The long gestation period of infrastructure projects increases the likelihood for unforeseen events taking place
By Michael Tichareva
In a recent article, we spoke about credit enhancement to accelerate infrastructure investment. Our experience in the African market has shown that credit enhancement is critical to attracting foreign direct investment towards infrastructure.
In this article, we discuss risk mitigation instruments that are typically used in credit-enhancing infrastructure transactions. The aim is to get project sponsors and Governments to understand them.
Such instruments are used extensively around the World and could be used even more in Zimbabwe and the rest of African market to accelerate infrastructure investment.
There is need to develop deeper understanding of these instruments and the requirements of the organisations that issue them. Project sponsors and Governments need to structure transactions that meet the requirements for securing such instruments.
In most cases, these risk instruments require the host Governments to provide commitments through Letters of Undertaking. It is important for the Government to understand this and create structures that allow such commitments to be provided.
Importance of risk mitigation
Risk mitigation addresses investors’ concerns over potential losses that are often significant in infrastructure projects.
Being physical, more visible and not moveable once constructed, it is difficult for project developers to abandon a project that encounters problems. The high visibility of large projects also means they have important political implications, exposing them to political interference.
This increases the risk of regulatory changes that could impact the operations and revenues of a project. Coupled with this, complex financing arrangements are often involved, including Special Purpose Vehicles that are set up, with a number of parties with different interests participating.
The long gestation period of infrastructure projects also increases the likelihood for unforeseen events taking place, which could undermine the successful completion of a project cycle.
The significant upfront capital costs of developing a project concept, in addition to high construction and operating costs, do not help the situation either. In addition, funding projects is often in foreign currency with the project earning revenues in local currency that is often volatile.
Currency depreciation would, therefore, increase the investors’ risks. There are then other force majeure risks, such as accidents, uncontrollable situations and extreme events that all need to be covered.
Risk Mitigation Instruments available
Various risk mitigation instruments have been developed by development finance institutions. Different providers have different eligibility requirements to issue these instruments.
It is those requirements with which we must familiarise to structure bankable projects that attract foreign direct investments.
The availability of cover and the cost of such cover is often highly correlated with how the project is structured, and the risk management structure in place given the location of the project and the commitments of the host Government.
The instruments are structured to credit enhance a transaction leading to better financing terms.
Depending on how they are structured, the instruments effectively substitute the borrower and project risk such that the investor is less exposed.
This provides access to the international capital markets, broadening the sources of funding available.
The instruments are discussed briefly below.
Credit Guarantees cover losses in the event of loan default, regardless of the cause of default (i.e. commercial or political). The coverage can be partial, covering only a part of the loan, or full, covering the whole amount.
Partial Risk Guarantees cover losses from loan default as a result of political events.
These include losses as a result of (1) expropriation of investments by government actions; (2) war and civil disturbance; (3) currency or transfer risk relating to restrictions on the ability to repatriate foreign currency earnings or to convert local currency into foreign currency, which is a major risk in Zimbabwe; and (4) breach of contract relating to government action to amend or cancel a contract.
Currency Risk Coverage cover foreign currency exchange risk for most infrastructure projects funded by foreign currency but earning revenues in local currency.
Export Credit Agencies (ECAs) provide cover to investing companies and exporters from their countries.
The aim is to support exports from their home companies abroad, insurance for investments abroad that are beneficial to the home country, and guarantees against political and commercial risks.
Challenges and benefits
There are both challenges and benefits in using these risk mitigation instruments, hence the need to understand them.
Benefits include protecting investors against political and commercial risks, obtaining longer-term loans, lower interest rates, and supporting a country’s development efforts.
They may also be restricted to strategic projects of national and regional importance, short-term in nature, high transaction costs, high contract monitoring costs, and the difficulty of determining the circumstances under which a guarantee is called.
However, the benefits seem to far outweigh the challenges, so they certainly require greater attention to accelerate infrastructure investment in Zimbabwe.
Michael Tichareva is the Managing Director of National Standard Finance Africa. He can be reached on email@example.com
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