Project finance is often regarded as ‘contract finance’ because a typical transaction can involve as many as 15 parties united in a vertical chain from input suppliers to output buyers through 40 or more contractual agreements (Esty 2004). To arrange project finance, there must be a gen- uine ‘community of interest’ among the stakeholders involved in the project. Finnerty (1996) suggests that project financing arrangements invariably involve strong contractual relationships among multiple parties. Lenders will require that such contractual security arrange- ments must be put in place to protect them from various risks.
The major contracts in typical project finance transactions are the construction contract, the product offtake contracts, the raw mate- rial supply contracts, the operations and maintenance contracts, and a large number of financial agreements, including loan agreement, bond agreement, shareholders’ agreement and agreements which address support from the host country (Merna and Njiru 2002). These contracts transfer many of the individual risk elements to appropriate parties. A typical structure of build-own-operate-transfer (BOOT) projects indi- cating the number of organisations and contractual arrangements that may be required to realise a particular project is shown in Figure 2.1.
Principal
Concession agreement
Lenders Lender assessment as discussed in Chapter 8 Promoter
Final assessment by SPV and lenders as discussed in Chapter 10 SPV
SPV assessment as discussed in Chapter 7
Assessment
Figure 6.1 Assessments by SPV and lenders to determine the commercial viability.
Figure 6.1 illustrates the assessments required by the SPV and lenders for this project. It should be noted that each assessment al- lows the SPV and lenders to determine whether the project assess- ment should continue and thus support the decision-making process as illustrated in Figure 5.1.
Project finance can work only for those projects that can establish such relationships and maintain them at a tolerable cost. The project’s cash flow is guaranteed by these contractual arrangements. These con- tracts should form an interwoven web that determines the project’s value and risk. Although the granting of a concession is legally crucial to a project, from a financial perspective, the arrangement of supply and offtake contracts is the basis on which revenue is generated (Elsey et al. 1996). Both lenders and sponsors, in this case the SPV, strive to en- sure a reliable, consistent supply of raw materials to achieve certainty of revenues generated by the sales of products. All the major contracts involved in BOOT are structured to serve the commercial objective of a project: cash flow being secured. Eventually, it is through the selling of products or providing services that a project can achieve revenue generation.
Therefore, it is important to explore the interrelationship between supply and offtake contracts and the interrelationship between these
60 Project Finance in Construction
contracts and the concession agreement. The issues such as how the durations of supply and offtake contract match the period of the con- cession agreement, and how an individual supply or offtake contract default can affect the contracts which are bundled with that contract should be assessed before making investment decisions.
Supply contracts
Merna and Njiru (2002) defined a supply contract as a signed agreement between suppliers and promoters in which the supplier is obliged to provide the raw materials needed by a project to produce a required output during the operation stage. This gives the fundamental defi- nition of a supply contract. Finnerty (1996) argues that raw material supply contracts oblige the suppliers of the project’s inputs to also lend credit support to the project.
Successful project operation requires that raw material must be available in quantities and of the quality needed to operate at its design capacity over its entire life. Supply contracts represent agreements to fulfil the project’s input requirements such as quality, quantity and price of raw materials. Long-term supply contracts for feedstocks, coal or energy are necessary for the financial feasibility of many projects (Nevitt and Fabozzi 2000). The project’s raw material supply requires just as much structuring as the offtake of the project’s product (Tinsley 2000).
A typical traditional supply contract is a supply-or-pay contract, which obligates the suppliers to supply the requisite amounts of the raw material specified in the contract or otherwise suppliers would in- demnify the project company for excess costs incurred in securing the inputs from third parties or make payment to cover debt service (Vega 1997). There are also other supply contracts such as sole supply con- tracts under which the SPV agrees with a single supplier from which the SPV will purchase the project’s required raw material. However, the actual amount and price of the raw material will not necessarily be specified (Cuthbert 2004). Thus, the form of supply contract may vary from project to project. The contract conditions and content entirely depend on the characteristics of an individual project. Packard (1996) claims major stakeholders require the following conditions to be elab- orated in great detail in the fuel supply agreement in a power plant:
❒ The quality of fuel;
❒ The length of the supply contract;
❒ The reserve and production levels for each supply;
❒ The pricing formula;
❒ The interpretability (and which party bears risks);
❒ The transportation arrangements;
❒ The backup arrangements;
❒ Minimum and maximum purchase.
Supply contracts have been used in many industrial projects, such as the Jawa power project in Indonesia (Johnson et al. 1996), the Dhahol project in India (Ullman and Dayal 1996), the Hubco power project in Pakistan (Schell 1996), the Paiton power plant development in eastern Java in Indonesia and the Hopewell energy project in the Philippines (Tinsley 2000). Table 6.2 illustrates the details of those contracts. Sup- pliers, or perhaps sponsors, commit to deliver the key inputs to a given standard for commissioning and during the operating phase of those projects.
It was found that most of these supply contracts were traditionally signed between promoters and local government, sponsors or some other major parties which have good credit. The inputs of these projects were contracted from reliable sources, which created a great certainty of project raw material supply in terms of price, quality, quantity and availability. The authors believe that the supply contracts used in those projects can be defined as traditional supply contracts. The traditional supply contracts vary from project to project and industry to industry.
However, those contracts are usually long-term contracts.
Offtake contracts
As limited-recourse projects are funded on the security of the future cash flow, there must be some form of offtake. Both supply and off- take contracts are fundamentally important to the project economics.
The purpose of supply contracts is to minimise supply risk in order to
62 Project Finance in Construction
Table 6.2 Projects with supply contracts (Chu 2007) Project name Supply contract arrangement
Jawa project Long-term supply contracts signed with two suppliers: PT Berau Coal and PT Kideco Jaya Dhahol power
plant
Long-term fuel contracts signed with Coal India Limited
Hubco power project
30-year oil agreement Paiton power
plant
The coal supplier dedicated some of its reserves in priority to Paiton sufficient to cover 83% power plant availability for 28 years
Hopewell power plant
The Filipino state electricity utility, National Power Corporation, contracted to supply the diesel oil fuel at no cost. It also contracted to take the electrical output on a peak-load capacity change basis provide secured raw material supply, whereas the aim of offtake con- tracts is to minimise the market risk and to provide the revenue stream to finance not only the supply of the raw material but also the construc- tion of the required processing plant, its operation and maintenance and the cost of financing. Elsey et al. (1996) claim that offtake con- tracts provide the revenue stream, which is the foundation of project finance.
Traditionally, there are two basic types of offtake contracts: the contract-led and market-led contracts (Merna and Njiru 2002). In a contract-led project, a contract is entered into between the promoter and the user. The user may be an individual or an organisation who has agreed to purchase an agreed amount of output. An ex- ample of a contract-led project is a power station which normally has power purchase agreements (PPAs) with reliable offtakers. Traditional contract-led offtake contracts can also be defined as the following types:
Take-if-offered contract: The contract obliges the purchasers to take delivery of, and pay for, the output or service only if the project is able to deliver to them. No payment is required unless the project is able to make deliveries (Finnerty 1996).
Take-or-pay contract: Take-or-pay contracts require purchasers to pay for a contractually specified minimum quantity of output; even if the good or service is not taken, payment must still be made (Masten and Crocker 1985). It gives the buyer the option to make cash payments in lieu of taking delivery, whereas the take-if- offered contract requires the buyer to accept deliveries (Finnerty 1996). The price which the user pays under a take-or-pay contract is sometimes directly related to an independent market price for the relevant product. In other take-or-pay contracts, the price is established through the application of a formula and may bear little resemblance to the market price (Terry 2000). Like take-if- offered contracts, a take-or-pay contract usually does not require the purchaser to pay if the project is unable to deliver the product or perform the services.
Throughput agreement: A throughput agreement is typically em- ployed in connection with oil or petroleum product pipeline finance. During a specified period, the oil or gas producers are required to provide a certain throughput to the pipeline so that the pipeline operator can cover all its operating expenses and meet its debt service (Finnerty 1996).
Tolling Contract: A tolling contract means the project offtaker also agrees to supply the key project raw materials, usually for free to the project entity (Tinsley 2000). Tolling contracts are usu- ally used in power and refinery projects (Beenhakker 1997). In a power station, these are sometimes called energy conversion agreements. For example, the government power utility of the Philippines, Napocor, has been a proponent of liquid fuel-based power generation, whereby it supplies the fuel for free, yet it is the offtaker of the electricity. The tolling commitment is the main support for mitigating market risk as well as avoiding the operating cost risk and supply risks of the fuel.
In projects where the use of contract-led contracts is considered unfeasible, a market-led contract is used. In a market-led project, rev- enues are generated only when users are using the facility. An example of a market-led project is a toll road. Revenues are generated only when motorists pay to use the toll road.
64 Project Finance in Construction
Table 6.3 Projects with offtake contracts (Chu 2007) Offtake contract Offtake contract arrangement Hubco power
project
30-year PPA with National Water and Power Development Authority
Indiantown cogeneration project
30-year PPA signed between Indiantown and Florida Power & Light Company
Shajiao power station
Long-term offtake with Chinese Electricity Authority (60% of electricity), 1987–1997 Petrozuata project 35-year guaranteed offtake contracts Ras Laffan LNG
project
The Ras Laffan LNG project in Qatar was
project-financed on the back of a 25-year contract on a take-or-pay basis
with South Korea
There are many projects which have employed offtake contracts all over the world, such as the Hubco power project in Pakistan (Schell 1996), the Indiantown cogeneration project (Finnerty 1996), the Shajiao power station (Merna and Njiru 2002), the Petrozuata project in Venezuela (Tinsley 2000) and the Ras Laffan LNG project in Qatar (Dailami and Hauswald 2000). The basic details of these contracts are illustrated in Table 6.3.
It was found that most of these contracts are used in natural resource-related projects and normally over a long term. Similar to traditional supply contracts, those offtake contracts have simple forms and are normally signed between promoters and end-users that have very good credit ratings. The authors define those offtake contracts as traditional offtake contracts.
Applications of supply and offtake contracts
The concepts of supply and offtake contract have been applied in many projects such as power station projects, mining projects and petroleum projects. Gatti (2005) claims that from a historical standpoint, project finance was first launched in well-defined sectors marked by two im- portant factors: (1) long-term contracts in return for predetermined
Long-term offtake contracts Long-term
supply contracts
Power station
Fuel suppliers Electricity
authority Government
Concession agreement
Figure 6.2 Supply contract and offtake contract arrangements in the power station (adapted from Merna and Smith 1994).
prices involving large, financially sound buyers and (2) absence of high-level technological risks when constructing plants.
In power station projects, the lender requires that projects must be capable of continuing to sell their power for at least the duration of the loan (Morcos 2001). The market demand risk is mitigated by PPA with high creditability of offtakers. Figure 6.2 shows a typical arrangement of supply and offtake contracts, which was used in the procurement of the Shajiao power station. In Shajiao, the Chinese Electricity Au- thority agreed to purchase a minimum of 60% of the electricity from the plant on a take-or-pay basis and also agreed to pay a fixed price per kilowatt hour over the concession period (Merna and Njiru 2002).
This has provided a steady stream of revenue for the promoter. As a result, the promoter has made positive cash flows since the start of the concession period through the sale of the electricity. Shajiao is the first BOOT project in China and was successfully transferred to the Shenzhen government in September 1999. Thus, it appears that the offtake contract is one of the most important factors that contributed to the success of the project.
The supply contract governs the supply of the raw material that is required to be processed in order to produce the end product, and the offtake contract governs the sale of this end product to the consumer in most raw material process projects.