Chapter 17 Use of Lien-Supported Financial Derivatives
A. Project Finance and Risk Management
In energy project financing, a “project company” seeks to develop and construct a capital-intensive project, such as an electric generation facility, and must obtain financ- ing to complete the project. Typically, a project company undertaking project finance is a special purpose entity with few assets other than the project sponsor’s equity investment, the intake (e.g., fuel) purchase and output (e.g., power) sales contracts entered into to support the project, some type of land rights to the proposed site for the project, and the governmental permits required to construct and operate the proposed energy project. Such a project company will not typically have a significant balance sheet nor a credit rating sufficient to support traditional “balance sheet” financing and instead relies on project financing.
The most common investment method in project financing is debt, where the proj- ect company takes out a bank loan from a lender, typically a financial institution. The project sponsor wants the project to be successful and needs access to credit to achieve that success. The lender expects that periodic payments on the debt will be repaid to the lender on a timely basis, which is the project company’s debt service obligation.
As debtor, the project company must meet its debt service obligations. However, because an energy project is capital intensive and does not produce revenue until post- construction — usually from one to three years after the initial construction financing is put in place — there is significant risk that the project company will fail to meet its debt service obligations. This risk is commonly referred to as “credit default risk.”
In a project financing, the lender, or group of lenders, will take a security interest in all the project company’s above-named assets, including the proposed energy project itself, as an inducement to and credit support for providing the construction financing and the permanent (postconstruction) financing for the energy project. Such security interest functions as a lien on all the project company’s assets.
If a project company is unable to meet its debt service obligations, then the project sponsor will likely lose its equity investment in the project company, and the lender may seek to realize on the liens granted to it by the project company in order for the lender or its designee to step in and complete the project as a means of producing sufficient revenues to repay the debt. This action is not a preferred outcome for the project sponsor, of course, nor is it the preferred outcome for the lender, because the lender would rather be in the financing business than in the project development business.
As a result, any commercially reasonable means available to reduce the credit default risk of the project company will meet an important goal of both the lender and the project sponsor. The mutual interest of reducing credit default risk has led to the financial innovation of the lien-supported financial derivative in project finance.
The use of financial derivatives in lien-supported project finance is a form of credit enhancement of the debtor because a properly negotiated derivative transfers some of the credit default risk of the debtor to the financial derivative counterparty (this counter- party is typically an entity other than the lender), which is typically more creditworthy than the project company.
What follows is a general discussion of financial derivatives, which will explain what a lien-supported financial derivative is and how it can be used to reduce credit default risk.
1. Understanding Financial Derivatives A financial derivative is a financial prod- uct whose value derives from an underlying item, which in the context of project financing can be interest rates, foreign exchange rates, commodity pricing, such as prices of electricity or natural gas, or various other items in which financial volatility can present a significant risk to such project financing. While this chapter will focus primarily on financial commodity derivatives, the concepts apply equally well to inter- est rates, foreign exchange rates, and other risks that a project company needs to manage in order to minimize its credit default risk.
Financial derivatives involving commodities include forward contracts, futures con- tracts, and options contracts, all of which are generally financially settled and rarely result in the actual physical delivery of the underlying commodity. Forward and futures contracts are transactions in which one counterparty commits to deliver a commodity on a future date at a price agreed upon at the time of entering into that transaction. For example, in an electricity future or forward contract, one trading party is obligated to deliver a quantity of electricity on a future date at a price per unit of electricity to be specified on a particular date, as determined in accordance with the contract. The fun- damental difference between a forward contract and a futures contract is that a forward contract is an over-the-counter (OTC) transaction, while a futures contract is traded through a regulated exchange, such as the New York Mercantile Exchange. This dif- ference creates several distinguishing elements between these two types of transac- tions, as discussed below.
A futures contract, because it is traded on an exchange, is a form contract in which the terms, conditions, and quantity are previously established and fixed by the relevant exchange, and all that the parties agree to is price and delivery date. In contrast, an OTC forward contract is a bilateral contract that is negotiated freely between two par- ties, which, in the project financing context, are the project company and a large finan- cial institution or a large energy trading company with an excellent credit rating, which is often referred to as a “hedge provider.”
When buying or selling futures contracts on an exchange, the exchange requires that each party to any futures contract maintain a minimum cash balance in a “margin account” to cover any potential credit exposure that it may fail to make a payment when due to a counterparty under a futures contract. By trading a futures contract on an exchange, the exchange provides all parties to transactions some level of protection against the risk that the other party will fail to meet its payment obligations under a futures contract.
In contrast, the parties to a forward contract bear the risk of such failure and have the responsibility to impose credit support requirements on the other party in any for- ward contract. Accordingly, although more flexible than futures contracts, forward contracts do not necessarily afford the standard protections of futures contracts.
As a result, credit support is a crucial negotiating point in all OTC financial derivatives and, thus, the creditworthiness of the parties is an essential element of the transaction.
APPLICATION OF FINANCIAL DERIVATIVES IN SUPPORT OF PROJECT FINANCING
Forward contract participants may afford themselves protection by, among other things, performing due diligence on the creditworthiness of their respective counter- party, obtaining a guaranty of that counterparty’s obligations from a more creditwor- thy affiliate or third party, requiring the counterparty to post cash-margin or a letter of credit as credit support for the counterparty’s obligations, and/or having the counter- party grant the other party a lien on certain assets of the counterparty (each of these topics is discussed later in this chapter). For example, in the context of an energy proj- ect financing, the project company typically enters into a financial derivative transac- tion with a large financial institution or a large energy trading company with an excellent credit rating, as its hedge provider, which leaves the project company in the position of having to provide credit support to its hedge provider.
Finally, the third common financial derivative used in project finance is the option contract. An option contract is an agreement pursuant to which a seller, for a fee known as the “option price,” grants the buyer of the option (which is merely a contractual right and not a contractual obligation) the contractual right to purchase from (a “call”
option) or sell to (a “put” option) the option seller a commodity (such as natural gas or electricity) at an established, fixed price at a specified date or during a specified time period. The seller of the option contract is obligated to sell or buy the commodity in accordance with the terms of the option contract if the buyer exercises the contractual right granted in such option contract.
Option contracts are used less often in project finance because one overriding objec- tive of project finance is the provision of revenue stream certainty to the project com- pany so that it can meet its debt service obligations, which obligation is better served by a forward contract.
2. Swap Transactions Swap transactions, which are a type of forward contract, are the most common type of financial derivative used in project financing. A swap trans- action is a financial product in which the parties agree to exchange future cash flows.
During the time period designated in a swap transaction, the floating price payer pays the market price (i.e., a price that floats with the prevailing market) multiplied by a notional quantity designated in the swap transaction to the fixed price payer, and the fixed price payer pays an agreed fixed price multiplied by the same designated notional quantity to the floating price payer. The two payment amounts are netted against each other so that only the party owing the larger amount pays the net incremental amount to the other party.
Swaps based on commodities, such as electricity, natural gas, oil, precious metals, various agricultural products, etc., are commonly referred to as “commodity swaps.”
These commodity swaps protect businesses against volatility in commodity market prices that can affect either the cost of a critical input (i.e., a commodity fuel or feedstock) to that business or the sales price of a primary output (i.e., the product) of that business.
Commodity swaps can protect project companies from unexpected market volatility for an input, an output, or both, by establishing floor prices, ceiling prices, or, in com- bination, a collar on prices for a specific commodity.
In our project finance example, the project company (debtor) and the hedge pro- vider exchange a floating market-based price for a fixed price of an underlying item,
frequently a commodity. As mentioned, the commodity that is subject to a swap agree- ment could be an input to the energy project, such as fuel, or an output, such as electric energy. By obtaining in the exchange a fixed price for the underlying commodity, the debtor is protected by the swap agreement from certain adverse changes in the market price for the input or the output of the debtor’s energy project.
During the term of the swap agreement, for example, the project company will never incur more than the fixed price for its purchases of a hedged input commodity, com- monly referred to as a “ceiling” price. Alternatively, the project company will always receive at least the fixed price for its sales of a hedged output commodity, commonly referred to as a “floor” price. A combination of a floor price and a ceiling price in one transaction would produce upper and lower limits for a commodity price, commonly referred to as a “collar.”
A more detailed example of a swap used in the project financing of an electric gen- eration facility is discussed later in this chapter.
Additionally, swap transactions used in energy project finance are not limited to commodities. Other types of swaps in energy project finance include currency swaps, in the case of an energy project with an international (multicurrency) component, and interest rate swaps, in the case of an energy project with a variable interest rate for all or a portion of its debt. In each case, the parties are exchanging cash flows related to an underlying item, in these examples, currency exchange rates and interest rates. Like electricity markets, currency markets and interest rates can be volatile at times, and thus project companies frequently seek to protect themselves from exposure to this sort of market risk. Each of these types of swaps is also common in energy project finance.