Risk Mitigation Instrument for Political Risks

Instruments to mitigate political risks and ease the access to financing for private infrastructure investment are critical especially in countries with high perceived risks. In 2012, insurance and guarantees covered about 6% of global FDI flows, and even 14.2% of FDI flows to developing countries, reflecting the importance of PRI cover for foreign direct investment.

Main instruments to reduce political risks applied in Southeast Asia are: Political Risk Insurance and Joint venture/alliances with local companies, followed by Risk Analysis and Consultations with governments and political leaders (see graph).

Main Risk Mitigation Instrument
PRI

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  1. Political risk insurance and guarantees enable investors and lenders to transfer political risks to a third-party.
  2. Joint ventures or alliances with local companies enable investors to collaborate with local counterpart which has a better knowledge of the local market, political system and specific risks allowing avoiding or reducing the likelihood of the occurrence of political risks.Joint ventures enable foreign investors to increase their knowledge on the market. Foreign lenders likewise seek to co-finance large infrastructure investment with domestic banks.
  3. Consultations with governments and political leaders enable investors and lenders to be informed on national development plans, infrastructure objectives and policy changes that affect infrastructure investment. Private stakeholders can express their perspective on public policies to improve the investment climate
  4. Risk Analysis seeks to manage risks throughout the life cycle of a project. Risk management analyses the risk profile of infrastructure projects to identify the main risks and best solutions to mitigate the negative impact of these risks.

Main political risks and selected financial risk mitigation instruments
Risks* Selected risk mitigation instruments* Providers
Expropriation (plant & equipment) Comprehensive Contractors Plant and Equipment insurance Private insurers
Force Majeure (i.e. natural disaster) Natural Catastrophe cover
Business interruption cover
Private &public insurers
Private insurers
Contract frustration (vs private or public) Contract frustration cover Private & public insurers
Expropriation & Regulatory changes Expropriation cover
International or national (NY, SG, HK law) arbitration courts (contractually defined)
Private & public insurers
(Arbitration) Courts
Political Violence Political violence cover (property damage) Private & public insurers
Currency inconvertibility/ Transfer restrictions Currency inconvertibility cover Private & public insurers
Breach of Contract & Non-honouring of financial obligations Comprehensive cover
Contract frustration cover Private & public insurers International or
national (NY, SG, HK law) arbitration courts (contractually defined)
Private insurers (few)
Private & public insurers (Arbitration) Courts
Not honouring an arbitration award Arbitral award cover Private & public insurers
Legal risk Denial of justice cover Private & public insurers
Note: * The table is not comprehensive but focuses on selected risks and risk mitigation instruments with a focus on insurance and guarantees

Main commercial risks in private infrastructure projects
Commercial risks Description
Availability risk Availability risk refers to underperformance of the facility which results in services being partially or wholly unavailable, or where these services fail to meet the quality standards. Off-take agreements might link payments to the availability of services, such as electricity or water.
Construction and completion risks Constructions risks derive from weak planning, due diligence and project appraisal in the project procurement and design phase. They include: time delay, cost overrun and performance risks.

Time delays in the construction phase

Reason include: Most commercial risks, like design risks; delay in land acquisition, permits and licences; technical problems in the applied construction or construction side; and physical risks. And: inaccurate contract time estimates; construction procedures; work permissions.

Impacts include: Time delay may translate into risk of substantial cost increases and forgone revenue streams.

Cost overruns
Reasons include: Higher construction costs, time delays, increased interest during construction (IDC).

Impacts include: Cost overruns may translate into lower return‐on‐investment for the investors, or even make the project unfeasible, higher fees for end‐users and reputation risks for construction companies.

Performance risks relate to the inability of the private partner to deliver the facility in the conditions as agreed in the contract.

Reasons include: Bankruptcy of the contractor; design faults; usage of untested/innovative technology in the construction and operation of the facility.
Impacts include: The performance deficiencies could cause lower productivity and higher maintenance costs.
Contractual and legal risk Legal risk refers to losses caused by: regulatory or legal action, legal disputes, inability to enforce or meet contractual obligations.

Reasons include: New stakeholders; stakeholder request changes; unreliable dispute settlement system.

Impacts include: Delayed dispute resolution, delayed payment on contracts or insolvency of contractor.
Credit risk Credit risk refers to the credit worthiness of the borrowing SPV/project company or the project sponsors.

Reasons include: Downgrading of the SPVs/project sponsors credit rating.

Impacts include: Increased risks from the lenders’ perspective which could increase financing costs.
Demand risk Demand and traffic determine the financial viability and bankability of PPI projects where direct user fees are the main source of revenue for the project company. Demand risks derive from the discrepancies between the actual and forecasted demand. Forecasting demand over periods of up to 20 or 30 years is at least difficult and often inaccurate. Demand depends on many factors that cannot be controlled by the project company. In addition, traffic forecasts are often prone to over-estimation (‘optimisms bias’) – forecasts from project sponsors seems to be more prone to optimism bias than lending banks’ forecasts (see Robert Bain, 2009). Too high traffic forecasts undermined the financial viability of, for example toll roads.

Reasons include: Demand and traffic fluctuations might result from factors such as the wider economic development, import competition, market trends, changes in income and demographics, change in end-users’ preferences, technological obsolescence, and emergence or disappearance of substitute or complementary products or competing facilities.

Impacts include: Demand and traffic fluctuations directly affect the project’s revenue stream and, thus, the ability to honour the debt service, pay dividends and ultimately the financial viability.
Design risks Reasons include: Inadequate and incomplete design; engineering errors; selection of unsuitable materials; design exceptions and owner demands changes.

Impacts include: Project fails to meet the agreed performance and service standards. A necessary rework of the design may entail substantial cost overruns and time delays
Financial risks Financial risks affect the cash flow of investors and their ability to honour their debt service, thus, 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, like revenue streams, supply and operational costs and debt service.

Reasons include: Exchange rates are determined by real interest rate differentials among countries, balance of payments and other variables which affect market expectations. Other factors include regulations on capital transfers, capital mobility,

Impacts include: Exchange rates positively and negatively influence the project company’s future cash flows. In the worst case, the revenue stream in a local currency might be insufficient to honour debt services for hard currency loans which ultimately could lead to the default of the project company.
Financing / re-financing risk Financing / re-financing risk refers to the access to financing such as loans, guarantees and equity.

Impacts include: Higher interest rates, debt services or shorter credit tenors could endanger the financing and implementation of projects.
Force majeure Risks beyond the reasonable control of a party, incurred not as a product or result of the negligence of the afflicted party, which have a materially adverse effect on the ability of such party to perform its obligations.
Land acquisition Land acquisition is a frequently mentioned risk in many ASEAN countries especially for large-scale infrastructure projects, like transportation or power plants.

Reasons include: Ineffective dispute settlements, strong opposition from citizens and NGOs, or significant prices increases. Unclear or not existing laws, regulations and procedures on the process, consultation, resettlement and compensation for land acquisition.

Impacts include: Time delays of the financial closure and the construction time.
Operational risk Operational and maintenance risks relate to the projects’ inability to run at the desired efficiency in service delivery or higher than expected operating and/or maintenance costs.

Reasons include: Inadequate or failed internal process, people, system or from external events

Impacts include: Inability to honour off-take agreements, loss of revenue, reputational risk.
Permits, licences and authorization The requirement for permits, licences and authorisation acts as a safeguard for e.g. economic, social and environmental standards, but the involved red tape is often mentioned as a critical constraint for PPI projects.
Reasons include: Unclear processes to require permits; changed regulations on permits.

Impacts include: Time delays in financial closure and project completion.
Physical risks Risks derive from the physical characteristics of the facility and construction site.

Reasons include: Contamination of the construction side; subsurface conditions / geology geotechnical conditions; topography.

Impacts include: Construction delay, additional costs
Property damage Property damage occurs in the construction and operational phase of the project.

Reasons include: Action like terrorism or by natural disasters, such as drought, cyclones or floods.

Impacts include: Injury or destruction of property with negative impacts on construction time and costs.
Social and environmental and risks Large scale infrastructure projects include large environmental and social risks and need to be managed. Risks are highest in the construction phase but affect the operational phase as well.

These risks have a strong impact on the acceptance of infrastructure projects by civil society and especially in the affected communities. Investors and lenders need to assess and reduce the projects’ social and environmental impact. Many larger financial institutions and countries adopted the Equator Principles, a risk management framework to determine, analyse and manage environmental and social risks (see http://www.equator-principles.com/).

Reasons include:
– Environmental risks relate to the projects' impact on climate change,renewable natural resources, biodiversity, water and soil contamination and pollution. Direct risks refer to proximity to floodplain, coastal zone, high sensitivity for palaeontology area.

– Social risks: Construction and (involuntary) resettlement impact human rights of the population and especially affected local communities and indigenous, disadvantaged or vulnerable groups. Others: health and safety of labour force and cultural property and heritage.

Impacts include:
– Risks could reduce the acceptance of the project in the civil society, which may hamper or impede the project's implementation.

– An increasing number of financial institutions apply the Equator Principles and, thus, the risks influence access to financing.
Supply risk Supply risks occur in the construction and operational phase: Access to input for the construction of the facilities like material, goods, services and labour. Access to input for operating the facility, for example labour or supply of natural gas for a gas power plant.

Reasons include: Unavailability and costs of required input materials and labour.
Impacts include: Construction delay or cost overruns. Operational phase – Higher costs or inability to provide services.
Technical risks Risks refer to the applied technology during construction and operation phase.

Reasons include: Usage of untested, innovative or out-of-date technology.

Impacts include: Time delays, cost overruns and performance risks in the construction.