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A Framework for Understanding

and Modeling Risk in Mega-


Projects and Its Impact on the
Markets for Project Finance
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ATANU MUKHERJEE AND PURNENDU CHATTERJEE

T
ATANU MUKHERJEE his article discusses our approach The worldwide market for infrastruc-
is president of Dastur to characterizing the risk of large ture projects is estimated to be more than
Business and Technology
projects from the perspective of $40 trillion over the next 20 years (Cohen &
Consulting (a division of
M.N. Dastur & Co.) in project finance markets. Unlike Steers [2009]). Large multi-billion-dollar
Kolkata, India. current statistical and correlation-based industrial infrastructure projects in such
atanu.m@dastur.com mechanisms of risk characterization, we areas as energy, steel, petrochemicals, and
evaluate the dynamic nature of complexity transportation can yield superior long-run
P URNENDU in large projects based on causality and commercial and social returns but are prone
CHATTERJEE
is chair of Aculead Cor-
explore its relationship to risk. We then sug- to cost and time overruns. These over-
poration in Houston, TX, gest a framework to understand and model runs can often be severe, leading to even-
and The Chatterjee Group complexity and risk so as to distill it into tual project suspensions and abandonments.
in New York, NY. components—their interactions and their Mega-projects, defined as projects with costs
pc@tcgny.com impact on access to project finance and risk above $1 billion and time spans greater than
premiums. We then argue that adoption of 36 months, are complex undertakings, with
such a framework can have a transformative uncertainties and changes being the norm
impact on mega-projects and the markets for and the success of the project depending on
project finance, and suggest how innovations the ability to characterize and control risks
in project finance can be accelerated using across the project lifecycle. This means that
our framework. We believe that infrastruc- for these projects to be successful, they need
ture projects, the project finance industry, to be structured, organized, financed, and
banks, institutional investors, mega-project managed in a way that accommodates change
sponsors, governments, and multi-lateral and characterizes risk while minimizing late
agencies will benefit from such a framework. cost, functionality, and schedule impacts.
By being able to model, measure, and monitor A key requirement for mega-projects
mega-project dynamic risk characterization, is the need for project financing. Project
these institutions will be able to structure, financing is different from traditional cor-
organize, and finance projects effectively on porate f inancing of projects in that the
an ongoing basis. This, we think, will even- repayment of debts is tied to the cash f lows
tually expand the market by increasing the generated from the project alone, and any
number of participants, leading to enhanced recourse to debt recovery in the event of
market liquidity and opportunity expansion default is collateralized only by the assets of
in functional project finance markets. the project. The corporation’s liability as a

88 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
sponsor of the project is limited to its equity or debt par- today are very limited. The options in these countries
ticipation, and the project finance agencies’ recourse to are limited to some traditional large liquid banks and
recoveries cannot be collateralized to the corporation’s institutions like the U.S. Export Import Bank and the
other assets and cash f lows. This separation is necessary International Finance Corporation of the World Bank
to encourage sponsors to undertake large and complex Group (IFC) funding projects through some forms
projects without jeopardizing their current operations of syndication. This has resulted in few participants,
while financing them through project finance markets leading to high market concentration and artificial buck-
at an appropriate cost of capital that is ref lective of the eting of all mega-projects into the generally undesirable
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risks of the project. below-investment-grade (BBB) category. Inadequate


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Financing projects at this scale requires the partici- characterization of risks thus engenders conditions in a
pation of capital markets, the government, and multi- funds-scarce market for higher project risk premiums,
lateral agencies. Unfortunately, financial markets have resulting in depressed project returns and often derailing
proven unequal to the task of funneling savings from the commercial viability of the project.
places where incomes exceed consumption to places This situation has come about largely because of
where infrastructure investment is needed. In a world ambiguity in the understanding of the dynamics of large-
with such huge infrastructure needs, the problem is not scale projects, resulting in a lack of clarity on the under-
a surplus of savings or a deficiency of good investment standing of project value, characterization and assessment
opportunities. The problem is probably related more to of risk, and structuring of project finance. Traditional
the underdeveloped frameworks, instruments, and insti- methods of statistical risk modeling techniques applied
tutions for infrastructure investments that incentivize a to mega-projects fall short of providing any meaningful
financial system to intermediate savings and investment value in risk assessment due to the highly inter-coupled,
on a global scale (World Economic Forum [2014]). feedback-driven, and non-linear nature of interactions
In the aftermath of the 2008 financial crisis, most in a mega-project. Additionally, the unique and crafted
of the existing structuring mechanisms and instru- nature of each mega-project limits the extent of reason-
ments for large-project financing disappeared, dealing able analysis based on correlations of comparative data.
a severe blow to the capital markets for project finance If the causative factors driving the dynamic
in the mature markets of Europe and the United States behavior of a project, its management, and hence, its
(European Investment Bank [2013]). In the past, one associated risks can be characterized, quantified, and
of the biggest constraints to project finance in mature monitored in an accurate manner, the transparency and
markets has been the perceived dangers surrounding understanding will result in meaningful assessment of
the initial construction phase of a project. This led to dynamic risk profiles, leading to better risk assessments
the muted development of project bond markets. In and investments at appropriately priced project risk pre-
developing economies, which have the greatest need for miums. These changes could also expand the market by
infrastructure capital, the markets for project finance are attracting many more participants by drawing in large
underdeveloped. Large transaction values, long tenors, institutional investors (e.g., insurance companies, pen-
ambiguity, and uncertainty that results in inadequate sion funds) whose investment horizons match those of
characterization of value and risk spreads are the pri- the project tenors, thus making the markets sufficiently
mary deterrents to markets for non-recourse or lim- liquid. Inclusion of additional institutional investors
ited recourse project financing. Thus, the incentives to complement existing banks and enhanced market
for banks, institutional investors, and other financial liquidity also leads the way toward greater financial
intermediaries in financing to participate in such large innovation and opportunity expansion in fully func-
projects are significantly reduced. Because of the large tional project finance markets. This can have a transfor-
transaction values, the liquidity requirements from the mative impact on the industry and society.
market are also high, and absence of scale in market The project finance industry and mega-project
participation makes the markets illiquid. Although sponsors need a framework to be able to model, measure,
mature markets have functioning project finance and and monitor mega-project dynamic risk characteriza-
limited project bonds markets (Wigglesworth [2012]), tion so as to structure, organize, and finance projects
the avenues for project finance in developing countries effectively on an ongoing basis.

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 89


APPROACH TO CHARACTERIZATION a very important factor in understanding the underlying
OF RISKS IN MEGAPROJECTS behavior of these projects and calls for a more careful
and rigorous causality-based approach to model and
In the context of mega-projects, we view risk as characterize risk.
the possibility that events, the resulting impacts, the Our approach to modeling causality in a dynami-
associated actions—and the dynamic interactions among cally complex system like a large project is based on
the three—may turn out differently than anticipated the fact that system structure gives rise to behavior and
(Lessard and Miller [2001]). Risks and uncertainty com- hence is key to understanding cause–effect relationships
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bine with indeterminacy to create ambiguous decision- in terms of attributions, feedbacks, delays, and nonlinear
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making contexts. and higher-order effects. Essentially, our claim is that if


Decision-analysis methodologies that have we do not understand how large projects are structured;
emerged over the last 50 years have been applied to how the elements interact with each other at the project-,
mega-projects with the goal to understand, anticipate, macro- and industrial-sector levels; and how such factors
and mitigate a mega-project’s turbulence. Some of the as change, shocks, and delay effects propagate through
risks that can be identified through statistical analysis the project, then we cannot characterize large-project
have been applied with limited success. The heuristics behavior and scenarios, and hence we will erroneously
and correlation-based mechanisms used to establish attribute causality and largely mischaracterize risk.
causal relations for risk characterization traditionally In other words, establishment of causality based
are weak because they systematically ignore feedback on current models is largely based on aggregate-level
effects, multiple interconnections, non-linearities, time black-box empirical observations and statistical infer-
delays, and other elements of dynamic complexity seen ence in an “open loop” system. Causality estimation
in large projects. Various methods to infer causality used based on facts, data, and intuition around system struc-
today are based on such factors as temporal and spatial ture and behavior in the context of the macro-industry
proximity of cause and effect, temporal precedence of dynamics allows us, therefore, to understand attribu-
causes, covariation, and similarity of cause and effect. tions, feedback effects, and time delays in a iterative
These methods lead to difficulty in complex systems like top-down, bottom-up manner in a “closed loop”
large projects where cause and effect are often distant system based approach. We characterize risk based on
in time and space, where actions have multiple effects, this model of causality by framing dynamic models of
and where the delayed and distant consequences are dif- project structure and interactions and infer patterns of
ferent than proximate effects. Furthermore, assumptions behavior based on hybrid simulations using techniques
in the statistical models are typically at higher levels of from system dynamics (Forrester [1961]) and traditional
aggregation of the project and often mischaracterize the Monte Carlo mechanisms.
pronounced effect of tail behavior and nonstationary
effects that are encountered in mega-projects. The mul-
THE NATURE OF RISK IN MEGAPROJECTS
tiple feedbacks in complex systems cause many variables
to be correlated with one another, confounding the task Megaproject risks differ according to types of
of judging cause through aggregate-level “black box” projects, depending upon the intensity of technical,
empirical observations. This correlation leads to inac- market, and institutional difficulties that they pose to
curate representation of risk because the causality is fre- the promoters. Integrated steel plants, for instance, are
quently misattributed, and we often hear consequences technically complex and challenging to execute, but
attributed to fat-tail effects and the like. they typically face fewer institutional risks, as they are
Understanding and modeling causality based on socially desirable because of their employment-gener-
system structure and interactions is thus a determining ation capabilities and industry-multiplier effects. The
factor in understanding the underlying behavior of these market risks are moderate, however, because they are
projects. In mega-projects, indeterminacy arising from particularly appealing in developing countries with a
possible external and internal events, nonlinear interac- high appetite for gross capital formation. Alternatively,
tions and feedbacks, along with randomness and uncer- power projects in developing countries, although techni-
tainty understanding and modeling causality is thus cally less challenging, can have significant institutional

90 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
and supply-side market hurdles. This is particularly tardiness in time to capture capacity and escalation of
true if the state owns the resources and institutional product price due to increased project costs can make
mechanisms for resource allocation are in their forma- many projects uncompetitive in the highly competitive
tive stages. As another example, petrochemical com- global commodity markets. The cost of the Chevron
plexes have high completion risks, low institutional risks, Gorgon LNG project in Australia jumped by over $15
and low market risks. Because the output can be sold billion to more than $50 billion (Hume [2012]), and
in both domestic and international markets, the pri- with a looming supply glut of liquefied natural gas, the
mary market risk is related to volatile prices rather than viability of the project remains to be seen. Similarly, the
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capacity utilization. Kashagan oil project in Kazakhstan, currently tracking at


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Megaproject risks can be largely put in the three $50 billion, is $35 billion over budget and nearly a decade
categories: market risks, execution risks, and institu- behind schedule (“Oil Firms in Kazakhstan” [2014]).
tional risks. Apart from institution-related external shocks, poor
project shaping, changes in scope, productivity, work-
Market Risks force availability, ordering delays, project supply chain
disruptions, rework, and so on, can escalate a project’s
Market forecasts for steel, transportation, and power time and cost baselines manifold. In our evaluation of the
projects are based on assumptions about the structure large projects, we find that interactions of these factors
and drivers of demand and supply. Demand projections form the basis of execution risk in large projects. It has
for high-volume commodity outputs from mega-proj- been argued that risk should be assigned and transferred
ects often turn out to be widely off the mark. Errors based on the capacity of the party to bear and control
result in some cases from shortfalls in overall economic the risk in a large project (Brealey et al. [2001]). Thus,
growth and in other cases from the unanticipated nature frequently attempts are made by mega-project sponsors
of changes in the structure of demand. This is because to control the execution risk by transferring the engi-
usually the demand projections are based on correlations, neering and construction risk to turnkey contractors. If
with inadequate consideration for understanding the the project execution risk is not well understood and its
underlying causality. Dynamic demand models, which impacts are not reasonably well comprehended, how-
model the underlying causality and interactions, supple- ever, attempts to transfer engineering and construction
mented with traditional methods will, in our opinion, risks wholesale to an EPC (engineering, procurement,
be a better predictor of demand behavior and associ- and construction) contractor may well increase the risk
ated variability. Similarly, supply risks also involve price of the project because the incompleteness of informa-
and access uncertainties. Particularly in a developing tion is likely to leave sufficient gaps for re-negotiations,
country, supply risks can be very important as nascent escalations, and claims in the contractual mechanisms.
state institutional mechanisms can misallocate raw mate- We think that dynamic modeling of project behavior
rial supply capacities. Understanding supply options and along with reasonably accurate stochastic characteriza-
alternatives, therefore, becomes very important in the tions of the risk levers in the execution phase give us
context of the mega-project risk characterization. better ability to characterize the dynamic behavior of
the project during execution. This gives us the ability
Execution Risks to make better qualitative and quantitative attribution
of risks during this phase.
The Achilles heel of mega-projects is in technical,
engineering, design, and construction risks during the Institutional Risks
execution phase. Although mega-projects usually have
mature technology, arguably, the principal risk in cost Mega-projects depend on laws and regulations in a
and time escalations is in the design, engineering, and given country that govern the degree to which returns,
construction phases of these projects. The nature and property rights, and contracts are subject to expropria-
scale of impact of risks in this phase can be severe both tion. Institutional risks are greatest in developing coun-
in terms of direct project costs and in terms of opportu- tries, where laws and regulations are in formative stages
nity costs lost due to schedule escalation. The resulting or are being reformed. Most common among these are

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 91


the regulatory risks associated with delays and difficulties 1. Shaping phase. This is the initiation and exploration
in obtaining approvals for environmental, land, or social phase, which has the highest risk and is typically
permits. Government agencies in many developing coun- financed by risk capital of the sponsoring parties
tries have labyrinthine bureaucracies that can delay and (Miller and Floricel [2001]). Working details to
effectively endanger projects simply by not granting per- ensure viability, front-end loading, and pre-fea-
mits. Rules on competition, pricing, entry, unbundling, sibility, identification of execution risks, identi-
regulated rates of returns, and other elements have adverse fication of sponsors, financing alternatives, and
impacts on mega-projects in most developing countries. evaluating options are key activities. While from
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Sovereign risks involve the likelihood that a government a project finance perspective there is little, if any,
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will decide to renegotiate contracts, concessions, or prop- capital committed by the financing institutions,
erty rights. Changes in rules, property rights, and so forth, it lays the groundwork for all future phases and
triggered by general economic or political shifts are sov- provides a key to understanding, shaping, and miti-
ereign risks, which can lead to expropriation risks. The gating risks in the later phases.
seeming unpredictability of these events and the degree of 2. Execution phase. This phase entails the design,
adverse impact on a project can well lead to catastrophic engineering, construction, and commissioning of
results, like what happened with Enron’s Dabhol Power a mega-project and has the maximum investment
Corporation in India (Minority Staff, Committee on intensity. For instance, project finance require-
Government Reform [2002]). In hindsight, however, the ments for a large integrated steel plant can range
seemingly unpredictable event of reneging on off-take from $3 billion to $20 billion or for an LNG
agreements in the Dabhol project was an event waiting plant, from $20 billion to $45 billion. Diligent
to happen. In this case, the business model of generating shaping has far-reaching impacts on risk charac-
power based on naphtha and LNG at four times the pre- terization and risk reduction strategies during this
vailing local power price was clearly unsustainable. phase. Characterization and mitigation strategies
The ability to enumerate and model causality based for execution risks during this phase largely shape
on scenarios of known unknowns can provide useful the financing options and the risk premiums of
insights into the nature of the impact of such events financing.
on a mega-project. This provides the project sponsors 3. Operations phase. The transition to successful and
and participants the ability to design options that can continued operation requires market risks to be
be exercised in the event such risks unfold. The ability contained and performance of the plant to reach
to inject external events in a mega-project simulator its quality and capacity goals. Although it is not
during the project lifetime allows the project sponsors possible to completely anticipate the supply- and
and participants to make more real-time decisions on demand-side risks during operations, a deeper
risk trade-offs and alternative strategies for coping with understanding of the industry dynamics at both
institutional risks. a macro and a micro level can lead to a model
framework that can be made sufficiently robust
THE DYNAMIC INTERACTION OF RISKS to indicate ranges of variation on demand- and
OVER THE MEGAPROJECT LIFECYCLE supply-side parameters to address the effects of
external shocks and variations. Insights on poten-
The market, execution, and institutional risks in tially knowable external shocks are industry exper-
megaprojects interact over time in such a way that the tise and knowledge dependent, and a project can
risks emerge and characterize themselves from the point yield useful information in framing the project
of decision to initiate a project, through execution to the investment strategy and mitigation mechanisms
operation and end-of-life. Exhibit 1 illustrates the inter- through potentially exercisable options.
action and evolution of risk over the project lifecycle.
Typical mega-project execution has three broad It might be now useful to look at how the different
phases and the dynamic interaction of risks become risks interact over time across the mega-project lifecycle.
manifest in varying magnitudes during each of these Institutional risks, for instance, usually diminish soon after
phases as illustrated in Exhibit 2. permits are obtained. However, they may re-emerge and

92 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
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FALL 2015
EXHIBIT 2
EXHIBIT 1

Phases in Mega-Project Execution


Interaction and Evolution of Risks over Project Lifecycle

THE JOURNAL OF STRUCTURED FINANCE


93
affect the supply side or demand side of market risks. For non-linear interactions, feedback delays along with the
example, a retroactive promulgation of an ordinance can- random nature of variability, which leads to indetermi-
celing the mining block allocations for a steel plant can nacy of outcomes in various forms.
negatively affect the cash flows in the operations phase and Our approach to modeling causality in mega-
adversely affect the returns temporarily or permanently. projects is based on an iterative staged method, which
Pricing de-regulation may emerge well after the initiation decomposes the structure and interactions into two
of the mega-project and may manifest itself in competitive stages. The first stage lays out the project in the context
demand-side and supply-side pricing, which will positively of the industrial sector and the related macro-economic
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affect the cash flows in the operations phase and hence the dynamics by using a top-down model. This presupposes
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cost of capital. Institutional risks may also affect the execu- a keen understanding of the working of the industry
tion risks due to duties, taxes, and labor laws, which may sector and the related macro-economic and policy envi-
positively or negatively affect the project cash flows. ronment. In the second stage, we model the dynamics
Execution risks, in contrast, can be characterized as of the project using a detailed bottom-up approach and
engineering design is initiated during the shaping phase integrate its outcome with the first stage.
and construction plans are firmed up. As the execution
phase evolves in the early stages and the parties get better Stage One Model in the Framework
visibility of the parameters that have higher likelihood
of changes and impacts on the schedule, resources, and The top-down Stage One Model structure is built
costs, the execution risks can be better understood. This around three interrelated blocks of demand, supply, and
growing understanding will be able to provide the spon- price along with representations of shocks on the demand
sors and the project financing institutions an increas- and supply blocks for each sub-area of the model. We
ingly objective and dynamic risk trajectory of project call this pattern an archetype—it is the building block
execution. Generally speaking, however, the execution for representing the sub-areas and interactions among
risks will start dropping after the initial engineering and them for the Stage One Model. Exhibit 3 gives our
design phase completions. representation of the archetype.
It is impossible to know, however, the magnitude of We have used this primary archetype for the other
all the risks and shocks that a mega-project will encounter, building blocks in the Stage One Model and then mod-
particularly during its protracted execution phase and to eled their interrelationships. An instance of the model
a lesser extent in its operations phase. Known risk levers, for the steel industry is shown in Exhibit 4. It inte-
whose magnitude may be unknowable in advance but grates the product market, raw-materials market, project
demand appropriate actions when they manifest them- investment, land, labor, and technology and equipment
selves, can be tested for their effect in a model simulator. instances of the basic archetype and drives the Stage
Our model framework acts as a management flight simu- Two Model through new project starts with the project
lator for the reasoned assignment of knowable risks within execution model (see Exhibit 6) archetype. We use a
which risks are discovered, imagined, and assigned to a hybrid continuous and discrete mechanism to simulate
coping strategy. The mitigation and coping strategies can the Stage One and Stage Two models to understand
be simulated using financial mechanisms, institutional the overall behavior of the project in the context of the
shaping, and project execution trade-offs. These what-if macro-economic and industrial environment.
simulations have the ameliorating effect of lowering the
risk trajectories by testing the effect of mitigation mecha- Stage Two Model in the Framework
nisms, thus helping to increase the incentives to invest
and lowering the risk premium of mega-projects. The Stage Two Model is embedded in the Stage
One Model, which is more of a bottom-up project exe-
A FRAMEWORK FOR RISK cution dynamics model based on our analysis. The Stage
CHARACTERIZATION OF MEGA-PROJECTS Two Model uses the outputs of workforce, supplier, and
resources (such as land) as stocks from Stage One Model,
In the preceding sections, we have laid out the which otherwise would have been defined exogenously.
nature of complexity and risk in large projects due to Similarly, the Stage Two Model outcomes further drive

94 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
EXHIBIT 3
Project Investment Causal Model Archetype
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EXHIBIT 4
Stage One Model

the supply and capacity addition parameters in the Stage engineering projects is particularly relevant in the execu-
One Model. tion phase of the project. This is especially germane
In our analysis of more than 10 mega-projects, we from a project financing perspective as the majority of
find that the degree and range of indeterminacy of out- the financing for large projects is committed based on
comes can be made more tractable by understanding cau- an understanding and mitigation of execution risks. We
sality across the various interacting external and internal begin by laying out a framework for understanding com-
factors across the project lifecycle. In particular, we think plexity and critical areas of risk assessment and charac-
that the interacting nature of those factors that drives terization, which addresses the execution phase through
complexity and its effect on risk characterization in large the Stage Two Model in the framework.

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 95


Typically, mega-projects have multistage project struction hours of work (Cheniere Energy [2014]). As
architectures where changes, rework, and information mentioned previously, sponsors, especially exhorted by
and physical delays are inherent characteristics. These financing agencies, frequently “outsource” the parti-
factors interact in seemingly unpredictable ways to tioning complexity and the associated risk through a
create impacts, which are delayed, nonlinear, indirect, turnkey EPC contracting mechanism with the hope that
and self-reinforcing. The nature of the interactions is the turnkey contractual mechanism will transfer the risk
such that it is difficult to perceive the full significance of partitioning complexity and execution. This is a big
before or even after the occurrence. This results in mis- fallacy and rarely does a contracting mechanism solve
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understood risk characterization and an obvious inability the problem of partitioning complexity and its related
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to comprehend the interconnectedness of the risks. As execution. That is because it is highly unlikely that a
described earlier, current models of risk for large projects sponsoring agency can design a bulletproof, turnkey
do not have appropriate mechanisms for understanding incentive-contract mechanism for risk transfer without
the nonlinear impacts and self-reinforcing degenera- clearly understanding the underlying drivers of execu-
tive dynamics of the risk factors, which often results in tion risk, which is closely related to the form, function,
incorrect conclusions and ineffective coping strategies. and interaction of work within and across the partitions
These counterintuitive effects then often prompt dys- (Merrow [2011]). A large project may also have procure-
functional management actions that can further desta- ment across a global project supply chain ranging any-
bilize the project. where from 200 to 2,000 suppliers. In our analysis, using
Execution complexity and its effect on risk at that our models, procurement structuring and sequencing,
stage can be better understood by understanding the and supply chain interaction and delays, have pro-
structural determinants of complexity in large projects. found and counterintuitive adverse impacts on project
We find that the major structural determinants of com- cost and timelines because they directly impact the erec-
plexity are as follows: tion sequence within and across partitions. Concurrent
Structure and form. Large projects have many and stage-gated partitioning is a key determinant to
interacting and overlapping stages across design, engineering, the structure of the organization across the sponsors,
construction, and commissioning. For example, stages of contractors, consultants, and vendors from a perspec-
design, also known as front-end loading (FEL) in industry tive of project execution. The structure of the resulting
parlance, can be stage-gated across three overlapping and organization thus determines the speed and accuracy of
interacting phases that can extend over 18 months and decision making. The delay effects of decision making
consume anywhere from 100,000 to 500,000 engineering create substantial cascading impacts in terms of time and
hours. The iterative and interactive nature of internal cost across the project, depending upon when and how
and external factors shapes the FEL stage. We find that they occur in the project lifecycle.
the initial stages of FEL are largely impacted by market Structuring and partitioning large engineering
factors and institutional factors—for example, land and projects is a foundational element in our framework for
zoning regulations, feedstock policy, sourcing constraints, understanding project behavior and hence the nature
environment, and competitive dynamics. of the risk that may evolve. In our projects, we have
Similarly, successful engineering and construction found design structure matrices (DSM) to be a useful
demand that the project be partitioned and structured tool to understand project structure from partitioning,
in a way that assigns functional coherence within parti- decoupling, sequencing, and interfacing perspectives
tions with clear interface definitions and dependencies (Eppinger [1994]). Exhibit 5 illustrates how we structure
while maintaining interface integrity across partitions. and partition mega-projects using DSM.
Structural integrity of these partitions is very impor- Changes and rework. One clear outcome from
tant for successful project execution due to the sheer the analysis of our large projects is the importance of
scale of engineering and construction. An adequately changes and the ability to manage the impact of changes
partitioned, multi-staged engineering and construc- and rework on the risk profiles and the success of project.
tion phase may have well over 100 interacting and After plans are in place, during the shaping and FEL
concurrently executing partitions or packages span- stage, changes occur. They occur on most projects and
ning more than 15–25 million engineering and con- throughout the life of many projects. They are the means

96 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
EXHIBIT 5
Design Structure Matrix of Partitioning Mega-Projects
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by which projects’ products are refined and improved. itself as cost of reworking previously completed work.
Some changes are institutionally mandated (e.g., Costs of changes have a cascading multiplier effect when
labor laws, resource allocation policy, environmental multiple changes occur across the lifecycle of the project.
regulations), some are market driven (e.g., changing The degree of rework varies depending upon the project
structure of demand or feedstock capacity), and some stage when the change is occurring. For example, a late-
reflect changing technical and performance requirements. stage design change discovered during the construction
Whatever the origin, change is a fact of life on most phase will have a much more pronounced impact than an
projects. The ability to progressively delineate change early-stage engineering change before the construction
scenarios and understand the critical levers for managing has started. Changes will have other multiplier effects,
and adapting to change is crucial in outlining possible such as productivity impacts, resource availability, coor-
project outcomes and their deviations from planned goals. dination effects, and quality, depending upon when
This then provides the sponsors and project participants and how they occur. For example, our model simu-
the ability to learn and proactively manage change in a lations consistently corroborate the fact that sustained
manner that minimizes the deviations and risks while overtime causes direct productivity loss and find that
conforming to the dynamic market requirements. knock-on productivity losses through attrition, new-
One of the important and seemingly indeterminate worker learning curves, and morale effects can be sub-
aspects of change is what we call the “second order” stantial (Thomas [1992]). Such productivity loss also
cascading impact of changes on project outcomes. Tra- occurs on unchanged work; people get tired and are
ditional project risk analysis methods typically underes- less productive on whatever they are doing. Overtime-
timate the impacts of the second-order effect of changes induced productivity loss thus, in general, means higher
as they are frequently unforeseen and because they tend cost to perform the work—hence, the second-order
to appear unexpectedly later in projects. Frequently, the impact. Through this and several other paths, changes
second-order impact of the effect of changes manifests cause productivity impacts that can substantially increase

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 97


the cost of executing the entire project. Although chal- equipment suppliers, late basic engineering development,
lenging to quantify and explain, this secondary impact approval cycles, delays in management response to
may well be the single largest source of project perfor- changes, and rework discovery time-constants. Some
mance problems. of the delays—what we refer to as time-constants and
Change impact quantification and the related information delays—are intrinsic to the nature of the
causal attributions is therefore an important factor in work and organization. For example, the rate at which
identifying the possible impacts on the project in terms rework is discovered follows a pattern that is dependent
of cost and time escalations. From a risk characteriza- on the organization, project type, nature of work, and
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tion perspective as a function of change, we need to the stage of the project execution, and is difficult to
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understand the scenarios and the project response to change in a short span of time. The rapidly growing
the following questions: a) What would happen if? b) impact of many small delays, especially the intrinsic time-
When is it likely to happen? c) What is the major cause constant-based delays, at various stages can snowball into
of the change? a large and seemingly unforeseen project impact.
The ability to model and manage the injection Understanding the timing and patterns of mate-
and mitigation levers for change and rework is thus the rial and information delays thus plays a significant role
second important structural factor contributing to the in terms of its effects on the possible project outcomes.
impact on project outcomes and the risk behavior. Qualifying and quantifying the causal effects of delays
Feedback and delay. Second-order impacts and their mitigation strategies is thus important in
in large engineering projects are not only because of understanding risk characterizations of large projects.
scope changes or visible direct changes like addition or This is the third building block for understanding the
modification of work. Delays are caused by changes as nature of risk in our framework.
well as information, for example, late arrival of data from Our Stage Two Model models these three struc-
tural blocks and along with the Stage
EXHIBIT 6 Two Model archetype (depicted in the
Project Work-Rework Cycle Model Archetype Appendix), we have found it to be a rea-
sonably accurate representation of the
project execution dynamics. The Stage
Two Model archetype is the work-re-
work-delay cycle that has been applied
to modeling execution dynamics of proj-
ects across design, engineering, and con-
struction phases as shown in Exhibit 6.
Using scenario simulations to
determine the interactions and the out-
comes, the causal models at this stage
are essentially the embodiment of our
mental models, and along with varia-
tions and simulated shocks on project
parameters and inputs from the Stage
One Model, the outputs typify the pos-
sible range of outcomes.

Synthesis of Framework by
Integrating Stage One and
Stage Two Models

As discussed earlier, our approach


is both top-down and bottom-up, based

98 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
on staged iterative evaluation of the causality at the macro approaches. This unit of work-rework is then
and micro levels in the context of the mega-project in aggregated at different levels of the model (see
the industrial sector and the macro-economic environ- APPENDIX).
ment. Specifically, our method does the following: 4. Our partitioning of the project also follows a
bottom-up approach to aggregate and determine
1. A top-down, macro-level, industrial, and sectoral couplings across activities. This allows us to struc-
dynamic model feeds into the project execution ture the project into partitions or packages. These
model. In the process, many of the factors that packages and couplings then form the basis of work
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would have been taken as exogenous are instead items for the causal model.
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endogenous to the execution model, providing


better fidelity on project behavior patterns in This method, we find, provides a more realistic
terms of outcomes, resiliency, and sensitivity to basis for characterizing risk behavior of the project and
these events. provides the basis for structuring, organizing, managing,
2. It models the project as a set of interactions across and potentially insuring mega-projects by integrating
project work items and resources along with delays, both micro- and macro-level effects in the context of
feedbacks, behavior functions, and policy response the large project. Exhibit 7 depicts our framework.
at an aggregate level. The level of aggregation is
dependent on the expected granularity level of the RISK SCENARIO ANALYSIS USING THE
output desired. FRAMEWORK
3. We also model the individual unit of project work
from dynamic bottom-up perspective through the Our scenario analysis for understanding the
work-rework cycle (Sterman [1992]), as opposed dynamic response of the modeled project starts by trying
to the static work unit modeled in typical project to understand the major internal and external input

EXHIBIT 7
Our Framework of Characterizing Risks

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 99


levers that can change—both in terms of extent/range magnitude of change in engineering by limiting the
and immediacy in terms of time. For example, based design-approval cycles. We may find that shifting the
on organizational knowledge and experience, we know deadlines gives us a window of change while minimally
the extent to which labor productivity changes over impacting the direct and opportunity cost. We may find
time if schedules are changed and overtime is increased. that simulating a range of price shocks in feedstock may
Similarly, based on the remoteness and location of the lead us to look at f lexible design options in the project for
project, we have reasonably good estimates of the effect a plant capable of handling multiple feed stocks (e.g., a
of a supply chain disruption on the magnitude of intro- dual-feed ethylene cracker plant option based on naphtha
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duced delay for an equipment supply. We can enumerate as well as natural gas or options for scrap, ore, or pellet
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with a reasonable degree of accuracy all such important charge for iron manufacturing).
internal and external levers affecting the project. The Once we have reasonably desensitized the project
model can evaluate how these changes, delays, and dis- along with mitigation and action plans, we will have a
ruptions propagate through the system and manifest in reasonably good estimate of the magnitude of variability
terms of schedule and cost impacts. Exhibit 8 represents of the risk factors. Exhibit 9 lists some of the typical ques-
an example screen showing the project’s sensitivities to tions and “what ifs” the framework helps to answer.
disruptions and changes. We then embark on the next stage of character-
In essence, our scenario evaluations attempt to rec- izing these range-constrained input risk factors using
ognize the major sources and ranges of overall execution statistical functions. These, we believe, are a much more
risk factors and interconnectedness of key risks. Based accurate and controlled representation of uncertainties
on this understanding, we evaluate various options for because they are steeper and tighter patterns and limit
desensitizing the projects and assess the value of reducing the fat tail effects encountered in other non-causal sta-
the range of uncertainty surrounding the significant risk tistical modeling approaches at aggregate levels of work.
factors; for example, mitigation measures to limit the We layer the Monte Carlo simulations based on these

EXHIBIT 8
Example Screen on Project Outcome Sensitivities to Changes

100 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
EXHIBIT 9
Strategic Questions on Market and Execution Risks
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patterns on our causal models to characterize and pattern institutions, such as the EIB, ADB, Exim, Mitsubishi
the behavior of the project over time. UFJ, and IFC. The commercial banks by their charter
and the nature of their business are not best suited for
SHAPING MARKETS FOR PROJECT FINANCE financing large-scale, long-tenor project transactions.
THROUGH FINANCIAL INNOVATION The Basel III liquidity requirements further limit the
ability of the banks to participate in such transactions
We think that our project dynamics and risk from a liquidity requirements perspective (Basel Com-
frameworks fill an important need in the area of risk mittee on Banking Supervision [2013]). The project
analysis, characterization, rating, and monitoring of finance markets for infrastructure financing fit more
large projects. This in turn can help in attracting and comfortably with natural, long-term institutional inves-
structuring syndications and private placements as well tors (e.g., pension funds and insurance companies),
as enable better functioning of project finance markets. who seek a diversified portfolio of assets to match their
While the applicability of our framework to syndication long-term liabilities. However, participation by these
and private placements for project finance transactions institutions is limited by their requirement for invest-
is straightforward, we next discuss its applicability in ment-grade ratings of projects at least at the A- level. In
exploiting the capital markets for project finance. our opinion, there are currently no known mechanisms
As discussed earlier, in the current market, large or institutions to rigorously and accurately analyze, rate,
international project finance transactions are primarily and monitor risk for large industrial infrastructure proj-
served by commercial banks and some multilateral ects, with a result that most of the projects are rated much

FALL 2015 THE JOURNAL OF STRUCTURED FINANCE 101


lower than investment grade. This mismatch between guarantees, letters of credit, or surety bonding. This
need for liquidity and financing and the availability of is both unattractive and expensive for contractors and
liquidity can perhaps be bridged though our framework sponsors and therefore inhibits the development of the
to enable an ecosystem of institutional investors, banks, project finance market.
risk arbitrageurs, and financial products. This in turn Alternative credit enhancement structures thus
can eventually help enable a vibrant capital market for provide an opportunity for securitizing project finance
project finance. transactions and making the investment opportunity
Up until the financial crisis of 2008, participation attractive to different class of investors with various
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of long-term institutional investors in the project finance risk appetites. Some of these structures, such as the EIB
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markets, especially in Europe, was enabled through Project Bond Initiative1 and the Hadrian’s Wall Capital
monoline insurers (Plimmer and Wigglesworth [2012]). product,2 are useful innovations in this area. They are
These were AAA rated entities providing credit insur- different from monoline insurance, wherein essentially,
ance (known as “wrapping”), typically for projects rated monolines swapped their AAA credit ratings for guaran-
BBB-/BBB and below, thereby enhancing the rating to tees on project finance risks for a fee. With the current
AAA and enabling debt to be sold to a bond market. products, the senior-level tranches are credit enhanced,
The monolines provided risk analysis, credit structuring, in that the “first loss” tranche of the debt for the project
and monitoring skills that meant institutional investors through the subordinated notes is funded in the form
did not have to invest in developing specialist in-house of draw-down rights or a fund for mezzanine-like debt.
project evaluation and risk analysis teams. After the Such credit enhancement of the senior notes draws in
financial crisis, the ratings of these companies began to the participation of long-tenor institutional investors,
crumble and this business model no longer worked. As increasing the liquidity of the market. Additionally, one
a result, project bonds almost completely disappeared as can imagine the growth of complementary risk insur-
a funding option in project finance markets. ance products around all the risk categories, and this
Today, institutional investors (i.e., insurance com- in effect can raise the ceiling on project bond issues,
panies and pension funds) face increasing pressure to improving their ratings and elevating them to invest-
find attractive investment opportunities. As a result, ment-grade status.
investors are re-exploring investment opportunities in For these credit structures to work on a consistent
industrial infrastructure. The common “deal breakers” and long-term basis, however, the risk characterization,
of the past (e.g., construction risk, deferred draw-downs analysis, and monitoring need to be reasonably bullet
in accordance with construction progress rather than one proof. We think that a delegated and objective institu-
single disbursement of the total amount at the start of tional structure based on our framework is an appro-
construction) are now increasingly accepted. The most priate mechanism to evolve such financial innovations
significant challenge, however, is in the risk assessment, for the project finance markets. Exhibit 10 illustrates
monitoring, and credit rating requirements of inves- how this would work in conjunction with EIB, NDB,
tors. Institutional investors do not have the resources, AIIB, and such multilateral institutions.
expertise, analytic frameworks, or monitoring systems We think that our framework can help in eventu-
to be able to evaluate and participate in this market. ally evolving the markets for project finance to a higher
Especially, the incomplete characterization of execu- level of liquidity and access by supporting both the cap-
tion risks tends to restrict the ability of mega-projects to ital markets and the syndication and private placement
achieve a high credit rating, and they are typically buck- markets. Its adoption along with the right institutional
eted at default ratings of BBB or go unrated. Significant structures can advance the state of the project finance
bond market liquidity really exists only for credit rat- markets with more mature capital markets, while
ings at BBB+/A- and above. Under these circumstances, enabling the creation of competitive capital markets for
achieving this level of rating for a mega-project to attract project finance in developing markets. Exhibit 11 illus-
financing will typically require significant construc- trates how we envision the markets for project finance
tion/delivery risk mitigation in the form of corporate to develop.
and third-party credit support through parent company

102 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
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FALL 2015
EXHIBIT 10

EXHIBIT 11
Development of Markets for Project Finance
Risk Framework Applied to Financial Innovation in Project Finance

THE JOURNAL OF STRUCTURED FINANCE


103
CONCLUSION to, and pricing of, funds on a more reasonable basis at
appropriately priced risk premiums. Characterization of
Characterization of risks and understanding risk also allows matching risks with a financial struc-
their interactions are key to accurately structuring and ture that allocates risks to the appropriate parties who are
financing large projects. The risk characterizations best able to bear them—through a combination of debt,
based on understanding and modeling of causality from equity, recourse, and guarantees. We believe that such
inception to completion along with the layering of the an approach to modeling mega-project risks will enable
stochastic nature of the related internal and external fac- the development of project finance markets along with
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tors lead to more transparent project assessments. This financial devices that eventually lead to widespread access
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results in better risk characterizations and hence access to funds for mega-projects.

APPENDIX
SYSTEM DYNAMICS MODEL FOR EXECUTION PHASE OF A MEGA-PROJECT

104 A FRAMEWORK FOR UNDERSTANDING AND MODELING R ISK IN M EGA-P ROJECTS FALL 2015
ENDNOTES Merrow, E. Industrial Megaprojects: Concepts, Strategies and Prac-
tices for Success. Hoboken, NJ: John Wiley and Sons, 2011.
1
See EIB’s website for more information on the “Europe
2020 Project Bond Initiative: Innovative Infrastructure Miller, R., and S. Floricel. “Transformations in Arrange-
Financing”: www.eib.org/products/blending/project-bonds/ ments for Shaping and Delivering Engineering Projects.” In
index.htm. R. Miller and D. Lessard, The Strategic Management of Large
2
See the Hadrian’s Wall Capital website: www.hadri- Engineering Projects. Cambridge, MA: Massachusetts Institute
answallcapital.com. of Technology, 2001.
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