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Project Finance: Why Ratings Above The Sovereign Are Uncommon

Market participants have recently been questioning whether project finance transactions can have a higher rating than that on the respective sovereign, particularly in low- and middle-income countries. Although S&P Global Ratings can rate project finance transactions above the level of the sovereign foreign currency rating, it is uncommon. This is because of the nature of the contracts in project finance, which can't always anticipate the country-specific circumstances that will unfold when a sovereign is under financial stress.

We define project finance as a method of financing certain capital-intensive assets, mostly in the infrastructure and industrial sectors. Examples are toll roads, power plants, oil and gas production or midstream assets, as well as airports and ports. Project finance transactions involve one or more limited-purpose entities that together undertake the construction and/or operation of an asset or set of assets.

What We Look For When Rating Project Finance Transactions

We look for seven critical attributes when rating debt under our project finance methodology (see table 1 and "General Project Finance Rating Methodology," published on Dec. 14, 2022).

Table 1

The critical attributes that we look for when rating debt using our project finance methodology
A bankruptcy-remote limited-purpose entity to build and/or operate the project. We expect the entity's purpose to be limited to activities necessary for the project.
A security package that gives lenders a right to the project's cash flows and assets. Among other things, this limits the disposal of key assets. Project assets include physical assets, permits, agreements, accounts, and equity.
A single asset, or a typically closed portfolio of assets, that has a determinable economic life.
A covenant package that ensures that the future actions of third parties will not disadvantage creditors.
A cash-management structure that includes a waterfall that prioritizes the payment of senior debt after the maintenance of the ongoing operations, as well as liquidity mechanisms that preserve cash to support senior debt service ahead of other project obligations and distributions.
A controlling stake in the assets via the debt-issuing limited-purpose entity's majority ownership or shareholder agreement. Alternatively, if the issuer does not have a controlling stake, its affirmative vote is required to approve major decisions.
Exposure to revenue risk, as well as either construction or operating risk, because the ability to service debt depends on the cash flows that the project assets generate.

As a general principle, we do not need to constrain all the ratings in a given country at the level of the sovereign rating. This is because a sovereign default does not imply that every entity in the country will default as well, judging by historical default patterns after sovereign defaults. Therefore, our methodology does not include a ceiling on other in-country ratings (colloquially known as a sovereign ceiling). This principle applies to project finance transactions as well.

Nevertheless, our methodology does reflect the likely effect of the economic conditions while a sovereign is under financial stress on the entities in that country. The economic stress that has accompanied sovereign defaults is severe, and it has typically led to a significant increase in nonsovereign defaults.

The economic conditions in a country in which the sovereign is either likely to default, or has defaulted, tend to be complex, fast-moving, and stressful, and these conditions are typically associated with significantly higher default risk for the entities in the country.

In our methodology, we reflect the linkage between the general environment in a country whose sovereign is experiencing credit stress, and the project's ability to withstand those conditions, in an assessment of the distance between the project's credit quality and that of the sovereign.

When We Rate A Project Finance Transaction Above The Sovereign

We can rate a transaction above the sovereign foreign currency rating if, in our view, there is an appreciable likelihood that the transaction would not default if the sovereign were to default. To evaluate that likelihood, we simulate a sovereign stress scenario when determining the rating on entities in a given jurisdiction.

We can rate entities that pass such a stress test up to two or four notches above the sovereign foreign currency rating, depending on whether we view their sector's sensitivity to country risk as moderate or high, respectively. Our rating methodology describes the steps that we follow, including the different approaches we take depending on the sovereign's credit quality (see "Ratings Above The Sovereign--Corporate And Government Ratings: Methodology And Assumptions," published Nov. 19, 2013).

An additional element that can constrain our ability to rate a project finance transaction above the sovereign foreign currency rating is our assessment of transfer and convertibility (T&C) risk. This risk is particularly relevant for lowly rated sovereigns, including some low- and middle-income countries.

The T&C assessment reflects our view of the likelihood of a sovereign restricting a project's access to foreign currency, thereby preventing it from transferring that currency to creditors to service the rated debt. Even if we expected a transaction to generate enough local currency under a sovereign stress scenario to buy the foreign currency to service the debt, our view of whether the sovereign would impose T&C restrictions in a default scenario could constrain our ability to rate the project higher than the sovereign foreign currency rating. This is why many emerging-market project finance transactions include structural features that aim to offset T&C risk.

Project Finance Contract Limitations

Project finance is a type of financial engineering that involves multiple contracts that allocate risk among the different transaction participants and establish what is expected and permitted of each of them. These contracts provide a certain degree of visibility on the cash flows that will constitute the source of debt repayment. Ultimately, the repayment of the debt relies on the fulfilment of the obligations under the different contracts.

However, the contracts are drafted with knowledge and understanding of the past, but limited visibility on the future general and economic conditions within the jurisdiction. This is why project finance is vulnerable to the unexpected and volatile conditions that may arise in times of sovereign credit stress.

The contracts cannot anticipate all possible scenarios, and the scope to make changes quickly is limited in practical terms. The more parties to a contract, the harder it is to bring them all to the table to agree new contractual conditions, particularly if the level of economic uncertainty is higher than usual. Even with a small number of parties, the ability to make timely changes tends to be limited.

Another issue is the fact that governments can change the laws governing the contracts. Some contracts may include change-in-law provisions, but even by changing minor aspects of the regulations, governments can alter the operating conditions--and thereby potentially the credit quality--of the underlying assets that are part of the project finance transaction. For example, in an effort to reduce the impact of inflationary pressures, governments can limit tariff adjustments. Even if it was possible to file a claim against such an action, its resolution might take time.

In an attempt to mitigate this risk, some contracts are governed by the law of a country that may be seen as having a stronger legal system (for example, the U.K. or the U.S.) than a low- or middle-income country. Although this allows creditors to petition under a legal system that has a greater degree of predictability in defending creditors' rights, our assessment of the transaction's credit quality not only considers the contracts, but also the operating assets and their location in the low- or middle-income country.

It can be extremely challenging to enforce the ruling of a foreign court in the country where the assets are located. Situations involving multiple assets in multiple countries are even more complicated. In all cases, even when it is theoretically possible for us to rate a transaction above the sovereign, practically it is impossible to eliminate all the potential consequences of a sovereign default, and so the relevant sovereign rating does influence the project rating. The risk that one or more sovereigns will add to a transaction will therefore always require a case-by-case analysis and will depend on the structure and the underlying credit quality of the relevant sovereign(s).

We Rate A Low Proportion Of Transactions Above The Sovereign

We rate 11 transactions, or less than 4% of the overall rated portfolio, above the relevant sovereign foreign currency rating as of June 28, 2024 (see table 2). Nine of these 11 transactions have unconditional and irrevocable guarantees that result in the full substitution of the transaction's underlying credit quality for that of the guarantor. We rate two projects above the relevant sovereign for underlying structural reasons rather than credit substitution reasons.

Table 2

Projects rated above the sovereign
Project name Asset class Country Sovereign foreign currency rating T&C assessment Issue credit rating* Main rating driver
Rating driven by a payment guarantee

Anselma Issuer S.A. Senior secured class A

Power Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guarantee of payment from Assured Guaranty (Europe) S.A. (AGE) (AA/Stable/--)

Autovia de la Mancha, S.A.

Transportation Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guanratee of payment from Assured Guaranty UK Ltd. (AGUK) (AA/Stable/--).

Desarrollos Empresariales Trafalgar S.A.

Power Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guarantee of payment from AGE (AA/Stable/--)

Enersol Solar Santa Lucia S.A.

Power Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guarantee of payment from AGUK (AA/Stable/--).

FSL ISSUER S.A.U.

Power Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guarantee of payment from AGE (AA/Stable/--)

Hypesol Solar Inversiones S.A.U.

Power Spain A/Stable/A-1 AAA AA/Stable Irrevocable and unconditional guarantee of payment from AGE (AA/Stable/--)

M6 Duna Autópálya Koncessziós Zrt.

Transportation Hungary BBB-/Stable/A-3 BBB+ AA/Stable Irrevocable and unconditional guarantee of payment from AGUK (AA/Stable/--).

Sociedad Concesionaria Vial Montes de María S.A.S.

Transportation Colombia BB+/Negative/B BBB AA/Stable Irrevocable financial guarantee from U.S. agency Development Finance Corp. (DFC), for interest and make-whole premium, in each case for the maximum guaranteed principal amount up to $350 million.

Verdun Participation 2 S.A.

Transportation France AA-/Stable/A-1+ AAA AA/Stable Irrevocable and unconditional guarantee of payment from AGE (AA/Stable/--).
Rating driven by underlying structural reasons

Mexico Generadora de Energia, S. de R.L.

Power Mexico BBB/Stable/A-2 A BBB+/Stable The transaction consists of two natural gas-fired electric facilities located in the mining complex of MexCobre in the state of Sonora, Mexico. The two facilities are fully contracted through a 20-year energy self-supply agreement with Mexicana del Cobre S.A. de C.V. and Buenavista del Cobre S.A. de C.V. These two entities are the offtakers and subsidiaries of Minera Mexico S.A. de C.V. (BBB+/Stable/--), which generates about 80% of revenues for its parent, Grupo Mexico S.A.B. de C.V. (BBB+/Stable/--).

MV24 Capital B.V.

Commodities & Natural Resources Brazil BB/Stable/B BBB- BB+/Stable Very predictable cash flows from availability payments for an asset that is tailor-made to operate in the Tupi field. This, in turn, is important for the country's energy matrix. There are also strong economic incentives to operate in the cost-efficient Tupi field.
Data as of June 28, 2024. *Only includes the most senior debt tranche. ICR--Issue credit rating. T&C--Transfer and convertibility.

Around 95% of the rated portfolio are projects located in countries that we rate investment grade, that is, 'BBB-' or higher (see chart 1). As a result, it is hard to draw conclusions from this data for projects in jurisdictions that we rate speculative grade, that is, 'BB+' or lower.

Chart 1

image

Generally, there is a gap between a project's underlying credit quality and the sovereign rating

We assess a project's underlying credit quality by excluding government support or guarantees. From this perspective, almost 90% of the transactions have lower ratings than the relevant sovereign rating, with an average gap of more than six notches, or two rating categories (see chart 2). This is unsurprising, because project finance transactions are typically structured to achieve low investment-grade, or 'BBB' category, ratings. Moreover, close to 70% of the portfolio have assets in the U.S., Canada, the U.K., Australia, and countries in Western Europe, which generally have ratings in the 'AA' category.

Chart 2

image

Excluding the projects we rate in these countries, the remaining 60 projects have average underlying credit quality of over four notches, or one rating category, below the relevant sovereign rating (see charts 3 and 4). The outcome would not change materially if we included projects with underlying credit quality that is on a par with that of the relevant sovereign.

These conclusions show general trends only. In addition, sovereign credit quality could also influence some transaction counterparties that cap the project's underlying credit quality.

Chart 3

image

Chart 4

image

For projects with underlying credit quality higher than that of the sovereign, but that we do not rate as such, the assets are in Latin America and the Caribbean. Most are transport- and power-related projects with significant regulatory influence over their tolls, tariffs, or revenues. This helps explain the rating limitation. The median gap between the underlying credit quality of the project and the relevant sovereign rating is two notches.

No Sovereign Rating Ceiling

Although we can rate project finance transactions above the sovereign rating with no inherent ceiling, we consider a number of factors when assessing projects' creditworthiness beyond sovereign levels. These include the economic conditions that could affect all the rated entities in a country experiencing severe financial distress following a sovereign default, a situation that is likely to be characterized by complex and rapidly changing circumstances. T&C risk is therefore a critical part of our analysis and could limit our ability to rate project finance transactions above the sovereign.

We only rate 11 project finance transactions above the relevant sovereign, and in most of these cases, this is due to guarantees that result in credit substitution. Moreover, most of the transactions are in developed and highly rated sovereigns, making it hard to draw conclusions for lowly rated sovereigns or for low- and middle-income countries.

This report does not constitute a rating action.

Primary Credit Analyst:Pablo F Lutereau, Madrid + 34 (914) 233204;
pablo.lutereau@spglobal.com
Secondary Contact:Vernice Tan, Singapore +65-6216-1145;
vernice.tan@spglobal.com

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