Risks that arise before and after construction of the project
It is hard to create counterparty obligations to mitigate these risk during the life of the project, because no one is directly responsible for them.
These can be any kind of environmental disaster like a hurricane, a storm, an earthquake or human related disaster intense pollution, nuclear explosion, fires. These events can affect the project by both disrupting the construction or the operations of the project.
Usually it is possible to subscribe to an insurance against these typical "force majeur" risks.
Environmental risk can also entail social conditions and public opposition, that can border judicial risk and political risk.
This can be a change in law or sector regulation.
Insurance can't be subscribed against changing laws...
Other political risks can be linked to instability in a country, terrorism or even war.
Insurance can be subscribed with specific conditions against these risks. Only very specific insurance companies can provide them like Export credit agencies.
Foreign exchange risk
The changes in the foreign exchange rate can:
- Increase or decrease the revenues and costs in local currency when the SPV is managed abroad with a different currency,
- Increase or decrease the revenues of sponsors (dividends) and lenders (interest and capital) when the SPV is managed with a different currency than the currency the investor is managed with (here we take the point of view of investors, but this is not a risk for the SPV itself).
- Increase or decrease the consolidated amount in financial statements when reporting and operations are done with different currencies.
Have a look at this memory card on the different uses of currencies with the management and reporting of a company (distinction between Local, functional and reporting currency).
Foreign exchange risk could be considered as market risk in a trading book, were this risk is one the company is willing to take and manage to get a profit. In Project finance however, this is a risk that is not linked to the activity of the project and that the SPV has no vocation to take and manage. So the SPV is expected to get rid of this risk via hedging or relocating the SPV in the country in which it operates.
This is usally not a risk if the inputs prices in the project construction and operation vary in the same way as the price of the service or output produced by the project. However if this is not completely the case, a basis risk can appear.
Basis risk is actually not limited at all to inflation, it also applies to foreign exchange (inputs and output are bought and sold in different currencies), interest rates (this shouldn't impact much the project though) and credit spread. If we were taking a trading book point of view, these would be included in market risk. But in project finance this is not a risk the SPV is willing to take at all, and it will be mitigated as much as possible.
What risk will be managed by the SPV or hedged
The lenders and sponsors expect the SPV to get rid of all macro risks that are not directly linked to its operations. This can be achieved via hedging, contractual obligations for certain risks, and here mostly insurance. This is usually a condition to get a loan from a bank.