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How ESG Factors Have Begun To Influence Our Project Finance Rating Outcomes

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How ESG Factors Have Begun To Influence Our Project Finance Rating Outcomes

Although ESG awareness might seem relatively new in the financial markets (the concept was originally introduced by former U.N. Secretary General Kofi Annan back in 2004), it has already affected and will continue to affect project finance transactions and our infrastructure ratings . More and more investment funds must now comply with ESG principles when choosing where to allocate capital, so we can safely say that consideration of ESG factors is no longer a "nice to have," but a must for a project that wants to be successful long term.

Broadly, investment firms have increasingly shown a negative bias for assets engaged in the use of tobacco, coal, genetically modified products or firearms for example. In January 2020, BlackRock wrote a letter to CEOs and clients committing to certain ESG initiatives, stating that it will be removing the public securities of companies that generate more than 25% of their revenues from thermal coal production from its discretionary active investment portfolios. It also intends to double its offerings of ESG exchange-traded funds over the next few years, and disclosed that it already voted against or withheld votes from 4,800 directors at 2,700 different companies because they did not effectively address a material ESG-related issue.

Under our project finance methodology, ESG credit factors (see chart 1 below) are embedded in our forecasts, analysis, and assessment of a project's construction and operations phases, including any assumed debt refinancing (see chart 2 below) despite not having a specific section to analyze them (compared to our corporate methodology for example, which includes management and governance-specific score). Project finance transactions can leverage more than otherwise similar pure corporates while still maintaining the same credit quality because of the many protections creditors are provided with (e.g. collateral on the asset and cash flows, restrictive covenants including limitations to additional debt, and a cash waterfall prioritizing debt service ahead of dividend distributions).

However, borrowers and investors still face the same or more ESG risks. This is because project finance can include construction work that can negatively affect the environment, as well as interaction with a wide variety of stakeholders including via participation in public tenders, negotiation with local communities, or exposure to several key counterparties or offtakers that have their own inherent ESG risks but that can still affect the project. For example, projects for which construction is in a location exposed to severe storms or flooding might need longer construction periods to capture possible delays, together with stronger liquidity reserves and insurance policies due to more likely force majeure events. On the other hand, our cash flow projections in the operations phase might contemplate higher costs due to environmental compliance regulations and site rehabilitation, or higher maintenance capital expenditures for projects in areas sensitive to higher environmental risks.

Where a project has refinancing risk, we also capture any ESG risks, to the extent known, in our cash flow forecasting post any bullet or balloon debt maturity. Importantly, many ESG risks, including the impacts of climate change and the energy transition, will likely be more acute and create more uncertainty the further we go in our projections. This means that the refinancing of projects that might have 20-30 years of remaining asset life is clouded with uncertainty. We use a net present value project life ratio as part of our assessment that also allows us the used risk-based discount rates. As part of our refinancing assessment, we review management refinancing plans, which typically set out how management plans to execute a project's refinancing strategy considering its economics, business risk, regulations, industry forecasts, and market conditions.

Additionally, we estimate a probable asset life (for example, we recently lowered our asset life assumption for coal power plants in the U.S. given our view that future regulations will result in early retirements of coal plants). We consider how the project's management addresses refinancing risk, which is also related to governance and captures how they will manage risk and execute a project's refinancing strategy per the refinancing plan. Although project finance documentation sets specific governance rules, some projects can still be affected by governance factors from any external stakeholders (such as sponsors or contract offtakers), or document clauses that can allow projects to incur additional debt to fund dividend distributions even if they need lender consent or a rating affirmation. Under our methodology, we can penalize structures that we believe have these credit negative features under our transaction structure adjustment.

ESG credit factors may also affect the counterparties on which a project finance transaction depends. In these situations, we would apply the relevant methodology--most often, our corporate or financial institution rating methodology--to the counterparty first, and then determine how counterparty affects the transaction. Counterparties in a typical project finance deal include construction counterparties, equipment supplier counterparties, operating and maintenance counterparties, raw material and supplier counterparties, and revenue counterparties.

ESG components are also captured in our industry-specific "Key Credit Factors" (KCFs), which are used as guidance for our ratings. In our KCF for power project financings, for example, we consider environmental regulations when analyzing the complexity of a power project's construction, which can lower our score if environmental conditions are challenging. This is because restrictions on the emission of environmental contaminants or other restricted discharges that could harm the environment can influence a power plant's design. These contaminants could include nitrogen and sulfur oxides, carbon, mercury, dust, and others. Additionally, contamination, endangered species, and unexpected archaeological finds could delay construction and increase construction costs. Another example is the construction of offshore wind plants in harsh sea environments.

Environmental risks are also considered in our KCF for oil and gas project financings. In our construction phase downside assessment, we consider possible change orders under engineering, procurement, and construction (EPC) contracts if the project is near a sensitive environmental location. In our operational phase assessment, we analyze if the project has resource or raw material risk. We also consider if projects are exposed to supply disruption because of social or political risks, such as projects dependent on feedstock (oil and gas) from Nigeria or through the Strait of Hormuz.

Chart 1


Chart 2


While ESG factors are embedded in each project finance credit rating, we also identified clear examples of projects globally that are close to a default, fallen angels, or experiencing credit deterioration due to ESG events. In a few other cases, we found that project-finance-like structures helped to maintain a project's credit quality despite severe environmental events.

Environmental Factors

Chief Power Finance LLC

Rating before ESG event:  'B/Negative' (May 2017)

Rating after ESG event:  'CCC+/Negative' (August 2019)

Project description:   Chief Power Finance LLC (Chief) is a project-financed merchant portfolio with interests in two coal-fired generating plants: Keystone (1,711 megawatts [MW]) and Conemaugh (1,711 MW), located in the Pennsylvania region of the Pennsylvania-Jersey-Maryland (PJM) Interconnection. Given that the project sells all of its energy in the merchant market, it is exposed to spot prices that fluctuate upon demand, supply and weather conditions.

ESG event:  Its debt due December 2020 was originally rated 'BB' in 2015, but we have downgraded the project in the past years because of increasing pressure on power prices, which affected Chief's margins and its debt service coverage ratios. Now that the refinancing date is approaching, we are seeing that Chief's ability to successfully refinance more than $300 million in debt is at risk. This is not only because of a weak power market, but also because it uses coal-based technology. Investors' long-term appetites for this type of asset have diminished significantly since the debt was initially raised. We recently lowered the rating on Chief to 'CCC+' with a negative outlook, highlighting lenders' potential reticence to finance coal-fired power plants (in part due to long-term regulatory uncertainties related to coal assets that might need to be retired) as a risk. Increasing investor wariness is also reflected in the trading levels of these bonds. As of Jan. 6 2020, yield on Chief Power's $340 million term loan B was 54.7%.

Where this is captured in our criteria:  Increased refinancing risk and reduced asset life under our operations phase stand-alone credit profile (SACP).

Longview Power

Rating before ESG event:  'B-/Negative' (February 2017)

Rating after ESG event:  'CCC/Negative' (November 2019)

Project description:   Longview is a project-financed entity operating a 700-MW coal-fired plant. It began operating in December 2011 and is the most efficient coal plant by heat rate in PJM, with advanced supercritical pulverized-coal boiler technology. The power plant is based in West Virginia and sells into the PJM Interconnection, with revenues mostly derived from the merchant market.

ESG event:  Longview shares a similar credit story as Chief Power, in which weak market conditions in the PJM market led to deteriorating cash flows (even negative free cash flows in the first half of 2019), and increasing liquidity concerns since the project's revolving credit facility is due in April 2020 and currently $16 million out of the $25 million is already drawn. We recently downgraded Longview to 'CCC/Negative' not only because of its worsening liquidity and weak expected cash flows, but also on our view of long-term risks because a coal-generating power plant presents complications that reduce our confidence in the sustainability of the project's capital structure. Despite the project's current compliance with all environmental regulations, more stringent regulatory pressures on coal under a future regime may impose steeper operational costs on the project. The ongoing substitution of base-load generation by renewables and gas-fired plants presents additional market challenges to coal plants as they become more vulnerable to periods of depressed natural gas prices. These periods contain lower power prices but provide coal plants none of the upside of lower fuel costs.

Further, lenders--eyeing both future regulation as well as their own ESG mandates--will likely continue to eschew financing coal plants. With a smaller pool of lenders from which to obtain financing, Longview may face permanently higher debt service costs, irrespective of broader financial conditions. These concerns, of course, also erode our confidence that Longview will be able to refinance or extend its revolver before it matures next year. Increasing investor wariness is also reflected in the trading levels of these bonds. As of Jan. 6, 2020, yield on Longview's $287 million term loan B was 45.2%.

Where this is captured in our criteria:  Increased refinancing risk and reduced asset life under our operations phase SACP.

FLNG Liquefaction 2 LLC

Rating before ESG event:  'BBB/Stable' (March 2017)

Rating after ESG event:  'BBB/Stable' (unchanged)

Project description:  FLNG Liquefaction 2 LLC (FLIQ2) is the second liquefaction train that U.S. liquefied natural gas (LNG) project developer Freeport LNG Development L.P. is developing on Quintana Island, near Freeport, Texas. Train 2 is part of a natural gas liquefaction and export terminal comprising three 4.64-metric-ton-per-year (MMt/y) liquefaction trains with a capacity of 13.92 MMt/y. Like the other two trains, train 2 will convert offtaker-supplied natural gas to LNG that the offtaker will purchase and export under a 20-year liquefaction tolling agreement.

ESG event:  The construction of train 2 was expected to be finalized by February 2019 per the initial EPC contract signed back in 2016. However, the current expected completion for train 2 is January 2020--about an 11-month delay from the original guaranteed completion date. What was the reason for this delay? Apart from some EPC contractor fabrication delays and quality issues, in 2017 Hurricane Harvey resulted in flooding at the pipe fabrication facility and laydown yards.

Did this environmental event put the project at risk or lower its credit quality? We believed that despite these unexpected events, the project was able to keep its credit quality (an investment-grade rating) due to significant liquidity available in the structure that allowed the project to pay its first debt service in September 2019, even in construction phase (originally, the project's first debt payment was structured to be made with operational cash flows because construction was expected to be finished by February 2019). However, the headroom to maintain the same credit quality has lowered because the project has needed to use additional liquidity and not operating cash flows to service debt.

Where this is captured in our criteria:  Funding sources and downside scenario under our construction phase SACP.

Autopistas Metropolitanas de Puerto Rico LLC

Rating before ESG event:  'BBB-/Negative' (March 2017)

Rating after ESG event:  'BBB-/Negative' (unchanged)

Project description:  Autopistas Metropolitanas de Puerto Rico LLC operates the PR-22 and PR-5 toll roads (including bus rapid transit/dynamic toll lanes) under a concession granted by the Commonwealth of Puerto Rico through 2061. PR-22 is a well-established, 52-mile toll road that runs along the northern coast of Puerto Rico from San Juan to Hatillo. The road has 118 bridges and seven toll plazas with an open-barrier system. PR-5 is a four-mile toll road running from San Juan to Bayamon, a key business district, and contributes about 5% of total revenue. Project revenues are entirely volume-based, and passenger cars are 96% of traffic.

ESG event:  In September 2017, Puerto Rico experienced two category 5 hurricanes, Irma and Maria. The island was beginning to recover from Irma when it was hit 15 days later by Maria. The second storm was catastrophic and severely damaged the island's power, transport, housing, and telecommunications infrastructure. The island's economy was already in crisis, especially from significant outmigration. While the toll road received minimal damage (net of insurance) from the hurricane and its usage quickly recovered, the hurricane further muddied any clear view of the timing and prospects for Puerto Rico's economic recovery. While there was no rating impact, we reassessed the project's market risk and business profile in early 2018 considering that the erosion of income on the island could lower the value of the toll road's time savings and make toll rate increases difficult to implement on a dwindling population. (This assessment is the operations phase business assessment [OPBA]; in this case we revised the OPBA to a weaker 5 from its former score of 3). We further lowered our near-term traffic volume projections to reflect an unusual level of uncertainty.

Where this is captured in our criteria:  Increased market risk in our operations phase SACP.

Nouvelle Autoroute 30 S.E.N.C.

Rating before ESG event:  'BBB+/Stable' (June 2019)

Rating after ESG event:  'BBB+/Stable' (unchanged)

Project description:  Nouvelle Autoroute 30 S.E.N.C. (A30 Express) operates and maintains a 42-kilometer road (including the 2.0-kilometer tolled Serge Marcil bridge), completed in 2012 to relieve congestion and improve access in Montreal, and another 32 kilometers of highway on Montreal's south shore under a 34-year concession agreement (23.5 years remaining) with Transports Québec through the end of 2042. The project earns a combination of highly stable and inflation-linked availability payments (about 63% of total revenues over the concession) and toll payments (the remaining 37%), which are exposed to traffic risk.

ESG event:  The project is exposed to weather-related events such as heavy snow or rain/storms that could impair revenues, as we believe occurred in 2018. Climate projections generally suggest that the impact of climate change could result in more severe Canadian winters over the long run, so revenue disruptions could become more pronounced over time. We are monitoring the impact of these weather-related events and may adjust our forecast if the weather significantly affects the project's year-over-year traffic. The project's minimum debt service coverage ratio is very close to our downgrade trigger of 1.2x, indicating that it has limited cushion to absorb any underperformance. As such, if car traffic remains depressed, absent any offsetting factors, it could have rating impact.

Where this is captured in our criteria:  Traffic projections in our operations phase SACP.

Aberdeen Roads (Finance) PLC

Rating before ESG event:  'A-/Stable' (February 2015)

Rating after ESG event:  'BBB+/Negative' (February 2017)

Project description:  Scotland-based limited-purpose entity Aberdeen Roads (Finance) PLC issued debt to finance the design, construction, and operation of the Aberdeen Western Peripheral Route (AWPR) in northern Scotland.

ESG event:  Severe weather conditions lead to flooding in a large part of the construction site including the winter of 2015/2016 and in June 2016. The flooding, combined with a delay in completing a number of key utility diversions, contributed to construction delays. Project construction was behind schedule by several months, and at the time we believed there was a chance that the contracting authority might not approve a revised construction schedule that the AWPR construction joint venture (CJV) was expected to propose. On Feb. 23, 2016, we revised the outlook to negative due to construction delays following the flooding, utility diversion delays, and uncertainty around the financial implications for the project.

On Feb. 14, 2017, we lowered the rating on Aberdeen Roads (Finance) PLC to 'BBB+' from 'A-', and the project continued to experience severe construction delays. Although the project has largely been compensated for the flooding by insurance claims, construction continued to be delayed and its schedule slipped further in 2016. The AWPR CJV's revised construction schedule had in February 2017 yet to be approved by the Aberdeen City Council, and we understood that resolution of contractual disputes had been slow. A breach of the project's contractual long-stop date could have led to an event of default under the project agreement and termination by the contracting authority.

The AWPR CJV fully opened the roads fully in February 2019, about 15 months after expected financial close and about three months ahead of the longstop date in the concession. The project is now entitled to receive 95% of the unitary charge from the contracting authority and is currently rated 'BBB+/Positive'. The positive outlook reflects that we expect to raise the rating by up to two notches when the rectification of the construction defects and snagging items is materially advanced. This will indicate significant progress toward final completion, at which point the projectco is entitled to receive 100% of the unitary charge from the authority.

Where this is captured in our criteria:  Construction phase SACP.

Panoche Energy Center LLC

Rating before ESG event:  'BBB-/Negative' (March 2016)

Rating after ESG event:  'BB/Stable' (March 2017)

Project description:  Panoche Energy Center LLC (PEC) is a special-purpose, bankruptcy-remote operating company formed to own and operate a 400-MW natural gas peaker plant in California.

ESG event:  Starting in 2018, California established a mandate to reduce greenhouse gases under the California Global Warming Solutions Act of 2006. California's clean energy mandate will likely pressure the market heat rate and suppress gas prices to weak levels. The market heat rate deteriorated by nearly 50% to a low of 5,906 in 2017 from a high of 8,769 in 2015, reflecting, in part, the impact of stronger-than-normal hydro-generation from a series of Pacific storms and improved snowpack conditions, coupled with growing solar and wind deployment in the state. In forecasts, carbon compliance obligations apply a stress of about $40 million in expenses through 2028. Ultimately, PEC was downgraded to 'BB' from 'BBB-' because of compiling costs and lower debt service coverage that is inconsistent with an investment-grade rating.

Where this is captured in our criteria:  Higher expenses forecast in our base-case operations phase SACP.

Social Factors

Rutas de Lima SAC

Rating before ESG event:  'BBB-/Stable' (July 2014)

Rating after ESG event:  'BB/Developing' (April 2017)

Project description:  On Jan. 9, 2013, the Lima municipality and Rutas de Lima SAC (RdL) executed a 30-year concession to build, operate, and improve three toll access highways to Lima, Peru. The concession consists of approximately 115 kilometers, of which 93.5 kilometers are existing highways and 19.3 kilometers will be constructed. The three roads are Panamericana Norte and Panamericana Sur, which are the main access roads to Lima from the north and south, and Ramiro Prialé, the access road to the city from the east.

According the concession contract, the municipality transferred the ownership of Panamericana Norte and Sur to RdL on Feb. 10, 2013. The municipality will transfer the Ramiro Prialé road after the land is expropriated and obligatory work ends. The work to be conducted is clearly outlined in the concession agreement, consisting of initial work, which RdL carried out during the first year of the concession period, obligatory work, and works triggered by demand that can be added to the concession scope subject to additional compensation.

ESG event:  As stated in the concession agreement, RdL incorporated a new toll plaza in the south-north direction of the Panamericana Norte toll-road in late 2016. However, in early 2017, protesters destroyed this newly opened facility and the municipality of Lima suspended toll payments there. We consider the protests are mostly related to poverty and wealth inequality and some local communities complaining about being charged for road usage. This event resulted in a loss of revenues and a deterioration of the main relevant coverage metrics. The project is now waiting for the resolution of an arbitration process to compensate for the situation. It is worth mentioning that the combination of these social events, plus the governance events described below, resulted in RdL being downgraded from investment grade when we first assigned the rating in 2014 to speculative grade.

Where this is captured in our criteria:  Lower tariff assumptions under our base-case operations phase SACP.

Governance Factors

Natgasoline LLC

Rating includes governance factor since debt was issued in November 2018.  Project description:

Natgasoline LLC is a natural gas-based methanol producer in Beaumont, Texas that is owned jointly by OCI NV and Consolidated Energy Ltd. The methanol plant has been operational since the second half of 2018.

ESG event:  On Nov. 13, 2018, we assigned a 'BB-' rating to Natgasoline's three new debt issuances totaling about $900 million. The financing documents for the senior secured debt permit Natgasoline to re-leverage the balance sheet to a cap of $900 million total project debt without a rating reaffirmation requirement if forward-looking first-lien net debt to EBITDA is no greater than 3x. We find this arrangement atypical in project finance transactions with a term loan B structure, which usually require the borrower to pay down the debt through excess cash flows depending on the leverage ratios after mandatory debt service. As a result, we notched the debt rating down by one to reflect this additional borrowing flexibility. Although the project has not exercised this option to re-leverage the balance sheet, we consider this flexibility in the financing documents to be weak from a governance standpoint compared to other North American project finance transactions that typically don't have this kind of flexibility.

Where this is captured in our criteria:  Transaction Structure criteria.

Rutas de Lima SAC

Rating before ESG event:  'BBB-/Stable' (July 2014)

Rating after ESG event:  'BB/Developing' (April 2017)

ESG event:  We believe RdL's credit quality was also affected by governance issues related to the eroded reputation of one of its sponsors, Odebrecht, which is under investigation for paying bribes in Latin America to win concessions. Given that construction work at Ramiro Priale road need additional funding, we believe that as long as Odebrecht remains within the structure, the project's ability to secure the last portion of the financing will continue to be at risk. Partly compensating for the greater funding risk is that, according to the concession contract terms, the 18-month period to complete construction on Ramiro Priale is triggered if the project can secure the financing and starts as soon as it receives 100% of the land on which the tranche will be located, but this hasn't occurred yet. In this case, although the project was structured as a nonrecourse vehicle that is de-linked to its sponsors from a legal standpoint, we believe it was still affected by the reputational risk from Odebrecht, and having this indirect exposure affected its ability to secure additional financing.

Where this is captured in our criteria:  Funding certainty under our construction phase SACP.

Nautilus Power LLC

Rating before ESG event:  'B+/Stable'; recovery: '2' (May 2018)

Rating after ESG event:  'B+/Stable'; recovery: '3' (May 2019)

Project description:  This project financing comprises an about 2.2 gigawatt power portfolio in the following markets:

PJM-Eastern Mid-Atlantic Area Council (EMAAC):

  • Lakewood Cogeneration L.P.: 280-MW dual fuel combined cycle facility.
  • Essential Power Rock Springs LLC 1, 2, 3, and 4: 744-MW natural gas-fired peaking facility.
  • Essential Power OPP LLC: 374-MW natural gas-fired peaking facility.

Independent System Operator-New England (ISO-NE)L

  • Essential Power Newington LLC: 630-MW dual fuel combined cycle facility.
  • Essential Power Massachusetts LLC: 254-MW portfolio of natural gas, oil, and diesel/kerosene peaking facilities.

ESG event:  In May 2017, the project upsized its term loan B by $70 million to perform a dividend distribution to its sponsor. Although with the upsize the updated debt service coverage ratios remained in line with our then-rating (although with a lower cushion), we revised our recovery rating due to a higher amount of debt under a hypothetical default scenario, which we model for our recovery ratings. Same as SJEC, we consider this to be a governance-related factor because we believe risk management includes protecting lenders from weak periods, most importantly volatile energy merchant markets, in which increasing debt to perform a dividend distribution is not credit supportive.

Where this is captured in our criteria:  Recovery rating.

Ruta del Sol (not rated) and Colombia 4G program

Project description:  Back in 2010, the Colombian government awarded a consortium led by Odebrecht (the Brazilian construction company, with a 65% stake) the construction and expansion of the Ruta del Sol Sector 2 highway in Colombia, covering 528 kilometers, with a contract worth more than $1 billion.

ESG event:  Although the project had already secured financing from seven Colombian banks and construction/improvement works were already ongoing, the Colombian government terminated the concession in 2017 after allegations that Odebrecht paid bribes to be awarded the contract. The Ruta del Sol II project was not part of Colombia's 4G program (the most ambitious infrastructure program in Colombia's history, related to improving and expanding roads for about $14 billion), but the Ruta del Sol scandal resulted in a slowdown in infrastructure financing in Colombia and significantly affected banks' confidence to finance those projects.

This report does not constitute a rating action.

Primary Credit Analyst:Diego Weisvein, New York (1) 212-438-0523;
Secondary Contacts:Michael T Ferguson, CFA, CPA, New York (1) 212-438-7670;
Aneesh Prabhu, CFA, FRM, New York (1) 212-438-1285;
Jason Starrett, New York (1) 212-438-2127;
Luisina Berberian, Madrid +(34) 91-788-7200;
Trevor J D'Olier-Lees, New York (1) 212-438-7985;
Stephen R Goltz, Toronto + 1 (416) 507 2592;
Dhaval R Shah, Toronto (1) 416-507-3272;
Boyan Kovacic, San Francisco + 1 (415) 371 5082;
Candela Macchi, Buenos Aires (54)-11-4891-2110;

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