Analysing Extreme Events

Navigator Flood Appeal – Analysing Extreme Events

Analysing Extreme EventsRaising awareness of low frequency, high impact events

An initiative by Navigator Project Finance in partnership with Allens Arthur Robinson

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Analysing Extreme Events

Introduction

• Catastrophic events occur more frequently than commonly believed

• If the return period of an event is 30 years, your project has a 1/30 (~ 3%) probability of occurring every year

• The longer the project life, the greater the chance of a major disaster affecting your project

• Many sponsors and banks are not prepared for a catastrophic event

• It is essential to be prepared – don’t be caught out

“By failing to prepare, you are preparing to fail” - Benjamin Franklin

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Why this seminar ?

• To share our knowledge and experience in best practice structuring, the force of nature and its impact on people, projects and markets

• To show our support for Australia’s flood victims.

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How can you help?

We encourage you to donate:

www.qld.gov.au/floods/donate.html

The Premier’s Disaster Relief Appeal

• Launched by the Queensland Premier, Anna Bligh, to help those affected by the wide-spread flooding

• The Queensland Government had made a contribution of $1 million to start the appeal

• To date over $120 million has been raised by private, corporate and government donors

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Australian Floods 2010

• Affected an area the combined size of France and Germany

• 200,000 people affected

• Estimated reduction in Australia’s GDP of A$30 billion ~ CPI down 0.5%

• Insurance claims in excess of A$1.5 billion

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Navigator Project Finance

Navigator is a global project finance

consultancy firm. Navigator provides

a full range of project finance

services for investors, sponsors and

lenders, specialising in project

advisory, financial modelling and

training services globally.

With offices in Sydney, London and

Singapore Navigator’s clients and

projects are distributed globally. Our

consultative approach has made us a

natural choice for project bankers

and developers seeking dedicated

project services.

Allens Arthur Robinson

Allens Arthur Robinson is a

leading international law firm, with

more than 800 lawyers, including

189 partners. They have staff on

the ground in 14 cities and

eight countries across Greater

China, South East Asia and

Australia, and one of the most

extensive legal networks in the

Asia Pacific region. They are

committed to providing excellent

service; combining technical

excellence with commercial insight

to provide the clearest of answers.

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Assumptions

• In presenting this session we are making the assumption that the audience understands the broad concept of Project Finance and the process involved.

• Debt financing where the primary source of repayment is the cashflow generated by the project

• Reduced or no cashflows will result in covenant breaches and ultimately default on loans.

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Overview

• Introduction and recent events

• Project Finance - Basics

• Risks and mitigants

• Case study and impacts to project

• Monte Carlo simulation

• Summary

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Extreme Events

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Catastrophic Events – Force Majeure?

Varieties

• Acts of nature, such as fire, flood and earthquake

• Acts of man, such as war, terrorism and riots

• Acts of government, such as a general strike

• Impersonal acts, such as collapse of a financial system

• Disease outbreaks

What’s not force majeure

• Project specific strikes

• Anything within control of management

Major events are often easily forgotten and seen as “one-off”. They’re not limited to floods and have major impacts on cashflow.

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A glance at just the last decade….

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

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Project Finance Basics

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A reminder

Projects are evaluated based using strict debt ratios

• Debt Service Cover Ratio (DSCR)

• Loan Life Cover Ratio (LLCR)

• Project Life Cover Ratio (PLCR)

Project finance is generally long term financing based only upon the projected cashflows of a project.

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Debt Service Cover Ratio (DSCR)

• Usually calculated on a per period basis

• Depending on the project, DSCR is typically in the range of 1.25x – 2.00x

• Calculated asDSCR = Cashflow Available for Debt Service (CFADS)

Scheduled Senior Debt Service (P + I)

Calculation of the ability of the project to meet its interest and principal repayments

For more information

www.navigatorpf.com/tutorials/dscr-debt-service-coverage-ratio

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Loan Life Cover Ratio (LLCR)

• LLCR at commercial operations date (COD) is important as it reflects the project’s ability to repay its obligations when the debt amount is at its maximum

• Typically, it is in the range of 1.25x – 2.50x

• Calculated asLLCR = NPV (r, CFADS over remaining life of loan)

Opening balance of the debt in the period

Calculation of the project’s ability to repay its outstanding debt over the loan tenor


www.navigatorpf.com/tutorials/llcr-loan-life-coverage-ratio

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Project Life Cover Ratio (PLCR)

• Generally higher than LLCR due to the longer evaluation period

• PLCR could be less than LLCR, particularly in resource projects because of rehabilitation costs at the end of the project

• Typically, it is in the range of 1.50x – 3.00x

• Calculated asPLCR = NPV (r, CFADS over remaining life of project)

Opening balance of the debt in the period

Calculation of the project’s ability to repay its outstanding debt over the life of the project


www.navigatorpf.com/tutorials/plcr-project-life-cover-ratio

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Risks and Mitigants

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Risks

Some of a few factors which face a project over its life

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Mitigants

Common methods to mitigate project finance risks include

•Insurance

•Force majeure clauses in contracts

•Establishment of debt service reserve account

•Hedging with options rather than forwards

•Management initiatives

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Insurance

• Typically required by banks before approval of funding

• The different types of insurance cover include

• Construction and Erection All Risks (CAR/EAR) – covers damages and delays during construction

• Business Interruption – pays for running costs during disruption periods

• Debt Insurance – covers debt repayments during disruptions

• Loss of Profits (usually not required by banks) – covers potential profits that would have been received if there was no disaster

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Force Majeure

• Frees both parties from liability or obligation when a disaster happens

• A force majeure clause is usually included in contracts between the SPV and a number of parties (eg shipping companies, banks and off-takers)

• Not typically included in forward contracts

• Seek good legal advice to ensure a well constructed force majeure clause and coverage for all contracts

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Establishment of DSRA/c

• Banks often require a sponsor to set up a Debt Service Reserve Account (DSRA/c)

• Typically, it holds two quarters of future debt service (Principal + Interest)

• In the event where cashflows do not cover debt service, the DSRA/c will fund the shortfall

For more information :

www.navigatorpf.com/tutorials/dsra-debt-service-reserve-account

Establishing a DSRA/c at the end of construction ensures that limited shortfalls in the future can be serviced

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Hedging with Options

• Options give the user the right to exercise when price is favourable (ie when the option is in the money)

• Options require an upfront premium – they come at a cost

• Can be exchange traded in some instances

• In contrast, forwards must be exercised – product available or not!!

For more information :

http://www.navigatorpf.com/blog/gold-price-hedging

Options help avoid losses when sellable product is not available

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Management Initiatives

• Maintain a good relationship with bankers, key offtakers and suppliers

• Banks may readjust repayment schedule in the event of a disaster to match revised cashflows

• Plan ahead by assuming that a disaster will happen during the life of the project

• Constant project monitoring and risk review through full project life

• Source alternative suppliers in the event of a disaster

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Case Study: Impact to a Project

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The Situation

Our case study is based on an Australian greenfield gold mine. The following is key information relating to the project

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The Situation

Funding assumptions for the project are laid out below

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Project Diagram

BorrowerBanks

SPV

EPC Contractor

Operating Contractor

Offtaker 1Long term sales contract

Offtaker 2Long term sales contract

Shareholders

Insurance

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Gold Mine Metrics

In the base case, the project is showing these key metrics

Note the following

• No covenant breaches in Base and Bank Case

• Base Case geared post-tax IRR at 26.32%

• Base Case geared post-tax NPV at 56 M

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Base Case

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Disaster Strikes!

Flooding occurs “unexpectedly”

Consequences of flood include

• Widespread damage

• Ore stockpile partially washed away

• Production halted temporarily until water

recedes

• Mine to port infrastructure damaged

• Financial obligations cannot be met

• Offtake contracts cannot be met

• Working capital reserves used up

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Commercial Impact?

• Disruption to operations

• Variable cost decreases

• Insurance claims

• Debt repayments are not met (out of CFADS)

• Potential losses on hedging

• Reduction in value to all parties

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Disruption to Operations

• Revenue to the project is reduced/removed due to limited or halted production

• Unable to deliver against contracted volumes

• Affected party will have to negotiate with offtakers

• Alternative is to purchase product from a third party producer, which is likely to result in losses as spot prices will rise during catastrophic event

Production halt removes revenue.

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Variable Cost Decreases

• Variable costs are no longer incurred because of halted production and the exercise of the force majeure clause

• Fixed costs continue to be paid (eg. Overheads, wages)

• Business Interruption Insurance pays for fixed costs, likely with a delay of receipts of claims

Fixed costs are paid but

variable costs are very low

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Insurance Claims

• Depending on the type of insurance in place, the affected party can claim to recover construction cost and/or operating costs

• Insurance receipts tend to be delayed due to the nature of the business/claims process

Insurance pays for fixed

operating costs but there may be delays in receipt

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Use of DSRA/c

• No or limited revenue during delays

• Can apply for principal relief from banks

• With bonds, renegotiation is difficult due to the number of parties involved

• Rely on Debt Service Reserve Account (DSRA/c) to service debt. This is default, however banks may provide some relief.

DSRA/c releases cash to fund shortfall during the delay period

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Potential Hedging Losses

• Forwards may incur losses in the event of non-delivery

• Catastrophic events will reduce supply of products and drive prices up

• Payout the difference in prices

• The affected party may negotiate with the financial institution to roll over forwards to a future period

• Difficult/costly to reverse position

Forwards no longer act as hedges since there are no sales

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Reduction in Value for All Parties

• Financial ratios are badly affected due to minimal/no revenue

• Project and equity returns are reduced significantly

One quarter of delay results in covenant breaches which may lead to default

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Disaster Case (Without Insurance)

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Scenario Comparison

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Monte Carlo Simulation

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Monte Carlo Simulation

What is it?

• A technique that involves using random numbers and probability to solve problems

• A type of spreadsheet simulation which randomly generates values for uncertain variables repeatedly

• Calculates multiple scenarios of a model by repeatedly sampling values from the probability distribution for the uncertain variables

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Log Normal Distribution

• Assumes a small chance of the unexpected event happening

• Typically used for

• Stock prices

• Survival rates

• Failure rates

• Disasters

Probability distribution of a random variable whose logarithm is normally distributed

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Assumptions

• Input: Reduction in production in one quarter

• Distribution : Log-normal

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Result

• Range of IRR with different probabilities as a result of the simulation

• Pink area represents scenarios below the hurdle rate of 25%

• A disaster (which is recovered from) can severely damage a whole of life IRR

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Summary

When analysing a project, it is important to understand

• Return period of potential disasters

• Probability of the disaster happening during the life of the project

• The likely impact to the project and overall market

• Need for robust model to test downside scenarios

• Knowing the above, informed decisions can be made as to the structures required for your project

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Useful resources

For ongoing resources, training or to have us assess your project for its ability to withstand extreme events.

•www.navigatorPF.com

•Book onto Navigator’s International Project Finance course.

•Call us on +61 2 9229 7400

Economy & Finance

Analysing Extreme Events