Understanding Infrastructure Disputes: Operational Risks
In the second series of BRG’s “Understanding Infrastructure Disputes” papers, our damages, construction, and energy and resources experts identify risks that can arise over the project lifecycle (i.e. from financing through to construction and operations) and identify how these risks may impact potential disputes.
As highlighted in previous parts of this series, infrastructure projects by their very nature are typically extremely complex, involve many parties from multiple jurisdictions, are capital intensive and often span lengthy time frames. Against this backdrop, it is important to assess operational risks involved, as they often act as an important driver of disputes.
In this third part of our series, we look at the types of operational risks firms should consider when embarking upon infrastructure projects and provide several case studies. Many risks outlined below are closely intertwined, with one risk giving rise to another. What is more, the list below is not exhaustive. Each infrastructure project must be carefully assessed to identify further risks.
Operational Risks – An Overview
Due to the complexity of infrastructure projects, operational risks that have the potential to disrupt implementation and give rise to industry disputes are wide ranging. In this paper, we look at six key operational risks.
Performance Risk
Performance risk is the most common type of risk endemic to infrastructure projects. It often stems from another operational risk, such as macroeconomic or political risks (see below).
Infrastructure projects traditionally commence with a clearly defined set of responsibilities and deliverables split among project participants. With projects typically spanning long time frames, capital costs are reimbursed over a long period of time at contractually-agreed prices. However, the time frames create significant potential for operating circumstances to change, which inevitably impacts counterparties’ ability to perform and deliver upon their contractual obligations. Some counterparties may attempt to extricate themselves from existing contracts as a result.
The renewable energy industry provides characteristic examples of projects with heightened performance risk. For example, parties may have entered a long-term contract to construct a wind power plant, with the consequent electricity price set at (say) 15 cents per kilowatt-hour (kWh). The rapidly developing renewable energy sector contains significant scope for price reduction as new technology appears, with newer plants able to sell at (say) 8 to 10 cents per kWh. Entities that pay more than that due to historic contracts will want to find ways to exit these out-of-market arrangements.
A case in point is a wind power construction programme in Spain, whereby in the late 1990s/early 2000s the Spanish government put in place a set of legislative measures to incentivise the development of the renewable energy sector by way of a special financial regime. As part of these measures, renewable energy generators received a premium or a fixed feed-in tariff at an above-market rate for the electricity produced, leading to numerous international investors acquiring stakes in renewable energy businesses such as wind farms. Due to the significantly changed economic circumstances as a result of the Global Financial Crisis in 2008, the Spanish government had to alter its tax policies, effectively reneging on the prior deals, which has led to many investment treaty disputes.
Cost Risk
Cost risk relates to changes in the real price of different components integral to the project.
Infrastructure project contracts will typically provide for selling outputs at predetermined prices, possibly with a degree of indexation for components such as labour costs, fuel prices, raw material, etc. However, due to the extended time frames such projects are operational for, it is often difficult to anticipate the true extent of some cost fluctuations.
A good example of this is the current volatility in oil and gas prices, which have suffered from significant inflation as a result of recent geopolitical events. The disruption in oil and gas and energy prices is likely to lead to disputes, as offtakers may challenge the price forecast–based calculations and counterparties look to terminate their commitments due to the changed economic viability of the projects they are involved in.
Supply Risk
Supply risk relates to whether key components (or inputs) for the project are available in the requisite quantity and quality. Energy, which is a key input in many infrastructure projects, is a classic example. As recent events in Europe have shown, that is a big risk. Due to current uncertainties in the energy markets globally, energy risk has become an urgent priority for infrastructure project managers. All energy threats must be identified and then addressed in terms of how the risk can be reduced or eliminated.
Macroeconomic Risks
Macroeconomic risks pertain to significant adverse impacts stemming from the wider economy, such as a fluctuation of exchange rates or rising inflation.
The uncertainty caused by current inflationary dynamics is a relevant example. International infrastructure projects may be underpinned by mixed-currency financing, resulting in currency value mismatches as a result of changes in exchange rates. This can expose projects to increased financial risk if the value of the currency of the debt changes suddenly. Additionally, macroeconomic drivers may cause other operational risks, including cost and supply risks, as infrastructure projects often rely on raw materials that may be priced in foreign currency. As a final point, given recent interest rate hikes across multiple jurisdictions, and with more likely to come in 2023, it is crucial to understand the impact of interest rises’ fluctuation on financing costs in order to better manage liabilities and preserve assets.
Counterparty Risk
Infrastructure projects that rely on a single offtaker will incur a higher level of operational risk and, as a result, higher likelihood of disputes if the offtaker seeks to evade obligations.
A typical infrastructure project scenario with enhanced counterparty risk is a power station, where a single buyer purchases the power. When selling to a single counterparty, investors and service providers must contend with the prospect of the offtaker defaulting, resulting in a domino effect for operational risks, with counterparty risk driving other risks, such as those related to performance and revenue. A project relying on a wider customer base is less exposed.
Regulatory and Political Risks
These risks are wide ranging and relate to changes in regulations, political support and risk of expropriation, as well as risks related to wars and sanctions.
In western jurisdictions, where the rule of law is the operating assumption, often reinforced by supranational regulation, political risks are less of an issue. However, projects may still need to seek contractual pass-through of costs imposed, for example, by stiffened environmental regulations.
The situation is vastly different in countries with less-developed legal systems. In jurisdictions subject to political instability, contracts underpinning infrastructure projects can benefit from additional protection by way of insurance against political risk. It is also important to note that recent geopolitical events in Europe have shown that stability is relative and can change quickly, even in the more established regions. Looking ahead, measures to safeguard against some of the impacts of such events are a worthwhile consideration for project developers.
Further, as a result of the ever-changing scope of the regulatory environment, infrastructure projects can suffer from stranded costs. As an example, against the backdrop of the ongoing wholesale drive towards green and sustainable energy, the demand for traditional fuel—and therefore petrol stations— is diminishing. Industry players who invested in refining, assuming that drivers will continue to rely on petrol and diesel, may see their assets stranded.
Peter Bird looks at types of risks that may arise during the operational phase of infrastructure projects and how they may affect potential disputes relating to the projects and impact organisations involved.