Risk Mitigation Mechanisms (including guarantees and political risk insurance)

Hedging and Futures Contracts

Some financial risks can be shared through financial instruments known as derivatives, futures contracts or hedging. For example, exposure to foreign exchange risk can be mitigated by swapping currency requirements with another market participant. Equally other risks such as interest rate risk can be managed through the use of derivatives. These arrangements are usually managed under the common terms set out in the International Swaps and Derivatives Association (ISDA) master agreement.

Hedging arrangements will influence the cost of debt, and the breakage costs to be included in termination compensation. Hedge counterparties, or possibly a hedging bank, will be a party to the intercreditor agreement to formalize the sharing of security and arrangements on default. To the extent that hedge counterparties benefit from project security, in theory their hedges should also be limited recourse. Similarly, if hedge counterparties get paid out if they suffer a loss when they close out their hedge, then lenders will argue that they should share any windfall profits. These issues will be addressed in the intercreditor arrangements.

Derivatives are used in many functions in project finance transactions, including

• interest rate swaps – to manage movements in exchange rates to convert variable rate debt to fixed rate debt;
• currency swaps – to manage movements in currency exchange rates; and
• commodity derivatives – to fix the price of commodities over time.

The offtake purchaser may agree to bear interest rate risk, by indexing part of its tariff to cost of debt. However, such tariff adjustments to account for interest rate fluctuations are unlikely to be applied at the speed at which interest rate fluctuations can arise, creating a mismatch risk. Guarantees and other credit enhancement mechanisms can be used to mobilize fixed rate debt.

Use of Insurance

Although the project participants may each provide insurance for the project, it is generally more efficient for the project company to provide or ensure provision of comprehensive insurance coverage for the entire project. In this way the interfaces between different insurance packages, the coverage provided by different insurance providers and the overlapping of the tasks performed by the various project participants will not result in overlapping insurance or gaps in insurance coverage.

The lenders may require that insurance proceeds received by the project company, in certain circumstances or over certain amounts and at their discretion, must be paid to the lenders for repayment of debt. The grantor and the project company will want insurance proceeds always to be used for reinstatement of the works. This is contrary to the interests of the lenders and will be a heavily negotiated issue. Restrictions imposed by insurers and at law will need to be considered in this context.

Required insurance may become too costly or unavailable. The project company will be required to have in place certain insurances, under the concession agreement and the financing agreement. The parties will need to agree how to manage risks that become "uninsurable", and the definition of this term. For certain risks, and in certain markets, the grantor may agree to be the insurer of last resort, effectively stepping in to insure risk in exchange for the payment of the premium last paid when the insurance was "insurable" or some other agreed rate. However, the grantor will want to be sure that the increased cost is not due to project company failure or actions.

Applicable law may require insurance to be obtained locally, in which case the project company will seek to reinsure those risks internationally in order to obtain the higher-quality insurance protection. Local law may limit the extent to which reinsurance can be used.

Lenders will likely seek cut through arrangements with reinsurers, to allow direct payment from reinsurers to the project company and or to the lenders.

Guarantee and Risk Insurance Products Provided by IFIs

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