Contract risks and credit spread determinants in the international project bond market

International bond markets have become an increasingly important source of long-term capital for infrastructure projects in emerging market economies over the past decade. The Ras Laffan Liquified Natural Gas (Ras Gas) project represents a milestone in this respect: its $1.2 billion bond offering, completed in December 1996, has been the largest for any international project. The Ras Gas project has the right to extract, process, and sell liquefied natural gas (LNG) from a field off the shore of Qatar. The principal off-taker is the Korea Gas Corporation (Kogas), which resells most of the LNG to the Korea Electric Power Corporation (Kepco) for electricity generation. In this clinical study the authors analyze the determinants of credit spreads for the Ras Gas project in terms of its contractual structure, with a view to better understanding the role of contract design in facilitating access to the global project bond market. Market risk perceptions have long been recognized to be a function of firm-specific variables, particularly asset value as embodied in contracts. The authors therefore study the impact of three interlocking contracts on the credit spreads of the project's actively traded global bonds: the 25-year output sales and purchase agreement with Kogas-Kepco, the international bond covenant, and an output price-contingent debt service guarantee by Mobil to debt holders. Using a sample of daily data from January 1997 to March 2000, the authors find that the quality of the off-taker's credit-and, more important, the market's assessment of the off-taker's economic prospects-drive project bond credit spreads and pricing. In addition, seemingly unrelated events in emerging debt markets spill over to project bond markets and affect risk perceptions and prices in this segment. Judicious use of an output price-contingent debt service guarantee by shareholders can significantly reduce project risks, and markets reward issuers through tighter credit spreads. Bondholders and shareholders share residual risks over time, despite covenants meant to preempt risk shifting. This type of risk shifting originates from incomplete contracts and the nonrecourse nature of project finance. It does not necessarily result from a deliberate attempt by management to increase shareholder value at the expense of debt holders by pursuing high-risk, low-value activities, although project managers and shareholders could still exploit their informational advantages by leaving output supply contracts incomplete in ways beneficial to their private interests. The results hold important lessons for global project finance. Projects incorporating certain design features can reap significant financial gains through lower borrowing costs and longer debt maturities: Judicious guarantees by parents that enjoy a particular hedging advantage enhance a project's appeal, as reflected in favorable pricing. Pledging receivables rather than physical assets as collateral and administering investor cash flows through an off-shore account offers additional security to debt holders. Projects should use their liability structure to create an implicit option on future private debt financing that matches the real option of a project expansion. The finding that bondholders bear residual risks means that shareholders can reduce their risks arising from bilateral monopolies and buy insurance against unforeseen and unforeseeable events.Payment Systems&Infrastructure,Economic Theory&Research,Banks&Banking Reform,Financial Intermediation,Environmental Economics&Policies,Banks&Banking Reform,Financial Intermediation,Economic Theory&Research,Environmental Economics&Policies,Housing Finance

Poseidon Principles: Legal Directions for Implementation & Enforcement

A group of global banks led by Citi, Société Générale and Danske Bank have collaborated to formulate a framework known as the Poseidon Principles, which will limit lending to shipping companies that fail to uphold increasing environmental standards. Signatories to the green deal will integrate climate considerations into lending decisions with the objective of achieving decarbonisation in the industry. This raises a number of questions pertaining to the contractual obligations that Signatories will impose on Borrowers in their financing agreements. This Paper specifically addresses the question of enforceability and the legal consequence of the Poseidon Principles Standard Covenant Clause (SCC), its available remedy, and the incorporation of environmental obligations into financing agreements. This Paper calls for a gradual implementation of stricter enforcement mechanisms as a set of green norms become increasingly pervasive throughout the shipping sector. The Poseidon Principles framework can become a powerful private governance tool in achieving international climate change goals through providing both directional industry guidance and legal avenues for accountability

Fiduciary Duties and Equity-Debtholder Conflicts

We use an important legal event as a natural experiment to examine the effect of management fiduciary duties on equity-debt conflicts. A 1991 Delaware bankruptcy ruling changed the nature of corporate directors' fiduciary duties in firms incorporated in that state. This change limited managers' incentives to take actions favoring equity over debt for firms in the vicinity of financial distress. We show that this ruling increased the likelihood of equity issues, increased investment, and reduced firm risk, consistent with a decrease in debt-equity conflicts of interest. The changes are isolated to firms relatively closer to default. The ruling was also followed by an increase in average leverage and a reduction in covenant use. Finally, we estimate the welfare implications of this change and find that firm values increased when the rules were introduced. We conclude that managerial fiduciary duties affect equity-bond holder conflicts in a way that is economically important, has impact on ex ante capital structure choices, and affects welfare.

Embedded Options and the Case Against Compensation in Contract Law

Despite the fact that compensation is the governing principle in contract law remedies, it has tenuous historical, economic and empirical support. A promisor's right to breach and pay damages (which is subject to the compensation principle) is only a subset of a larger family of termination rights that do not purport to compensate the promisee for losses suffered when the promisor walks away from the contemplated exchange. These termination rights can be characterized as embedded options that serve important risk management functions. We show that sellers often sell insurance to their buyers in the form of these embedded options. We explain why compensation is of little relevance to the option price agreed to by the parties, which is a function of the value of the option to the buyer, its cost to the seller and the market in which they transact. We thus propose a novel justification for why penalty liquidated damages may be higher than seller's costs: they are option prices that reflect the value of the options to the buyer. The regulation of liquidated damages is thus tantamount to price regulation, which is outside the realm of contract law. Moreover, in light of the heterogeneity among optimal option prices, we also make the case against having an expectation damages default rule to begin with. In thick markets, we argue for enforcing the parties ex ante risk allocation with market damages. In thin markets, we propose that parties be induced to agree explicitly with respect to all termination rights, including breach damages, by the threat of specific performance of their contemplated exchange or, in the case of consumers, by a default rule that provides them a termination option at no cost.