The most basic benefit of project risk identification is that it informs project stakeholders of potential threats and subsequent losses if threats materialize. The analysis of risks identified goes deeper and examines the sources and causes of those risks and provides insights as to how they should be addressed effectively at the root cause level. The benefit of the risk management evaluation process is that it uses the sponsor's internal expertise and external advice to assign ranges of likelihood of occurrence and it estimates the
interaction and impact of different risks. The risk mitigation component is where all the benefits of the earlier risk management parts come together in effectively screening and prioritizing, avoiding, allocating, sharing, insuring, or absorbing risks in a fair and
equitable manner among project stakeholders best able to handle. Only when risk mitigation is performed well does expected project value have reasonable chances of being realized.
The monitoring, tracking, auditing, and reporting aspect of the risk management progression is of equal importance because it helps detect risks as they begin to materialize. This helps understand the causes of events triggering risk occurrence,
prepare effective responses, and make suitable changes to minimize risk impacts. Taken together, the benefits of effective risk management manifest themselves in reduced additional capital requirements, quicker contract negotiations and financing close, lower cost of funding, and achievement of project objectives. Another benefit that is often omitted in the discussion of risk management is the identification of opportunities to increase value creation through different project structures, financing, contracts, and business plan enhancements. Here, identification of new opportunities opens up
additional avenues to augment expected project value and lessons to apply in subsequent projects.
Effective risk management is necessary to build a foundation for project financing, but it comes at significant costs. The reason costs need to be considered is because they can guide the decision of where to stop mitigation and prepare for risk absorption, project restructuring, or even abandonment of the project. The costs of project risk management evolve around the following cost elements:
1. Sponsor company's human resources from different departments are assigned risk management responsibilities
2. Fees and expenses of external advisors and consultants for research, data and
information gathering, verification and validation, and preparation of expert opinion reports
3. Incremental cost for more in depth project lifecycle analyses and evaluations undertaken to strengthen the project economic evaluation and the due diligence report
4. Various types of funding, institution, and private insurance contracts, and security packages
5. Development and negotiation of balanced and sustainable contracts supporting effective risk management
6. Creation of response plans, changes in project company operations, and options to mitigate risks appearing on the horizon
7. Contingency planning for risks determined to be unknowable or uncontrollable that could have severe, if not catastrophic, impacts on the project
8. Preparation of materials and convincing evidence of effective risk management used for project rating and in the project prospectus or information memorandum
A significant element usually overlooked in project finance is that of the opportunity cost.
Namely, what other opportunities the sponsor company is foregoing by investing in the project. And, as is true with every other aspect of project finance, a well considered
balance of interests, costs, and benefits to different stakeholders in risk allocation goes a long way towards making contracts and agreements sustainable over the long run. It also helps in avoiding costly litigation and project value destruction.
Risk management is of high importance in project finance, but sometimes it is left to external advisors or legal experts to administer it because it involves contracts and
agreements. We also observe that project teams undertaking this effort alone get lost in the process and end up giving that responsibility over to advisors, the lender group, and insurance agents. Often, data used in risk assessment do not always reflect the actual state of the project context, which is always evolving. This is true especially when the project context is not monitored properly. Additionally, risk tradeoffs are difficult to evaluate because of the many soft, qualitative types of information that are available and because they are not always subject to negotiations.
Risk management usually deals only with identified and known project risks while every other risk is lumped under contingency planning. Often, contingency planning is
considered beyond the scope of project teams' responsibilities. Only in sponsor
organizations does risk management include contingency planning, which is based on scenario simulation and scenario planning. Even in those instances, preparations for
unforeseen events are mostly left to external experts or the project company's prospective management team to manage. Lastly, a lack of early warning systems and an ability and capability to respond are challenges to risk management, especially in the absence of forecast realization and response planning.
The sketch of a more effective risk management method is illustrated in Figure 10.7. The main features of this method are the following:
Figure 10.7 Broad Method to Project Risk Management
1. Project risks are a subset of uncertainty facing all stakeholders with different
ambiguity levels. Collective assessment of uncertainty helps narrow the risk domain 2. Uncertainty may not involve all risks and risks may involve some uncertainty around
sources and impacts
3. Communication is crucial and deals with disseminating information about the different parts of risk management to project participants at different times
4. Risk management is not only a sponsor's concern; it is shared by participants whose interests are better served by cooperating and coordinating individual risk
management activities
5. Risk management is enhanced by soliciting and learning from the experiences of project participants and even from earlier competitor activities
6. Agreements on risk allocation and sharing are far quicker to reach and more effective when approached from a common platform
Risk management success factors are activities and undertakings that ensure a project reaches its objectives effectively. Experience and lessons learned in this area suggest that successful risk management is characterized by the following elements:
1. A risk management culture and mindset that permeates the project sponsor organization
2. The risk management function and its processes are integrated with those of the PFO, strategic planning, financial planning, and business development functions
3. Strong senior management support and funding to ensure organization wide
commitment to effective risk management, a prerequisite to obtaining competitive advantage
4. Sponsors build risk management capabilities with adequate resources allocated to team member training and development of a system to monitor risks on an ongoing basis
5. Project managers define the responsibilities assigned to risk management team members, pay attention to the processes used, and ensure knowledge to implement them
6. Undertaking risk management early, starting with an assessment of the RFP and the prefeasibility screening of the project and involving experts from appropriate
functional areas to assess risks related to those areas
7. Risk management requires asking “what if,” “why,” and “why not” to understand the nature of risks and determine actions to take to mitigate their impact
8. Risk management builds on earlier internal project experiences and lessons learned as well as on the research and benchmarking of other companies with breadth and depth of experiences
9. Participation of all project stakeholders affected by risk management working from a common base to prioritize their activities and agree on the allocation of risks
10. Risks are prioritized after thorough assessment and based on a high probability of occurrence, high impact basis
11. Sound project management judgment, trust, and reliance on risk management experts, and verifying if the right decisions are made and ensuing actions taken
12. Close monitoring of project development, financing, construction, and project company operations
CHAPTER 11
Project Due Diligence
A Pillar of Viability and Financeability
A good part of the project evaluation is done in the project development stage and summarized in the feasibility study. As a project moves along the assessment process, new data and information is obtained, additional analyses and evaluations are performed, and when the decision to move forward is made, the due diligence takes place. The due diligence is paid by the sponsor(s) and done primarily for the benefit of lenders, but sponsor(s) and other project stakeholders benefit from it and may be involved to some degree to ensure that the proposed project structure meets their objectives.
The intent of the feasibility study is to provide a common understanding of project particulars to participants and specify items they are committed to after financial close.
The project due diligence is a thorough investigation to confirm data, information, and representations made before entering into project agreements leading to financial close.
It is an extension of the feasibility study and its focus is on identifying missing
information, validating analyses and evaluations performed, and establishing that the risk management and security package are complete and adequate to ensure project
bankability.
The due diligence is performed to give the funding sources a critical, independent, and objective assessment of the project's viability and provide a reasonable comfort level concerning risk assessment and mitigation effectiveness. To do that, the due diligence first reassesses each stakeholder's ability to deliver on current and future requirements and, by extension, their qualification to share in the project benefits. The due diligence is thought of as a form of project risk management validation because it:
1. Confirms the accuracy of technical and financial data provided and the credibility of the engineering, technical, and economic aspects of the project
2. Validates the processes, analyses, methods, tools, and techniques used to evaluate the technical and financial project feasibility and project value creation
3. Tests and validates the assumptions and the baseline scenario underlying the cost and revenue projections and the project financial viability
4. Substantiates that a thorough and complete risk identification and mitigation are performed on a fair, reasonable, and the best equipped party to bear remainder risks basis
5. Confirms that negotiated contracts adequately address all areas of concern to stakeholders and are enforceable in the host country
6. Validates and verifies that the project financial model is well structured and its inputs and outputs tested and found acceptable
The project due diligence is crucial to determine project funding needs and project viability and financeability. Its approach, depth, and requirements vary by project size, scope, and potential risk impacts; the nature of project finance due diligence is exhibited in Figure 11.1. It shows the many sides of due diligence and the functions it serves, which are discussed in ensuing sections. Section 11.1 tallies the main costs of project due
diligence, which are fully justified by the many benefits derived from it. The first part is due diligence on the host country and industry to determine whether conditions are adequate to undertake a project. This is the subject of Section 11.2. Section 11.3 is a brief introduction to the technical due diligence that confirms if the engineering and design aspects meet project specifications and requirements.
Figure 11.1 The Nature of Project Due Diligence
Environmental due diligence is the topic of Section 11.4 to confirm that no adverse
environmental and social effects are produced by the project, while Section 11.5 discusses the project's commercial aspect of due diligence. The validation of the adequacy of project contracts and agreements is the legal due diligence—an important part to confirm that project financing can reasonably be expected to develop—and this is dealt with in Section 11.6. The various financial considerations are enumerated in Section 11.7 and discussed in more detail in Chapters 13 and 14.
Operational aspects are verified and validated in the operational due diligence part, which is presented in Section 11.8 in order to provide assurances of continuity of operations. The crux of the project due diligence, however, is the risk management part that is discussed in Section 11.9. If its findings are unduly negative, the project is subject to restructure, additional support, or even termination. Other due diligence considerations that do not fit
well in the above categories are presented in Section 11.10. Lastly, Section 11.11 discusses the due diligence report, its assessment, and quality characteristics.