Cost Overruns in Infrastructure Projects
February 12, 2025
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Equity and debt are the most commonly used sources of funding when it comes to infrastructure financing. However, in many cases, revenue is also an important source of funding. This is because, in many cases, revenue from previous phases of the project is used to fund the construction of newer phases of the project, thereby leading to an expansion in the capacity.
For instance, if one part of a bridge has already been built, then the revenues generated by that part can be used to fund subsequent construction of the bridge.
Infrastructure projects generally take some time to reach maturity. Hence, during the earlier stages, the revenues from such projects cannot be considered to be very stable. As a result, companies use a wide variety of measures that are designed to reduce the riskiness of cash flows expected from past revenues.
There are several measures that are commonly used by companies to mitigate revenue risks. Some of them have been listed below:
An offtake agreement can be thought of as a futures contract. As per this contract, the buyer will be legally bound to purchase a certain quantity of goods at a predetermined rate on a certain date.
For instance, one company may agree to provide liquefied natural gas to another company for many years. However, the price of the gas may vary every day. As such, long term contracts are designed in such a way that both companies arrive at the same price. This is commonly done by benchmarking the price to a widely followed index.
A CFD agreement is a mechanism under which the price of an asset is fixed. Later, the seller has to pay the buyer money if the market value of the asset decreases further. On the other hand, if the market value increases, the buyer will have to pay the seller.
Using these contracts, infrastructure companies are able to fix the revenues which they will receive from the projects and shield themselves from the vagaries of the market.
Once an electricity company enters into a contract for difference agreement, they have locked in their prices regardless of where the market prices move in the future.
In its essence, a contract for difference is actually a swap contract that can be used to mitigate revenue risk. The biggest challenge here is finding a counterparty that is willing to hold up the other end of the deal.
The bottom line is that there are several measures to reduce the riskiness of revenues that arise from an infrastructure project. However, even after taking all these measures, the infrastructure company must be conservative while estimating the revenues. Failure to do so could mean financial duress for the firm in the future.
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