Improved credit rating methods will help attract funds for infrastructure projects.
The 12th Five-Year Plan (2012-17) envisages investments worth $1,000 billion in infrastructure, 50 per cent of which would come from the private sector. So, about $100 billion would be required in the private space, in both equity and debt, every year from April 2012 onwards. Assuming that between promoters, foreign direct investment, private equity funds et al equity will be raised, the challenge is to mobilise about $66 billion of debt funds every year, or roughly Rs 3,30,000 crore per annum — not counting the debt required by the public sector.
The oft-discussed “debt gap” in financing Indian infrastructure investments has not yet emerged because of the slower roll-out of infrastructure projects. However, it is expected to be an effective constraint soon. Various policy and institutional initiatives are being directed towards increasing financial intermediation. These include enabling policy and regulation for infrastructure finance companies, infrastructure debt funds, revised external commercial borrowing norms, buyback/refinancing of loans from commercial banks, take-out financing and credit enhancement/guarantees.
It is also recognised that capital markets do not participate much in financing infrastructure. Dedicated infrastructure debt funds would provide a way for investors to invest in bonds issued by operating infrastructure special purpose vehicles (SPVs). Both supply and demand sides have to find common ground for credit markets to work effectively for financing infrastructure projects. In the highways of capital markets all over the world, credit ratings provide the effective “signalling” system for capital traffic-flows to happen. (Though junk bonds prove there is nothing magical in AAA bond ratings!)
My colleague Mr Dhruba Purkayastha, who has been intimately associated with infrastructure financing, postulates that use of conventional credit rating methodologies for infrastructure projects leads to markets often getting the wrong signal.
For those uninitiated to the complex world of ratings, here is a quick primer. Conventional projects of the manufacturing kind are rated according to the format shown in Table A.
|TABLE A: LONG-TERM RATING SCALE
||Highest degree of safety regarding timely servicing of financial obligations
||High degree of safety
||Adequate degree of safety
||Moderate degree of safety
||Moderate risk of default
||High risk of default
||Very high risk of default
||In default or expected to be in default soon
Infrastructure projects are traditionally considered “riskier” by rating agencies. This is because cash flows arise from a single asset, and carry higher political and regulatory risks. Assigned ratings are usually at BBB levels, which means a default probability of around eight per cent in a year. The application of this typical BBB rating and the rationale for classifying infrastructure projects at this level are, however, not clear, since there is lack of adequate historical data to confirm this.
Research carried out on the UK Private Finance Initiative and European project-financed projects has shown that for PPP financing in infrastructure, the likelihood of default may be the same as or lower than that of corporate finance. Commercial risks in infrastructure project finance could in many cases be lower because of steady cash flows, near-monopoly market structures, pricing power and low technological obsolescence, which characterise such projects.
While project loans are supposed to be “non-recourse” (based only on SPV economics), in most cases they are actually backed by collaterals, debt servicing structures and other partial guarantees, which effectively reduce the extent of possible credit loss. Limited historical data and lack of institutional mechanisms to capture project default data lead to risk loading by rating agencies. For rating agencies, there is no commercial incentive to address this issue specifically. Financial investors, thus, have no choice but to adhere to conventional credit rating methods.
This leads to higher or mispriced loans for projects as well as greater capital requirements for banks and financial institutions. Access to bond markets remains constrained. This does not allow investment from longer-term sources such as pension and insurance, where the stipulated requirements are AAA- or AA-rated securities. Thus, lower conventional credit ratings lead to poor capital allocation for infrastructure in the economy.
It is time we review this reliance on conventional credit ratings for financing infrastructure and design or evaluate alternative yardsticks.
Table B illustrates the possibility of having an “infrastructure-focused” rating scale.
|TABLE B: SPECIFIC RATING GRID FOR INFRASTRUCTURE PROJECTS
||Scale and determinants
|Assess preliminary project
attractiveness based on impact
of identifiable risks at the project
|D1 - D5:
||> Robustness of demand
> Technology/construction risks
> Regulatory, environmental, political
and force majeure risks
|Assess ease of financial closure
based on the review of the various
risks pre-financial closure and
aggressiveness of bid
|B1 - B5:
||> Chances of project achieving financial
closure within the stipulated/
||Assess possibility of time/cost
overrun and its impact on
financial viability by reviewing
project status and possible risks
|C1 - C5:
||> Likelihood of the project being
completed on schedule and within
the envisaged cost parameters
|Estimate losses to investors by
assessing possibility of debt service
being impacted by volatility in
revenue and costs, adjusting for
credit enhancements/ collaterals
|F1 - F5:
||> Envisaged expected loss for investors
based on stability and robustness of
cash flows to sustain debt repayment,
adjusting for credit enhancements/
Such ratings across the life cycle of an infrastructure project will enable greater professionalism in decisions regarding investment in huge project development/pre-bid activities, as well as capture the sharp change in risk parameters across the life cycle of a project. For example, the Delhi Airport concession is for a period of 30 + 30 years. Much changes in these many years!
The following measures would help correct the existing failure in the credit market for infrastructure PPP investments in India.
* Credit Information companies like CIBIL are capturing retail and corporate credit information with respect to loan repayment defaults. A similar institutional initiative needs to be developed for infrastructure projects. This would help banks and financial institutions take better-informed credit decisions.
* The practice of relying on conventional credit ratings only for infrastructure projects needs to be supplemented with specifically tailored ratings as illustrated in Table B.
* Facilitate capacity building in infrastructure project appraisal and risk assessment at commercial banks and non-banking financial companies through use of specialist independent infrastructure-project service specialists in the same manner as transaction advisers are being used by PPP implementing agencies.
Given that regulators, investors and sovereigns are raising questions on the efficacy and appropriateness of prevalent rating methods and scales, the time has come, certainly in infrastructure PPP financing, to examine this aspect afresh.
The author is the Chairman of Feedback Infrastructure. These views are personal.