Major Types of Risks in Project Management

Whenever a new projects starts, it start with risk and uncertainty levels which sometimes create deadlocks for project completion. Project risk management ensures if risks are evaluated and decreased as assessment carried, then it increased opportunities. This is for sure project management cannot eliminate all risk from the project but with good planning and statistics level of risk can be minimized, and which will acceptable for project making. Some of risk can be beyond the range of control which can affect the project length or budget, for that instance planning should carry out before those risk hit to project and prior to unwanted events occurring. Analysis and planning are the factor for key to success for project management. In the start of project major decision are carried out which impact on multiple stages for the project which base on incomplete information or inaccurate. To ensuring the best decision policy it is needed to have all risk assessment n the start of project as early as possible, to make the decision very powerful and effective. Risk can occur in any stage of the project some are associated with particular task and some are distinct and may originate outside the boundary of project management.

Every project is different and it is not possible to compile an exhaustive list of risks or to rank them in order of priority. What is a major risk for one project may be quite minor for another. In a vacuum, one can just discuss the risks that are common to most projects and possible avenues for minimizing them.

Major Types of Risks in Project Management

1. Completion Risk

Completion risk refers to the inability of a project to commence commercial operations on time and within the stated cost. Given that project financiers are often reluctant to underwrite the completion risk associated with a project, project structures usually incorporate recourse to the sponsors during the construction stage. However, this link gets severed once the project starts generating its own cash flows. Hence, during the construction period, risk perception is significantly influenced by the credit worthiness and track record of the sponsors and their ability and willingness to support the project via contingent equity/subordinated debt for funding cost and time over-runs, if any.

The risks are also dependent on the complexity of construction, as greater the complexity (for instance, in the case of a petrochemical facility), higher the risks arising on this count. In addition, for projects with strong vertical linkages, the non- availability of upstream and downstream infrastructure is an important source of completion risk. Typical examples of such projects would be LNG, power, and toll road projects. In certain types of projects, such as ports and roads, project completion is also a function of the permitting risks associated with obtaining the necessary Rights of Way (ROW), environmental clearances and Government approvals.

Completion risks are usually mitigated through strong fixed price; date certain, turnkey contracts with credit-worthy contractors, along with the provision of adequate liquidated damages for delays in construction, which need to be seen in relation to debt service commitments. While assessing completion risk, adequate attention is also paid to the experience of the Engineering, Procurement & Construction (EPC) contractor and its track record in constructing similar projects, on time and within the cost budgets. Further, it looks at the reasonableness of the time available for project completion, and an aggressive schedule for project completion, which does not provide for adequate contingency provisions, is often viewed negatively.

2. Funding and Financing Risks

A project company’s financial structure and its ability to tie up the requisite finances are the focus of analysis here. The financing structure is usually reviewed for the capital structure of a project, which is evaluated to assess whether the debt-equity ratio is inline with the underlying business risks and that of other projects of similar size and complexity.

The protections provided to bondholders such as minimum coverage ratios that must be met before shareholder distributions are made, and the availability of substantial debt reserves to meet unforeseen circumstances. The matching of project cash flows (under various sensitivity scenarios) with the debt service payouts and the potential for cash flow mismatches.

The pricing structure adopted for debt and the exposure of the debt to interest rate and currency risks. Such risks are particularly significant where the project raises variable rate debt or liabilities in a currency other than the one in which its revenues would be denominated. The presence of an experienced trustee to control cash flows and monitor project performance on behalf of the bondholders.

Limitations on the ability of the project company to take on new debt. The average cost of debt, given that the cost of financing is increasingly becoming a key determinant of project viability, in view of the fact that differences in technical and operating abilities have virtually become indistinguishable among front-runners. Usually, most projects have a high leverage, and while equity is arranged privately from sponsors, the project would be dependent on financial institutions and banks for arranging the debt component. In assessing the funding risk, the extent to which the funding is already in place and the likelihood of the balance funding being available in time is considered, so that the project’s progress is not delayed.

3. Operating and Technology Risk

Operating and technology risks refer to a project’s inability to function at the desired production levels and within the design parameters on a sustainable basis. Such risks usually arise in projects using complex technology (power plants or refinery projects, for instance); for projects in the roads, ports, and airport sectors, such risks are usually of a lower order. Technology risk usually arises because of the newness of technology or the possibility of its obsolescence, most often seen in telecom projects.

Where technology is well established, the focus of analysis is usually on determining its reliability and the sustainability of the technology platform over the tenure of debt. The Independent Engineer’s Report (IER) is used to review and assesses whether the engineer’s findings support the views of the sponsors and the EPC contractor. Technology risks, where imminent, are usually mitigated through performance guarantees/warranties from the manufacturer, contractor or operator, and the availability of adequate debt reserves to allow for operating disruptions.

The sponsors would conduct a due diligence to establish the credit-worthiness of the technology suppliers/operators and the ability of these participants to compensate the project for failure of the technology adopted. The risks associated with disruptions in operations due to mechanical failure of equipment are usually mitigated through Operations and Maintenance (O&M) contracts.

Here again, sponsors evaluates the quality/experience of the O&M contractor, the familiarity of the O&M contractor with the technology being used, and the adequacy of the performance guarantees from the O&M contractor.

4. Market Risks

Market risks usually arise because of insufficient demand for products/services, changing industry structures, or pricing volatility (for input and also output). Given the long-term nature of project financing, a considerable source of market risk is the possibility of dramatic changes in demand patterns for the product, either because of product obsolescence or sudden and large capacity creations, which could severely affect the economics of the project under consideration.

For analytical convenience, one can group projects into two categories: one, which produces commodities (e.g. LNG projects, refinery projects, and power projects), and two, where certain natural monopolies exist (e.g. roads, ports, airports, power or gas transmission projects). While the first category of projects is exposed to most of the risks identified above, the market risks for the latter type of projects are more demand related, with the pricing usually being subject to regulatory or political controls.

Until recently, the implementation of some of these “commodity” projects, such as power and LNG projects, in the international markets was supported by long-term off-take contracts, which provided considerable comfort to project financiers. However, with the development of a spot market for these commodities, customers of such projects are not willing to commit themselves to such long-term contracts; this has considerably increased the market risks associated with such projects. Under these circumstances, cost competitiveness and the nature (regional or global) and adequacy of demand have emerged as critical determinants of a project’s long-term viability.

For instance, even in India, despite power projects being backed by off-take commitments and adequate payment security mechanisms, there are numerous instances where cost competitiveness has emerged as the principal mitigant against the rather well documented market risks associated with India’s power sector. Thus the point of focus, while assessing market risks for projects producing a commodity, is usually the cost structure of a project, which is a function of the capital costs incurred to set it up, the input costs and also the costs required to operate and maintain the asset.

One usually benchmarks the capital cost of a project with those of recently commissioned facilities across the world to ascertain the global cost competitiveness of the project; this is a key determinant of the project’s long-term economic viability. On the input side, the credit rating agencies looks at issues related to certainty of supply, ability of the supplier to meet contractual commitments over the life of the project, the pricing structure of such supplies, and the ability of the project to pass on variations in input costs. In situations where the primary input is scarce or is not actively traded, one attempts to evaluate the cost implications for replenishing shortfalls in supply and the availability of liquidated damages in the supply contracts for compensating the project for such costs. For the second category of projects, the primary focus is on evaluating the adequacy of existing demand, the potential for growth in demand and the possibility of alternative assets being created, which could undermine demand for the project being financed.

Assessing demand patterns for such projects, particularly road projects, is often a daunting task since in most cases, the demand is highly price elastic and a function of the pattern of socioeconomic development in the service area of the road.

One refers to “independently” conducted traffic/demand studies by reputed agencies to establish the veracity of the demand estimations prepared by the project sponsors.

5. Counter — Party Risk

As discussed earlier, a project involves a number of counter-parties who are bound to it by the contractual structure. Therefore, an evaluation of the strength and reliability of such participants assumes considerable importance in ascertaining the credit strength of the project. Counter-parties to projects usually include feedstock/raw material suppliers, principal off takers, and EPC contractors.

Even a sponsor could become a source of counter-party risk, as it needs to provide equity during the construction stage. Because projects have inherently complex structures, a counter-party’s failure can put a project’s viability at risk. The counter-party risks are usually addressed through performance guarantees, letters of credit and payment security mechanisms (such as escrows), most commonly seen in the case of power projects.

However, it has been observed that such contractual risk mitigants, however strong, may not be effective in insulating a project from this risk, unless the project is fundamentally cost competitive and makes commercial sense for all the project participants.

6. Regulatory and Political Risks

Political and regulatory risks continue to play an important role in the development of the project finance business in India. Most project financing transactions carry an element of political risk by virtue of the fact that they are often related to capital-intensive infrastructure development and the resultant goods/services are consumed by the masses, directly or indirectly.

Political and regulatory risks could manifest themselves in various forms, and significantly impact the economics of the project under evaluation. For instance, such risks may take the form of: Lack of transparency and predictability in the functioning of the regulatory commissions which are typically involved in granting licences, specifying the terms and conditions for use of infrastructure on a “common carrier” basis and fixing tariffs.

For instance, some of the stand-alone LNG projects being set up in the country require a change in regulatory policy for allowing them to use the available gas evacuation infrastructure on a common carrier basis. Resistance to increases in user charges for common utilities such as water charges, toll tax rates, and energy charges, despite such tariff increases being envisioned in the project documents. Changes in environmental norms, which could impact power plants and refinery projects by requiring them to invest substantially in meeting such norms.

Problems in acquisition of land, which are typical in the case of road projects. As is apparent from the discussion, regulatory and political risks are often difficult to quantify and also mitigate. While assessing such risks, an attempt is often made to understand the vulnerability of the project to such risks and also the nature of the relationship between the local/central Government and the project under review.

7. Force Majeure Risks

Project financed transactions, which are different from corporate or structured finance because of their dependence on a single asset for generating cash flows, are potentially vulnerable to force majeure risks. The legal doctrine of force majeure excuses the performance of parties when they are confronted by unanticipated events beyond their control. A careful analysis of force majeure events is critical in project financing because such events, if not properly recompensed, can severely disrupt the careful allocation of risk on which project financing depends.

Natural disasters, such as floods and earthquakes, civil disturbances, and strikes can potentially disrupt a project’s operations and hence its cash flow. In addition, catastrophic mechanical failure, due to either human error or material failure can be a form of force majeure that may excuse a project from its contractual obligations. Projects are usually not able to cope with force majeure events as well as large corporations, which have a diversified portfolio of assets.

It is therefore important that force majeure events be tightly defined, and that such risks be allocated away from the project through suitable insurance covers taken from financially strong insurance companies. One usually studies the nature, coverage and appropriateness of the insurance policies taken and also evaluates the adequacy of debt reserves for meeting debt service commitments in force majeure circumstances.

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