The Project Finance Law Review: Counterparty Risk
The risk attached to counterparties supplying feedstock or offtaking project product are usually termed 'supply risk' and 'offtake risk'. These risks are associated with the inputs and outputs of a project and the failure of suppliers (or users) or offtakers to pay or otherwise perform their obligations. While the risk profile of these issues will be very different depending on the project, some methods of mitigation of these risks through contractual arrangements with suppliers, users or offtakers are similar.
II Supply and offtake risks
i Supply risk
Many projects rely on raw materials or commodities for a project to succeed. For example, a coal or natural gas-fired power plant requires access and rights to an uninterrupted supply of coal or natural gas. Similarly, a waste-to-energy project relies upon a supply of waste input (and often the gate receipts received by the project as a disposal price will underpin the economics of the project rather than the revenue from power sales).
The prices of these raw materials or commodities can be volatile and their availability for the life of the project may not be assured.
Similarly, any tolling structured project will generally require consistent usage to be financed regardless of the sector where the financed infrastructure may be used (e.g., a liquefied natural gas (LNG) train for an oil and gas development or rail and port infrastructure for a bulk mining commodity project).
ii Offtake risk
An important consideration for any project financier is whether the project will generate the expected revenues from sales of product produced or, at least, sufficient revenues to service the debt and pay the project company's expenses (and, preferably, to generate a return for the project sponsor). In addition, the parties must consider how revenue shortfalls, if they occur, will be addressed. Usually, lenders will carry out considerable due diligence on the relevant market for the project product, using market consultants.
To ensure the project generates the level of revenues that the project participants forecasted for the success of the project, proponents will often enter into offtake agreements to contractually allocate the risk to creditworthy offtakers.
iii Price risk and variations across sectors
Counterparty risk is to an extent inseparable from market price risk as it is usually where the price for the relevant commodity being supplied or purchased (or underpinning usage in a tolling model) fails to meet its forecasts where counterparty risk presents a significant issue for a project's financing.
While these risks and issues apply to all projects, there are variations across industry sectors and it is important to consider the risks and mitigation methods that apply in the context of the relevant sector.
III Strategies for risk mitigation
i Long-term supply or offtake agreements
The project participants can mitigate both supply and offtake risks by contractually allocating these risks to counterparties through long-term agreements.
On the supply side, a long-term supply agreement insures or guarantees the project company's access to key supplies at a pre-agreed price for an agreed period. Similar contracts may be put in place for long-term use.
In Australia, the project financings of both the US$2.4 billion Newcastle Coal Infrastructure Group2 and the US$3.5 billion Wiggens Island Coal Export Terminal (WICET)3 were underpinned by ship-or-pay arrangements for rail and port infrastructure for coal exportation. In 2018, US$2.5 billion of the senior debt for WICET was refinanced in challenging circumstances, not least because of the insolvency of three of the eight take-or-pay shippers that underpinned the original financing structure, leaving the remaining shippers with a heavier debt load that was supported through their ship-or-pay pricing.4 Despite these insolvencies, the nature of the ship-or-pay arrangements allowed for a solvent refinancing, albeit in a challenging context.
However, it may be that a long-term agreement is not in the best interests of the project company. For example, if prices drop significantly, the costs under the supply agreement may be significantly higher than what the project company can obtain in the spot market (that is, were it to be purchased at the prevailing market price in the relevant market). Moreover, even at a premium price, long-term certainty of supply is not available in some markets, perhaps for reasons relating to the required volumes or the specialist nature of the supplies required. Periodic price review mechanisms provide parties with some protection against market volatility in long-term agreements and the ability to renegotiate a price that is more aligned with the market at the relevant time. However, from a financing perspective this also presents risks as financiers will wish to ensure that their forecast pricing is in line with any renegotiated price.
On the revenue side, ideally from the project financiers' perspective the project proponents will secure a robust offtake contract on a take-or-pay or other firm basis. The offtake contract may take the form of a power purchase agreement (for a power project), a gas or LNG sales agreement (for an LNG project) or a sale agreement (for a mining project).
In a take-or-pay agreement, the buyer must take and pay for or alternatively pay (as liquidated damages) the contract price even if it does not buy or use the entire agreed amount of the relevant product being produced by the project. Where any such payment is made, the purchaser is sometimes entitled to receive an equivalent amount of product at a later date.
Similar to a supply agreement, offtake contracts are typically for a pre-agreed period at an agreed price. However, project products may be highly or somewhat commoditised or marketable (or both) such that sales on a shorter term or spot basis at prevailing market prices may be more appropriate or achievable for the relevant product's market. This will be particularly so where the project product is highly traded or where there are a large number of potential buyers as opposed to products for which there is a limited market and associated small pool of available potential offtakers.
Pricing under offtake agreements may be critical and, depending upon the particular project product and its market, project financiers may require price certainty. Alternatively, financiers may take some or all of the market price risk, but seek certainty around volume of offtake to gain assurance regarding revenue flow.
Depending upon the market for the project product, it may be a priority for the project company to enter into appropriate marketing arrangements. Often, project sponsors (or their relevant marketing affiliates) will act as a marketer of project product and sell the product on behalf of the project participants as they may have relevant experience, relationships and portfolio that they can utilise in return for a fee or alternative remuneration or benefit (for example, the right to purchase or sell a volume of product).
ii Selecting a qualified supplier, user or offtaker
The supplier or offtaker must be creditworthy and financially sound so that the likelihood of it suffering a cash flow issue or insolvency event is minimised. Similarly, where a project company is particularly dependent on the skills of a marketer, the financiers will likely be concerned to verify the financial health of, and ongoing participation by, that entity.
On the supply side, if the raw materials or commodities are being sourced from politically or economically volatile jurisdictions, the parties may want to consider a supplier with a global reach who is able to source the materials from less volatile places, if required.
Where offtake agreements are entered into after closing, financiers may require that any offtaker have a minimum credit rating or otherwise satisfy minimum financial standing tests, and perhaps criteria in relation to diversity of portfolio of offtakers.
Often the financiers' relationship with the offtaker group will be critical to the bankability of project financings for resources projects. Offtake arrangements into the financier's home country may determine eligibility for certain export credit agency or development bank support and long-term access to commodities for home markets may be an important policy consideration for those institutions. Similarly, commercial banks normally will be more attracted to and far more likely to support a project financing where the contracted offtaker for the project has an existing relationship with the bank. Often, financially strong offtakers may play a significant role in securing financing for junior resources companies through their connections and relationships.
Sometimes, supply or offtake will be entered into by project sponsors or their affiliates, which is a significant risk mitigant as financiers can be confident that equity interests and suppliers' or offtakers' interests are aligned in supporting a successful project. Sponsor commitment supports other contractual involvement in a project generally, and is often a key assessment criteria for financiers. While understanding of the sponsors' need for flexibility in recycling capital, financiers often will be keen to ensure that key suppliers, users or offtakers commit to retaining an equity participation in a financed project over its term.
For example, the US$24 billion Ichthys LNG project supported US$20 billion of limited-recourse financing from export credit agencies and bank lenders. At the time of the financing, the project was owned by a sponsor group led by Inpex Corporation of Japan and Total SA of France. Ownership interests were also held by affiliates of Japanese utility companies involved in the offtake of LNG from the project including Tokyo Gas Co Ltd (1.575 per cent), Osaka Gas Co Ltd (1.2 per cent), Chubu Electric Power Co Incorporated (0.735 per cent) and Toho Gas Co Ltd.5
Two Japanese consortia together account for almost 60 per cent of the offtake, with CPC Corporation taking approximately 20 per cent. The balance of the LNG offtake was allocated to be taken by the Inpex and Total groups.6
iii Deliver: use-or-pay or take-or-pay provisions
Often, project participants will seek to enter into take-or-pay or liquidated damages arrangements for failure to supply or take offtake to underwrite a financing.
Supply agreements will generally include damages regimes for failure to make supply available.
In contrast, tolling or merchant arrangements, where the infrastructure company typically takes low project risk, provide for a limited reduction in fees payable to the infrastructure provider if the infrastructure or services are not available to users. Use-or-pay provisions are included in tolling agreements to provide the project company with a minimum assured revenue stream to ensure adequate returns from the capital investment. If the returns from the tolling arrangements are considered too low to compensate the infrastructure operator for early-stage construction or technical risk (or both), the operator may seek greater exposure to the rewards (and risks) of the whole project through participation in production or marketing.
These type of contractual arrangements and project structures may also be used where it is commercially favourable to isolate and separately finance the relevant infrastructure without the lenders being exposed to upstream development risk. For example, the Australia Pacific LNG project financed only the LNG downstream infrastructure and the upstream development was funded by equity. Gas was supplied under the master gas supply agreement entered into between the seller of gas derived from the upstream coal seam gas fields, and the borrower, as the buyer of gas for processing into LNG.7 Similarly, financing FPSO projects on a tolling model would allow for similar risk insulation from upstream risks.
Sometimes, the nature of the supplier will be such that minimum amounts are not achievable and any commitment to supply may be limited to the particular input available. For example, in waste-to-power projects, regional or local government entities are often unwilling to take risk (and potential liabilities) relating to amounts of waste produced so may only commit to supply what is produced. In such circumstances, financiers may need to rely on market supply forecasts to assess the supply risk.
In the case of offtake agreements, a robust take-or-pay provision (for price and volume) will require the buyer to take delivery, other than where that failure is solely attributable to the actions of the seller, and the buyer is not otherwise excused from taking delivery under the relevant offtake agreement (e.g., circumstances of force majeure may excuse the buyer from taking delivery). Generally, if a traditional take-or-pay model is adopted, then a buyer will be required to pay the project company if it fails to take and has a right to receive an equivalent volume of product at a later date.
An alternative model that is common in liquid markets and in the oil and gas industry is for the seller to receive liquidated damages in an amount equal to the seller's direct damages arising as a result of the buyer's failure to take or an agreed percentage of the quantity of product scheduled to be delivered multiplied by the expected price of the product. The buyer's obligation to pay those damages can be triggered on an annual, monthly or per cargo basis depending on the nature of the product being sold.
A project company (as seller) may have some obligation to mitigate its losses. This is particularly the case for less marketable products such as, for example, speciality metals where the total market for each metal is small, dominated by few producers and easily disturbed by new large producers. If possible, care should be taken to ensure that a project company's contractual obligation to sell in mitigation does not require it to prejudice its broader commercial or strategic interests, including the impact on the market pricing for the product, or the supply and demand of the product. Even where there is no contractual obligation to mitigate losses, an obligation to use reasonable endeavours or some other standard to do so may be implied at law. Generally, liquidated damages are calculated by reference to estimated direct damages.
Any cap on take-or-pay liquidated damages should also be closely considered. For highly traded products, a lower cap may be acceptable, whereas for less liquid products, a 100 per cent cap may be desirable. Higher caps also apply in the case of wilful default or gross negligence and may be used as a mechanism to disincentivise parties acting in their own commercial interests. Reciprocity between the seller and buyer or user in respect of the damages caps should be carefully assessed.
Pricing negotiations will often be challenging in take-or-pay arrangements. Project financiers will ideally want to achieve price certainty for the projected production sufficient to service debt. It will come as no surprise that long-term fixed prices are usually not reflective of the normal practice in commodities markets.
In many cases, the market pricing convention is sufficiently established that market participants will not be willing to agree to depart from it and financiers may consider a market sufficiently established that they are willing to accept some pricing risk. For example, financiers may accept gas and LNG price risk for projects (set against the usual market indices such as, for LNG, Henry Hub, S-Curve, Brent or JCC), but may seek some comfort on volume of offtake.
However, where markets for particular project products are not as developed and future pricing is less certain, project financiers will often seek a floor price for offtake contracts (perhaps subject to an escalation mechanism like the Consumer Price Index). Understandably, this will usually be the subject of significant negotiations with offtake counterparties. Offtakers will understandably resist a floor price under which they absorb the risk of a downturn in market pricing. Sometimes offtakers, particularly in shallower markets where the relevant market may be dominated by a small number of buyers, may expect that any agreed pricing will include a price ceiling as a quid pro quo for their support of a particular project and their provision of some certainty around offtake volume. There may be sound commercial reasons for the buyer's position. It may be the case that, for example, the buyer is a particularly strong counterparty, enjoying a degree of market power, and they risk prejudicing their existing supply arrangements through entering into a future offtake arrangement to support a development project that is not yet in production.
Project proponents will commonly be unwilling to trade the benefit from a potential commodity price increase (e.g., through a price ceiling) for the reciprocal downside protection of a price floor that project financiers require. This might be a difficult compromise to accept if a proponent's equity investor base is motivated by potential commodity price rises.
Project financiers should beware of other contractual provisions that may compromise pricing or volume.
For example, in minerals projects, the calculation of any deductions in relation to items such as separation and refining costs and distributor margin should be carefully considered as well as their mechanisms for verification. It should be considered whether any pricing adjustments can be fixed for greater certainty.
A right of rejection for out-of-specification product is often a feature of commodity sale agreements. The ability to reject volume for specification reasons should be carefully considered and technically assessed, together with rights to claim compensation if this arises. This is particularly important in projects where the delivery of off-specification product may have a significant impact on other customers or related project infrastructure.
In addition to direct assignments, consideration should be given to whether change of control provisions to regulate indirect transfers should be included. Whether these should be restricted will largely turn on the creditworthiness of the supplier or buyer and whether a parent company guarantee or some other form of credit support is provided by the supplier or buyer. Consideration should also be given to the extent to which the project relies on the technical or operational capability of the counterparty (or other members of its group) as this may be another reason to limit a party's right to transfer.
Force majeure events that relieve the supplier or the buyer of their obligations, particularly any take-or-pay, deliver-or-pay, or use-or-pay obligations should be carefully considered. Often there will be a limited extension of the supply or purchase term. Usually, force majeure provisions would also allow for termination in circumstances of prolonged force majeure. Market practice in respect of force majeure will vary across sectors. While use-or-pay contracts for infrastructure projects typically include very limited relief for the user from the obligation to pay for capacity, in the minerals or LNG sectors relief may generally be more broadly permitted.
It should at least be ensured that any supplier or buyer will not be entitled to claim that a change in market conditions is a force majeure event and no economic hardship or equivalent provisions should be included for their benefit if a deliver-or-pay or take-or-pay obligation is to be robust. To the extent possible, force majeure provisions should be carefully checked against insurance coverage to ensure any gaps in supply or revenue risk mitigation are closed or identified for consideration.
Other provisions that should be carefully reviewed include sanctions and anti-corruption provisions that may allow counterparties to suspend or terminate obligations in a broad range of circumstances, which may not be in the buyer's or the seller's (or the financier's) commercial interests.
In relation to revenue risk, whether the commodity is sold FOB (free on board) or ex-ship, lenders will wish to understand the details of how the shipping will be arranged and any risks involved. Each step of the supply chain is critical in ensuring that the cash flows from the project are sufficient to repay project debt.
iv Hedge agreements
Commodity price-hedging agreements (through swaps, options or forward sales) may allow the project entity to receive payment from a third party if the price for the project's output on the spot market falls below a certain amount. Alternatively, hedging agreements may allow the physical delivery of the product into a fixed price (or a price floor), also mitigating downside price risk.
Whether commodity price hedging is available for the particular project commodity will depend upon the depth of the market and the corresponding willingness of hedge providers (typically banks) to accept commodity price risk and indeed pass some of that risk off to others.
Precious metals have relatively deep hedging markets and while project financiers may be willing to take offtake risk in respect of these metals because of the deep markets and relative predictability of future pricing, they may insist that some or all of the price risk is hedged through commodity price hedging depending upon the maturity profile and debt sizing of the project. On the other hand, metals such as iron ore have a shallower hedging market where hedging may only be available for a relatively short period. While that hedging market may develop over time, that will not be sufficient to significantly mitigate price risk on a project that has an expected mine life of 20 to 30 years or longer. Also because of the lack of market clarity for some metals, there may be no hedging available.
v Cash sweep and reserve accounts
As mentioned above, if the project product is to be marketed openly, particularly in commoditised or volatile global markets, the project company may be exposed to significant offtake risk.
In addition, or as an alternative to entering into hedging arrangements, the project company may be required by the financiers to set aside cash in a secured account designed to be used where volatile revenues are insufficient to meet debt service obligations.
Of course, this type of reserving of cash will often come at a cost to the equity participants in the project company, so the scope of the arrangements is likely to be heavily negotiated or resisted by project proponents.
A cash sweep under which financiers share a percentage of the excess cash flow of a project, together with equity participants, that is then applied to mandatory prepayment of finance debt will also help mitigate the risk of volatility in commodity prices and is accordingly a feature of many resources project financing structures.
vi Contractual terms
A project financier needs to have an understanding of the key contractual risk mitigants that may be built into relevant contracts to mitigate counterparty risk as well as what is acceptable and achievable in the particular market and the trends at the time.
For example, in the LNG market there has been a trend in LNG sales agreements towards shorter term contracts and a more liquid and developed spot market. In this context, financiers may be more willing to accept some LNG price risk based on a suite of long-term and short-term supply contracts. Similarly, we have seen financiers be more willing to consider offtake arrangements without take-or-pay arrangements. Suppliers (and financiers) will rely upon the usual damages calculations for failure to take cargos against a more liquid spot market to underpin revenue risk. Typically, in this case the LNG sales agreements require the counterparty to pay the full value of a cargo that it fails to take and the seller is obliged to return the net proceeds of any sale to the buyer. So, the seller maintains revenue flow in this way.
In a more standard take-or-pay contract where the buyer has an annual rather than a per cargo take obligation, LNG sellers may require shorter term take-or-pay settlement periods of six rather than 12 months, which was more usual in the market to ensure that payments remain current and credit risk is more tightly managed.
Also, as new and less well established buyers enter the market, we have seen the LNG offtake market move towards requiring credit support such as letters of credit or parent company guarantees upfront rather than relying upon contractual provisions that allow for a seller to require credit support upon the occurrence of a negative counterparty credit event. In most LNG sale and purchase agreements, the seller has a right to suspend performance if there is a payment default, or if a letter of credit or parent company guarantee is not made available within the required time frame. During the suspension period, typically the buyer is considered to be in default and the seller is free to sell the product that would otherwise have been taken by the buyer. This preserves the seller's revenue stream and also enables it to claim damages for any losses from the buyer.
vii Letters of credit, parent company guarantees and other performance security
Letters of credit are a widely used means of guaranteeing payment and liquidated damages for performance, particularly in international trade. In Australia, bank guarantees often serve the same function. Letters of credit are often required to enhance counterparty credit risk, both in terms of financial credit standing and in terms of practicality of recovery against counterparties outside of the seller's home jurisdiction.
Letters of credit are carefully drafted to be irrevocable and unconditional, and are intended to provide the highest degree of payment security (subject, of course to the credit standing of the issuer).
Accordingly, requirements in relation to the creditworthiness of the issuer are worthy of attention (e.g., that the issuer be a financial institution of a certain minimum credit rating and that the letter of credit be replaced if it is downgraded below that minimum rating).
The following practicalities of claims should also be considered:
- the letter of credit should be in place before costs are incurred or at least before the product is loaded or delivered;
- the amount of the letter of credit should be considered closely within the market context. For example, in the context of mining commodities, the amount of a letter of credit may be set higher than the shipment value to cater for non-payment issues such as demurrage. For certain commodities, 115 per cent of the shipment value is market standard, although sometimes the percentage is set at less than 115 per cent (but it is usually a minimum of 100 per cent);
- a claim should be able to be presented at an office at a convenient jurisdiction;
- the expiry date of the letter of credit (or other instrument) should leave sufficient time to consider and make a claim if the relevant obligation is not met. A letter of credit expiring before a counterparty is able to claim under the terms of the relevant contract can cause significant detriment to project proponents and their financiers, but it is not a scenario that has been unheard of;
- if the letter of credit requires documentary presentation, it should be ensured that those documents (such as a demand in the relevant form) can be obtained without cooperation from the counterparty;
- in some jurisdictions there are insolvency law advantages to direct pay (rather than standby letters of credit) that can remove any argument of preference risk;
- ideally, the issuer of the letter of credit (or other performance support) will be required to satisfy the claim immediately or in a very short period of time to reduce any risk that the counterparty providing the letter of credit might take legal action to attempt to thwart payment, such as an injunction based upon a counterclaim; and
- from a financier's perspective, effective security over the letter of credit should be considered, including whether the security agent should be named as a beneficiary.
In some markets, insurance bonds are increasingly being used as performance security in place of letters of credit or bank guarantees. These are insurance products for which a premium is paid and cross-indemnities are given. As between the insurer and the party providing the bond, no cash collateral or less than 100 per cent cash collateral may be required, providing cash-flow benefits to the party giving them. Insurance bonds are generally considered riskier security, and financiers should ensure that these are in fact irrevocable and unconditional if they are accepted as a replacement to traditional bank letters of credit.
Parent company guarantees are another common way of enhancing a counterparty's credit standing. Often, supply or offtake agreements may be entered into by operating subsidiaries of corporate groups. While an operating subsidiary may have sufficient credit standing for its ordinary course trading, where the supply agreement or offtake agreement is for a particularly long term or for a very significant value then project financiers may require enhancement of the credit of the subsidiary where the subsidiary's own assets and business are not sufficient to support the relative counterparty risk. Of course, it does not necessarily have to be the parent to provide a guarantee; credit enhancing guarantees can be provided by other affiliates of the relevant counterparty.
The terms of any guarantees should be carefully considered, for the following issues, among others:
- parties to a guarantee will often negotiate whether the guarantee is a primary obligation (allowing recovery from the guarantor directly without reference back to the underlying contract and without the need to sue under that contract for breach) or, more usually in this context, a contingent obligation;
- any separate limitation of liability under the guarantee requires consideration, as do rights of set off and counterclaim; and
- the guarantor should consent and agree to any changes to the underlying agreements to ensure the guarantee is not compromised.
viii Insolvency laws
A project financier should also assess the impact of insolvency laws on relevant counterparty risk positions.
For example, Australian insolvency law contains ipso facto rules designed to provide greater opportunities to restructure failing businesses during external administration. This legislation restricts enforcement of contractual rights (including termination) triggered by certain insolvency events.
Without detailing the provisions, the legislation may result in a project company not being able to terminate a long-term supply agreement or commodity sales contract solely for the insolvency of its counterparty, without a performance breach. While there will usually be some sort of performance breach in due course, this legislation could make management of counterparty insolvency (and the replacement of the relevant contract) more challenging.
Australia is not alone in the global trend towards implementing legislation aimed at assisting the restructuring of businesses and preserving jobs. Accordingly, the relevant legal framework should be considered in assessing counterparty risk.
1 Ben Farnsworth is a partner at Allens.
2 'Newcastle loads the deal' Project Finance International dated 15 December 2010.
3 'Asia-Pacific Awards' Project Finance International dated 18 December 2011.
5 'Ichthys LNG Project Completes Project Financing Arrangements' media announcement by INPEX Corporation dated 18 December 2012 (www.inpex.com.au/media/4ysmaf51/ichthys_lng_project_completes_project_financing_arrangements.pdf).
6 'Ichthys LNG – The biggest, ever', PFI Project Finance International 500th Edition Special Report, March 2013 (www.pfie.com/ichthys-lng-the-biggest-ever/21071972.fullarticle).
7 'Australia Pacific LNG – A case study' Project Finance International dated 13 March 2013.