Increasingly popular "project on project" structures for refinery and petrochemical projects have a number of advantages, but also expose project sponsors and financiers to a host of potentially costly risks in the absence of preventive measures.
An increasing number of refinery and petrochemical projects are being developed under a project structure in which one or more associated facilities (AFs) are constructed, owned, financed, operated and maintained independently of the main project (MP). We call this an "MP/AF structure."
Associated facilities—which can include power, water, and industrial gas facilities; pipelines; terminals; and wharves—are those that are both essential to the operation of the main project and being constructed (or expanded) specifically to serve the main project.
Sponsors adopt an MP/AF structure for a number of reasons, including to:
- Reduce the capital cost of the main project, and, consequently, the funding required if the main project is financed on a project-finance basis
- Increase efficiencies through the sharing of the associated facilities with other projects
- Gain needed specialist and proprietary technology and experience not otherwise available to the main project's sponsors
But projects using MP/AF structures are subject to complicated project-on-project risks that can erase the expected benefits, potentially forcing projects into the red. These risks tend to increase in proportion to the technical complexity and cost of the associated facilities and the length of the construction period required for those facilities.
We highlight four main risks that pose the biggest challenges for many sponsors and financiers involved in large refinery and petrochemicals projects with MP/AF structures, along with some insights about how participants may manage the risks effectively.
When interdependent projects fall out of sync
In many projects with an MP/AF structure, the main project can't begin to operate until the associated facilities are ready to run. When delayed from operating by an unfinished associated facility, the main project's owners may not be able to generate revenues and service their debt. The main project may also incur expensive penalties under its agreements with other project participants, such as companies that have agreed to supply feedstock to, or purchase outputs produced by, the main project.
Sponsors can sometimes prevent or reduce such losses by requiring that the associated facilities be completed before the main project is expected to be operational, to allow for sufficient time to remedy any issues that may arise during construction of the associated facilities. But this, too, brings risk. The sponsors of the main project may be required to cover expensive take-or-pay obligations related to the associated facilities if they are operational for a long time before the main project is ready to run.
Sponsors may also require the owner of the associated facilities to pay liquidated damages for failure to complete the associated facilities on time as a means of hedging against the cost of delays in associated facility completion. But liquidated damages for delay are typically set at an amount that is proportional to the overall investment made by a project's owner––that is to say, the price paid by the owner to its contractor under the relevant construction contract. Because the investment made by the owner of the associated facilities is typically smaller than the investment made by the sponsors of the main project, the liquidated damages payable by the associated facility owner may be insufficient to cover the sponsors' losses stemming from the delay.
Sometimes sponsors of the main project are able to negotiate higher liquidated damages. In such cases, though, the costs incurred by the owner of the associated facilities for making higher damages available to the main project could wind up being indirectly paid by the sponsors of the main project anyway––for example, through an adjustment in price under the supply or offtake agreements with the associated facility owner.
Securing additional and alternative sources of supply to or from the main project can help alleviate the impact of delayed associated facilities as well. For example, when the associated facility is an independent power producer, the main project's sponsors would want to connect the main project to the power grid (if possible) so the grid can supply back-up power to the main project if completion of the associated facility is delayed or its capacity is derated. Similarly, a main project may be able to use an alternative method of transporting its products to market (by rail or truck, for example) if completion of a marine terminal or pipeline associated facility runs late.
To the extent that this combination of available remedies is not sufficient to hedge against the schedule and completion risk of associated facilities, the main project's financiers may choose to seek out sponsor support in the form of contingent equity or completion guarantees. In fact, financiers typically require such support more often in MP/AF structures than in other types of projects.
Sponsor support would provide financiers with comfort that funds will be available to service the debt that comes due or to cover damages that are payable under project agreements prior to the completion of the associated facilities and the starting point for revenue generation by the main project.
When operations don't meet expectations
Even when associated facilities are completed on schedule, the main project faces losses when an associated facility cannot operate at optimal capacity, and as a result cannot deliver or receive the contracted-for quantity of products, utilities or other inputs or outputs, or cannot do so in conformity with agreed specifications.
To reduce such technical risks, sponsors and their financiers typically perform strict due diligence on the construction, technology licensing, equipment supply and operation and maintenance agreements, and other such project documents and facts related to the associated facilities to assess, among other things:
- The reputation, experience and financial standing of the contractors for the associated facilities
- The reliability of the technology used in the design and construction of the associated facilities
- The adequacy and scope of the associated facilities' technical specifications
- The robustness of the contractual framework and the various rights and remedies granted to the owner of the associated facilities vis-à-vis its contractors
Sometimes, the main project's sponsors or financiers request monitoring, consultation, assignment and/or cure (including step-in) rights under the project agreements for the associated facilities so that they are aware of, and are able to react to, any potential technical/capacity issues when they first appear. The sponsors and/or financiers will obtain these rights either directly, by joining these agreements as parties, or indirectly, by entering into one or more third-party consents with the relevant contractors. Negotiating these and other rights with third-party contractors may be challenging, though, as third parties would typically be reluctant to assume any liability to the main project's participants.
The main project's sponsors can also require the owner of the associated facilities to pay liquidated damages or other penalties for failure to deliver to, or take from, the main project the agreed input or output. But due in part to the typical discrepancies in the size of the investments made in the main project and its associated facilities (as noted previously), such payments are unlikely to fully cover the losses that may be incurred by the main project when associated facilities underperform.
When party priority is hard to pin down
Issues related to allocation of supply from, or offtake by, associated facilities and corresponding priority rights are especially thorny where the associated facilities are shared by a number of separate projects. When the aggregate capacity of the associated facilities falls below the minimum level required, how should the shortfall be allocated among the various main projects? In accordance with what priority?
The sponsors of the various main projects would typically try to curb priority risks by requiring that the associated facilities be designed and constructed with surplus capacity. The surplus capacity could be owned and paid for by the projects on a pro rata basis, or by the owner of the associated facilities who would then have the right to sell the surplus capacity on the open market. When the associated facilities own the surplus, they are usually contractually obligated to supply to or offtake from the dependent projects first, on a priority basis, before selling any excess capacity to third parties.
In addition to these allocation and priority issues, the following would typically also be agreed among the sponsors of the respective projects and the owner of the associated facilities in one or more multi-party services agreements:
- Coordination of the maintenance and shutdown of the associated facilities and the dependent projects
- Granting of step-in and cure rights in respect of the associated facilities to the various projects and their financiers
- Termination of respective supply or offtake agreements and the enforcement of related rights by the various projects
In some transactions, for example, there may be an "anchor" sponsor that holds highest priority of supply or offtake. The sponsors of dependent projects may agree that the anchor sponsor will take primary operational responsibility vis-à-vis the associated facilities, or they may agree that all sponsors will take turns in this role. Reaching a definitive agreement on these and similar issues is likely to require lengthy and complex negotiations.
When having different groups of financiers creates complexity
The main project's sponsors and financiers must consider whether it is acceptable for the associated facilities to be financed on a non- or limited-recourse basis. Permitting such financing will create a number of complicated issues between the various sponsors and financiers as well as among the financiers themselves.
For example, financiers of both the main project and the associated facilities may want their loan documentation to contain cross-default or cross-acceleration provisions, but the sponsors may resist such provisions on the basis that a problem with either the main project or the associated facilities should not in and of itself give rise to such remedies (especially where the associated facilities are, for example, an independent power producer and the main project can connect to the grid).
Financiers of the associated facilities may require a first-priority security interest over the associated facilities, entitling them to take over those facilities in the event of a default under their loan documentation. Although the interests of the associated facilities' financiers and those of the main project's financiers will often be aligned, complex arrangements akin to intercreditor agreements may need to be negotiated among the various stakeholders in order to coordinate the enforcement rights of the main project's and associated facilities' financiers over their collateral, and to address other intercreditor issues.
Given all of these complex questions and the time-consuming negotiations to which they may give rise, the main project's financiers may prefer to see the associated facilities financed solely by sponsor equity.
In circumstances where the main project is financed on a non- or limited-recourse basis, the financiers may sometimes request that the environmental, health and safety (EHS) standards with which they are requiring the main project to comply also be met by any associated facilities, particularly where the associated facilities are new or are being expanded to accommodate the main project.
In such circumstances, challenging negotiations between the main project's sponsors and the owner or operator of the associated facilities could ensue. The owner or operator of the associated facilities would typically resist agreeing to be bound by EHS standards imposed by third-party financiers, especially where the standards are more stringent than those currently imposed by applicable law or adopted by the owner or operator of the associated facilities.
When considering or crafting an MP/AF structure, savvy sponsors must be alert to material project-on-project complications and issues that may arise. A deep investigation of these potential complications and issues as early as possible in the main project’s development stage will help sponsors establish a deal structure that adequately addresses these complications and issues and thereby reduces risks in a manner that is time and cost-efficient, and that improves the overall bankability of the main project.