Conflict and Project Finance

Exploring Options for the Better Management of Conflict Risk

<p>Investment projects in politically unstable countries present considerable risk management challenges to project sponsors, as well as their financiers and insurers. In particular, conflict risk – the risk that a project’s development, construction or operations may be adversely affected by the outbreak of violent conflict - can be a major threat to a project’s creditworthiness. Demonstrations and blockades by local communities; sabotage of project installations or facilities; kidnapping or assault to staff; outbreak of violent clashes between armed groups; demanding of payments by armed groups to project sponsors – all of these expressions of violence can impose direct costs to an investment, including reputational and even legal challenges arising from proximity to these factors.</p><p>At the same time, no project located in a politically unstable, conflict-prone area will be neutral. That is, just as a project may be adversely affected by violent conflict at the project or national levels, the project itself will have an impact on the conflict context within which it is located. The project and its context thus must be understood to have a two-way relationship.</p><p>This background paper focuses on the linkages between project finance and conflict. Project finance is frequently used to fund investments in higher-risk developing countries – particularly for large infrastructure and natural resource extraction projects. These investments are often linked to violent conflict at local and national levels due to interactions with certain structural and proximate causes of conflict, including economic underdevelopment and natural resource dependence. Even where conflict appears to be geographically far from a project, it is possible that investments, in contexts where resources are scarce, will soon become part of the conflict dynamic, boosting government access to revenue that can be used to prosecute conflict; attracting attention and demands from conflict actors; bringing migrant workers into a locality; and becoming a source of heightened competition locally.</p><p>Project financiers are particularly exposed to conflict risk due to the non-recourse and limited recourse nature of the financing structure. Hence, financiers need to be specifically concerned about managing their exposure to conflict-related credit risks. Business interruptions can lead to project downtime; legal injunctions can lead to expensive delays; and larger compensation packages can create cost overruns. All these developments can directly affect a project’s ability to repay debt in a timely manner. And as project finance is very specific to a particular activity, a clear line of responsibility connects financiers with social impacts caused by a project, thus exposing the financier to reputational risks.</p><p>Despite the strong case for closer thinking on the appropriate assessment and management of conflict risk on the part of project financiers, there has been limited attention to this issue to date. Lenders and insurers currently employ advanced risk management processes to deal with a range of commercial and non-commercial risks associated with projects in higher risk markets. Most financial institutions rely on a combination of techniques to assess environmental, social and political risks: country level risk indices, political risk assessments, as well as social and environmental impact assessments are all helpful to varying degrees. However, these are inadequate in terms of conflict risk: they fail to systematically examine the two-way interactions between projects and the conflict context in which they are developed and operated.</p><p>The weaknesses of current conflict risk assessment practices are reflected in the existing strategies employed to manage conflict risk. In particular, reliance on political risk insurance (PRI) to mitigate risk is problematic. While PRI insurance or hedging instruments do provide cover for political violence and other events, cover is expensive, and may not extend to sub-state conflict risks faced by clients. Nor is PRI a risk management tool in the sense of ensuring a project will not aggravate existing tensions throughout development, operation and closure. Further, from a conflict prevention perspective, PRI is problematic as it may create a moral hazard whereby the provision of the insurance itself may act as a disincentive for sponsors to take steps to avoid exacerbating conflict.</p><p>Despite current gaps in conflict risk assessment and mitigation processes, the project finance community is well-placed to improve its understanding and management of conflict risk. This may be done through adopting what this paper terms a ‘conflict-sensitive’ approach to project finance. This encourages enhanced due diligence by financial institutions to better understand the conflict context in which a project is developed; to identify the interactions between the project activities and that context; and to act to prevent any negative impacts that may be the result of that interaction. A conflict-sensitive approach would also require encouraging improved conflict risk mitigation by project sponsors in line with international best practice. This approach also advocates that public sector lenders and insurers work to ensure cross-institution and inter-departmental coherence on poverty reduction, private sector investment and conflict prevention policies.</p><p>Enhanced understanding of conflict risk may bring a number of benefits to project financiers. For commercial lenders, enhanced understanding of the two-way nature of conflict risk facing a project may give a competitive advantage in that a bank may reduce the risk of certain projects, thus either improving the risk-reward tradeoff they face or opening up opportunities to lend to projects with which they would not otherwise become involved. More indirectly, reducing the potential for negative impact on risk from projects contributes to an enhanced and more sustainable global economy. Improved understanding of conflict risk may also assist those financial institutions with a ‘footprint’ in conflict-prone areas, as conflict-sensitive approach to lending could contribute to more informed and sustainable business relationships with governments, business partners and other stakeholders, as well as to a more stable operating environment.</p><p>A conflict-sensitive approach to project finance should also appeal to public sector lenders and insurers. While multinational development banks and export credit agencies may be brought into higher-risk projects due to the level of political protection afforded by them or home governments, conflict may also reduce MDB and ECA scope for business by foreclosing areas from consideration for lending. Improved conflict risk assessment and management may open up new investment opportunities, as well as assisting institutions pursue international development goals. At the same time it will alert organisations to situations where the risk of violent conflict is so high that proceeding with investment may not be viable.</p><p>Until now the financial sector has had limited involvement in international debates on business and conflict. This background paper seeks to stimulate greater consideration of conflict risk and a more constructive path for project finance backed investments in conflict-prone regions.</p>

Corene Crossin and Jessie Banfield
January 2006
Economic development
International Alert
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