Home » Project finance: Time for calculating the risks

Project finance: Time for calculating the risks

Project finance: Time for calculating the risks

Employing probabilistic risk models could provide an objective basis of evaluating and tracking risks as they wax and wane through the project stages. Infrastructure projects are all about taking calculated risks, but before taking the risks, one needs to calculate them well, writes Debal Mitra.

‘Mind the gap’ – the cautioning advice on the Delhi Metro aptly symbolises the concern on meeting the targets on infrastructure spending, at least for the 12th Five Year Plan. The scepticism regarding the infrastructure financing gap being bridged is part of the conventional narrative that has for long bemoaned the unavailability of natural long term financing sources, like insurance and pension funds, on account of regulatory constraints, and the absence of deep financial bond/capital markets. The onus of funding infrastructure has by and large fallen on banks, which are not only unnatural financiers of long term infrastructure assets, but also constrained by sectoral caps. Foreign capital also remains elusive given the volatility in global financing markets, and India’s sovereign credit rating, which is maintained – many would say questionably – at rather suppressed levels.

Besides, low domestic credit ratings on liabilities of infrastructure companies – mirroring the high risk perceptions of the infrastructure sector – have been an issue. Infrastructure loans all around the world have been generally perceived to be riskier than corporate loans. In India, the ever-increasing complexities associated with almost every segment of infrastructure have ensured that most project ratings remain range-bound within non-investment to low investment levels. The return expectations on projects with such low standalone ratings are typically high, which the projects are ill-equipped to provide. On the other hand, institutional mechanisms for guaranteeing or credit-enhancing such loans have been limited, with Special Purpose Vehicles (SPVs) relying on corporate guarantees from group flagships, which might themselves be considerably leveraged already.

To be fair, in recent times, there has been a renewed thrust by the government and its enabling institutions to confront these problems head on. The imperative of relieving banks’ burden has been realised through facilitating takeout financing mechanisms. IIFCL, set up as the apex infrastructure financing institution in India, has evolved a takeout financing scheme for financing viable infrastructure projects. It has also come up with a pilot credit enhancement scheme in collaboration with ADB to guarantee projects that have already been rated by an Indian rating agency. Last year, the first such transaction on a road SPV (GMR Jadcherla Expressways Ltd) has been successfully completed. In addition, Infrastructure Debt Funds (IDFs) have been mooted as a new financing avenue to facilitate access to stable long-term funds from domestic and overseas investors for the infrastructure sector. IDFs could take the form of companies, ie, as Non-Banking Financial Companies (NBFCs) or as trusts, ie, mutual funds (MFs), with the former issuing bonds to raise money, and the latter units. (Already four IDFs have been registered with the SEBI and the RBI.) Besides, over the past two years, there have been considerable moves to ease foreign inflows into corporate debt market. Through successive directives, the RBI has raised the investment limit in corporate bonds by foreign institutional investors (FIIs) to $50 billion, with a sub-limit of $25 billion for infrastructure bonds. It has also dispensed with the lock-in period requirement for a significant portion of the investment in infrastructure bonds. The government has also relaxed external commercial borrowings (ECBs) in roads and power sectors, among others.

Notwithstanding the clear policy direction from the government to effect greater financial facilitation, the institutional mechanisms laid out need further streamlining. While takeout financing from IIFCL releases funds for banks for fresh disbursements, the assets taken out are those that have reached commercial operation date (COD). These are typically standard assets, which the banks have been reluctant to let go off their books. In addition, there is an ambiguity in determining the post-COD interest rates, which should be lower than the rates charged by banks during construction. The post-COD takeout rates on the project loan would be recalculated based on a premium on IIFCL’s benchmark rates, the premium being determined by credit ratings, and not as a certain reduction from the existing borrowing rates charged by the banks, based on an assessment of the risks shed off at the point of COD. Moreover, credit rating agencies, which like to ensure stability in their ratings, would not guarantee an automatic upgrade after COD, since they would ideally have factored it in their original analysis. Consequently, the extent of benefit would be uncertain.

Similarly, the benefits offered by IIFCL’s credit enhancement product remains to be tested since there has been only one credit guarantee transaction till date. Typically, bonds require AA rating levels for successful placement. On the other hand, infrastructure projects are typically rated at BBB levels or below on a standalone basis. For such projects, the credit enhancement, which is capped at 40 per cent of the exposure, may not be sufficient to reach AA bracket.

As regards IDFs, there would be definite benefits accruing from diversification of risk exposure across a slew of pre-identified infrastructure assets. However, cherry-picking these projects among many others may ideally call for a new internal basis of risk assessment, especially given the limited dispersion offered by credit ratings. In case of IDF-MFs, especially, the investors or unit-holders would be directly exposed to losses on the constituent assets through the decline in their NAVs, establishing the need for continuous risk tracking of the assets.

While the government has been creating the vessels and clearing the conduits for foreign investments in infrastructure, overseas investors would additionally need to map the relative riskiness of assets across the country to decide where to put in their money. Investors worldwide typically choose from a spectrum of instruments from senior debt through mezzanine to equity, based on the perceived risks from the assets or asset portfolio. Hence, they require an understanding of the extant risk determinants of various infrastructure sectors.

The risk environment for three such sectors – roads, power and urban infrastructure – is discussed in the following sections.

Road sector: other paths opening too

Till two years ago, the road sector seemed to be the trendsetter in reforms amongst all infrastructure sectors, with the first Model Concession Agreement being evolved there, and the then Union Minister, Kamal Nath, targeting 20 km per day of highway development through successful public-private partnerships (PPPs). However, while the need for laying or debottlenecking roads across the country promises a strong pipeline of projects to be bid out in the long term even today, progress on existing concessions has hit a rocky terrain. Inadequate traffic, delays in land acquisition, shifting of utilities and obtaining environment clearances, high interest rates and soaring material and labour costs (especially in case of toll roads with non-inflation linked toll rates) have been the major bottlenecks.

Besides, there have been issues with the state of finances of the promoter groups themselves, which has affected their equity commitments to their road SPVs. The bidders for the National Highways Authority of India’s (NHAI) BOT contracts have been primarily large Indian construction groups who have been bidding aggressively by dint of their confidence in their mainstay EPC business. However, the grim economic conditions over the past two years, inflation and high interest rates have often led to a severe lag on the execution of their order books. In addition, they have suffered from long working capital cycles on account of stretched receivables, which have resulted in cash flows thinning out.

The silver lining is the likely reduction in interest rates expected in the near future, which may work through interest resets to shore up the bottomlines of existing projects. For the promoter groups, improvement in their financial buoyancy to support their subsidiaries would hinge on improvements in the macroeconomy and fresh lease of economic activity in the country, which may come about slowly. Meanwhile, they would continue with their strategy to restructure their asset portfolio, by exiting some of the projects at or below par, and using the proceeds to accelerate the others.

While any systemic changes in ease of land acquisition or improvements in traffic appear unlikely in the short term, there are other contractual changes expected in the near future. Lenders have started flexing their muscles demanding 100 per cent land acquisition before awarding road contracts. The government is also planning to amend the MCA to empower lenders to substitute the concessionaire, which fail to meet milestones even before the project attains COD.

On the developers’ end, paucity of funds, and particularly lack of enough project-enabling commitments from the government, has led to a sharp decline in participation interest in fresh BOT projects. On the other hand, the government itself has laid down stiff completion targets for itself, which it cannot afford reneging on substantially, more so as it faces general elections next year. As a consequence, the sustainability of BOT, till now held sacrosanct as the primary mode of private sector engagement in road projects, has been put to question. The government may return to developing projects itself and awarding more projects on EPC, at least in the short term, if only to meet its target.

All this makes a case for a more rigorous analysis of the project risks in roads and highways projects for ascertaining its feasibility, whether to bid it out and in what mode, and on an ongoing basis thereafter. While roads have been built and operated mainly through private BOTs world over, in the US, France and Japan these have been developed and are operated by public sector authorities. The UK and some other European countries, on the other hand, have successfully employed shadow tolling to a large extent. For many prospective Indian road projects, it would be worthwhile to explore options of partial shadow tolling or shadow tolling followed by a slow ramp-up in toll rates. In addition, any techno-economic feasibility needs to be sensitised much more to the different levels of toll acceptance for different projects/project stretches, which ultimately determine the toll elasticity.

Besides, the extent of land acquisition – the primary issue concerning a road project – has often been treated perfunctorily during analysis, without reckoning the various stages of the elaborate process. NHAI Act lists out the various notifications that are required for garnering possession of the identified land. The authority’s responsibility ends with issuance of the 3D notification, which only declares the acquisition, while it is only after issuance of 3F notification by the government that land can be acquired. Hence, a 3D notification on say, 80 per cent of the land would not ensure acquisition of the entire land. Lenders, who are becoming increasingly risk-sensitive, would need an objective basis to assess and score risks of land acquisition, getting approvals and other project risks.

Power sector: from what burns to what glows and blows

The power sector, arguably the most complex of all infrastructure sectors, has witnessed a lot of government action over the past two years to get the sector out of its morass. Major among these was the National Tariff Policy directive mandating the procurement of power by distribution licensees through competitive bidding from January 2011, by central and state public sector and private generating companies alike, with the premise that competitive bidding would reduce power prices. Besides, at the distribution end, the government has recently (in October 2012) notified a Financial Restructuring Scheme for state distribution companies (discoms), which would, on the one hand, provide temporary relief to the financially beleaguered utilities, and on the other, commit them to reduce Aggregate Technical and Commercial (AT&C) losses and improve operational performance, including yearly tariff revisions. It has recently extended the date by which discoms can avail of this scheme from 31 December 2012 to 31 March 2013. In addition, new tariff orders have been issued in 2012-13 by state electricity regulatory commissions (SERCs) in most states, following directives by Appellate Tribunal for Electricity (ATE), thereby facilitating long pending tariff revisions. Tariff petitions have been filed by many discoms, and more are likely to follow suit given the linkage of the tariff revisions with the restructuring package.

These well-intended steps notwithstanding, the sector remains caught up in myriad problems, as ever, like yawning supply deficit, access to fuel, delays in land acquisition and environmental clearances, absence of open access in intra-state transmission, continuous AT&C losses, and procurement of technology. While the Planning Commission had envisaged addition of around 72 GW of thermal capacity in the 12th Five Year Plan period (see page 80 for statistics), there are likely to be slippages on account of land and other issues. Besides, arranging fuel for the enhanced capacity would be a Herculean task, considering that the coal deficit could surpass 200 million tonne by 2017. Coal India (CIL), which has witnessed severe constraints in ramping up production, would be unlikely to be able to meet the requirements, given the substantial delays of commencing its own projects. The supply constraints at CIL, coupled with the abrupt benchmarking of Indonesian coal prices with international prices, had come like a double whammy for the coal-based developers. In natural gas, the petering out of KG Basin reserves has meant increasing reliance on LNG for the future. While new gas supplies are coming up [for example, the new LNG terminal at Dabhol (Ratnagiri Gas & Power) is expected to come on stream in 2013-14], they would serve to push gas-based power prices upwards.

Against the backdrop of high and increasing fuel supply risks, the competitive bidding regime has been controversial since it has ushered in a step increase in risks from cost-plus tariff regime, with the fuel pricing risk transferred entirely to the supplier. As a result, it has seen limited penetration, with state-owned discoms reluctant to issue RFPs for power procurement and continuing to award projects on cost-plus basis through bilateral MoUs. On the other hand, those opting for the bidding route are heavily pricing in the fuel risks. While the earliest competitive bids (for Case 1 and Case 2) were significantly aggressive, the recent Case 1 bids (eg, for some states like UP) have tried to price in these risks, resulting in tariff bids at around Rs 5-6/kWh.

From the project finance point of view, the sector does not hold out any new promises in the short term. The restructuring package would come as a reprieve for those discoms, which are able to get the support of their states. But the benefits for banks and lenders would only accrue in the long term, and would depend upon the extent to which the utilities can push through tariff increases and efficiency improvements. In 2012-13, the high interest rates in the economy combined with the relaxation in use of ECBs for the power sector – approval for utilising 40 per cent of the ECBs to refinance rupee debt and the balance for new projects – resulted in some inflow of foreign debt into the sector (see page 80 for some of the major ECBs in power). ECBs are cost-effective means of financing, especially so in times of high interest rates (the overall cost of borrowings – including cost of hedging – could be lower by 200 bps from domestic loans). However, in order to attract foreign capital as a steady source of financing/refinancing, the profitability metrics of the overall sector would need to be improved substantially.

The events in the recent past like Indonesian coal price hikes and CIL fiasco, and the inability of the experienced power sector participants to foresee them call for substantial upgradation in risk analysis and surveillance. There are too many variables to consider in risk models; apart from fuel shortage and price volatility, there are issues of ease of land acquisition and environment clearances; availability of water (many Indian power plants are located in water-scarce areas); availability of technology and quality EPC and balance-of-systems; possibility of contractual slippages on quality, service and maintenance if any in case of overseas suppliers or vendors (most coal-based power plants today are coming up on Chinese technology), ability of state discoms to push through tariff hikes or reduce AT&C losses, and so on.

At the level of government, given the abiding risks in conventional power, both central and various state governments must consider an appropriate energy strategy for the country. It may be argued that the energy sector across the country needs a more rapid and resolute shift towards renewables, especially the non-fuel based sources like solar and wind. Solar energy presents the brightest option for the future, considering the plummeting of panel prices over the last two years, which has brought solar tariffs very close to the marginal cost per unit of conventional (coal-based) power. With coal-based power cost expected to move northwards and solar power continue to fall, at a certain point of convergence, it is expected that the renewable energy certificate (REC) market will be triggered in the near future. As regards wind, with the government returning its generation-based incentives to the sector in this year’s Budget, capacity augmentation is likely to resume in near future. With the prospects brightening in these two sectors, bottlenecks in obtaining non-recourse financing (project-specific) from banks and lenders are expected to clear off steadily, while equity infusion from domestic companies and overseas entities would be more forthcoming.

The other paradigm shift which is likely to happen will be in the realm of decentralised off-grid generation. This again will be facilitated by solar energy, aided by the fact that solar energy can be generated where it is required, thereby cutting on the requirements of transmission infrastructure and the concomitant transmission losses. There are already some indigenous entrepreneurs who have developed rooftop solar systems, which can be purchased in monthly instalments out of savings from not using conventional energy (grid/diesel gensets). The rooftop revolution is expected to start with industrial installations and commercial establishments, and spread to apartment complexes, cooperative housing complexes, etc.

Electricity cooperatives – both distribution and generation and transmission (G&T) – have been in vogue in the West for many decades. These are autonomous entities which are independent of state utilities. In India, distributed solar probably presents the correct vehicle by which these can be ushered in. These are typically financed by a mix of loans, grants, fiscal concessions and private financing, but considering the participative ownership model and less proneness of the model to losses, these could turn out to be much more self-reliant entities than the existing utilities.

Urban infrastructure: garner enough ‘own resources’ to build upon

With India rapidly urbanising, providing adequate urban infrastructure would be one of the key challenges for the future. It is estimated that urban population currently accounting for around 30 per cent of the country’s population (340 million among 1.2 billion) would, by 2050, swell to more than 50 per cent (900 million among 1.7 billion). The driving force has been, and will remain the yawning income disparity between urban and rural India – from similar levels in 1950s, it went up to 4:1 in 1990s and has reached 9:1 in 2009-10, according to findings from a recent National Sample Survey (NSS) Round. The objective would involve continued provision of urban roads and public transportation networks, water and sewerage systems, electricity grids and solid waste management systems. In each of these, there have been severe service backlogs in the past. For example, on an average, only 30 per cent of the sewage is treated in Indian cities, the percentage being <10 per cent for Class II towns (Table 1). Urban roads too, across various classes of cities, demand substantial improvement (Table 2).

The High Powered Expert Committee (HPEC), Ministry of Urban Development (MoUD) has estimated a total investment requirement of Rs 31 lakh crore (at 2009-10 prices) for urban infrastructure for urban infrastructure over the next 20 years. Further adding costs on renewal and redevelopment, capacity building and other heads, the total required investment could be as high as Rs 39 lakh crore (at 2009-10 prices) over 20 years.

The whopping figure instantly raises a question regarding the possible means of financing of these investments. While the country’s urban infrastructure sector has long come out of the era of directed credit from HUDCO and LIC, it has not been able to patch up a viable set of financing alternatives of that magnitude. The Jawaharlal Nehru National Urban Renewal Mission (JNNURM) has set forth a commendable urban reform agenda, which includes providing grants to identified urban projects against reforms to be implemented. However, grants can only fulfil a portion of the overall funds, being leveraged upon to raise further debt capital from markets/lenders. On the other hand, to meet the funding requirements, Urban Local Bodies (ULBs) would need to access capital markets or municipal bond markets, which, unfortunately, only the financially stronger municipal corporations (MCs) are capable to do. In the past, relatively better-managed MCs in India have been able to raise money by issuing municipal bonds entirely by themselves (ie, escrowing portions of their own revenues); on the other hand, others have had to be supported by state government grants. Besides municipal bonds, there has been a concept of ‘pooled financing’ to help small and medium local bodies, as in Karnataka and Tamil Nadu, to access the capital markets. Based on the success of these two issues, the Government introduced a scheme for a Pooled Finance Development Fund that would support small and medium-sized local bodies to access capital markets, which however did not take off.

While there have been funds raised in the past by ULBs through these options [till 2009, Rs 1,224 crore had been raised through municipal bonds (taxable and tax free) and pooled finance], the quantum has to be multiplied many times to meet the required numbers for future investments. Since leverages could not be raised, the only way it can be done is the individual ULBs shoring up their finances substantially. The municipalities have been rather indifferent to increasing their ‘own revenues’; according to the 13th Central Finance Commission, proportion of own revenues of total revenues has slipped from 64 per cent in 2002-03 to around 54 per cent in 2007-08. The ULBs have not been able to ramp up collection of property tax, one of their major revenue sources. Property tax revenues in most states constitute 0.16 to 0.24 per cent of their GDP, while many developing countries collect 0.6 per cent. In case of the US and Canada, they can reach 3 to 4 per cent of their GDP. For a city like Delhi (with a GDP of Rs 3.14 lakh crore), benchmarking to global property tax/GDP rates could release at least Rs 1,500-2,000 crore every year. This can be brought about by improving assessment rate, collection efficiency, and updating property valuation methods. Other possible areas of increasing revenue can be vehicle tax, which is loaded in favour of personal cars, and against public transport vehicles (Table 3). This can also serve as a proxy for congestion tax, which is more difficult to be administered.

To add to this, devolution from state governments also have been inadequate and unscheduled. In other countries like Brazil and South Africa, devolutions are pre-guaranteed by the law. Of course, the 13th Central Finance Commission has recommended a two-part devolution including a basic unconditional grant and a performance-linked conditional grant, for systematising fund transfers from the state. Another means of shoring up municipal finances would be by unlocking land value through conversion charges (rural to urban; leasehold to freehold) and betterment/development charges.

Municipal bonds are typically structured finance instruments, typically with the ULB’s own revenue streams like property tax and utility bill collections escrowed. As prevalent in the US and other countries, these could be further credit-enhanced with insurance companies’ guarantees, which could prop them to AAA levels. Of course, incremental benefits on interest cost would have to be weighed against guarantee fees. Nonetheless, for now, own resources and state devolution hold the key, as debt can be raised primarily by leveraging upon them. Hence, slippages in collection of property tax, user charges and other revenues, and financial conditions of states and uncertainties in devolution of state and funds are the major risks that need to be measured, besides long-term demographics, migration, attitudes and pressure on infrastructure.

Need a fresh look at project risks

As seen in these sections, the scripts for all infrastructure sectors have a common watermark of risk analysis running under them. Effective financial facilitation of infrastructure projects in India demands a whole new look at project risks, and devising novel and effective methods of mapping, measuring and monitoring risks through the stages of a project. For one, it calls for registering and measurement of risks as they impinge upon the project through its various phases. Unlike a corporate, a project goes through several discontinuous stages from conceptualising, arranging equity and debt financing, putting up the assets, commissioning, and operating and maintaining the project till the end of its allotted life (say, concession period), with risks varying over time. For a typical project, therefore, its overall riskiness increases through the construction period, and thereafter declines as operations are streamlined.

Moreover, the risks involved in various project stages are different, both in terms of their incidence and weightage, and how they are shared among various stakeholders. As the project progresses, it goes through certain checkpoints where some risks are offloaded, entirely or substantially, and others picked up. These points of discontinuity are award of the contract, financial closure, commercial operations date (COD), maintenance milestones, and the like. On the other hand, risks not addressed in a previous stage would impact progress in a subsequent stage. Thus, every stage requires its own risk register, which includes unabated risks from previous stages and new risks that appear in that stage.

The other issue is the level of sophistication of the financial projection models used for evaluating projects, by all concerned including developers, investment bankers, lenders and rating agencies. With the increased complexity in the project environment, the number of variables and events that could potentially affect a project has grown significantly. Taking a cue from the worldwide shift in bank credit paradigm towards recognition and measurement of unexpected losses, infrastructure sector too has to put in place systems for duly reckoning and measuring the risk of events which may be less probable but have catastrophic implications, with greater use of probabilistic risk models based on simulation, rather than deterministic ones that accommodate at best quantised sensitivities on a few major parameters. Modern projects are facing such risks almost on a regular basis; these include inter alia counterparty risks, abrupt regulatory changes and, of course, force majeure. Besides, existing models are incapable of accommodating project delays (say, in getting land clearances, project approvals, financial closure and equipment supplies), which impact project returns and cash flows through cost escalations, liquidated damages, etc.

One would need simulation models working upon the basic project activity schedules, incorporating the distribution in duration in each activity for an overall risk distribution. Running the models for an n (say n = 10,000) number of iterations would yield an overall distribution in all parameters – investment returns for the developer; coverage ratios and losses for the lender and equity returns and valuations for the equity investor. Employing probabilistic risk models could thus provide an objective basis of evaluating and tracking risks as they wax and wane through the project stages. Infrastructure projects are all about taking calculated risks, but before taking the risks, one needs to calculate them well.

Leave a Reply