As each party assesses a project's risk, they will establish a price for their services taking into account a profit margin that is required and expected to compensate for taking on the project and bearing the risks. If risks are not accurately assessed, too many risks at too high of a premium can be transferred to the wrong parties substantially increasing the cost of the project. Ultimately, all these are integrated into the project cost, which will ultimately be paid for in either higher taxes or user fees.
All financial arrangements involve exposure to various types of risk, what financiers do is to minimize the possible impact of this exposure. Financiers look to negotiate financial structures designed to protect themselves from potential downsides due to identified project risks. Financiers want to assess all potential events or factors that can impact a project's cash flow. Then they are looking at the probability of one of these events occurring and the probability of that event forcing the project to default on its debt obligations. The level of risk perceived is priced into the risk premium, which is then priced into the cost of capital. The greater the perceived risk by the financier, the greater the risk premium. Different weightings will be put on different risk criteria depending on the financier's risk appetite; and the decision to invest will be based on whether the potential returns are greater than the perceived risk. Ultimately, the risk premium is based on a number of factors as highlighted in a recent World Bank study (see Box 4 - 1).
Box 4 - 1 Dilami and Hauswald evaluated a representative sample of 105 US Dollar denominated emerging market project bonds issued between January 1993 and March 2002 in order to evaluate credit spreads and covenants. Their study found that emerging-economy project bonds had, on average, a risk premium of approximately 300 basis points over US-Treasuries45, a maturity of slightly less than 12-years and a credit rating of BBB- and BBB (slightly below investment grade). They also found a "high degree of variation across bonds…depending on project-specific characteristics, bond features, and the quality of host-countries' legal institutions in determining investor rights and the degree of their protection". |
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44 Dailami and Hauswald World Bank Policy Research Working Paper "The Emerging Project Bond Market - Covenant Provisions and Credit Spreads", July 2003
45 For US$ denominated bonds, US Treasuries represent the risk-free rate.