A) The Angra 3 Nuclear Power Project

Nuclear energy provides about 3% of Brazil’s electricity. In 2007, gross production was 445 billion kWh, with net imports of 39 billion kWh being required. Of the total generated in the country, 84% of power was from hydro, 3.5% from gas, 4% from biomass, just over 5% from coal and oil, and 3% (12.4 million kWh) from nuclear. In 2009, nuclear power generated 13 billion kWh of electricity. Per capita electricity consumption in Brazil has grown strongly since 1990 – from under 1500 kWh/yr in 1990 to nearly 2200 kWh/yr in 2007.

The high dependence on hydro gives rise to some climatic vulnerability which is driving policy to diminish dependence on it. Despite this, in February 2010 the government approved $9.3 billion investment in the new 11.2 GWe Belo Monte hydro scheme, which will flood 500 sq km of the Amazon basin and supply about 11% of the country’s electricity. About 40% of Brazil’s electricity is produced by the national Eletrobrás Systema. About 20% of electricity is from state-owned utilities, and the rest is from privately-owned companies.

Angra 1 suffered continuing problems with its steam supply system and was shut down for some time during its first few years. Its lifetime load factor over the first 15 years was only 25%, but since 1999 it has been much better. Civil works on Angra 2 started in 1976 and, due to a lack of financial resources and a lower than expected growth in demand, only commenced operation at the end of 2000. Angra 3 was designed to be a twin of unit 2, with a 1,400MW generating capacity. Work started on the project in 1984 but was suspended in 1986 before full construction began. Around 70% of the equipment is on site, full construction did not begin and work on the project was suspended in 1986.

In November 2006 the government announced plans to complete Angra 3 and also build four further 1000 MWe nuclear plants from 2015 at a single site. Angra 3 construction approval was confirmed by Brazil’s National Energy Policy Council in June 2007 and received Presidential approval in July. Environmental approval was granted in March and all other approvals by July 2009. In December 2008, Eletrobrás Termonuclear S/A (Eletronuclear) signed an industrial cooperation agreement with Areva, confirming that Areva will complete Angra 3 and be considered for supplying further reactors. Areva also signed a services contract for Angra 1. First concrete for Angra 3 was due in 2009. A construction licence was granted by the National Nuclear Energy Commission (CNEN) at the end of May 2010, and construction resumed two days later, in June. The plant is expected in operation at the end of 2015 after 66 months.

B) Financial challenges

Economically, power from existing nuclear plants is about 1.5 times more expensive than that from established hydro, and power from Angra 3 is expected to be slightly over twice as expensive as old hydro, about the same as that from coal and cheaper than that from gas. Overall, including Angra 3 in projections reduces network prices slightly. Plans to build two new nuclear plants in the northeast and two more near Angra in the southeast are underway1. At the end of 2009, Eletronuclear commenced initial siting studies at four potential locations in the northeast2, and is aiming to present a list of 40 possible sites to the Mines & Energy Ministry by mid-2011. Eletronuclear is looking at the Westinghouse AP1000 (which is reported to be favoured), the Areva-Mitsubishi Atmea-1 and Atomstroyexport’s VVER-1000.

In December 2010, The Brazilian Development Bank (BNDES) approved BRL 6.1 billion (US$ 3.6 billion) in financing for Angra 3, covering almost 60% of the BRL 9.9 billion estimated cost. This month Eletronuclear received an offer for a EUR1.5bn (US$2.02bn) loan from a pool of five French banks led by Société Générale to develop its Angra III nuclear power plant in Rio de Janeiro state. This is only one of many recent developments in the country’s nuclear sector. Sustained by strong economic and demographic growth, Brazil’s power demand is indeed expected to increase significantly in the coming years and the country is planning to boost nuclear generation along with its more developed hydro generation. Brazil’s Senate still has to approve the loan, and a decision on the matter is not expected until the second half of 2011. Construction of Angra 3is currently underway and the new nuclear power plant is expected to start production by 2015. The total investment for the project has been estimated at BRL9.9bn (US$5.91bn).

C) About Eletronuclear and BNDES

Eletronuclear was established in 1997 for the purpose of operating and building thermal nuclear power plants in Brazil. A subsidiary of Eletrobrás, Eletronuclear is a government-controlled company that accounts for the generation of approximately 3% of electric power consumed in Brazil. By the interconnected electric power system, such power reaches the main consumer centers in Brazil and corresponds, for example, to more than 50% of electric power consumption in the State of Rio de Janeiro, a proportion to be considerably expanded on completion of the third unit of Admiral Álvaro Alberto Nuclear Power Station (CNAAA). At present, nuclear power plants Angra 1 – with a generating capacity of 657  electric megawatts, and Angra 2 – rated at 1350 electric megawatts are in operation. Angra 3, to practically be a replica of Angra 2, (incorporating the technological advances made since the construction of the latter) is also planned

BNDES is the main financing agent for development in Brazil. Since its foundation, in 1952, the BNDES has played a fundamental role in stimulating the expansion of industry and infrastructure in the country. Over the course of the Bank’s history, its operations have evolved in accordance with the Brazilian socio-economic challenges, and now they include support for exports, technological innovation, sustainable socio-environmental development and the modernization of public administration. The Bank offers several financial support mechanisms to Brazilian companies of all sizes as well as public administration entities, enabling investments in all economic sectors. In any supported undertaking, from the analysis phase up to the monitoring, the BNDES emphasizes three factors it considers strategic: innovation, local development and socio-environmental development. The BNDES’ disbursements reached R$ 168.4 billion in 2010, a 23% increase when compared to the previous year. The result takes into consideration Petrobras’ R$ 24.7 billion capitalization operation. When this operation – a one-off and non-recurring – is not considered, the Bank’s disbursements ended 2010 at R$ 143.7 billion, a 5% increase when compared to 2009, growth which is compatible with previously made projections. Industry accounted for 47% of the Bank’s total disbursements, followed by Infrastructure, with 31% presence, and by Trade and Services, at 16%. In all areas of activity (agriculture, industry, infrastructure, trade and services) disbursements grew in 2010, resulting mostly from the successful Investment Maintenance Program (PSI). Launched in July 2009 and expected to last until next March 31, 2011, PSI guaranteed the return of investment to the country amidst the global financial and economic crisis.

In the UK, the head of the National Audit Office (the body scrutinising public spending on behalf of Parliament) has called for a project-by-project review of future private finance initiative contracts, with stricter criteria being employed than in the last two years, to establish the most appropriate funding methods. The “Private Finance Initiative” is the UK’s own version of Public Private Partnerships or PPP and since its inception in the early 1990′s has resulted in over 500 operational projects in England alone with a capital value in excess of £28 billion (according to the National Audit Office Report published 3 November 2009).

Whilst obviously specific to the UK and PFI, the NAO’s report is revealing about the effects of the banking crisis on privately financed projects (PPP) and more interestingly, about the likely prospects for such projects in the future. Its recommendations for how such projects can be more efficient and offer better value for money make interesting reading in light of the UK government plans to put in place “an economic, efficient and effective strategy for financing public services”.

Approval of Treasury response to the credit crisis

The report commends the previous Labour government in its commitment to “reactivating” the financing market at a time when finance became increasingly unavailable, limiting the opportunity for the agreement of sizeable contracts. It also commends the Treasury’s approach at this time and suggests it was successful when establishing the Infrastructure Financing Unit in March 2009 to address the scarcity of debt finance. The Unit was tasked to ensure that 110 privately financed infrastructure projects (exceeding £13billion) would continue by funding any shortfalls in bank finance. For example, this Unit directly assisted the “Greater Manchester Waste Project” in April 2009 providing £120million to the project.

The UK Treasury’s willingness to lend improved market confidence and 35 government infrastructure projects were subsequently agreed without further public lending. However, although banks continued to lend, priority was given to closing deals at prevailing market rates, even if that meant that the public sector was paying more and the private sector was taking on less risk. The total interest cost of bank finance increased by one-fifth to one-third despite the fall in short-term borrowing rates and little change in the risk profile of the projects concerned.

Warning: Change to come

The NAO’s report reveals that higher financing costs added 6-7% to the annual charge of PFI projects. Between £500m and £1billion in higher costs has been built in over 30 years, although this has been partly offset by an increased public sector share in refinancing gains. In October 2008 the Treasury increased the public sector share of such gains from 50% to 70%.

The warning issued by the NAO is that, while the extra finance costs for projects in 2009 were able to provide value for money in the short term and achieve the government’s objective of stimulating the economy, “the Treasury should not presume that continuing the use of private finance at current rates will be value for money”.

Value for Money and Funding Options?

The Report states that the Treasury was justified in not reconsidering the individual business case of projects in 2009 but that in future, there should be “no presumption, based on previous business case analysis, that continuing the use of private finance at current rates will provide value for money”. In addition, the NAO recommends that more exacting and narrower criteria be applied to projects in development than at the height of the crisis. Key recommendations to the Treasury include:

• Analysing the lessons of the last two years with the view to preparing a contingency plan for how government departments should handle future market disruption affecting procurement plans.
• Where there are material changes, such as project costs increasing by 15%, require the department to re-evaluate the project. Such a re-evaluation would “assess all the benefits, and potential loss of benefits, of continuing the project in its current form, compared to other available options, including other forms of procurement”.
The report also highlights a number of alternative funding models for projects that are being developed and that greater emphasis should be placed on assessing the merits of other models when addressing funding issues. These funding models / options have the potential to be key factors in the future implementation and success of PFI projects. Recommendations to the Treasury include:
• During procurement, departments should assess a range of funding options to assess value for money including all public finance or part public and part private finance.
• Government departments should make greater use of sensitivity analysis to inform their decision-making when negotiating small changes in finance rates or considering requests to take on additional project risk.
• Continue to consider how a greater mix of finance sources, with less emphasis on the use of commercial bank loans, can be used to finance infrastructure projects. For example, other options highlighted include the approach of the French government in guaranteeing 80% of debt when a project is operating successfully and loans from the European Investment Bank which is generally able to make funding available on more favourable terms than commercial banks.
• The adoption by the Treasury of a portfolio approach to refinancing, so that individual authorities do not exercise any right to a refinancing on a piecemeal basis. Such an approach would enhance the public sector bargaining position, reduce transaction costs and increase potential gains.

The Future?

 There is a note of optimism in the Report. Infrastructure UK, the new coordinating body established within the Treasury “estimates that the Government needs to continue to encourage substantial investment in new infrastructure, possibly £40-50 billion per annum until 2030″.

Now comes the difficult bit – implementing the recommendations of the Report – and providing structures and funding for PFI projects that secure better value for money. If the private sector’s enthusiasm for PFI was cooling because of high bid costs and lengthy tendering periods, the tendering process will become an even more crucial part of the whole PFI deal, for both the public and private sector. The potential of increased unavailability of government funding will mean that the public sector has few choices outside PFI for the funding of capital projects and a focus and investigation of a variety of alternative funding options will be needed.

Do you have any experience of developments outside the UK for increasing the efficiency of similar projects – and particularly the tender process? If so, your input will be very welcome!

“Thus the future American Business will require the highest degree of sensitivity to the political framework in which it functions and to the great coming changes in the World political process.” KISSINGER, Henry A. (1977). Speech before the Future of Business Project of the Center for Strategic and International Studies. Georgetown, Virginia, Washington, D.C.

“First, it is clear that managers consider political instability and/or political risk, typically quite loosely defined, to be an important factor in the foreign investment decision. Second, It is just as clear that rigorous and systematic assessment and evaluation of the political environment is exceptional. Most political analysis is both superficial and subjective and not integrated formally into the decision making process. It would appear that the resulting subjective perceptions of ‘political instability’ are equated on almost a one to one basis with a poor investment climate. The response frequently is avoidance; firms simply do not get involved in countries or even regions, they perceive to be risky. Last, managers appear to rely primarily on internal (to the firm) sources for environmental information. Wlien they look for outside data, they are most likely to go to their banks or the general and business media.” KOBRIN, Stephen Jay (1978). Political risk : a review and reconsideration. Cambridge, Mass. : Alfred P. Sloan School of Management, Massachusetts Institute of Technology.

In any cross-border financing, parties (banks specially) take a political risk in the sense that a collapse of the existing political order in the borrower’s country or the imposition of new taxes, exchange transfer restrictions, nationalisation or other laws may jeopardise the prospects of repayment and recovery. In project financing, the political risks are more acute for many reasons, including:

a) the project itself may require governmental concessions, licences or permits to be in place and maintained, particularly where the project is for power generation, transport, infrastructure or the exploitation of the country’s natural resources – oil, gas and minerals; and

b) the project may be crucial to the country’s infrastructure or security and accordingly be more vulnerable to the threat of expropriation or requisition – power projects, airports, seaports, roads, railways, bridges and tunnels are obvious examples.

The term political risk is widely used in relation to Project Finance and can conveniently be defined to mean both the danger of political and financial instability within a given country and the danger that government action (or inaction) will have a negative impact either on the continued existence of the project or on the cash flow generating capacity of a project. Different projects and different project structures will obviously encounter different types of political risk. However, examples of events that might be classified as political risks are set out below:

a) expropriation or nationalisation of project assets (including the shares of a project company);

b) failure of a government department to grant a consent or permit necessary for starting, completing, commissioning and/or operating a project or any part of it;

c) imposition of increased taxes and tariffs in connection with the project, including products generated by the project, or, perhaps, the withdrawal of valuable tax holidays and/or concessions;

d) imposition of exchange controls restricting transfer of funds outside of the host country or availability of foreign exchange;

e) changes in law having the effect of increasing the borrower’s or any other relevant party’s obligations with respect to the project, e.g. imposing new safety, health or environmental standards or other changes in law that result in changes being necessary to the design of any equipment or process;

f) politically motivated strikes; and

g) terrorism.

There is no single way in which a lender can eliminate all project risks in connection with a particular project. One of the most effective ways of managing and reducing political risks, however, is to lend through, or in conjunction with, multilateral agencies such as the World Bank, the European Bank for Reconstruction and Development and other regional development banks such as the African Development Bank and the Asian Development Bank.

There is a view that, where one or more of these agencies is involved in a project, then the risk of interference from the host government or its agencies is reduced on the basis that the host government is unlikely to want to offend any of these agencies for fear of cutting off a valuable source of credits in the future. This is a persuasive argument and certainly one that has some historical basis. For example, when countries such as Mexico, Argentina and Brazil were defaulting on their external loans in the early 1980′s, they went to some lengths to avoid defaulting on their multilateral debts, whether project-related or not.

Other ways of mitigating against political risks include:

a) private market insurance – although this can be expensive and subject to exclusions. Further, the term that such insurance is available for will rarely be long enough;

b) obtaining assurances from the relevant government departments in the host country, especially as regards the availability of consents and permits;

c) the Central Bank of the host government may be persuaded to guarantee the availability of hard currency for export in connection with the project; and/or

d) as a last resort, but an exercise which should be undertaken in any event, by a thorough review of the legal and regulatory regime in the country where the project is to be located to ensure that all laws and regulations are strictly complied with and all the correct procedures are followed with a view to reducing the scope for challenge at a future date.

In some countries, host governments (or their agencies) may be prepared to provide firm assurances on some of the above matters to foreign investors and their lenders. Obviously such assurances are still subject to a performance risk on the host government concerned, but at a minimum they can make it very difficult, as well as embarrassing, for a government to walk away from an assurance given earlier in connection with a specific project and on the basis of which foreign investors and banks have participated in a project.

As indicated by ASHLEY and BONNER:  ”Political risk identification, measurement, and management are key to successful international construction contracting. Multinational contractors are particularly sensitive to quick, unexpected change in the political environment that affects principal cash-flow elements of their projects. Traditional political risk analysis used by manufacturing or heavy industrial firms for capital investment decisions does not adequately address contracting risks. An alternate approach is presented to fill this important gap. Essential to this treatment is the identification of the primary political source risks and their impacts on project cash-flow elements. Recognition and planning, rather than gambling, is emphasized as a contractor’s best approach to successful international construction.” Let’s learn with them.

Reference:

AHARONI, Yair (1966). The Foreign Investment Decision Process. Boston, Harvard University Press.

ALFARO, L., KALEMLI-OZCAN, S. and VOLOSOVYCH, V. (2008). Why doesn’t capital flow from rich to poor countries? An empirical investigation, Review of Economics and Statistics, Vol. 90, pp. 347–368.

ASHLEY, David B. and BONNER Joseph J. (1989). Discussion of ‘Political Risks in International Construction’, Journal of Construction Engineering and Management, Vol. 115, Issue No. 1 (March/April, 1989), pp. 161-161.

FITZPATRICK, Mark (1993). The Definition and Assessment of Political Risk in International Business: A Review of the Literature, The Academy of Management Review, Vol. 8, No. 2 (April, 1983), pp. 249-254.

FRYDMAN, R., GRAY, C., HESSEL, M., and RAPACZYNSK, A. (1999). When does privatization work? The impact of private ownership on corporate performance in the transition economies, Quarterly Journal of Economics, Vol. 114, No. 4, pp. 1153-1191.

GLEASON, K. C., MCNULTY, J. E., and PENNATHUR, A. K. (2005). Returns to acquirers of privatizing Financial Services Firms : An International Examination, Journal of Banking and Finance, Vol. 29, pp. 2043-2065.

KOBRIN, Stephen J. (1979). Political risk : A review and reconsideration, Journal of International Business Studies, Vol. 10, pp. 67-80.

KOBRIN, Stephen J. (1980). Foreign enterprise and forced divestment in the LDCs, International Organization, Vol. 34, pp. 65-88.

LEWIS, M. (1979). Does political instability in developing countries affect foreign investment flow?, Management International Review, Vol. 19, No. 3, pp. 59-68.

REEB, D. M., KWOK, C., and BAEK, Y. (1998). Systemic Risk of the Multinational Corporation, Journal of International Business Studies, Vol. 29, No. 2, pp. 263-280.

SCHMIDT, D. A. (1986). Analyzing political risks, Business Horizons, Vol. 29, No. 4, pp. 43-50.

With the loss of capability of investment by the public sector, there was a global tendency in 80’s and 90’s to diminish the role of the State, with the privatization and concession of public services to the private sector. In Brazil, The Brazilian Privatization Program – PND, was instituted under the Law No. 8,031, of 04/12/1990, when the concept of privatization became an integral part of the economic reforms initiated by the Federal Government. At that time, all effort was concentrated on the sale of productive state owned companies, tied to strategic sectors, which allowed the inclusion of steel manufacturers, petrochemical and fertilizer companies in the PND.

Between 1990 and 1994, the Federal Government privatized 33 companies, 18 of which were controlled companies and 15 minority shareholder participations of Petroquisa and Petrofertil. Other eight auctions of minority shareholdings were held under Decree No. 1,068. Through these operations the Government obtained receipts of US$ 8.6 billion that, along with the US$ 3.3 billion in debt transferred to the private sector, brought the total to US$ 11.9 billion.

Due to the large amount of funds needed for the viability of infrastructure projects, private companies were incapable of compromising their budgets during the long course of maturation of such projects. The transfer of part of the infrastructure to private initiative, demanding substantial investments in its planning, development and operation, began to be financed by other agents and other sources, due to the integration of the partners in the respective projects.

Commercial banks, multilateral agencies, export credit institutions, pension funds, insurance companies and participants in international capital markets became important financiers of infrastructure projects in Brazil through Project Finance. As a financial model which adapts itself to the need of funds for projects developed by the private sector, Project Finance represents an important instrument to make investments in infrastructure viable in developing countries viable.

The Practical Use and Importance of Project Finance

Project Finance is usually defined as the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. In this context, it represents a financing technique which generally allows a company to raise funds to set up a project based on the feasibility of such a project and its ability to generate revenues at a level sufficient to cover construction and operational costs, as well as debt service and a return for the investor (cf. FINNERTY, John D. Project Financing: Asset-Based Financial Engineering. London: John Wiley and Sons, 2007, p. 4).

Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging. Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors’ base, but might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. Project Finance is than used to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties.

Project Finance transactions require joint efforts from lenders, investors, suppliers, off takers and sponsors of the project in order to make feasible the implementation of a project, dealing with special challenges, such as:

(1) They require large indivisible investments in a single-purpose asset: Project Finance than deals have contemplated the creation of a special purpose vehicle with bankruptcy remoteness features, as a ring fencing technique, which usually results in credit enhancement for financiers and cost reductions for sponsors, although the creation of a project company is not necessarily a rule inherent to project finance;

(2) Projects usually undergo two main phases (construction and operation) characterised by quite different risks and cash flow patterns: Construction primarily involves technological and environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting to accrue only after the project has begun operation; and

(3) The success of large projects depends on the joint effort of several related parties so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs: From the construction company to the input supplier, from the host government to the off-taker, all parties have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.

Trends of Project Finance Structures in Brazil

A. Detailed Financial Structure

In project finance, several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project. The definition of the advantages and limits of a Project Finance structure requires a detailed analysis of the various aspects must be made by those interested, involving, amongst others:

(1) A study of the structure that comprises Project Finance, detailing the advantages, the disadvantages and limits of each model;

(2) The criteria of evaluation and requirements established by the agents in charge of classification of credit and the respective impact on the composition of the interest rate of the financing;

(3) Identification, allocation and development and implementation of the criteria and methods to manage the risks involved;

(4) Formulation of an accurate economic-finance model to obtain the resources on the international market;

(5) Techniques and implications of the necessary due diligence; and

(6) Monitoring the project during its building and operational phases and respective management of financial documents, also contemplating the securitization of the receivables.

In Project Finance equity is held by a small number of sponsors and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce project specific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments. The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets.

Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors’ on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors’ core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, lenders are making increasing use of innovative risk-sharing structures, alternative sources of credit protection and new capital market instruments to broaden the investors’ base.

Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks while host governments cover market risks.

There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees, credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries. Examples include: refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.

Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitize project loans, thereby creating a new asset class for institutional investors. Collateralised debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.

B. Partnering Construction Contractual Structure

Within time and the more use of Project Finance structures, parties have evolved to the use of Engineering Procurement Construction (EPC) – the favourite contract model for the lenders – and Engineering Procurement Construction Management (EPCM). Nevertheless, because the EPC contract approach shifts all the risk of project completion cost and performance onto the contractor’s shoulders, it tends to trigger an adversarial project team relationship, potentially leading to a breeding ground for conflict, contractual disputes and major claims that undermine the project’s financials and its ultimate successful outcome. Therefore, the challenge in Project Finance has been the adoption of the Alliance contracting as a viable, proven alternative to adversarial business-as-usual contracts.

Alliance contracting offers a unique system of project delivery whereby risks are shared between owner and contractor. They are incentive-based relationship contracts in which the parties agree to work together as one integrated team in a relationship that is based on the principles of equity trust, respect, openness, no dispute and no blame. Alliance contracting can relieve the pressure of the short-term demands on the industry and set the foundation for longer term structural improvement in the way the industry works. Also, significantly reduces, the risk of claims and disputation between the parties through the use of inclusive and collaborative legal and commercial arrangements. These arrangements enable the parties to work together in an open and generative manner and to strive to achieve the business goals of everyone in the relationship and can provide a bankable project delivery method even for project financing.

C. Submission to the Equator Principles

Project Finance transactions may encounter social and environmental issues that are both complex and challenging, particularly with respect to projects in the emerging markets. Large industrial and infrastructure projects, such as for power generation, are becoming increasingly conditioned to social and environmental risk assessments in order to be approved. In this context, Brazil is following the international trend to adopt the Equator Principles for Project Finance transactions.

Equator Principles represent a set of socioenvironmental guidelines adopted by 61 banks worldwide for financing projects amounting to US$10 million or more and are intended to serve as a common baseline and framework for the implementation by each lender of its own internal social and environmental policies, procedures and standards related to its project financing activities.

Today, 7 banks are signatories of the Equator Principles in Brazil. They work to ensure that the projects they finance are developed in a manner that is socially responsible and reflect sound environmental management practices. By doing so, negative impact on project-affected eco-systems and communities should be avoided where possible, and if this impact is unavoidable, it should be reduced, mitigated or compensated for, or both, appropriately.

Conclusion

The success in the financing of an infrastructure project, by means of Project Finance, depends on all the parties involved satisfactorily complying with their various contractual obligations under the Project Finance Documentation. Lenders, as well as the other participants, in accordance with the level of risk being assumed and in proportion to the benefits received from the implementation of the project, will undertake the due diligence needed to adequately measure the risks involved.

The viability of the Project Finance model, in short, is based on the consistency and efficiency of its network of agreements. Such documents must be structured and negotiated in a consistent manner with the respective legislation applicable in the jurisdictions involved, and be constructed in such a way as to allow full implementation of their respective terms and conditions, notwithstanding the natural complexity of the same, in a form which will satisfactorily identify, mitigate, allocate and allow the adequate management of the various risks involved in the Project Finance.

I had the good fortune to attend the Middle East Nuclear Energy Summit in Amman, Jordan last month. Jordan is arguably second only to the UAE in the race for peaceful nuclear energy. Indeed the Chairman of the Jordan Atomic Energy Commission told the conference of his country’s plan to become a net exporter of electricity, and to use their indigenous supply of uranium as part collateral to assist with the financing of new nuclear new build. There has been further progress in Jordan since the conference with the site selection team identifying suitable sites for a nuclear power plant, the inauguration of a waste facility for low and medium level waste and the award of a contract to build a 5MW research reactor.

Other countries in the region plan to follow suit: at the conference we heard from representatives from Bahrain and Yemen who are considering nuclear power. Separately the Kingdom of Saudia Arabia recently launched plans to consider the feasibility of nuclear power, and Qatar, Kuwait and Oman are reputed to be engaged in similar plans.

However it was clear from all the speakers that one of the big unresolved issues for many of them (and for some countries in the region this will be more critical than for others as there is a vast disparity in wealth), is securing the financing that will be necessary to pay for these very capital intensive projects. There was a good deal of debate on whether project financing, which has been successfully used in a number of countries in the region to finance significant power and water projects, could be the answer.

As the global nuclear renaissance marches on and the world becomes more familiar and relaxed about nuclear technology it seems likely that in due course there will be a nuclear power project that is project financed. For now though, risks that will concern lenders of project will be many and varied but are likely to include political risk, the reliability of the chosen technology and the reliability of the price to build it, the legal and regulatory frameworks including the robustness of the licensing regime and the nuclear liability regime, demand risk and so on. Arguably, many of the mitigants to these risks (eg robust licensing frameworks, de-politicised decision making, compliance with international conventions on third party nuclear liability) are more readily found in countries with experience of nuclear power and which are well immersed in the nuclear industry, rather than countries seeking to build their first nuclear power plant. Jordan may be an exception that proves this rule though as it has clearly evinced an intention to adopt a PPP model for delivery of its nuclear power ambitions. Indeed Abu Dhabi is also reputedly about to appoint a further set of financial advisers which suggests they again might be about to break new ground. Time will tell.

It must be the case though that not every Middle Eastern country claiming an interest in nuclear power will be successful. The reasons are well documented in the industry and the problems well rehearsed – there are serious shortages in the supply chain to meet the current and predicted global demand, there are insufficient people with the sufficient skills and experience to meet the current and predicted global demand, and perhaps even more obviously the economics don’t make sense: if most countries in the region have a nuclear power plant, to whom will they all export their electricity?

The case of R.D. Harbottle (Mercantile) Limited v National Westminster Bank Limited and Others [1977] 1 WLR 752 concerned guarantees by sellers, confirmed by banks, in favour of buyers. The amount secured was payable on the buyers’ demand. The sellers had provided cross indemnities in very wide terms to the banks, enabling the banks to deduct any payments made from their account; the bank’s demand being conclusive evidence of the sum due.

The buyers demanded payment from the banks (Nat West and others) but the sellers contended that there was no justification for the demands and made an application to the court seeking declaratory relief to that effect and also applied for injunctions restraining the banks from paying, and the buyers from demanding payment, under the guarantees. On an interim basis, the Plaintiffs secured ex parte injunctions against the banks.

Nat West applied successfully to have the injunction against them discharged. Kerr J (as he then was) explained the rationale behind the Court’s approach to such cases:

“It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by banks. They are the life blood of international commerce… Except possibly in clear cases of fraud of which the banks have notice, the courts will leave merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts. The courts are not concerned with their difficulties to enforce such claims; these are risks which the merchants take.” [at p.761]

Kerr J was also the judge at first instance in the Edward Owen Engineering case . In the Edward Owen case the Court of Appeal approved Kerr J’s decision in Harbottle and held that a performance bond stood on a similar footing to a letter of credit and that a bank giving such a guarantee must honour it according to its terms unless it had notice of clear fraud. (see Denning MR at p.169 and 171)

In Edward Owen, Denning LJ referred to the authorities concerning letters of credit and cited the American case of Sztein v J. Henry Schroder Banking Corporation (1941) 31 NYS 2d 631 heard in the New York Court of Appeals. In that case the Court had upheld a challenge on the basis that the bank had knowledge of the fraud prior to the presentation of the documents for payment. Shientag J said:

“…where the seller’s fraud has been called to the bank’s attention before the drafts and documents have been presented for payment, the principle of the independence of the bank’s obligation under the letter of credit should not be extended to protect the unscrupulous seller.”

In his judgment in Edward Owen Lord Denning described a performance bond as a “new creature” (ibid at p.169A), and he concluded that:

“the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a performance guarantee must honour that guarantee according to its terms… The only exception is when there is a clear fraud of which the bank has notice.” (ibid at p. 171)

As far as fraud was concerned, Lord Denning confirmed that it was not enough simply to allege fraud, it had to be established. In fact it had to be, “very clearly established.”

These cases, decided thirty years ago, established the “fraud exception” as a principle in English law. Lord Denning’s statement that any fraud must be “very clearly established” for the exception to operate has been recognised and applied consistently since that time as recognised in the case of Enka Insaat ve Sanayi AS v Banco Popolaire Dell’Alto Adige SPA; Enka Insaat ve Sanayi AS v Cassa Di Risparmio Di Bolzano SPA [2009] EWHC. Teare J noted the consistency of tribunals post “Edward Owen” when faced with this issue:

In Turkiye Is Bankasi AS v Bank of China [1996 2LLR 611, Waller J held (and was approved by the Court of Appeal):

“That passage identifies the difficulty that a plaintiff has in succeeding in stopping payment on a performance bond. He may show an arguable case that the demand is not honest, but that it not sufficient. He must also establish that: “the only realistic inference is that the demands were fraudulent.”” (P.616)

Rix J looked at the same issue in another way in the case of Czarnikov-Rionda v Standard Bank [1999] 2LLR 187:

“However the fact that the claimant gets the benefit of a lower standard of proof for the purposes of a pre-trial hearing, places on the Court, as I believe the cases demonstrate, an additional requirement to be careful in its discretion not to upset what is in effect a strong presumption in favour of the fulfilment of the independent banking commitments.” (p.202)

In Solo Industries v Canara Bank [2001] 1WLR 1800, Mance LJ cautioned the court against allowing any dilution of the presumption in favour of upholding independent banking obligations. Equally in Banque Saudi Fransi [2007] 2LLR 47, Pill LJ noted that the task of demonstrating a “real prospect” that at trial it could be proved that the beneficiary calling the bond could not honestly have believed in the validity of the demands was “a high hurdle, as the authorities in my judgment recognise.” (p.55)

In Enka the Court had little difficulty in concluding that the “fraud exception” while alleged, had come nowhere close to being proved sufficiently even to meet the “real prospect” test necessary to obtain leave to defend an application for summary judgment. The case is of course decided on its own facts but it is interesting to note that the Court required only that the beneficiary should have held the belief that there had been breaches of the contractual obligations of the sub-contractor. The Court held that upon the true construction of the APG and PG there was no necessity for there to be any causal connection between the allegation of breach against the sub-contractor and the amount of the sums claimed.

In arriving at his construction of the guarantees Teare J was keen to emphasise that it was necessary to bear in mind the nature of performance guarantees or bonds as explained in the authorities. In particular, in Cargill International v Bangladesh Sugar and Food Industries Corporation [1996] 2 LLR 524, Morison J said, when considering an application for an injunction to restrain a call on a bond;

“However, it seems to me to be implicit in the nature of a bond, and in the approach of the Court to injunction applications, that, in the absence of some clear words to a different effect, when the bond is called, there will, at some stage in the future, be an “accounting” between the parties in the sense that their rights and obligations will be finally determined at some future date. The bond is not intended to represent an estimate of the amount of damages to which the beneficiary may be entitled for the breach alleged to give rise to the right to call.” (p.528)

When read in that context the Court had no hesitation is dismissing the claim of fraud on the basis that when the calls on the guarantees were made there was no obligation on Enka to state that it had an honest belief that it had suffered damage in the amount claimed under the PG, or that it was entitled to payment equal to the sums demanded under the APG. On a true construction of the guarantees, there needed only to be an honest belief in the allegation of a failure on the part of the sub-contractor to fulfil its obligations under the sub-contract. The fact that the loss was not as much as the value of the guarantees, or indeed even if it could be shown there was no loss, was immaterial to the bank’s obligation to pay . In order to avoid the obligation to pay, the banks had to show that the only realistic inference was that when the demands were made, Enka could not honestly have believed in the validity of their demands.

What the authorities here demonstrate is that while the fraud exception is an established part of English jurisprudence, which in principle gives rise to a right to avoid payment of a demand on a performance bond, in practice it seldom operates successfully so to do.