Principal-agency risk in project finance.pdfVIP

Principal-agency risk in project finance L.M. Farrell* Ecole des hautes etudes commerciales, HEC Montreal, Que?bec, Canada Received 28 September 2001; received in revised form 24 September 2002; accepted 19 November 2002Abstract Unlike traditional asset-based financing, where lenders have recourse to the assets of the project sponsor, ‘‘pure’’, zero recourse project finance is a method of financing large-scale, capital intensive projects, in which only the cash flows generated by the project serve as the source of loan repayment and project assets serve as collateral for the loan. The exact nature and duration of the complex set of property rights in a project are established in detailed and complex contracts which define the relationships between various project participants. As the number of project stakeholders increases, the agency risk, that some will take unobserved actions to transfer wealth from the unwary to themselves, increases. The failure of accounting standards to adapt to the explosion of new property rights, as in the case of the collapse of Enron Corp in the United States, would tend to increase project agency risk. The purpose of this paper is illustrate, using a numerical example, a potential agency risk problem for unwary suppliers of project- based financing due to asset substitution. # 2003 Elsevier Ltd and IPMA. All rights reserved.Keywords: Project finance; Risk identification; Agency; Asset substitution; Accounting standards wealth transfer; Contracting; Property rights1. Introduction Project finance has become an important method of financing large-scale capital-intensive projects, such as power plants, oil pipelines, integrated oil refineries, automated steel mills, and chemical fertilizer plants, in which the demand for financing exceeds the financing supply capacity of the project sponsor itself and of local capital markets [1]. Used to finance the Suez Canal, various British railway projects [2], and more recently the development of the