Project finance is a financing technique applied to large-scale projects that require large amounts of capital. According to Finnerty, its origins date back to the 13th century when the English Crown negotiated a loan known today as a pay-as-you-go loan to exploit the silver mines of Devon. This technique took off in the 1980s as a means of financing projects designed to meet developed countries’ infrastructure needs, especially in emerging markets. In 1989 Chen, Kensinger, and Martin, cited by Finnerty (1998), identified 168 projects financed with this technique, which totaled more than $23 billion, one of the most important being the Trans Alaska Pipeline System project.
Project financing is conceived when an organization is established to build, own and operate a project profitably as an independent economic unit. It is a mechanism for large-scale funding investments based on the project’s ability to generate cash flows that can service loan repayments and contracts between various stakeholders that ensure the project’s profitability. They are also projects characterized by the inclusion of widely mature technologies. In other words, it is financial engineering for fundraising, project finance, and economically independent capital investment, designed in such a way that debt service is repaid exclusively from project cash flow while providing an acceptable rate of return to equity investors. It is essential to clarify that it does not mean raising funds to finance an unprofitable project and, therefore, cannot service its debt or provide an acceptable rate of return. This mechanism is based on the project’s ability to generate cash flows that can service loan repayments and contracts between various stakeholders that ensure the project’s profitability.
Project financing has been evolving along with the discovery and implementation of new financial engineering techniques. It is mainly applied to projects where the construction and operation time is long, and the resources to service the debt can be guaranteed.
This technique can be used in various economic activities; however, it is currently gaining momentum in electricity and transportation, making it possible to shift these significant investments, historically driven by the public sector, to the private sector. Consequently, the increase in substantial personal investments in infrastructure and governments’ tendency to reduce their budget deficits have contributed to the development of project financing because this modality allows both the public administration and private companies to undertake projects with a high level of capital investment.
Project financing can be an attractive strategy when the project is large and capable of sustaining itself as an independent economic unit and when the promoter is sensitive to the use of its borrowing capacity to support the project, is aware of its risk exposure, wishes to maintain operational control of the project and is willing to accept complex contractual arrangements. An essential aspect in which project financing differs from traditional financing is that the project’s assets are not an integral part of the project sponsor’s asset portfolio.
Besides, project finance has significant advantages over traditional financing:
- it allocates profits and risks more efficiently than traditional financing through contractual agreements;
- it allows for greater financial leverage, which implies higher financial risk but more excellent interest tax benefits;
- the reduction of overall risks for project participants, reducing them to an acceptable level, is typical for emerging market projects and projects with significant risks.
However, it also has the disadvantage of higher transaction costs, especially in the design of financial arrangements and monitoring. Therefore only large projects are financed because their size allows them to generate sufficient benefits to offset the necessary expenses. However, despite these costs, project finance reduces the cost of capital.