Principal-agency risk in project finance

Abstract

Unlike traditional asset-based financing, where lenders have recourse to the assets of the project sponsor, “pure”, zero recourse project finance is a method of financing large-scale, capital intensive projects, in which only the cash flows generated by the project serve as the source of loan repayment and project assets serve as collateral for the loan. The exact nature and duration of the complex set of property rights in a project are established in detailed and complex contracts which define the relationships between various project participants. As the number of project stakeholders increases, the agency risk, that some will take unobserved actions to transfer wealth from the unwary to themselves, increases. The failure of accounting standards to adapt to the explosion of new property rights, as in the case of the collapse of Enron Corp in the United States, would tend to increase project agency risk. The purpose of this paper is illustrate, using a numerical example, a potential agency risk problem for unwary suppliers of project-based financing due to asset substitution.