A major challenge facing market participants who want to invest in project finance is having insufficient knowledge to make informed decisions, nor the right tools to be able to manage, measure and price potential risk.
This is especially true where projects are exposed to heightened political and regulatory risk and where investors don’t have external credit ratings that they can rely on.
Fortunately, however, there are frameworks that can be used to understand and measure risks associated with project finance. These frameworks can be applied to a wide range of projects from the construction of offshore wind farms and oil and gas pipelines through to the building of bridges, roads, hospitals and schools.
At S&P Capital IQ, for example, we develop our own credit assessment scorecards that use quantitative and qualitative factors, financial benchmarks and scoring guidance to assess risk. Investors can then use these to determine the probability of default.
The scorecard for Project Finance, which replicates Standard & Poor’s Rating Services Criteria, comprises of approximately 77 risk factors that are grouped together in two different risk profiles – Construction and Operations. Three further external risk dimensions are also taken into account: Full Credit Guarantees, Limitations of Sovereign Credit Ratings and Government Support.
With Construction, the risk assessment is primarily focused on the nature of the project itself. So it looks at factors including the design and complexity of the project, how it is being funded, whether proven technology is being used to complete it, the strength of the management team and the reputation of the contractors that have been engaged.
Assessment of Operations, on the other hand, encompasses a far broader range of risk factors that can be grouped into these three categories: Performance risk, Market risk and Country risk.
The way in which these three factors are measured can be complex, but assessment must be done thoroughly since Performance, Market and Country factors all have the potential to significantly influence the revenues that a project receives and hence increase or decrease the possibility of the project defaulting on its debt.
Measurement of Performance risk tends to focus on the factors that determine whether a project will deliver in line with expectations.
Assessment might therefore explore whether a project is more prone to production or operational failure compared with its peers or whether the project’s ratio of fixed operating and routine major maintenance expenses to revenues is higher than that of its peers.
It might also consider whether the project is exposed to resource or raw material risk. A project that relies on solar power might have a high solar resource risk if it is in a country with an unpredictable climate, for example.
Market risk relates to the market factors that have the ability to impact on the project’s long-term cash flow and create volatility. For example, a project that has a credit lease or hell-or-high-water contract in place may be regarded as no risk because even if the project is an operational failure, it will receive sufficient revenue payments to service its debts.
The Competitive Position is also analysed in this dimension and encompasses project-specific business features that differentiate projects in the same asset class. Projects with superior competitive position assessments are more likely to persevere through adverse industry conditions than those with worse competitive position assessments, everything else being equal.
Country risk should not be confused with Sovereign risk since the two are distinctly different. The former refers to the downside of a country’s business environment, which includes its legal and regulatory environment, levels of corruption, literacy rates, political stability, technological sophistication and socioeconomic variables. While the latter refers to the risk of a country’s government defaulting on its commercial debt obligations.
While project and infrastructure finance is rightly seen as a low-risk investment, it is essential that investors undertake a thorough credit risk assessment so that they understand the true nature and extent of the risks that they face.
Begin your credit assessment process here – contact us for more information on our credit assessment scorecard for project finance.