What is a letter of credit?

A letter of credit is a written undertaking by a bank, given at the request of an applicant, to pay a named beneficiary a stated amount on presentation of specified documents within a stated period.

Two features do all the work.

It is independent. The bank's obligation stands apart from the contract that gave rise to it. If the documents conform, the bank pays. A dispute between the applicant and the beneficiary about whether the underlying obligation was really breached is a matter for those two parties to resolve between themselves, afterwards. That independence is the source of the instrument's value — and also its sharpest edge, because it means an applicant can find the credit drawn while it believes itself to be in the right.

It is documentary. The bank deals in documents, not in facts on the ground. It does not inspect a construction site or verify a delivery; it examines whether what was presented matches what the credit requires.

Two forms are worth distinguishing. A commercial or documentary credit is a payment mechanism in a trade of goods: it is expected to be drawn, in the ordinary course, when the goods ship. A standby letter of credit is credit support: it is expected never to be drawn, and a drawing signals that something has gone wrong. Almost every letter of credit on an infrastructure project is a standby, and the rest of this page concerns those.

A standby credit is a substitution mechanism. Understanding what it replaces explains why each party wants it.

For the beneficiary, it replaces reliance on the counterparty. A utility, a supplier or a landlord dealing with a newly formed project entity is facing an entity with no history, no balance sheet, and — by design — no other business to fall back on. That is precisely the point of a [special-purpose vehicle](special-purpose-vehicle), and it is a problem for anyone the vehicle needs to deal with. A credit from a rated bank converts that unknown counterparty into a known one.

For the applicant, it replaces cash. The alternative to posting a credit is usually posting cash — a deposit, a funded reserve, collateral held by someone else for years. Cash posted is capital not deployed, which on a project competing on speed is expensive. A credit keeps the cash working, at the cost of fees and of the collateral or facility capacity the issuing bank requires behind it.

It can also replace a guarantee. A parent guarantee gives the beneficiary a claim against a stronger entity, but realising it means a claim, and possibly litigation. A credit is drawn by presenting documents. Where the beneficiary values speed and certainty over amount, it will prefer the credit even where the guarantor is strong.

What it does not replace is credit itself. The issuing bank has extended credit to the applicant and will hold collateral, security, or capacity under an existing facility against it. The obligation has moved; it has not disappeared. A common mistake is to treat undrawn credits as costless because they sit off the balance sheet in the sponsor's own mental model — they consume real capacity, and that capacity is finite.

The instrument shows up at every stage of a build, and almost always at the point where a counterparty is being asked to commit something before the project can prove itself.

• Interconnection and utility security. Utilities commonly require security against network upgrade costs and against a load that may never materialise. This is frequently the first credit a project needs, and it is needed at the point the project is least able to demonstrate anything.
• Long-lead equipment. Turbines, transformers and switchgear require substantial payments at order, years before delivery. Security runs in both directions here: the supplier wants assurance the buyer will take and pay for the equipment, and the buyer may want assurance against advance payments made for equipment that does not yet exist.
• Construction contracts. Performance security from the contractor, and payment security to the contractor, both commonly take this form. The interaction with the [construction loan](construction-loan) matters, because credits issued for the build consume the same capacity the build itself needs.
• Leases and site agreements. A landlord or ground lessor taking a project entity as tenant will usually require security for the rent obligation.
• Reserve accounts. Financing structures often require a reserve holding a period of debt service. Many permit that reserve to be satisfied with a credit rather than cash, which frees the cash for the project — a routine and material optimisation.
• Credit support behind an offtake obligation. Where an offtaker's own credit does not carry a [take-or-pay](take-or-pay) obligation, a credit posted in favour of the project can close the gap and make the contract count for more than the counterparty alone would support.

The last of these is the one that most often changes what a project can do, because it operates directly on the quality of the contracted cash flow that everything else is sized against.

A credit is only worth the terms it is written on, and the failures are consistent.

• Who issued it, and is that issuer acceptable. The whole instrument rests on the issuer's credit. Where it does not meet the beneficiary's requirement, a confirming bank can add its own undertaking — which is the ordinary answer where the parties sit in different markets.
• Expiry, and what happens at it. This is the most common failure in practice. A credit securing a multi-year obligation is usually issued for a shorter period and renewed. The protection is an evergreen provision: automatic renewal unless the issuer gives notice, with the beneficiary entitled to draw on receiving that notice. Without it, the security has a cliff edge in the middle of the obligation it exists to support.
• The drawing conditions. What must be presented, in what form, and by whom. A credit requiring documents the beneficiary cannot realistically produce — or requiring the applicant's own countersignature — is not the instrument it appears to be.
• Amount against exposure. Whether the face amount actually covers what it is securing, and whether it steps down as the underlying obligation reduces.
• Transferability and assignment. Whether the beneficiary's rights can move if the project or the contract is transferred.
• The governing rules and the reimbursement terms. Which internationally recognised rule set applies, and what the applicant owes the issuing bank on a drawing. That reimbursement obligation is immediate and rarely negotiable, and it is where a drawn credit becomes a liquidity event for the applicant. The legal analysis belongs to counsel; the commercial point is that a drawing is not the end of the applicant's exposure but the start of it.

Continuum's role around these instruments is structural: establishing where in a build credit support is actually required, what it needs to cover and for how long, and coordinating the parties so the support is in place before the obligation it secures is committed to.