Thought leadership from our experts

Project Finance is “Hot” Once Again

Project finance lawyers have come to expect the unexpected and to see opportunity wherever plausible. In recent years, natural resource projects have been challenged by impaired revenues as commodity prices tumbled, and the renewables sector has dealt with uncertainty as tax incentives were debated; but things are now on the up. A number of legal journals predict that project finance will be one of the "hot" practice areas in 2017. This is largely attributable to the Trump administration's stated objective of making America's infrastructure great again with $1 trillion of much-needed investment. The new administration has also mandated lighter federal regulation, in particular environmental enforcement by the EPA, which has already begun to ease the permitting and licensing burden on a number of pipeline, power station and drilling projects. These policy initiatives are taking place just as the first signs of recovery in the oil, gas and other commodity sectors are improving the prospects for green-field development not only in the US, but across the globe. All of this presages opportunities that, although perhaps unexpected, are realistic rather than merely plausible. What remains to be seen is exactly which sectors and regions will be the most active in the months to come.

Large-scale projects have long been a feature of the global economy. Many of us learned our trade from reading case studies of the financing of rail projects in Argentina and of the Panama Canal in the early 20th century, and we developed our skills working on North Sea oil and gas and US independent power projects in the 1980's. Since then, there has been considerable variation in where projects are undertaken and in what they entail. Growing demand for natural resources has driven sponsors to exploit reserves in ever more remote locations. Global economic growth and urbanization has spurred the development of power, transport and other infrastructure projects in an ever-broadening range of countries, and technological advancement, most notably in the telecommunications and renewables sectors, has made possible new and innovative industries. As the focus of project finance activity has broadened, the range of economic and political influences on the pace of development has expanded commensurately, and thus predicting where, and what kind of, projects will progress at any given time has become more challenging.

The confluence of global economic recovery and a business friendly administration in Washington warrants an optimistic view of the overall current investment environment. Road and other transport projects, as well as water and electricity transmission and storage projects, will be targeted for investment. Plans abound for green-field power projects, both to meet new demand and to replace older, carbon-intensive plants. With the bottom of the commodity price cycle seemingly reached, the economics of the extractive and processing industries are on the mend. M&A activity has also picked up. Companies affected by the impact of low commodity prices have sought to sell assets to raise capital to fund ongoing operations or implement strategic projects. Governments continue to seek buyers for airports and other assets as a means of bridging funding gaps. This has, in turn, presented opportunities for those with access to capital (including funds and development companies backed by funds) to acquire assets in auctions and from distressed sellers.

Renewables have been a significant feature on the projects playing field, but the extent to which they remain so may turn in part on whether the momentum behind the implementation of the 2016 Paris Climate Agreement can be sustained. While there is little doubt that climate change has been moved down Washington's priority list, a significant number of States have adopted ambitious renewable portfolio standards that will continue to drive clean energy investment. The implication of reduced tax rates on the equity market for renewable projects needs to be assessed, but the effect may be limited to increasing the cost of capital rather than putting a real dampener on investment flows. For now, the drive towards carbon light power sectors in Europe, Latin America and even in the GCC appears likely to continue. In Asia, the effect of air pollution on urban centers should sustain the drive for clean energy, and we may see a shift in the region away from new coal-fired power plants to cleaner alternatives.

One of those cleaner alternatives is power sourced from nuclear energy. Despite the tightening of regulatory oversight (and consequent increased costs) following the Fukushima disaster, and the recent write-offs by Toshiba, a degree of optimism has returned to the nuclear sector. The past year has seen the Barakah nuclear power plant in Abu Dhabi finally reach financial close, the roll out of the UK government's plans for a nuclear new-build power plant at Hinkley Point, and the advancement of negotiations for new UK plants being developed by Horizon and NuGen. The Sinop nuclear power plant in Turkey is now moving into the feasibility stage, and India is implementing plans for a fleet of nuclear power plants. We can look forward to activity on one or more of these large-scale deals in the near future.

Can all of these projects be financed? Although the prospect of the withdrawal of the Basel IV initiative will be welcomed by most commercial banks, they will likely continue to face regulatory constraints in funding the long term loans needed to finance projects. The liquidity gap resulting from the reduced funding capacity of banks is being filled by private equity houses, which have raised significant funds to invest in senior and mezzanine debt products in the energy sector, and insurance and pension companies, including most recently those from Japan and Korea, which have announced multi-billion dollar investment programmes to fund infrastructure deals. Most (with the exception of the US) export credit agencies continue to finance exports from their domestic industries, and multilateral and regional development banks remain committed to fulfil their missions in the developing world. So there are deals to do and sources of capital to fund them.

However, our optimism should be somewhat tempered. We have yet to recover fully from disruption in the oil, gas, petrochemicals and metals markets. The potential of fracking technology (on the supply side) and the fragility of the Chinese economy (on the demand side) could still combine to keep prices low for years to come. Oil and mining majors are beginning to return to profitability, but they remain cautious about implementing all but the most critical large-scale investments. That said, these companies are opportunistic by nature, and where the feedstock or resource is sufficiently economic, investment will proceed at the earliest signs of a turn in the market price cycle. The impact of reduced engineering costs (as contractors compete for fewer deals), low iron, steel, cement and energy prices, and continued low interest rates, will tempt sponsors to embark on projects that may not begin production for several years on the assumption that, by the time commercial operations begin, output prices will have increased. Eventually, supply and demand will be brought back into balance and prices will rebound, as they always have, until the next cycle reaches its peak. The question is less whether investment take place than when and at what pace.

Optimism may also need to be tempered by the reality of geo-political volatility. It seems a very short while ago that many of us were embarking on the first major projects in Syria and Yemen, countries that are now in turmoil, or in Egypt and much of Eastern Europe, which also now face uncertain futures. For others, Africa has long been the market of the future, and so it seems to remain as the revolving doors of governments and their policies continue to turn. Large-scale oil and gas deals in Venezuela, once seen as stable investments, have been expropriated in the years that followed, and the corruption scandals that have swirled around Petrobas and other Brazilian state owned enterprises have led to losses for many investors. And what now of the prospects for Mexico behind a fence?

Although volatility has been a challenge across the globe, for every regional crisis there seems to be another opportunity. Indonesia, Vietnam and now even Myanmar are hosting large-scale projects, many of which seemed improbable after the last Asian financial crisis. With the closing of the financing of the massive Oyu Tolgoi copper mine, Mongolia is taking steps to reach its potential. In Latin America, Colombia, Chile and now Argentina are hosts to ambitious projects. Turkey, although politically unsettled, is pushing forward broad investment initiatives across a wide range of sectors.

The political climate across the Western economies is also somewhat in flux, presenting both opportunities and challenges. Having failed to predict both Brexit and Trump, most analysts are now naturally circumspect in their assessment of the impact of these election results, so we have little clarity on the consequences of a wide variety of new policies emanating or soon to emanate from Washington, London and Brussels. What we do know is that with the withdrawal of TPP, and the possible renegotiation of NAFTA, not to mention the imposition of a border tax, there will be a deterioration in global trade flows, which could be disruptive to a wide variety of industries. In terms of domestic American energy policy, the unifying themes for the Trump administration are only beginning to come into focus, but they will likely encourage an expansion of domestic drilling and pipeline construction, which may offset some of OPEC's efforts to raise prices. It remains to be seen what the Brexit process will bring and what the outcome of key elections in Europe will have on the broader EU vision. The direction of sanctions, which has deterred Western investment in the Russian and Iranian energy sectors, also remains uncertain. And a means to fund expenditure on infrastructure will have to be found in Congress, which may be particularly challenging at a time when tax rates (and consequently public revenues) will likely be reduced.

In a year presenting all manner of changes, some good, some bad, and many unexpected, navigating the current landscape will require experience, judgment and skill. Although the investment environment appears to be improving, there remains much to be cautious about as we consider where the most tangible investment opportunities will lie. Whether as project finance lawyers we will be supporting new green-field investment, focusing on M&A and acquisition finance, or battling through work-outs, is to be seen, but whatever the nature of our activity, our practice area will likely again be "hot" as the world returns to focusing on economic growth and its infrastructure needs.