US power fuels project finance defaults

The default rate in project finance has shown an upward trend between 2008 and 2012, with all defaults in the past two years occurring in the US and primarily in the power sector, ratings agency Standard & Poor’s found, citing low natural gas prices as the main culprit.

“We saw two defaults in each of 2008 to 2010, three in 2011, and five in 2012,” S&P wrote in a study released last week. Of the eight defaults that happened in 2011 and 2012, seven were in the power sector, according to the study.

The reason recent defaults occurred exclusively in the US is because the US market accounts for a greater percentage of speculative-grade project finance debt. “Market participants may be more willing to accept greater risk in this region, with a combination of greater debt leverage or greater construction and operating risk present in many projects in the region,” according to the study, titled “Project finance default and recovery: Shale gas fuels rise in US defaults”.

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S&P also noted that the uptick in project finance defaults was slower to materialise compared with the uptick in corporate defaults that occurred in 2009, shortly after the 2008 financial crisis. “This suggests that some of the project financings, with their debt service reserves and distribution traps, have been able to continue to operate under stress for another two years before reaching default,” the study said.

Still, the good news is that while the average default rate varies depending on economic conditions, projects on average are no more risky than corporate entities at comparable rating levels, according to S&P.

In addition to updating its last study, the ratings agency also looked at the performance of all S&P project finance ratings from 1992 – when it first started issuing such ratings – to 2012. Unsurprisingly, the agency found a clear correlation between ratings assigned at inception and the rate of default. “That is, the higher the initial rating, the lower the observed default frequency,” S&P said.

Another encouraging finding, which is in line with other ratings agencies’ findings, is that rated project finance issues generally had low default rates equivalent to low investment-grade corporate entities and higher recovery prospects.

While typical project financing, which includes features such as pledged collateral and contracted off-take agreements increases creditor protection the structure does not always insulate a project from the economic cycle.

“We have seen increases in project finance defaults during two periods – around 1999-2002 and in the past three years,” S&P stated in its study.