Global Head of Infrastructure & Utility Ratings and Regional Head Nordics at S&P Global
Andreas Kindahl (AK), Global Head of Infrastructure & Utility Ratings and Regional Head for the Nordics, and Michele Sindico (MS), Director and Lead Analyst in the EMEA Infrastructure team, from S&P Global talk to Nordea Thematics’ Viktor Sonebäck (VS) about the case for project ﬁnance, and how it differs from traditional corporate funding. They see Europe’s energy security as a catalyst for an investment supercycle, and consider that project ﬁnance could enable the mobilisation of new capital.
VS: Can you briefly describe your roles, and S&P Global's project ﬁnance rating business? What part do credit ratings play in project ﬁnance globally today, and how does that differ from their role for other types of bond issuers?
AK: I joined the Ratings division in 2000 and am now the Global Head of Infrastructure & Utility Ratings, as well as the Regional Head for the Nordics.
MS: And I am Lead Analyst in the EMEA Infrastructure team specialising in project ﬁnance transactions, and have a background in structured ﬁnance.
AK & MS: The global infrastructure team comprises around 130 analysts in 24 offices and covers over 1,200 ratings, of which about two-thirds are more corporate-like infrastructure entities, such as utilities and transportation infrastructure companies (airports, ports, etc), and one-third are transactions rated using project ﬁnance or project developer ﬁnancing techniques (across multiple asset classes, but mainly infrastructure related). Our Stockholm office opened in 1988 and currently has about 50 employees, around half dedicated to ratings.
About half of the 300 project ﬁnance ratings we maintain globally are in the low investment-grade category ("BBB-" or above), and the remainder are in the "BBB" category. Our project ﬁnance portfolio is split between three main sectors – power, social infrastructure and transportation. Power is the largest sector, making up 37% of the ratings, followed by social infrastructure at 28% and transport at 27%; oil and gas account for 7%, and the remainder is spread among industrial, desalination, and sporting team projects. About one-third of our project ﬁnance ratings are in the US and another third in EMEA, with the balance split between mainly Latin America and Canada, and, to a smaller extent, Asia Paciﬁc.
Traditionally, capital markets' receptiveness for project ﬁnance debt has depended largely on the debt having an investment-grade rating and the price competitiveness of capital market issuance versus bank or private ﬁnancing. This means high-risk projects are generally funded in the bank market or by state or multilateral lending institutions such as development banks or export credit institutions. We anticipate that capital markets will gradually become more attractive for speculative-grade project ﬁnance transactions, as they have for corporate issuers.
VS: How does S&P deﬁne project ﬁnance, and how do you view it compared with other types of ﬁnance, for example in terms of risk proﬁle or speciﬁc beneﬁts or disadvantages?
AK & MS: Project ﬁnance is a non-recourse ﬁnancing technique typically affiliated with capital-intensive infrastructure assets, but that can be applied to most real assets with a long-term revenue proﬁle.
In a broad sense, we talk about a project in the instance whereby a limited purpose entity (or LPE), ﬁnancially and legally independent from its shareholders or sponsors, is tasked to build and/or operate a deﬁned asset or a set of discrete assets for a ﬁnite period. The LPE may not have the tools or the appetite to directly perform all the tasks necessary to complete its mandate, so it may subcontract speciﬁc tasks, such as the construction or the ongoing maintenance of the asset, to third parties with the right skills. In doing so, the LPE allocates not only responsibilities but also the associated risks to those third parties.
The LPE would fund itself via a combination of equity and project-speciﬁc debt. The lenders look to the cash flow generated by the assets as the primary means for the debt to be serviced, and therefore are allowed to exercise considerable control on the operation of the project. Their primary instrument of intervention is represented by the ability to enforce their security interest over the assets and the contracts that govern them.
One of the main advantages for sponsors choosing to ﬁnance assets through an LPE is that the project and sponsor are separate entities. This means that if a project fails, lenders have no claim on the sponsor's other assets. On the other hand, if the sponsor defaults, the assets securing the project ﬁnance would not be included in the sponsor's insolvency proceedings. Additionally, project ﬁnance issuers are typically subject to limitations on what they can and cannot do, and generally aim to allocate risks and responsibilities between transaction participants. Depending on the stability of future cash flow generation, project ﬁnance structures grant sponsors the possibility of achieving higher debt-to-equity ratios, which could, under certain conditions, result in lower cost of debt than for conventional corporate ﬁnancing. Moreover, depending on the sponsor's standalone creditworthiness, it is possible for project ﬁnance debt to be rated higher than the sponsor itself.
From a lender's standpoint, the beneﬁts of project ﬁnancing versus corporate ﬁnancing arise mainly from the issuer's restrictions – which enhances visibility on the business by limiting new activities or asset acquisitions – the security – which provides lenders with material control on the assets and higher recovery prospects – and insulation from the sponsor's bankruptcy risk. Equally important, unlike traditional corporate entities, which can hold onto any free cash flow and reinvest it in the business, the cash flow generated by a project ﬁnance structure flows directly from the project to creditors and can only be disbursed to the sponsors if the assets are performing well.
On the flipside, project ﬁnance lenders typically rely on a single or discrete number of assets and their associated contractual arrangements. Although a lien is generally created over substantially all the assets and key contracts, the repayment of the debt depends on the ongoing operation of the business rather than on the assets' sale. Therefore, project ﬁnance lenders are more exposed than corporate lenders to unexpected events that could undermine the viability of the assets and key contracts. Financing a project therefore requires an in-depth analysis of the likelihood that a project will be sufficiently equipped to be built and completed on time and within budget, and capable of operating as designed and expected. This is where we come in. Before we assign a rating to project ﬁnance debt, we examine all of these factors in detail.
VS: Are there any regional differences in the extent to which corporates utilise project ﬁnance structures? If so, what would you attribute this to? Legacy? Regulations? Political stability? Other factors?
AK & MS: We believe the motive behind corporate sponsors' use of project ﬁnance structures is to be found in a cost-beneﬁt analysis that is unique to each company regardless of region. Naturally, each corporate entity will use the form of ﬁnancing that optimises its cost of ﬁnancing. For project ﬁnance, the jurisdiction and legal regimes are very important, since the structures are based on contractual elements that must be enforceable and on structural separation (bankruptcy remoteness). This means that completing project ﬁnance transactions in jurisdictions with weak legal frameworks and rule of law is more complex and could be commensurate with speculative-grade ratings (i.e., "BB+" and below).
In developed markets, and based on our experience, the size of the project matters, and even a corporate with a solid balance sheet may be more prone to adopt a project ﬁnance approach in the context of large-scale projects than small ones. Additionally, in the presence of a consortium with weaker sponsors, any corporate may favour a project ﬁnance structure to streamline the funding process and indirectly beneﬁt from the creditors' protections during the funding stage.
The Nordics in our view represent a fertile region for project ﬁnancing, primarily in the power sector but less so for social infrastructure. Within power, the size of the transactions, the appetite for renewable power generation assets, and competitive pricing, make this part of the world largely dominated by bank lenders and institutional investors.
VS: With Paris Agreement commitments to address climate change requiring massive investments in the green energy transition and related infrastructure, is there a role to play for project ﬁnance to help fund them?
AK & MS: Absolutely. We expect the energy transition together with the European Commission's "Fit for 55" package will sharply increase growth in demand for electricity, primarily from 2030, which will likely support high power prices in the long run. Europe will need to add between 45 and 55 gigawatts (GW) of renewable capacity a year this decade (20-30 GW annually for solar and 25 GW for wind). That compares with 30 GW added in 2020 (20 GW of solar and 10 GW of wind). Under the plan, electriﬁcation would increase to 30% of the ﬁnal energy demand by 2030 and to 57% by 2050, from just 25% today. This will trigger an investment supercycle to massively expand renewable generation and upgrade energy networks in the region to improve resilience, integrate new renewables, and manage intermittency. For example, we project annual investments of European utilities to increase, on average, by 30% annually over the next three years, to about EUR 133bn on aggregate for all entities we rate.
Furthermore, and as a result of Russia's military actions in Ukraine, the European Commission is looking to drastically reduce Europe's imports of fossil fuel from Russia. The proposal – REPowerEU – will seek to diversify gas supplies, speed up the rollout of renewable gases, and replace gas in heating and power generation, thereby reducing EU demand for Russian gas as soon as possible, with the target initially set at two-thirds before the end of the year. As essential as such a plan is for Europe's energy security, it may not be easy to implement. Nevertheless, and in addition to accelerating renewable energy generation, this could lead to new investment opportunities in
"megaprojects", such as LNG terminals, large-scale green hydrogen systems (renewable power combined with hydrogen electrolysers), new nuclear reactors, large battery storage units, etc.
To support these large investments, we expect to see a signiﬁcant mobilisation of capital that will inevitably result in an increase in debt issuance, both through traditional corporate borrowing and project ﬁnancings. We see two main factors supporting a boost in project ﬁnance debt:
VS: Do investors have different needs to assess project ﬁnance risks compared with risks associated with other asset classes?
AK & MS: Yes. The risk assessment of a project ﬁnance debt instrument requires a unique analytical mindset and set of tools relative to conventional corporate debt. There are two primary reasons why project ﬁnance analysis is somewhat more granular.
First, project ﬁnancings are generally designed around, and dependent on, discrete assets. Before investing in a project ﬁnance bond or loan, and to appreciate its credit risk, it is therefore essential to understand inside out the underlying cash-flow generating asset. The unavoidable technical analysis may be complicated by the fact that the asset may at the time exist only as drawings and remains exposed to construction unknowns until ﬁnal completion. The need to scrutinise and assess the quality of the construction phase is even more crucial because the tenor of project ﬁnance debt is generally longer than for most corporate ﬁnancings. Any analysis therefore needs to critically consider whether, with the right maintenance, the asset can meet any operational and contractual obligations until full repayment of the debt. If the asset operates in a competitive environment, to assess its ability to service the debt, we – like investors – need to assess features and operating attributes that may differentiate the project and its assets from the rest of the pack.
The lenders' reliance on discrete assets over a materially longer time horizon than pure corporate debt requires also a granular approach to environmental, social and governance (ESG) factors. When they can materially influence creditworthiness, ESG credit factors are embedded in our forecasts, analysis and assessment of a project's construction and operations phases.
Furthermore, project ﬁnance can be pictured as a network of contracts that aims to establish roles and responsibilities, and ultimately to determine how participants, including lenders, share the risks. A thorough understanding of who contractually bears the risk for which part of the project is paramount in assessing project ﬁnance risk. And even when contracts clearly set out roles and responsibilities with respect to immediate risks, such as delays in a project in construction, anyone performing the necessary contract analysis inevitably needs to make projections and forward-looking conclusions to determine the potential risk of a shift in responsibilities away from the relevant participant.
At S&P Global Ratings, we have developed a granular framework to assess the risks that underpin project ﬁnancing, along with a set of sector-speciﬁc key credit factors that complement our analytical approach and aid the analysis of the assets we see being ﬁnanced via this technique.
Global Head of Infrastructure & Utility Ratings and Regional Head Nordics at S&P Global
Director, Lead Analyst in the EMEA Infrastructure team at S&P Global
Project ﬁnance structures may allow for higher debt-to-equity ratios
Lenders beneﬁt from higher issuer restrictions and insulation from sponsor bankruptcy risk
Debt repayment depends on the ongoing operation rather than on asset sales.
Energy transition will trigger an investment supercycle where project ﬁnance structures will play a role.
Europe's move from Russian fossil fuels could lead to new investment opportunities in "megaprojects".
Discrete assets coupled with the long debt tenor require an ad-hoc risk assessment.
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