No One’s Fault, Everyone’s Problem: Shield against the unforeseen

Managing Change in Law, Force Majeure and Black Swans

Last week’s newsletter had addressed risk allocation and mitigation, covering how there are many project failures arising from inadequate project preparation and fragmented approaches, then going on to discuss the necessity of robust risk identification and allocation.

A three-step process was provided to transfer concepts, feasibility studies, and environmental studies that had been generated during the concept and early stages of project development into a proper risk matrix, where risks are best allocated to parties best suited to provide operational execution and have the capacity to bear them financially.

I wish I could tell you that anticipating and preparing for the likely was enough.

I am afraid that on project-financed deals, it is not.

It is necessary to take it a step further and anticipate the risks that are not any party’s fault and caused by events that are very difficult to properly predict and anticipate.

Here is the thing: project agreements must still contain robust provisions to address these unusual and unforeseen events, ensuring equitable risk allocation and project viability or cost recovery for investors, particularly lenders, if these situations do arise.

There are 3 broad categories of unforeseen events of this nature,

Recommendations for the rest of this edition cover these types of events and how they could be managed in large-scale PPP projects where a contracting government authority is often one of the counter-parties.

1. Change in Law

A change in law refers to an alteration in the legal or regulatory environment that affects the Project Company's business, potentially incurring additional capital or operating costs. This includes anything with the force of law, such as industry regulations. While not the government’s fault, changes in law are typically passed to the contracting government authority in a PPP.

Categories of Change in Law:

• General Change in Law: Applies to the country as a whole, not a specific industry or project, such as an increase in company tax rates or new building regulations. In some countries, this risk may remains with the Project Company, though in others countries, compensation for tax changes may be common. Review precedents and see what applies

• Specific Change in Law: Affects the specific industry or services of the Project Company, like higher taxes on power station emissions or reduced emissions limits. (Nigeria’s Electricity Act 2023)

• Discriminatory Change in Law: Specifically targets the Project Company, a particular project, or all projects of that type. It is generally expected that the Contracting Authority covers costs arising from discriminatory changes in law.

Risk Implications and management through project agreements:

• Passing Costs to Contracting authority: Project Companies often aim to pass on the risk of increased costs or loss of revenue due to changes in law to the Contracting Authority, as the public-sector entity is often better positioned to assess and control this risk.

• Treat as a Compensation Event: If the costs of a change in law are to be covered by the public contracting authority, then it is treated as a Compensation Event, i.e, an event entitling the Project Company to reimbursement for additional costs or losses. The principle behind this compensation is "Financial Equilibrium", aiming to place the Project Company, investors, and lenders in a "no better no worse" position than before the event.

• Government Support Agreements: In some cases, a Government Support Agreement may be required to deal with change in law risks, providing assurances and compensation, especially with new projects that limited or no precedence in that region.

• Consistency Across Contracts: Changes in clauses law must be tracked and kept consistent across all Project Contracts, such as Construction Contracts, off-take agreements, concession agreements other project agreements as they are applicable and relevant

• Long-Term Flexibility with commercial terms: For much longer-term Project Agreements, it is more difficult for the Contracting Authority to be certain its requirements will not change, highlighting the need for provisions for upgrading and renewal of certain commercial aspects of the project in the event of a change in law

• Investment Protection Treaties: Foreign investors and lenders may seek protection from bilateral investment-protection treaties between their home country and the Host Government in cases of adverse changes in law.

Acceptance of the risks and provision of compensation from change in law, may not always be done by the contracting authority, especially where a significant amount of project viability gaps support has already been provided by the government authority or if any other major contribution has been made towards the project (Land, guaranteed offtake) etc.

Methods for Recovery and Paying Lenders:

• Compensation Mechanisms: If covered by governments, then compensation can be a lump-sum payment, or it may involve the Project Company reducing contractual payments to the government to ensure the same investor return and lender cash-flow cover is maintained, or extensions of the Project Agreement terms.

• Reserve Accounts: Lenders may require a Change in Law Reserve Account to provide funds for this purpose, though determining the precise amount can be challenging.

• Political risk insurance: While general insurance typically does not cover economic loss from changes in law, some specific policies or Political Risk Insurance (PRI) may cover indirect effects if they lead to a payment default.

• Treaties: Bilateral investment-protection treaties can offer foreign investors and lenders protection against adverse government actions.

2. Force Majeure

Force Majeure (FM) refers to an events that make it impossible for one or more parties to fulfil their contract. They are often local events that may or may not have been foreseen, they are also not unique or rare occurrences globally or in the area: for example, bad weather, accidents, war, or labor strikes

Temporary Force Majeure (Relief Events)

It is also called a relief event. This type of force majeure causes damage or obstructions that can eventually be repaired or removed. Once any damage is repaired or obstruction removed, the project should be able to resume its operations. Relief Events generally provide the Project Company with more time but no money; this means the Project Company is protected against termination for default but is often not relieved from loss of income, penalties, or deductions.

Typical Categories of Relief Events:

• Damage to the project due to natural causes like fire, flood, or storm.

• Accidental damage to parts of the project.

• Unforeseen ground conditions or archaeological/fossil discoveries during construction.

• Unforeseeable weather conditions.

• Delays in obtaining permits or licenses.

• Failures by utility suppliers to carry out works or provide supplies.

• National strikes or strikes at suppliers' plants.

Risk Implications in Project Agreements:

• Construction Delays: Relief Events can cause delays in project completion, but the Construction Contractor is usually excused from liability for liquidated damages (LDs) for these delays.

• Operational Interruptions: If a Relief Event affects project availability during operation, the Project Company is typically relieved from penalties but does not receive the Capacity Charge or Service Fee.

• Financial Risk for the Project Company: The Project Company generally bears the financial loss for Relief Events, as there is usually no direct compensation from the Contracting Authority.

• Coordination: Coordination between different project contracts regarding Relief Events is crucial to avoid "contract mismatch".

Methods for Recovery and Paying Lenders:

• Insurance Coverage: Many Relief Events are expected to be covered by insurance, which should aim to restore the Project Company to a position of 'Financial Equilibrium'.

• Gaps in Insurance: There can be gaps in insurance coverage, as policies mainly cover physical damage or economic loss derived from it, not events like national strikes that cause delays without direct physical damage.

• Debt Service Reserve Account (DSRA): This account provides a cushion against temporary interruptions of revenue not covered by insurance, ensuring debt service payments can still be made.

• Contingency Reserves: A contingency reserve is also used to cover delays or costs not covered by insurance.

Permanent Force Majeure

This type of Force Majeure refers to events that permanently prevent the completion or continued operation of a project, making it permanently impossible for one party to fulfil its contract.

Typical Categories of Permanent Force Majeure:

• Natural Force Majeure ("Act of God"): Events such as complete destruction of the project by fire, explosion, or flood.

• Political Force Majeure: Events like protracted war, persistent terrorism, civil unrest, or blockades that physically damage the project or prevent its operation.

Risk Implications in Project Agreements:

• Project Destruction/Inoperability: If a Force Majeure event destroys the project and restoration is not financially viable, it usually leads to termination of the Project Agreement.

• Financial Impact and Termination Sums: In cases of permanent force majeure, there are provisions for a 'Termination Sum' payment, especially in Reverting Asset-based Contracts (where assets are handed back after a concession period). In this case, the contracting authority often agrees to repay debt and provide some compensation for the equity investment, less any insurance proceeds. This compensation aims to ensure lenders are repaid.

• Political Interference: Direct government actions like expropriation or blocking currency transfers are usually treated as a default by the public-sector Contracting Authority, triggering compensation.

Methods for Recovery and Paying Lenders:

• Insurance as Primary Mitigation: For Natural Force Majeure, insurance is the primary mechanism to cover physical damage, and the proceeds are typically used to rebuild the project or repay debt.

• Contracting Authority Responsibility: In PPPs where the asset reverts to the Contracting Authority, this authority is generally expected to bear long-term ownership risks and thus compensate the Project Company for Political Force Majeure events, repaying debt and offering some equity compensation.

• Political Risk Guarantees (PRGs) or Insurance (PRI): These are crucial, especially in developing countries, to cover the risk of Host Governments being unwilling or unable to fulfil their obligations related to political events, including expropriation or blocking currency transfers.

• Termination Sum Calculation: The calculation of the Termination Sum can be complex, often designed to cover outstanding debt, sub-contractor liabilities, and the Project Company's loss of profit. Tax implications may require "grossing up" to ensure sufficient net compensation.

3. Black Swan Events

Black swans are rare, random, and extremely difficult to predict events that have large-scale, disruptive impacts on economies and sectors globally. Examples include the 9/11 attacks, the 2008 global financial meltdown, and the COVID-19 pandemic.

Challenges in Addressing Black Swans:

• They are rarely considered due to limited precedence, very low likelihood of occurrence, inability to contemplate their impacts, and the perception that time spent on doing so is a waste.

• Addressing them may require setting aside even larger contingency reserves, which can significantly decrease project value and viability.

• They are so rare, often once in a lifetime, that there are no reliable, standardized approaches to identify their nature, causes, timing, and duration. Very difficult to model or predict.

Risk Implications in Project Agreements and Methods for Recovery:

Due to their unpredictable nature, black swan events are challenging to mitigate directly through pre-defined contractual mechanisms or insurance, like force majeure.

Instead, managing their potential impact relies on broader risk management and financial planning strategies:

• Holistic Risk Management and Organisational Adaptation: A proactive approach focuses on resilience and adaptability rather than perfect foresight. Companies with strong resources build experience-based strategies, understand internal risks, and prioritise identified risks to manage black swan events. This includes developing organisational adaptation skills and capabilities to anticipate and make sense of threat events as they occur.

• Assumption Analysis: An approach that helps consider black swans from a forward-looking perspective by shifting focus to exposing implicitly made assumptions and looking beyond first-order relationships.

• "What If" Analysis and Scenario Planning: Coupled with knowledge of global affairs, "what if" analysis can identify plausible scenarios of events triggering black swans and assess their possible impacts.

• Beyond Contingency Reserves: Relying solely on traditional contingency reserves (e.g., 5-10% of project value) is often insufficient for black swan occurrences; other initiatives and response plans are necessary, though increasing reserves significantly can decrease project value.

• Data Analytics and Technology: Using data analytics and technology as essential tools for managing the effects of black swans is recommended.

• Continuous Monitoring and Early Warning Systems: These systems help to identify and assess risks continuously, enabling timely risk mitigation options.

• Stress Testing: Project teams use stress tests to evaluate the company's ability to withstand black swans.

• Adaptive Response Plans: Creating comprehensive, flexible response plans for unpredictable black swan events, which involve identifying levers to change results and evaluating remedial actions.

Scenario Planning for Robust Risk Identification and Allocation

Scenario planning is a powerful methodology for anticipating and then managing future uncertainty. It acts as a "flight simulator," enabling project teams and senior management to visualise various situations, then define pathways to manage them.

Why is Scenario Planning Crucial?

• Long-Term Strategic Decision Forecasts: Infrastructure projects demand long-term forecasts, often spanning 15 to 30 years, where predicting events with certainty is impossible.

• Reducing Uncertainty: It introduces discipline and helps identify sources of risks, thereby reducing uncertainty in decision-making.

• Identifying Enabling Scenarios: It also facilitates the identification of enabling scenarios for project success, fostering a more effective planning environment and intentionality with deploying optimisation or prevention tools

• Handling Unidentified Risks: It is particularly useful when project risks are not fully identified and mitigated, or when there is significant uncertainty about external factors impacting project revenue.

• Quantifying Wildcards: Scenario analysis can help identify and quantify the impacts of "wildcard possibilities" and black swan events.

Using Scenarios to Assess Project Resilience:

Scenarios can be used to test project resilience and inform decision-making through:

1. Financial Model Simulations: Use the project financial model to simulate the impacts of different scenarios on output variables, including black swan events, defining the range of possible outcomes at different probability levels.

2. Sanity Checks and Validation: Conduct thorough sanity checks on assumptions, actions, reactions, and their timing, as well as the processes that generate future project outcomes. This involves validating consistency with past experiences and evaluating the reasonableness of financial model results.

3. Early Warning Systems (EWS): Implement a system of early warning indicators to monitor each scenario's drivers over time and set up triggers and warnings that signal the need for mitigation actions. This is especially useful during the operational phase of the project, for adapting solutions to fit evolving circumstances. EWS use both quantitative and qualitative information to predict emerging risks and help minimize their impacts.

By integrating these strategies, organizations can significantly enhance their ability to anticipate, assess, and respond to unforeseen risks, ultimately safeguarding project value and fostering long-term success.

Bringing it all home

Bankability requires moving beyond feasibility and viability; it requires long-term protection of the asset over the project life.

Protection from predictable and unforeseeable risks

Even risks that are no one's direct fault must still be anticipated and managed because they profoundly impact project execution and the ability to pay back investors.

For project finance, where lenders primarily rely on the project's cash flow as security to recover investments, addressing these even these type of risks cannot be overlooked.

Therefore, these risks must be contemplated and, wherever possible, still allocated to parties best able to bear them or clear and practical approaches employed to mitigate their impact on the project.

Mechanisms such as contractual compensation, robust insurance policies ( Political Risk Insurance, special perils), the establishment of adequate reserve accounts, and the willingness of Host Governments to absorb certain risks (e.g., through guarantees or termination sums) are crucial.

For the rare and difficult to anticipate black swan events, adopting a holistic approach to risk management, utilising advanced tools like scenario planning and modelling, prioritising early assessment and continuous monitoring, leveraging independent expertise, and

Developers who carry out the detailed and diligent allocation and mitigation of risks, even for- acts of God and rare once in a lifetime events - are the ones who inspire confidence in lenders that they can deliver long-term value to all stakeholders.

Reviewed to prepare this edition

• Principles of Project Finance - E.R. Yescombe

• Project finance for Business Development - John Triantis

• Public-Private Partnerships in International Construction – Albert P.C. Chan and Esther Cheung

• Navigating Project Selection and Execution for Competitive advantage – John Triantis

• International Project Finance Law and Practice Edited by John Dewar