Categories of Risk Allocation

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From the course by Columbia University

Construction Finance

403 ratings

Columbia University

Construction Finance

403 ratings

Course 4 of 4 in the Specialization Construction Management

The final course of the specialization expands the knowledge of a construction project manager to include an understanding of economics and the mathematics of money, an essential component of every construction project. Topics covered include the time value of money, the definition and calculation of the types of interest rates, and the importance of Cash Flow Diagrams.

From the lesson

Project Finance

Professor Bob Dewing discusses project finance and provides an overview of Global Project Finance. The roles of stakeholders in project finance is reviewed in depth.

Global Project Finance Overview and by Sector8:25

Stakeholders in Project Finance6:00

Stakeholder Roles9:48

Principles of Project Financing8:54

Risk and Risk Allocation16:16

Categories of Risk Allocation7:23

Sponsor Perspectives - Structuring and Documentation11:54

Completion Risks / Government Perspectives15:23

Contract Parties9:54

Contracts and Agreements17:32

Meet the Instructors

Ibrahim Odeh, Ph.D., MBA
Instructor, Department of Civil Engineering and Engineering Mechanics, Columbia University
Director of Research and Founder, Global Leaders in Construction Management

The second of the two risk categories in risk and

risk allocation is the macro-economic risks.

These are financial and generally external.

Some of these would be inflation, interest rates, and foreign exchange.

Not all of them apply to all of the projects.

Is inflation a likely contribute to changes in cash flow in the project?

Or is the project indifferent to inflation?

Or is it in all the contracts to inflation index?

But in general, there will be a mismatch between some of the contract

parties of inflation, and the project needs to understand, and the project

financiers need to understand how they're going to manage the inflation risk.

Interest rate risks, it's settlement if issue with projects,

but in general projects have hedged out interest rate risk.

Most project financiers don't expect and

don't want projects to take interest rate risks.

Going back to the second tenant of

project financing to allocate those risks to parties best able to bear them.

Well, at the end of the day most of the contract parties can't manage

interest rate risks.

Occasionally maybe the government or

central bank may be a responsible party that could influence interest rate risk.

But in general, a much better solution is to have the investors

take the interest rate risk by having fixed rates of interest,

which is what a number of investors are looking for.

Or if their banks are financing it on a floating rate basis,

sign a hedging agreement with a part of the bank or

another institution that can manage that interest rate risk.

But interest rate risks in general shouldn't be taken by projects.

Projects are often financed cross border, and what are the foreign exchange risks?

They generally fall into convertibility and transferability.

And so on convertibility and transferability,

many projects keep the cash flows off shore.

And if they are export projects, and if they don't have

foreign exchange revenues, what are the opportunities for

mitigating the convertibility and transferability risks?

Sometimes currencies can be hedged, junior currencies from

smaller currencies often can be hedged long enough for projects.

So how does one manage that risk?

And no sort of cross border risks can sometimes be managed by

direct agreements with governments or central banks or

development banks, or just routing the financing through

financiers that have an ability to manage those risks.

But foreign exchange risks are something that projects routinely manage,

and there are parties that are capable of managing those.

And finally, we've got political risks.

These are a country and they are certainly external risks.

The investment risks in the country,if you put the capital in,

are you likely to be able to get the capital out?

Both currency, convertibility, and transferability?

Isthe project have a possibility of expropriation?

An expropriation is something that one should anticipate in every jurisdiction.

Governments and governmental entities can always expropriate a project.

The important part here is to understand what the compensation is in expropriation.

You'd like to see your capital back again.

The third tenet of project financing is term risk, not principal risk.

If there is an expropriation event, how do you get your capital back?

How do you avoid a principle risk?

Is the compensation within the country, and will it be paid?

Or can you buy sovereign risk insurance?

But an expropriation should be considered in every jurisdiction.

It doesn't matter whether it's developing or

are we see the expropriation is always a possibility.

And financiers should understand what their rights are, and

what their potential remedies are in an expropriation event.

War and civil disturbance is harder to deal with.

It's possible to get sovereign risk insurance for

some jurisdictions where war and civil disturbance is a legitimate and

possible risk, but that's not always the case.

And sometimes project finances have to accept

that they're going to take some war and civil disturbance risk.

Some of this possibly can be dealt with if it's short term with business interruption

insurance, and other sorts of insurance.

But at the end of the day, that risk generally falls back,

in worst possible case to project financiers, and sponsors would sometimes

recognize opportunity there to exercise their walk-away option.

And finally in this section here is the change of laws.

What is the regulatory environment like?

Is the government likely to support the regulatory environment, or

are they likely to change the regulatory environment?

Is the regulatory environment, if it is a question,

is it non-discriminatory, or is it possible that the government could be

discriminatory in their regulatory environment and

support one project versus one of the other projects?

And what are the remedies in a regulatory environment for breach of contract?

So you may have a contract,

an offtake contract under a certain regulatory environment, but

if the regulatory environment changes, what are the arrangements for

adjusting that contract if there is a change in regulatory environment?

Sometimes that responsibility goes to the offtaker or the supplier.

Sometimes it has to remain with the project.

Sometimes the government provides

compensation if there's a change in regulatory environment.

But it should be understood, if you're relying on a regulatory environment,

what the remedies are there.

So going back to our big picture

here of project finance structure,

let's look at the sponsors and

investors in the red box here.

This is the equity that drives a project.

What are sponsors in equity looking for in the project finance?

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