Project Finance Transactions – Legal Risks And Risk-Mitigation Strategies

Growing populations and increasing infrastructure demands continue to create a need for large-scale projects across multiple industries, including natural resource development, energy projects, transportation, technology, and industrial plants. These projects are usually capital-intensive, making them impossible to finance using conventional loan structures¹. Thus, project finance becomes a ready technique for funding large-scale, capital-intensive projects.

Unlike traditional corporate loans, the viability of financed projects is tested on cash flow forecasts rather than the credit-worthiness of sponsors or the actual value of the project assets². That is, it relies on a non-recourse or limited recourse structure, where lenders look primarily to the cash flows generated by the project for repayment.

Project finance holds significant benefits for stakeholders, including:

1. Efficient risk allocation among parties best able to manage specific risks³
2. Mobilization of large capital pools
3. Realization of economies of scale

However, these benefits come with a corollary of legal risks. Due to the significant capital requirements, financing is typically achieved through partnerships, bonds, syndication, and risk-sharing arrangements among multiple stakeholders⁴. This complex structure opens the project finance model to major legal risks. In this article, we discuss some of the legal risks at both pre-completion and post-completion stages

Completion Risk (pre-operational phase):

Completion risk refers to the possibility that the project is not completed on time, within budget, or to the required specifications. Since cash flow generation begins only after completion, delays or failures can jeopardize the entire financing structure. Without completion, all other risks arise, making financial losses inevitable. Financial difficulties faced by the contractor and variations by the project sponsors are the leading causes of construction delay. Other factors that extend the time required to complete projects include Severe weather conditions and changes in law.⁵

At the preoperational stage, the project may require regulatory approvals, licenses, or permits. It is important to obtain these licenses before commencing the project. Failure to obtain licenses before commencement may truncate the project if regulators refuse requisite approvals, leading to abandonment. Additionally, defective title, encumbrances, or community disputes can affect site access. The financial agreement should include comprehensive conditions precedent, making the lender’s payment obligations contingent on the prior obtaining of the requisite permits, land title verifications, consents, and approvals.

Also, many projects require construction contracts. Imprecise drafting may lead to disputes over scope, timelines, or performance standards. Clearly drafted fixed-price, date-certain EPC contracts with bankable standards ensure protection against delays arising from variations and unforeseen circumstances. An elaborate force majeure clause can be a good mitigating tool. Permissible non-performance during a set force majeure period (natural disasters, pandemics, political events, etc.), together with clear payments and settlement obligations for contractor costs if force majeure persists, can be advantageous to the contractor. The project company, on the other hand, can benefit from termination rights where the contractor abandons the project or fails to comply with key obligations under the agreement. The right to terminate and recover site materials and equipment, together with damages, can enable the project company to engage another contractor to complete the works.

Unenforceable or poorly structured Liquidated Damages clauses may fail to compensate lenders. Liquidated damages should be payable if completion is not achieved by a fixed date, and those liquidated damages should be adequate and at least cover interest payable on the loan.⁶ Sponsors are usually required to provide robust liquidated damages provisions and completion guarantees. The contractor should provide extensive guarantees and, if the contractor is to be released from liability for defects after a period, that period should be long and only run from the passing of a well-defined completion test.⁷

Sponsors are also usually required to provide completion guarantees or sponsor support undertakings, while contractors provide performance bonds, advance payment guarantees, and maintenance bonds to secure their obligations. Additionally, contractor bonds serve as key risk mitigants, motivating performance and offering financial recourse if projects are not completed or if advance payments are misused. Certifications from independent technical advisors before drawdowns further ensure that construction milestones and performance standards are achieved.

Post-completion risks (Operational Phase): After completion, the project must generate stable, predictable cash flows to service debt and provide returns. A robust system for the collection and distribution of project proceeds is essential to ensure timely debt servicing and sponsor distributions. This ensures disbursements to sponsors and timely repayment of the project loan.

Some legal risks in this stage are discussed below.

1. Offtake Agreement Risk: Offtake agreements are important for ensuring a ready buyer for the project’s products. Unenforceable or poorly drafted Offtake Agreements with buyers can pose significant risks. If an offtake agreement has weak payment obligations, it can become difficult to repay or service the loan. One way to mitigate this risk is through the use of take-or-pay structures in offtake agreements. Under a take-or-pay structure, the buyer has to pay a basic cost of the project products even if delivery is not taken⁸ or the buyer commits to a fixed charge, whether or not the buyer requires the project products on an ongoing basis. The rights under this contract will usually be assigned to the lenders who will have a direct claim under it should the borrower experience payment shortfalls.⁹

2. Operations and Maintenance (O&M) Risk

Post-completion performance relies heavily on the efficiency of project operations and maintenance. Poor operational performance can decrease output levels and, in turn, revenue. This risk is mitigated through strong Operations and Maintenance (O&M) agreements, which include clearly defined performance standards, key performance indicators (KPIs), and penalty regimes for underperformance.

3. Currency and Repatriation Risk

In cross-border projects, particularly within emerging markets, restrictions on foreign exchange availability or capital repatriation can impede the ability of investors and lenders to access project revenues. This risk is mitigated through the use of hedging arrangements and, where appropriate, political risk insurance, which collectively enhance the security and transferability of project cash flows.

CHANGE IN LAW RISK

Changes in regulatory policies or laws risk cutting across both the construction and operational phases of a project. For instance, carbon emission laws and standards can have significant negative impacts on ongoing energy projects, particularly those reliant on fossil fuels (coal, oil, natural gas). These regulations, including carbon taxes, cap-and-trade systems, and stricter emission limits, increase operational costs, reduce profitability, and risk turning even existing infrastructure into “stranded assets”.

To mitigate this risk, project agreements commonly include “change-in-law” provisions that allocate the financial consequences of such changes, often through tariff adjustments or compensation mechanisms designed to preserve the project’s economic equilibrium.

“Change in Law” Clauses should explicitly include climate-related regulations (carbon taxes, new emission standards) as a “Change in Law” event, allowing for contract renegotiation, cost-sharing, or price adjustments. It is therefore germane to negotiate definitions to include sudden, extreme regulatory changes that make a project economically unviable.

Also, carbon laws can influence the architecture of project agreements and may call for more tailored provisions. Where the project generates carbon credits or offsets, clearly defining which party owns, manages, and benefits from these credits or offsets can help prevent conflicts. The inclusion of emissions reporting obligations is also advisable to comply with such environmental and sustainability-driven laws, particularly in the oil sector. Continuing transparent Monitoring, Reporting, and Verification (MRV) routines to meet compliance standards and avoid penalties should be embedded in the project agreement.

Some agreements are starting to include technology & retrofitting clauses. This provides for mandatory adoption of emission-reduction technology such as Carbon Capture, Utilization, and Storage – CCUS¹⁰, and outlines responsibility for costs.

Finally, government support agreements or guarantees, where available, provide additional comfort to lenders by mitigating regulatory and political risks, including adverse changes in law or indirect expropriation.

CONCLUSION

Project finance remains a critical tool for delivering large-scale infrastructure and industrial projects. However, its success depends on careful legal structuring and risk allocation throughout the project lifecycle. From completion risk during construction to revenue and regulatory risks during operation, each stage presents distinct challenges.

Ultimately, the bankability of a project depends on the extent to which legal frameworks are able to secure, stabilize, and protect project cash flows, ensuring that lenders are repaid and investors achieve their expected returns.

Footnotes

1. Beidleman, Carl R; Fletcher, Donna; Veshosky, David, On Allocating Risk: The Essence of Project Finance, Sloan Management Review; Cambridge Vol. 31, Iss. 3, (Spring 1990): 47.

2. Andrew Fight, Introduction to Project Finance, 2006, Chapter 1, pages 1 & 8

3. https://www.lexology.com/library/detail.aspx?g=87dd721a-64cf-4b4f-b24d-c6846fee507b; Paul D. Clifford, Project Finance – Applications and Insights to Emerging Markets Infrastructure; Hoboken, New Jersey: Wiley 2021

4. Yescombe, E.R. (2014). Principles of Project Finance. 2nd Edition, Elsevier Science, Burlington. Pages 16, 21, https://doi.org/10.1016/B978-0-12-391058-5.00002-3

5. G. Sweis, R. Sweis, A. Abu Hammad, A. Shboul, Delays in construction projects: The case of Jordan, International Journal of Project Management, Volume 26, Issue 6, 2008, Pages 665-674, ISSN 0263-7863,

https://doi.org/10.1016/j.ijproman.2007.09.009.

(https://www.sciencedirect.com/science/article/pii/S0263786307001573)\

6. Andrew @ page 114

7. ibid

8. Ibid

9. ibid

10. https://ccushub.ogci.com/ccus-basics/understanding-ccus/