Rating Methodology Profile for Project Finance

Project finance transactions revolve around a collection of contracts and agreements among various parties, typically including the government as a regulator and / or a concessionaire, sponsors (private or government related entities), operators, and lenders. Project finance often involves a project company, structured as a special purpose vehicle (SPV), which may borrow funds. There are several project models to accommodate private sector participation that include build-operate-transfer (BOT), build-own-operate-transfer (BOOT) etc. In project financings the lenders typically look only to the projects’ assets to generate the cash flows that are the sole source of principal and interest payments, without recourse to others.

RISKS OF PROJECT FINANCINGS

The major credit risks in project financings can be grouped into three major categories: political risk, commercial or project risk, and financial risk. By understanding the components of these risk categories, one may assess them more systematically and determine what risks can be mitigated through sounder structures.

Sovereign or Political Risks

Sovereign or political risks can be defined narrowly as the risks to a project financing emanating from governmental sources, and can be divided into two categories, legal risk and regulatory risk. Legal risks include inadequate protections for physical, movable or intellectual property, inability to perfect security interests, inadequate mechanisms to establish and operate special purpose investing or borrowing entities, “creeping expropriation” through contract frustration or abrogation, inadequate de facto or de jure protection of foreign investors in local courts and unwillingness to submit to international arbitration. Regulatory risks include changes in taxation or lack of enforcement of provisions for rate increases to recover project costs, promises to limit new licenses, and other regulatory risks which can alter the level and nature of competition and the certainty and quality of a project’s cash flows through influencing project costs, revenues, or both.

The analysis of sovereign or political risks should also include consideration of the general business environment, whether it is hospitable for investment activity, the level of development of the economic and political system, and macroeconomic performance.

Legal Risk: Contracts, Dispute Resolution and Arbitration

The analysis of legal risk is focused on the rule of law and its application to project financings. Broadly, legal risk takes into account the course of conduct within the jurisdiction as it pertains to honoring contracts, particularly those germane to private sector investment.

Project operations and economics are governed by a complex set of arrangements and contracts with respect to the concession and the financing. Governments and corporate entities act as counterparties with duties and responsibilities that must be performed for the project to be successful. The timely enforceability of the contractual obligations of the parties is subject to many uncertainties, including whether the contracts are clear, the parties work together in good faith, whether there are political pressures on some parties to renege on their obligations, etc.

Credit risks are lower if contractual rights are protected through prior consent to use dispute resolution processes in neutral international (rather than local) jurisdictions. Local partners may prefer dispute resolution in the local jurisdictions where they may have some influence. A critical related question is whether there is legislation to enable external judicial and arbitral settlements to be enforced domestically.

Regulatory risks are common in projects. Regulatory authorities can reject tariff formulas designed to ensure adequate cash flow during the life of the project. Project completion and operations can be delayed through challenges to the environmental clearances for the project and once operating, a change in environmental standards can add cost to the operation which may or may not be able to be passed on to rate payers. The best mitigant for regulatory risk is a regulatory authority that operates with maximum transparency within a system of laws that provides some recourse against arbitrary action. However, such may not be the case in emerging markets. Following is a chart of the main elements of political risk and the attributes that differentiate strong from weak transactions.

Political and Legal/Regulatory Risk

COMMERCIAL OR PROJECT RISKS

Commercial or project risks concern the economic or financial viability of a project and thus include demand and supply risks, losses due to catastrophe, project completion risk, performance of third parties (such as a power purchaser or fuel supplier) and operational risks. It also should be noted that loan terms for loans made during or covering the construction phase may differ from the terms of loans made for the post-construction phase, where debt service payments are expected to come principally or only from project cash flows.⁹

Completion or Construction Risks

A project that has been conceived, designed, sponsored, approved by the authorities and financed must still be constructed by a certain date. Construction risk refers to developments during the construction period that lead to time or cost overruns and/or possibly changes to the specifications that may lead to operating parameter shortfalls. The capital-intensive nature of infrastructure and long construction periods make projects susceptible to delays and cost overruns.

Completion risk is thus simple to define. It is the risk that an otherwise well conceived and executed project fails to be completed for any of a range of possible reasons and thus fails to generate any cash flow. While construction risk is generally assumed to have ceased when a project is operational, planned modifications (such as conversion from high cost oil to low cost gas or other modification) may re-introduce construction risks.

Completion risks can be reduced through a variety of means. One such method is to shift a portion of the construction risk to contractors through engineering, procurement, and construction contracts (EPC) that carry penalties for delays and or performance shortfalls It is important to note that construction risk can be reduced through EPC contacts but not entirely eliminated since penalties typically are capped. Obligations pursuant to an EPC contract are only as good as the credit of the construction company. Accordingly, the reputation and experience of the construction contractor are of utmost importance. Following is a chart of the main elements of commercial/project risks and the attributes that differentiate strong from weak transactions.

⁹There must be a consensus regarding how to adjust the risk weights when some project risks are no longer relevant. For example, construction risk in effect disappears when the project is completed. One method would be to increase the weights of remaining RAMP factors pro-rata and a second possibility is to assign the risk that has disappeared an assessment signifying the lowest degree of risk.

Sponsor Risks

In the context of a project financing, the sponsor is defined as the principal equity investor and/or promoter of the project. Project financings are often structured with a special purpose vehicle as a project owner and the same or another special purpose vehicle as the borrower so the financing is non-recourse to the sponsor. While the sponsor may or may not be responsible to meet financial obligations of the project, the sponsor is the “driving force” behind the borrower and may influence borrower actions. In some situations, there may be recourse to the sponsor in the form of a “full faith and credit obl igation” or partial guarantee or a termination payment guarantee.

Following is a chart of the main elements of such sponsor risks and the attributes that differentiate strong from weak transactions.

Operational and Supply Risks

Once the project has been built and is operational, it may face a variety of operating problems that may cause the level of production or its quality to suffer below levels projected by investors. This could arise from poor management, labor strife, financial problems, equipment failures, or natural disasters. Operating risk is lowest for projects employing a tested technology. Operating risks are mitigated first through careful selection of the operator and/or maintenance contractor as well as contractual provisions that include payment of liquidated damages should the project operations fall below levels anticipated. Moreover, many operating risks underlying force majeure, which can excuse performance and hence contractual obligations when the responsible parties are confronted with circumstances outside of their control, are insurable though they add to project costs.

One element of operating risk, especially in the power sector, is supply risk that the raw materials needed to generate power may not be available in sufficient quantity for the project to fulfill its power delivery obligations. As in the case of other operating risks, the supplier should be carefully selected and the supply contract should contract for sufficient inputs to support project operations at projected levels. To protect the project against the risk of inadequate supplies, it may be possible to obtain a performance guarantee, where an insurer agrees to indemnify the project payment of cash or provision of the supplies to cover any shortfall in performance by the fuel supplier.

Following is a chart of the main elements of operational and supply risk and the attributes that differentiate strong from weak transactions.

Demand / Concession / Offtake Risks

The project typically generates a good or a service designed to meet expected demand, which may fail to materialize at the level expected. It is possible that demand projections made in assessing the viability of a project are not realized. For example, a toll road may generate lower level of traffic than expected because the toll may be unaffordable or because alternative roads may retain their attractiveness. A power project may have the capacity to produce a lot more power than current demand requires, which may lag projections. When demand falls short of expectations, cash flows may suffer, reducing the likelihood of timely repayment.

One way to protect against such a risk, say for a power project, is to undertake a Power Purchase Agreement (PPA) with an offtaker, which may be a public or private sector entity, generally a monopoly power distribution company within a specified service area. Under the PPA, the power producer is promised that the offtaker will take a certain level of power output (and capacity) for a certain price or pay the generating company a minimum amount if it fails to purchase such power. In such a PPA, the credit quality of the offtaker must be considered as a part of the overall transaction rating.

Following is a chart of the main elements of off-take and concession risk and the attributes that differentiate strong from weak transactions.

FINANCIAL RISK

Projects must withstand numerous financial risks on the revenue and the expenditure sides, such as market risk when the interest rate on the financing is not fixed but floating, or when loans are in a currency that is different from the currency in which the project earns its revenues, etc. .

A baseline consideration is the economic viability of the project. In this regard, cost of production relative to the market is an important consideration. High cost production, in the absence of mitigating circumstances, will almost always place the lenders at risk. The second element in analyzing the project’s viability is demand, which can change over time, sometimes dramatically.

Projects often face purely financial risks such as exposures to interest rate and foreign currency volatility, inflation risk, liquidity risk, and funding risk, which can be mitigated in a number of ways. First, in facing such risks, a project’s capital structure could be a strength or a weakness. Too much debt could increase vulnerability to currency and interest rate volatility and reduce financial flexibility. Second, the structure of debt can be a strength or a weakness. Amortizing debt is preferable to bullet maturities because few projects can adequately cope with the refinancing risk of bullet maturities. The project may establish minimum debt-service coverage ratios (DSCRs), a primary quantitative measure of a project’s financial credit strength. The DSCR is the ratio of cash from operations (CFO) to principal and interest obligations. CFO is calculated carefully and conservatively by deducting from revenues all expenses and taxes (but excluding interest and principal payments) associated with ongoing operations. The ratio also excludes any cash balances that a project could draw on to service debt, such as a debt service reserve fund or maintenance reserve fund. Tax obligations, such as host country income tax, withholding taxes on dividends and interest paid overseas, etc., are also netted out.

Following is a chart of the main concerns related to market conditions and financial structure and the attributes that differentiate strong from weak transactions.