What are the Special Features of “Project Finance Contracts”?

The Special Purpose Vehicle (SPV) sits at the center of any project, it is the main legal entity that owns and operates the project and with which other parties establish their contractual responsibilities. The project contracts can be broadly classified into three groups: financing contracts, engineering, procurement and construction (EPC) contracts and operational contracts.

Key Learning Points

  • The financial crisis caused a shift in financial contracts. Debt financing. Traditionally provided by syndicated bank loans has seen increasing participation from pension and life insurance entities buying long dated debt securities
  • Equity participation contracts have also seen a shift from operational sponsors to financial participants (such as private equity funds)
  • The SPV uses contracts to shift risks to other entities which are better able to manage them, this applies across the entire contact structure of the project.

Financial Contracts

A significant proportion of a project’s capitalization will come from debt funding, in fact, it would be quite common for debt capital to account for over 90.0% of total project funding. Given the sheer size of a typical project this funding is commonly provided by banks through syndicated loans. However recent developments have seen increasing participation by pension and life insurance investors, in the form of both direct loans and long dated bond issuances. This shift has been brought about as a direct result of the tougher regulatory regimes facing banks, restricting their ability to grant loans at the kinds of maturities required within project finance.

Equity investment tended to be traditionally dominated by both operational sponsors, providing both equity and expertise in running the project and also by public sector investors, focusing on public welfare maximization. However, following the financial crisis there has been a shift toward financial participants that are entirely focused on financial returns, with no operational involvement.

Operational Contracts

Often participants can have both operational and financial involvement in the project, this joint role helps to incentivize operational contractors.

A typical list of operational contracts would include the construction contract, for the build of the actual facility and the operation and maintenance contract, which kicks in post completion. The sales contract and supply agreement contracts primarily apply to the post completion phase. Where relevant there may exist a concession agreement with the government, where the project requires specific regulatory approval.

Risk Management

The SPV will seek to contract in such a way that risk is shifted toward suppliers.

Typically, the EPC will be contracted on a “turnkey” basis whereby the contractor agrees to fully develop the facility, so that it is ready to go on completion, stipulating key milestones, quality requirements and price controls, with penalties for nonperformance.

Purchasing agreements with suppliers will be contracted on a “put or pay” basis, if the supplier fails to deliver the required quantity or quality on time then they agree to pay damages.

Selling agreements will often be carefully contracted where there are a few key buyers, known for example in the oil industry as the “off-taker”. In this situation the buyer sings up to a long term “take or pay” agreement, paying compensation if they fail to meet the requirements of the contract.