RATING METHODOLOGY PROFILE FOR PROJECT FINANCE
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
|Political risk, including transfer risk, considering project type and mitigants||Very low exposure; strong mitigation instruments, if needed||Low exposure; satisfactory mitigation instruments, if needed||Moderate exposure; fair mitigation instruments||High exposure; no or weak mitigation instruments|
|Force majeure risk (war, civil unrest, etc),||Low exposure||Acceptable exposure||Standard protection||Significant risks, not fully mitigated|
|Government support and project’s importance for the country over the long term||Project of strategic importance for the country (preferably export-oriented). Strong support from Government||Project considered important for the country. Good level of support from Government||Project may not be strategic but brings unquestionable benefits for the country. Support from Government may not be explicit||Project not key to the country. No or weak support from Government|
|Stability of legal and regulatory environment (risk of change in law)||Favorable and stable regulatory environment over the long term||Favorable and stable regulatory environment over the medium term||Regulatory changes can be predicted with a fair level of certainty||Current or future regulatory issues may affect the project|
|Acquisition of all necessary supports and approvals for such relief from local content laws||Strong||Satisfactory||Fair||Weak|
|Enforceability of contracts, collateral and security||Contracts, collateral and security are enforceable||Contracts, collateral and security are enforceable||Contracts, collateral and security are considered enforceable even if certain non-key issues may exist||There are unresolved key issues in respect if actual enforcement of contracts, collateral and security|
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.
|Design and technology risk||Fully proven technology and design||Fully proven technology and design||Proven technology and design — start-up issues are mitigated by a strong completion package||Unproven technology and design; technology issues exist and/or complex design|
|Permitting and||All permits have||Some permits are||Some permits are still||Key permits still need|
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.
|sitting||been obtained||still outstanding but their receipt is considered very likely||outstanding but the permitting process is well defined and they are considered routine||to be obtained and are not considered routine. Significant conditions may be attached|
|Type of construction||Fixed-price date- certain turnkey construction EPC (engineering and procurement contract)||Fixed-price date- certain turnkey construction EPC||Fixed-price date-certain turnkey construction contract with one or several contractors||No or partial fixed- price turnkey contract and/or interfacing issues with multiple contractors|
|Completion guarantees standing||Substantial liquidated damages supported by financial substance and/or strong completion guarantee from sponsors with excellent financial standing||Significant liquidated damages supported by financial substance and/or completion guarantee from sponsors with good financial standing||Adequate liquidated damages supported by financial substance and/or completion guarantee from sponsors with good financial standing||Inadequate liquidated damages or not supported by financial substance or weak completion guarantees|
|Track record and financial strength of contractor in constructing similar projects||Strong||Good||Satisfactory||Weak|
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.
|Sponsor’s track record, financial strength, and country/sector experience||Strong sponsor with excellent track record and high financial standing.||Good sponsor with satisfactory track record and good financial standing||Adequate sponsor with adequate track record and good financial standing||Weak sponsor with no or questionable track record and/or financial weaknesses|
|Sponsor support as||Strong. Project is||Good. Project is||Acceptable. Project is||Limited. Project is not|
|evidenced by equity, ownership clause, and incentive to inject additional cash if necessary.||highly strategic for the sponsor (core business-long-term strategy)||strategic for the sponsor (core business-long-term strategy)||considered important for the sponsor (core business)||key to sponsor’s long term strategy or core business|
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.
|Scope and nature of operations and Maintenance (O & M) contracts||Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts||Long-term O&M contract, and/or O&M reserve accounts||Limited O&M contract or O&M reserve account||No O&M contract: risk of high operational cost overruns beyond mitigants|
|Operator’s expertise, track record, and financial strength||Very strong, or committed technical assistance of the sponsors||Strong||Acceptable||Limited/weak, or local operator dependent on local authorities|
|Supply Risk Price, volume and transportation risk of feed-stocks, suppliers track record and||Long-term supply contract with supplier of excellent financial standing||Long-term supply contract with supplier of good financial standing||Long-term supply contract with supplier of good financial standing-a degree of price risk may remain||Short-term supply contract or long-term supply contract with financially weak supplier-a degree of price risk definitely|
Reserve risks (e.g. natural resource development)
|Independently audited, proven and developed reserves well in excess of requirements over lifetime of project||Independently audited, proven and developed reserves in excess of requirements over lifetime of project||Proven reserves can supply the project adequately through the maturity of the debt||
remains with supplier of excellent financial standing
Project relies to some extent on potential and undeveloped reserves
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.
|Off-Take Risk and Concession Risk|
|(a) If there is a take-or-pay , fixed-price off- take contract, concession agreement :||Excellent creditworthiness of offtaker; strong termination clauses; tenor of contract comfortably exceeds the maturity of the debt||Good creditworthiness of off-taker; strong termination clauses; tenor of contract exceeds the maturity of the debt||Acceptable financial standing of off-taker; normal termination clauses; tenor of contract generally matches the maturity of the debt||Weak off-taker; weak termination clauses; tenor of contract does not exceed the maturity of the debt|
|(b) If there is no take-or-pay or fixed-price off- take contract:||Project produces essential services or a commodity sold widely on a world market; output can readily||Project produces essential services or a commodity sold widely on a regional market that will||Commodity is sold on a limited market that may absorb it only at lower than projected prices||Project output is demanded by only one or a few buyers or is not generally sold on an organised market|
|be absorbed at projected prices even at lower than historic market growth rates||absorb it at projected prices at historical growth rates|
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.
|Market Conditions||Few competing suppliers or substantial and durable advantage in location, cost, or technology. Demand is strong and growing||Few competing suppliers or better than average location, cost, or technology but this situation may not last. Demand is strong and stable||Project has no advantage in location, cost, or technology. Demand is adequate and stable||Project has worse than average location, cost, or technology. Demand is weak and declining|
|Financial ratios (e.g. debt service coverage ratio (DSCR), loan life coverage ratio (LLCR), project life coverage ratio (PLCR), and debt- to equity ratio)||Strong financial ratios considering the level of project risk; very robust economic assumptions||Strong to acceptable financial ratios considering the level of project risk; robust project economic assumptions||Standard financial ratios considering the level of project risk||Aggressive financial ratios considering the level of project risk|
|Stress analysis||The project can meet its financial obligations under sustained, severely stressed economic or sectoral conditions||The project can meet its financial obligations under normal stressed economic or sectoral conditions. The project is only likely to default under severe economic conditions||The project is vulnerable to stresses that are not uncommon through an economic cycle, and may default in a normal downturn||The project is likely to default unless conditions improve soon|
|Duration of the credit compared to the duration of the project||Useful life of the project significantly exceeds tenor of the loan||Useful life of the project exceeds tenor of the loan||Useful life of the project exceeds tenor of the loan||Useful life of the project may not exceed tenor of the loan|
|Currency risk arising from financing in a currency different than the currency in which revenue is denominated||Indexation of tariffs||Rolling forward hedge|
|Amortization schedule||Amortizing debt||Amortizing debt||Amortizing debt repayments with limited bullet payment||Bullet repayment or amortizing debt repayments with high bullet repayment|