How Investors Encounter Political Risk in Project Finance Finance Essay

Project Finance is a long term project which needs political will of the governments. It is a long term investment which needs political motivation as well as the continuation of the economic policies of the government. The governments adopts project finance for the provision of public infrastructure through PPPS. The success or failure of project finance has severe political consequences.

It is difficult to made or run any project finance without any political support. For example a project finance agreement between a state owned power company and a project company for the construction of power station can not be possible unless the top management of the official company decides that the project is in their interest. The break through can only be possible when there is a strong direction of the government.

Political support is needed from initiating the project till the completion of the project. Financers need to take steps for the alleviation of political risks before providing any finance to the project. There are three classes or groups of political risks which includes investment risks and investment risks includes Currency convertibility and transfer, expropriation of the project by the state and political violence.

Political risk in project finance also includes the change of law which means legislative, judiciary or executive can take a decision in which laws are changed which includes new import export restrictions, changes in environmental law, and new tax regulations. Quasi-Political Risks includes breach of contract and court decisions.

Project financers and sponsors can reduce political risk by signing an investor friendly agreement between the sponsor and the government. Political risk can be reduced through the risk insurance through the insurance companies present in the private sector. Companies should also take legislative protection by signing an agreement with the government that any change of law will not affect the terms and conditions of the government.

Government should gave permission to the company that there is no restriction on the company if it will take loan from the private sector.

After the 9/11 incident in America there were claims of billions of dollars which insurance companies had to pay to the claimants of world trade center. So now it is difficult to buy any risk insurance policy because now insurance company is selling terrorism insurance policy. The problem is that terrorist activities in the world is increasing and now no company is ready to take the risk.

In the thirld world counteries financing of large projects wrere managed by the governments. In thirld world counteries most projects were given on Built, Operate and Transfer basis. Governments gave such type of projects to the companies in which they don’t want to involve due to some reasons which includes   pessure from international organizations, local pressures and environmental issues.

Economic benefits of project finance includes a secured loan to the sponsor secured by the project assets would normally give lenders recourse to sponsors’ assets in addition to project assets in the event of default.  At the same time, depending on applicable insolvency laws, a secured lender’s claim over the project assets may be subordinated to the claims of other creditors of the sponsor.

Project finance is typically used for projects in infrastructure and extractive industries, including ,mines, water and sewage systems, power plants, energy transmission systems, pipelines, roads, railways, airports, ports.

 Project finamnce has a social, economic and political impact on the host society. Many large projects promote the economic development of the host country by providing employment, profits and technology transfer for local suppliers, tax revenue for the state, and, in some cases, additional goods or services for local customers.

However, the operation of projects that make use of project financing may also have adverse effects in the host society.  For instance, many of the projects listed above can result in environmental pollution or displacement of residents. In addition, where the project creates a monopoly over the production of locally-consumed goods or services, such as electricity, water or transportation, local consumers may be prejudiced by exploitative pricing policies. 

Projects that generate revenues from overseas can also be associated with adverse economic or political effects within the host state. 

Economic effects of project finance is that it gives a a large boost in exports, the result may be that the host nation’s currency will appreciate in value.  Generally, an appreciation of this sort makes a nation’s other exports less competitive, as foreign buyers essentially must pay a higher price for them.  It also gave boost to the real estate. This can be problematic if manufacturing is more likely to contribute to growth than other industries. Governments can take proactive steps to reduce these effects (known as the ‘Dutch Disease’), such as investing certain amounts of money overseas so as to avoid driving up either the currency or the price level and thereby crowding out non-resource exports.

Political effects includes more access a state has to cashflows from export-oriented projects the less dependent it is on tax revenues or foreign financiers.  This makes governments less accountable to external constituencies and can undermine their incentives to govern soundly.

States sometimes respond to these concerns by adopting special laws that govern how revenues from projects are to be spent.  This strategy is particularly common among oil-producing countries.  Usually the proceeds from projects are put into special funds that serve specific purposes, such as investing in education or simply to serve as reserve for a future time when revenues are inadequate.

The international community has responded to these concerns by promoting transparency in financial transactions between states that host lucrative export-oriented projects and foreign companies.  For instance, the Publish What You Pay coalition of over 300 NGOs worldwide calls for the mandatory disclosure of the payments made by oil, gas and mining companies’ to all governments for the extraction of natural resources. The coalition also calls on resource-rich developing country governments to publish full details on revenues. Advocates of the movement argue that transparency will place pressure on governments to use the revenues from projects to more effectively promote economic growth.  The World Bank has endorsed this strategy by adopting its Extractive Industries Transparency Initiative.

 In project finance there is a role of project agreements. The project documents serve to allocate risks amongst the parties involved the transaction.  From a commercial perspective, the most important risks are the following completion risk, operating risk, resource risk (availability of inputs), market risk/currency risk (value of outputs), political risk (state actions that affect revenues).

The social, economic, and political implications of projects are influenced by a variety of bodies of law.  Projet finance investors need to follow the host state regulation of foreign investment. Countries have laws that limit foreign investment in various sectors or only permit it at the discretion of government officials. Many states are subject to international obligations that limit their ability to regulate foreign investment.  The sources of those obligations include agreement on Trade-Related Investment Measures (TRIMs), general Agreement on Trade in Services (GATS) , bilateral Investment Treaties (BITs) and regional agreements such as the North American Free Trade Agreement (NAFTA), many multilateral organizations discourage countries from adopting restrictions on foreign investment.

Many enders require the projects they support to meet social and environmental standards that are independent of any binding legal obligations.  A significant number of private project finance lenders have endorsed the Equator Principles, which commit them to ensure that the projects they support meet social and environmental standards set by the International Finance Corporation to guide its own operations.

Methods of enforcing these obligations vary.  For instance, some of the ultilateral financial institutions have established ombudsmen or quasi-judicial bodies charged with overseeing compliance with their operational policies.

While making a contract law in public policy there are few concerns which include enforceability of stipulated damages clauses, enforceability of choice of law, choice of forum and arbitration clauses, enforceability of obligations in the hands of assignees, recognition of foreign judgments and arbitral wards.

Concerns like domestic laws that that affect the value of the project to its investors and sponsors. Projects typically implicate a broad range of domestic laws of general application, including, immigration laws. Many projects will require professionals with specific technical skills to be on site.  Often such labor cannot be supplied domestically and must be brought in from elsewhere, environmental and safety laws, tax laws, currency controls.

Changes in these laws, or outright physical expropriation, can seriously impair the value of the project to investors and sponsors.

Projects are often designed to minimize the host state’s incentive to take such action. Staging the investment, withholding critical technology, or involving actors such as official creditors or political risk insurers who can threaten to cut off future dealings with the state are all ways of creating disincentives to expropriate. 

Sponsors and financiers of large projects often obtain agreements that require the host state to exempt them from specified domestic laws or to provide compensation for changes in the law.  (Provisions designed to insulate foreign investors from the effects of changes in the law are sometimes referred to as stabilization clauses.)

International legal obligations such as customary international law and the provisions of Bilateral Investment Treaties (BITs) limit host states’ ability to expropriate the assets of foreign investors or otherwise treat them unfairly, including by reneging on agreements designed to insulate them from the effects of domestic law. Many commentators are concerned that these sorts of international obligations place undue restrictions on host states’ ability to adopt socially beneficial laws.

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How Investors Encounter Political Risk In Project Finance Finance Essay. (2017, Jun 26). Retrieved June 23, 2021 , from

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