Thought leadership from our experts

Project Finance: Then, Now and in the Future

Phillip Fletcher, Milbank, US

A Look Back

I have had the pleasure of contributing to this compendium of the leaders of our industry for nearly a decade, having effectively inherited the role from Graham Vintner upon his retirement from active practice. Over these years, I have seen a number of the individuals who first structured the deals that pushed the boundaries of complexity and remoteness move on, frequently to senior positions with the banks and sponsors whom we serve. I have also seen the emergence of new stars, including lawyers from an ever-widening range of jurisdictions who have brought diversity in nationality, language and traditions to our midst. The more thoughtful among these new stars have contributed during this period to a deepening body of literature on our field, with perhaps John Dewar's guide published by Oxford University being the most prominent, and through their thought leadership we have come to develop market norms that have made it far easier to close deals.

The last decade has, however, shown that our field is far from settled. Projects regularly face technological innovation (that can give rise to new opportunities but also undermine the economics of older facilities), political and social transformation (on the positive side) and strife (on the negative), and the consequences of inevitable economic cyclicality. As I have reviewed the themes reflected in my periodic contributions to this guide, I am reminded that times of economic expansion and unbridled optimism are generally followed by periods of contraction and pessimism. However, the overall trend has been one of new activity in a growing range of industries in ever more remote locations, all of which have presented new legal and commercial challenges that have frequently required ingenuity to overcome.

During the early part of the last decade, we grew accustomed to the steadily rising demand for goods and resources from the so-called BRIC economies (Brazil, Russia, India and China), which underpinned the performance of a wide range of oil and gas and natural resource projects. The global financial crisis interrupted that positive trend, and in more recent times, as growth in China, in particular, has slowed, demand for most commodities has fallen. We also saw the growth of "fracking" in North America combine with the decision by Saudi Arabia and other oil exporters to maintain high levels of production to preserve market share, resulting in an unprecedented expansion in the global supply of oil and natural gas. This expansion, coming at the same time as a contraction in demand, has led to a sharp, and largely unexpected, reduction in global prices for energy.

We have also seen political changes with dramatic and unanticipated impacts on global markets. Perhaps among the most notable have been civil disturbance in North Africa and the Middle East and the deterioration of relations between the West and Russia, but other examples abound. The recent Brexit vote in the United Kingdom has led the new government to reexamine the further development of the heralded nuclear power station at Hinkley Point and the High Speed 2 rail project; and that vote, coupled with the refugee crisis and terror attacks, has delayed the long-awaited recovery in Europe. But not all has been bad, a number of formerly troubled countries, such as Colombia, Argentina and Myanmar, are becoming havens of economic activity.

Project Finance Today

As a result of depressed market conditions, a broad range of oil, gas and other natural resource projects have been deferred or cancelled, and we are now regularly engaged to help restructure deals that closed in a more optimistic time. Many of these projects have faced huge construction cost overruns, and others have begun to ramp up operations at a time when the revenues from their output are impaired by low prices. Host governments, seeing cash-flows from royalties and taxes fall below optimistic projections, are seeking to renegotiate concession and similar agreements to capture a larger share of revenues, and some host states, such as Yemen, are falling into civil war, causing operations at major projects to be suspended.

Fortunately, sound projects have been designed to withstand both market and political volatility. Projects have life spans that extend through multiple economic and electoral cycles, and therefore the well-structured among them can remain solvent during lean times. In more extreme cases, sensible sponsors are funding operating costs and interest payments, and lenders are reciprocating by deferring amortizations, to ensure that projects remain viable. Making commitments of this sort can require particular bravery when projects are faced with the extreme dangers of war or threatened expropriation, but even then, lenders and sponsors with a long-term view will want to preserve their investments in the hopes of a more stable future.

Not all is gloom. As we approach what we hope is the bottom of this economic cycle, a range of new projects are in the early stages of development. As with other cycles, the confluence of reduced engineering costs (as contractors compete for fewer deals), low iron, steel, cement and energy prices, and continued low interest rates, is tempting entrepreneurial sponsors to begin construction of projects that may not begin production for several years, at a time when prices for their output are likely to have turned. They recognize that as investment in competing projects is deferred, eventually supply and demand will be brought back into balance and prices will, as they always have, rebound, until the next cycle reaches its peak.

We are also seeing businesses and individual projects change hands. Private equity and infrastructure funds, as well as more established industrial companies, are taking advantage of opportunities presented by stretched investors that need to attract new capital to bring projects to completion. Although it can be difficult to bridge the gap between sellers' frequently inflated expectations and buyers' hesitancy to invest before the bottom is reached, eventually deals are struck and investments are made, frequently with the benefit of leverage provided to the buyers from banks and bond investors.

Even in a period of lull, there are sectors that are terrifically busy. An increase in concern over climate change, coupled with advances in solar and other renewables technology, has given huge stimulus to the alternative energy sector. The 2016 Paris Climate Agreement was an historical demonstration of the value placed on the issue, but a complex interplay of political, financial and social change is needed to accomplish the goals agreed to by countries around the world. As coal and other thermal power generation sources reach the end of their lifecycle, renewable energy markets have capitalized on the social and financial support provided to their projects. This has certainly been the case in both Europe and North America, and a short list of emerging countries are dedicating billions of dollars to renewable energy, including Mexico, Chile, South Africa, Morocco and the UAE. Whether the demand for carbon intensive energy production will be constrained by concerns over global warming, or whether those concerns will instead be subsumed by short-term economic considerations, remains to be seen.

Urbanization and population growth are similarly driving the development of utilities, roads and railways. Massive investments in both developed and developing countries are underway as the integrated global economy continues to spur demand for improved transportation infrastructure and public services. Continued funding will be needed to reduce the infrastructure gap and provide transportation and communication access to previously remote locations. Among the more ambitious schemes, China's 'One Belt One Road' initiative is a massive transportation infrastructure push to increase ties from China through Central and Southeast Asia.

In this period of uncertainty, the availability of financing sources can also be somewhat uncertain. The Basel Accords continue to restrain the ability of commercial banks to fund the long-term needs of projects, leaving multilateral and export finance lenders to lead many of today's largest projects. Those lenders, however, somewhat chastened by recent experience, are taking more conservative positions on the allocation of project risks. At the same time, institutional and other debt investors, faced with a dearth of opportunities to invest at an attractive yield, will lend to somewhat less conservatively structured projects if they offer a sufficiently attractive return. Since the larger projects will often require a combination of lenders to meet their funding requirement, achieving harmonized positions across diverse lending groups can be challenging. Combining a varied group of investors into a single financing is like putting together a puzzle: the first steps generally appear intractable, but perseverance usually pays off.

What Does the Future hold?

Change is the only certainty in the project finance market, and the industries in which we operate will continue to evolve. The attorneys named in this Expert Guide will inevitably need to meet demands for creative legal structuring, and as project finance has become truly global, those attorneys will have to master an ever-broader range of legal, language and cross-cultural skills to address the new challenges.

The one thing we can be certain of is that the group of lawyers named in this guide will continue to provide the ideas needed to develop creative solutions to unique financing situations. Leading project finance law firms will have to deploy not only project finance lawyers, but also a diverse array of experts in their structured finance, tax, regulatory, dispute settlement and even insolvency practice areas to provide the perspectives needed to guide increasingly complex transactions. These lawyers, and those firms, will thrive on meeting these challenges. I have considered myself to be fortunate to be included amongst this terrific group of practitioners, and I look forward to sharing with them the challenge and opportunity of finding solutions to the impediments to further global economic growth.