Privatesector P U B L I C P O L I C Y F O R T H E Note No. 157 November 1998 World Bank Guarantees for Oil and Gas Projects Scott Sinclair Private investors are considering several large-scale oil and gas production, pipeline, and cross- border pipeline projects in developing countries, including in West Africa and in the Caspian Sea region. While the World Bank and the International Monetary Fund are well known for their work in helping to create enabling environments for foreign investment in large infrastructure projects, by supporting reform in such areas as taxation and energy legislation, this Note focuses on a different role for the World Bank—encouraging private sector involvement in large-scale oil and gas projects by providing guarantees in direct support of the government contractual undertakings that may be needed to induce foreign direct investment in these projects. World Bank guarantees offer a unique type of risk mitigation that may prove to be a catalyst in raising finance for these projects. In developing countries hydrocarbon resources Government undertakings have traditionally been owned and developed by the state. But as recovering these resources The concession agreement between a govern- has become increasingly difficult and costly, ment and the project entity is the document governments have begun inviting foreign in- that defines the government’s obligations to the vestors to become involved in the sector. The project. This Note uses the term concession role offered to private sector participants var- agreement broadly, to include production shar- ies from country to country, but in all cases ing agreements, transport and transit agree- the government continues to play a significant ments, and government offtake agreements. role, sometimes as a regulator, sometimes as an investor, sometimes as an offtake purchaser, In a typical oil and gas concession agreement and sometimes as all three. the government grants to the project entity the right to develop the project in exchange for a Because of the large capital requirements for stream of payments or payments-in-kind. This many oil and gas projects, and the growing re- government revenue stream may take several luctance of many oil and gas companies to use forms, but typically includes one or more of their balance sheets to fund these projects, many the following: private sector sponsors are pursuing project fi- ▪ Fixed rents. nancing. A successful project financing depends ▪ Royalties (based on sales). in large part on the strength of the contractual ▪ Profit overrides (effectively reducing the commitments of the various project participants, upside potential to sponsors). which, taken together, ensure lenders that there ▪ Taxes (income or otherwise). will be a reliable source of cash flow for repay- ment of the debt. Among the most important In some concessions the government, or a state- commitments are the contractual undertakings owned enterprise such as the state gas com- of the host government or governments. pany, will contract to purchase the oil or gas The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 World Bank Guarantees for Oil and Gas Projects produced by the project. If the state enterprise might otherwise hinder a project financing. contracts for a significant share of the through- Such risks include political force majeure events put, the creditworthiness of this offtake obli- (such as civil unrest and general strikes), cur- gation becomes key to the project’s rency availability and convertibility, and per- financeability. mitting (box 1). A comprehensive concession agreement for a What are the consequences if a government fails large oil and gas project should address the to meet its obligations under a concession agree- government’s obligations to establish a frame- ment? Clearly, a simple right to terminate the work for dealing with a variety of risks that concession agreement offers no real remedy to the project sponsors and no comfort to their lenders. Instead, a concession agreement needs to provide for financial compensation to the project sponsor, through a compensatory reduc- BOX 1 POSSIBLE GOVERNMENT UNDERTAKINGS IN A tion of the government’s revenue stream or CONCESSION AGREEMENT through contingent payment obligations. ▪ Maintain the same scheme of rents, royalties, taxes, duties, and A government’s willingness to bear such a con- accounting procedures. tingent liability is in theory a function of its re- ▪ Grant rights of way, easements, permits, and licenses without ward for doing it. The desirability of the project delay. to the country will guide the government’s pro- pensity to take risk in general. In other words, ▪ Grant import and export rights and visas. if the government views the benefits as high, it ▪ Provide physical security of assets and personnel. will be willing to stand for a large contingent ▪ Adjust rents and royalties or make financial compensation to obligation to the project. But if the government sponsors to maintain economic equilibrium in the event of political views the benefits as modest, it will be willing force majeure such as: to stand for only modest undertakings. ▪ Civil unrest, war, terrorism, blockade. Whatever the scope of government undertak- ▪ National or general strikes. ings, and regardless of the methodology used ▪ Expropriation and withdrawal of authorization. to calculate adjustments or compensation, the ▪ Diversion or interruption of the commodity flow (including at the ability of a government to meet its obligations, wellhead). financial and nonfinancial, may well be the ▪ Change in relevant law. factor that determines a project’s financeability. ▪ Permit foreign currency transactions, banking, and bank accounts. Supplementing the government obligations with a World Bank guarantee covering part of ▪ Guarantee cleanup of preexisting contamination. the project debt may add the element that will ▪ Use international dispute resolution procedures. make successful financing and implementation ▪ Guarantee payments by government entities, such as possible. ▪ Demand charges (for example, from the state enterprise fuel purchaser). Cross-border complications ▪ Specified damages. Cross-border projects pose additional structur- ▪ Economic equilibrium (a mechanism for making compensatory ing challenges. Because some level of agree- payments or adjustments when there is a divergence from the ment is needed between the two governments economic transaction negotiated between the contractual on the desirability of the project, cross-border parties). projects should include an intergovernmental agreement. Such an agreement would consti- tute an international treaty. These are typically The World Bank Group 3 less detailed than private sponsors might like. In the complex negotiations for a cross-border It is perhaps wishful thinking by project spon- project the principals will need to reach a mu- sors to expect that intergovernmental agree- tually beneficial agreement on the appropriate ments would address with any detail financial compensation if a breach should occur. While compensation and risk allocation, although a government might agree to a contingent li- cross-border technical issues, such as facilitat- ability exceeding the investment in its country, ing continuous maintenance services on a the World Bank’s Articles of Agreement limit transnational pipeline could be included. But its ability to guarantee loans to the investment the existence of an agreement should provide project that is in the member country. significant comfort to project sponsors and their lenders. World Bank guarantees The structuring of financial compensation for A government’s financial obligations that flow which a government might become liable also to commercial lenders to a project (through, gets complicated in cross-border projects. In say, bank loans, Eurobonds, or 144A bonds), addition to reparations for costs directly caused may be credit-enhanced by the World Bank by a breach of undertaking or a political risk using a partial risk guarantee. World Bank guar- event, private sponsors might ask for financial antees are “partial” in that they cover the mini- compensation to cover consequential losses, mum number of risks and the smallest amount such as: of debt consistent with successful implemen- ▪ Carrying costs of an entire chain of projects tation of a project. In general, if project debt (for example, debt servicing and other fixed service is interrupted by failure of the govern- costs, or equity return in all countries). ment to make payment as required by the con- ▪ The inventory carrying cost of interrupted cession agreement, guaranteed lenders may call throughput throughout a pipeline. on the World Bank for payment (exceptions FIGURE 1 CROSS-BORDER SALES TO MARKET Government A Intergovernmental agreement Government B (weak credit) (adequate credit) Indemnity A Production sharing Transit (guarantee A) agreement agreement Joint venture Pipeline Offtakers (unaffiliated) (market) Loan Project lenders Guarantee A (production sharing and transit agreements) World Bank International border 4 World Bank Guarantees for Oil and Gas Projects include payment failures resulting from events Structuring agreed to be commercial risks or events of natural force majeure, since the Bank does not To use World Bank guarantees, two require- underwrite such risks as a matter of policy). ments have to be met: the government in whose The World Bank would promptly pay undis- territory the project is located must indemnify puted amounts, a commitment that raises the the Bank, and the government whose obliga- credit rating of the government’s payment ob- tions are being supported by the guarantee ligation to AAA in the eyes of the project lend- must indemnify the Bank. In most project struc- ers. The World Bank would then demand tures, these two requirements would be met reimbursement from the government under the by the same government, but in cross-border terms of an indemnity agreement (World Bank projects the structures can be problematic. guarantees are not insurance policies). Some simple examples illustrate the issues. In most countries the World Bank considers its Figure 1 shows a relatively simple structure in guarantees to be additional to its annual lend- which a joint venture develops an oil or gas ing program. The provisions of the guarantees project in one country and delivers the prod- do not create new obligations but merely back- uct to the international border. Government A, stop the obligations that a government has al- which the project lenders perceive as a weak ready made to a project in the concession financial credit, enters into concession agree- agreement. Bank regulators in most major econo- ments with the joint venture. The project lend- mies have exempted loans covered by Bank ers agree to make a term loan to the joint guarantees from certain provisioning require- venture on the condition that the World Bank ments, lowering the cost of the loans and in- guarantee that loan against the risk of govern- creasing the appetite of lenders to make them. ment A breaching either of its concession agree- FIGURE 2 CROSS-BORDER SALES TO A STATE ENTERPRISE Government A Intergovernmental agreement Government B (adequate credit) (weak credit) Guarantee of state Indemnity A Production sharing Transit enterprise payments Indemnity B (guarantee B) agreement agreement (guarantee B) Offtakers Pipeline (weak state Joint venture (unaffiliated) enterprise) Loan Project lenders Guarantee B (state enterprise payments) World Bank International border The World Bank Group 5 ments and causing an interruption in debt ser- cated) and government B (whose obligations vicing. The downstream part of the project is are being backed) will have to indemnify the creditworthy, so from the World Bank’s per- Bank for the amount of the loan. Depending spective the “project” is entirely within coun- on the economic benefits accruing to country try A, the obligations being backed are those A, the requirement for an indemnity from gov- of government A, and thus the indemnity of ernment A could prove to be difficult to ar- government A covers the Bank’s requirements. range without some clever structuring. The example in figure 2 reverses the credit sce- Figure 3 shows a simple cross-border joint ven- nario. Government A has sufficient credit stand- ture where a single joint venture holds the con- ing so that its concession agreements need no cessions for a production facility and pipeline further support. But because the product is to in country A and for a pipeline in country B. be sold at the border to a state enterprise in Both governments are perceived as weak finan- country B that lacks independent creditwor- cial credits by the project lenders, which will thiness, government B will have to guarantee lend to the joint venture only if the Bank guar- the payment obligations of the state enterprise. antees the governments’ payment obligations. The project lenders, perceiving government B The World Bank views the initiative as two as a weak financial credit, agree to make a “projects” divided by the international border. term loan to the project on the condition that To maintain transparency, the Bank prefers that the World Bank back the guarantee obligations the project lenders provide two separate loans, of government B. Again, in the World Bank’s with the proceeds of each loan to be used view the “project” is entirely in country A. To exclusively for expenditures in one country. meet the Bank’s requirements, both govern- The Bank’s indemnity requirements can easily ment A (in whose territory the project is lo- be met in this structure, with government A FIGURE 3 SINGLE CROSS-BORDER PROJECT Government A Intergovernmental agreement Government B (weak credit) (weak credit) Indemnity A Production sharing Transit Transit Indemnity B (guarantee A) agreement agreement A agreement B (guarantee B) Offtakers Joint venture (market) Loan A Loan B Project lenders Guarantee A Guarantee B (production sharing and transit agreements) (transit agreement B) World Bank International border 6 World Bank Guarantees for Oil and Gas Projects indemnifying the Bank for claims under guar- The variations on the theme are endless. antee A (which covers loan A for the “project” These four examples are meant only to illus- in country A), and government B doing the trate the possibilities for using World Bank same for the “project” in its country. guarantees. Figure 4 merely pulls the pieces together in The process what is perhaps a more likely scenario. In this example the functions are split among sepa- For the World Bank the process of issuing a rate joint ventures, each constituting a “project” guarantee begins with requests to the Bank from the Bank’s perspective. (There are often from a host government and the private spon- business reasons for separate joint ventures, sors to provide a partial risk guarantee to the such as to accommodate local ownership and project lenders. Bank procedures require ap- local financing.) The Bank considers joint op- proval of each guarantee by its board of ex- erations agreements between these joint ven- ecutive directors. Each project must meet the tures (including cross-default provisions in loan Bank’s standard technical, environmental, eco- agreements) as commercial risks outside the nomic, and financial criteria and be in a coun- scope of its guarantees. If each guarantee backs try that is reforming to the Bank’s satisfaction. a term loan for expenditures only in the coun- The Bank must determine that the project is in try of the “project,” each government’s expo- the best interest of the country and that allo- sure under its indemnity to the World Bank is cating guarantee coverage to the project is in limited to the amount invested in its territory the Bank’s and the country’s best interest. At and the Bank’s indemnity requirements are its discretion, the Bank may incorporate in its clearly met. own appraisal the results of technical, finan- FIGURE 4 MULTIPLE PROJECTS, MULTIPLE GUARANTEES Government A Intergovernmental agreement Government B (weak credit) (weak credit) Guarantee of Indemnity A Production sharing Transit Transit state enterprise Indemnity B (guarantees agreement agreement A agreement B payments (guarantee 3) 1 and 2) Offtakers Joint venture 1 Joint venture 2 Joint venture 3 (weak state enterprise) Upstream loan Pipeline loan A Pipeline loan B Project lenders Project lenders Project lenders Guarantee 1 Guarantee 2 Guarantee 3 (production sharing (transit agreement A) (transit agreement B agreement) and state enterprise) World Bank International border The World Bank Group 7 cial, and other assessments undertaken by ad- visers to the project lenders. For an oil or gas project World Bank policy generally requires public disclosure of an en- vironmental assessment in final and agreed form at least sixty days before board approval of the project. Preparation of the environmen- tal assessment is chiefly the responsibility of the sponsors. The sponsors are also responsible for arrang- ing their own financing. With the permission of the appropriate central bank, loans guaran- teed by the World Bank can be in any freely convertible currency or the local currency of the country in which the project is located.1 Conclusion In the financial structuring of oil and gas Viewpoint is an open projects World Bank guarantees can comple- forum intended to ment loans from the International Finance Cor- encourage dissemina- tion of and debate on poration and the Bank and insurance from the ideas, innovations, and Multilateral Investment Guarantee Agency. best practices for ex- Guaranteed debt is often arranged at lower panding the private sector. The views pub- costs and longer maturities than would other- lished are those of the wise be possible; the pass-through of these authors and should not savings to the government can be an impor- be attributed to the World Bank or any of tant part of the Bank’s value added in a project. its affiliated organiza- But the World Bank’s presence in a project tions. Nor do any of the reaches beyond the guaranteed debt, often conclusions represent official policy of the bringing comfort to other parties not directly World Bank or of its benefiting from the guarantee. Executive Directors or the countries they represent. 1 For more information see The World Bank Guarantee: Catalyst for Private Capital Flows or the Guarantees Handbook, available from To order additional the Project Finance and Guarantees Department, (202) 473-1650. copies please call 202-458-1111 or contact Suzanne Smith, editor, Scott Sinclair (ssinclair@worldbank.org), Senior Room F6P-188, Financial Officer, Project Finance and The World Bank, Guarantees Department 1818 H Street, NW, Washington, D.C. 20433, or Internet address ssmith7@worldbank.org. The series is also available on-line (www.worldbank.org/ html/fpd/notes/). Printed on recycled paper.