of millions of euros, which poses serious long-term financing problems for sponsors.

Project finance is now widely used in the thermal power industry, providing companies with the effect of high financial leverage and convenient financing mechanisms with minimal risk.

Some features of PF model are listed below:

• Flexible application of a wide range of financial mechanisms, including long-term investment loans, the issuance of corporate securities and others.

• Using future financial flows as collateral for debt, as well as providing assets of a special project company created as part of a specific thermal power plant project as collateral.

• Energy project financing is carried out through a specially established legal entity (SPV, SPE, SPC), which is formally independent of the initiators and has separate assets.

• Adequate level of financial participation of the project sponsors, which can reach 10-20% of the estimated project cost or more, depending on the agreements. Thus, 80-90% of project costs are covered by banks / investors, which allows using the effect of financial leverage.

• Given the complete absence of collateral or its limited nature, the reliability of the PF model is ensured by a complex multilateral contractual structure with a rational distribution of risks and responsibilities of the parties.

In fact, the project finance (PF) is justified only by the high reliability of the project and the high confidence in the technologies, which can be achieved with sufficient experience and professional approach of the contractors.

Obviously, this is much more applicable to traditional energy sources than to little-studied alternative technologies.

Combined cycle power plants

Project finance, based on the repayment of project debts from future cash flows, has been considered for several decades as one of the best solutions for conventional energy facilities.

This is especially true when it comes to large capital-intensive projects built on proven and reliable low-risk technologies. Highly efficient and reliable Combined Cycle Gas Turbine (CCGT) power plants are now considered mainstream in the thermal power sector. This is an area where the potential benefits of project finance models are fully realized.

World experience in the construction and operation of thermal power plants has shown that the generation of electricity and heat at them is most effective in combined-cycle gas turbine power plants, which include a gas turbine and a steam turbine.

As a result of this combination, the heat is fed into the gas turbine (the cycle at a high initial temperature of the combined system), and the unused heat is removed to the steam turbine, which operates at a relatively low temperature.

This technology provides the maximum efficiency that can be achieved by burning fossil fuels.

As an important bridge between conventional energy and a carbon-free future, gas turbine combined cycle power plants powered by natural gas are now regarded as one of the most important sources of electricity for industry and households in developed countries.

Despite the problems caused by the explosive growth in hydrocarbon prices, highly-efficient CCGT projects continue to be seen as one of the pillars of the global economy for the coming decades.

Project finance plays an important role in modernizing and improving the efficiency of the European energy sector, supporting local economies against the backdrop of rising hydrocarbon prices. One example is the recent 560MW CCGT plant project in Grudziadz, which is being developed jointly with MYTILINEOS and Siemens Energy Global GmbH.

The power plant, an EPC contract for the construction of which has been signed since May 2022, will be financed through a special purpose vehicle on a PF basis.

Modernization of coal-fired thermal power plants

Risk management and project finance is an important element financing method based on the distribution of risks among the participants.

This issue is especially relevant for large projects based on innovative technologies, which carry the greatest risk for potential investors and lenders.

CP Finance UK Finance offers long-term financing for projects around the world, including loan guarantees.

We offer professional customer support at all stages of investment, including professional planning and risk management in project finance.

The concept of risk in project finance

Risk management in project finance is one of the most important elements of project management.

While much attention has been devoted to describing the various types of risk in the project finance literature, the definition of risk itself has been largely ignored. In its most simplified form, risk can mean a threat to the implementation of plans.

However, such a general definition has the disadvantage that it is difficult to draw conclusions about the nature of the risk and the type of risk based on it.

In the case of investments in the securities market, the measure of risk is the dispersion of predicted or empirically observed results in relation to the expected level. A commonly used synthetic risk measure defined in this way is the standard deviation. The disadvantage of this risk measure is that it takes into account both negative and positive deviations from the expected value, in connection with which the concept of semi-deviation was introduced, which takes into account only those situations that have a negative impact on the result of the project.

Both standard deviation and semi-deviation require a large amount of data to obtain reliable results.

Due to the significant differences between individual investment projects, it is difficult to find comparable historical data that could be used to assess the risk of each new project.

The only way out in this situation is the expert method and modeling of various scenarios and their chances, as well as sensitivity analysis. The use of these methods makes it possible, for example, to compare two projects in terms of the impact of interest rate risk on the final effect of the project.

At the same time, the complexity of the projects does not allow for a deep study of all the factors that affect the final result of the investment project. There are threats here that cannot be quantified. This happens, for example, when the implementation of the project is under threat due to the lack of appropriate qualifications of management personnel. It is impossible to estimate in advance either the potential losses that may arise as a result of inefficient management, or the likelihood of such a situation occurring.

There is no doubt, that large companies need to protect themselves from such a threat, and from this point of view, this is an element of risk management.

It is assumed that a risk can be considered when the chance of an event affecting the outcome of a project is known. When this chance is unknown, we are dealing with a decision-making situation under conditions of uncertainty. However, the goal of risk management in project finance is not so much to quantify all risks, but to accurately identify areas of threat and develop effective methods to protect against them.

Based on these considerations, a general definition of risk can be adopted.

Risk in project finance can be viewed as the possibility of a situation or event that has a specific negative impact on the financial result of an investment project.

There are several implications of this definition of risk.

First of all, we are talking about the possibility, not the probability of a certain situation.

This approach not only allows the inclusion of non-quantifiable hazards in the analysis, but also has a significant impact on the risk testing methodology.

In the case of project finance, the emphasis is on qualitative rather than quantitative description of threats. Among other things, the so-called risk classification. This is a grouping of project risks into classes and a subsequent risk assessment of each risk group. If a comprehensive and unified risk classification and comparable risk measures are used, the result of the analysis will be a complete picture of the risks associated with the project.

Another distinguishing feature of risk is that it covers the possibility of only such an event that has a specific financial impact on the investment project. For example, in the case of the construction of a cement plant, the element of risk will not be a fall in demand for concrete, but a possible fall in prices caused by it. With a simultaneous decrease in the supply of gasoline on the market, factories can sell all products at a constant price, despite the decrease in demand.

Another important feature of the aforementioned concept of risk is that only those events that have a negative impact on the finances of the project are taken into account. It is not the fluctuation of the exchange rate itself that is an element of risk, but its changes, leading to a decrease in project income or an increase in project costs.

This distinguishes the concept of risk management in project finance from the simple equation of risk with variability in outcomes that occurs in many areas.

Corporate finance vs project finance

Due to the large scale of investment projects covered by the project finance, as well as the long payback periods of these investments, most of these projects are characterized by high risk.

For these reasons, the rational sharing of risks management among project finance participants is considered to be the most important advantage of this method of investment financing.

In the case of a traditional investment loan, the borrower is liable to the bank with its assets and thus assumes all the risk associated with the project. Both banks and other lenders, in order to minimize the risk associated with issued loans, often require collateral that significantly exceeds the value of loans issued. Thus, lenders increase their chances of getting their money back in case of failure of the investment project or financial difficulties of the debtor.

The situation is different with project finance.

Due to the scale of projects and their isolation from sponsors, the assets of a special purpose vehicle (SPV) are usually not enough to repay the debt. For this reason, lenders have to look for alternative ways to secure their financial interests.

These may be guarantees from large financial institutions or other parties involved in the project.

There are two basic forms of project finance:

• Non-recourse financing.
• Limited recourse financing.

Although one of the main benefits of project finance is to reduce the risk of sponsors, non-recourse financing in its purest form is extremely rare.

In such a case, the project proponents would only be liable to the extent of their contributions to the capital of SPV, and the lenders would bear a very high risk. For this reason, limited recourse financing is most commonly used. This provides a reasonable level of risk for lenders, which will be lower than with traditional financing methods.

Some experts mention full recourse financing, but this method differs little from traditional debt financing. Regardless of the extent to which the obligations of the project sponsors are guaranteed, the principle of risk sharing transfers some of the risk that usually falls on the project initiators to other participants.

There are three levels of risk sharing that can be distinguished here:

1. The large scale of projects implemented under project finance schemes usually involves the presence of several sponsors. By creating a separate entity in which each of the sponsors has a certain share, they share the risk associated with this project among themselves.

2. The risk is shared between the sponsors and the SPV implementing the project and the entities providing external capital. Lenders waive traditional guarantees, and are limited to project assets. Certain part of the risk associated with the failure of the project, the delay in debt repayment or the need for additional financing, is assumed by lenders.

3. Both project initiators/sponsors and lenders try to minimize their risk by transferring it to third parties. Potential risk areas are analyzed and project finance participants that have the greatest impact on minimizing a certain type of risk are identified, after which they are made responsible for managing this risk. For example, to minimize the risk of delaying commissioning, contractors must ensure that work is completed on time.

The introduction of project finance schemes is excellent for risk management, which is of great importance in the case of large investment projects, the failure of which means huge losses for both their initiators/sponsors and lenders.

Due to the isolation of the project from the structures of its initiators, it is relatively easy to identify and manage areas of potential risk. This allows companies to implement projects with a relatively high level of risk, which they previously did not dare to.

On the other hand, the additional risk to the lenders makes the project finance more expensive due to the higher risk premium.

Project finance is a method that allows such contracts to be structured on a case-by-case basis where each participant bears an acceptable level of risk.

Moreover, the rational division of risks between the most competent participants leads to a decrease in the overall risk level of the project.

For example, burdening a construction contractor with the consequences of delaying the commissioning of a building will force him to do everything to prevent this from happening. The capital provider, for example, has no such influence on the construction schedule, and therefore cannot influence the risk sufficiently.

Types of risks at different stages of the project

A large number of risks associated with projects and their diversification cause problems with classification.

Depending on the purpose of the risk analysis, they can be classified according to different criteria. In PF, insured risks, bank risks, and sponsor risks are often distinguished.

While insurance risk is easy to separate, the division between bank risk and sponsor risk is highly variable. While banks try to minimize exposure to other types of risk besides credit risk, in the case of project finance they tend to take on most of the risks traditionally borne by business owners. Moreover, it is rare that only one project participant bears a certain type of risk. Typically, risks are distributed in such a way that each participant has an acceptable level of risk.

Another proposed risk classification is the separation of internal and external threats. This classification is difficult in practice for two reasons.

First, he does not clearly separate the causes and characteristics of these two groups of risks, as well as the tools for managing them.

Secondly, it causes significant difficulties in classifying certain risks.

For example, the risk of cost overruns is classified as an internal risk, but one possible reason for cost overruns is changes in regulations requiring the purchase of equipment that meets more stringent standards (external).

Groups of risks with similar characteristics can usually be minimized using similar tools, so this classification greatly facilitates the development of a risk management strategy and is an excellent starting point for further risk analysis.

Due to the complexity of risk classification in project finance, a single universal scheme has not yet been developed.

This classification is used quite often, but there is no consensus among financial experts regarding a more detailed classification of risks within these three groups.

This classification covers all the most important types of risks arising from the implementation of investment projects based on project finance. It also groups risks so that appropriate tools can be selected to manage each of the identified risk groups.

It is worth mentioning the classification of risks by phases of the investment project. This is extremely useful from a risk management and project finance point of view and is often used in practice to prepare appropriate strategies for each stage of an investment project.

Modern approach to risk management in project finance

The state of uncertainty is inconvenient for all participants in investment projects.

The higher the risk, the higher the probability of business failure and loss of invested funds. At the same time, there is increasing pressure from lenders to pay higher risk compensation. This increases the cost of the project, and high risk is often the reason for abandoning it.

There are many methods, schemes, models and tools to reduce the uncertainty associated with the investment process.

Risk management in project finance consists of analyzing information about potential threats, and taking active steps to counter them.

These areas are not independent, but complement each other. Analysis of risk information allows the project team to assess whether the level of risk is acceptable or mitigation measures are needed. On the other hand, risk cannot be managed without continuous monitoring of the consequences of the actions taken. Therefore, continuous collection of risk information is essential for effective risk management in project finance.

Therefore, risk management is not a one-time activity performed during the planning phase of a project. At this stage, it is necessary to carefully analyze the risks of the project and develop ways to deal with them. At the same time, it is critical to constantly monitor the situation and adjust the risk management strategy in accordance with the changing situation.

The risk management process can be represented as follows:

1. Identification of risk areas.
2. Determining the threat posed by the different types of risk.
3. Choice of strategies and tools of risk management.
4. Implementation of the chosen strategy.
5. Monitoring and control of project results.

In a complex investment project, it is not easy to renegotiate contracts between participants, but there are a number of tools that can be used to manage risks in the investment process.

This can be, for example, additional insurance or swaps. Their number is not limited, and their use depends on the experience and qualifications of the project team. The main risk management tools in project finance will be presented below.

The template use of one tool helps to protect against any risk only in rare cases. For this reason, several options are usually used, and the risks are shared among the participants. For example, a special purpose vehicle can reduce risk by using non-combustible materials in the construction of the facility. This will reduce the threats associated with fire.

However, SPV can pass on some of the fire risk to the insurance company by purchasing a policy.

In some cases, the interests of individual project finance participants seem to conflict with the interests of the project as a whole.

For example, shifting foreign exchange risk to lenders is contrary to their desire to minimize their risk. On the other hand, banks are best prepared to work with financial instruments, so taking on the management of cash flows in various currencies is optimal from the point of view of the project, as it minimizes the likelihood of losses associated with incorrect financial decisions.

It should be emphasized that both methods of risk management, risk minimization and risk sharing, are equally important, since the main goal of risk management in project finance is to structure the project in such a way that each participant bears an acceptable risk while minimizing the risk of the project as a whole.

Risk management in Project finance is characterized by a broad understanding of project management.

Risk minimization methods include not only classical instruments, such as, for example, insurance policies, swaps or guarantees, but also all actions aimed at reducing the risk of certain situations.

This includes proper project design, hiring experienced engineers and operators, or the aforementioned use of non-combustible materials in construction.

Risk of depletion of natural resources

This is a risk inherent in projects aimed at the extraction or processing of natural resources (mining and processing plants, quarries, mines, cement plants, etc.).

Such projects are often carried out using the PF method, and therefore this risk is considered an important element of project management.

If the mineral reserves turn out to be less than predicted, there is a serious threat to the continuation of the entire investment project. Under extremely unfavorable circumstances, too small deposits can lead to a situation in which the operating profit of the project will not be enough to repay the debt.

On the other hand, the deposit may turn out to be of much worse quality than expected. This results not only in a lower sale price, but also in higher extraction costs, which can also increase the loan repayment period. Similarly, more inaccessible deposits require higher extraction costs and more time to exploit.

The risk of depleting reserves could lead to the threat of timely debt service and force creditors to reduce subsequent tranches and change the terms of financing.

In the worst case, the SPV may be unable to repay its debts as a result of unsuccessful operating activities.

The following are some of the risk management and project finance tools:

• Choosing an experienced operator.
• Conducting independent research.
• Financing flexibility.
• Sponsor guarantees.

While this risk is typical of the business activities of project sponsors, banks often take on some of this risk.

Financing projects to develop mineral deposits is a highly profitable but high-risk activity. For this reason, banks involved in projects of this type do so with the utmost care and make every effort to minimize the uncertainty that accompanies each project.

Operational risks

This is another technical risk, but it only occurs during the operational phase of the project.

As already mentioned, each project phase is characterized by a different risk management strategy.

During the operational stage, collateral and most of the safeguards used in earlier phases of the project are no longer valid.

For these reasons, debt repayment depend on the facility’s operating performance. Both technical (equipment failures, infrastructure problems) and economic (fuel prices), as well as organizational and other problems can affect the business.

If the production is lower than expected, the revenue is also lower, which may threaten the timely payment of the debt. Similarly, poor quality can lead to lower prices and marketing problems. On the other hand, high production costs reduce operating income, which also negatively affects the SPV’s ability to service debt.

The most important reasons for operational risk include the following:

• Implementation of innovative, untested technologies.
• Errors in the design and construction of structures and devices.
• Low quality products and the use of cheap materials.
• Wear and tear of machines and equipment.
• Improper operation and maintenance.
• Low infrastructure efficiency.

In the case of project finance, this risk is very important, because projects implemented with this method are often so large and technologically complex that even experienced teams of engineers have problems with predicting threats to the proper operation of their projects.

Nevertheless, the operational risk can be reduced and shifted to other project participants.

Some tools for risk management:

• Right choice of technology.
• Selection of experienced contractors.
• Independent technological expertise.
• Contractor’s guarantees.
• Sponsor guarantees.
• Investment support.
• Insurance.

Financial risks

Financial risk is an integral element of any investment project.

Due to the large scale of projects, high debt, and significant cash flows that accompany project finance, this risk can have a significant impact on the success of a project and its ability to repay debt.

This group includes inflation risk, currency risk, and interest rate risk. Serious threats posed by the financial risk to the project require a comprehensive analysis and development of appropriate tools to manage these risks.

These tools include, among others:

• Fixed interest rates.
• Balancing cash flows.
• Interest rate swaps.
• Foreign exchange swaps.
• Currency options.
• Forward contracts

Refinancing risks

This is a specific group of risks, since it mainly concerns lenders, while collateral and refinancing risks can be transferred to other entities to a very limited extent.

Collateral risk is a typical credit risk. Each bank carefully examines the collateral for a loan before making a decision on its issuance. However, the basis for granting a loan is the solvency of the borrower, and the collateral is only a type of guarantee for the return of invested funds in case of financial problems of the borrower.

Risk management in project finance focuses on the project’s ability to repay debt with expected cash flows.

Collateral is a secondary element of credit risk minimization and is usually not of sufficient value to cover liabilities to the bank.

This can be explained not only by the nature of project finance, but also by the high specialization of investments made using this method.

Changes in the value of collateral can have many reasons, including instability of commercial law, borrower’s actions leading to a decrease in the value of assets, and the situation on a given market. In practice, lenders have very little influence on the collateral risk in the case of project finance.

For example, it is impossible to force SPV, to provide more liquid assets, because the company only has limited assets needed to implement a given project.

This risk can be managed to a limited extent by the following tools:

• Collateral valuation.
• Guarantees and security system.
• Involvement of a legal advisor.

Since the impact of force majeure on the project cannot be prevented, the management of this risk is focused on providing ex post coverage of losses and is very limited.

If you are interested in project finance, please contact CP Finance UK Finance.

Our experienced financial team is ready to offer you customized solutions for any project, including professional risk management and consulting support from planning to the operation stage.

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Over the past few decades, developed countries have used a new method of financing of real estate projects and risky development projects 

This method is called project finance (PF).

This concept is usually characterized as leveraged financing of a project with limited recourse by raising funds through a specially created independent company.

Thus, project finance differs from traditional construction finance in at least two ways.

First, lenders share some of the business risks with the project company.

Secondly, the project finance is provided against the future cash flow generated by the project.

A very important feature of the projects implemented in this way is the sharing the risk between the participants. Each PF initiative is assessed by the participants mainly in accordance with its ability to generate cash flows, which become the main guarantee of debt repayment and return on equity.

Project finance is a flexible combination of financial products / services that makes it possible to finance projects in the field of residential or commercial construction against a guarantee of expected future cash flows.

In order to obtain a safe environment for invested funds, the generated cash flows must be isolated from any other property of the participants.

This is achieved through the establishment of a special purpose vehicle (SPV / SPE). Thanks to a formally independent company, in the event of a project failure, creditors can only seek to satisfy their claims within the assets of the project company. Accordingly, the initiators risk only those funds that were invested in this company.

Conversely, in the event of shareholder insolvency, the SPV / SPE will continue to operate under all circumstances.

This guarantees the completion of the development project regardless of the financial health of the initiating companies.

The global project finance and bank lending market continues to grow exponentially, offering large businesses new tools for implementing capital-intensive and high-risk projects in various industries.

project finance and bank lending plays a critical role in the development of such projects, being the main way to provide funds for the construction, expansion and modernization of factories, power plants, seaports, roads and pipelines.

CP Finance UK, specializes in project finance and bank lending services for capital-intensive projects and large businesses.

We are ready to offer project finance and bank lending to clients with loans from 50 million euros with a maturity of up to 20 years on the most attractive terms in your sector.

The list of our offerings also includes financial modeling services, bank guarantees, project management, investment engineering, industrial engineering, consulting and much more.

Thanks to broad competencies, international business contacts and rich practical experience, our financial team successfully implements projects in most countries of the world. Share your investment plans and learn more about our advantages.

The essence of project finance and bank lending

PF is the most difficult method of financing in terms of organization and planning.

This method is applicable to projects whose value significantly exceeds the current assets of the initiators. The reason is that it is extremely difficult for project sponsors to convince a financial institution to borrow more than the value of their entire business.

Loan terms in project finance are set according to the expected cash flow, so the maturity, interest and fees associated with the repayment of loans are adjusted individually depending on the specific project and its market.

At present, the capitalization of the banking system of the USA, Great Britain, as well as Spain and other developed European countries makes it possible to issue loans for capital-intensive projects.

However, in the case of loans exceeding several hundred million euros, syndicated loans are often used, including those issued by international consortiums.

Banks and large banking consortiums are the main lenders that provide debt financing for large projects in the form of a principal loan or a subordinated loan.

Project finance (PF) uses a wide range of alternative and complementary financing schemes that share common features.

The concept of project finance for large business projects does not depend on the creditworthiness of shareholders (sponsors) and the value of assets involved in a particular project. This tool allows businesses to finance bold ideas based on forecasting financial flows and profitability. In other words, the decisive factors in project finance lending are the forecasting of the effectiveness of a particular project and the assessment of its risks, but not the financial health of its sponsors.

In a sense, this is a violation of the fundamental principle of corporate finance, according to which the key requirement for lending is the reliability (creditworthiness) of the borrower.

The distinctive feature of project financing is the possibility of issuing a loan for large projects without regard to the positive financial history of the borrower.

Debt incurred on a Special Purpose Vehicle (SPV) created by sponsors for a specific project is not reflected in their balance sheet. For sponsors, this means the off-balance sheet nature of the debt, which is consistent with the principle of limited liability of shareholders and is associated with increased creditworthiness.

SPV debt does not burden the financial statements of member companies, or shareholders.

On the other hand, the existing financial obligations of the shareholders do not have a direct impact on the debt of the Special Purpose Vehicle and its current operations.

An indirect connection between the reputation of the participants and the financing of the project still exists. Although project finance is based on lending to companies without a long credit history, the creditworthiness of the company’s shareholders is taken into account by the potential lender and reflected in the terms of the loan agreement.

The ability of the new entity to incur debt may be higher in the case of project finance, as the high proportion of debt in the project’s capital structure allows participants to use high financial leverage.

This imposes certain requirements on the professional management of the project and creates the prerequisites for more active participation of the lender at all stages of the project life cycle. The intervention of the lender covers all stages of the project, up to the repayment of the loan with the corresponding interest. Strict control over investments requires the establishment of an independent company that “isolates” this project from other activities.

The risks, profits and responsibilities of each of the participants in project finance schemes must be legally and economically separated in order to ensure effective project management at all stages.

Differences between PF and corporate lending

Project finance lending is based on specific methods of risk analysis and protection of participants’ interests.

Unlike traditional methods of corporate lending, it is initially impossible to adequately assess the future financial results and assets of a company created to implement a specific project.

In corporate lending, the bank pays attention to the following:

• The financial health of the borrower, assets and creditworthiness, which means the ability to repay the principal and interest under the loan agreement within the specified time frame.

• Key financial parameters of the investment project, its advantages and risks for the borrower in the context of their impact on creditworthiness.

In Project finance and bank lending, the bank evaluates the following aspects:

• An investment project in terms of efficiency, profitability and benefits for its participants.

• The reputation of the project participants in terms of their creditworthiness and professional competencies, their ability to obtain the predicted benefits from the project.

In the case of corporate lending, we deal mainly with the assessment of the borrowing company, but in the second case (PF), the investment project assessment comes first.

The order, content and volume of the analyzed questions are radically changing.

The corporate finance model for large projects is based on separating bank risk from project risk. Credit risk is identified with the solvency of the borrower and the value of the collateral offered, regardless of the success or failure of the financed investment project.

The PF usually does not include borrower checks or only minimally includes them. In this case, the borrower arranges the financing scheme in such a way as to meet the strict requirements of all the parties involved in the project, primarily banks.

The reliability of sponsors, contractors and other business partners associated with investments is carefully evaluated. In both cases of corporate and PF lending, the risk and possible causes of its occurrence are carefully studied, and measures to minimize it are developed.

In project finance, the risk of a bank is in practice equal to the risk of a given investment project.

The analysis of credit risk is carried out in terms of the total return and debt servicing capacity of the SPV on a current basis. This analysis is based on capital structure and debt coverage ratios.

In addition to the difference in the order and volume of analyzes and studies carried out in corporate lending and PF, experts point out another difference in the procedure for obtaining a large loan.

The traditional framework procedure is as follows: the borrower learns the terms of the loan, applies for the loan, and accepts the bank’s decision. Since in the case of PF there is no borrower at the very beginning of the project organization process, the approach to obtaining a loan is changing.

The terms of the loan affect the profitability of the investment, so the sponsors expect the bank to initially evaluate the project in terms of the correctness of its assumptions. In PF models, lenders can assess the investment risk of a project before the SPV is established, and sponsors will take the necessary steps to adjust the investment vehicle when they hear the lender’s opinion.

The above considerations show that, compared to traditional financing methods, project finance can be a more expensive solution. These will be higher interest rates and higher fees as the terms of the loan are overly flexible and the risk is much higher. 

Planning and organizing lending in project finance

The main stages of deal preparation and project evaluation are presented below:

1. Analysis of the project, including the identification of potential risks, their assessment and the development of practical measures to minimize and control them.

2. Optimization of the project financing structure, including the share of sources of debt financing, the size and form of the authorized capital of the SPV.

When evaluating an investment project by a bank, four types of analyzes can be distinguished, covering various areas.

These are technical analysis, financial analysis, reliability analysis of project participants, identification and distribution of risks.

The technical analysis evaluates the technological feasibility and operational efficiency of the project. Among other things, the expected costs, the investment period, the technical parameters of the facility, the expected operating costs, and the compliance of the planned facility with environmental protection standards are checked.

Economic and financial analysis is used to objectively assess the sufficiency of the projected financial flow generated by the project to service the debt.

This analysis provides an answer to the question of whether the remaining funds will be a satisfactory reward for investors.

The main risk assessment tools are financial analysis based on cash flow forecasting, as well as debt service ratio calculation and sensitivity analysis. To evaluate the project, lenders use such financial indicators as the rate of return and cost of capital, payback period, NPV, IRR and others. In these studies, discounted cash flow methods, sensitivity analysis, scenario and simulation modeling play an important role.

When accepting increased project risk, the lender applies more sophisticated procedures to evaluate the effectiveness and risk of investments.

Identifying potential threats is critical as any unidentified risk remains uncovered and exposes the bank to excessive risk.

The high profitability of the project, taking into account the risk, is a necessary but not sufficient condition for lending. The bank should conduct a credit risk analysis based on the assumption that the main threat is a decline in the borrower’s ability to service credit. This analysis is based on debt structure and debt coverage.

The Risk Identification and Allocation Analysis includes elements of all analyzes and summarizes them. Among other things, financial experts identify and evaluate individual types of risk, after which a risk distribution diagram is developed. Individual project finance participants are assigned risks that they can most effectively take on (for example, an engineering company can most effectively control construction risks).

The reliability analysis of project participants covers their goals, responsibilities and experience.

The idea of increasing security in project finance lending is based on a professionally developed system of responsibilities for each of the participants, so a competent contractual structure is the basis for the success of the project.

Development of a loan agreement

Large loans in project finance mean high risk for capital providers.

Of course, the decision to issue such loans will be based on a number of analyzes and examinations, and is usually associated with tightening the terms of the loan (terms, debt repayment procedure, interest).

The bank’s conclusion on the possibility of providing credit funds can be made after a preliminary review of the project documentation.

The consent of creditors is expressed in the form of an official document that defines the main terms of the loan (Head of Terms), which contains the following:

• Loan amount.
• Loan maturity.
• Loan interest and bank charges.
• The procedure for transferring funds.
• Debt repayment procedure.
• Loan security (if applicable).

Head of Terms in the preparatory period helps to verify the assumptions of the feasibility study and the correct definition of the capital structure of the special project company.

Since the issuance of this document, the chances for the implementation of the project will increase many times over, and in the future this financial document becomes the basis for the development of a loan agreement.

From the sponsors’ point of view, preparation for financing a capital-intensive project begins with the hiring of a professional consultant who prepares a memorandum and a list of entities that can be invited to tender. The investment memorandum contains a detailed description of the company and its environment, a detailed financial model of the enterprise.

The so-called Term-sheet lays the foundation for future negotiations with creditors.

Loan agreements in project finance are very extensive and vary widely from bank to bank.

Therefore, the more accurate the request, the greater the influence of the company on the future loan agreement.

If the loan agreement will be based on international law, it is advisable to hire consultants who specialize in the law of the host country and at the same time have a local office. In the case of capital-intensive projects, when choosing banks for a financial consortium, it is worth choosing a bank that is well acquainted with local legal realities.

The second element in preparing for a project finance loan is the Mandate Letter.

This document includes, among other things, the following elements:

• Terms of the loan agreement specified in the Term-sheet.

• Mode of fulfillment of contractual obligations by the parties (best effort or underwritten).

• Duration of the agreement: the longer it is, the higher the chance of avoiding a situation in which the bank can initiate changes in terms.

• Exceptional clauses: for example, the so-called Market Adverse Change Clause allows the bank to withdraw from the contract in the event of a sudden change of market conditions, which is a highly unfavorable clause for project sponsors.

In the next step, the SPV signs a contract with a law firm.

The latter acts on behalf of the bank and carries out due diligence of the project (these services are paid for by the bank). Next, the company and its consultants, representatives of the bank and their lawyers enter into negotiations. The decisive moment is the signing of the loan agreement, which establishes the obligations of the participants until the project is finished and the loan is repaid.

A loan agreement in project finance and bank lending typically includes the following:

• Conditions for granting financing.

• Rules for repayment of the main part of the loan and interest payments.

• Financial conditions that the borrowing company undertakes to comply with.

• The method and frequency of the borrower’s reporting to the bank.

• Conditions that allow the bank to terminate agreements and demand immediate repayment of the loan or seizure of assets that were provided as collateral.

• Certificates, acts and statements that ensure the fulfillment of the contract.

An important part of the project finance and bank lending procedure is the development of loan security conditions.

In the case of project finance, securing a loan with SPV shares makes it possible to sell assets as soon as possible in the event of the borrower’s insolvency (project failure).

Project finance and bank lending is a fairly flexible and efficient tool that ensures the effective implementation of expensive and risky projects based on future financial flows.

This mechanism is quite developed, provided with a solid regulatory framework and is widely used in various industries around the world.

In project finance, we are dealing with a high flexibility of conditions, where the basis for minimizing risks is the cash flow (income) received from investments.

However, the lender does not completely abandon the traditional methods of securing a loan, such as bank guarantees and collateral.

Adequate cash flow and collateral allow banks to take on project risk.

If you are interested in long-term lending and project financing in the fields of energy, heavy industry, infrastructure, real estate, mining or processing of minerals, please contact the CP Finance UK

We provide a full range of project finance and bank lending services, including the establishment and management of SPV, financial modeling, project management, and a range of engineering and consulting services for large businesses.

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