Commercial risks over the project life cycle
Commercial risks over the project life cycle
Commercial risks broadly cover all non-political risks. These may include, for example, completion and financing risks in the construction phase and demand, or supply and exchange rate risks in the operational phase of infrastructure projects. From an exporter’s point of view, commercial risks relate to non-payments by non-sovereign private sector buyers or borrowers, arising from default, insolvency and/or failure to take up goods that have been shipped according to the supply contract. Commercial risks negatively affect project costs and revenue streams and may ultimately call into question the commercial viability of a project.
Commercial risks can broadly be divided into the following categories:
- Economic or market risks which may include changes to input and output prices; variations in demand from projected levels; access to and the cost of debt and equity financing; and counterparty risks.
- Technical or physical risks may be associated with the physical characteristics of the facility and construction site (i.e. contamination); applied technology during construction and operation; and the social and environmental impact of the facility.
A project’s life cycle can be separated into a construction phase and an operational phase, each of which is susceptible to commercial risks:
- Construction & completion risks (time delays, cost overruns, performance-related)
- Design risks
- Financing risks
- Social and environmental risks
- Property damage
|Availability risks||Availability risk refers to the under-performance of the facility, resulting in services either being partially/wholly unavailable or failing to meet quality standards. Offtake agreements might link payments to the availability of services, such as electricity or water.|
|Construction and completion risks||Constructions risks derive from weaknesses in planning, due diligence and project appraisal in the project procurement and design phase of the project. They might constitute time delays, cost overruns or performance-related risks.
Potential causes: delays in land acquisition, permits and licences; technical problems on the applied construction or construction side; circumventing physical risks; inaccurate contract time estimates; lengthy construction procedures; obtaining work permissions.
Potential impact: substantial cost increases; forgone revenue streams.
Potential causes: higher construction costs; time delays; higher Interest During Construction (IDC).
Potential impact: lower return‐on‐investment (ROI) for investors, potentially making the project unfeasible; higher fees for end users; reputation risks for construction companies.
Performance-related risks (relating to the inability of the private partner to deliver the facility in the conditions as agreed in the contract)
Potential causes: contractor bankruptcy; design faults; use of untested/innovative technology in the construction and operation of the facility.
Potential impact: lower productivity; higher maintenance costs.
|Contractual and legal risks||Legal risk refers to losses caused by regulatory or legal action, legal disputes or inability to enforce/meet contractual obligations.
Potential causes: new stakeholders; stakeholder request changes; unreliable dispute settlement systems.
Potential impact: delayed dispute resolution, delayed payment on contracts; insolvency of contractor.
|Credit risks||Credit risk refers to the credit worthiness of the borrowing SPV/project company or the project sponsors.
Potential causes: downgrading of the SPV/project sponsor's credit rating.
Potential impact: increased risks from the lender's perspective, which could increase financing costs.
|Demand risks||Demand and traffic determine the financial viability and bankability of a PPI project when direct user fees are the main source of revenue for the company. Demand risks derive from the potential discrepancies between forecasted and actual demand. Forecasting demand over periods of up to 20 or 30 years is challenging and often inaccurate, as demand depends on many factors that cannot be controlled by the project company. In addition, traffic forecasts are often prone to over-estimation (‘optimism bias’) and forecasts from project sponsors seems to be more prone to this than lending banks’ forecasts (see Robert Bain, 2009). Traffic forecasts that are too high may undermine the financial viability of, for example toll roads.
Potential causes: broad economic development; import competition; market trends; changes in income and demographics; change in end users’ preferences; technological obsolescence; the emergence or disappearance of substitute or complementary products or competing facilities.
Potential impact: may affect the project’s revenue stream, hence the ability to honour the debt service, pay dividends and ultimately the financial viability.
|Design risks||Potential causes: inadequate and incomplete design; engineering errors; selection of unsuitable materials; design exceptions; changes demanded by the owner.
Potential impact: project failing to meet the agreed performance and service standards, resulting in a necessary rework of the design which may entail substantial cost overruns and time delays.
|Financial risks||Financial risks
Financial risks affect the cash flow of investors and their ability to honour their debt service, thereby directly influencing credit risks. Main factors are inflation, interest and exchange rate currency risks. The long tenure of infrastructure projects and loans increase the importance of these risks.
Exchange rate / currency risks
Foreign exchange rate risks can affect the project company’s future cash flows, including revenue streams, supply and operational costs and debt service.
Potential causes: exchange rate fluctuations caused by real interest rate differentials among countries, balance of payments and other variables affecting market expectations; regulations on capital transfers; capital mobility.
Potential impact: can be positive or negative on a project company’s future cash flows. In the worst case scenario, the revenue stream in a local currency would be insufficient to honour debt services for hard currency loans, ultimately leading to the default of the project company.
|Financing / re-financing risks||Risks to access to financing such as loans, guarantees and equity.
Potential impact: higher interest rates, debt services or shorter credit tenors could endanger the financing and implementation of projects.
|Force majeure||Risks incurred not as a result of the negligence of the afflicted party and beyond its reasonable control, but which have a materially adverse effect on the party's ability to perform its obligations.|
|Land acquisition||A frequently cited risk in many ASEAN countries, especially for large-scale infrastructure projects such as transportation or power plants.
Potential causes: ineffective dispute settlements; strong opposition from citizens and NGOs; significant price increases; unclear or non-existent laws, regulations and procedures for the process, consultation, resettlement and compensation for land acquisition.
Potential impact: time delays in financial closure and construction.
|Operational risks||Operational and maintenance risks relate to a projects inability to run at the desired efficiency of service delivery, or higher than expected operating and/or maintenance costs.
Potential causes: inadequate or failed internal processes; external events.
Potential impact: inability to honour off-take agreements; loss of revenue; reputation risk.
|Permits, licences and authorization||The requirement for permits, licences and authorisation acts as a safeguard for e.g. economic, social and environmental standards, however the red tape involved is often mentioned as a critical constraint for PPI projects.
Potential causes: unclear processes for acquiring permits; changing regulations on permits.
Potential impact: time delays in financial closure and project completion.
|Physical risks||Risks deriving from the physical characteristics of the facility and construction site.
Potential causes: contamination of the construction site; subsurface conditions or geotechnical conditions; topography.
Potential impact: construction delays; additional costs.
|Property damage||May occur in the construction and operational phase of the project.
Potential causes: terrorism; natural disasters such as drought, cyclones or floods.
Potential impact: injury; destruction of property, with negative impact on construction time and costs.
|Social and environmental and risks||Large scale infrastructure projects are associated with large environmental and social risks which need to be managed. These are highest in the construction phase, but may affect the operational phase as well.
These risks will strongly influence whether the infrastructure project will be accepted by affected communities and by civil society at large. Investors and lenders are therefore required to assess and reduce a project's social and environmental impacts. Many larger financial institutions and countries adopted the Equator Principles, a risk management framework to determine, analyse and manage environmental and social risks.
– Environmental risks relate to a project's impact on climate change, renewable natural resources, biodiversity, water and soil contamination and pollution. Direct risks refer to proximity to floodplains, coastal zones or high sensitivity paleontology areas.
– Social risks relate to the impacts of construction and (involuntary) resettlement on the human rights of the population, especially affected local communities and indigenous, disadvantaged or vulnerable groups. It can also refer to the health and safety of the labour force, as well as cultural property and heritage.
– Risks could reduce the project's acceptance in civil society, which may impede its implementation.
– Given an increasing number of financial institutions are applying the Equator Principles when assessing projects for financing, environmental and social risks can influence access to financing.
|Supply risks||Supply risks may occur in the construction and operational phases. Risks include access to inputs for the construction of the facility (e.g. material, goods, services and labour) or access to inputs for operating the facility (e.g. labour, natural gas for a power plant).
Potential causes: unavailability and/or high costs of required input materials.
Potential impact: construction delays or cost overruns; higher costs or an inability to provide services during the operational phase.
|Technical risks||This refers to the applied technology risks during both the construction and operation phases.
Potential causes: use of untested, innovative or out-of-date technology.
Potential impact: time delays, cost overruns and performance risks during construction.