I POLIcY RESEARCH WORKING PAPER 2712

# Summary findings

International bond markets have become an increasingly important source of long-term capital for infrastructure projects in emerging market economies over the past decade. The Ras Laffan Liquified Natural Gas (Ras Gas) project represents a milestone in this respect: its $1.2 billion bond offering, completed in December 1996, has been the largest for any international project. The Ras Gas project has the right to extract, process, and sell liquefied natural gas (LNG) from a field off the shore of Qatar. The principal off-taker is the Korea Gas Corporation (Kogas), which resells most of the LNG to the Korea Electric Power Corporation (Kepco) for electricity generation.

In this clinical study Dailami and Hauswald analyze the de terminants of credit spreads for the Ras Gas project in terms of its contractual structure, with a view to better understanding the role of contract design in facilitating access to the global project bond market. Market risk perceptions have long been recognized to be a function of firm-specific variables, particularly asset value as embodied in contracts. The authors therefore study the impact of three interlocking contracts on the credit spreads of the project's actively traded global bonds: the 25-year output sales and purchase agreement with Kogas-Kepco, the international bond covenant, and an output price-contingent debt service guarantee by Mobil to debt holders.

Using a sample of daily data from January 1997 to March 2000, the authors find that the quality of the offtaker's credit-and, more important, the market's assessment of the off-taker's economic prospects-drive project bond credit spreads and pricing. In addition, seemingly unrelated events in emerging debt markets spill over to project bond markets and affect risk perceptions and prices in this segment. Judicio as use of an output price-contingent debt service guarar tee by shareholders can significantly reduce project ri,ks, and markets reward issuers through tighter credit sareads.

Bondholders and shareholders share residual r-isks over time, despite covenants meant to preempt risk ,hifting. This type of risk shifting originates from incorr plete contracts and the nonrecourse nature of project finance. It does not necessarily result from a deliberate attempt by management to increase shareholder value at the expense of debt holders by pursuing high-risk, low-value activities, although project managers and share iolders could still exploit their informational advantag-i by leaving output supply contracts incomplete in ways beneficial to their private interests.

The results hold important lessons for global project finance. Projects incorporating certain design features can reap significant financial gains through lower borrowing costs and longer debt maturities:

* Judicious guarantees by parents that enjoy a particular hedging advantage enhance a project'; appeal, as reflected in favorable pricing.

Pledging receivables rather than physical assets as collateral and administering investor cash flows through an off-shore account offers additional security to debt holders.

* Projects should use their liability structure tv create an implicit option on future private debt financing that matches the real option of a project expansion.

* The finding that bondholders bear residual risks means that shareholders can reduce their risks arising from bilateral monopolies and buy insurance against unforeseen and unforeseeable events.

This paper-a product of the Governance, Regulation, and Finance Division, World Bank Institute-is part of a larger effort in the institute to disseminate the lessons of experience and best practices in infrastructure finance and risk management. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact William Nedrow, room J3-283, telephone 202-473-1585, fax 202-676-9874, email address wnedrow@a worlcbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at mdlailami@worldbank.org or rhauswald@Crhsmith.umd.edu. November 2001. (48 pages) _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas aoout development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. Phe papers carry the names of the authors and should he cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represen_ **_t_** _he view of the World Bank, its Executive Directors, or ehe countries they represent._ Produced by the Policy Research Dissemination Center