Project Finance in the Energy Industry: An Integrated Approach to Credit Risk Assessment

Abstract

Project finance has emerged as a leading way to finance large projects in energy industry. The basic characteristic of project finance is that lenders loan money for the development of a project solely based on the specific project’s risks and future cash flows. This highlights a key feature of project finance due to the capacity to generate cash flows to ensure the repayment of loans and adequate returns on equity capital. A revenue stream from the project large enough is a prerequisite for project financing. The paper aims to assess the drivers of credit risk in project finance. Credit risk is one of the risks to which the project lenders are exposed. In particular, the proposed paper aims to analyse some critical issues related to credit risk assessment by lending banks. It is particularly complex to evaluate credit risk because of large infrastructure projects in energy industry, large sums of capital required to finance energy projects, new technologies involved, complex project agreements, legal and contractual structures, state-level regulation and tax treatment. The creditworthiness of the project is a fundamental structural component that characterizes any project finance transaction. It has a huge impact not only on borrowing costs, lending contracts, capital raising, and project feasibility, but also on project marketability, contractual commitments, structures of investments, guarantees, and private-public partnerships. The credit risk assessment of project finance will determine whether lenders view the project as financeable. Energy projects usually require a long time period to execute and obtain a return on investment. This critical aspect requires the identification of appropriate investors and adequate financial structures of energy projects.