With over 20 years’ experience of rating global project finance debt, Standard and Poor’s (S&P) has seen the sector learn some hard lessons from its pioneering days, such as how to counter market exposure (the biggest cause of default), enhance transaction structures, mitigate construction risk and reduce counterparty exposure.
As a result, we have seen an increase in non-investment-grade rated projects and a surge of bonds issued prior to construction – historically, institutional investors predominantly invested in operational projects – indicating that the market for project finance debt has broadened over the years.
That said, some projects still continue to fail. Of the 513 different projects we have rated in the past two decades, 34 issuers (or 6.8 percent) have defaulted. Overall, this is a low proportion. But it is important that the market learns from these lessons.
To help improve the market’s understanding of the risks at play, S&P has redesigned its methodology for rating project finance debt. In doing so, we have isolated the different types of risk factors: market exposure, technology/design failures, structural weakness of a parent or counterparty, operational underperformance, commodity exposure and changing regulation (see the table below). As the table shows, some factors are more influential than others.
The data confirms that market exposure is the key reason behind project failure – leading to approximately 26 percent of total defaults in S&P’s portfolio. Companies are particularly vulnerable to market exposure risk when natural resources are a key input.
For example, the collapse in natural gas prices and reduced energy demand after the 2007 economic downturn caused complications at many power projects and led to several defaults. AES Eastern Energy LP, an operator of four coal plants in New York, reduced its hedging and derivative-market liquidity in response to falling prices and the project could not meet its debt-service requirements as a result.
Market exposure risk is not limited to power projects, however. US-based Windsor Petroleum Transport Corp, which operates four large crude oil carriers, recently defaulted when US demand diminished as a result of the boom in shale oil. As a result, there were far more oil tankers than necessary for demand, leading to the worst shipping rates since 1999.
Technological and design faults (during construction) are to blame for approximately 20 percent of project defaults. Technological problems during construction typically bring down a project when unforeseen issues lead to overspending and strangled cash-flows. And projects susceptible to technological failure can be varied: from mining to transportation ventures.
For example, Bulong Operations Pty. Ltd, a nickel and cobalt mining company in Western Australia, experienced increased construction costs due to technological failures and depleted cash reserves. As a result, the project was forced to take on more debt, leading to further pressure on its cash flow and, ultimately, default.
In our analyses we separate technological issues during construction from those that occur when a project is fully operational. Project default is less likely to occur as a result of technological problems during the operational phase, with only around 9 percent of defaults occurring due to operational underperformance.
That said, Choctaw Generation LP, a power plant based in Texas, defaulted at the end of 2012 because a turbine design flaw and succession of equipment failures led to on-going underperformance. As a result, the plant did not meet its contracted heat rate (which inversely measures plant efficiency) with extended low production hurting revenues.
STRUCTURAL WEAKNESS OF COUNTERPARTIES AND PARENT COMPANIES
Of the historic defaults in S&P’s portfolio, around 18 percent were primarily caused by structurally weak parent companies. For example, the default of unrated US-based parent York Research Corp. significantly damaged York Power Funding Ltd – a project that included four power stations in Texas, New York, and Trinidad & Tobago.
Counterparty issues are more common than some projects account for – especially when the counterparty company proves to be irreplaceable. For instance, a sewage plant project may be unable to find a new concession provider when a local government water utility terminates its contract. And even if a replacement can be found, there are no guarantees that an economically viable contract will be agreed.
ADAPTING TO CHANGING MARKETS
Indeed, government bodies can have significant effects on the health of individual projects, and we have seen some projects get into financial distress after tariff or regulatory changes.
Examples of regulatory risks include a local government not approving expected tariff increases, as happened with The Panda Global Energy Co project that failed after disagreements with a local government body in China which refused increased rates. Despite regulatory risk being the least influential factor in our table and only causing around 3 percent of total defaults, it cannot be ignored.
Indeed, our goal with the revised criteria is to add transparency by isolating all weak points in projects and dealing with each section separately through a more detailed assessment of individual risk factors.
For example, the construction section of our revised criteria seeks to clearly define the types of risks in such situations. We concentrate our assessment on the quality of the technology, the extent of design completion, the complexity of the schedule, the availability of funds set aside for contingencies, and the experience of the construction management team. Meanwhile, on the operational side of our criteria, we conduct on-going surveillance that considers actual performance history, meaning that continuing poor performance cannot go unnoticed.
In addition, our revised criteria include an assessment of all economically meaningful counterparties and a section on how we view counterparties throughout a project’s life. With new methods for assessing liquidity and dispensability, we are able to provide more transparency regarding the risk created by individual counterparties. Although the default of a counterparty is often hard to forecast, our goal is to provide transparency on how such a default could affect a project.
While we have not changed our broad approach, our redesigned ratings criteria create a consistent approach for testing downside scenarios that aids comparisons between projects – something that we hope will improve transparency in project finance risk and contribute to another 20 years of progress.