Common Contractual Risk Allocations in International Power Projects

Monday, January 1st, 1996 at 12:00 am by John G. Mauel
John G. Mauel, Common Contractual Risk Allocations in International Power Projects, 1996 Colum. Bus. L. Rev. 37

Rational people and entities are generally averse to risk. Therefore, the shifting of a risk from one party to another can be viewed as the providing of a good by the risk bearer to the risk shifter. It follows that risk allocation should be guided by the two basic economic principles that are applicable to any other type of exchange of goods — the fundamental theory of exchange and the general theory of competitive equilibrium. Under the fundamental theory of exchange, both parties to a transaction are made better off if each party provides the good with respect to which such party has a comparative cost advantage. Under the general theory of competitive equilibrium, the optimum quantity of the good exchanged should be that quantity with respect to which the marginal cost of the last unit to the provider of the good is equal to the marginal benefit of the last unit to the receiver of the good. The fundamental theory of exchange suggests that a risk should be shifted to the person or entity that is best able to control or manage the risk. The general theory of competitive equilibrium suggests that a risk should be shifted until the marginal cost to the risk bearer of bearing the risk is equal to the marginal benefit to the risk shifter of shifting the risk. Risk allocation in an international project can be interpreted as a complex set of contractual arrangements that result from risk markets that exist among the different project participants with respect to the various risks associated with the project. Because of the variety and gravity of the risks and the disparity between the ability of the different project participants to control the risks, proper risk allocation can be used as a significant tool for enhancing the financial viability of the project by shifting each risk to the party with the lower marginal cost of bearing or mitigating the risk. Surely one of the more significant contributions to be made by the various counsel to the project participants is the proper identification of risks to their respective clients and the proper documentation of the negotiated allocation of such risks. Each project is faced with a unique combination of risks. The degree of uncertainty with respect to each common risk also varies from project to project. The risks inherent in international power projects are exacerbated by high capital outlays, long construction and operation periods, a need for a permanent stream of fuel, and unstable markets. The natures of the risks facing a particular project depend on the technology involved in the project, the availability of fuel for the project, the political stability of the country in which the project is located, and the nature and affiliations of the project participants.

Author Information

Partner, Fulbright & Jaworski L.L.P. in Houston, Texas.