Contracts, governance, and country risk in project finance: Theory and evidence

- We model project finance (PF) in the presence of external risk and agency problem.
- PF is structured to balance financial returns and operational controls.
- Contract and ownership structures together are important governance mechanisms.
- We find that governments grant concessions in exchange for operational control.
- Private sponsors give up control over the project for enhanced financial returns.

Project finance links financial structure to the operational characteristics of the project to optimize the allocations of various project risks. We develop a model in which concession grants and offtake agreements benefit both public and private sponsors in the presence of political risk. The public can use these contracts to incentivize the private sponsor to undertake an otherwise unacceptable project while benefiting from delegating the process of financing, building, and operating the project to the private sponsor. For the private sponsor, the government concession grant, while improving financial returns, entails political influence. We develop hypotheses connecting these contract choices to the public-private partnership governance structure of project finance and provide supporting evidence. Our findings suggest that a country's political and financial risks have significant impacts on the contract choice as well as the public-private governance structure in project finance. Projects in greater political risk countries tend to be structured with less government involvement in order to avoid political influence of the local government. Projects with the private finance initiative end up with more government involvement and control in order to protect the public interest.