Infrastructure Companies | Infomerics Ratings

RATING METHODOLOGY – INFRASTRUCTURE COMPANIES

ROAD PROJECTS

OVERVIEW

The road projects under the Public Private Partnership (PPP) model are being awarded on Built Operate Transfer (BOT) basis. BOT is further segmented into BOT-Toll and BOT-Annuity basis. The projects are implemented through project specific Special Purpose Vehicles (SPVs) in which the debt is raised to fund part of the project cost. The main source of revenues for these SPVs is the toll revenue, which is used to meet the contractual obligations including operational and maintenance expenses, payments to NHAI (in case of negative grant/revenue share) and servicing of debt obligations.

The rating methodology developed by Infomerics for debt issues of road projects (RPs) is designed to facilitate appropriate credit risk assessment, keeping in view the characteristics of the Indian road sector. The methodology examines the broad parameters of the project based on the Information Memorandum (IM) submitted by the client. The following key risk areas are covered:

SPONSOR RISKS

Despite the non-recourse nature of the SPV, the financial strength of the sponsor is a key credit determinant given that apart from contributing promoter’s share in the form of equity capital and/or subordinated debt, the sponsor is also directly or indirectly responsible for ensuring financial closure of these projects. Further, during the pre-COD stage, most of the toll projects involve recourse to the sponsor for debt servicing as termination payments from the project owner are not available during this period. The presence of financially strong sponsor(s) lends comfort, basing on their ability to provide support to the SPV in case of any contingency or short-term cashflow mismatches.

PROJECT IMPLEMENTATION RISK

The nature of the project and its scope in terms of By-pass, Lane expansion, additional bridge, road modernisation, etc are examined as the risks vary depending upon the scope of the work. Also of importance is location of the project which will determine the viability. A key component of the completion risk is the permitting risk which refers to a project’s ability to acquire all statutory clearances prior to the commencement of construction activity. Typically, for a road project this would include right-of-way acquisition, rehabilitation and resettlement, clearances from the Ministry of Environment and Forest (MoEF), Pollution Control Board and Railways, and clearances for shifting all utilities that lies in project area. The permitting risks are usually low where the project involves upgradation of an existing operating stretch, however such risks are significant where projects involve bypasses or involve construction of entirely new stretches, where considerable amount of land needs to be acquired.

Infomerics examines the extent of tie-up for finance. Also being evaluated is the vulnerability of the project cost and time overruns, and the promoter’s capability to raise additional resources to fund these over-runs. Further, factors such as difficult terrain, inadequate investments in construction equipment, weather and labour problems also contribute to construction delays and cost escalations. These risks are partially mitigated through strong fixed-price fixed-time EPC contracts with strong counterparties with adequate liquidated damage provisions for non-performance. Also being assessed is the financial and operational capabilities of the EPC contractor and its ability to meet the contractual commitments.

Also being evaluated is the quality of construction and robustness of the project design. Project owners usually lay down the design and quality parameters in the concession agreement. These parameters would need to be adhered to by the concessionaire and certified by the independent engineer before the stretch can be opened to the traffic. In many NHAI owned BOT road projects, there is a clause of provisional COD if at least 75% of the project stretch is completed and the remaining work is pending due to reasons attributable to the authority. Provisional COD gives the concessionaire the right to start partial tolling and protects the revenue loss in case of delays in project completion. Further, in many cases the authority also has to provide atleast 80% of the RoW before the commencement of the concession of the project. These provisions protect the concessionaire from loss of revenues on account of delays in handing over of the required RoW and mitigate the project execution risks to that extent.

DEMAND ANALYSIS, COMPETITION AND TOLL PRICING

The debt investors in toll road projects are primarily exposed to the risks associated with the build-up of traffic volumes and the user’s willingness to pay tolls as per the prescribed rates. The analysis especially focusses on traffic demand and potential variation of demand due to economic changes and competition. The linkage of demand to toll pricing and the users’ willingness to pay is also examined critically.

Demand analysis involves analysis of the toll road region in terms of economic strength and diversity. The projects which serve a captive demand, such as stretches which connect to port or city bypasses which relieve congestion levels, carry relatively lower levels of traffic risks. The regional wealth indicators like level of industrialisation, availability of facilitating infrastructure etc are examined. The analysis examines the level of commercialisation, level of business travel traffic which would be the mainstay for revenue generation. The viability of the project depends upon the assessment of demand which is critical as wrong estimation of demand or deterioration in the economic base would adversely affect viability and debt servicing capability of a project. Infomerics relies on independently conducted traffic studies to assess the future potential of the projects. The traffic studies are however suitably sensitised to assess the cash flow protection available to debt investors in case of shortfall in traffic levels. The nature and composition of traffic as well as volatility of traffic due to business cycles, natural factors (floods, landslides, etc), social unrest and escalation in fuel prices is studied critically.

A balance between commercial and private vehicle traffic is viewed favourably though commercial traffic tends to serve as a stabilising force. In case of commercial traffic, the toll burden is passed on to the customers and hence it is less sensitive to toll increases than private traffic. Normally, a diverse traffic mix cushions the impact of a decline in any one segment.

Toll roads are generally developed in areas with high traffic density to ease traffic congestion or cut down on distance between destinations. This justifies levy of tolls, either on account of savings in distance or time, or both. Toll roads in the initial years face little competition. The availability of alternate freeways and other competing modes of transport (such as railways) could lead to traffic diversion. Also development of toll-free roads can divert traffic away from a toll facility and disturb the projected traffic growth and subsequent revenues. It is therefore critical to examine the capital programmes of the appropriate state, regional and local authorities to factor in any possible competing facility. Covenants in the Concession Agreement (CA) which explicitly prohibit the government from setting up competing facilities up to a stipulated period will mitigate ‘diversion risk’ of the project to a large extent.

The toll pricing based on user’s ‘willingness to pay’ is criticall for the success of any road project. Typically, a toll road project would result in benefits in form of (i) savings in vehicle operating costs (VOC), (ii) savings in time and (iii) savings in distance covered. Savings in VOC is considered as the most important criteria in determining the users’ willingness to pay. The composition of traffic along the stretch and the sensitivity of various user segments towards payment of tolls are also being examined.

A Concession Agreement providing for an ‘automatic’ revision with pre-defined formula for revision in toll rates e.g. linkage to inflation index along with requisite authority to the project directors to implement toll rate revisions is considered as a positive for the project. An important prerequisite in this regard is favourable socio-political climate for revision of tolls and such decisions being shielded from normal political processes.

EVALUATION OF CONCESSION AGREEMENT (CA)

Concession Agreement (CA) between the project owner and the concessionaire defines the framework within which such projects operate. Such projects are usually implemented through special purpose vehicles (SPVs) which enable legal separation of the credit risk profile of the project from that of their sponsors. The concession period for such projects usually ranges between 15 and 30 years, dependent on the projected toll collections along the stretch. CA provides the mandate to implement the project and to levy and collect tolls. Hence, the terms of the CA are carefully examined, especially those relating to:

Tenor of concession and provision of extension of concession period in case of shortfall in revenues.
Levy of tolls and their periodic revision
Termination of CA.
Issues relating to land acquisition.

CA is examined to check whether it contains sufficient safeguards to provide disincentive to any of the contracting parties to default. Quantum of Compensation payments in the event of termination of the CA and their adequacy to repay outstanding debt servicing obligations of the SPV is analysed critically. Provision of assignability of the CA in the covenants in the event of non-completion or non-satisfactory progress would be viewed favorably by Infomerics. Some CAs provide the SPV an option for seeking property development rights in case of insufficient revenue generation. This would have a positive impact from a credit perspective.

OPERATING RISKS

Operating risk is the risk of the project not conforming to the required performance parameters over the period of the concession agreement. Typically, performance parameters specified in the concession agreement are driving quality of the carriageway, safety standards, adherence to maintenance schedule, and road availability standards. Non-compliance with some of the performance parameters may be an ‘event of default’ and impinge on the developer’s ability to collect tolls. The concessionaire’s ability to fairly assess operating expenses and lay down a proper maintenance schedule is important to protect future revenue streams. Operation and maintenance (O&M) expenses cover periodic maintenance, involving relaying the asphalt-concrete once every five to seven years. The O&M estimates would be highly sensitive to inflation and would therefore be difficult to budget over a 15 year period.

FINANCIAL ANALYSIS

Similar to other infrastructure projects, road sector are also characterised by fairly high levels of capital intensity. Infomerics carries out in-depth analysis of the projected operations to get a clear indication of the SPV’s ability to service debt. The analysis would include critical examination of the underlying assumptions, location of possible stress points and the extent of flexibility to tide over difficulties. A key element of the analysis is an assessment of the sufficiency of revenues for meeting operating expenses and debt service obligations. The key sensitivity scenarios include variability in traffic volumes and toll rates, time and cost overruns during the construction phase and variability in operations and maintenance expenses post completion. Stress tests are all the more important if it emerges that significant traffic and revenue growth is necessary for meeting contractual obligations. Other factors being taken into consideration are as follows:

STRUCTURAL RISKS

Apart from assessing the economic viability of the project, Infomerics also reviews certain structural aspects of these projects, which include the process by which these revenues streams are aggregated in collection accounts and subsequently transferred to the debt service reserve accounts (DSRA) after funding the O&M and major maintenance reserve account (MMRA). Presence of strong escrow mechanism and ring fencing of cash flows to prevent any leakage of funds are some of the structural considerations. Availability of adequate funds in DSRA so as to cover at least six months of debt servicing obligations also provides structural support for ratings.

CREDIT ENHANCEMENT

Private road projects in India so far have been either without recourse or with limited recourse to the sponsors. To the extent the project has some form of recourse to a strong sponsor, it serves as a source of credit enhancement. Forms of support may include undertaking to cover cost overruns, cash support in case of any shortfall in repayment of loan, undertaking to provide funds to SPV to maintain a level of DSCR etc. A debt service reserve, fully funded can provide significant protection to bondholders, especially if chances for delays in implementation of increase in toll rates exist.Guaranteed take-out financing via repurchase of bonds by highly rated entities has been used in India to serve as credit enhancement for the initial investors in the bonds.Traffic guarantees and Partial/ full exchange risk cover offered by the government has been used as a source of credit enhancement internationally.At times the relevant state, regional or local authority budgets may also provide for meeting shortfall in debt servicing requirements.

QUALITY OF INVESTMENTS

Pending redemption of debt obligations, surplus funds would have to be appropriately invested by the SPV. The proposed investment policies of the company for deployment of surplus funds are examined to ensure the safety of such investments. Liquidity aspects of the proposed investments also are considered. Each of the above factors and their linkages are examined to arrive at the overall assessment of credit quality. The reduction in credit risk due to any credit enhancements provided is carefully evaluated before assigning the rating.

MANAGEMENT EVALUATION

All ratings necessarily incorporate an assessment of the quality of the issuer’s management, as well as the strengths/weaknesses arising from the issuer’s being a part of a “group”. Also of importance are the issuer’s likely cash outflows arising from the possible need to support other group entities, in case the issuer is among the stronger entities within the group. Usually, a detailed discussion is held with the management of the issuer to understand its business objectives, plans and strategies, and views on past performance, besides the outlook on the (issuer’s) industry. The management capability is evaluated from different perspectives like financial capabilities, track record in implementing and operating projects of similar nature and size and availability of technical manpower.

CONCLUSION

The rating process ultimately determines the likelihood of the rated debt obligation being repaid in full and on time. Infomerics analyses each of the above factors and their linkages to arrive at the overall assessment of credit quality of an issuer. The credit rating is an overall assessment of all aspects of the issuer factoring comprehensive technical, financial, commercial, economic and management analysis.

POWER GENERATION

OVERVIEW

Power sector following the liberalisation process has encouraged private investment and such investment is expected to go up substantially in the near future. Power projects are capital intensive and for funding them, recourse to publicly issued debt would be necessary. The rating methodology developed by Infomerics for debt issues of power projects (PPs) is designed to facilitate appropriate credit risk assessment, keeping in view the characteristics of the Indian power sector. The methodology examines the broad parameters of the project based on the Information Memorandum (IM) submitted by the client. The following areas are covered:

PROJECT IMPLEMENTATION RISK

New Projects generally entail higher risks than operational projects. The gestation period for thermal plants is around 3-4 years, while that of a hydel plant is higher because of delays caused by political and regulatory disruptions. The focus here is to determine the risks faced by the company in completing the projects. Infomerics examines the pattern of financing employed by the company for approved and ongoing projects, and whether the financing has been tied up. The financing mix in terms of market debt and internal accruals/ government support is indicative of the company’s financial policy. Infomerics conducts sensitivities on time and cost overruns to assess the company’s ability to meet debt-servicing obligations. Projects nearing completion are viewed more favourably than green field projects because they represent a relatively lower construction risk. Also given due weightage to the company’s track record in setting up projects. Fixed-price, fixed time contracts, with adequate clauses for liquidated damages (LD), are usually the mitigants against construction risk. During project implementation, progress would be monitored vis-a-vis the initial cost and time estimates to determine the effect of variations from schedule on the ability to meet debt servicing obligations.

FUNDING RISK:

The ability to meet debt service obligations in time depends critically on the financing plan of the project. The capital structure of an IPP is evaluated to assess whether the debt-equity ratio is in conformity with that of power projects of similar size and complexity. The technical aspects of the project, financial structure, the funding profile in terms of maturity, proportion of foreign currency loans & rupee loans and the hedging strategies to be used for covering exchange risk are examined in detail. The strength of the promoter would also impart financial flexibility in funding shortfalls for equity tie-up as well as funding for cost overruns or other contingencies. Any covenants in the debt documents or PPA, which can impair debt servicing capability, are also evaluated critically.

EVALUATION OF POWER PURCHASE AGREEMENT:

Power Purchase Agreement (PPA) is a crucial document outlining the rights and responsibilities of the power producer and evaluation of the same forms a critical part of the rating exercise. The minimum off-take of power committed by the purchaser and the incentives and penalties based on the cut-off Plant Load Factor (PLF) to be achieved are some of the factors being critically examined. The demand-supply situation in the area to be serviced is assessed. Also being evaluated is the terms and conditions to be met before commissioning of the project, clearances and agreements with different agencies and consequences of non-fulfillment of stipulated conditions. The funding pattern, construction schedule, penalties for late completion, achievement of projected capacity and the role of the operating company with regard to plant operation and fuel arrangements are studied. The tariff rates are critically analysed to determine their adequacy to ensure the profitability and debt servicing capability of the PP at the minimum performance level and at higher levels of performance. The focus here is to evaluate the adequacy of both the fuel cost pass-through available in the terms of PPA as well as that of tariff compensation mechanism if approved by SERC. Projects with competitive bid based PPAs where the fuel cost is largely a pass-through based on quoted heat rate, are relatively less risky

COUNTER PARTY CREDIT RISK:

In assessing counter-party credit risk, evaluation is done on the counter-party and the extent of capacity contracted through a long term PPA. Most long term PPAs with state owned distribution utilities provide for a three-tier payment security mechanism (PSM) consisting of Letter of Credit, Default Escrow agreement and Right for third party sale of power, which is a source of comfort. While the structure of the PSM provides comfort, the focus is to assess the past performance record of such mechanisms for operational projects. Revenue generation for a PP depends on the financial strength of the buyer(s) of power and often determines the maximum rating a PP can obtain. The assessment of the power purchaser is, therefore, an integral part of the rating of a PP. While credit quality of state owned distribution utility is linked with the intrinsic credit quality of State Government, the analysis is done on the distribution utility’s financial position in terms of trends in cost coverage ratio (Cost Coverage Ratio = Annual Revenue Realisation (ARR) less Average Cost of Supply (ACS); ARR = Cash Collection inclusive of subsidy receipts / Units Input ; ACS = Total expenditure / Units Input) , adequacy of subsidy release by State Government, extent of cost reflective tariffs and ability to improve the efficiency levels & keep actual costs in line with regulatory targets.

OPERATING RISK

The operating risks for a power plant arise from two sources: uncertainty over fuel supply and possibility of plant performance being lower than the normative parameters as specified in the PPA. An assessment of fuel supply risks involves evaluation of the sources of supply, locational proximity to the sources, reserve availability, contractual obligation of the seller, and price of supply. Operating risk for a power plant also involves assessment of fuel price risk exposure in PPA. Unlike cost plus based projects where the cost is a pass-through subject to achieving the normative level, the extent of pass-through of costs in a competitively bid based PPA varies depending on the bid structure. For projects bidding for coal blocks through auction route any aggressive bidding approach would be viewed cautiously, especially with most bidders having limited experience in mining operations. Also being examined technology used, plant availability, plant efficiency, administrative efficiency, environmental issues and billing and collection.

FINANCIAL RISK

Infomerics carries out in-depth analysis of the projected operations to get a clear insights into the PP’s ability to service debt. The analysis would involve critical examination of the underlying assumptions, location of possible stress points and the extent of flexibility available to tide over difficulties. The financial analysis takes into account the following factors:

ACCOUNTING QUALITY

Some accounting policies that significantly influence the genco’s profitability include depreciation, capitalisation of interest and expenses, provisioning for receivables and bad debts, prior period expenses, contingent liabilities and the like. If required, financial statements are adjusted to provide an accurate picture of the genco’s financial position.

PAST PERFORMANCE

The focus here is on analysing the genco’s past performance. The parameters assessed include trends in revenue from operations, costs and profitability analysis, management of receivables and payables, capitalisation, analysis of loans and borrowings, payment track record, coverage ratios and return on capital employed.

PROFITABILITY

The profitability for power project is critically dependent upon nature of PPA and the mix of PPAs for capacity tie-up which determines net realisation. A PPA can be cost-plus based, competitively bid or bilateral short term based / spot tariff based. In case of cost-plus based PPA, profitability depends upon the issuer’s ability to declare the plant availability and maintain the actual costs within the normative benchmarks. In case of competitively bid based PPA, actual returns for a company would be dependent upon its ability to keep actual operating and cost parameters within the tariff bid levels. In case of PPA based on mutually negotiated short term tariff, the company’s profitability remains exposed to volatility in the fuel price level. Further, vulnerability of profitability remains the highest in case of merchant sales on power exchange where power tariffs are volatile. All the above mentioned factors are critically analysed to review the performance.

GEARING & COVERAGE INDICATORS

Given the capital intensity of a power project and the normative debt:equity ratio allowed by CERC of 2.33 times, leveraging levels (Total Debt / Tangible Net Worth) in the sector are inherently high. Generally, a conservative leverage ratio is viewed favourably as it reflects a lower quantum of committed outflows, while a long maturity profile and lower cost of borrowing can partially offset the risk associated with a high financial leverage. Also, a back ended or ballooning structure of debt repayment can partially mitigate the risk of cash flow mismatches in the initial period, post commencement of operations.

Infomerics compares a genco’s key debt-protection ratios such as debt-service coverage ratios (DSCR), Interest coverage and net cash accruals to total debt with other gencos and companies across other industries. Also scenario analysis is done to assess the average DSCR over the debt repayment period as well as the project IRR, with the key sensitive variables being project cost overrun, plant efficiency (heat rate and auxiliary consumption), receivable days and cost of debt (only for average DSCR). Further in case of projects with competitively bid based PPAs, additional sensitivity factors include the actual cost of fuel, fuel price escalation in the PPA and exchange rate (in case of projects with foreign currency debt as well as projects using imported coal).

FUTURE CASH FLOWS AND FINANCIAL FLEXIBILITY

Infomerics focuses on the genco’s operational and financial forecasts to assess the degree of certainty in cash flow projections. Future cash flows are projected after taking into account the tariff structure, PLF, O&M cost, interest cost, debt repayment schedule, working capital funding requirements, other funding requirements related to expansion capital expenditure and available funding options. These cash flows are then used to determine the company’s future debt servicing capability. In the cash flow projections, also being analysed is other ratios such as Fund Flow from Operations to debt coverage and Retained Cash Flows to debt coverage, as inputs to the credit rating.

Also being evaluated is the issuer’s relationships with banks, financial institutions and other intermediaries, its financial flexibility—as reflected by its unutilised bank/credit limits, liquid investments – as well as financial strength of the promoter group to infuse funds (either equity capital or unsecured debt ) to meet cash flow shortfall, if any.

MANAGEMENT EVALUATION:

CONCLUSION

The credit ratings assigned by Infomerics are a symbolic representation of its current opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at following a detailed evaluation of the issuer’s business and financial risks, its likely cash flows over the life of the instrument being rated, and the adequacy of such cash flows vis-à-vis its debt servicing obligations. Even though the financial projections assesses the adequacy of cash flows from the debt servicing perspective, the final rating assigned is also critically dependent upon the strength of the sponsors and the track record of the sponsor group in power project development and operations.