When discussing about construction risk, we mentioned the environmental risk and as, for example, natural disasters. Can you say something more on how these risks can be specifically addressed? >> These kinds of risks are important in project finance. But unfortunately, the key point is that environmental risks, sometimes natural disasters for the most part, cannot be controlled by anyone. And so, it is really hard to find a contractual obligation that can be attached to one specific counterparty of the SPV. And, this is important because these risks, tipically, can be defined as risks that are common to both phases. So, you will experience the probability of a natural disaster during construction, but also during operation. You can have a political risk, during construction and operation. And it could go on, and on in this respect. But, just to give you and to clarify which kind of risks are common, can be found in both phases. Let me briefly use a short taxonomy. The first one were the risks that were mentioned in the natural disasters. Take the case of a hurricane, a flood an earthquake, it is obvious that in this case no one can be considered responsible for this. But however, there are insurance policies in the market that you can enter as a special purpose vehicle in order to protect you against this kind of risk. The second category is typically represented by political risk. Political risk in the jargon of insurers is due to very different kinds of effects. For example, there is the so called changing law. All of a sudden, a government changes the regulation of a sector. And you can face the risks that your plant indictment is not compliant with that specific regulation. And unfortunately, changing law cannot be insured. And so changing law remains on your own shoulders as an SPV throughout your life. Another possible example of political risk is what insurers call as investment risk. Take for example the case of a project development in a country that is experiencing a civil riot or a civil war, or a revolution. You are building the plant and all of a sudden the plant is expropriated without any kind of indemnification. And you lose all the value that you have invested there. Or, suppose for example, that you have built the plant, now the plant is up and running. It's generating profits, but the country puts a ban on the convertibility of the currency between the local currency and your own local currency. From this point of view, you face a problem because you can't repatriate the cash flows. Typically, political risk can be insured. And there are specific insurance policies. Most of them are guaranteed by the so-called expert credit agencies. So special insurance companies that are set at the governmental level, close to the Ministry of Economy of every single state. And so you can also find protection for those kinds of things. The third possible example, but I could go on and on, is environmental risk. Environmental risk has to do with a couple of effects. On one side you can have public opposition, that is opposing to the construction of the plant. Or the functioning of the plant, if the plant is already up and running. And you can face the risk that this kind of public opposition can turn into a petition for changing regulation. And you can, again, face some problem, which is not insurable. Or environmental risk can determine some form of contamination of the surrounding environment. Take for example the case of nuclear contamination for nuclear plants. And, in this case, you can find in the market some good insurance policies that can protect you against this kind of risk. So, returning to your question, we have named acts of God, natural disasters that also can force majeur risk. Political risk, environmental. Not to mention the risks derived from the fluctuations of macroeconomic variables that can influence the performance of the project. Take for example, the case of inflation risk. You have estimated that your tariffs will be revised according to an expected inflation rate of 2% while exposed to the inflation that turns out to be only 1%. And this can create problems because your revenues will not grow as expected. Interest rate risk. If you have entered into a long-term loan agreement with banks. Or, if you have issued bonds the market that are playing a floating rate. You could face the risk that the level of interest rate increases more than what you had in mind in your business plan and this creates a concern, again, because it will burn cash flow from the project. again, because it will burn cash flow from the project. If you are a company and you are developing an international project, very likely some of the counter parties will invoice you in a currency different from yours. Or you will invoice your counterparts in your local currency creating a mismatch in terms of currencies that you use for cost and revenues. And this can create problems, particularly if you don't take into account these kinds of fluctuations. So at the end of the day, you can appreciate that risks that you can find in both phases are really numerous. And for the most part we have seen, can be covered by typically insurance policies whenever they are available. >> Well professor, with respect in particular to the math, to the risk related to the fluctuation of microvariables, which we have just mentioned. Are these always hedged or are the hedged in some circumstances in particular? >> Good question. I would say interest rate risk probably is the variable, together with currency risk that lenders typically require to hedge against. This is obvious for a couple of reasons. The first one is you don't want to get profit out of fluctuations or variables that you are not able to control. So banks typically say, if you want really to safeguard the value of your cash flow, hedge against any kind of macro risk that can trigger some problem in the project. I would say more, this is typically a condition precedent. So a condition that marks banks require in order to use their offers. So if you don't demonstrate them that you have entered into derivative contracts that hedge against this risk, you can simply use the money coming from lenders. One could debate in terms of the need instead to hedge against inflation. In some cases, hedging against inflation, and you have financial instruments in financial markets. Consumer price index swaps are becoming something that is pretty used in financial markets can be used. However one thing that typically financial analysts do when they have to decide whether or not to use this kind of instrument, is to verify if costs and revenues, when they are indexed to inflation, move in the same way or not. Think the extreme case, where you have a project whose revenues and operational costs are linked to the same inflation rate. And that escalated, revised, using the same level of inflation rate. You can understand that if the inflation rate will raise 1%. This is will have the same effect on cost of revenues if the inflation parameter is equivalent. So, from this point of view you don't have to hedge because the margin is self protected because cost and revenues move in the same direction. And the same holds true when the inflation goes down, instead there could be the necessity to protect you against inflation. If the two inflation rates that typically, revenues and cost, are linked to are different, in this case you are facing what in finance is called base risk. The fact that inflation can move in a different way on the revenue side and on the cost side. And so, this typically could require you some requests from creditors to hedge also against this risk.
