Managing Revenue Risks in an Infrastructure Project
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.
Measures Used to Mitigate Revenue Risks
There are several measures that are commonly used by companies to mitigate revenue risks. Some of them have been listed below:
- Offtake Agreement: An offtake agreement is an agreement between a buyer and a seller of a product or service. Under this agreement, the buyer agrees to buy all or part of the goods that will be produced by the seller at a later date.
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.
- This feature comes in very handy since it helps ensure revenues. For instance, while constructing a power plant, a company may not be sure whether or not it will be able to sell all the power it generates. However, if it enters into an offtake contract, this uncertainty is done away with. The firm can be relatively sure that it will receive revenue at a later date. Hence, marketing no longer remains a concern, and the firm can concentrate on completing the project.
- The only problem with an offtake agreement is that it binds both the parties into a legally binding contract. Hence, if the infrastructure company is not able to hold up its end of the deal, it will have to pay demurrages and penalties to the other parties. Hence, it would be fair to say that offtake agreements should only be signed if the infrastructure company is relatively certain that their construction will not be delayed and that they will be able to provide the goods and/or services on the agreed-upon date.
- It needs to be understood that the infrastructure company is still taking a huge risk. They are assuming that the off-taker will be able to pay for the goods and services as per the agreed-upon schedule. There is always a credit risk inherent while making these kinds of assumptions. Hence, while entering into offtake contracts, it is necessary to ensure that the counterparty is working in a stable environment and will be able to honor their financial commitments.
- Long Term Contracts: A long term contract is like an offtake contract. However, it only removes the volume risk from the balance sheet of the infrastructure company. The price risk still remains with the company. These types of contracts are used when a firm is likely to supply products for many years.
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.
- Long term contracts can be used in conjunction with other derivative instruments. If that is done, the company can virtually determine a stable top line unless the counterparty goes out of business.
- Contract for Difference (CFD): A contract for difference is a kind of derivative arrangement which is commonly entered into to protect the investors from the volatility of the market.
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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- Infrastructure Finance: An Introduction
- Infrastructure as an Asset Class
- Infrastructure Finance Projects: Major Sources of Funding
- Why Doesn’t the Private Sector Invest In Infrastructure Projects?
- The SPV Structure in Infrastructure Finance
- Financing Needs of Infrastructure Projects at Different Stages
- Different Types of Contracts for Infrastructure Projects
- Distribution of Risks in an Infrastructure Project
- Risks Faced By Infrastructure Projects in Emerging Markets
- Bank Loans vs. Bonds: Debt Financing In Infrastructure Projects
- Key Decisions to Be Taken During Infrastructure Bond Issuance
- Parties Involved in Infrastructure Debt Issuance
- External Credit Enhancement in Infrastructure Financing
- Revenue Bonds and the Cash Trap Mechanism
- Managing Revenue Risks in an Infrastructure Project
- Cost Overruns in Infrastructure Projects
- Causes for Cost Overruns in Infrastructure Projects
- Third-Party Risks in an Infrastructure Project
- Vendor Finance in Infrastructure Projects
- Securitization in Infrastructure Finance
- Leasing in Infrastructure Finance
- Strategic Use of Land in Infrastructure Financing
- Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance
- Infrastructure Investments in Renewable Energy
- Should the Government be an Equity Partner in Infrastructure Projects?
- Lifecycle of Public Private Partnership (PPP) Projects
- Payment Mechanisms in Public-Private Partnerships
- Adjustment Mechanisms in Publich-Private Partnership (PPP) Contracts
- Early Termination of a Public Private Partnership