The Role of Project Finance in the Provision of Large Infrastructure Projects Essay

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THE ROLE OF PROJECT FINANCE IN THE PROVISION OF LARGE INFRASTRUCTURE PROJECTS

Project finance is the structured financing of a project through a special purpose vehicle created by sponsors for the sake of the project where loan reimbursement is totally dependent on the cash flow of the project itself with no credence attached to the sponsors themselves. Project finance is centered around the SPV “which acts as the nodal agency for bringing together private investors and concerned Government agencies for the project“(Gupta and Sravat, 1998). The credit worthiness of a sponsor is not taken into account in project finance. Here, lenders have to partake in non-recourse funding i.e., they do not have access to the sponsors’ assets. The two primary methods of financing infrastructure projects are project finance and corporate finance. Under favorable conditions, most organizations prefer using corporate finance as a means of financing. However, as is the case with infrastructure projects, certain situations dictate that project finance be used. One of the big factors that support the use of project finance is risk management. According to E.R.Yescombe (2002) there are three commonly perceived risks involved. They are commercial risks, financial risks and political risks. The other key advantages of project finance are high leverage, off balance sheet financing, tax benefits and long term financing. Commercial risks are generally related to the internal factors contributing to the project realization. It refers to the constructional phase and operational phase where there is a possibility of environmental protection risk, operation risk, revenue risk or contractual risk. According to Gary (2005), financial risks deal with economic aspects and their effect on the success of the project. It can adversely affect the cash flow during realization as compared to the projected cash flow. Political risks refer to possibility that the host government, where the project is developed, may implement policies that can directly affect the long-term sustainability of the project. Projects in politically volatile areas come with their own unique set of problems. Forming a partnership with the host government or public sector companies provides the other sponsor(s) sufficient shielding from hostile actions against the project. The government would want to ensure that the credit rating of the country is not adversely affected. To entice possible sponsors, governments sometimes resort to providing tax benefits and subsidize cost of raw materials. This was particularly true when PDVSA and Conoco Inc. struck up a partnership to explore the crude oil fields of the coast of Venezuela in the 1990s’. Conoco Inc. had the technological know how required to carry out such a project and by teaming up with PDVSA, they had access to the rich resources. The flip side of such projects is that there is a chance that the government could implement policies that affect the long-term sustainability of the project. “Strategic partnership will be jeopardized if it finds itself in the center of political events in the country and becomes the subject with which the opposition uses to attack the government.” (Nikolić et al., 2011). The Venezuelan government was known to be flick with it policies and most rating agencies were unwilling to improve its credit worthiness beyond the Republic of Venezuela’s rating. Convincing the rating agencies required detailed analysis on the future projections and provision of adequate proof that project was a good opportunity

for the sponsors and lenders. Also, outside lenders would need political risk insurance (PRI) and the market for PRI is very thin which made it very expensive. In project finance, a project is financed outside of the balance sheet of the project sponsors i.e., “off balance sheet”. “This term is highlighted in project finance as nonrecourse and is at one end of the
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