Reducing Financial Risk during Project Development

Owners and operators swap stories about gaining financing for their projects, but the evaluation of risk from the lenders’ perspective is often an untold side of the process.

The lenders’ technical advisor (LTA) plays a key role in identifying and mitigating risks in hydropower projects on behalf of a proposal’s financiers, with services required to manage four key phases, including due diligence, pre-financial closing, construction and financing.

The LTA – also known as the independent engineer, bankers’ engineer or lenders’ independent consultant – is selected jointly by the financiers and project developer but is usually contractually appointed and paid by the project developer (the borrower).

However, the LTA’s selection process is rarely as straightforward as just described, given that lenders tend to look for experience, reputation and quality, whereas the developer will additionally look for the most competitive price. Lenders are also looking for an LTA who can provide advice on contractual, engineering and, though not instantly evident by the title, environmental and social issues. The LTA role is commonly used among the traditional sources of debt funding, such as World Bank, IFC, Asian Development Bank, African Development Bank, several European based development banks, Export-Import banks and some high street lenders.

Engaging the LTA

Lenders normally prepare requests for proposals for LTA services, tailored to the needs of a particular project and perceived key areas of concern – but with fairly common underlying terms of reference for most LTA roles.

With the lenders’ reputation at risk if a project fails to follow good practices, the importance of independent monitoring and reporting throughout the construction and operation periods is clear.

Flexibility is a key attribute, which may be from the perspective of having the depth of in-house expertise to cope with issues that arise to the flexibility or “nimbleness” at the individual level to cover a wide range of issues. A typical LTA team will include up to 15 individuals, but sometimes as few as three or four, with intermittent involvement across the phases from initial due diligence through to operations. Key disciplines required would be a team leader, geologist, hydrologist, environmental, social/resettlement, hydraulics, tunneling, electrical, mechanical and hydro-mechanical. Most would be involved in the pre-construction phases, whereas a rotating schedule for disciplines during construction would depend upon the activities at the time, with quarterly visits arranged throughout the construction period.

For example:

– A recognition that the LTA’s role, while necessary and important, is no more so than the owner’s permanent site team, and that any reviews by the LTA should be within the time scale for others so as not to cause a delay in the approvals process;

– The ability to provide a “one-stop shop” for all commercial, environmental, social and engineering disciplines required in the LTA role;

– The ability to cope with tight schedules; and

– The ability to understand and cope with the lenders’ commercial administrative process.

This selection also considers:

– A strong technical track record;

– Credibility in the international arena;

– The ability to present highly technical issues in a language suited to the non-technical reader; and

– Effectiveness in dealing with potential disputes.

The LTA’s “duty of care” is to the lenders. In other words, the party not normally paying for the LTA’s services. Notwithstanding this, the objectives of the lenders and the borrower are usually closely aligned – which is, to have a project that delivers a satisfactory financial return, completed safely and on time.

If they are not aligned, then there is a fundamental flaw in the drivers for the project, as both parties should be seeking to use the services of the LTA to reach common ground so the project proceeds with a known and agreed risk profile and minimum of uncertainty.

The LTA and owner’s engineer roles

The role differs from that of the owner’s engineer (OE). Although the LTA and OE are effectively both employed by the owner, the OE’s duty of care is solely to the owner. It can be considered that the OE is employed to ensure that the contractors deliver on their obligations to the owner, whereas the LTA is employed to ensure the owner delivers on its obligation to the lenders.

The LTA’s role remains essentially the same whether or not there is an OE engaged for the project. Clearly all medium and large schemes have the traditional OE role, but some small schemes have been developed without a formal OE role.

While this is justifiable in many cases, particularly if the developer has in-house expertise, it does not mean the LTA for such projects will necessarily explore certain technical issues deeper than might otherwise be the case.

In one small project just completed, I was acting as both OE (not including environmental and social aspects) and LTA. However, each of those service contracts had a provision declaring that in the event of conflicting positions for a particular issue, the position of LTA takes priority. Given that the objectives of the lender and owner are, or should be, closely aligned, a lender can therefore be considered the majority owner over the tenure of the loan in a simplistic form.

One important consideration is that the LTA is not employed to give a design solution. Instead, the role is to be aware of all technical issues at a high level, intervening in the interests of the lenders and/or the project when concerned about an issue. The LTA has neither the budget nor the remit to get too involved. The LTA will use his or her experience to gauge which issues might be of material concern to the particular designer, contractor or management team and, if necessary, withhold acceptance for deficient designs. Thus, the ‘materiality test’ is a constant check meter for the LTA when confronted with a large project having a wide range of issues.

Likewise, it is important the LTA does not try to impose “their way” when reviewing and commenting on project designs or methodologies. It requires a “back-to-basics” sense and for the LTA to be open to means and methods that get the green light, assuming they meet sound engineering principals. The experienced LTA does, however, build up considerable new experience on every project, gaining the opportunity to see what does and doesn’t work on a wide variety of projects, resulting from interactions with the world’s leading lenders, clients, consultants, contractors and advisors.

The LTA’s authority

During the construction phase, an LTA team will give recommendations to the lenders after its regular site visits. While one might think they are firm requirements, they effectively become mandatory only once the lenders give their support to them. Even then, they need to be within the remit of the services. Hence, for timely resolution of issues as they emerge, it is best if each LTA visit to the site concludes with either a wrap-up meeting with the lenders (in-person if geographically convenient) or for the lenders to join some of the visits. This keeps topics live and issues can be explored at greater depth. When the lender joins a visit, it adds significant weight to dealing with issues that arise and usually allows for a speedier resolution.

The ultimate authority resides with the lenders. However, at the core of an LTA’s role is the regular certification of loan drawdowns. This is often quarterly but can be monthly. The LTA attends the site, typically quarterly, for a relatively short visit of a few days, essentially gaining a snapshot of numerous issues. The LTA is then expected to form an opinion on a multitude of topics.

Key issues normally required to be covered within an LTA certificate for a loan disbursement or drawdown include:

– Progress of the work;

– Expenditure for the work against observed progress;

– Tracking of drawdown against the original planned schedule; and

– Compliance with borrower’s obligations under all licensing agreements.

Most projects go through a wave of different types of issues emerging at different times. From the lenders’ perspective, often the engineering and safety issues are at the fore from the start of a project, when all parties are trying to establish the right level of good practice and the owner’s team is getting to know the strengths and weaknesses of its contractor. Any weaknesses in environmental management plans will manifest at this stage, and the LTA normally needs to have some level of intervention to ensure things are on track according to the LTA’s expectations.

It is therefore quite normal for tensions between parties to emerge in the early stages, but that should rapidly fall away. After this, experience shows once the contractor is at full speed on construction (or design and construction, if using the engineering, procurement and construction model), technical issues inevitably emerge and it is in this phase the site management team is tested to keep all parties satisfied. This is a key area for the LTA to monitor.

On one large project the LTA was dissatisfied with the level of owner’s engineer’s staffing based permanently at the Site. Although it was a single EPC contract and frontline QA/QC supervision should have largely been within the EPC team, there were several complex technical issues requiring design changes and therefore the LTA considered it was important for the owner (borrower) to have a much greater degree of oversight of design changes, and general progress overview. Several fundamental quality issues started to emerge and the LTA insisted that staffing be increased. Lenders gave full support and the issue, among several other concurrent issues, was elevated to the brink of having to make recommendations for a loan stop unless the situation changed. Clearly there were underlying serious issues here, but this example underlines the intervention rights that should and do exist.

The LTA will normally present a tracking log for issues to the lenders. A log of issues is a valuable barometer of how the project is proceeding at many levels – in terms of schedule, expenditure, safety, non-compliance, community support, etc. Graphical presentation makes for a powerful summary of the quarterly snapshot for feedback to the lenders. The categorization of issues into health and safety, technical engineering, environmental and social categories (as seen in Figure 1) is a good way to separate the issues, which also aligns with broad organizational responsibilities.

The LTA needs to be nimble in his or her response to issues as they emerge and in many cases will be the initiator and subsequent “manager” of an emerging issue that needs to be resolved. With so many technical and managerial tasks being handled by the developer at any one time, the LTA needs to retain a focus on what does and does not matter in terms of his or her responsibilities to the lenders.

The LTA’s added value to the project comes down to one key function: risk mitigation. The LTA should not be a last line of defense against high-risk items being realized, but this does happen. When it does and the LTA picks up a real issue, it is assumed the owner would be comforted by the presence of another set of eyes watching over its investment.

The LTA is passing opinions on the ability of the owner to carry out a project, and information provided to and by the LTA is usually subject to a confidentiality agreement with the technical bank. This situation can lead to some tension between the owner and LTA, and it is very important to be clear as to the roles and responsibilities of all parties and what information can or cannot be readily shared.

The steps to loan signing and financial closing

There is a growing trend for projects attempting to reach financial close on the basis of a feasibility study. This can be straightforward, but given the original limitations on the budgets for such studies (meaning a project is not known to be feasible until the study is completed), there is a risk that certain key aspects of that study may have been skipped or inadequately covered. Most lenders have strict requirements to achieve credit approval, which is a step before loan signing. If the developer has not understood those from an early point in time (as in the feasibility study stage), there is a likelihood of delays in reaching credit approval until the gaps in information are filled.

This is one area where the LTA performs a key role by sifting through what is important and anticipating what lenders will need to know.

For environmental and social matters, these can require a lengthy process of studies that are simply not appropriate for fast-tracking. In the author’s experience, it is important to engage the LTA sufficiently early in the pre-financial close process such that the LTA’s findings and recommendations can be incorporated into loan documents or construction contracts before it is too late otherwise negotiations become strained. This also applies to the assessment of environmental and social aspects, in particular where baseline social surveys such as annual income and livelihood surveys, as otherwise there will be inevitable delays to the financial close without adequate length of baseline data. However, providing the LTA is engaged early enough, then there are ways to effectively deal with the actions stemming from the LTA’s due diligence so that they are prioritized into various categories, to be resolved according to their criticality.

One such way is to adopt a three-step categorization to resolve actions arising from the LTA’s due diligence:

Category 1: To be resolved to the LTA’s satisfaction before financial close, which also means before the lenders’ timeline for achieving credit or board approval.

Category 2: To be resolved to the LTA’s satisfaction before the first (or subsequent) drawdown.

Category 3: Recommended actions to be addressed during the final design or project implementation.

What lenders want to know

Several key issues dominate the discussion in determining credit approval, including:

– Price certainty of the overall development;

– Environmental and social status and the evolution of risks;

– Questions regarding a project’s compliance with widely accepted standards, such as World Bank and International Finance Corporation guidelines;

– Contractual arrangements;

– Timelines for all stages of development, from pre-financial closure through commissioning;

– Operation and maintenance agreements;

– Planning restrictions;

– Availability and condition of interconnections and other local infrastructure; and

– Appropriateness of the owner’s organization, the competence of its personnel and operational readiness of the completed facility.

Keeping track of the lenders’ requirements

In the period approaching loan signing, it is common for the lenders and LTA to establish a set of conditions precedent (CPs) that are linked to either the loan signing, or the first or subsequent disbursements from the loan. The CPs may cover a range of topics including commercial, contractual, technical or environmental and social conditions for which the lenders and LTA require more comfort that the critical aspects have been, or will be, satisfactorily closed out at a set time.

Risk management

Risk management is at the core of the LTA’s role. From a lender’s perspective, the definition of risk is the probability of a cashflow outcome different from the one projected or forecast. For an investor, the definition might also include the possibility of not achieving the expected financial return.

The LTA will review the technical aspects of the construction contracts, often in parallel to a legal review undertaken by the lenders’ legal advisors (LLA) and an insurance review by the lenders’ insurance advisors (LIA). Liquidated damages that may be imposed upon the owner are a key consideration, as is the assessment of whether the contract provisions have adequate pass-through down to the contractor level – in the case of an EPC agreement – of those aspects that are relevant to the EPC’s supplier’s plant and equipment.

The LTA will advise on a suitable “stress test” to be applied to the financial model based on technical assumptions in the event that the project commissioning date is delayed or if there are major cost overruns. As a rule of thumb, at least six months’ schedule overrun is recommended as a stress test, or in areas where there are known geological risks, to assess the impact on a borrower’s financial situation if, when late, a whole set of additional costs are directed at the borrower. These can include the prolongation of costs of an owner’s site team; lost earnings from delayed commissioning; additional financing costs; additional LLA, LIA, LTA and other advisor costs; and possible liquidated damages for late completion.

While some of these may be recoverable from the contractor if it is the contractor’s fault, any money for prolongation will usually have to be initially met by the borrower until the contractual issues are resolved. In this regard, the LTA is truly part of the collective lenders’ team whereby the lenders will asses the financial aspects, the LLA the legal aspects, and the LIA the insurance aspects, with the LTA feeding into each of these where technical or engineering and safety aspects relate.

A project’s risk profile will change over time, often following a bell curve that rises steeply during construction, with the peak of risks culminating just after commissioning. At this point, virtually all monies have been loaned, the technical issues might be at the forefront due to teething problems, and the developer’s cash flow is probably at its worst position since the project began.

Liquidated damages provisions in the construction contract provide only limited mitigation against completion risks or risks of plant performance below guaranteed values because the cap may only be 10% or 20% of contract value. This is normally adequate incentive to perform but inadequate to save the project if things turn bad. A robust mitigation strategy involves at least ensuring sound performance warranties and contractual terms and that all parties to the contract are able to deliver on their respective obligations. This is effectively seeking a full pass-through of liquidated damages.

The environmental and social risk profile over time follows a similar trend to the profile of the physical and monetary risks. The risk profile tends to mirror that of the engineering set, as it is the construction activities that require the environmental impact mitigation and the social program to follow them. It is at this time when any resettlement of project-affected peoples starts to take place and the real scale of construction begins to be realized.

The LTA should have intervention rights on a variety of aspects that are not mainstream engineering and that might appear relatively benign or minor but could turn out to be key factors in getting a hydro plant into reliable service. The LTA’s job will therefore include an assessment of staff training programs, operations and maintenance manuals, operating procedures, as-built documentation and the inventory of spare parts. The LTA may also focus attention on ancillary elements of the project, such as ensuring access roads are designed and maintained, and will look beyond its footprint to the wider setting with regard to access or security of supply from surrounding countries.

Lessons learned

In addition to the recommendations above, it is also suggested that:

– The LTA thoroughly vet lists of pre-selected subcontractors and subconsultants;

– Lenders check to see if the facility agreements include terms allowing them to insist on strengthening a project’s construction team, should questions arise about their qualifications;

– LTAs coordinate with dam safety experts, government engineers and others to have an open dialogue throughout development;

– LTAs carefully evaluate operation and maintenance contracts as the operational phase is the revenue-generating phase. However, this aspect is often given the least forethought by developers who might prefer to address staffing until late in the construction phase.

The primary lesson, however, is that any issue can potentially become a major concern to the lenders, and borrowers need to make an extra effort to understand what is considered material and therefore may worry potential financiers.

Andrew Noble, a hydropower specialist for WSP (formerly Parsons Brinckerhoff), has provided LTA services for conventional hydro and pumped-storage projects from 5 MW to 500 MW in Africa and the Asia-Pacific region.

Tailor-made, Long-term Financing

By Andreas Hutzler

To harness Africa’s vast hydropower potential, financing that is tailor-made is essential. Hydropower plants are a capital-intensive investment, and financial solutions ease the up-front financial burden by spreading the development cost over a long period. This is particularly important in developing economies, which in many cases have no access to the international capital market. Engineered financing concepts or financial engineering, in cooperation with development financial institutions (DFI), private commercial banks and state-backed export credit insurers (which are usually based in the home country of the project’s main supplier), are of enormous importance. Therefore, every concept needs to be customized to specific needs, based on local variables, project details and the customer’s financial situation.

The modernization of the 88-MW Mount Coffee hydro project on the St. Paul River in Liberia is a good example of a fitting and long-term financing package. Mount Coffee originally had a capacity of 64 MW from four turbine-generator units, but the facility was destroyed during the Liberian Civil War in the 1990s. Bringing it back online required extensive modernization work that cost US$230 million.

This rehab work was financed by the Liberian and Norwegian governments, the European Investment Bank, Germany’s KfW Bank, and the Millennium Challenge Corporation of the US government.

Voith — which supplied the new Francis turbines, generators, control technology, and electrical and mechanical power plant equipment for Mount Coffee – works closely with such financial institutions and insurers to help African customers spread the cost of building or rehabilitating hydropower facilities over realistic time frames.

It is important to keep in mind that, with regard to the overall life cycle, hydropower has the lowest cost of all energy generation forms and its long-term return is among the highest. Still, investment needs for a low-carbon future are enormous. There are ambitious targets requiring major investments that will depend on private sector finance. Meeting these investment objectives requires not only active private sector participation, but also a policy and regulatory framework that incentivizes and supports private sector financing for the transition to a low-carbon economy. To help mitigate risk in environmentally sustainable and low-carbon markets, the public sector can play a key role in supporting the effective mobilization of private sector sources of green finance.

Andreas Hutzler is senior manager with Voith Financial Services.

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