Type of Risk

Definition

How can it be covered?

Project Disruption Caused by Events Outside the Control of the Parties

These risks are widely varied and can either be man-made (e.g. civil war, revolutions) or naturally occurring (e.g. natural calamities such as earthquakes, etc.). Typically, force majeure risks are not reasonably covered by insurance mechanisms. Such unforeseen or extraordinary events may cause a temporary interruption of the project implementation or operation, resulting in construction delay, loss of revenue and other damage. Severe events may cause physical damage to the project or even destruction beyond repair.

This is often a contentious and grey area. Best practice is to agree for the LGU to offer coverage up to 50% of uninsurable and uncontrollable natural and political events if it is clear that (a) the risk is truly uninsurable or only insurable at price that is unreasonable; and (b) the lender requires the cover as a precondition for extending the loan(s).

Ideally, the provisions of the Project Agreement will stipulate that the LGU and the developer will share the obligation to:

(a)  Rehabilitate the project, if damaged;

(b)  Provide for consequential loss of income for the period the project is out of commission; or

(c)  LGU will pay 50% of the loss experienced by the project upon termination, based on an agreed formula.

When identifying and negotiating these risks, it is important for the LGU to have professional advice from insurance experts. The lenders may adopt the view that the LGU should cover their residual exposure to the project company since it is the party best able to bear the financial consequences of the risk.

Project Disruption Caused by Adverse Acts of the LGU or Its Instrumentalities (Political Risks)

Risks in this basket can be segregated into three broad categories:

Traditional political risks, such as confiscation, expropriation, nationalization or deprivation (CEND) of project rights, benefits, or assets. The risks could also include imposition of new taxes that jeopardize the project company's prospects for debt repayment, investment recovery and profit;

Regulatory risks, for example, introduction of more stringent standards for service delivery or opening of a sector to competition; and

Quasi-commercial risks, for example, breaches by the LGU or project interruptions due to changes in the LGU's priorities and plans.

Generally, the LGU would be expected to assume 100% of the financial consequences of this Risk Basket. For each broad category of political risks identified in the left column, the LGU would be expected to provide compensation for:

(a)  Consequential loss of income due to:

•  New and higher taxes, or new regulatory standards, that call for unanticipated capital expenditure and/or the loss of cash flow; and

•  Loss of revenue, particularly the introduction of competition, if due to breach of contract;

and/or

(b)  Termination payments in the event of a CEND event or other breach followed by a cure period in which no agreement is reached as to how best to go forward.

Inflation and financial risks

Inflation risk is caused by the unexpected rise in input prices for the project, and is primarily felt during the construction phase (e.g. an unexpected rise in building materials). These are normally caused by macro-level changes, such as the rise in interest rates, increased labor costs and fluctuations in foreign exchange rates. In effect, the cost involved in conceptualizing, constructing, and operating the project would be higher than originally projected.

Financial risk is caused by an increase in the cost of borrowing, particularly interest rate fluctuations.

An LGU can require a fixed price, date-certain, lump-sum, turnkey contract for the construction of the facility, while the project proponent can include price escalation clauses or parametric rate adjustment formula for tariffs of services provided to cover inflation, among other cost factors.

To mitigate financial risks proponents should secure fixed interest rate loans or hedge through interest rate caps.

Government performance risks

These are risks brought about by the concerns of both lenders and equity investors on the ability of the LGU or any cooperating government agency to fulfill its obligations in the risk-sharing arrangement. For instance, lenders might consider an LGU with an unstable revenue base as prone to default on the risk allocations agreed upon.

Provide limited sovereign guarantees such as performance undertakings the national government may also guarantee the contractual obligations of the contracting local government with its "full faith and credit."

However, current national government policy suggests this is for very rare and exceptional cases only.

Alternatively, the LGU may get commercial guarantees for government performance risks such as off-take obligations from such agencies like the LGU Guarantee Corporation or Philippine Export Import Credit Agency (otherwise known as the Trade and Industry Development Corporation of the Philippines.)