Commercial Risks in Project Finance – Market & Operational Risks
Commercial risks are business-related risks that affect the project's ability to generate revenue and profit. These are the most critical risks for both sponsors and lenders.
Commercial Risk = Revenue Risk
If the project cannot generate expected revenues, it cannot repay debt or provide returns to equity - making commercial risk the #1 concern in project finance.
Types of Commercial Risks
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1. Market Risk (Demand Risk)
Definition
The risk that demand for the project's output will be less than projected.
Examples
Toll Road:
- Projected traffic: 15,000 vehicles/day
- Actual traffic: 10,000 vehicles/day (33% shortfall!)
- Impact: Revenue falls by 33%, DSCR drops below 1.0
Power Plant:
- Expected capacity utilization: 85%
- Actual: 60% (due to grid constraints or lower demand)
- Impact: Revenue shortfall of 30%
Airport:
- Projected passengers: 10 million/year
- Actual: 7 million/year
- Impact: Lower aeronautical and non-aeronautical revenues
Causes
- Over-optimistic projections (most common!)
- Competing infrastructure (new expressway diverts toll road traffic)
- Economic slowdown (reduces travel, power consumption)
- Population migration (affects urban infrastructure demand)
- Technology disruption (electric vehicles reduce fuel station demand)
Risk Allocation
Who bears the risk?
| Project Type | Risk Allocation |
|---|---|
| Toll Roads (BOT) | SPV bears full demand risk |
| Power (Merchant Plant) | SPV bears full risk |
| Power (PPA-based) | Off-taker (Govt) bears risk (Must-run status, capacity charge) |
| Regulated Assets | Pass-through to consumers via tariff revision |
Mitigation Strategies
- Independent Market Study: Hire reputed consultant for traffic/demand study
- Conservative Projections: Use pessimistic scenarios for financial modeling
- Offtake Agreements:
- Power Purchase Agreement (PPA) - Guaranteed offtake for power
- "Take or Pay" contracts - Buyer pays even if doesn't take supply
- Government Support:
- Minimum Revenue Guarantee (e.g., government guarantees 90% of projected toll revenue)
- Viability Gap Funding (VGF) - Upfront grant to make project viable
- Ramp-up Protection: Lower debt service in initial years
- Tariff Adjustment: Link tariff to inflation, fuel costs
2. Price Risk (Tariff Risk)
Definition
The risk that the selling price of project output will be lower than expected.
Examples
Merchant Power Plant:
- Expected tariff: ₹4.50 per unit
- Actual market price: ₹3.20 per unit
- Impact: 29% revenue shortfall
Toll Road:
- Government freezes toll increases due to political reasons
- Inflation erodes revenue in real terms
Causes
- Regulatory intervention (government caps prices)
- Competition (oversupply reduces prices)
- Input cost changes (if tariff is cost-plus based)
- Policy changes (subsidy removal, tax changes)
Mitigation Strategies
- Fixed Tariff Contracts:
- Long-term PPA with fixed tariff for 25 years
- Escalation clauses (3-5% annual increase or inflation-linked)
- Cost-Plus Tariff: Tariff covers costs plus reasonable return
- Regulatory Support: Get regulatory approval for periodic tariff revision
- Hedging: Financial hedges for commodity-linked projects
3. Operational Risk
Definition
The risk that the project will not operate as efficiently as designed.
Components
A. Performance Risk
Project fails to meet technical specifications:
- Power plant: Designed for 100 MW, produces only 85 MW
- Highway: Designed for 30 years, needs major repairs after 15 years
- Water treatment plant: Designed for 100 MLD, achieves only 80 MLD
B. Availability Risk
Project is unavailable due to:
- Breakdowns and equipment failures
- Unscheduled maintenance
- Force majeure events (floods damage toll road)
Example: Solar plant designed for 19% Capacity Utilization Factor (CUF) achieves only 16% due to higher-than-expected soiling and equipment downtime.
C. Maintenance Risk
Maintenance costs are higher than budgeted:
- Unexpected equipment failures
- Shorter equipment life than expected
- Higher spare parts costs
D. O&M Cost Escalation
Operating expenses increase faster than budgeted:
- Wage inflation
- Utility cost increases
- New environmental compliance costs
Causes
- Design defects: Poor engineering design
- Construction defects: Substandard construction quality
- Equipment quality: Using cheaper, lower-quality equipment
- Inadequate maintenance: To save costs in short-term
- Operator incompetence: O&M contractor lacks expertise
- External factors: Severe weather, accidents
Risk Allocation
Construction Phase: EPC Contractor bears performance risk
- Performance guarantee
- Liquidated damages for delays/defects
- Defects liability period (1-2 years)
Operations Phase: O&M Contractor bears operational risk
- O&M Agreement with performance standards
- Penalties for non-performance
- Incentives for over-performance
Mitigation Strategies
- Proven Technology: Use technology with 3-5 year track record
- Quality EPC Contractor: Select contractor with experience, financial strength
- Performance Guarantees:
- Power plant: Minimum 95% availability, 85% PLF
- Highway: Guaranteed riding quality (IRI index)
- Experienced O&M Contractor:
- Sometimes the EPC contractor itself
- Long-term O&M Agreement (10-15 years)
- Performance-based Payments: Pay O&M contractor based on actual performance
- Insurance: Property insurance, Business Interruption insurance
- Maintenance Reserve: Set aside cash reserve for major overhauls
- Independent Engineer: Monitor construction quality and operations
4. Technology Risk
Definition
The risk that the chosen technology is unproven, becomes obsolete, or fails to perform.
Examples
High Risk:
- First-of-its-kind technology in India
- Unproven suppliers
- New renewable technologies (e.g., floating solar, hydrogen)
Low Risk:
- Proven technology (crystalline silicon solar, onshore wind)
- Reputed suppliers (Siemens, GE, Tata)
- Multiple reference projects globally
Impact
- Equipment failures requiring costly replacements
- Lower efficiency than expected
- Higher maintenance costs
- Obsolescence (technology becomes outdated mid-project life)
Mitigation Strategies
- Proven Technology: Must have 3-5 operational projects using same technology
- Technology Warranties: Equipment manufacturers provide performance warranties
- Insurance: Technology risk insurance (costly, rarely used)
- Reputed Suppliers: Use Tier-1 suppliers with long track record
- Pilot Projects: Test new technology on small scale before large deployment
- Technology Upgrade Clauses: Allow for technology upgrades during project life
Lenders' Stance
Banks will not finance unproven technology. If technology has <3 years track record, expect equity to be 40-50% (vs usual 20-30%).
5. Input Risk (Supply Risk)
Definition
The risk that inputs (raw materials, fuel) are unavailable or become too expensive.
Examples
Thermal Power Plant:
- Designed for domestic coal at ₹2,000/ton
- Domestic coal unavailable, must import at ₹6,000/ton
- Impact: Fuel cost triples, project becomes unviable
Toll Road:
- Designed bitumen price: ₹30,000/ton
- Actual bitumen price during construction: ₹50,000/ton
- Impact: 15% cost overrun during construction
Mitigation Strategies
- Fuel Supply Agreement (FSA): Long-term contract with coal/gas supplier
- Fuel Cost Pass-Through: Tariff adjusts if fuel cost changes
- Alternative Suppliers: Have 2-3 backup suppliers
- Strategic Reserves: Maintain 30-60 days fuel inventory
- Price Hedging: Financial instruments to hedge commodity prices
Risk Matrix - Commercial Risks
| Risk Type | Probability | Impact | Overall Risk | Primary Allocation |
|---|---|---|---|---|
| Market/Demand Risk | Medium-High | Very High | Critical | SPV (unless govt guarantee) |
| Price Risk | Medium | High | High | Shared (via PPA/escalation) |
| Operational Risk | Medium | Medium | Medium | O&M Contractor |
| Technology Risk | Low (if proven) | High | Medium | EPC/Equipment Supplier |
| Input Risk | Medium | Medium | Medium | Supplier (via FSA) |
Case Study: Toll Road Demand Risk
Project: 6-lane expressway (100 km), BOT model
Projected Traffic: 25,000 PCU/day Actual Traffic (Year 5): 15,000 PCU/day (40% shortfall)
Reasons:
- Over-optimistic traffic study
- Competing national highway upgraded (free alternative)
- Economic slowdown
Impact:
- Revenue: ₹300 crore (vs projected ₹500 crore)
- DSCR: 0.85 (vs projected 1.45)
- Project in distress, lenders invoke covenants
Resolution:
- Government agreed to extend concession period from 20 to 28 years
- Toll rates increased by 15% (one-time)
- Sponsors injected additional equity of ₹50 crore
Summary
- Commercial risks relate to revenue generation capability
- Market/Demand risk is the #1 risk in most projects
- Price risk mitigated through PPAs and escalation clauses
- Operational risk allocated to EPC and O&M contractors via performance guarantees
- Technology risk minimized by using proven technology
- Input risk managed through Fuel Supply Agreements
- Risk allocation is key - allocate each risk to party best able to manage it
- Lenders focus on commercial risks more than any other risk
- Mitigation: Conservative projections + Strong contracts + Independent studies
Quiz Time! 🎯
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