Generally, mitigation measures are available for most risks. An effective strategy in risk management is to consider suitable mitigation measures for risks at the project planning stage. As appropriate, their consideration needs to be reflected in contract design and negotiation, and later on in designing a contract management process to address them during the construction and operation periods. The basic approaches to risk mitigation include:
• Transparency in the whole process, including participation of key stakeholders from the beginning;
• Properly executed project appraisal with details of risks and their likely effects, and return expectations;
• Cash flow projections based on technical, market and financial analysis;
• Structured finance16 to meet the characteristics of the project;
• Security package and elaborate documentation; and
• Project monitoring and contract compliance.
Following are some of the commonly applied tools for risk mitigation:
• Measures that can de-risk to the extent possible or minimize the possibility of risk occurrence;
• Obligations and comforts in contract agreement through allocation of risks to identified parties with penalties and/or responsibilities for consequences;
• Insurance when available;
• Financial instruments (hedge, swap, etc.); and
• Designing of financial structure to minimize the risk of default.
The risk matrix in table 3 shows some examples of possible mitigation measures against the risks.
Table 3. Risk matrix
| Category of risk | Description and likely effect | Mitigation measures | Allocation |
| Developmental risk | Insufficient preparatory tasks and project planning leading to delays in procurement and financial close | - Good feasibility study (that includes comprehensive analysis of risks, possible effects and how to address them as well as de-risking to the extent possible) - Institutional due diligence - Competent transaction advisor | Government/ implementing agency |
| Sponsor risk | Financial strength (ability to participate with equity, can arrange third party equity, financially solvent and financial requirement does not exceed capacity, can provide limited recourse, if needed) | - Credit references and rating - Minimum level of equity stake - Bank guarantee and undertaking - Bid bond from banker(s) - Track record - Financial statement analysis - Ensure adequacy of finance under loan facilities - Use of non-financial evaluation criteria and due diligence on private parties | Government/ implementing agency |
| Cost overrun risk | During the design and/or construction phase, the actual project costs exceed the estimated cost | - Fixed price and fixed time EPC contract - Review by lender's engineer - Contingency provisions; standby debt facilities/additional equity commitments (commitments are needed upfront) - Equity stake of EPC contractor | |
| Time overrun risk | Takes longer time to complete the project | - Technical competence and experience of EPC contractor and subcontractors - Retainage, completion bond - Penalty regime - Full powers for implementation to IA | |
| Input supply risk | Raw materials and inputs not supplied in time or of less in quantity or of low quality, price escalation of inputs | - Contractual framework (provision for liquidated damages) - Secured supply source - Relief may be considered if failure or shortage not attributable to any private party | |
| Operating risk | Factors negatively impacting upon operation and available capacity such as, unreliable/ untested technology; increased cost of operation, lower capacity; nature and cost of O&M; inefficient operation | - Proven technology, technology transfer - Clear output specification - Independent/lender's engineer report - Guarantee by technology provider, EPC contractor - O&M contract - Sinking fund, maintenance reserve - Maintenance bond - Contractual framework (penalty regime) - Substitution right | |
| Demand/ revenue risk | Insufficient demand and/or revenue (due to low demand, leakage, competing facilities, capacity, price setting, augmentation) | - Realistic demand studies, sensitivity analysis - Regular monitoring - Contractual framework - Price indexation - Long term offtake contracts - Take or pay | SPV/PP; Government in case of PFI type or projects with off-take agreements with government |
| Change in tax rates | Changes in tax law or policy that have negative effect on the private party, its assets, or the project | - Sensitivity analysis to test the - Compensation if such effects are discriminatory | SPV/PP if changes were foreseeable and not discriminatory, otherwise government |
| Repatriation of capital and profit | Unable to repatriate capital or profit, currency convertibility and transfer | - Partial risk guarantee provided by some development banks and ECAs - Insurance for political risks (see notes at the bottom of the table) | SPV/PP |
| Force Majeure Natural events | Flood, earthquake, cyclone etc; closure of operation and negative effects on assets and project | - Robustness of cash flow - Provision of reserves - Contractual provisions to withstand effect of such periods - Relief for short-term close down | SPV/PP |
| Force Majeure-Political events | Change in law, expropriation, revocation of licences, permits etc, civil disturbance, war, non-default termination of contract. | - Insurance for political risks - Contractual framework - Provision of compensation | SPV/PP |
| Dispute between parties | Non-compliance of contract provisions, or difference in interpretation of provisions | - Establishment of a contract management framework and formalization of management responsibilities - Well defined dispute resolution mechanism spelt out in the contract - Appropriate regulatory mechanism - Termination of contract | Government/ SPV/PP |
Notes: EPC = Engineering, Procurement and Construction; IA = Implementation Agency; O&M = Operation and Maintenance; PP = Private party in contract with the IA or Government; SPV = Special purpose vehicle.
Government means government in general or the concerned ministry, department or an organ of government as the case may be.
The table merely shows some examples of the common risks and their typical mitigation measures that may be considered. It does not provide any exhaustive list of risks, their nature or mitigation measures. Many mitigation measures shown in the third column may also apply to other risks identified in the second column.
Although the general principle of allocating risk that the party who is in the best position to manage should assume the risk applies to all situations, the party in the best position to manage a particular risk may vary from one situation to another. Many risks are project and situation specific.
A relief event is an incident that temporarily prevents the private company/SPV from completion or operation of the project. The private company is not penalized but also does not receive any compensation.
Some risks may remain unallocated to any specific party. These residual risks would have to be implicitly assumed by the SPV and the lenders.
Multi-lateral agencies such as Multilateral Investment Guarantee Agency or MIGA of the World Bank Group provide loan guarantee for developing country private sector projects. MIGA provides guarantee against foreign currency transfer restrictions, expropriation, breach of contract, war and civil disturbance. Many other development banks such as the Asian Development Bank, and ECAs have also similar mechanisms for providing loan guarantee to private projects.
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16. In project finance, structured finance broadly means debt structured to fit the cash flow.