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Understand how project finance uses structured contracts, like fixed-price EPC agreements, to allocate the significant risks of construction delays and cost overruns among stakeholders, including sponsors, lenders, and contractors, to protect a project’s viability.
Question
Which risk is shared among stakeholders in project finance?
A. Consumer brand loyalty
B. Construction delays and cost overruns
C. Employee absenteeism
D. Personal credit card debt risk
Answer
B. Construction delays and cost overruns
Explanation
Risks are shared through contracts and financing structures.
In project finance, the risk of construction delays and cost overruns is a fundamental and significant risk that is explicitly shared and allocated among the various project stakeholders. The entire financing structure is designed to anticipate and manage this specific risk through a series of contractual agreements and financial arrangements.
Allocation of Construction Risk
Construction risk is one of the most critical threats to a project’s success because delays postpone the start of revenue generation and cost overruns can deplete contingency funds, jeopardizing the project’s financial model. This risk is too large for any single party to bear alone and is therefore carefully distributed.
- To the Contractor: A large portion of construction risk is transferred to the Engineering, Procurement, and Construction (EPC) contractor. This is typically done through a fixed-price, turnkey contract, where the contractor guarantees to deliver the fully operational project for a specific price by a guaranteed completion date. If the contractor fails to meet these terms, they are often liable for liquidated damages.
- To the Sponsors (Promoters): Sponsors share in this risk through their equity investment, which acts as a buffer for lenders and is the first to be lost if there are cost overruns that exceed the planned contingency. They are also incentivized to oversee the contractor to ensure the project stays on track.
- To the Lenders: Lenders are exposed to construction risk because their repayment is dependent on the project being completed and becoming operational. They mitigate this risk by conducting extensive due diligence on the contractor and the project plan, requiring performance bonds and guarantees, and structuring loan disbursements to be conditional on meeting construction milestones.
Irrelevance of Other Risks
The other risks mentioned are not central to the strategic risk-sharing framework of project finance:
A. Consumer brand loyalty: This is a commercial risk relevant to retail and consumer goods businesses, not large, single-asset infrastructure projects like power plants or pipelines, which often have a single buyer (offtaker) for their output.
C. Employee absenteeism: This is a minor operational issue managed by the project’s operator (the O&M contractor), not a strategic risk allocated among the main financial stakeholders.
D. Personal credit card debt risk: This is a personal finance matter and is entirely unrelated to corporate or project finance structures.
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