Methodology Rating Project Finance august 2013 previous release: april 2011
CONTACT INFORMATION Eric Beauchemin, CFA Group Managing Director, Co-Head Global Corporate +1 416 597 7552 apassi@dbrs.com Kent Wideman Chief Credit Officer +1 416 597 7535 kwideman@dbrs.com DBRS is a full-service credit rating agency established in 1976. Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.
Rating Project Finance TABLE OF CONTENTS Introduction to DBRS Methodologies 4 Project Finance: An Overview 5 Construction Period 6 Risk Allocation 6 Complexity of Construction 6 Quality of the Construction Contractor 6 External Enhancements 7 Other Considerations 8 Operating Period 10 Risk Allocation 10 Revenue and Off-Take Agreement 10 Operating and Maintenance Risks and Costs 12 Technology Risk 13 Sponsorship, Financial, Legal and Other Consideration 14 Sponsor Strength and Equity Contributions 14 Debt Structure 14 Reserves 15 Credit Quality of Financing Parties 15 Debt Service Coverage 15 Legal Considerations 16 Country and Political Risk 18 Summary of Rating Drivers 19 3
Introduction to DBRS Methodologies DBRS publishes rating methodologies to give issuers and investors insight into the rationale behind DBRS s rating opinions. In general terms, DBRS ratings are opinions that reflect the creditworthiness of an issuer, a security or an obligation. DBRS ratings assess an issuer s ability to make timely payments on outstanding obligations (whether principal, interest, preferred share dividends or distributions) with respect to the terms of an obligation. DBRS rating methodologies include consideration of historical and expected business and financial risk factors as well as industry-specific issues, regional nuances and other subjective factors and intangible considerations. Our approach incorporates a combination of both quantitative and qualitative factors. The considerations outlined in DBRS methodologies are not exhaustive and the relative importance of any specific consideration can vary by issuer. In certain cases, a major strength can compensate for a weakness and, conversely, a single weakness can override major strengths of the issuer in other areas. DBRS may use, and appropriately weight, several methodologies when rating issuers that are involved in multiple business lines. DBRS operates with a stable rating philosophy; in other words, DBRS strives to factor the impact of a cyclical economic environment into its ratings wherever possible, which minimizes rating changes due to economic cycles. Rating revisions do occur, however, when more structural changes, either positive or negative, have occurred, or appear likely to occur in the near future. DBRS also publishes criteria which are an important part of the rating process. Criteria typically cover areas that apply to more than one industry. Both methodologies and criteria are publicly available on the DBRS website. 4
Project Finance: An Overview Project finance is, broadly speaking, the long-term financing of infrastructure, power generation and other types of assets in a manner that is non-recourse (or limited recourse) to the sponsor of the project and where only the cash flow from the specific assets, typically isolated in a special-purpose vehicle, is used to service the project debt secured by those assets. DBRS uses this methodology for a broad range of energy- and non-energy-related projects, although power generation and oil and natural gas pipelines projects are used as examples here. DBRS also has separate methodologies for rating solar and wind power generation projects, public-private partnerships, and airport authorities, as well as for corporate power generators that sell electricity from multiple and dispersed power generating assets, each of which can be found at www.dbrs.com. DBRS divides its review of a project finance transaction into three general sections: (1) construction period; (2) operating period and (3) sponsorship, financial, legal and other considerations. For projects that have a construction period, it is typically the weaker of either the construction or the operating period that determines the overall rating. The following schematic shows the typical contractual and cash flow relationships in a project financing. Project Finance Structure Revenue Counterparty Payments Revenue Contract Offtake Volume Sponsors Dividends Project Co Debt Service Lenders Equity Financing EPC Contract O&M Agreement Construction Payments O&M Payments EPC Contractor O&M Contractor Project finance structures rely on contracts to manage risk during construction and operation. Project assets are typically held in a special purpose vehicle (SPV), here labeled ProjectCo. The engineering, procurement and construction contract (EPC) sets out the terms of construction of the project, typically at a fixed price. The revenue contract (e.g., a power purchase agreement (PPA)) permits ProjectCo to sell its output (e.g., electricity) to the off-taker or revenue counterparty. The operating and maintenance (O&M) agreement sets out the terms of services provided by the O&M contractor(s) and sub-contractors during the operating period. Finally, a variety of financial agreements (trust indentures, hedging agreements) and SPV constitution documents address certain financial, legal and other considerations. The terms of the contracts typically transfer, or partially transfer, a variety of risks from ProjectCo to its counterparties in the transaction. Such risks include construction completion risks, the credit risk of various counterparties, operational risks, price and inflation risks as well as catastrophic risks, each of which are typically transferred to the entity best able to bear them. These risks and others are discussed in detail in the sections that follow. 5
Construction Period The construction period is generally the riskiest portion of the project as it entails considerable uncertainty (e.g., site conditions, weather and availability of labour and materials) and requires specialized project management skills including quality control, schedule adherence and critical path management, as well as managing relationships with key stakeholders and permitting authorities. These factors typically rely on the performance of the construction contractor, who commits to design and build the asset on behalf of ProjectCo for a fixed price by a date-certain but whose credit profile is often in the BB to BBB range. An independent engineer (IE) is engaged to assess the construction schedule, budget, design, EPC contract, technology, technical staffing, protections against completion delays and initial performance risk, and the operating period cost components of the financial model. DBRS s assessment of construction period risk includes the following: Risk allocation Complexity of construction Quality of the construction contractor External enhancements Other considerations RISK ALLOCATION ProjectCo is typically structured as an SPV with little ability to perform construction. Accordingly, construction completion risk and any commissioning requirements specified in the revenue contract are generally transferred to a construction contractor via a fixed-price, date-certain, turnkey EPC contract. DBRS assesses the degree of pass-down of construction risks and, to the extent ProjectCo is left with any construction risks, the potential frequency and severity of adverse outcomes will be evaluated. DBRS cautions that even low-probability events can affect the rating if a particular risk has not been adequately transferred under the EPC contract. COMPLEXITY OF CONSTRUCTION Construction risks increase with more complex schedules and technologies, as well as when difficult terrain and/or geographical location is involved. For power generation, DBRS generally ranks complexity by technology (from most to least complex) as follows: nuclear, coal, natural gas, hydroelectric, wind and solar. DBRS s assessment of complexity during construction may be affected by a number of factors, including (1) design and technical requirements; (2) technology; (3) the nature of the contract (fixed-price versus cost plus); (4) scale of the project; and (5) the experience level of the sponsor, EPC contractor and O&M contractor. Projects incorporating new technology may increase completion test requirements and time frames, ramp-up times, and add to initial operation teething problems. Typically, the equipment vendor is motivated to support the early installations of new-generation equipment and will provide additional ramp-up and initial performance support, as well as increased warranty support. Due diligence should confirm that additional support is provided under the vendor sales contract when new-generation technology is used. QUALITY OF THE CONSTRUCTION CONTRACTOR The credit quality of the construction contractor can anchor the construction period risk rating, particularly for large projects with four- to five-year construction periods and moderate to high complexity. Contractor credit risk is assessed using a separate DBRS methodology entitled Rating Companies in the Engineering and Construction Industry. Critical factors for rating contractor-specific risks include: (1) risk management and project control; (2) project complexity and contractor expertise; (3) scale of operations; (4) nature of contracts (i.e., percentage of fixed-price contracts); and (5) diversification of revenue. 6
Proven technical capability of the EPC contractor is important, as is its financial capability. Financial capability analysis includes review of key financial ratios as well as the contractor s order book and available liquidity. Technically capable contractors can be victims of their own success, so to speak, if liquidity cannot match order book volume created by successful winning of mandates. In certain cases, higher working capital requirements from rapid growth may stress contractor bank covenants and trigger delays for construction-in-progress. The fit of the construction contractor with respect to the type and size of the project is important. DBRS evaluates the construction contractor s size, reputation and track record in completing similar projects on time and on budget, as well as the construction contractor s ability to perform the construction tasks. Where a contractor lacks experience in a specific sector or region, DBRS examines the strategies proposed to fulfill all obligations, including the use of experienced subcontractors and the timing of their engagement, planning for labour and materials acquisition, and the securing of permits necessary to complete the project. EXTERNAL ENHANCEMENTS Financial contingencies in the construction budgets of most project financings can be modest, providing ProjectCo with limited protection from substantial cost overruns should a non-performing contractor need to be replaced. Instead, construction enhancements provided by the EPC contractor can be used to support its performance. These enhancements are designed to increase the likelihood of successfully replacing a defaulted contractor and achieving completion, allowing the construction period rating to exceed that of the EPC contractor. When assessing quality and the degree of ratings uplift provided by construction enhancements, DBRS considers the size, timeliness and certainty of the enhancements, which may include a parent guarantee, letters of credit (LCs) and/or cash reserves, performance bonds, labour and materials bonds or other types of insurance, and/or trapping mechanisms, as explained below. Cash and LCs DBRS affords the most value to highly liquid support, such as LCs and cash. LCs should permit draws: (1) upon a default of the contractor; (2) upon non-renewal of the LC before maturity; or (3) if the LC provider is downgraded below a certain threshold and the LC is not replaced within a suitable time period. The LC should be issued by an institution of acceptable credit quality (i.e., notably higher than the project debt rating see the section below entitled Credit Quality of Financing Parties ). Cash reserves are sometimes provided instead of LCs and must be held with a suitable financial institution and be able to be drawn on demand. DBRS generally expects a component of liquidity in every project financing. For low- to moderate-complexity power, oil and gas, pipelines and infrastructure projects, DBRS views an LC or cash reserve of 5% of the construction price as providing one notch of uplift to the rating of the construction phase. Some construction contracts may also trap progress payments to prefund expected liquidated damages if the project falls behind schedule and is no longer likely to achieve substantial completion by the target date. Triggers are typically linked to missed milestones or the accumulation of delays exceeding a prescribed threshold. As the trapping mechanism does not bring additional resources to the project (it only reserves payments otherwise made to the contractor), it typically would not provide any uplift to the rating. Performance Bonds, Labour and Materials Bonds and Insurance Products A performance bond is an agreement between a surety, the construction contractor and ProjectCo whereby the surety commits to completing the work upon a default of the contractor on its obligations. The surety will typically have several options: perform a defaulting contractor s obligations, re-tender the obligations to another contractor or pay out the maximum amount specified under the performance bond to ProjectCo. For low- to moderate-complexity projects, the presence of a performance bond from an appropriately rated surety will typically result in a one-notch uplift to the construction phase, reflecting the financial backing, expertise and project management capabilities contributed by the surety company. 7
DBRS will typically recognize greater levels of support to surety products that provide a more streamlined claims-paying process or access to liquidity in a timely, demand-like fashion. However, performance bonds are viewed by DBRS as less liquid than LCs, as amounts and timeliness of payment are less certain. A labour and materials bond may also be part of a project enhancement package and commits the surety to making unpaid suppliers and subtrades current upon a default of the EPC contractor. Labour and materials bonds serve as a complement to, rather than a substitute for, performance bonds, as claims under both instruments for the same event are typically not permitted. Labour and materials bonds are not present in all projects and DBRS will not usually make a rating distinction if they are absent from a well-structured project. Subcontractor default insurance may be used in construction if a large portion of the work is subcontracted to local trades. These policies typically have larger deductibles and may also have a co-pay provision whereby the EPC contractor is required to prefund the first portion of any award. Subcontractors are prequalified, which streamlines the claims-payment process, and given the first dollars received have been prefunded by the EPC contractor, subcontractor default insurance is understood to be more liquid and timely than a surety product. To recognize the incremental value provided by subcontractor default insurance and performance bonds together, DBRS will generally assign 1.5 notches of uplift to the construction period rating for low- to moderate-complexity projects. The policy must include appropriate financial interest endorsements to ensure it would survive insolvency of the EPC contractor/guarantor. The construction period may feature other forms of performance support. In order to determine what degree of uplift these provide to the rating during construction, DBRS will examine the credit quality of the entity underwriting the performance support, the speed at which claims are historically settled and the liquidity of the particular instrument. Enhancements are analyzed in relation to the complexity of the project and the credit quality of the EPC contractor, and are expected to be assignable to bondholders. For a low- to moderate-complexity project, DBRS will limit the maximum rating uplift achievable through construction support (for a contractor that has the size and expertise appropriate for the project) to five notches, provided that the contractor replacement mechanism allows for timely replacement. As such, a project with a construction contractor rated BB could potentially be enhanced to an A (low) rating, whereas a contractor rated BB (low) would likely limit the rating on the same project to BBB (high). OTHER CONSIDERATIONS Other construction-related considerations assessed by DBRS and discussed below include factors that may signal a potential flaw in the project or incomplete preparation by the project team. Project Schedule The scheduling should be considered achievable by the IE and demonstrate a clear sequencing of tasks and a logical critical path that supports commissioning by the target substantial completion date. In addition to adequate levels of contingency, the construction schedule should be based on a standard work week, without the expectation of material overtime. Otherwise, the project may have less flexibility to catch up should it fall behind schedule. DBRS notes that some projects may have long construction periods across multiple sites with staggered delivery dates for particular facilities. Sections of the project may begin operating prior to full completion of the project. In such cases, DBRS reviews each stage of construction to ensure that the presence of several phases running in parallel does not materially increase the complexity or risk of the project. Off-take contracts often have in-service drop-dead or long-stop dates. Failure to meet contracted in-service dates can cause legal disputes between the project and the EPC contractor and trigger penalty payments to the off-taker. As the complexity of a project increases, so too does the importance of a comprehensive change orders process and dispute resolution mechanism. Dispute resolution, in particular, needs to be comprehensive, efficient, fair and timely. 8
Construction Budget DBRS compares the construction budget with those of project peers and incorporates the opinion of the IE in its assessment. Construction contracts typically include contingencies of 10% to 20%, including profit margin, to account for cost overruns, materials inflation and wage escalation. Firm quotes from key subtrades are expected to have been used to develop the budget, with a plan for managing input prices and lock in key subtrades by financial close. DBRS attributes significant importance to the IE report and its opinion with respect to the complexity of construction and the reasonableness of cost and timing estimates. Site Conditions DBRS expects site conditions to be have been thoroughly assessed by the equity sponsor and reviewed by the IE. This ensures geotechnical conditions are well understood, that there is a sound basis for the excavation and foundation work plan and that a proper mitigation strategy has been developed for potential archaeological or environmental issues. Site access and the proximity of the site to other operating structures are also considered carefully as they have the potential to increase the complexity of the project. Monitoring Construction Period Risk Periodic reports by the IE during construction comparing actual-to-plan percentage completion data are common practice, enabling quick response to delays. Another discipline for construction performance is to require completion milestones to be certified by the IE at key stages. The language employed in the certification is important. A general opinion from the IE, at each milestone, that the project can still be completed on time and on budget is less effective than a specific opinion that each milestone has been achieved and the project is actually on time and on budget. Linking IE milestone certificates to approval of phased lender advances and funding to the project focuses contractors and owners on solving construction period problems and reduces risk. 9
Operating Period For most types of project finance, operating period risk is generally lower than construction period risk. Analysis of operating period risk includes the following elements: Risk allocation Revenue and off-take agreement Competitiveness and input costs Operating and maintenance risks and costs Technology risk RISK ALLOCATION While construction period risks are typically entirely transferred to an EPC contractor under a fixed-price contract, O&M contracts are often subject to renewal risk or may be established on a cost plus basis and/or with an operator that is an affiliate of the equity sponsor. O&M costs for most power projects, however, are a fairly modest percentage of the cost structure and even significant increases in O&M costs generally have limited impact on debt service coverage. This is also generally the case for projects with penalties for missing prescribed operating period performance thresholds, although the potential for penalties is carefully reviewed to assess their likelihood and severity of impact. In general, breakeven resilience for O&M cost increases (i.e., the ability of a project to absorb increases in operating costs) is high and operating period contractors are easily replaced in the case of an operator default, with limited risk to project bondholders. DBRS will review the IE s opinion of the operator s experience and track record, the ease with which the operator can be replaced and the resulting costs. The typical project financing has low O&M costs, high breakeven resilience and high operator replaceability such that the retention of operating risk by ProjectCo is generally acceptable. This is not the case, however, for management of the service phase risks of public-private partnership (PPP) facilities management and lifecycle obligations. For PPP projects, the combination of substantial completion payments from public authorities and return conditions requirements can make operating and maintenance costs a much more material source of risk. Further discussion of PPP resiliencies can be found in the DBRS methodology entitled Rating Public-Private Partnerships. REVENUE AND OFF-TAKE AGREEMENT Project risk is reduced when revenues match operating and financing costs. In general, more stable revenues and debt service coverage arise from: (1) a longer contract term; (2) fixed pricing; and (3) a close match of revenues to capital, financing and operating costs. DBRS notes that a low-cost project with a proven revenue stream but no off-take contract, can still be favourably rated (e.g., an established hydroelectric asset in a region where higher-cost power assets set the market s marginal price). Merchant Risk Projects Projects that sell output at the spot market price (i.e., merchant risk projects) generally are substantially higher in risk than projects that sell output under a fixed-price, long-term contract. DBRS will typically require an independent market study to assess a project s competitive position and exposure to lowerthan-forecast prices. In general, ratings on merchant power projects will be rated two or more notches lower than their fully contracted equivalents. Quality of Revenues An off-taker s credit strength as well its ability and motivation to honour the revenue contract are key determinants in a project rating. Off-takers with a strategic need that is met by the siting, technology type, capacity and load type of the project, are considered positive for the durability of the power purchase contract and for credit quality. The rating of a project s debt is typically lower than the off-taker s rating, 10
given that there are generally other material risks present. Furthermore, changes in the off-taker s rating could affect the project s rating. For example, if an operating project were rated A (high), based primarily on an off-taker s AA (low) rating, and the off-taker were downgraded to A (high), all else equal, the project debt would likely be notched down to A. Where a project has a superior market-based competitive position (e.g., an established hydroelectric power generation project in a market region with higher-cost power and suitable transmission and market access), off-taker strength could be less important. Revenue and Cost Basis For projects with revenue contracts, differences between the basis for revenue and costs are assessed. Fixed or variable revenue flows can increase or decrease risk, depending on how well they match the cost components and how the operating margin is protected. Variable revenues (revenues with a market-based pricing component) can increase risk if most costs are relatively fixed. Conversely, a fixed-price revenue contract can increase risk if costs, especially fuel costs, are highly variable. Contract pricing of power may include a fixed capacity payment, as well as a variable energy component. Fixed capacity payments are charged to the off-taker based on availability of power and not on the actual dispatch of electricity. The capacity payment is independent of demand or off-take volume and is often sized to ensure that all fixed costs, including debt service obligations, are covered. Some pipelines have fixed/variable tolls under which contracted shippers pay the fixed component regardless of usage and pay the variable component according to actual usage. The variable component of revenue should be compared with the underlying fuel and variable operating and maintenance costs. Where the variable component of power price is based upon a market index, the index should mirror fuel costs. Basis risk can arise from differences in the index used to calculate power prices and the index used to calculate fuel costs, which may pose risks to cash flow. The variable component of fuel pricing may have certain fixed rate factors for example, total fuel costs may be fixed by a ceiling on recovered cost but vary with output volume up to that ceiling. If the fuel component in an off-take contract is fixed as to price or quantity, basis risk may be reduced by corresponding fixed fuel supply contracts. Long-term fuel supply contracts can include certain minimum takes, which can generate inventory charges. In those cases, minimum takes should be part of the operational risk evaluation. Availability Availability clauses can demand onerous operating standards, such as high efficiency (i.e., low heat-rate) or very few outages, if set at levels close to the attainable plant and equipment performance range. Failure to meet such requirements could cause penalty payments flowing from the project to the off-taker, or a deduction in the revenue payments. Contracts with stringent availability conditions can increase risk and impair the rating. Accordingly, availability clauses are carefully reviewed and are normally included within the IE s scope of engagement, with peer group comparisons and known equipment ratings, to ensure that they are reasonably achievable. Contingencies/Contract Outs Off-take contracts are reviewed to ensure that all obligations and contractual outs are assessed. Longterm contracts that impose onerous above-market obligations on ProjectCo may be difficult to honour and may be no better than short-term contracts with few obligations. For example, if a long-term contract imposes abnormally high availability standards on a project (e.g., very limited downtime allowed for outages), and performance below the onerous standard becomes a termination event with tight cure periods, then contract risk is high. 11
Renewable Resource For renewable generators, revenue variability can arise from the inherent volatility of the underlying resource (e.g., hydrology, wind volume, or solar irradiance). For hydro projects, hydrology variability can be managed through transfer to the off-taker, storage or operational design characteristics. A detailed independent consultant review of the resource and expected power production is a critical component of risk assessment. DBRS notes that the quality of this study can be affected by the amount of historical data available; for example, a renewable project at a new site with limited onsite historical data could increase risk. (For more on the DBRS approach to renewable resource based projects please see Rating Wind Power Projects and Rating Solar Power Projects.) COMPETITIVENESS AND INPUT COSTS For projects with off-take contracts, the cost of power can affect the level of commitment to a project for both off-taker and ProjectCo. Regulatory and community support for a project can decline if costs rise. If a project supplies a consistently economic source of power under most market conditions, stakeholders are motivated to keep the project operating. Contracts that pass fuel costs on to the purchaser reduce market risk. However, if contracts increase the price to the end-consumer, this may provoke opposition from the purchaser, and the project may experience political pressure. In general, merchant contract strategies exposed to market prices for both input costs and revenues are expected to be inferior to fully contracted arrangements from a ratings perspective. On the other hand, fully contracted fuel arrangements are not without risk either. Long-term prices may be fixed prior to a significant and sustained decline in spot prices, making the project expensive vis-à-vis other projects that have sourced market-priced fuel. In evaluating competitiveness and the input costs of a contracted project, DBRS considers, among others, the following factors: (1) efficient and proven generation technology compared with current alternatives; (2) fuel arrangements that provide stability against price hikes, including the credit strength of fuel suppliers; (3) potential for low fuel cost or other energy source cost; (4) above-market pricing arrangements with related parties and/or politically motivated entities; (5) risky fuel, pricing or operating strategies; (6) proximity to customer base and fuel supplies (lower transportation costs); (7) potential for liability (e.g., environmental, land claims) that may cause expensive litigation or delays, and (8) potential emissions costs (a coal-fired project versus natural gas-fired or renewable). Of all the fuel/technology types, renewables are typically among the most competitive in terms of cash operating costs (i.e., excluding capital costs). Of the renewable asset types, hydroelectric has a very long proven history of low and predictable operating costs. While solar and wind have a shorter track record, they are also characterized by low complexity and low-cost O&M requirements, although there may be higher capital costs per megawatt (MW) of capacity. OPERATING AND MAINTENANCE RISKS AND COSTS O&M Contractor, Independent Engineer and Reporting O&M costs for most types of project assets are modest and defaulting operators are easily replaced so that overall project risk from O&M cost increases is generally low to moderate. In certain circumstances, O&M costs can be affected by the performance of the O&M contractor or owner operator, particularly where outages and availability below prescribed thresholds have a material negative economic impact. Power projects are often operated by affiliates of the equity sponsor where that arrangement has a consistent history of on-budget, low-outage operating performance and the affiliate operator s interest is aligned with that of the equity sponsor and ProjectCo. If third-party service companies are responsible for operation and maintenance, then appropriate controls are required to ensure compliance with maintenance guidelines and to contain costs. In general, pass-down of risk to an operator under a long-term fixed-price contract (versus retention of that risk at ProjectCo) does not typically have a rating impact for non-ppp projects, so long as O&M costs are stable and constitute a small percentage of the cost structure (and the operator is a proven performer). 12
The IE report typically includes a review of operating period risks. That review should include assessment of: (1) the reasonableness of expected operating costs and maintenance costs; (2) expected operating levels; (3) expected maintenance and repair costs; (4) spare parts supply (can reduce downtime for unplanned outages); (5) future major maintenance and capital costs; and (6) the useful life of the assets. Control of maintenance costs and the availability of spare parts are verified. Assessment of operating risk and performance is facilitated by reporting requirements. Operating project reporting commonly includes (1) annual and interim financial reporting; (2) annual capital budgets; (3) availability and efficiency data; (4) energy sales volume data; (5) covenant compliance certificates (confirming that debt service coverage ratio (DSCR) tests have been met); (6) annual insurance certificates and any other compliance certificates; (7) IE reports, if major unanticipated repairs have been required; (8) environmental permits and licensing; and (9) in general, reports on any unexpected change in plant condition or operating performance. Careful review of operating and financial performance data supports operating risk surveillance. Availability and Efficiency (Heat-Rate) Plant availability below standard is a key operating risk since revenue is often tied to availability performance, actual power production and/or other operating performance criteria. In power projects, for example, plant availability and energy (or heat rate) efficiency are key factors in plant competitiveness. DBRS s analysis will include a review of peer group data for comparisons with similar facility types and related average availability and heat rate, and incorporates the IE s review of expected performance. TECHNOLOGY RISK Projects using proven technology have lower risk than projects with newer, untested technology. When new technology is involved, unit availability can be unpredictable, especially in the initial start-up phase. A manufacturer should be able to demonstrate success across its installed fleet of similar units and/or show that so-called teething issues have been resolved or are mitigated by more comprehensive warranties and technical support. Ineffective operating procedures and management can reduce plant availability and efficiency. As such, proven prior experience managing similar project facilities reduces operating risk. Careful oversight by the manufacturer during the first few critical years is also positive for achieving planned operating metrics. Given the long life of most projects, issues such as environmental compliance and capital costs associated with tightening environmental and emission controls are reviewed. This is especially relevant for technologies that are currently considered less desirable from an environmental standpoint (e.g., coal-fired power projects). Where operating risks are high due to relatively new or sophisticated technology, maintenance risks may also be high. An established track record of technology performance and proven capability on the part of an experienced O&M contractor in maintaining similar projects and/or a manufacturer-managed maintenance program mitigates technology risk. For example, hydroelectric facilities generally experience very high levels of reliability, with the lowest forced outage rates (about 1%). This is attributable to a stable, proven technology that has been in use for decades, and the fact that there is no thermal component to the production process. If properly maintained, hydroelectric facilities also feature very long asset lives compared with all other generating assets. 13
Sponsorship, Financial, Legal and Other Considerations The financial and legal profile of ProjectCo is important in both the construction and operating periods but is especially critical to assessing financial flexibility and the ability to absorb downside scenarios in the operating period. Discussed below are key financial and legal considerations included by DBRS in analysis of project finance transactions. SPONSOR STRENGTH AND EQUITY CONTRIBUTIONS Consistent with the non-recourse nature of project financing, a project s rating typically incorporates no lift from the sponsor. However, an experienced sponsor can reduce development, construction and operational risks of the project. A sponsor with a long and established track record in managing similar project assets can reduce credit risk. Such a sponsor can provide comfort that a project with construction risk will be delivered on time and on budget, and that once in operation the facility will be operated and maintained to minimize outages and achieve its expected useful life. The equity percentage of total capital invested in the project can reflect the level of its owners commitment for projects under construction or that are newly completed. A higher level of equity contribution can motivate a sponsor to monitor and solve problems early, particularly during construction. A sponsor with modest investment in a project may be more inclined toward higher-risk strategies or less motivated to resolve issues for projects that underperform. However, the presence of equity may add little to the financial flexibility of a project given its small size relative to the construction budget and the fact that equity funds are typically earmarked to construct the asset; that is, unless equity is retained as a reserve, it does not represent a potential source of contingent liquidity and by commissioning has usually been fully deployed in the constructed asset. Nonetheless, in DBRS s view, to constitute adequate commitment to a greenfield project and to incentivize the sponsor, as well as achieving minimum DSCRs consistent with the rating, equity for a greenfield project of low to moderate complexity in the A range should generally account for between 10% and 20% of the capital structure at financial close. Failure to meet this requirement would be expected to have an adverse effect on the rating. Equity may be in the form of a traditional cash equity contribution or deeply subordinated debt and, if not contributed at financial close, is usually secured by an LC until fully drawn. For a project under construction, if equity is to be contributed in stages during construction, certainty of equity contributions must be assessed. Subject to the project rating and credit quality of equity participants, a bank letter of credit or other third-party support will generally be required. DEBT STRUCTURE DBRS considers the characteristics of the debt instruments issued by ProjectCo, including deferred pay obligations, real return bonds, inflation-indexed bonds and subordinated debt, as well as the maturity profile of the debt structure. The less flexibility ProjectCo has to increase revenues in response to unexpected cost increases, the more stable the debt structure and servicing requirements are required to be, especially for A -range ratings. As such, most projects are funded with fixed-rated debt that fully amortizes over the life of the project, with payments often sculpted to match anticipated cash flows and provide for a stable DSCR. Debt structures often contain covenants that include limitations on asset dispositions, a negative pledge, compliance with material contracts, limitations on additional debt, and limitations on distributions, reserve accounts and payment priority, in addition to timely and full payment to bondholders. Tenor and Refinancing Risk The tenor of project debt is typically six to twelve months shorter than the revenue contract term, which is typically less than the expected economic life of the project. A typical structure amortizes debt to remove 14
or minimize refinancing and obsolescence risk. A debt term exceeding the term of the off-take contract introduces market risk in the transaction at contract expiry. Depending on project type, unless there is a corresponding step-down in debt service, the transition from fixed contract to market-based prices will increase risk, which, if material, could affect the rating. A project with a strong current and forecasted competitive position can reduce this market risk. If the tenor of debt exceeds the term of an off-take contract, interest rate risk may also arise. Refinancing risk is often material; however, there are also situations where its impact is limited. If debt is refinanced when a substantial period remains under the existing contract, the refinancing risk during the remaining term of the contract is mainly the potential DSCR impact of a higher interest rate. If the original minimum DSCR was high for the rating, the effect on the rating of refinancing risk may be relatively low, because the coverage could remain robust even for a sharp increase in interest rates at refinancing. If moderate increases in interest rates reduce DSCRs that were already close to the bottom of the range for the project s rating, then the effect of refinancing risk on the rating would be moderate to high. Hydro projects are better positioned than most to bear refinancing risk, given their long asset life and low operating costs. RESERVES A debt service reserve holding short-term, high-quality funds equal to at least six months of principal and interest payments is standard for an investment-grade project. A major maintenance reserve is also typical, particularly if ProjectCo is exposed to significant major maintenance expenses or if asset performance is less predictable over the life of the project. In reviewing reserves, DBRS pays particular attention to the constraints surrounding the use of the funds and the type and tenor of investments (typically very low risk) permitted to be made with the funds. To prevent aggressive distributions to equity, the financing structure also typically includes a cash trap provision which prevents equity distributions if ProjectCo s DSCR falls below a certain threshold or reserves have been previously drawn and not yet fully funded. CREDIT QUALITY OF FINANCING PARTIES DBRS assesses the credit quality of financing parties, including swap providers, LC providers, account banks and lending syndicate members. DBRS expects that the credit quality of these key players will be notably higher than the rating of the project to support the underlying project risk within a stable financing framework. In its analysis, DBRS also considers the country of domicile of the financing parties since the stability of the financial and legal systems can potentially introduce additional risk to ProjectCo, even in instances where the financing party is currently highly rated. DEBT SERVICE COVERAGE Financial performance is typically measured by the minimum DSCR (i.e., the ratio of operating cash flowto-the sum of required principal and interest payments, after capital expenditures). The level, stability and certainty of cash flow coverage are assessed by DBRS. In calculating the DSCR, all fixed charges are considered, including subordinated debt (unless these obligations have explicit deferability clauses that extend beyond the maturity of the senior debt and/or subordination of payments and cure of default). Stable DSCRs based on conservative contract strategies and terms are favourable for ratings. For projects with fixed payments from the off-taker, some form of inflation protection on the non-capital components of the cost structure will typically be provided to ProjectCo through the payment mechanism. The portion of ProjectCo s revenues subject to indexation will often closely match the operating expenses and is typically subject to escalation. DBRS verifies there is no material mismatch between costs and revenue by stress testing the inflation assumption in the final model. Investment-grade projects can typically withstand inflation of roughly 10% annually throughout the life of the project without having the DSCR fall below 1.0 times. 15
The financial model captures the economics of the project and is the basis for testing the sensitivity of the project s DSCR to various drivers such as: (1) construction delays; (2) construction or operating cost overruns; (3) equipment underperformance (capacity and availability below specification); (4) higher fuel costs (for market-based, variable component fuel supply contracts); (5) lower power prices (for marketbased variable component PPAs); (6) production volumes; and (7) inflation. Other financial and structural features included in the financial model and carefully reviewed by DBRS are: (1) use of fixed- or floating-rate debt; (2) fully amortizing versus balloon/bullet repayment; (3) debt and/or maintenance reserve funds; (4) distribution test; and (5) additional debt test. Investment grade-rated project finance debt must be able to survive reasonable worst-case scenarios. Key Financial Metrics Key Ratio A BBB BB DSCR > 1.5x 1.6x to 1.3x < 1.4x Identifying typical DSCR bands by rating category is difficult, given the wide-ranging characteristics of projects. Overlapping ranges are therefore used to encompass the variance in underlying project characteristics. The table above provides an example DSCR for a typical natural gas-fired generation facility, and can be used to illustrate the wide range of rating outcomes for a particular type of project. For example, a 1.5 times (x) minimum DSCR for a natural gas-fired facility (in each case assuming a highly rated revenue contract counterparty) would be consistent with: (1) a combined cycle power plant under an availability-based tolling or cost-of-service-type agreement having a rating in the low A range; (2) a combined cycle power plant with a traditional PPA (not a tolling or cost-of-service-type agreement) exposed to volume or production risk having a rating in the high BBB range; (3) a rating in the B range for a merchant gas peaker. Factoring in the other types of production (hydroelectric, coal, wind, solar, geothermal), as well as all of the other considerations described in this methodology, the range of possible ratings for a given DSCR level can be quite wide. It should be emphasized that qualitative factors affecting certainty of cash flows and related counterparty credit risk can have as much of an impact on a rating as absolute coverage ratios. For example, a fixed-price take-or-pay revenue contract with a highly rated purchaser may achieve a higher rating than a project where projected coverage ratios are higher but cash flow is less stable. All else being equal, higher coverage ratios will support higher ratings. DBRS reviews forecast cash flow coverage ratios as well as forecast coverage ratios in stressed scenarios. The pattern of DSCRs over time can also affect the rating, as lower coverage in early years may reduce credit quality, or higher DSCRs in later years may be required where tail-end risks are significant. The debt-to-capital ratio is considered more relevant in a project under construction or newly completed. For existing hydroelectric power projects, non- or partially-amortizing debt is supported by the very long life of the assets. Where projects have some operating history and audited annual financial reports, historical coverage is evaluated with a focus on trend and as a basis for future performance expectations. Typical ratios reviewed are: (1) EBITDA-to-interest; (2) debt-to-cash flow; and (3) debt-to-(cash flow minus capex). 16 LEGAL CONSIDERATIONS Special Purpose Vehicles Unlike a traditional securitization transaction where self-liquidating financial receivables are securitized in a true sale to a bankruptcy-remote special purpose vehicle (SPV), obtaining complete isolation from the bankruptcy estate of a parent company is more difficult for SPVs created for project finance assets. These operating asset SPVs typically engage in a wider, although still limited, range of activities, creating the potential for broader credit risks or business liabilities compared to the typical passive securitization trust. Project finance transactions, however, are typically only structured to achieve ratings in the BBB/A range, unlike structured finance ratings, where AAA ratings are commonplace.
In evaluating the merits of an SPV structure for project finance, DBRS will typically expect to see the separateness covenants and other transaction features noted below maintained through the life of the transaction: Separate legal identity organized for the sole purpose of carrying out the relevant business with restrictions on: (1) changes in the business activity of the SPV; (2) commingling of assets with the parent or any other person; (3) disposition of assets; (4) additional assets; (5) additional liabilities; (6) the granting of additional security; (7) amalgamating, merging or joining with another entity or otherwise reorganizing. Bank accounts, financial statements and books and records separate from the parent or any other person. Covenant of the SPV to hold itself out as a separate person from the parent or any other person and to conduct business in its own name. Covenant of the SPV to maintain an arm s-length relationship with its parent or any other person. Covenant of the SPV to pay its own expenses and liabilities out of its own funds. Restrictions on guarantees to and from the parent or any affiliate. Organizational documents that include separateness covenants as well as a covenant to maintain the SPV structural features throughout the term of the transaction. Other transaction features may be relevant to this analysis, such as, for example, an independent director of the SPV or ownership of the SPV by two or more independent owners with equal voting rights. DBRS will review these additional features in the context of the specific SPV and transaction to ascertain whether sufficient isolation of the SPV from the bankruptcy estate of the parent has occurred. Creditor Cure of Contract Defaults and Security Provisions Project financing relies on contracts with the SPV. Lenders should be informed of any default by the SPV under its contract obligations, and should have the ability to cure SPV defaults. Security provisions are an essential feature of a project financing arrangement. Generally, bondholders will have a first-priority, perfected, senior security interest, mortgage, hypothec and/or other appropriate security over the assets of the SPV, including any cash flows and contractual rights of the SPV. In a default by the SPV, bondholders should be able to obtain control of the SPV s assets and should also have the right to take over any contractual rights and obligations of the SPV, including the assignment of cash flows. Dispute Resolution Most projects have a prescribed process for settling commercial disputes between ProjectCo and the revenue counterparty or between ProjectCo and its contractors. When evaluating a dispute resolution process, DBRS looks for an efficient, timely and transparent framework that limits the automatic requirement of legal recourse and supports continued construction or operation while a dispute is ongoing. Legal Opinions DBRS will typically expect to see opinions covering, among other things: (1) the creation and legal existence of the SPV; (2) the power, authority and capacity of the SPV to enter into various binding project agreements; and (3) the validity, perfection and enforceability of the security granted to the security holders. DBRS may also require a non-consolidation opinion. DBRS expects to be named as an addressee on all such legal opinions that may be required by DBRS. Insurance In general, DBRS evaluates the amount of insurance coverage compared with: (1) the force majeure provisions of the key contracts; (2) the replacement cost of the project; and (3) the extent of potential business interruption. Bondholders should be an additional insured party and be able to choose whether the notes are paid out or the plant/asset is rebuilt or replaced. If insurance premiums are not paid by the SPV, bondholders should be notified and no changes to the insurance coverage should be made without the consent of bondholders. Insurance coverage must be from an institution with a reasonable credit rating compared with the project debt rating (generally not significantly lower than the project debt rating) and 17
may be evaluated by an independent insurance consultant for bondholders. The SPV should be required to provide annual insurance certificates proving continuing adequacy of coverage and compliance with project terms. Insurance renewal risk is present in most projects, although in the normal course, insurance premiums are a small percentage of overall operating costs. Most projects have the ability to absorb a significant multiple of base case insurance premiums and while shortages in global insurance capacity do occur, they are generally short-lived. Expert Reports In most project finance transactions, bondholders retain experts such as independent engineers, resource consultants, insurance consultants, environmental consultants and market consultants in order to aid in assessing the level of many of the types of risk mentioned above. Issues that require expert evaluation may include: (1) environmental assessments of potential liability (such as pre-existing conditions and the risk of lender liability when enforcing security rights); (2) construction process, schedule, and costs; (3) operating and maintenance costs; (4) operating requirements of the off-take agreements; and (5) various other matters including financial projections, asset quality and the condition of existing projects, adequacy of the insurance package, and, for renewable generation, a resource study forecasting expected production levels. It is preferable that experts be engaged on behalf of investors to minimize any potential conflicts of interest. COUNTRY AND POLITICAL RISK The political, regulatory, legal and economic environment of a project s country location can affect its performance and credit quality. The main country risk factors include (1) expropriation or creeping expropriation (arbitrary, unanticipated adverse revenue-sharing by the host state including tax increases, import and export tariffs, licensing fees, local content and directed procurement rulings, and projectspecific levies); (2) risk to currency transfer and convertability; (3) regulation regarding the currency and economic environment that affects the exchange rate; (4) the regulatory environment with respect to licenses, permits, tariffs and rate-setting; (5) the legal framework and jurisdiction, including contract enforcement and dispute resolution; and (6) degree of social stability (e.g., absence of war or civil unrest). A project s credit rating can also be constrained by the credit rating of its host country. Where political insurance or structural features are used to mitigate the key country or political risk issues, careful review and assessment is part of the rating process to determine whether coverage is sufficient. For projects requiring political risk insurance, the strength, track record and experience of the insurance provider(s) would also be reviewed. 18
Summary of Rating Drivers DBRS methodologies consider a number of rating drivers, both general and project-specific. By analyzing the key drivers, which vary by industry, it is possible to accurately capture essential strengths and challenges by industry, providing transparency for outside readers. Ultimately, the specific drivers and key financial considerations metrics capture the essence of the credit profile. Below are the main factors considered by DBRS when rating projects and the ranges generally associated with each rating category. DBRS notes that while the qualitative rating drivers are recognized as key factors, they should not be expected to be fully adequate to provide the exact rating for a project. In addition, given the highly structured nature of many project financings, projects can also have different or unique features and characteristics that may affect the rating and warrant special attention. It should be noted that the various aspects of a project are often interrelated and interactive and should be assessed holistically, not in isolation. Project Risks - Critical Factors Rating A BBB BB Strength Superior Adequate Weak CONSTRUCTION PERIOD (if applicable) Construction Complexity Proven technology; predictable construction process and costs. Proven technology. Relatively new technology or complex construction process. Risk Allocation Experienced contractor(s) of strong credit quality. Robust fixed-price, turnkey EPC contract with comprehensive protection against delay, cost overruns and performance defects. Experienced contractor of reasonable credit strength. Reasonable contract protections against delay, cost overruns and performance defects. Contractor with weaker credit quality. Weak or no protection against delay, cost overruns or performance defects. OPERATING PERIOD Revenue/Off-take Agreement Stable and predictable revenues. Contracts with strong off-takers or a consistent high-margin competitive position from uncontracted sales. Revenues are quite resilient to resource variability. Highly achievable performance thresholds and low expectation of material adverse penalties. Reasonably stable and predictable revenues. Contracts with off-takers of acceptable credit quality, or a reasonably consistent high-margin competitive position from un-contracted sales. Revenues are resilient to resource variability. Reasonably achievable performance thresholds and low to moderate expectation of material adverse penalties. Less stable and predictable revenues owing to volume or price variability. Contracts with weak off-takers or off-taking contracts, or revenues exposed to lower-margin competitive position. Revenues are less resilient to resource variability. Onerous performance thresholds and high expectation of material adverse penalties. Competitiveness and Input Costs Superior competitive position providing strong economic rationale for the contracts and resulting in predictable profitability even without contracts. Reasonable costcompetitiveness protected by some degree of barrier to entry. Weak or no competitive advantage. Potential erosion of competitiveness in a market equilibrium process. 19
Project Risks - Critical Factors Rating A BBB BB Strength Superior Adequate Weak Operating and Maintenance Risks and Costs Proven technology with predictable operating characteristics and performance. Strong contract protections on key operating parameters. High replaceability of operators with predictable O&M costs that are a low percentage of cost structure and high breakeven resilience. Proven technology with reasonably stable operating performance and costs. Some contract protection. Reasonable replaceability of operators with reasonably stable O&M costs that are a low to medium percentage of cost structure and reasonably high breakeven resilience. Relatively new technology or complex operation resulting in uncertainties in production interruption or reduction and/or cost escalation. Low replaceability of operators with unstable O&M costs that are a material percentage of cost structure and modest breakeven resilience. SPONSORSHIP, FINANCIAL, LEGAL AND OTHER CONSIDERATIONS Sponsor Strengths and Equity Contributions Highly experienced sponsor(s) with acceptable credit quality and proven expertise in project type. Demonstrated sponsor commitment to the project in the form of strong equity contribution and/or other business and credit supports. Experienced sponsor(s) with acceptable credit quality. Demonstrated sponsor commitment in the project with reasonable equity contribution and support. Sponsor(s) with limited or no track record in the type of projects being developed and financed. Sponsor(s) with weak credit quality. Weak equity contribution and/or credit support. Financial Risk Reliable financial projections based on assumptions supported by definitive data and high statistical confidence for relatively new projects or established financial performance track record for long-existing projects. Strong debt service coverage given the contract and structure features. All other relevant metrics (such as leverage ratio for projects under construction) are robust. Multiple reserves meeting or exceeding traditional project finance standard. Acceptable financial track record or reasonable projections based on adequate data and statistical confidence. Solid debt service coverage and other relevant ratios given the project type. Reserves meeting traditional project finance standard. Limited financial history or projection. Financial ratios are weak without adequate structural enhancement or protection. Inferior reserves. Country and Political Risk Countries with a mature and established legal framework for project finance and a reasonable presumption of due process. Stable political, regulatory and economic environments resulting in minimal or no uncertainties in terms of contract enforcement, currency transfer and convertability, asset ownership, or potential war or civil unrest. Countries with reasonably stable political, regulatory or economic environments. In cases where there exist potential issues in terms of country or political risk, these risks are wellmitigated. Countries with one or more political risk factors that are difficult to gauge or mitigate due to weakness in the legal framework or uncertainty in political, regulatory or economic environments. 20
Copyright 2013, DBRS Limited, DBRS, Inc. and DBRS Ratings Limited (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is obtained by DBRS from sources DBRS believes to be accurate and reliable. DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance. The extent of any factual investigation or independent verification depends on facts and circumstances. DBRS ratings, reports and any other information provided by DBRS are provided as is and without representation or warranty of any kind. DBRS hereby disclaims any representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability, fitness for any particular purpose or non-infringement of any of such information. In no event shall DBRS or its directors, officers, employees, independent contractors, agents and representatives (collectively, DBRS Representatives) be liable (1) for any inaccuracy, delay, loss of data, interruption in service, error or omission or for any damages resulting therefrom, or (2) for any direct, indirect, incidental, special, compensatory or consequential damages arising from any use of ratings and rating reports or arising from any error (negligent or otherwise) or other circumstance or contingency within or outside the control of DBRS or any DBRS Representative, in connection with or related to obtaining, collecting, compiling, analyzing, interpreting, communicating, publishing or delivering any such information. Ratings and other opinions issued by DBRS are, and must be construed solely as, statements of opinion and not statements of fact as to credit worthiness or recommendations to purchase, sell or hold any securities. A report providing a DBRS rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. DBRS receives compensation for its rating activities from issuers, insurers, guarantors and/or underwriters of debt securities for assigning ratings and from subscribers to its website. DBRS is not responsible for the content or operation of third party websites accessed through hypertext or other computer links and DBRS shall have no liability to any person or entity for the use of such third party websites. This publication may not be reproduced, retransmitted or distributed in any form without the prior written consent of DBRS. ALL DBRS RATINGS ARE SUBJECT TO DISCLAIMERS AND CERTAIN LIMITATIONS. PLEASE READ THESE DISCLAIMERS AND LIMITATIONS AT http://www.dbrs.com/about/disclaimer. ADDITIONAL INFORMATION REGARDING DBRS RATINGS, INCLUDING DEFINITIONS, POLICIES AND METHODOLOGIES, ARE AVAILABLE ON http://www.dbrs.com.
www.dbrs.com Corporate Headquarters DBRS Tower 181 University Avenue Suite 700 Toronto, ON M5H 3M7 TEL +1 416 593 5577