Risk Mitigation Techniques – Guarantees, Insurance & Hedging

Risk cannot be eliminated in project finance - but it can be mitigated, transferred, or shared through various mechanisms.

Risk Mitigation Framework

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1. Guarantees

A. Performance Guarantees (by EPC Contractor)

Purpose: Ensure contractor completes project as per specifications.

Types:

1. Bank Guarantee (BG) for Advance Payment:

• Value: 10-20% of contract value
• Example: EPC contract = ₹500 crore, BG = ₹50 crore
• Purpose: If contractor abandons project, SPV can invoke BG

2. Performance Bank Guarantee:

• Value: 5-10% of contract value
• Valid till project completion + defects liability period
• Example: ₹25 crore BG valid for 4 years

3. Technical Performance Guarantee:

• Contractor guarantees specific performance parameters
• Example - Solar Plant:
  • Guaranteed CUF (Capacity Utilization Factor): 18%
  • Actual CUF: 16%
  • Penalty: ₹2 crore per 1% shortfall = ₹4 crore payable by contractor

B. Government/Sponsor Guarantees

1. Completion Guarantee (by Sponsors):

• Sponsors guarantee to complete the project
• If cost overrun, sponsors inject additional equity
• Required by lenders for greenfield projects

2. Viability Gap Funding (VGF) - by Government:

• Government provides upfront grant (up to 40% of project cost)
• Makes otherwise unviable projects bankable
• Example: Metro rail projects

3. Minimum Revenue Guarantee - by Government:

• Government guarantees minimum traffic/revenue
• Example: "Government will compensate if toll revenue < 90% of projected"

4. Subordinated Debt/Quasi-Equity - by Sponsors:

• Sponsors provide subordinated loan (ranks after senior debt)
• Absorbs first losses
• Comfort to senior lenders

C. Off-taker Guarantees

Power Purchase Agreement (PPA) - by DISCOM/Government:

• Guaranteed offtake of power for 25 years
• Fixed tariff or formula-based tariff
• Two-part tariff:
  • Capacity Charge: Paid even if power not taken (fixed cost recovery)
  • Energy Charge: Paid per unit consumed (variable cost recovery)

Take or Pay Contract:

• Buyer must pay even if doesn't take the product
• Common in gas pipelines, petrochemicals

2. Insurance

Projects use 10-15 different insurance policies. Key ones:

A. Construction Phase Insurance

1. Contractors All Risk (CAR) Insurance

Coverage:

• Damage to works under construction
• Perils: Fire, flood, earthquake, cyclone, theft, riots
• Third-party liability

Sum Insured: Full replacement cost of works Premium: 0.2-0.5% of sum insured Example: ₹1,000 crore project → ₹2-5 crore annual premium

2. Erection All Risk (EAR) Insurance

For projects involving machinery erection (power plants, factories):

• Covers equipment damage during erection
• Testing and commissioning coverage

3. Marine Cargo Insurance

• For imported equipment during shipping
• Coverage: Port-to-site

4. Third-Party Liability Insurance

• Covers injury/death to third parties
• Property damage to neighbors
• Example: Crane falls on neighboring building - insurance pays

B. Operational Phase Insurance

1. Property Insurance (Fire & Allied Perils)

• Covers damage to project assets post-completion
• Perils: Fire, explosion, natural disasters
• Sum Insured: Replacement value of assets

2. Business Interruption (BI) Insurance

• Covers loss of revenue if project cannot operate due to insured peril
• Example:
  • Fire damages solar plant, 6 months to repair
  • Lost revenue: ₹30 crore
  • Insurance pays ₹30 crore

Indemnity Period: 6-24 months

3. Machinery Breakdown Insurance

• Covers sudden/accidental breakdown of machinery
• Example: Turbine rotor damage → ₹10 crore repair cost

4. Terrorism & Political Violence Insurance

• Covers damage from terrorism, war, civil commotion
• High-risk areas: ₹2-5 crore premium for ₹500 crore asset value (vs ₹2-3 lakh in normal property insurance)

5. Directors & Officers (D&O) Liability Insurance

• Protects directors from personal liability for company decisions

C. Political Risk Insurance (PRI)

Covered earlier - MIGA, ECAs, private insurers.

Coverage:

• Expropriation
• Currency inconvertibility
• War & political violence
• Breach of contract by government

D. Environmental Liability Insurance

• Covers costs of pollution cleanup
• Third-party claims for environmental damage
• Example: Chemical spill damages farmland → ₹20 crore compensation

3. Hedging Instruments

A. Interest Rate Hedging

1. Interest Rate Swap (IRS):

Mechanism:

• SPV pays fixed rate to bank
• Bank pays floating rate (MCLR+spread) to SPV
• Net effect: SPV has fixed-rate debt

Example:

Loan: ₹700 crore at MCLR + 2.5% (floating)
Current MCLR: 7.5% → Total: 10%

IRS: SPV pays 9.5% fixed, receives MCLR+2.5%
Net Interest Cost: 9.5% (fixed for 10-15 years)

If MCLR rises to 9%, SPV still pays 9.5%
If MCLR falls to 6%, SPV still pays 9.5%

Cost: Embedded in fixed rate (typically 0.5-1% higher than current floating)

2. Interest Rate Cap:

• Option to cap interest rate at (say) 12%
• If market rate > 12%, option seller pays the difference
• Example:
  • Floating rate: MCLR + 2.5% = 13%
  • Cap rate: 12%
  • Bank pays SPV: 1% of ₹700 crore = ₹7 crore

Cost: Upfront premium = 0.5-1% of loan amount (₹3.5-7 crore)

When to Use: If uncertain about interest rate direction but want protection against spike

B. Foreign Exchange Hedging

1. Forward Contract:

• Lock in exchange rate for future date
• Example:
  • USD 10 million payment due in 12 months
  • Current rate: ₹82/USD
  • 12-month forward rate: ₹83.50/USD
  • Book forward → Pay ₹83.50 crore after 12 months (certainty!)

Cost: Forward premium/discount (~1-3% p.a.)

2. Currency Option:

• Right (not obligation) to buy/sell USD at fixed rate
• Example:
  • Buy USD Call Option at ₹84/USD
  • If spot rate in 12 months = ₹88/USD → Exercise option, buy at ₹84 (save ₹4)
  • If spot rate = ₹80/USD → Don't exercise, buy at ₹80 (better rate)

Cost: Premium (2-4% of notional)

3. Cross-Currency Swap:

• Swap USD debt into INR debt
• Converts currency and interest rate exposure

C. Commodity Price Hedging

For projects exposed to commodity prices (oil, coal, metals):

1. Futures Contracts:

• Lock in price for future delivery
• Example: Coal plant locks coal price at ₹2,500/ton for next 2 years

2. Price Collar:

• Buy price floor + Sell price ceiling
• Example: Coal price range ₹2,000-3,000/ton
  • If market < ₹2,000 → Receive payment (floor protection)
  • If market > ₹3,000 → Pay out (capped cost)

4. Contractual Risk Mitigation

A. EPC Contract Protections

1. Fixed-Price Lump-Sum Turnkey Contract:

• Contractor bears cost overrun risk
• SPV pays fixed ₹500 crore (regardless of actual cost)

2. Liquidated Damages (LD):

• Pre-agreed penalty for delays/defects
• Typical: 0.5% of contract value per week of delay
• Cap: 10% of contract value
• Example: 20 weeks delay → ₹50 crore penalty

3. Performance Guarantees:

• Guaranteed plant output, efficiency, availability
• Shortfall → Financial compensation

4. Defects Liability Period (DLP):

• 12-24 months post-completion
• Contractor fixes all defects at no cost

B. O&M Contract Protections

1. Performance-Based Payment:

• Pay based on actual availability/performance
• Example: ₹10 crore/year base + ₹5 crore bonus if availability > 95%

2. Step-in Rights for Lenders:

• If O&M contractor fails, lenders can appoint replacement

C. Concession Agreement Protections

1. Change in Law Clause:

• If law/regulation changes adversely, government compensates or extends concession period

2. Force Majeure Clause:

• Excuses performance during events beyond control (earthquake, war)
• Relief: Extension of time, cost compensation

3. Termination Payments:

• If government terminates early, must pay:
  • Outstanding debt + equity (with reasonable return)
  • OR Fair market value

5. Credit Enhancement

A. Debt Service Reserve Account (DSRA)

• Cash reserve = 6-12 months of debt service
• Example: If annual debt service = ₹120 crore, DSRA = ₹60 crore
• Acts as buffer if cash flow shortage

B. Escrow Account

• All project revenues flow into escrow account
• Lenders control disbursements (waterfall mechanism)
• Prevents sponsors from siphoning cash

C. Senior vs Subordinated Debt

• Senior Debt: First claim on assets and cash flows (70-80% of debt)
• Subordinated Debt: Second claim, absorbs losses before senior (10-20% of debt, provided by sponsors or DFIs)

Risk Mitigation Cost Summary

Example: ₹1,000 crore project → ₹20-50 crore total mitigation cost over project life

Summary

• Risk mitigation is achieved through Guarantees, Insurance, Hedging, and Contracts
• Guarantees: Performance (EPC), Completion (Sponsor), Revenue (Government), Off-take (PPA)
• Insurance: CAR, Property, Business Interruption, Political Risk, Terrorism
• Hedging: Interest Rate Swaps/Caps, Forex Forwards, Commodity Futures
• Contractual: Fixed-price EPC, Liquidated Damages, Change-in-Law clause
• Credit Enhancement: DSRA, Escrow, Subordinated Debt
• Total cost: 2-5% of project cost (necessary to make project bankable!)

Quiz Time! 🎯

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