Operational and Supply Risk Mitigation
Operational risks relate to the risk that a project will be unable to run at the desired level of efficiency in service delivery, or that it will incur higher than expected maintenance costs. Supply risk refers to access to inputs for operating the facility.
Contractual agreements and public support have been reported as the most effective instruments for mitigating operational and supply risks. Contractual arrangements include Put-or-Pay and Pass-Through clauses, which transfer supply risks from the private operator to either the supplier or the off-taker, often a public authority or SOE.
Contractual arrangements might involve:
- Put-or-Pay contracts, whereby the supplier guarantees the availability of inputs (such as fuel for a gas power plant) for the project. If the supplier fails to honour the contract, indemnity payments would be made to compensate for the higher costs of purchasing the inputs on the market ,or for foregone revenues.
- Pass-through contracts, which reduce price risks for the project company by linking input prices of the supply contract with off-take prices.
Debt service/contingency reserve funds reduce the risk that the project company will not be able to honour its debt services due to cash flow shortages.
Contingency reserves are created through equity contributions or cash flow reserves. They ensure debt service payments are made in case of an abrupt and short-term decline of the project’s cash flow.
Cash reserve mechanisms/cash traps limit dividend payments if the cash flow drops below a minimum debt service coverage ratio (DSCR). These equity lock-ups are applied when the cash flow is just large enough to meet debt services but lower than a given threshold.
Other instruments include standby letters of credit and project sponsor guarantees.