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November 2007<br />
<strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
<strong>European</strong> <strong><strong>In</strong>frastructure</strong><br />
<strong>Finance</strong> <strong>Yearbook</strong> 2007/08
20 Canada Square<br />
Canary Wharf<br />
London E14 5LH<br />
www.standardandpoors.com
CONTENTS<br />
<strong>In</strong>troduction<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
CONTENTS<br />
2007: New Challenges And Threats, But Sector Remains Robust 3<br />
Michael Wilkins<br />
<strong><strong>In</strong>frastructure</strong> Commentaries<br />
How <strong><strong>In</strong>frastructure</strong> Assets Have Weathered A Decade Of Storms 4<br />
Lidia Polakovic, Michael Wilkins, Jonathan Manley, and Peter Kernan<br />
The Changing Face Of <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong>: Beware The Acquisition Hybrid 8<br />
Michael Wilkins and Taron Wade<br />
<strong>European</strong> Utilities 12<br />
Credit FAQ: Assessing The Credit Implications Of EC Legislative Proposals For 13<br />
The <strong>In</strong>ternal Energy Market<br />
Peter Kernan and Beatrice de Taisne<br />
Nuclear Power <strong>In</strong> The EU: The Sleeping Giant Is Only Gradually Waking Up 17<br />
Hugues de la Presle and Peter Kernan<br />
Volts And Jolts: What To Expect As Russia Restructures Its Power Markets 22<br />
Eugene Korovin and Peter Kernan<br />
Combating Climate Change <strong>In</strong>The EU: Risks And Rewards For <strong>European</strong> Utilities 33<br />
Peter Kernan, Michael Wilkins, Mark Schindele, and Hugues de la Presle<br />
Summary analyses<br />
Electricite de France S.A. 40<br />
Endesa S.A. 41<br />
Enel SpA 42<br />
E.ON AG 43<br />
Gaz de France S.A. 44<br />
Iberdrola S.A. 45<br />
RWE AG 46<br />
Scottish and Southern Energy PLC 47<br />
Suez S.A. 48<br />
Vattenfall AB 49<br />
Transportation <strong><strong>In</strong>frastructure</strong> 51<br />
Skies Remain Clear For <strong>European</strong> Airports, Governance <strong>In</strong>creasingly Important<br />
Alexandre de Lestrange and Lidia Polakovic<br />
52<br />
BAA Ltd. 56<br />
Alexandre de Lestrange and Michael Wilkins<br />
Channel Link Enterprises <strong>Finance</strong> PLC 67<br />
Alexandre de Lestrange, Michela Bariletti, and Michael Wilkins<br />
NOVEMBER 2007 ■ 1
CONTENTS<br />
2 ■ NOVEMBER 2007<br />
CONTENTS CONTD.<br />
Summary analyses<br />
Copenhagen Airports A/S 85<br />
Deutsche Bahn AG 86<br />
DP World Ltd. 87<br />
Sanef 89<br />
VINCI S.A. 90<br />
Project <strong>Finance</strong> and Public-Private Partnerships 92<br />
Updated Project <strong>Finance</strong> Summary Debt Rating Criteria<br />
Terry A Pratt, Ian Greer, Arthur F Simonson, and Lidia Polakovic<br />
93<br />
Credit FAQ: Accreting Debt Obligations And The Road To<strong>In</strong>vestment Grade 105<br />
For <strong><strong>In</strong>frastructure</strong> Concessions<br />
Paul B Calder, Kurt Forsgren, Ian Greer, and Lidia Polakovic<br />
Credit FAQ: The Evolving Landscape For Subordinated Debt <strong>In</strong>Project <strong>Finance</strong> 116<br />
Andrew Palmer, Kurt Forsgren, Terry A Pratt, Paul B Calder, Lidia Polakovic,<br />
and Santiago Carniado<br />
Credit FAQ: Recently Upgraded Nakilat Provides Case Study For Credit 122<br />
Analysis Of LNG Shipping Projects<br />
Karim Nassif, Terry A Pratt, and Michael Wilkins<br />
Standard & Poor’s Methodology For Setting The Capital Charge OnProject 126<br />
<strong>Finance</strong> Transactions<br />
Lidia Polakovic, Parvathy Iyer, Arthur F Simonson, Dick P Smith, and David Veno<br />
Sweden Moves Closer To PPP Model As Alternative Financing For 129<br />
<strong><strong>In</strong>frastructure</strong> Assets<br />
Lidia Polakovic, Karin Erlander, and Michael Wilkins<br />
Summary analyses<br />
Abu Dhabi National Energy Company PJSC 132<br />
Autoroutes Paris-Rhin-Rhone 133<br />
Metronet Rail BCV <strong>Finance</strong> PLC/Metronet Rail SSL <strong>Finance</strong> PLC 136<br />
Peterborough (Progress Health) PLC 138<br />
Transform Schools (North Lanarkshire) Funding PLC 142<br />
Ratings List 144<br />
Key Analytical Contacts 149<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
INTRODUCTION<br />
2007: New Challenges And Threats, But Sector<br />
Remains Robust<br />
The year 2007 marks Standard & Poor’s <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings group’s 10th anniversary.<br />
I am therefore delighted to introduce this year’s <strong>European</strong> <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> <strong>Yearbook</strong>, in<br />
which we discuss the continuing evolution of the asset class and highlight the year’s key<br />
transactions, sectors, and trends. <strong>In</strong> addition we set out the latest developments in our ratings criteria<br />
and methodology. We have also taken the opportunity to look back over the decade and examine the<br />
phenomenal growth the asset class has experienced as well as the challenges it has faced.<br />
<strong>In</strong> accordance with the past few years, throughout 2007 infrastructure has remained a highly sought<br />
after asset class in the financial markets, continuing to attract new investors with its reputation for low<br />
volatility and high stability. Yet, with this sustained growth in appetite has come a simultaneous push<br />
on the boundaries of infrastructure finance--with investors eager to pay higher acquisition multiples and<br />
employ novel financing techniques to purchase infrastructure assets. Consequently, the level of credit<br />
risk across the sector has escalated, as debt multiples have continued to creep upward.<br />
<strong>In</strong> particular, Standard & Poor’s has witnessed an increasing number of infrastructure assets being<br />
purchased using a new form of acquisition financing in the debt markets. When acquiring both<br />
traditional assets, such as water and toll roads, and nontraditional assets, for example motorway service<br />
stations, participants are increasingly combining project finance structuring techniques with covenants<br />
prevalent in corporate-style leveraged finance facilities. Standard & Poor’s believes such structuring<br />
techniques can involve significantly more credit risk than is usual among previous infrastructure finance<br />
transactions, as favorable debt terms are often coming at the expense of necessary protections.<br />
Consequently, we have warned market participants that, as credit markets become increasingly tight-as<br />
has been the case in the second half of 2007--some of these more loosely structured and highly<br />
leveraged acquisition loans may find it hard to attract lender and investor interest. Nevertheless, we<br />
have also been keen to highlight that for well-structured infrastructure finance transactions funding<br />
traditional infrastructure assets--such as the Thames Water refinancing transaction--investor appetite<br />
looks set to remain, due to the assets’ strong credit quality. For this reason, such transactions are likely<br />
to show significant resilience in the face of the current market volatility.<br />
<strong>In</strong>deed, such stability has been the case for infrastructure assets throughout the past decade, despite<br />
substantial market shocks. Notably, Standard & Poor’s has analyzed the project, utility, and<br />
transportation sectors through numerous difficult environments--such as the Asian crisis that threatened<br />
many credits across the region in 1997, as well as the California power crisis, Enron Corp. bankruptcy,<br />
Brazilian energy crisis, and events of Sept. 11, 2001, all of which placed ratings under downward<br />
pressure in later years. Despite such pressures, on the whole, project and infrastructure credits have<br />
remained robust in the longer term, and the credit trends of the past decade illustrate the strength of the<br />
infrastructure sector.<br />
Unsurprising, therefore, that the market has continued to expand--with the booming global economy<br />
driving demand for supporting infrastructure. Consequently, the demand for Standard & Poor’s ratings<br />
has similarly grown in the sector, with the number of global project finance ratings alone reaching 304<br />
in total at the beginning of this year, a dramatic increase from the 93 we rated in 1997.<br />
The articles within this year’s <strong>European</strong> <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> <strong>Yearbook</strong> reflect this continued<br />
development of the infrastructure market. We discuss the growth in project, utility, and transportation<br />
finance transactions in new jurisdictions--such as Russia and Eastern Europe--as well as our approach to<br />
rating increasingly complex structuring techniques. Importantly, Standard & Poor’s continues to closely<br />
follow the trends across the infrastructure sector, extending and revising our criteria to enable the<br />
appropriate assessment of risk originating from the new markets, new structures, and new avenues of<br />
infrastructure ownership.<br />
I therefore hope you find this 2007 <strong>European</strong> <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> <strong>Yearbook</strong> of considerable use<br />
and we look forward to receiving any feedback or questions you may have on this publication.<br />
Michael Wilkins<br />
Managing Director and Head of <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
INTRODUCTION<br />
NOVEMBER 2007 ■ 3
COMMENTARY<br />
Publication Date:<br />
Oct. 31, 2007<br />
Primary Credit Analysts:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
Secondary Credit Analysts:<br />
Arthur F Simonson,<br />
New York,<br />
(1) 212-438-2094<br />
Ian Greer,<br />
Melbourne,<br />
(61) 3-9631-2032<br />
Peter Rigby,<br />
New York,<br />
(1) 212-438-2085<br />
Other Secondary Credit<br />
Analysts:<br />
Jonathan Manley,<br />
London,<br />
(44) 20-7176-3952<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
Paul B Calder, CFA,<br />
Toronto,<br />
(1) 416-507-2523<br />
HOW INFRASTRUCTURE ASSETS HAVE WEATHERED A<br />
DECADE OF STORMS<br />
Over the past decade, Standard & Poor’s<br />
Ratings Services has witnessed<br />
phenomenal growth in demand for<br />
infrastructure assets. A highly sought after asset<br />
class in the financial markets, infrastructure<br />
benefits from its reputation for stability and<br />
flexibility to respond to changing investor needs.<br />
The sector is evolving, with assets becoming more<br />
varied and the financial structures that support<br />
their financings increasingly sophisticated, making<br />
risk analysis more complex than ever.<br />
This year marks Standard & Poor’s<br />
<strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings group’s 10th<br />
anniversary. It therefore seems appropriate to<br />
review the highs and lows of the past decade, and<br />
to consider how infrastructure has matured as an<br />
asset class.<br />
<strong>In</strong> 1997, infrastructure finance faced a difficult<br />
environment. The Asian crisis was unfolding,<br />
threatening many project and infrastructure<br />
credits rated by Standard & Poor’s across the<br />
region. <strong>In</strong> many cases the crisis derailed projects<br />
at all stages of the pipeline--from many in<br />
development infancy to a handful ready to close<br />
on their financings. Market shocks have followed.<br />
Notably, the California power crisis, Enron Corp.<br />
bankruptcy, Brazilian energy crisis, and events of<br />
Sept. 11, 2001, caused widespread disruption in<br />
the project, utility, and transportation sectors.<br />
Through it all, though, infrastructure assets<br />
have shown resilience, and the market continues<br />
to grow. This should surprise few. As the global<br />
economy has boomed, the need for supporting<br />
infrastructure has exploded, which has also<br />
resulted in a significant rise in the number of<br />
Standard & Poor’s ratings in the sector. Project<br />
Chart 1<br />
Breakdown Of Projects By Sector,<br />
December 1997<br />
4 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
finance ratings alone rose to 304 at the beginning<br />
of 2007, from 93 in 1997. Project finance<br />
transactions have also spread globally to markets<br />
such as Latin America, the Middle East, and-more<br />
recently--Eastern Europe. New forms of<br />
project finance have gained popularity, with the<br />
U.K. public-private partnership (PPP) market<br />
growing in importance over the decade. This<br />
market continues to expand, with several<br />
countries developing their own PPP models-including<br />
Canada, Australia, and most recently<br />
the U.S.--as a means of delivering public sector<br />
services using private sector expertise. <strong>In</strong>creasingly<br />
more diverse assets are being presented to us as<br />
infrastructure (see charts 1 and 2 below), and<br />
infrastructure finance now includes wind and<br />
solar power projects, as well as more unusual<br />
asset types such as stadiums and car parks.<br />
The <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings team has<br />
followed the cycles of infrastructure finance of the<br />
past decade and studied their causes and effects.<br />
Here are some of the decisive moments in the<br />
development of the infrastructure asset class.<br />
Power Projects Hit By Falling<br />
Commodity Prices<br />
After the Asian financial crisis in 1997-1998, the<br />
majority of infrastructure assets enjoyed rating<br />
stability. This all changed in 2002, when rated<br />
project credit quality precipitously fell. Collapsing<br />
commodity prices drove many of the negative<br />
credit trends. Most of the project finance<br />
downgrades occurred in the U.S. power sector,<br />
affecting projects exposed to contracts with<br />
weakening power offtakers in particular. Notably,<br />
a number of rated AES Corp. projects that sold<br />
Chart 2<br />
Breakdown Of Projects By Sector,<br />
May 2007
ject <strong>Finance</strong> Rating Distribution: <strong>In</strong>vestment Grade Versus Speculative Gr<br />
100%<br />
90%<br />
80%<br />
70%<br />
60%<br />
50%<br />
40%<br />
30%<br />
20%<br />
10%<br />
0%<br />
<strong>In</strong>vestment grade Speculative grade<br />
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007<br />
© Standard & Poor's 2007.
The ever present demand for infrastructure<br />
assets across the globe ensures that the drivers of<br />
infrastructure are set to remain. As the sector<br />
matures, so too will the <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong><br />
team’s credit risk analysis methodology and<br />
analytical approach.<br />
Note<br />
Additional research by Deepti Hemnani, Archana<br />
Sharma, Ganesh Iyer, and Kaustubh Shrotriya,<br />
and by Caroline Hyde of Moorgate Group. ■<br />
COMMENTARY<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK NOVEMBER 2007 ■ 7
COMMENTARY<br />
Publication Date:<br />
Sept. 7, 2007<br />
Primary Credit Analyst:<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
Leveraged <strong>Finance</strong><br />
& Recovery:<br />
Taron Wade,<br />
London,<br />
(44) 20-7176-3661<br />
THE CHANGING FACE OF INFRASTRUCTURE FINANCE:<br />
BEWARE THE ACQUISITION HYBRID<br />
Bank lenders and institutional investors have<br />
traded favorable debt terms against the<br />
management of credit risk during the<br />
infrastructure finance boom of the past 18<br />
months. Now, with the cycle turning in the global<br />
credit markets, loosely structured and highly<br />
leveraged acquisition loans are looking far less<br />
attractive. As a result, it is estimated that up to<br />
$34 billion of leveraged infrastructure loans may<br />
be left paralyzed under current market conditions.<br />
Cheap debt with relatively generous terms has<br />
been the order of the day among infrastructure<br />
sponsors. To meet market demand, banks have<br />
combined project finance structuring techniques<br />
with covenants prevalent in leveraged<br />
finance facilities--allowing sponsors to acquire<br />
infrastructure assets at record-breaking<br />
debt multiples.<br />
Despite the advantages for borrowers, Standard<br />
& Poor’s Ratings Services believes that this new<br />
form of acquisition hybrid poses a significant<br />
credit risk to the infrastructure sector. Many<br />
assets recently purchased for eye-watering<br />
acquisition multiples have failed to boast the<br />
operating and cash flow strengths assumed typical<br />
of infrastructure assets. Such risks are likely to be<br />
exacerbated as credit markets become increasingly<br />
volatile and investor confidence fragile.<br />
With $332 billion in leveraged loans currently<br />
sitting on banks’ balance sheets globally, bankers<br />
are unlikely to be keen to lend to infrastructure<br />
assets in the current climate without comfort that<br />
credit risks are well mitigated. <strong>In</strong>vestors and<br />
lenders alike therefore need to examine the risks<br />
associated with each individual transaction, and if<br />
necessary seek more credit protection than is<br />
currently being provided within the hybrid<br />
structure to ensure that the level of debt can be<br />
supported by the underlying asset. This is<br />
particularly pertinent as new assets are brought<br />
under the infrastructure umbrella--with car parks,<br />
motorway service stations, and motor vehicle<br />
certificates now claiming to be strong<br />
infrastructure assets.<br />
Breaking New Boundaries: Hunger For<br />
<strong><strong>In</strong>frastructure</strong> Drives Development<br />
Over the past few years the boundaries of<br />
infrastructure finance have been increasingly<br />
pushed, with investors hungry for new types of<br />
assets and financing techniques. Consequently, the<br />
lines between project finance and leveraged<br />
finance have become evermore blurred, with<br />
8 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
investors marrying together structuring techniques<br />
from both financing classes to acquire<br />
infrastructure assets. Crucially, the high debt<br />
multiples usually associated with project finance<br />
transactions have been adopted in conjunction<br />
with the relatively flexible controls, hurried due<br />
diligence, and weak security packages more<br />
common in LBOs. As a result, increased debt<br />
multiples are often coming at the expense of<br />
necessary risk mitigants.<br />
Since 2006 a phenomenal appetite for<br />
infrastructure assets has spread worldwide. This,<br />
in turn, has fuelled a surge in the number of<br />
acquisitions within the sector, making it a<br />
significant area of growth for the syndicated loan<br />
market. Landmark deals include the purchase of<br />
U.K.-based airport operator BAA Ltd.<br />
(BBB+/Watch Neg/NR) by a consortium led by<br />
Grupo Ferrovial S.A. in February 2006 for $30.2<br />
billion, the acquisition of the <strong>In</strong>diana Toll Road<br />
for $3.8 billion by Macquarie <strong><strong>In</strong>frastructure</strong><br />
Group and Cintra Concesiones de <strong>In</strong>fraestructuras<br />
de Transporte, and Goldman Sachs’ Admiral<br />
Acquisitions consortium’s £2.8 billion acquisition<br />
of Associated British Ports (ABP).<br />
Fusion Of Project <strong>Finance</strong> And<br />
Leveraged <strong>Finance</strong><br />
As for the financing of “greenfield” infrastructure<br />
assets, investors have turned toward project<br />
finance to raise funds when acquiring mature<br />
infrastructure assets--securing high leverage<br />
multiples due to the stable cash flows and<br />
monopolistic environment. They have then<br />
incorporated leveraged finance structuring<br />
techniques instead of carrying out an LBO of the<br />
asset as would traditionally have been the case for<br />
the acquisition of mature infrastructure assets<br />
(see table on next page for the various structuring<br />
techniques typically associated with leveraged<br />
finance transactions and project finance<br />
transactions, respectively).<br />
Of key concern for Standard & Poor’s is that,<br />
in combining techniques, investors have been<br />
trading favorable debt terms against the<br />
management of risk. Often we are seeing new<br />
infrastructure acquisition financing structures<br />
employing structural features, such as short<br />
shareholder lock-in periods, that are weaker than<br />
those of traditional transactions, coupled with a<br />
very aggressive financial structure. ABP, for<br />
example, was purchased for £2.8 billion with an<br />
enterprise value (EV)-to-EBITDA ratio of 16.6x.
Leveraged <strong>Finance</strong> And Project <strong>Finance</strong> Structuring Techniques<br />
Leveraged finance Project finance<br />
Despite the asset’s strong monopolistic position<br />
and stable cash flows, these terms are unlikely to<br />
fully mitigate risk arising from the high level of<br />
debt. Nor are they likely to mitigate market risks<br />
such as the increasing environmental and<br />
regulatory hurdles limiting ABP’s ability to<br />
expand capacity in the future.<br />
<strong><strong>In</strong>frastructure</strong>--An Ever Expanding<br />
Asset Class?<br />
For the past 18 months, sponsors have also been<br />
using the hybrid structure to acquire assets not<br />
traditionally considered as infrastructure. These<br />
assets do not benefit from the significant track<br />
record of other sectors such as ports and airports<br />
and therefore may not be suitable to support high<br />
debt multiples, lacking the necessary long-term<br />
stable cash flows or a strong monopoly position<br />
in the market.<br />
The recent refinancing of Autobahn Tank &<br />
Rast Holding GmbH, a German motorway<br />
service area operator, is a clear example of the<br />
market opening up to new assets and financing<br />
acquisitions that would not previously have been<br />
recognized as infrastructure-style deals. <strong>In</strong>deed,<br />
the initial acquisition of Tank & Rast by privateequity<br />
investor Terra Firma for €1.1 billion in<br />
November 2004 involved traditional leveraged<br />
finance techniques. The acquisition was financed<br />
using an all-senior debt facility, with a debt<br />
multiple of 6x debt to EBITDA.<br />
As little as two years later, in June 2006, Terra<br />
Firma was able to refinance the debt, obtaining<br />
greater leverage at a cheaper price. The<br />
refinancing transaction involved a €1.2 billion<br />
seven-year senior loan with a cash sweep, and<br />
COMMENTARY<br />
Corporate entity in competitive environment Asset with stable cash flows over the long-term, monopolistic<br />
environment<br />
Debt capacity dictated by market-driven multiples Debt capacity dictated by discounted cash flows<br />
Medium-term maturity, lower leverage, bullet repayment Long-term maturity, higher leverage, amortizing repayment, lower<br />
margins<br />
Standardized due diligence Detailed due diligence<br />
Key ratio: debt to EBITDA Key ratio: loan to project life coverage<br />
Flexible financial undertakings Fixed financing structure, monitored/ updated<br />
Capital expenditure lines accounted for, but not Future expenditure (i.e., restoration of assets) accounted for<br />
mandatory future capital expenditure<br />
Standardized security interest charges Ring-fencing security and "cash waterfall" controls<br />
leverage was about 8x. Significantly thinner<br />
margins were attained via the refinancing--with<br />
pricing falling to a range of 125 basis points (bps)<br />
to 150 bps in 2006, from a range of 212.5 bps to<br />
262.5 bps in 2004. Importantly, the arrangers of<br />
the refinancing--Royal Bank of Scotland, Barclays<br />
Capital, Société Générale, and West LB--marketed<br />
the transaction as infrastructure play, highlighting<br />
the asset’s 90% market share and stable,<br />
predictable cash flows.<br />
<strong>In</strong>vestors and lenders need to be aware of the<br />
credit risk of applying significant leverage to a<br />
new asset type. The experience of U.K. motorway<br />
service operator Welcome Break Group<br />
demonstrates the pitfalls of assuming that this<br />
asset class can support significant levels of debt.<br />
Standard & Poor’s believes that applying<br />
infrastructure-style financing techniques to less<br />
mature asset types could serve to undermine the<br />
sector’s reputation for strong, long-term revenue<br />
flows if appropriate risk mitigants are<br />
not employed.<br />
The Origins Of The Acquisition Hybrid<br />
Hybrid acquisition financing structures are fairly<br />
new to the infrastructure sector, with the South<br />
East Water deal in 2003 heralding the first<br />
transaction of this kind on a large scale. It was<br />
the subsequent flurry of French toll road deals in<br />
2005 and 2006 that brought infrastructure<br />
acquisition transactions into the mainstream--with<br />
Eiffarie’s purchase of Autoroutes Paris-Rhin-<br />
Rhone (APRR) providing a template for<br />
future transactions.<br />
Techniques from both leveraged finance and<br />
project finance were evident in the APRR<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK NOVEMBER 2007 ■ 9
(Bil. )<br />
140<br />
120<br />
100<br />
80<br />
60<br />
40<br />
20<br />
0<br />
First quarter Second quarter Third quarter<br />
Fourth quarter Transaction count*<br />
1999 2000 2001 2002 2003 2004 2005 2006 2007<br />
*Transaction count takes first- and second-lien portions of a single transaction as<br />
one event and excludes any amendments. For the first half of 2007, the transaction<br />
count was 214.<br />
© Standard & Poor's 2007.<br />
(No. of<br />
transactions)<br />
320<br />
280<br />
240<br />
200<br />
160<br />
120<br />
80<br />
40<br />
0
Contractual terms have also been weakening<br />
elsewhere in the loan markets, with the<br />
introduction of “covenant-lite” LBOs further<br />
reducing lenders’ control over borrowers’<br />
performance. Furthermore, Standard &Poor’s has<br />
recorded that the level of senior debt amortizing<br />
within <strong>European</strong> LBOs has dropped steeply, to<br />
15% at the beginning of 2007 from 50% in 2001.<br />
With risk mitigants deteriorating in this fashion<br />
across the loan market in general, Standard &<br />
Poor’s does not believe that the infrastructure<br />
asset class can withstand a continued<br />
deterioration in underwriting quality. Hybrid<br />
acquisitions must therefore be restricted to<br />
infrastructure assets operating within<br />
monopolistic environments with stable cash flows<br />
over the long term. Moreover, high leverage<br />
should be accompanied bythe necessary<br />
structural package and creditor protections.<br />
Notes<br />
Additional data provided byThomson Financial.<br />
Additional research by Caroline Hyde of<br />
Moorgate Group. ■<br />
COMMENTARY<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK NOVEMBER 2007 ■ 11
UTILITIES<br />
EUROPEAN UTILITIES<br />
Once again, while the <strong>European</strong> utility sector continues to exhibit generally strong credit<br />
characteristics, credit quality has come under pressure--with increased debt-financed M&A<br />
activity and heightened levels of regulatory risk the principal drivers of this pressure. Favorable<br />
operating conditions have, however, continued for many utilities--particularly among generators and<br />
vertically integrated power companies in the deregulated markets, where high power prices and strong<br />
free operating cash flows have remained a source of credit strength.<br />
M&A activity has continued at a high level since 2006, and has resulted inseveral downgrades--at<br />
E.ON, EDP, Enel, and Iberdrola for example--and a number of CreditWatch listings across the sector.<br />
Crucially, these negative rating actions have been catalyzed byaweakening of companies’ financial<br />
profiles following debt-financed acquisitions, as exemplified by Enel’s downgrade to‘A’ from ‘A+’, with<br />
all ratings remaining on CreditWatch with negative implications, following its acquisition of Endesa. We<br />
believe that the consolidation trend will continue and is likely tokeep ratings under pressure. Of the top<br />
20 <strong>European</strong> utilities, five companies are on CreditWatch negative as a result ofM&A activity (Enel,<br />
Iberdrola, Endesa, Scottish Power, and Gaz de France) and a further four companies have negative<br />
outlooks.<br />
Meanwhile, the <strong>European</strong> Commission’s ongoing scrutiny of <strong>European</strong> utilities, together with the<br />
recently announced legislative proposals to further liberalize the internal energy markets, has highlighted<br />
the regulatory and political risk many companies remain exposed to. <strong>In</strong> particular,ofthe measures<br />
proposed, any forced ownership unbundling of transmission grids would have the greatest impact on<br />
credit quality, affecting vertically integrated utilities in Germany (such as E.ON and RWE), France,<br />
(EDF and GDF), and Greece (Public Power Corp.). At this stage, we do not factor in any assumption<br />
that those companies that currently own and operate transmission networks will be forced to sell their<br />
networks. We believe there continues to be significant uncertainty about both the final form of any<br />
legislative package and whether ownership unbundling will be required, asthere is no unanimity<br />
between the ECand the member states about whether unbundling is necessary.<br />
The future direction of climate change policies adds a further layer of uncertainty and risk to the<br />
utility sector. Phase 2 of the EU’s Emission Trading Scheme comes into force from Jan. 1, 2008. Given<br />
the high level of uncertainty over future climate policy initiatives and long-term carbon pricing, this<br />
issue will remain asignificant challenge for generators, especially when taking long-term investment<br />
decisions. Nevertheless, it is clear that the outlook for both renewable and nuclear energy investment<br />
has improved and will continue to do sodue to the heightened global focus on environmental issues,<br />
while that of coal--the most CO2-intensive fuel--has weakened. The need for technological<br />
developments to reduce the CO2 intensity of coal will be key to the future of coal-fired generation.<br />
Accordingly, the articles included here provide animportant insight into the current environment<br />
<strong>European</strong> utilities face, as well as detailed analyses of the resulting credit issues.<br />
Based in London, Paris, Frankfurt, Madrid, Milan, Moscow, and Stockholm, our regional utilities<br />
infrastructure analysts welcome your feedback; their contact details are listed at the end of this book.<br />
Please do not hesitate to contact me, or any of the analysts, if you require further information.<br />
Peter KKernan<br />
Managing Director and Team Leader<br />
<strong>European</strong> Utilities Team<br />
12 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
Sept. 21, 2007<br />
Primary Credit Analysts:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
Beatrice de Taisne,<br />
London,<br />
(44) 20-7176-3938<br />
CREDIT FAQ: ASSESSING THE CREDIT IMPLICATIONS<br />
OF EC LEGISLATIVE PROPOSALS FOR THE INTERNAL<br />
ENERGY MARKET<br />
On Sept. 19, 2007, the <strong>European</strong><br />
Commission (EC) published a package of<br />
legislative proposals for the internal<br />
energy market. One of the EC’s principal goals is<br />
to correct what it sees as structural failings in<br />
some EU electricity and gas markets. According to<br />
the EC, “the current rules on the separation of<br />
network activities from supply and production of<br />
energy do not ensure proper market functioning.”<br />
The EC recommends that this be remedied either<br />
through ownership unbundling, so that a single<br />
company could no longer own transmission and<br />
generation or supply activities, or by<br />
implementing an independent system operator<br />
(ISO) model that would make it possible for<br />
existing vertically integrated companies to retain<br />
network ownership, provided that the assets are<br />
operated completely independently from the<br />
generation and supply operations.<br />
To highlight the potential implications of the<br />
EC’s findings for the credit quality of <strong>European</strong><br />
utilities, Standard & Poor’s Ratings Services<br />
addresses below some of the most frequent<br />
questions we have been receiving.<br />
Frequently Asked Questions<br />
What are the key potential credit stress points in<br />
the draft legislative package?<br />
The measure that could have the most marked<br />
effect on credit ratings would be the unbundling<br />
of network assets by vertically integrated utilities.<br />
The EC’s current proposals include unbundling as<br />
the default option, with the possibility for<br />
member states to apply for a derogation and use<br />
the ISO model.<br />
What is the next stage in the process?<br />
The EC’s proposal now has to go through the<br />
normal codecision process with the <strong>European</strong><br />
Parliament and <strong>European</strong> Council, whereby both<br />
institutions can amend the current text in the<br />
course of two readings. A third reading allows for<br />
formal negotiations between the two institutions<br />
if they cannot agree. Standard & Poor’s<br />
understands that there are some strongly<br />
divergent views within and between the member<br />
states on the proposals, and specifically on the<br />
subject of ownership unbundling. As such, we<br />
believe that some member states and EU<br />
parliamentarians could work to alter or remove<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
some of the proposals--specifically to take out one<br />
or both of the proposals for the ownership and<br />
operation of transmission networks.<br />
Which member states would be most affected?<br />
A number of member states, including the U.K.,<br />
Sweden, Portugal, Italy, and Spain, have already<br />
implemented ownership unbundling of<br />
transmission networks. For these countries, a<br />
legal requirement to unbundle would have no<br />
impact on domestic energy markets. Some<br />
member states, however, such as France,<br />
Germany, and Greece do not currently require<br />
ownership unbundling of transmission networks.<br />
The domestic energy markets of these countries<br />
could therefore be significantly affected by any<br />
obligation to implement ownership unbundling.<br />
When would the member states have to<br />
implement the legislative package?<br />
The earliest member states would have to<br />
implement the unbundling and/or ISO<br />
requirements is likely to be around 2012 on the<br />
basis of a normal legislative procedure and<br />
assuming that the current text is the one that is<br />
finally adopted. The text could change during the<br />
course of the legislative debate, however, and<br />
implementation could be delayed beyond 2012, as<br />
it is the member states who determine the timing<br />
of their domestic legislative programs.<br />
What assumption do the ratings on affected<br />
companies make about the likely outcome of the<br />
legislative process?<br />
At this stage, we do not factor in any assumption<br />
that those companies that currently own and<br />
operate transmission networks will be forced to<br />
sell their networks or will pre-empt a potential<br />
legislative requirement by unilaterally deciding to<br />
sell their networks. We believe that there<br />
continues to be significant uncertainty about both<br />
the final form of any legislative package and<br />
whether ownership unbundling will be required,<br />
as there is no unanimity between the EC and the<br />
member states about whether unbundling is<br />
necessary. For example, there is significant<br />
opposition to forced ownership unbundling in<br />
France and Germany, two of the largest and most<br />
influential member states, which, if sustained,<br />
increases the likelihood that an alternative<br />
NOVEMBER 2007 ■ 13
UTILITIES<br />
approach to ownership unbundling--such as the<br />
ISO model or some other proposal--will be<br />
included in the final legislation. <strong>In</strong> addition, even<br />
if ownership unbundling were required it is<br />
possible that the affected companies could<br />
mitigate the impact on credit ratings by using any<br />
received proceeds to reduce debt.<br />
Why does the vertically integrated model support<br />
credit quality and credit ratings?<br />
From a rating perspective, the <strong>European</strong> utility<br />
sector has favorable credit characteristics, as<br />
reflected in the relatively strong credit ratings on<br />
many of the largest companies in the sector. One<br />
of the key factors underpinning this credit<br />
strength is that many of the rated utilities own<br />
monopoly transmission and/or distribution<br />
networks whose cash flow and earnings are<br />
relatively stable and low risk. These favorable<br />
credit characteristics provide strong support for<br />
debt capacity and credit ratings. Stand-alone EU<br />
transmission and distribution companies are<br />
typically rated in either the ‘AA’ or ‘A’ categories,<br />
depending on financial risk factors such as<br />
balance sheet leverage, dividend policy, and<br />
acquisition appetite. National Grid PLC, for<br />
example, is rated ‘A-’, while the smaller Danish<br />
national energy transmission company<br />
Energinet.dk SOV is rated ‘AA+’.<br />
On the other hand, the EU electricity generation<br />
and supply markets are open and competitive<br />
(albeit that there are significantly different levels<br />
of competition within different member states),<br />
and are therefore characterized by actual or<br />
potential earnings volatility. Wholesale and retail<br />
prices are largely determined by the market<br />
(although some member states continue to set<br />
regulated supply tariffs), and generation and<br />
supply businesses face price and volume volatility<br />
and lack revenue and earnings predictability.<br />
Accordingly, generation and supply businesses are<br />
inherently riskier from a credit perspective than<br />
transmission and distribution businesses.<br />
The vertical integration model bears lower<br />
credit risk than generation only and generation<br />
and supply models, as the ownership of a<br />
network business provides a relatively stable, and<br />
predictable, regulated earnings base, underpinning<br />
cash flows and borrowing capacity. The<br />
integration of generation with supply operations<br />
(providing a customer base to which power can<br />
be sold), and generation and supply operations<br />
14 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
with network operations, provides a strong<br />
competitive advantage for many<br />
market participants.<br />
How common is the vertically integrated model?<br />
The predominant business model in the EU<br />
electricity market is that of vertical integration,<br />
which combines generation and supply operations<br />
with distribution and/or transmission networks.<br />
Of the top 20 rated <strong>European</strong> utilities (see table<br />
on next page), 15 are vertically integrated<br />
companies, for which network earnings account<br />
for a significant share of consolidated earnings<br />
and represent a key credit strength.<br />
Of the 15 vertically integrated utilities, six own<br />
distribution networks only and nine own<br />
distribution and transmission networks, of which<br />
seven also operate transmission networks. The<br />
seven utilities that own and operate transmission<br />
networks are E.ON AG (A/Stable/A-1), RWE AG<br />
(A+/Negative/A-1), EnBW Energie Baden-<br />
Wuerttemberg AG (A-/Stable/A-2), and Vattenfall<br />
AB (A-/Stable/A-2) (who all own and operate<br />
regional electricity transmission networks in<br />
Germany), Electricite de France S.A. (EDF; AA-<br />
/Stable/A-1+) and Gaz de France S.A. (AA-/Watch<br />
Neg/A-1+) (who respectively own and operate the<br />
electricity and gas transmission networks in<br />
France), and Public Power Corp. S.A.<br />
(BBB+/Stable/--) (which owns and operates the<br />
electricity transmission network in Greece).<br />
Scottish Power PLC (A-/Watch Neg/A-2) and<br />
Scottish and Southern Energy PLC (A+/Stable/<br />
A-1) own transmission networks in Scotland, but<br />
these networks are operated by National Grid<br />
PLC (A-/Stable/A-2), which provides an example<br />
of a functioning ISO model.<br />
Would ownership unbundling of transmission<br />
networks threaten the ratings of affected<br />
companies?<br />
Yes. Ownership unbundling would increase the<br />
overall risk and volatility of the consolidated<br />
business model. As such, if the impact of<br />
unbundling were not offset by--for example-either<br />
a reduction in overall debt and materially<br />
stronger forward cash flow credit protection<br />
measures, or the adoption of compensating<br />
strategic measures (such as the use of proceeds<br />
from unbundling to acquire other low-risk<br />
earnings streams), ratings would be threatened.
Would ownership unbundling automatically<br />
result in lower ratings?<br />
No. While ownership unbundling of transmission<br />
networks would increase consolidated business<br />
risk by reducing the share of earnings and cash<br />
flow generated from monopoly operations, and<br />
increasing the proportion of earnings generated<br />
from more volatile and competitively exposed<br />
generation and supply operations, this could be<br />
compensated for by lowering the overall leverage<br />
and financial risk of the group. <strong>In</strong> other words, it<br />
is possible that the credit impact of any<br />
unbundling could be negated through a<br />
sustainable reduction of total debt and overall<br />
financial risk and/or a counterbalancing change in<br />
strategy that would lower business risk.<br />
Furthermore, the lower the proportionate<br />
contribution of transmission networks to the<br />
consolidated cash flow of the group, the lower the<br />
overall impact of any unbundling. For example,<br />
Top 20 Rated <strong>European</strong> Utilities<br />
UTILITIES<br />
there was no impact on the ratings on Enel SpA<br />
(A/Watch Neg/A-1) when it sold down a minority<br />
stake in Italian power transmission grid owner<br />
Terna SpA (AA-/Stable/A-1+) in 2005, as Terna<br />
contributed only 5%-6% of Enel’s then<br />
consolidated operating income. The degree of<br />
headroom in a company’s ratings could also have<br />
a bearing on the impact of unbundling if, for<br />
instance, there is significant capacity within the<br />
ratings for a weakening of the consolidated<br />
financial and business risk profile.<br />
Are competitively exposed utilities always rated<br />
lower than network companies?<br />
No. For example, of the rated nonvertically<br />
integrated <strong>European</strong> utilities, Centrica PLC<br />
(A/Negative/A-1), which owns and operates<br />
generation and supply businesses, is rated higher<br />
than National Grid PLC (A-/Stable/A-2), which<br />
owns and operates the electricity and gas<br />
Company Country Business Model Transmission Corporate Credit<br />
Assets Rating*<br />
Centrica PLC U.K. Generation and supply No A/Negative/A-1<br />
E.ON AG Germany Vertically integrated Yes A/Stable/A-1<br />
EDP - Energias de Portugal, S.A. Portugal Vertically integrated No A-/Negative/A-2<br />
Electricite de France S.A. France Vertically integrated Yes AA-/Stable/A-1+<br />
EnBW Energie Baden-Wuerttemberg AG Germany Vertically integrated Yes A-/Stable/A-2<br />
Endesa S.A. Spain Vertically integrated No A/Watch Neg/A-1<br />
Enel SpA Italy Vertically integrated No A/Watch Neg/A-1<br />
Fortum Oyj Finland Vertically integrated No A-/Stable/A-2<br />
Gaz de France S.A. France Vertically integrated Yes AA-/Watch Neg/A-1+<br />
Iberdrola S.A. Spain Vertically integrated No A/Watch Neg/A-1<br />
National Grid PLC U.K. Transmission and Yes A-/Stable/A-2<br />
distribution<br />
Public Power Corp. S.A. Greece Vertically integrated Yes BBB+/Stable/--<br />
RWE AG Germany Vertically integrated Yes A+/Negative/A-1<br />
Scottish and Southern Energy PLC U.K. Vertically integrated Yes A+/Stable/A-1<br />
Scottish Power PLC U.K. Vertically integrated Yes A-/Watch Neg/A-2<br />
Suez S.A. France Diversified No A-/Watch Pos/A-2<br />
Union Fenosa S.A. Spain Vertically integrated No BBB+/Stable/A-2<br />
United Utilities PLC U.K. Combination utility No A/Watch Neg/A-1<br />
Vattenfall AB Sweden Vertically integrated Yes A-/Stable/A-2<br />
Veolia Environnement S.A.<br />
*At Sept. 21, 2007.<br />
France Water No BBB+/Stable/A-2<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK NOVEMBER 2007 ■ 15
UTILITIES<br />
16 ■ NOVEMBER 2007<br />
transmission grids in England and Wales (as well<br />
as some U.S. network assets). While Centrica has<br />
a higher level of business risk than National Grid<br />
because its earnings are competitively exposed<br />
and are more volatile, this is compensated by<br />
Centrica’s significantly lower leverage. Following<br />
National Grid’s recent acquisition of U.S.-based<br />
KeySpan Corp. (A-/Stable/A-2), unadjusted net<br />
debt will increase to approximately £19.5 billion<br />
by 2009, from £11.8 billion in 2007, with<br />
consolidated funds from operations (FFO) interest<br />
coverage of about 3.5x and FFO to total debt of<br />
about 15%. By comparison, in the 12 months to<br />
June 2007, Centrica’s FFO coverage of adjusted<br />
net debt was very strong at about 97%.<br />
Why would an ISO model have less of an impact<br />
on credit quality than unbundling?<br />
An ISO model in which the operational<br />
management and investment plans of transmission<br />
networks would be controlled and determined by<br />
parties independent of the owners has been<br />
presented as an alternative--and potentially less<br />
politically divisive--option than ownership<br />
unbundling. The impact of such a move on the<br />
ratings in the sector would in principle be<br />
significantly less than that of unbundling, because<br />
the network owners would not be forced to divest<br />
and would retain access to the relatively solid,<br />
stable, and predictable network earnings<br />
(compared with, for example, volatile power<br />
generation earnings).<br />
An ISO model would mean that the vertically<br />
integrated utilities--such as E.ON, RWE, EDF,<br />
EnBW, and Vattenfall--that own transmission<br />
networks and whose credit quality benefits from<br />
such ownership, would continue to own the<br />
network and consolidate their earnings. Rating<br />
risk under an ISO model would, therefore, be<br />
limited compared with the significant rating risk<br />
presented by ownership unbundling.<br />
The ultimate effect of such a move would<br />
depend, however, on factors such as whether the<br />
networks would continue to be fully consolidated.<br />
<strong>In</strong> addition, current transmission network owners<br />
could decide to unilaterally sell networks if an<br />
ISO system were introduced, thereby redeploying<br />
capital from what would be a passive low-risk<br />
investment into a fully controlled and managed<br />
investment such as high-risk power generation.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
What was the impact on Scottish Power and<br />
Scottish and Southern Energy when the operation<br />
of their transmission networks moved to an<br />
ISO model?<br />
None. National Grid has operated the<br />
transmission networks of Scottish Power and<br />
Scottish and Southern Energy since 2005.<br />
Both companies continue to consolidate their<br />
transmission networks, and their consolidated<br />
credit quality continues to benefit from the<br />
relatively stable earnings of the<br />
transmission networks. ■
Publication Date:<br />
(Tons of 2<br />
equivalent gigawatthours)<br />
1,000<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
Carbon Emissions By Type Of Power Generation<br />
oal il Natural as ydroelectric Nuclear<br />
Source orld conomic ouncil, 2004.<br />
© Standard & Poor's 2007.<br />
South frica<br />
(Nami ia)<br />
(5 )<br />
Source uratom.<br />
ustralia<br />
(14 )<br />
thers<br />
(23 )<br />
© Standard & Poor's 2007.<br />
The EU's Main Providers Of Uranium, 2006<br />
Niger<br />
(16 )<br />
anada<br />
(24 )<br />
ussia<br />
(19 )
UTILITIES<br />
18 ■ NOVEMBER 2007<br />
Limited Nuclear Revival <strong>In</strong> The EU<br />
Nevertheless...<br />
Following the commissioning in September 2007<br />
of the Cernavoda 2 reactor in Romania, 146<br />
reactors are currently in operation in the EU<br />
providing 30% of the region’s electricity.<br />
Only four plants are currently being built and<br />
another four are planned (see table 1). This<br />
compares with 33 plants being currently built<br />
worldwide and 94 planned. A number of<br />
additional nuclear plants are being considered in<br />
other EU countries, especially the Czech Republic<br />
and Finland as well as Lithuania and Romania,<br />
but with no firm commitment so far.<br />
...Given Relatively Limited Political And<br />
Public Support So Far...<br />
Although the EU is generally supportive of the<br />
development of nuclear power, support at state<br />
level is more mixed.<br />
Recognizing the right of each member state to<br />
decide on its energy mix, in March 2007 the EU<br />
Council underlined nuclear power’s place within<br />
the region’s carbon-reduction strategy, and its<br />
contribution to addressing growing concerns<br />
about security of supply. However, the council<br />
also highlighted nuclear power’s drawbacks in<br />
terms of safety, decommissioning, and<br />
waste management.<br />
Within the EU, some countries are clearly<br />
supportive of nuclear power, especially France,<br />
Finland, and a number of Eastern <strong>European</strong><br />
countries. <strong>In</strong> The Netherlands, the government<br />
Country Existing nuclear phase out legislation/policy State of debate<br />
Belgium A 2003 law imposes the closure of nuclear plants after 40 The "Commission Energie 2030" in its<br />
years of operation--with exceptions possible for security of 2006 report recommended the reversal<br />
supply concerns--and prohibits the building of new nuclear<br />
plants. Gradual phase out planned to be completed in 2030,<br />
with first plant closure to occur in 2015.<br />
of the nuclear phase out policy.<br />
Germany Based on the "Atomausstiegsgesetz" law, government and The German government's coalition<br />
nuclear operators agreed in 2001 to limit the average life agreement includes a clause stating<br />
of nuclear plants to 32 years based on production quotas. that there is no agreement on this<br />
The building of new nuclear plants is also prohibited. matter.<br />
Spain Policy is to phase out nuclear power but no schedule or Policy of current government is to reduce<br />
specific strategy set. recourse to nuclear power without<br />
compromising security of supply.<br />
Sweden The "Nuclear Power Decommissioning Act" of January 1998 No decision on phasing out of nuclear<br />
allows the government to decide that the right to operate a power to be taken by current<br />
nuclear power plant will cease to apply at some point. Such government during term in office<br />
a decision infers the right to compensation from the state. (2006-2010).<br />
Source: Standard & Poor's.<br />
Table 2 - Nuclear Power Phase Out Policies <strong>In</strong> Europe<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Table 1 - Nuclear Power Plants <strong>In</strong> the EU<br />
Nuclear reactors<br />
Under<br />
Operational construction Planned<br />
France 59 1 0<br />
Germany 17 0 0<br />
Spain 8 0 0<br />
Sweden 10 0 0<br />
United Kingdom 19 0 0<br />
Finland 4 1 0<br />
Bulgaria 2 0 2<br />
Romania 2 0 2<br />
Slovakia 5 2 0<br />
Others 20 0 0<br />
Total 146 4 4<br />
Source: World Nuclear Association, October 2007.<br />
signed the Borssele covenant in June 2006, under<br />
which the operating life of the country’s only<br />
nuclear power station in Borssele has been<br />
extended until 2033 at the latest, as long as it<br />
remains in the top quartile of the safest power<br />
stations of its kind within the EU, the U.S., and<br />
Canada. <strong>In</strong> its May 2007 energy white paper, the<br />
British government also clearly reiterated its<br />
support for new nuclear power stations, the costs<br />
of which, including for decommissioning and<br />
waste disposal, must, however, be entirely borne<br />
by the private sector.
ncreased<br />
(14 )<br />
aintained the<br />
same<br />
(34 )<br />
Eurobarometer: <strong>European</strong> And Nuclear Safety<br />
<strong>In</strong> your opinion, should the current level of nuclear energy as a proportion of all energy<br />
sources be reduced, maintained the same, or increased?<br />
on't know<br />
(13 )<br />
Source uro arometer Fe ruary 2007 uropean and nuclear safety .<br />
© Standard & Poor's 2007.<br />
educed<br />
(39 )<br />
Neither<br />
(spontaneous)<br />
(6 )<br />
The advantages<br />
outweigh the risks<br />
(33 )<br />
Eurobarometer: <strong>European</strong> And Nuclear Safety<br />
on't know<br />
(8 )<br />
Source uro arometer Fe ruary 2007 uropean and nuclear safety .<br />
© Standard & Poor's 2007.<br />
When you think about nuclear power, what first comes to mind?<br />
The risks outweigh<br />
the advantages<br />
(53 )
UTILITIES<br />
20 ■ NOVEMBER 2007<br />
• For TVO, a strong turnkey, time-certain<br />
supply contract with ample guarantees,<br />
backed by strong suppliers and security<br />
bonds in the construction phase, as well as<br />
by offtake agreements with its main<br />
shareholders during the operation phase.<br />
• For EDF, during the construction phase by<br />
the group’s expertise in building nuclear<br />
plants, its last such plant in France having<br />
been commissioned in 2002, and by the<br />
group’s leading domestic position and the<br />
protective French regulatory environment in<br />
the operation phase.<br />
• For the Slovakian plants by the strong<br />
support of the government, which owns<br />
34% of SE.<br />
From a financial perspective, both EDF and<br />
Enel have the financial flexibility to carry out the<br />
investments necessary for their new builds of,<br />
respectively, € 3.3 billion and $2.2 billion. TVO is<br />
much smaller, but the protective turnkey contract<br />
and the offtake arrangements with its major<br />
shareholders provide substantial comfort.<br />
That said, in August 2007 we revised to<br />
negative the outlooks on Estonia-based integrated<br />
electric utility Eesti Energia AS (A-/Negative/--)<br />
and Lithuania-based electricity transmission<br />
company Lietuvos Energija (A-/Negative/A-2) to<br />
reflect the risks stemming from their possible<br />
participation in a prospective new nuclear power<br />
plant at Ignalina, Lithuania.<br />
The Ignalina nuclear project is based on a 2006<br />
agreement between the governments of Lithuania,<br />
Estonia, Latvia, and, at a later stage, Poland.<br />
However, realization of the project, including<br />
funding, will be the responsibility of the<br />
participating state-owned power companies. Eesti<br />
Energia could participate in the nuclear project<br />
with a 22% stake, while Lietuvos Energija would<br />
have a 34% stake and would be responsible for<br />
the plant’s operations. The nuclear power plant<br />
would have maximum installed capacity of 3,400<br />
MW at a projected cost of up to €4 billion.<br />
Extension Of Existing Plants Would Be<br />
Credit Positive<br />
A number of EU nuclear operators are seeking to<br />
extend the operating life of their plants drawing<br />
on the U.S. example, where at the end of 2006,<br />
47 licenses extending the operating life of nuclear<br />
plants to 60 years had been granted and an<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
additional eight were being reviewed.<br />
<strong>In</strong> the U.K., British Energy Group PLC (BE;<br />
BB+/Watch Neg/--) obtained approval in 2005 for<br />
a 10-year extension of its Dungeness plant. <strong>In</strong><br />
2008, BE may apply to extend the lives of its<br />
Hinkey Point and Hunterston plants, which are<br />
currently scheduled to close in 2011. Extending<br />
the operating life of its nuclear plant beyond the<br />
current 40 years is also a key pillar of EDF’s<br />
strategy. Czech operator CEZ a.s. (A-/Stable/--),<br />
has also launched an upgrade program at its<br />
Dukovany nuclear plant, with a view to<br />
increasing capacity by 160 MW and extending<br />
operating life by up to 20 years. Although<br />
Swedish utilities have not applied for life<br />
extensions they have obtained approval for<br />
uprates (capacity increases), which will<br />
significantly boost their nuclear capacity: Uprates<br />
underway and planned between 2006-2011 at the<br />
Ringhals plant, which is operated by Vattenfall<br />
AB (A-/Stable/A-2), will increase its capacity by<br />
close to 500 MW. The group will also boost<br />
capacity at its other nuclear plant, Forsmarks, by<br />
410 MW between 2008-10. E.ON Sverige AB<br />
(A/Stable/A-1) is also planning a 250 MW uprate<br />
of its Oskarshamn-3 reactor, to increase its<br />
capacity to 1,450 MW.<br />
We view such extensions very positively as,<br />
while running, nuclear power plants are highly<br />
cash generative in light of their low variable costs<br />
and limited capital expenditures for maintenance.<br />
Such extensions also delay decommissioning<br />
liabilities and capital expenditures for<br />
capacity replacement.<br />
Conversely, New Nuclear Build Is<br />
<strong>In</strong>herently Risky<br />
Building new nuclear plants is challenging given:<br />
• Long lead times with no offsetting revenue.<br />
EDF Energy PLC (A/Stable/A-1), which is<br />
interested in building four new nuclear<br />
plants in the U.K., believes that the earliest<br />
such a plant can be commissioned is 2017.<br />
•High upfront capital costs (about € 3<br />
billion), with the risks of delays overruns,<br />
especially for “first of a kind” plants. The<br />
TVO plant in Finland is now about two<br />
years late and has experienced very<br />
substantial cost overruns.<br />
Such features are specific to nuclear power<br />
plants, conventional power plants having much<br />
shorter lead times and much lower capital costs.
Conversely, conventional power plants are much<br />
more exposed to the vagaries of fuel prices.<br />
New nuclear plants also represent large<br />
capacity increases in one step (the new French<br />
and Finnish plants both have 1,600 MW<br />
capacity), whereas incremental capacity additions<br />
are better suited to deregulated markets.<br />
Operational <strong>In</strong>flexibility Is A Drawback<br />
<strong>In</strong> A Competitive Environment<br />
<strong>In</strong> operation, nuclear plants’ low operating costs<br />
and lack of carbon emissions are key competitive<br />
advantages. Yet operational inflexibility partially<br />
offsets these benefits, with nuclear plant operators<br />
limited in their ability to alter output in response<br />
to fluctuating energy demands, which weakens<br />
their market position. Nuclear plants provide<br />
base-load power and are, therefore, price takers<br />
rather than price setters. This is a significant<br />
drawback in today’s largely unregulated<br />
markets, which are characterized by volatile<br />
demand patterns.<br />
The risks of investing in new nuclear<br />
power stations are mitigated to a degree by the<br />
EU’s rapidly declining capacity margin and<br />
the resulting substantial investments in power<br />
generation required to meet the growth in<br />
demand and planned power<br />
plant decommissioning.<br />
Moreover, only the largest EU utilities will be<br />
able to invest significantly in new nuclear<br />
capacity. These groups all have large customer<br />
bases as well as a diversified generation mix-except<br />
EDF, which has a quasi-exclusive focus on<br />
nuclear power but benefits from the protective<br />
French environment--and extensive experience in<br />
running nuclear plants. What is more, to mitigate<br />
risks they may chose to expand, especially<br />
abroad, through partnerships, and/or to enter into<br />
offtake agreements.<br />
The large <strong>European</strong> utilities are likely to invest<br />
both in their own markets--if nuclear phase-out<br />
agreements are revised--but also abroad. EDF and<br />
the German utilities have highlighted their interest<br />
in new nuclear builds in the U.K., while five<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
groups--Electrabel, which is part of Suez S.A.<br />
(A-/Watch Pos/A-2), CEZ, E.ON AG (A/Stable/<br />
A-1), Enel, and RWE AG (A+/Negative/A-1)--have<br />
placed indicative bids for an up to 49% stake in<br />
the Belene nuclear power plant project in<br />
Bulgaria. Likewise Enel, Electrabel, Iberdrola S.A.<br />
(A/Watch Neg/A-1), RWE, and CEZ have bid to<br />
participate in the construction of reactors 3 and 4<br />
in Romania at Cernavoda. Only EDF appears<br />
interested in investing in nuclear projects outside<br />
of Europe. It is focusing on the U.S., China, and<br />
South Africa. EDF recently announced an<br />
agreement with U.S. utility Constellation Energy<br />
Group <strong>In</strong>c. (BBB+/Negative/A-2) to set up a 50/50<br />
joint venture to build, own, and operate <strong>European</strong><br />
pressurized reactors (EPRs) in the U.S.<br />
<strong>In</strong> the short term, we expect investments in<br />
nuclear power by EU utilities to increase only<br />
gradually, reflecting the long lead time for new<br />
nuclear projects and the time needed to build up<br />
political and public support. <strong>In</strong>vestments in<br />
nuclear power are therefore unlikely to<br />
significantly weigh on ratings. Risks may increase<br />
in the medium term as investments in nuclear<br />
power rise, though. The pace of such investments<br />
and the context--the degree of competitiveness of<br />
power markets, share of generation to be derived<br />
from nuclear power, life extensions of existing<br />
nuclear plants, level of expected wholesale and<br />
carbon prices, and political environment--in<br />
which they are carried out, will be key to our<br />
assessment of any rating impact. As a rule of<br />
thumb, we are likely to consider too strong an<br />
exposure to nuclear power in an open market<br />
as risky.<br />
We expect most investments in nuclear power<br />
to be on balance sheet, given the financial<br />
firepower of major <strong>European</strong> utilities, the<br />
difficulty of nonrecourse funding of such projects<br />
in light of the risks entailed, and the difficulty of<br />
replicating alternatives approaches such as<br />
TVO’s mixed-ownership structure, which<br />
encompasses both utilities and electro-intensive<br />
industrial groups. ■<br />
NOVEMBER 2007 ■ 21
Publication Date:<br />
osenergoatom<br />
(state nuclear<br />
monopoly)<br />
(16 )<br />
Source S of ussia.<br />
© Standard & Poor's 2007.<br />
ussia's Power Produ tion Mar et 2006<br />
ther producers<br />
(14 )<br />
S<br />
(70 )
and its subsidiaries. The majority of the new<br />
gencos are still UES subsidiaries but are likely to<br />
be privatized in the short term.<br />
Some observers refer to UES’ new investment<br />
program as ‘GOELRO-2’ (the first GOELRO was<br />
the original Soviet plan in 1920 for national<br />
economic recovery and development). GOELRO-<br />
2 envisages heavy investment in new generation<br />
capacity, which should result in an additional 34<br />
gigawatts (GW)--the equivalent of 16% of the<br />
current national generation capacity--by 2011.<br />
The investment plan relies heavily on external<br />
equity and debt financing, and consequently<br />
most gencos are tapping the equity and debt<br />
capital markets (see map above and table 1 on<br />
next page).<br />
The reform plan stipulates that the privatization<br />
of all thermal generation will take place during<br />
2007-2008 through IPOs, secondary public<br />
offerings, sales of equity stakes owned by UES,<br />
and the allocation of the remaining stakes to UES<br />
shareholders at the end of UES’ restructuring,<br />
scheduled for mid-2008. Between December 2006<br />
and October 2007 generating companies WGC-3,<br />
WGC-4, TGC-1, TGC-8, and Mosenergo (AO)<br />
(BB/Stable/--; Russia national scale rating ‘ruAA’)<br />
completed share issues, and WGC-5 and TGC-5<br />
were spun off, resulting in UES’ equity interest<br />
Russian Energy Production<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
falling below 50%. Many of the gencos remaining<br />
under control of UES already have a strategic<br />
minority investor that is looking to acquire a<br />
controlling stake through participation in IPOs<br />
and stake auctions. Strategic investors include<br />
major Russian industrial groups, coal and gas<br />
producers, and major <strong>European</strong> utilities and<br />
investment funds.<br />
The Russian government, however, is likely to<br />
remain the largest player in the power sector: It<br />
will retain all of Russia’s nuclear generation<br />
capacity through Rosenergoatom, most of the<br />
hydro generation capacity through Hydro-WGC,<br />
and a significant portion of thermal generation<br />
capacity through OAO Gazprom (BBB/Stable/--)<br />
and <strong>In</strong>terRAO UES (not rated). Gazprom, which<br />
controls Russia’s gas reserves and pipelines and is<br />
an important fuel supplier to the electricity<br />
generators, has recently underscored its<br />
investment ambitions in the electricity generation<br />
sector by acquiring major stakes in Mosenergo<br />
and TGK-1 and negotiating a swap of its 10.5%<br />
stake in UES for controlling stakes in OGK-2 and<br />
OGK-6. Gazprom is also playing a leading role in<br />
the creation of a joint venture with coal producer<br />
SUEK, which might receive most of Gazprom’s<br />
and SUEK’s generation assets.<br />
Standard & Poor’s views the change of the<br />
NOVEMBER 2007 ■ 23
UTILITIES<br />
24 ■ NOVEMBER 2007<br />
Table 1 - Russian Energy Producers’ Statistics<br />
Electricity<br />
production<br />
(full-year Capacity UES Strategic (potential)<br />
<strong>In</strong>stalled capacity 2006) factor Fuel holding investor<br />
Share of<br />
national<br />
GW total (%) TWh (%) (%)<br />
Rosenergoatom 23.2 11 154.7 76 Nuclear 0 Russian Federation<br />
Hydro-WGC 21.7 10.3 74.6 39 Hydro 100 Russian Federation<br />
Irkutskenergo 12.9 6.1 57 50 Hydro, 0 UC RUSAL<br />
Coal shareholders<br />
TGC-3 10.5 5 64.4 70 Gas 36 Gazprom<br />
WGC-1 9.5 4.5 47.2 57 Gas 92 N.A.<br />
WGC-6 9.1 4.3 32.9 42 Gas,<br />
Coal<br />
93 Gazprom<br />
WGC-2 8.7 4.1 48.1 63 Gas,<br />
Coal<br />
65 Gazprom<br />
WGC-5 8.7 4.1 40.4 53 Gas,<br />
Coal<br />
0 Enel<br />
WGC-4 8.6 4.1 51 68 Gas,<br />
Coal<br />
29 E.ON<br />
WGC-3 8.5 4 30.6 41 Gas 37 Norilsk Nickel<br />
Tatenergo 7 3.3 24.9 40 Gas 0 Republic of Tatarstan<br />
TGC-7 6.9 3.3 27.2 45 Gas 54 Gazprom, IES<br />
TGC-1<br />
Far Eastern<br />
6.1 2.9 23.6 44 Gas,<br />
Hydro<br />
14 Gazprom<br />
Generation<br />
Company<br />
5.8 2.7 21.5 44 Coal 48 Russian Federation<br />
Bashkirenergo 5.1 2.4 25 56 Gas 21 N.A.<br />
TGC-9 4.8 2.3 20.1 48 Gas 50 IES<br />
TGC-5 3.8 1.8 12.5 37 Gas 0 IES<br />
TGC-12 3.6 1.7 19.9 63 Coal 49 Gazprom/SUEK<br />
Prosperity Capital<br />
Management<br />
TGC-4 3.3 1.6 13 45 Gas 47 Transnafta, CEZ,<br />
Korea Electric<br />
Power Corp<br />
TGC-8 3.3 1.6 15.3 53 Gas 11 IFD Kapital<br />
TGC-6 3.1 1.5 13.2 48 Gas 50 IES<br />
Novosibirskenergo 3 1.4 14.3 55 Coal 14 N.A.<br />
TGC-10 2.6 1.2 16.8 73 Gas,<br />
Coal<br />
82 Gazprom, E.ON<br />
TGC-13 2.5 1.2 10.4 48 Coal 57 Gazprom/SUEK<br />
<strong>In</strong>terRAO UES 2.3 1.1 N.A. N.A. Gas 60 Russian<br />
Federation/Rosenergoatom<br />
TGC-11 2 1 8.4 47.1 Gas,<br />
Coal<br />
100 Gazprom<br />
TGC-2 1.4 0.7 6.4 52.7 Gas 49 Prosperity Capital<br />
Management<br />
TGC-14 0.6 0.3 2.8 49.9 Coal 50 Norilsk Nickel<br />
GW--Gigawatts. WGC--Wholesale generation company. TGC--Territorial generation company. N.A.--Not available. Source: RAO UES of Russia, media,<br />
corporate filings, and Web sites.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
controlling owner as a major credit risk factor in<br />
2007-2008 for thermal gencos due to the impact<br />
on business strategy, operational profile, and<br />
financial policy. The level of actual or implied<br />
support from the new owner is another<br />
consideration. The credit quality of gencos may<br />
therefore diverge substantially, with that of some<br />
improving and others weakening.<br />
Gencos may benefit from becoming part of<br />
diversified, vertically integrated energy groups and<br />
from ownership changes, if, for example, they<br />
then have better and cheaper access to fuel<br />
supplies, as well as financial support from the<br />
new owners. Any new controlling owner could,<br />
however, pursue a more aggressive financial<br />
policy, including higher debt leverage and higher<br />
dividend payouts to raise equity returns. Creditors<br />
of companies whose strategic investor is a large<br />
customer or fuel supplier also face the risk that<br />
transfer pricing may eliminate any benefits of<br />
higher wholesale power prices following price<br />
deregulation, if the corporate governance at new<br />
generation companies is not effective enough to<br />
balance the inherent conflicts of interest.<br />
UES intends to limit the strategic discretion of<br />
new owners by retaining minority stakes after<br />
privatization, shareholder agreements with new<br />
controlling owners, and contracts for generation<br />
capacity availability. Although these measures<br />
may reduce strategic risk, they create new<br />
challenges such as burdensome fines for delayed<br />
delivery of contracted capacity. This is likely to<br />
happen given the high construction risk inherent<br />
in all greenfield power projects and the risk that<br />
external funding or necessary equipment may<br />
be unavailable.<br />
After Privatization, More Consolidation?<br />
<strong>In</strong>creased M&A is likely to follow the gencos’<br />
privatization and become an important credit risk<br />
factor. We expect that the new controlling owners<br />
will employ asset consolidation, asset swaps,<br />
restructuring, and divestments to align their<br />
holdings with their business strategies. This is<br />
because, first, many strategic investors have<br />
demonstrated an interest in acquiring more than<br />
one generation company, as well as assets in other<br />
business segments such as electricity distribution<br />
and supply. These may be consolidated into one<br />
entity within existing unbundling requirements.<br />
Second, the government determined the current<br />
configuration of gencos with the primary purpose<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
of creating a fair competitive landscape, while<br />
business logic may favor other asset<br />
combinations. Third, current UES shareholders,<br />
who will receive proportional stakes in the gencos<br />
and grid companies after liquidation of the UES<br />
holding, are likely to attempt to swap relatively<br />
small holdings for larger and more influential<br />
stakes in successor gencos and grid companies,<br />
giving additional impetus to M&A.<br />
The credit impact of post-privatization M&A<br />
may be both positive and negative depending on<br />
the credit quality of combined entities, the<br />
benefits of vertical integration, the synergies<br />
derived from new business combination, and the<br />
impact of transactions on the new entity’s<br />
consolidated financial profile.<br />
Vertical integration might underpin generators’<br />
business profiles<br />
One of the main aims of the Russian power sector<br />
reform is to unbundle each business segment in<br />
the electricity value chain--generation,<br />
transmission, distribution, and supply--to make<br />
each more competitive, gain efficiency, and<br />
improve the regulatory regime’s transparency. So,<br />
wholesale generation companies (WGCs) and<br />
territorial generation companies (TGCs) have only<br />
generation operations in the electricity supply<br />
chain. We believe that deregulated, unbundled<br />
generation has relatively high business risk<br />
compared with other operations in the value<br />
chain. This is because of the high level of capital<br />
intensity; the commodity nature of the industry,<br />
with price-based competition, high exposure to<br />
other commodity prices (for example, fuel), or<br />
fluctuation of water resources; and high levels<br />
of competitive risk compared with transmission<br />
and distribution operations, which are<br />
natural monopolies.<br />
After unbundling, we expect Russian gencos to<br />
focus their strategies on business risk<br />
diversification by vertically integrating lower-risk<br />
regulated businesses segments and fuel and retail<br />
electricity supply operations. A similar approach<br />
is already taking place as fuel supply companies<br />
look to invest in power generation to unlock the<br />
benefits of vertical integration of power and fuel<br />
production and supply. Non-government<br />
controlled electric utilities, such as Irkutskenergo,<br />
AO EiE (B+/Positive/--; Russia national scale<br />
rating ‘ruA’), have shown a similar strategic intent<br />
by acquiring coal mines (to hedge fuel price and<br />
NOVEMBER 2007 ■ 25
UTILITIES<br />
26 ■ NOVEMBER 2007<br />
supply risk) and obtaining control of municipally<br />
owned electricity and heat distribution networks<br />
(to provide a base of stable, network earnings and<br />
improve operations). However, the potential<br />
degree of diversification is limited by the legal<br />
prohibition of simultaneous ownership of<br />
“monopoly” (transmission, electricity distribution,<br />
and dispatching) and “competitive”<br />
(generation and supply) assets within one market<br />
price zone. The two power market zones are<br />
Europe and the Urals, and Siberia. This law<br />
prohibits the vertically integrated generation and<br />
distribution structures typical of <strong>European</strong><br />
power utilities.<br />
Diversification, the potential synergies, and<br />
hedging opportunities should support the interest<br />
of gencos and their strategic minority investors to<br />
invest in supply companies, all of which UES<br />
plans to sell in 2007-2008. A combination of<br />
wholesale generation and supply should reduce<br />
overall business risk through diversification of the<br />
customer base and higher customer loyalty. This is<br />
likely to result in lower competitive pressure and<br />
reduced customer attrition, as well as higher<br />
margins in retail electricity sales. At the same<br />
time, on their own, electricity supply operations<br />
have the highest business risk in the electricity<br />
value chain.<br />
A Whole New Wholesale System<br />
<strong>In</strong> September 2006, Russia introduced new rules<br />
for its electricity market that are a big step<br />
toward full deregulation of wholesale power. <strong>In</strong><br />
place of the old regulated pool system, where<br />
generators sold power at cost-based rates and<br />
received regulated payments for fixed capacity<br />
costs, the new market is based on bilateral<br />
regulated contracts between generators and<br />
wholesale customers, which initially covered 95%<br />
of planned generation volumes. Generators sell<br />
any volumes not covered by regulated contracts,<br />
and customers sell any surplus power from<br />
regulated purchases on the deregulated spot<br />
market. Actual supply/demand dynamics<br />
determine the deregulated market’s share.<br />
The government intends to deregulate the<br />
market and reduce volumes sold under regulated<br />
contracts. <strong>In</strong> April 2007, it approved a new<br />
deregulation plan that would fully evolve from<br />
2007 to 2010 (see chart 3). This is well ahead of<br />
previous plans that had a seven- to 20-year<br />
time frame.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
The contracts have “take-or-pay” terms (that is,<br />
buyers will make payments to the electricity<br />
wholesaler for the contract electricity volume<br />
regardless of their actual power demand). Since<br />
2008, the contracts will also have an automatic<br />
adjustment for passing fuel costs on to customers<br />
and an annual adjustment to regulated rates for<br />
other increasing costs through an inflationbased<br />
formula.<br />
<strong>In</strong> the new market model, a generator also<br />
recovers fixed costs through regulated bilateral<br />
contracts. The government plans to deregulate<br />
capacity payments in line with the spot market by<br />
reducing the portion of generation capacity<br />
covered by regulated payments. Wholesale market<br />
participants will have to procure capacity<br />
covering their peak demand, minus capacity paid<br />
through regulated contracts from generators<br />
through a market-based mechanism. The first<br />
auction is likely in 2007 for capacity to be<br />
delivered in 2008 and 2012.<br />
Exposure to spot price volatility will grow in line<br />
with market deregulation<br />
Seasonal, daily, and intraday power-demand<br />
variations make spot electricity prices highly<br />
volatile (see chart 4 on next page). While gencos’<br />
current exposure to the spot price is limited<br />
because only 10% of the wholesale market has<br />
been opened, this exposure will increase in line<br />
with wholesale market deregulation and will<br />
reach 100% by 2011.<br />
Spot-price deregulation for generators in<br />
<strong>European</strong> Russia and in the Ural region has been<br />
positive to date (see chart 5 on next page).<br />
Chart 3<br />
Russian Wholesale Market<br />
Deregulation Schedule
( h)<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
ont ly A era e Spot Electr c ty r ce <strong>European</strong> u a And e ral<br />
verage deregulated price<br />
(left scale)<br />
Spot sales as percentage of total<br />
(right scale)<br />
verage regulated price<br />
(left scale)<br />
0<br />
0<br />
SSept. t ct. t NNov. ec. an. Fe F . ar- pr-07 07 ay- un- ul-07 l 07 ug. SSept. t<br />
2006 2006 2006 2006 2007 2007 07<br />
07 07 2007 2007<br />
-- u le. h-- egawatt-hour.<br />
© Standard & Poor's 2007.<br />
( )<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
( h)<br />
900<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
0<br />
Sept. S t ct. t NNov. ec. an. Fe F . ar- pr-07 07 ay- un- ul-07 l 07 ug. SSept. t<br />
2006 2006 2006 2006 2007 2007 07<br />
07 07 2007 2007<br />
( per tcm)<br />
3,000<br />
2,500<br />
2,000<br />
1,500<br />
1,000<br />
500<br />
0<br />
an. 1,<br />
2006<br />
verage deregulated price<br />
(left scale)<br />
Spot sales as percentage of total<br />
(right scale)<br />
-- u le. h-- egawatt-hour.<br />
© Standard & Poor's 2007.<br />
uly 1,<br />
2006<br />
an. 1,<br />
2007<br />
uly 1,<br />
2007<br />
an. 1,<br />
2008<br />
uly 1,<br />
2008<br />
an. 1,<br />
2009<br />
uly 1,<br />
2009<br />
an. 1,<br />
2010<br />
-- u le. tcm--Thousand cu ic feet. Source ussian Federal Tariff Service.<br />
© Standard & Poor's 2007.<br />
verage regulated price<br />
(left scale)<br />
( )<br />
14<br />
12<br />
10<br />
8<br />
6<br />
4<br />
2<br />
uly 1,<br />
2010
UTILITIES<br />
28 ■ NOVEMBER 2007<br />
pressure on market prices. However, new plants<br />
can’t be built quickly, so it will take some time to<br />
ease this capacity constraint.<br />
Higher profitability from increased power prices<br />
will underpin generators’ business profile<br />
As seen in Western Europe, moving from<br />
regulated cost-plus regimes to a deregulated spot<br />
electricity market typically increases generators’<br />
business risk and can often dilute credit quality.<br />
Standard & Poor’s believes that the new path to<br />
deregulation might support improved credit<br />
quality in the sector through higher transparency<br />
and price growth, while capacity payments and<br />
hedging will smooth the impact of volatile<br />
spot prices.<br />
The deregulated market will translate rising gas<br />
prices into higher electricity prices, reflecting the<br />
costs of the least efficient (marginal) gas-fired<br />
generators for all market players.<br />
Generators using other fuels such as coal,<br />
nuclear, hydropower would consequently reap<br />
higher margins, as would more efficient<br />
gas-fired producers.<br />
We expect the higher profitability to mitigate<br />
increased price volatility because stronger margins<br />
will cushion the impact on cash flow. This will<br />
somewhat offset price deregulation’s negative<br />
impact on cash flow stability. Generation<br />
companies’ profitability is currently low, with an<br />
average 10% EBITDA margin for UES and a tiny<br />
1%-2% for some thermal generators. Despite<br />
most electricity being sold at regulated tariffs,<br />
relatively small changes in price or fuel costs-together<br />
with weak margins--result in substantial<br />
cash flow fluctuation. That implies high<br />
business risk.<br />
Political risk remains key to power price<br />
deregulation and growth<br />
Political risk, however, overshadows the rosy<br />
prospects for power generators in the new market<br />
deregulation plan. Customers will bear substantial<br />
price increases and could face soaring electricity<br />
bills in the next three to four years, potentially<br />
leading to a political backlash. <strong>In</strong> addition, most<br />
of the market deregulation and corresponding<br />
price increases are scheduled for 2009-2010. But<br />
this comes after the 2008 presidential elections,<br />
when Russia will have a new president who may<br />
have different views on electricity price policy and<br />
perhaps even on the sector’s overall strategy.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Generators’ active hedging strategies could<br />
provide further cash flow stability<br />
After the wholesale market is fully deregulated,<br />
each generator’s decision on how to balance<br />
potentially profitable but volatile opportunities<br />
from spot sales in order to lock in a more certain<br />
level of profits will determine its spot-market<br />
exposure. More forward electricity sales at a fixed<br />
price that allows the generator to earn sufficient<br />
profits to support its credit quality (assuming that<br />
generation costs are also fixed) would imply a<br />
lower business risk. Generators currently can<br />
hedge price volatility through nonregulated<br />
forward contracts at a fixed price. Power<br />
exchanges plan to introduce other instruments,<br />
such as power futures, to expand hedging<br />
opportunities. Thus, a conservative hedging<br />
strategy would limit the impact of changes in spot<br />
prices on cash flow volatility in the coming one to<br />
two years.<br />
How capacity market contracts could help<br />
The proposed capacity market, a system of<br />
payments to generators that cover fixed costs, will<br />
also mitigate the impact of spot price volatility on<br />
cash flow stability.<br />
Standard & Poor’s believes that recovering<br />
fixed costs through the capacity market will<br />
underpin generation companies’ credit quality.<br />
Capacity payments, now accounting for about<br />
one-half of wholesale generation revenues,<br />
substantially reduce the operational ‘gearing’ (the<br />
level of fixed operating costs that determines the<br />
dependence of operating income variability on<br />
sales variability) of generators. These payments<br />
aren’t common in other <strong>European</strong> generation<br />
markets. The still-to-be-determined capacity<br />
pricing mechanism will heavily influence the level<br />
of market-based capacity payments and<br />
generators’ profitability and cash flow. The final<br />
mechanism expected in 2007-2008 will reduce<br />
this uncertainty.<br />
Who will benefit from market deregulation?<br />
The competitiveness and profitability of gencos in<br />
the deregulated market depend heavily on their<br />
marginal cost position. The main factor for<br />
gencos is fuel costs and for hydro generators,<br />
water tax charges.<br />
Deregulation of the electricity market will result<br />
in a gradual transition of the average electricity<br />
price from regulated tariffs that reflect costs to a
era e e ulated Electr c ty ar ff And Spot r ce n <strong>European</strong> u<br />
Sept<br />
verage regulated electricity tariff for 2007<br />
verage spot electricity price an.-Sept. 2007<br />
a a<br />
( per<br />
900<br />
h)<br />
800<br />
700<br />
600<br />
500<br />
400<br />
300<br />
200<br />
100<br />
0<br />
-- u le. h-- egawatt-hour.<br />
© Standard & Poor's 2007.<br />
osenergoatom<br />
idro ( urope)<br />
T -1<br />
T -10<br />
-4 ( urope)<br />
nter S<br />
T -3 ( osenergo)<br />
-2<br />
T -5<br />
-5<br />
-1<br />
Tatenergo<br />
T -8<br />
T -7<br />
T -6<br />
Bashkirenergo<br />
T -9<br />
T -4<br />
-3 ( urope)<br />
-6 ( urope)<br />
T -2<br />
ra e e ulated Electr c ty ar ff And Spot r ce n S ber an u a an S<br />
( per h)<br />
450<br />
400<br />
350<br />
300<br />
250<br />
200<br />
150<br />
100<br />
50<br />
0<br />
-- u le. h-- egawatt-hour.<br />
© Standard & Poor's 2007.<br />
verage regulated electricity tariff for 2007<br />
verage spot electricity price an.-Sept. 2007<br />
rkutskenergo<br />
T -13<br />
-4 (Si eria)<br />
-6 (Si eria)<br />
T -12<br />
Novosi irskenergo<br />
thers (Si eria)<br />
-3 (Si eria)<br />
T -11<br />
T -14
UTILITIES<br />
30 ■ NOVEMBER 2007<br />
Table 2 - Russian Thermal Generation Companies’ IFRS Financial Statistics<br />
(RUR mil.) Mosenergo HydroOGK OGK-5 OGK-1 OGK-2 OGK-3 OGK-4 TGK-1 TGK-5 TGK-12<br />
Period 12 months 2006 12 months 2006 2006 2006 2006 2006 2006 2006<br />
ended ended<br />
June 30, June 30,<br />
Total<br />
2007 2007<br />
revenues<br />
Funds from<br />
operations<br />
67,336 24,468 26,081 30,062 25,433 23,070 26,110 21,594 11,402 19,637<br />
(FFO) 4,738 4,942 2,729 2,105 (28.0) 386 1,720 441 476 2,252<br />
Capital<br />
expenditures<br />
Cash and<br />
18,853 15,532 5,578 1,738 826 1,265 1,092 3,372 512 1,249<br />
investments 50,483 6,768 11,925 549 1,720 355 778 650 132 271<br />
Debt<br />
Common<br />
17,722 17,179 5,089 1,622 5,737 3,704 1,023 6,397 868 1,254<br />
equity 135,963 81,868 50,071 23,708 13,075 15,256 22,436 24,595 10,400 15,874<br />
Total capital 153,685 120,033 55,159 25,330 18,812 18,960 23,459 30,991 11,267 17,128<br />
Adjusted ratios<br />
FFO interest<br />
coverage (x)<br />
3.2 13.8 6.9 20.2 0.8 2.6 10.7 2.0 14.0 6.8<br />
FFO/debt (%)<br />
Operating<br />
income<br />
(bef. D&A) /<br />
26.7 28.8 53.6 129.8 (0.5) 10.4 168.1 6.9 54.9 179.6<br />
sales(%)<br />
Return on<br />
11.7 28.1 11.0 10.4 1.5 4.7 8.7 9.6 8.4 11.3<br />
capital (%)<br />
Debt to<br />
2.0 3.8 1.5 8.2 (3.5) 0.0 3.7 2.3 5.1 3.9<br />
capital (%) 12.0 14.0 9.0 6.0 30.0 20.0 4.0 21.0 8.0 7.0<br />
RUR--Ruble. D&A--Depreciation and amortization.<br />
(although for some companies, very weak<br />
cash flow results in poor cash flow protection<br />
measures).<br />
<strong>In</strong> the next three to four years, the gencos’ debt<br />
levels are likely to grow substantially. This is a<br />
result of the sector’s heavy capital-investment<br />
needs to replace capacity that’s reaching the end<br />
of its productive life, to add capacity for demand<br />
growth, and to maximize returns for private<br />
shareholders. UES expects the financing of the<br />
huge investment program (which UES has<br />
estimated to be RUR1.45 trillion over the period)<br />
to result in significant borrowing by gencos of up<br />
to RUR400 billion-RUR500 billion.<br />
<strong>In</strong> 2007-2008, however, equity financing can<br />
cover the majority of external funding needs. For<br />
example, UES has set an ambitious target to raise<br />
as much as $17 billion in equity financing.<br />
Gencos are therefore generally likely to rely<br />
more on equity financing in 2007-2008, with<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
most of the debt hitting in 2009-2010. By that<br />
time, electricity market deregulation and likely<br />
price increases should have improved the gencos’<br />
profitability and operating cash flow, and helped<br />
to mitigate increasing debt levels.<br />
While the proceeds from the share issues and<br />
sales in 2007 have been above expectations, the<br />
availability of equity financing that UES expects<br />
in 2007-2008 is subject to general capital market<br />
conditions, as well as investor perceptions of the<br />
risks involved. Those risks may be subject to<br />
change, and so the ability of UES and the gencos<br />
to meet the target is uncertain. If proceeds from<br />
equity sales fall below expectations, additional<br />
borrowing may be needed--assuming lenders are<br />
willing. Of course, such borrowing could weaken<br />
the gencos’ credit quality. If financing isn’t<br />
available, the investment program would need to<br />
be scaled back and delayed.
<strong>In</strong>vestor Rating <strong>In</strong>vestment Timing Cost<br />
E.ON AG A/Stable/A-1 60.7% in WGC-4 Oct. 2007 $5.9 bil.<br />
Enel SpA A/Watch Neg/A-1 29.9% in WGC-5 June 2007 $2.2 bil.<br />
Enel SpA A/Watch Neg/A-1 49.5% in Rusenergosbyt<br />
(supply company)<br />
2006 $105 mil.<br />
Fortum Oyj<br />
N.A.--Not available.<br />
A-/Stable/A-2 25.5% in TGC-1 2003-2005 N.A.<br />
Why Russia Is Tempting For EU<br />
Power Utilities<br />
The fast-growing Russian power sector and its<br />
ongoing liberalization present a particular lure for<br />
Western <strong>European</strong> utilities. The industry predicts<br />
that the sector will grow at about 5% over the<br />
next few years and that it will need investments of<br />
more than $20 billion per year over the next 15<br />
years to modernize power stations and<br />
transmission systems and to construct new<br />
generation capacity.<br />
The restructuring and liberalization process that<br />
Russia is now undergoing is similar to what has<br />
occurred in the EU over the past seven or eight<br />
years. <strong>European</strong> companies such as E.ON AG<br />
(A/Stable/A-1), Enel SpA (A/Watch Neg/A-1), and<br />
Fortum Oyj (A-/Stable/A-2) have therefore gained<br />
valuable experience domestically and in other<br />
Eastern <strong>European</strong> countries that they can<br />
potentially transfer to Russia. This includes<br />
managing operating and capital costs, as well as<br />
regulatory and network risks in liberalized<br />
markets. <strong>In</strong> addition, new entrants can bring<br />
trading and hedging expertise to mitigate the<br />
commodity and power-price risks that are<br />
characteristic of liberalized power markets.<br />
Leveraging these skills is one way for the<br />
<strong>European</strong>s to add value to the sector. <strong>In</strong>deed,<br />
several major <strong>European</strong> utilities have already<br />
made large investments in Russia’s power industry<br />
(see table 3).<br />
As Russian utilities have so far been statecontrolled<br />
companies, could find opportunities to<br />
improve efficiency. Up until now, the Russian<br />
tariff system has often been based on cost<br />
recovery, so that remuneration earned on assets<br />
depends on a cost-plus system that allows a<br />
return on reported costs, leaving no great<br />
incentive to improve efficiency. However, smaller,<br />
privately owned generation utilities have been<br />
very successful in cutting costs.<br />
Table 3 - <strong>European</strong> <strong>In</strong>vestments <strong>In</strong> The Russian Power <strong>In</strong>dustry<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
<strong>European</strong> utilities will have to guard against<br />
credit dilution<br />
<strong>In</strong>vestments in the Russian power sector would<br />
generally dilute credit (as would most investment<br />
in Eastern Europe), owing to Russia’s greater<br />
macroeconomic, sovereign, and country risks. The<br />
Russian economy is less diversified and may be<br />
less stable over time, the political system may be<br />
subject to change, and the regulatory system is<br />
less mature, all of which creates regulatory and<br />
political uncertainty. These risk factors translate<br />
into a weaker business profile for Russian power<br />
utilities compared with Western <strong>European</strong> peers.<br />
Therefore, the average credit quality of Russian<br />
and Eastern <strong>European</strong> power companies is lower<br />
than that of EU power companies.<br />
The ratings on Russian utilities are below<br />
investment grade, in the ‘BB’ or ‘B’ category,<br />
because the companies are smaller, less diversified,<br />
and less profitable than Western <strong>European</strong> peers.<br />
They generate less or no free cash flow and face<br />
greater political, legal, and regulatory risks than<br />
utilities in the EU. By contrast, more than 90% of<br />
EU utility ratings are rated in the investmentgrade<br />
rating categories (‘BBB’ or higher).<br />
Although investments in Russia would dilute<br />
credit quality, we would expect EU utilities to<br />
manage the rating risk by proactively managing<br />
their exposure. Western <strong>European</strong> companies such<br />
as Germany’s E.ON or Italy’s Enel are large,<br />
diversified companies with relatively strong<br />
balance sheets. We don’t expect the share of<br />
future consolidated earnings and investment from<br />
Russia to represent a concentration risk. We<br />
expect the same to be true for smaller companies<br />
such as Czech Republic-based CEZ a.s.<br />
(A-/Stable/--) or Nordic utility Fortum, which also<br />
regard Russia as a target market. Other large<br />
acquisitions, however, such as Enel’s planned<br />
debt-financed purchase of Spanish power utility<br />
Endesa S.A. (A/Watch Neg/A-1), could lower<br />
ratings and debt capacity for Russian investment.<br />
NOVEMBER 2007 ■ 31
UTILITIES<br />
32 ■ NOVEMBER 2007<br />
The ultimate impact of any Russian investment on<br />
the credit ratings of a company depends on<br />
several factors. Among them are its size, whether<br />
it represents a majority interest that would be<br />
consolidated or a minority investment that would<br />
be accounted for using the equity method, how it<br />
is funded, its earnings and cash-flow visibility,<br />
and how much headroom is in the current ratings<br />
to absorb such an investment.<br />
Better Credit Quality Likely, But Regulatory<br />
Risk Remains<br />
Overall, the restructuring of UES and<br />
deregulation of the power prices may support<br />
improved credit quality in the sector through<br />
lower business risk strategies, higher transparency,<br />
and price growth, while capacity payments and<br />
hedging will smooth the impact of volatile spot<br />
prices. The downside is that customers will likely<br />
face much higher electricity bills in the next three<br />
to four years and political and regulatory risks<br />
will remain a key challenge for credit quality in<br />
the sector. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
May 10, 2007<br />
Primary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
Secondary Credit Analysts:<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
Mark Schindele,<br />
Stockholm,<br />
(46) 8-440-5918<br />
Hugues De La Presle,<br />
Paris,<br />
(33) 1-4420-6666<br />
COMBATING CLIMATE CHANGE IN THE EU: RISKS<br />
AND REWARDS FOR EUROPEAN UTILITIES<br />
Climate policy is a key high-level issue for<br />
the EU and its member states. <strong>In</strong>deed, the<br />
<strong>European</strong> Council, the EU’s main decisionmaking<br />
body, recently reaffirmed its commitment<br />
to the reduction of carbon dioxide (CO2) and<br />
other greenhouse gases (GHGs). It recommended<br />
that the Emissions Trading Scheme (ETS), which<br />
is the EU’s principal policy instrument for hitting<br />
its emissions targets, be strengthened and<br />
broadened in scope. As a result, the ETS--and<br />
other climate policy initiatives such as the drive to<br />
increase the share of GHG-clean renewable<br />
energy in the energy mix--will continue to have a<br />
major impact on <strong>European</strong> electricity generators<br />
and vertically integrated utilities that Standard &<br />
Poor’s Ratings Services rates. That’s because the<br />
burning of fossil fuels such as coal, oil, and gas to<br />
generate electricity accounts for a very significant<br />
share of EU GHG emissions (see footnote at end<br />
of article). The most visible effect of the ETS to<br />
date has been through an increase in power<br />
prices, as fossil fuel generators in liberalized<br />
(deregulated) markets now include the cost of<br />
CO2 emissions in their pricing decisions. We<br />
expect the ETS to potentially have a greater<br />
impact on power prices in Phase 2 of the ETS<br />
(2008-2012), as the cap on CO2 emissions will<br />
be tighter.<br />
Until the form of any potential successor treaty<br />
to the Kyoto Protocol (an agreement made under<br />
the UN Framework Convention on Climate<br />
Change that requires industrialized signatory<br />
nations to collectively reduce GHG emissions)<br />
becomes known, <strong>European</strong> utilities lack visibility<br />
on the scope and potential impact of global<br />
climate change policies beyond 2012, when Kyoto<br />
expires. The <strong>European</strong> Council’s decision in<br />
March 2007 to adopt either a 20% or 30% GHG<br />
reduction target by 2020, depending on the scope<br />
of any successor treaty to the Kyoto Protocol,<br />
reflects this uncertainty. Nevertheless, it is clear<br />
that GHG emission reduction will continue to be<br />
central to EU policy over the long term and that<br />
the operating and regulatory environment for<br />
electricity generators will remain influenced by<br />
this focus.<br />
<strong>In</strong> considering the effects of climate change<br />
policy on <strong>European</strong> utilities, we examine the<br />
impact of the ETS on power prices and on the<br />
profitability of the power generation sector. We<br />
discuss the challenge for generators in taking<br />
long-term investment decisions given the high<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
level of uncertainty about future policy, the<br />
possible roles that renewable and nuclear energy<br />
will play in the generation mix, and why<br />
technological developments will be key to the<br />
future of coal-fired generation.<br />
High Power Prices Under The ETS: Benefits<br />
For Some, Rising Costs For Others<br />
The principal impact of EU climate change<br />
policies has been a continued boost in the<br />
profitability and cash flows--and therefore credit<br />
quality--of <strong>European</strong> generation companies that<br />
operate in countries in which wholesale and retail<br />
power markets and prices have been fully<br />
liberalized. The key instrument of these policies<br />
has been the ETS.<br />
The ETS restricts CO2 emissions and requires<br />
power generation and energy-intensive companies<br />
in what are known as the “covered sectors”<br />
(encompassing oil refineries; coke ovens; iron and<br />
steel plants; and factories making cement, glass,<br />
lime, brick, ceramics, and pulp and paper) to hold<br />
tradable allowances to match their CO2<br />
emissions. The covered sectors account for about<br />
50% of total EU GHG emissions. The ETS began<br />
on Jan. 1, 2005, and Phase 1 will run until Dec.<br />
31, 2007. Phase 2 will run from January 2008 to<br />
December 2012, the period over which the<br />
performance of the Kyoto signatory nations<br />
against their GHG emission reduction targets will<br />
be assessed.<br />
The impact of the ETS on the power generation<br />
and energy-intensive industrial sectors differs<br />
markedly. While both power generators and<br />
energy-intensive industrial power users face caps<br />
on CO2 emissions and have been granted free<br />
allowances to at least partly cover their emissions,<br />
it is the power generators that benefit from higher<br />
power prices, at the expense of electricity users.<br />
One of the foremost effects of the ETS has been<br />
to increase wholesale power prices in markets<br />
such as the U.K. and Germany in which fossil<br />
fuel-fired generation is the marginal price-setting<br />
plant. Electricity generators that burn fossil fuels-coal,<br />
lignite, gas, and oil (fossil fuel-based<br />
generation accounts for about 50% of EU<br />
generation)--include the cost of CO2 emissions in<br />
their cost base and pricing decisions. All other<br />
things being equal, the higher the price of CO2<br />
allowances, the greater the impact on power<br />
prices. EU fossil fuel power generators that emit<br />
CO2 receive “free” allowances, however, under<br />
NOVEMBER 2007 ■ 33
UTILITIES<br />
34 ■ NOVEMBER 2007<br />
their respective governments’ national allocation<br />
plans (NAPs). These plans are vetted and<br />
approved by the EU. Allowances for Phase 1 are<br />
already known, while Phase 2 allowances are<br />
currently being finalized. Even though a generator<br />
will have received free allowances to cover its<br />
carbon emissions, it will still price emission costs<br />
as if it had purchased the allowances from the<br />
market, leading to higher wholesale prices. For<br />
many generators, these higher wholesale prices<br />
drop directly to the bottom line as windfall<br />
profits, either because the allowance was never<br />
purchased or because the generator (nuclear and<br />
hydro plants, for example) does not emit<br />
greenhouse gases. Companies currently benefiting<br />
from windfall profits are those operating in the<br />
U.K., German, and Nordic electricity markets,<br />
and include E.ON AG (AA-/Watch Neg/A-1+),<br />
RWE AG (A+/Negative/A-1), EnBW Energie<br />
Baden-Wuerttemberg AG (A-/Stable/A-2),<br />
Vattenfall AB (A-/Stable/A-2), Scottish and<br />
Southern Energy PLC (A+/Stable/A-1), Scottish<br />
Power PLC (A-/Watch Neg/A-2), and EDF Energy<br />
PLC (A/Stable/A-1).<br />
Approved NAPs indicate a tighter market in<br />
Phase 2 of the ETS<br />
The <strong>European</strong> Commission has now decided on<br />
the first 20 national plans for allocating CO2<br />
emission allowances to energy-intensive industrial<br />
plants and the power sector for Phase 2 of the<br />
ETS (see table on next page). Seventeen of the 20<br />
member states were told to reduce proposed<br />
allowances by almost 12.5% on average, while<br />
allowances for the U.K., France, and Slovenia<br />
were approved as presented (the adjustment to<br />
Spain’s proposed cap was negligible). To date, the<br />
overall cap allowed by the EU for Phase 2 is<br />
about 9% lower than the cap allowed for Phase 1.<br />
It is likely the electricity generation companies<br />
will take a significant share of this tightening<br />
through a lower allocation of free allowances in<br />
Phase 2. From an equity standpoint, the electricity<br />
generation companies may be best positioned to<br />
absorb a lower level of allowances given that they<br />
benefit from higher CO2-induced power prices<br />
while industrial and residential power users bear<br />
the cost.<br />
The tightening in Phase 2 could lead to stronger<br />
CO2 and power prices, albeit that the precise<br />
impact and direction for prices depends on a large<br />
number of other factors such as the generation<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
mix, oil and gas prices, and demand. This<br />
highlights the EU’s continuing commitment to<br />
cutting greenhouse gas emissions, and to meeting<br />
targets under the Kyoto Protocol.<br />
Windfall profits will diminish as free allowances<br />
go down<br />
Under Phase 1 of the ETS, free allowances<br />
covered a very significant share of generators’<br />
actual and forecast CO2 emissions. Despite an<br />
expected reduction of free allowances granted to<br />
generators in Phase 2, we expect the windfall<br />
profits generated in liberalized energy markets-such<br />
as the U.K., Germany, and the Nordic<br />
market--to continue, albeit to a lesser extent,<br />
reflecting a pricing strategy based on the marginal<br />
cost of generation (i.e. including emissions costs).<br />
The windfall benefit remains controversial<br />
because it applies not only to nonemitting<br />
facilities but to all--including coal plants, which<br />
emit the most GHGs. Many industrial end users<br />
have voiced their discontent. They maintain that<br />
while end users suffer from the higher cost of<br />
electricity due to the cost of CO2 emissions, the<br />
electricity generators--those actually releasing<br />
much of the CO2--are gaining incremental profits.<br />
As a result, Standard & Poor’s expects that the<br />
level of free emission allowances granted to fossil<br />
fuel-fired generators may continue to go down in<br />
future phases of the ETS (2012 and beyond).<br />
These generators will therefore either have to buy<br />
a greater proportion of their carbon allowances in<br />
the market or actually reduce CO2 emissions.<br />
They could cut their carbon output by switching<br />
generation from coal-fired to less CO2-intensive<br />
gas-fired generation, improving the efficiency of<br />
their coal plants, or by using carbon capture and<br />
sequestration (CCS) storage technology.<br />
Climate Change Policies Present<br />
<strong>In</strong>vestment Challenges<br />
<strong>In</strong> addition to its focus on slowing climate change,<br />
the EU is also trying to increase competition in<br />
the power sector and to reduce dependence on<br />
imported gas, two goals that it believes are<br />
compatible. EU climate change and market<br />
liberalization policies have to date favored gas<br />
and--to a much lesser extent--wind power in the<br />
generation mix at the expense of coal, as wind<br />
and gas are cleaner than coal and it takes less<br />
time to build a gas plant than it does to build a<br />
coal plant, an important factor in liberalized
Member State Annual CO2 Allowances Under The EU Emissions Trading Scheme<br />
markets. From a security-of-supply perspective,<br />
however, the resulting larger exposure to gas<br />
imports, particularly from Russia, raises a number<br />
of concerns about the EU’s import dependency.<br />
For <strong>European</strong> utilities, these potentially conflicting<br />
priorities present challenges in investment<br />
planning. This emphasizes the potentially<br />
important role that could be played by<br />
technologies to reduce the CO2 intensity of coal<br />
and by nuclear power in mitigating security-ofsupply<br />
risk while meeting GHG reduction targets.<br />
The <strong>European</strong> Council’s recent decision to<br />
adopt a variable 20%-30% GHG reduction target<br />
by 2020 reflects the still significant uncertainty<br />
about the form and breadth that any successor<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
(Mil. tons) Cap 2005 Verified Cap allowed Additional emissions<br />
2005-2007 2005-2007 emissions 2008-2012 in 2008-2012*<br />
Austria 33.0 33.4 30.7 0.4<br />
Belgium 62.1 55.6¶ 58.5 5.0<br />
Czech Republic 97.6 82.5 86.8 N/A<br />
Estonia 19.0 12.6 12.7 0.3<br />
France 156.5 131.3 132.8 5.1<br />
Hungary 31.3 26.0 26.9 1.4<br />
Germany 499.0 474.0 453.1 11.0<br />
Greece 74.4 71.3 69.1 N/A<br />
Ireland 22.3 22.4 21.2 N/A<br />
Latvia 4.6 2.9 3.3 N/A<br />
Lithuania 12.3 6.6 8.8 0.1<br />
Luxembourg 3.4 2.6 2.7 N/A<br />
Malta 2.9 2.0 2.1 N/A<br />
The Netherlands 95.3 80.4 85.8 4.0<br />
Poland 239.1 203.1 208.5 6.3<br />
Slovakia 30.5 25.2 30.9 1.7<br />
Slovenia 8.8 8.7 8.3 N/A<br />
Spain 174.4 182.9 152.3 6.7§<br />
Sweden 22.9 19.3 22.8 2.0<br />
U.K. 245.3 242.4** 246.2 9.5<br />
Total 1,834.7 1,685.2** 1,663.5 53.4<br />
*The figures indicated in this column comprise emissions from installations that come under the coverage of the scheme in 2008-2012 due to an extended<br />
scope applied by the member state and do not include new installations entering the scheme in sectors already covered in the first trading period.<br />
¶<strong>In</strong>cluding installations that Belgium opted to exclude temporarily from the scheme in 2005. §Additional installations and emissions of more than 6 million<br />
tons are already included as of 2006.**Excluding installations that the U.K. opted to exclude temporarily from the scheme in 2005 but that will be covered<br />
in 2008-2012 and are estimated to amount to about 30 million tons. CO2--Carbon dioxide. N/A--Not applicable. Source: DG Environment (reference:<br />
IP/07/613, May 4, 2007).<br />
treaty to the Kyoto Protocol may take (assuming<br />
that the successor treaty has sufficient<br />
international support, the EU is willing to commit<br />
to a 30% reduction target, if all developed<br />
nations agree to comparable targets). <strong>In</strong> addition,<br />
companies operating with GHG constraints under<br />
the ETS do not know what the absolute level of<br />
GHG caps will be beyond Phase 2, or what the<br />
level of free allowances at the installation or<br />
company level will be. Of course, if the EU were<br />
to adopt a 30% rather than a 20% GHG<br />
reduction target, the emissions cap would need to<br />
be tighter to support a higher emissions price and<br />
the higher target. Electricity generators operating<br />
in liberalized markets such as the U.K., Germany,<br />
NOVEMBER 2007 ■ 35
UTILITIES<br />
38 ■ NOVEMBER 2007<br />
Evolving political climate suggests long-term<br />
potential for increased nuclear generation<br />
The long-term outlook for significant nuclear<br />
construction is better today than it has been for<br />
many years. If the industry can overcome its<br />
unique problems of safety, decommissioning, and<br />
waste storage, and if political and social<br />
acceptance increases, a new generation of power<br />
plants could be built in the U.K. New build is<br />
currently being undertaken in France and Finland,<br />
with potential for new plants in the Baltic region<br />
and across a number of the Eastern <strong>European</strong><br />
member states. The German nuclear consensus,<br />
which caps the lifetime of nuclear plants at 32<br />
years and requires them to be phased out, could<br />
possibly be revisited, although the policies of<br />
Germany’s main political parties differ sharply on<br />
the question of nuclear power.<br />
Nuclear has a competitive advantage in terms<br />
of CO2 emissions and security-of-supply risk<br />
mitigation, and longer term visibility on the price<br />
of CO2 and the level of allowances that will be<br />
provided to fossil-fuel generators, for example,<br />
could have a strong impact on the profitability of<br />
new nuclear generation.<br />
Clean Coal And CCS Could Allow<br />
Coal-Heavy Economies To Meet<br />
Reduction Targets<br />
GHG reduction targets could present mediumterm<br />
credit risk to companies that are heavily<br />
exposed to coal-fired generation such as Drax<br />
Power Ltd. (BBB-/Stable/--). Larger, more<br />
diversified companies like CEZ a.s. (A-/Stable/--),<br />
Vattenfall, and RWE that also generate power<br />
using coal face increasing risk that the relative<br />
economics and social acceptance of coal-fired<br />
generation may deteriorate.<br />
Although liberalization and climate change<br />
policies favor gas-fired over coal-fired generation,<br />
the latter reduces fuel supply risk and dependence<br />
on fuel imports from Russia, the Middle East, and<br />
Africa. Recognizing this and the economic and<br />
social dependence of several EU countries on coal,<br />
the <strong>European</strong> Council has urged member states<br />
and the Commission to work toward<br />
strengthening R&D and developing the necessary<br />
technical, economic, and regulatory frameworks<br />
to deploy environmentally safe CCS through new<br />
fossil-fuelled power plants--if possible, by 2020.<br />
According to the EU, “coal can continue to make<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
its valuable contribution to the security of energy<br />
supply and the economy of both the EU and the<br />
world as a whole only with technologies allowing<br />
for drastic reduction of the carbon footprint of<br />
its combustion.”<br />
Policymakers and certain generators are<br />
therefore researching ways of making coal more<br />
efficient and environmentally friendly, primarily<br />
through “clean coal” technologies and CCS. RWE<br />
has made it clear that it will continue to build<br />
coal plants, but with the help of clean-coal<br />
technologies it will achieve CO2 reduction<br />
requirements. Vattenfall has similar plans.<br />
Cleaner coal is possible, but there are drawbacks<br />
The two leading clean-coal technologies are<br />
integrated gasification combined-cycle technology<br />
(IGCT) and supercritical technology. IGCT turns<br />
coal into gas (usually hydrogen and other byproducts)<br />
and then burns this gas in a traditional<br />
gas-fired combined-cycle unit (with some<br />
modification to accommodate the burning of<br />
hydrogen). Supercritical technology works on the<br />
principle that the fuel efficiency of a traditional<br />
steam coal plant can be raised if it operates at a<br />
higher temperature and pressure. Both approaches<br />
have drawbacks, however. Supercritical<br />
technology, although no more expensive than<br />
traditional techniques, does not reduce CO2<br />
emissions to anywhere near the levels of other<br />
fuels. And IGCT’s effectiveness comes at a cost,<br />
threatening the relative economics of coal<br />
production and reducing the incentive for<br />
companies to invest in new coal plants.<br />
CCS could enhance competitive position of coalfired<br />
generation, despite costs<br />
CCS involves capturing carbon and piping it<br />
underground before it reaches the atmosphere.<br />
The technology could significantly enhance the<br />
competitive position of coal-fired generation by<br />
alleviating its environmental impact, which would<br />
enable coal to maintain a role in the EU<br />
generation mix and would also mitigate securityof-supply<br />
risk. CCS has a number of<br />
disadvantages, however: Its use would increase<br />
costs, and its technical effectiveness and<br />
scalability is still unproven. Nevertheless,<br />
decarbonizing economies and industrial and<br />
generation processes clearly will not happen<br />
without cost and investment, and the EU and a
number of member states have announced their<br />
intention to champion CCS technical<br />
development. The U.K. government, for example,<br />
announced in March 2007 a competition to<br />
develop the U.K.’s first full-scale CCS<br />
demonstration (the details are likely to be<br />
announced in the U.K.’s Energy Policy White<br />
Paper, which could be published as early as May<br />
2007). And the EU has said it would like to see<br />
12 large-scale CCS projects operational by 2015<br />
CCS. It also aspires to seeing CCS capture 4.5%<br />
of CO2 emissions from fossil fuel power plants by<br />
2020, rising to 30% by 2030.<br />
The future of coal-fired generation will be<br />
significantly affected by the extent to which<br />
member states will subsidize or otherwise<br />
incentivize CCS. <strong>In</strong> the absence of such support,<br />
CCS development could be hindered and could<br />
render coal uneconomical and further weaken its<br />
competitive position in the generation mix. Given<br />
the importance of coal-fired generation to the<br />
EU’s goal of easing supply risk, however, we<br />
expect policymakers to continue examining ways<br />
to speed the development of clean-coal and<br />
CCS technologies.<br />
Note<br />
<strong>In</strong> 2004, public electricity and heat production<br />
accounted for 24% of EU-15 GHG emissions.<br />
The other main sources were road transportation<br />
(19%), manufacturing industries and construction<br />
(13%), industrial processes (8%), agriculture<br />
(9%), residential emissions (10%), waste (3%),<br />
and oil refining (3%).<br />
Additional writing by Anna Crowley. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
NOVEMBER 2007 ■ 39
UTILITIES<br />
Publication Date:<br />
Aug. 29, 2007<br />
Issuer Credit Rating:<br />
AA-/Stable/A-1+<br />
Primary Credit Analyst:<br />
Hugues De La Presle,<br />
Paris,<br />
(33) 1-4420-6666<br />
Secondary Credit Analyst:<br />
Beatrice de Taisne,<br />
London,<br />
(44) 20-7176-3938<br />
40 ■ NOVEMBER 2007<br />
ELECTRICITE DE FRANCE S.A.<br />
Rationale<br />
The ratings on French electricity incumbent<br />
Electricité de France S.A. (EDF) reflect its standalone<br />
creditworthiness--which would ensure an<br />
‘A+’ rating--and a one-notch uplift for state<br />
support, given the group’s primary focus on<br />
nuclear power generation and the entailed<br />
significant operational risks and<br />
decommissioning liabilities.<br />
EDF’s stand-alone credit quality reflects the<br />
significant contribution to earnings, especially in<br />
France, of regulated businesses; its leading<br />
position by far in the only moderately competitive<br />
French generation and supply market,<br />
underpinned by its efficient nuclear generation<br />
fleet; the refocusing of its international operations<br />
on Western Europe; and its superior free<br />
operating cash flow generation. These strengths<br />
are offset to a degree by EDF’s financial profile<br />
which, although improving, remains moderate<br />
given sizable unfunded postretirement and<br />
nuclear liabilities.<br />
EDF’s French operations (64% of 2006<br />
EBITDA) are split between regulated transmission<br />
and distribution operations (40% of French<br />
EBITDA), and competitive generation and supply<br />
operations (60%). EDF’s leading position in the<br />
latter is underpinned by its efficient nuclear<br />
plants, which accounted for 88% of its French<br />
electricity production in 2006. EDF’s French<br />
supply operations benefit only in part from higher<br />
wholesale power prices, however, as about twothirds<br />
of sales are made at much lower, regulated<br />
supply prices. These have been rising recently,<br />
albeit slowly.<br />
The group has refocused its international<br />
operations on the U.K. (9% of 2006 EBITDA),<br />
Germany (7%), and Italy (6.6%). EDF’s financial<br />
profile has improved with funds from operations<br />
(FFO) coverage of adjusted net debt of 22.5% in<br />
2006, thanks to the group’s superior free cash<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
flow generation, which, excluding tax<br />
exceptionals of €0.5 billion, was €6.2 billion in<br />
2006. To a large extent this reflects the cash flow<br />
profile of EDF’s nuclear plants, which, while<br />
running, are highly cash generative given low<br />
variable costs and limited capital expenditure<br />
for maintenance.<br />
EDF’s financial profile remains moderate,<br />
though, given substantial net unfunded nuclear<br />
and postretirement benefit obligations of €19<br />
billion and €10.6 billion, respectively, in 2006.<br />
EDF will be increasing its dedicated assets<br />
covering nuclear liabilities by €12.1 billion<br />
between 2006 and 2010, however.<br />
Short-term credit factors<br />
The ‘A-1+’ short-term rating is supported by<br />
EDF’s strong liquidity and recurring free cash<br />
flow generation. EDF’s available cash and<br />
liquidity of €13.4 billion at year-end 2006--which<br />
includes the proceeds of the €6.35 billion capital<br />
increase at the end of 2005--together with a €6<br />
billion undrawn long-term syndicated bank<br />
facility maturing in 2012 at the Electricité de<br />
France level, more than adequately cover the<br />
group’s €8.7 billion of long- and short-term<br />
financial debt maturing in 2007.<br />
Outlook<br />
The stable outlook reflects Standard & Poor’s<br />
Ratings Services’ expectation that EDF will<br />
maintain a financial profile in line with the<br />
ratings, in particular FFO coverage of fully<br />
adjusted net debt in excess of 20% (22.5% in<br />
2006). EDF has the flexibility within the current<br />
ratings to carry out its significant €26 billion<br />
investment program for 2006-2008. The ratings<br />
also factor in EDF’s retention of significant<br />
regulated operations and the continued support of<br />
the Republic of France (AAA/Stable/A-1+). ■
Publication Date:<br />
Aug. 10, 2007<br />
Issuer Credit Rating:<br />
A/Watch Neg/A-1<br />
Primary Credit Analyst:<br />
Ana Nogales,<br />
Madrid,<br />
(34) 91-788-7206<br />
Secondary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
ENDESA S.A.<br />
Rationale<br />
The ratings on Spanish utility Endesa S.A. were<br />
placed on CreditWatch with negative implications<br />
on Sept. 6, 2005, at the start of what has since<br />
been a very long and protracted bidding war for<br />
this company.<br />
On April 11, 2007, Italian utility Enel SpA<br />
(A/Watch Neg/A-1) and Spanish construction<br />
company Acciona S.A. (not rated) announced a<br />
€41.3 per share conditional all-cash joint<br />
takeover bid for the remaining 54% of Endesa’s<br />
that they do not own. This represents an offer<br />
value of nearly €25 billion. Enel has a 25% stake<br />
in Endesa, and Acciona owns 21%. The offer has<br />
received all regulatory approvals and is now<br />
subject only to shareholder approval.<br />
The CreditWatch status reflects the risks and<br />
uncertainties that surround this new bid, as well<br />
as those presented by Endesa’s potential future<br />
strategy and financial structure after the<br />
prospective change of ownership. Furthermore,<br />
Endesa’s business profile will change if the offer is<br />
successful, owing to the asset split agreed between<br />
the new bidders and German utility, E.ON AG<br />
(A/Stable/A-1). The agreement stipulates that<br />
E.ON will receive a portfolio of Endesa assets in<br />
Spain, Turkey, and Poland, as well as Endesa’s<br />
share of Endesa France and Endesa Italia, and<br />
assets in Spain owned by Enel (through Enel-<br />
Viesgo), for a total estimated value of<br />
€10 billion.<br />
The terms and conditions of the bid reflect Enel<br />
and Acciona’s March 26, 2007, agreement. The<br />
offer is conditional upon a minimum acceptance<br />
of 50% of the share capital and the amendment<br />
of some of Endesa’s bylaws, including the removal<br />
voting-right restrictions. Acciona will purchase<br />
about 4% of Endesa’s capital, and Enel will<br />
purchase the rest of the tendered shares; both<br />
companies, however, will have equal<br />
representation on Endesa’s board.<br />
One of the world’s largest electricity utilities,<br />
Endesa has total installed capacity of 47,385 MW<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
and 22.7 million customers. It has a market share<br />
of about 40% of Spain’s electricity production,<br />
distribution, and supply. This strong domestic<br />
position is one of the main rating supports.<br />
Operations in Spain and Portugal provided about<br />
55% of EBITDA in 2006 and 52% in the first<br />
half of 2007.<br />
Short-term credit factors<br />
The short-term rating is ‘A-1’, reflecting Endesa’s<br />
acceptable liquidity. At June 30, 2007, the<br />
company (excluding subsidiary Enersis S.A.<br />
{BBB/Stable/--}) had €6.2 billion in undrawn,<br />
committed facilities, and about €0.3 billion in<br />
cash and equivalents, which together cover the<br />
final dividend paid against 2006 earnings on July<br />
2, 2007, and debt maturing over the next<br />
23 months.<br />
At the same date, Enersis had €0.5 billion in<br />
undrawn, committed facilities, and about €0.5<br />
billion in cash, together covering debt maturing at<br />
Enersis over the next 19 months. Endesa’s debt<br />
maturity schedule is manageable, and the average<br />
life of the debt is 5.3 years.<br />
According to Endesa, there are no cross-default<br />
clauses for the debt at Enersis or any of its<br />
subsidiaries, and these entities are financed on a<br />
nonrecourse basis.<br />
Endesa generated funds from operations of<br />
about €4.6 billion in 2006. This strong<br />
performance should continue, mitigating the<br />
financial-flexibility constraints arising from the<br />
utility’s large capital-expenditure plan and<br />
generous dividend policy. Endesa is committed to<br />
paying out 100% of capital gains on asset<br />
disposals and increasing ordinary dividends by at<br />
least 12% annually. This will result in the<br />
payment of €9.9 billion in dividends over 2005-<br />
2009, of which €4.4 billion has already been<br />
paid. A change in financial, investment, and<br />
dividend policies may result, however, from the<br />
prospective change in control. ■<br />
NOVEMBER 2007 ■ 41
UTILITIES<br />
Publication Date:<br />
Nov. 12, 2007<br />
Issuer Credit Rating:<br />
A/Watch Neg/A-1<br />
Primary Credit Analyst:<br />
Ana Nogales,<br />
Madrid,<br />
(34) 91-788-7206<br />
Secondary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
42 ■ NOVEMBER 2007<br />
ENEL SPA<br />
Rationale<br />
The ratings on Enel SpA remain on CreditWatch<br />
with negative implications, where they were<br />
placed on April 3, 2007, following the company’s<br />
€40 billion joint debt-financed takeover bid with<br />
Spanish construction firm Acciona S.A. for 100%<br />
of Spanish utility Endesa S.A. (A/Watch Neg/A-1).<br />
The continued CreditWatch listing reflects<br />
Standard & Poor’s Ratings Services’ expectations<br />
that Enel’s financial profile will further deteriorate<br />
as a result of the tender offer for Endesa. The<br />
offer was completed on Oct. 1, 2007, and Enel<br />
now owns 67% of Endesa. <strong>In</strong> connection with<br />
this acquisition, Enel and Acciona will sell certain<br />
Enel and Endesa assets in Italy, France, Poland,<br />
Turkey, and Spain to German utility E.ON AG<br />
(A/Stable/A-1) in the first half of 2008 for an<br />
expected €13 billion-<br />
€14 billion.<br />
We expect to resolve the CreditWatch status<br />
once details about Enel’s business strategy and<br />
capital structure are available.<br />
The current ratings reflect Enel’s significant<br />
position in the Italian power market, which is<br />
sustained by its vertically integrated operations.<br />
The acquisition of Endesa should enhance Enel’s<br />
business profile, through increased size and<br />
diversification. <strong>In</strong> addition, operating synergies<br />
could be material. Enel’s ability to reap the<br />
potential benefits, however, will depend on its<br />
degree of control of Endesa and the functioning<br />
of its partnership with Acciona. Although the<br />
transaction will enhance Enel’s business profile, it<br />
will lead to a material deterioration in the<br />
company’s financial position, notwithstanding the<br />
benefit of the asset sales to E.ON. Enel’s debtfinanced<br />
investment in Endesa totals about<br />
€28 billion (equity value). This compares with<br />
net reported debt of €24.8 billion at Sept. 30,<br />
2007, which already included the debt financing<br />
of a 25% Endesa stake.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Enel’s acquisition earlier this year of about<br />
€1.8 billion in Russian assets and its desire to<br />
become an integrated energy player in the Russian<br />
market will also weigh negatively on the<br />
company’s credit quality, due to country and<br />
industry risks, as well as to the financial impact.<br />
The company’s public announcement that it has<br />
now almost completed its M&A activity and that<br />
it will focus on integrating all of its international<br />
assets somewhat reduces acquisition-related risks.<br />
Short-term credit factors<br />
Enel’s short-term rating is ‘A-1’. At Sept. 30,<br />
2007, the company had committed credit lines of<br />
€5 billion, of which €2 billion had been drawn,<br />
and uncommitted credit lines of €2.6 billion, of<br />
which €0.9 billion had been drawn. The finance<br />
documentation for these facilities does not include<br />
material covenants. <strong>In</strong> addition, Enel had a €35<br />
billion committed credit line to fully finance the<br />
Endesa acquisition, which has now been reduced<br />
to €23 billion after the June and September bond<br />
issues and the results of the Endesa tender offer.<br />
This credit line is split into three tranches with<br />
different maturities: 1) one year, subject to a termout<br />
option for a further 18 months, for a residual<br />
amount of €2.5 billion; 2) three years, for a<br />
residual amount of €12.3 billion; and 3) five<br />
years, for a residual amount of €8.2 billion.<br />
Consequently, short-term refinancing risk seems<br />
modest. Given Enel’s size and market position,<br />
and the successful placement of its $3.5 billion<br />
bond issued in the U.S., access to the capital<br />
markets and the ability to issue debt of an<br />
appropriate tenor are not credit concerns, even<br />
under current market conditions. Enel’s ultimate<br />
debt profile, in terms of maturity and<br />
composition, will depend upon the permanent<br />
financing that it arranges to replace the<br />
acquisition facility. ■
Publication Date:<br />
Aug. 28, 2007<br />
Issuer Credit Rating:<br />
A/Stable/A-1<br />
Primary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
Secondary Credit Analysts:<br />
Ralf Etzelmueller,<br />
Frankfurt,<br />
(49) 69-33-999-123<br />
Amrit Gescher,<br />
London,<br />
(44) 20-7176-3733<br />
E.ON AG<br />
Rationale<br />
The ratings on Germany-based utility E.ON AG<br />
factor in that the company will releverage its<br />
balance sheet through increased organic<br />
investment, a share buyback, and acquisition<br />
expenditure. Specifically, the ratings incorporate<br />
the assumption that the company’s funds from<br />
operations (FFO) to net adjusted debt will remain<br />
above 20% and at levels commensurate with an<br />
‘A’ rating (absent any greater-than-expected<br />
increase in business risk that could necessitate a<br />
higher level of credit protection).<br />
E.ON’s revised medium-term strategy includes<br />
significant organic growth investments (a €60<br />
billion investment program has been budgeted<br />
through 2010), increased returns to shareholders<br />
(a €7 billion share buyback by the end of 2008),<br />
and more active management of the balance sheet.<br />
Further to E.ON’s decision to withdraw its €70<br />
billion bid for Endesa S.A. (A/Watch Neg/A-1) of<br />
Spain, E.ON has an agreement with Enel SpA<br />
(A/Watch Neg/A-1) and Acciona to acquire<br />
generation assets from Enel and Endesa mainly in<br />
Italy, Spain, and France for an estimated<br />
enterprise value of €10 billion, if Enel and<br />
Acciona gain control of Endesa. Large<br />
acquisitions also remain possible but are expected<br />
to be funded in line with the company’s minimum<br />
rating target of ‘A’ and its 3x economic net debtto-EBITDA<br />
target ratio (barring any material<br />
change in its business risk). As at Dec. 31, 2006,<br />
E.ON calculated that its ratio of economic net<br />
debt to EBITDA was 1.5x.<br />
Standard & Poor’s Ratings Services regards the<br />
company’s business risk profile, pro forma for the<br />
new higher investment program, as slightly<br />
increased compared with the Endesa acquisition<br />
bid, owing to the lack of acquired vertical<br />
integration (including distribution assets) and<br />
focus on riskier growth markets.<br />
E.ON expects its <strong>European</strong> generation capacity<br />
to increase by 50% to 69 gigawatts (GW) from<br />
46 GW by 2010, of which about 12 GW will<br />
come from generation assets and projects<br />
acquired under the agreement with Enel and<br />
Acciona. A materially increased earnings<br />
contribution from undiversified generation or<br />
from riskier growth markets could ultimately<br />
weaken E.ON’s business risk profile. That said,<br />
the company still clearly recognizes the benefit of<br />
integrated generation and supply operations and<br />
fairly matched position, especially in highly<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
competitive markets, as well as a proactive<br />
generation margin hedging policy (for 2007 and<br />
2008, 90% and more than 60%, respectively, of<br />
E.ON’s economic generation has been hedged).<br />
Short-term credit factors<br />
The short-term rating on E.ON is ‘A-1’, reflecting<br />
the company’s significant cash flows, a securities<br />
portfolio totaling about €11 billion at Dec. 31,<br />
2006 (notionally available to meet future pension<br />
and nuclear liabilities), and significant unused<br />
facilities--specifically, an undrawn €10 billion<br />
syndicated multicurrency loan.<br />
E.ON’s liquidity also benefits from the group’s<br />
significant operating cash flow. <strong>In</strong> 2006, under<br />
U.S. GAAP, cash provided by operating activities<br />
was almost €7.2 billion, which comfortably<br />
financed E.ON’s 2006 capital expenditure of<br />
€4.1 billion, and made a significant contribution<br />
to the group’s €4.6 billion dividend paid in 2006.<br />
Although capital and investment expenditure will<br />
increase significantly and free cash flows before<br />
dividends might be negative and reach a low<br />
point in 2008, a significant portion of firmly<br />
planned capital expenditures and increased<br />
dividends should remain internally funded over<br />
2007-2009. Ongoing financial flexibility is<br />
supported by the largely discretionary nature of<br />
the planned investments as well as E.ON’s wide<br />
and discrete asset base, which could be reduced<br />
without affecting crucial core operations.<br />
Outlook<br />
The ratings factor in E.ON’s plans to significantly<br />
releverage its balance sheet. The stable outlook<br />
reflects the company’s continued strong financial<br />
flexibility. The ratings could conceivably improve<br />
in the case of a better-than-expected business<br />
profile, for example due to riskier investments not<br />
materializing (and barring other material changes<br />
in the company’s business environment).<br />
A significantly better-than-expected financial<br />
profile could also have a positive effect on the<br />
ratings. The ratings could deteriorate, for<br />
example, due to greater-than-expected business<br />
risk from German or EU-wide regulatory<br />
initiatives or significantly increased exposure to<br />
the Russian Federation or Eastern Europe.<br />
Neither scenario is expected to have an impact on<br />
the ratings in the near term, owing to E.ON’s<br />
clearly articulated strategy and its strong financial<br />
profile for the ratings. ■<br />
NOVEMBER 2007 ■ 43
UTILITIES<br />
Publication Date:<br />
Sept. 3, 2007<br />
Issuer Credit Rating:<br />
AA-/Watch Neg/A-1+<br />
Primary Credit Analyst:<br />
Hugues De La Presle,<br />
Paris,<br />
(33) 1-4420-6666<br />
Secondary Credit Analyst:<br />
Beatrice de Taisne,<br />
London,<br />
(44) 20-7176-3938<br />
44 ■ NOVEMBER 2007<br />
GAZ DE FRANCE S.A.<br />
Rationale<br />
On Sept. 3, 2007, Standard & Poor’s Ratings<br />
Services said that its ‘AA-/A-1+’ ratings on French<br />
gas utility Gaz de France S.A. (GDF) remain on<br />
CreditWatch with negative implications following<br />
the announcement of the revised terms for the<br />
merger between GDF and Franco-Belgian multiutility<br />
Suez S.A. (A-/Watch Pos/A-2). The ratings<br />
were placed on CreditWatch on Feb. 27, 2006,<br />
following the initial merger announcement.<br />
The continued negative CreditWatch reflects<br />
that, notwithstanding changes in the terms of the<br />
merger, it should have a dilutive impact on GDF<br />
from a credit standpoint--in terms of both<br />
business and financial risk--given Suez’s weaker<br />
business mix and financial profile. This is despite<br />
the fact that the merger would address GDF’s<br />
strategic issues, especially those related to its<br />
plans to expand further abroad and in electricity.<br />
From a business risk perspective, although Suez<br />
is larger and more diversified than GDF, Standard<br />
& Poor’s views GDF’s business risk as lower,<br />
given the large share of earnings it derives from<br />
regulated French businesses. From a financial risk<br />
perspective, although Suez’s financial profile has<br />
improved, its credit ratios remain significantly<br />
weaker than GDF’s.<br />
Under the revised terms, 21 GDF shares will be<br />
exchanged for 22 Suez shares, with no special<br />
dividend being paid. <strong>In</strong>itially the terms of the<br />
merger were a one-for-one share exchange plus a<br />
€1 billion special dividend to be paid to Suez<br />
shareholders prior to completion. To mitigate the<br />
difference in the share prices of Suez and GDF,<br />
65% of the share capital of Suez’s environment<br />
arm (20% of first-half 2007 Suez EBIT) will be<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
spun off to Suez’s shareholders at the time of the<br />
merger, with the enlarged group retaining a 35%<br />
stake. The environment business had reported net<br />
debt of €5.4 billion at the end of June 2007,<br />
out of Suez’s reported consolidated debt of<br />
€12.9 billion.<br />
Although the lack of a special dividend and the<br />
spin-off of Suez Environment--given its significant<br />
debt--are favorable from a financial standpoint<br />
compared with the initial terms, the enlarged<br />
group intends to offer substantial returns to its<br />
shareholders. From a business perspective,<br />
although the <strong>European</strong> water operations (39% of<br />
the EBIT of Suez Environment in first-half 2007)<br />
rank amongst Suez’s strongest businesses, they<br />
would have been small in the context of the<br />
enlarged group.<br />
These revised terms are a significant step<br />
forward but the merger still faces some hurdles,<br />
especially its approval by both groups’<br />
shareholders; the signing of the decree allowing<br />
the privatization of GDF following the passing of<br />
the law in the French parliament; and the<br />
opposition of GDF’s unions.<br />
To resolve the CreditWatch placement we will<br />
focus on the enlarged group’s strategy and<br />
financial policy.<br />
Short-term credit factors<br />
The ‘A-1+’ short-term rating is supported by<br />
GDF’s sound liquidity, with available cash at the<br />
end of June 2007 of about €3 billion and an<br />
undrawn €3 billion committed syndicated credit<br />
facility, which more than cover short-term debt<br />
maturing in the next 12 months of €1.1 billion.<br />
Beyond 2007, GDF has limited debt maturities. ■
Publication Date:<br />
July 4, 2007<br />
Issuer Credit Rating:<br />
A/Watch Neg/A-1<br />
Primary Credit Analyst:<br />
Ana Nogales,<br />
Madrid,<br />
(34) 91-788-7206<br />
Secondary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
IBERDROLA S.A.<br />
Rationale<br />
The ratings on Spanish utility Iberdrola S.A.<br />
remain on CreditWatch with negative implications<br />
following the acquisition of Scottish Power PLC<br />
(A-/Watch Neg/A-2) on April 23, 2007, and the<br />
company’s announcement on June 25, 2007, of its<br />
bid to acquire 100% of U.S. utility Energy East<br />
Corp. (BBB+/Negative/A-2).<br />
For a summary of Iberdrola’s CreditWatch<br />
history, see the section “CreditWatch History”<br />
toward the end of this article.<br />
Iberdrola will pay €3.4 billion in cash and<br />
assume Energy East’s debt of €3 billion. The<br />
transaction, subject to approval by Energy East’s<br />
shareholders and to receipt of all the necessary<br />
authorizations, is expected to close in the second<br />
half of 2008. Notwithstanding this, Iberdrola has<br />
already raised close to €3.4 billion of new equity<br />
to fund this transaction.<br />
Energy East is a holding company that owns six<br />
regulated utilities (mainly transmission and<br />
distribution) and several smaller, nonregulated<br />
companies in upstate New York, Connecticut,<br />
Maine, and Massachusetts.<br />
The ratings will remain on CreditWatch<br />
pending Standard & Poor’s meeting with<br />
Iberdrola in the second half of 2007 to discuss the<br />
group’s revised business and financial strategy and<br />
analyze its financial forecasts and planned<br />
financial structure. We will also focus on the<br />
group’s future risk tolerance and acquisition<br />
strategy. Standard & Poor’s understands that<br />
Iberdrola aims to maintain an ‘A’ category rating.<br />
Based on publicly available information, we<br />
expect any lowering of our long-term rating on<br />
Iberdrola upon resolution of the CreditWatch<br />
listing to be limited to one-to-two notches. This<br />
preliminary assessment does not, however, include<br />
the potential fiscal benefits from the amortization<br />
of the goodwill from the acquisition of Scottish<br />
Power PLC or from synergies from Scottish<br />
Power’s integration within Iberdrola.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
Iberdrola’s strong position as one of Spain’s two<br />
largest vertically integrated electricity groups<br />
underpins the ratings. The recently acquired<br />
business will increase the group’s earnings<br />
diversity, both geographic and operational, but<br />
will result in a weaker capital structure and will<br />
present integration challenges. At March 31,<br />
2007, the group’s debt and EBITDA pro-forma<br />
figures (including the Scottish Power acquisition)<br />
were €29.8 billion and €5.8 billion, respectively.<br />
Short-term credit factors<br />
Iberdrola’s short-term rating is ‘A-1’, underpinned<br />
by an acceptable liquidity position prior to the<br />
acquisition of Scottish Power. At end-March<br />
2007, available cash, short-term financial<br />
investments of €1.15 billion, and committed<br />
undrawn credit facilities of €2.2 billion, more<br />
than fully covered the €1.1 billion in debt<br />
maturing in 2007. <strong>In</strong> addition, the group<br />
announced on May 28, 2007, that it intends to<br />
carry out a partial IPO of the combined group’s<br />
renewable business, which could generate<br />
€3.3 billion-€4.5 billion.<br />
CreditWatch History<br />
The ratings on Iberdrola were placed on<br />
CreditWatch with negative implications on Sept.<br />
6, 2005, following Spanish utility Gas Natural<br />
SDG, S.A.’s (A+/Negative/A-1) €22.55 billion bid<br />
for a 100% stake in Endesa S.A. (A/Watch<br />
Neg/A-1) and its agreement to a subsequent sale<br />
of an estimated €7 billion-€9 billion in assets to<br />
Iberdrola. On Dec. 1, 2006, we lowered our longterm<br />
rating on Iberdrola to ‘A’ from ‘A+’, owing<br />
to the group’s offer for Scottish Power made on<br />
Nov. 28, 2006. The ratings on Iberdrola have<br />
remained on CreditWatch with negative<br />
implications since then, despite the withdrawal of<br />
Gas Natural’s bid on Feb. 1, 2007, owing to the<br />
expected negative financial impact of the<br />
acquisition of Scottish Power. ■<br />
NOVEMBER 2007 ■ 45
UTILITIES<br />
Publication Date:<br />
Aug. 17, 2007<br />
Issuer Credit Rating:<br />
A+/Negative/A-1<br />
Primary Credit Analyst:<br />
Peter Kernan,<br />
London,<br />
(44) 20-7176-3618<br />
Secondary Credit Analysts:<br />
Amrit Gescher,<br />
London,<br />
(44) 20-7176-3733<br />
Ralf Etzelmueller,<br />
Frankfurt,<br />
(49) 69-33-999-123<br />
46 ■ NOVEMBER 2007<br />
RWE AG<br />
Rationale<br />
The ratings on Germany-based utility RWE AG<br />
reflect the group’s strong competitive position in<br />
the German electricity market, which provides the<br />
majority of group earnings and has delivered<br />
sustained strong operating performance. The<br />
ratings also reflect the group’s strong financial<br />
profile. These strengths are partially offset by the<br />
weakening of RWE’s business profile following<br />
the sale of its regulated water operations and its<br />
reliance on competitively exposed generation for<br />
future growth.<br />
Competition in the German retail market<br />
remains moderate. Nevertheless, the introduction<br />
of a network regulator and tariff cuts will likely<br />
increase competitive pressures. Meanwhile, RWE’s<br />
substantially lower level of freely granted carbon<br />
dioxide (CO2) allowances for phase 2 of the EU<br />
Emissions Trading Scheme (2008-2012) will likely<br />
reduce generation margins. (RWE estimates that<br />
slightly more than 50% of its German CO2<br />
emissions will be covered by free allowances.)<br />
RWE will, however, benefit from changes in the<br />
German tax regime, which will result in the<br />
average tax rate on German profits dropping to<br />
31% from about 39%, from 2008.<br />
RWE’s balance sheet has further strengthened<br />
following the sale of RWE Thames Water for an<br />
enterprise value of £8.0 billion (sale price of £4.8<br />
billion plus pro forma net debt of £3.2 billion) in<br />
December 2006. At June 30, 2007, net debt<br />
(including pension provisions, and under RWE’s<br />
definition) was €6.8 billion. RWE plans to<br />
complete the sale of its U.S. water business<br />
through an IPO by the end of 2007, subject to<br />
market conditions, which will further deleverage<br />
the group. RWE has a general net debt cap of<br />
between €22 billion and €24 billion and has<br />
substantial headroom relative to this cap to<br />
increase leverage. RWE has material nuclear asset<br />
retirement obligations, of which Standard &<br />
Poor’s Ratings Services treats about €7 billion<br />
as debt.<br />
The group’s financial performance has been<br />
strong over the past few years, with funds from<br />
operations (FFO) increasing to more than €7<br />
billion for full-year 2006, on the back of strong<br />
power prices. The medium-term outlook for<br />
power prices continues to be favorable on the<br />
back of tight capacity margins and tightness in<br />
fuel markets--given strong global demand for<br />
commodities--as well as a tighter market for CO2.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
RWE’s target for 2007 is that revenue will rise<br />
slightly above the 2006 level of €44.2 billion and<br />
that EBITDA will rise by between 5% and 10%<br />
above the 2006 level of €7.17 billion.<br />
There is an ongoing debate within the EU about<br />
levels of competition in power markets, and a<br />
draft third liberalization directive is expected later<br />
in 2007. Among other areas, the debate has<br />
focused on ownership unbundling of transmission<br />
businesses to increase competition. Such a<br />
measure could adversely affect RWE’s German<br />
business, but Standard & Poor’s currently<br />
considers that it is unlikely that this change will<br />
be required.<br />
Short-term credit factors<br />
The ‘A-1’ short-term rating is underpinned by<br />
large and diversified cash flows (cash flows from<br />
operating activities were in excess of €2.5 billion<br />
for the six months to June 30, 2007), RWE’s<br />
current low level of net debt, and a benign<br />
maturity profile. The rating is also supported by<br />
substantial alternative sources of liquidity,<br />
including more than €12 billion of liquid<br />
securities held to offset on-balance-sheet nuclear<br />
liabilities. At Dec. 31, 2006, €5.5 billion of<br />
RWE’s €20.0 billion debt issuance program was<br />
available. RWE faces a moderate maturity peak of<br />
about €3.7 billion in 2007. <strong>In</strong> addition, the<br />
company had unused funds of €3.5 billion<br />
equivalent under its $5.0 billion CP program at<br />
Dec. 31, 2006.<br />
Outlook<br />
RWE’s financial profile is strong for the ratings.<br />
The negative outlook, however, reflects some<br />
near-term uncertainty about the direction of<br />
RWE’s strategy, financial and acquisitions<br />
policies--in part due to planned changes in senior<br />
management--and the manner in which RWE<br />
could releverage its balance sheet.<br />
The deterioration of RWE’s business profile as a<br />
result of the water disposals could negatively<br />
affect the ratings if the disposals are followed by<br />
rapid and substantial investments in riskier<br />
operations. To maintain the ratings, RWE needs<br />
to restrict itself to moderate-scale or low-risk<br />
acquisitions, and maintain conservative financial<br />
policies. The outlook could be revised to stable<br />
if RWE maintains its current strong<br />
financial profile. ■
Publication Date:<br />
Aug. 30, 2007<br />
Issuer Credit Rating:<br />
A+/Stable/A-1<br />
Primary Credit Analyst:<br />
Paul Lund,<br />
London,<br />
(44) 20-7176-3715<br />
Secondary Credit Analyst:<br />
Mark J Davidson,<br />
London,<br />
(44) 20-7176-6306<br />
SCOTTISH AND SOUTHERN ENERGY PLC<br />
Rationale<br />
The ratings on U.K.-based energy utility Scottish<br />
and Southern Energy PLC (SSE) and its<br />
subsidiaries are supported by strong, predictable<br />
cash flows from the group’s regulated monopoly<br />
electricity and gas network businesses, which will<br />
likely contribute 40%-45% of operating profits<br />
over the medium term. The group’s strong<br />
financial profile, low-cost generation portfolio,<br />
and strong cost-cutting record also support<br />
the ratings.<br />
These strengths are offset by the exposure of<br />
SSE’s operating profits to movements in<br />
wholesale-power, coal, and gas prices as well as<br />
the risk of customer losses in the highly<br />
competitive electricity and gas retail markets. An<br />
increase in the proportion of profits derived from<br />
the group’s unregulated businesses, which is likely,<br />
could increase business risk.<br />
SSE is the third-largest electricity and gas<br />
supplier in the U.K. in terms of customer<br />
numbers. <strong>In</strong> June 2007, its customer base had<br />
increased to about 5 million electricity and 2.9<br />
million gas customers, despite a period of<br />
significant increases in electricity and gas supply<br />
prices. The company remains the cheapest<br />
supplier of energy and was the first to reduce<br />
prices on March 1, 2007, lowering average<br />
annual electricity and gas bills by 5% and 12%,<br />
respectively. The group has a relatively diverse<br />
fuel portfolio compared with other U.K. powerstation<br />
operators, which provides good<br />
operational flexibility and risk mitigation in<br />
volatile markets.<br />
SSE’s long generating and contractual position<br />
in relation to its residential supply volumes<br />
exposes its cash flows to greater long-term price<br />
risk than some of its peers (although this position<br />
is beneficial in a high wholesale-price<br />
environment). Accordingly, cash flows at SSE are<br />
vulnerable to a downward shift in long-term gas<br />
and power prices, although any such trend should<br />
largely be offset by higher supply margins. <strong>In</strong><br />
addition, the company’s diverse fuel portfolio<br />
allows for optimization of fuel sources.<br />
Standard & Poor’s Ratings Services<br />
proportionally consolidates the accounts of gas<br />
distribution networks Southern Gas Networks<br />
PLC (BBB/Positive/--) and Scotland Gas Networks<br />
PLC (BBB/Positive/--)--including £1.1 billion of<br />
debt at March 31, 2007--into SSE’s financial<br />
statements. This reflects our view that the two<br />
entities (together known as Scotia) represent a<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
core investment for the group. Excluding Scotia,<br />
SSE’s financial profile remains solid. Adjusted<br />
EBITDA grew by more than 21% to £1.42 billion<br />
in the year ended March 31, 2007, from £839<br />
million one year earlier. Standard & Poor’s<br />
adjusted gross consolidated debt figure for SSE,<br />
excluding Scotia, was £2.66 billion at March 31,<br />
2007. This includes approximately £400 million<br />
in adjustments for operating leases, postretirement<br />
debt obligations, and power purchase agreements.<br />
Short-term credit factors<br />
The short-term rating is ‘A-1’. SSE has<br />
satisfactory liquidity, with a £650 million, fiveyear<br />
committed revolving credit facility due in<br />
2009 to cover maturing obligations (principally<br />
CP). SSE’s debt is generally long term, with only<br />
£40 million due to mature before March 2008.<br />
The group has good access to CP markets under<br />
a €1.5 billion program, which it has used<br />
only lightly.<br />
SSE will likely be required to raise debt and<br />
refinance maturing bonds to fund capital<br />
expenditures in 2008. The group has good access<br />
to capital markets, although it is a relatively<br />
infrequent issuer. Some financial flexibility is<br />
available from its dividends. SSE’s financial<br />
flexibility has improved, as its additional debt<br />
requirement should be reduced in view of<br />
planning issues that are expected to delay the<br />
Beauly-Denny transmission line (which will have<br />
a knock-on effect on investment in major<br />
renewables projects in Scotland).<br />
Outlook<br />
The stable outlook reflects the likelihood that SSE<br />
will maintain cash flow protection measures in<br />
line with our expectations. Consolidated FFO to<br />
interest, excluding 50% contributions from Scotia<br />
that Standard & Poor’s rates on a consolidated<br />
basis, will likely remain close to current levels of<br />
about 9x, with FFO to debt at about 42%.<br />
Acquisition activity could, however, result in<br />
higher-than-expected debt levels, which could put<br />
pressure on the ratings. Furthermore, lower-thanexpected<br />
gas or electricity prices, or any largescale<br />
customer loss, could threaten cash flow<br />
ratios, which could also weigh on the ratings.<br />
Retaining customers and energy-supply margins<br />
will be challenging as wholesale prices fall back<br />
from the peaks of 2005 and 2006. Ratings upside<br />
potential is very limited over the short term. ■<br />
NOVEMBER 2007 ■ 47
UTILITIES<br />
Publication Date:<br />
Sept. 3, 2007<br />
Issuer Credit Rating:<br />
A-/Watch Pos/A-2<br />
Primary Credit Analyst:<br />
Hugues De La Presle,<br />
Paris,<br />
(33) 1-4420-6666<br />
Secondary Credit Analyst:<br />
Beatrice de Taisne,<br />
London,<br />
(44) 20-7176-3938<br />
48 ■ NOVEMBER 2007<br />
SUEZ S.A.<br />
Rationale<br />
On Sept. 3, 2007, Standard & Poor’s Ratings<br />
Services said that its ‘A-/A-2’ ratings on Franco-<br />
Belgian multi-utility Suez S.A. remain on<br />
CreditWatch with positive implications, following<br />
the announcement of the revised terms for the<br />
merger between Suez and French gas utility Gaz<br />
de France S.A. (GDF; AA-/Watch Neg/A-1+). The<br />
ratings were placed on CreditWatch on Feb. 27,<br />
2006, following the initial merger announcement.<br />
The continued positive CreditWatch reflects<br />
that, notwithstanding changes in the terms of the<br />
merger, it should have a beneficial impact on Suez<br />
from a credit standpoint--in terms of both<br />
business and financial risk. From a business risk<br />
perspective this reflects that, although Suez is the<br />
larger and more diversified company, Standard &<br />
Poor’s views GDF’s business risk as lower, given<br />
the large share of earnings it derives from<br />
regulated French businesses. Likewise, from a<br />
financial risk perspective, although Suez’s<br />
financial profile has improved significantly, GDF<br />
still has much stronger credit ratios.<br />
Under the revised terms, 21 GDF shares will be<br />
exchanged for 22 Suez shares, with no special<br />
dividend being paid. <strong>In</strong>itially the terms of the<br />
merger were a one-for-one share exchange plus a<br />
€1 billion special dividend to be paid to Suez<br />
shareholders prior to completion. To mitigate the<br />
difference in the share prices of Suez and GDF,<br />
65% of the share capital of Suez’s environment<br />
arm (20% of first-half 2007 Suez EBIT) will be<br />
spun off to Suez shareholders at the time of the<br />
merger, with the enlarged group retaining a 35%<br />
stake. The environment business had reported net<br />
debt of €5.4 billion at the end of June 2007, out<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
of Suez’s reported consolidated debt of<br />
€12.9 billion.<br />
Although the lack of a special dividend and the<br />
spin-off of Suez Environment--given its significant<br />
debt--are favorable from a financial standpoint<br />
compared with the initial terms, the enlarged<br />
group intends to offer substantial returns to its<br />
shareholders. From a business perspective,<br />
although the <strong>European</strong> water operations (39% of<br />
the EBIT of Suez Environment in first-half 2007)<br />
rank amongst Suez’s strongest businesses, they<br />
would have been small in the context of the<br />
enlarged group.<br />
These revised terms are a significant step<br />
forward but the merger still faces some hurdles,<br />
especially its approval by both groups’<br />
shareholders; the signing of the decree allowing<br />
the privatization of GDF following the passing of<br />
the law in the French parliament; and the<br />
opposition of GDF’s unions.<br />
To resolve the CreditWatch placement, we will<br />
focus on the enlarged group’s strategy and<br />
financial policy.<br />
Short-term credit factors<br />
Suez’s <strong>European</strong> utility activities’ recurring cash<br />
flow generation and strong liquidity underpin the<br />
‘A-2’ short-term rating. Debt maturities in the<br />
second half of 2007 amount to €5.1 billion<br />
(including €2.3 billion of CP) and represent €3.3<br />
billion and €3.5 billion, respectively, in 2008 and<br />
2009. These are covered by about €8 billion of<br />
available cash, excluding €1 billion of overdrafts<br />
in the next 12 months, while the group has €6.7<br />
billion of undrawn bank lines, excluding the €2.3<br />
billion of CP drawings. ■
Publication Date:<br />
June 11, 2007<br />
Issuer Credit Rating:<br />
A-/Stable/A-2<br />
Primary Credit Analyst:<br />
Mark Schindele,<br />
Stockholm,<br />
(46) 8-440-5918<br />
VATTENFALL AB<br />
Rationale<br />
The ratings on Sweden-based utility Vattenfall AB<br />
reflect its strong, vertically integrated position in<br />
the north <strong>European</strong> electricity market, competitive<br />
generation portfolio, significant monopoly utility<br />
operations, and strong cash flow generation.<br />
Negative rating factors include Vattenfall’s<br />
exposure to competition and price volatility in<br />
power generation, political risks related to nuclear<br />
and coal generation, and increasing regulatory<br />
pressure on monopoly network operations.<br />
Standard & Poor’s Ratings Services currently<br />
factors no direct support from Vattenfall’s 100%<br />
owner, the Kingdom of Sweden, into the ratings.<br />
Political and taxation pressures on the company<br />
have increased, although the Swedish<br />
government appears to have no plans for<br />
restructuring or major strategy changes. <strong>In</strong><br />
addition, there is no plan to privatize Vattenfall<br />
in the foreseeable future.<br />
Vattenfall’s capital expenditure is likely to<br />
increase over the medium term. By 2011, the<br />
company plans to invest about Swedish krona<br />
(SEK) 134 billion, mainly in new power<br />
generation capacity, reinforcement of its electricity<br />
network, and reinvestments.<br />
Following the integration of its acquired<br />
German operations, and the acquisition of<br />
SEK12.6 billion (on a net basis) of Danish power<br />
generation assets in 2006, we expect Vattenfall to<br />
continue its growth strategy and to be acquisitive<br />
--both in its current markets and in neighboring<br />
<strong>European</strong> countries. The number of potential<br />
acquisition targets will likely be limited and any<br />
acquisitions will be highly contested, however.<br />
Vattenfall’s financial performance remains<br />
strong for the ratings, with funds from operations<br />
to adjusted debt of about 39% in 2006 (treating<br />
SEK8.9 billion in hybrid capital notes as 50%<br />
debt and 50% equity). Standard & Poor’s expects<br />
Vattenfall to exploit the financial headroom in the<br />
current ratings through debt-financed acquisitions<br />
or capital expenditures. <strong>In</strong> the absence of major<br />
acquisitions or large scale capital expenditures,<br />
and in view of strong wholesale power price<br />
developments, funds from operations to adjusted<br />
debt should remain at above 30% over the<br />
medium term.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
UTILITIES<br />
Short-term credit factors<br />
Vattenfall’s short-term rating is ‘A-2’. The<br />
company is expected to have adequate internal<br />
liquidity over the short term, reflecting strong<br />
operating cash flow protected by hedging<br />
arrangements, and significant access to alternative<br />
sources of liquidity. Although much of Vattenfall’s<br />
operations are in highly competitive and volatile<br />
markets, movements in sales prices and volumes<br />
are not expected to have a material negative<br />
impact on the company’s liquidity and financial<br />
performance over the short term.<br />
The company’s adequate liquidity position is<br />
supported by the following factors:<br />
• Cash and short-term investments at March<br />
31, 2007 of about SEK27.9 billion,<br />
compared with SEK15.9 billion in shortterm<br />
debt.<br />
• Strong free operating cash flow (about<br />
SEK23.4 billion for the twelve months ended<br />
March 31, 2007), reflecting solid<br />
profitability and manageable capital<br />
expenditure needs in the utility operations.<br />
• Access to unused committed credit facilities<br />
of SEK9.7 billion as of March 31, 2007. <strong>In</strong><br />
February 2006, the company refinanced a<br />
€600 million revolving credit facility and at<br />
the same increased the amount to<br />
€1 billion. The new revolver matures in<br />
2013, and the company has good access to<br />
public debt markets.<br />
•The absence of rating triggers or onerous<br />
covenants in Vattenfall’s financing<br />
agreements.<br />
• Free operating cash flow is expected to<br />
remain at SEK5 billion-15 billion a year,<br />
based on sustained operating profitability.<br />
• Company policy is to maintain the<br />
equivalent of 10% of group turnover in cash<br />
or committed credit lines, or the equivalent<br />
of the next 90 days’ debt maturities,<br />
whichever is greater.<br />
Outlook<br />
The stable outlook reflects the increasing<br />
regulatory and political pressure in Vattenfall’s<br />
main markets, which tempers the prospect of<br />
continued improved credit quality from its current<br />
NOVEMBER 2007 ■ 49
UTILITIES<br />
50 ■ NOVEMBER 2007<br />
strong level. Such pressure has resulted in<br />
increasing shareholder demands, stricter<br />
regulation, and an increased focus on<br />
environmental and energy policy objectives for<br />
the company. Further adverse political or<br />
regulatory actions cannot be ruled out.<br />
The stable outlook also reflects our expectation<br />
that Vattenfall will continue its growth strategy,<br />
remain acquisitive, and increase capital<br />
expenditures over the medium term. This could<br />
weaken the financial profile from its current,<br />
strong, level, although we do not expect the<br />
company to jeopardize its objective of<br />
maintaining a rating in the ‘A’ category. <strong>In</strong> the<br />
current environment, with increased political and<br />
regulatory uncertainty, upside ratings potential<br />
is limited. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
TRANSPORTATION INFRASTRUCTURE<br />
Standard & Poor’s rates a wide range of transportation infrastructure entities in Europe, including<br />
airports, rail companies, toll road concessions, and ports. Continuing the trend of recent years,<br />
2007 has been characterized by further M&A and privatization activity, with sponsors seeking to<br />
significantly increase debt leverage on the back of solid business risk profiles to fund the acquisition<br />
price or provide for shareholder returns. As a result, we have seen a number of ratings on stable<br />
investment-grade entities withdrawn, only to be replaced by much more aggressive--and likely noninvestment-grade--financial<br />
structures. Whether such structures are sustainable over the business cycle as<br />
it becomes more challenging remains to be seen.<br />
<strong>In</strong> recent years, acquisition has been the easiest part of the equation given the plentiful supply of<br />
credit and this, for the vendor, has given meaty returns. For some new owners, the second stage--the<br />
syndication of the acquisition debt into the secondary loan market or refinancing through the capital<br />
market--is proving more elusive. For example, the approximate £6.7 billion of acquisition debt<br />
following the acquisition of BAA PLC by Spanish infrastructure company Grupo Ferrovial S.A. remains<br />
outstanding 18 months after the launch of the acquisition despite the intention to undertake a capital<br />
markets refinancing. While the delay reflects a combination of factors, including the regulatory process<br />
and the complexity of the structure being developed, it will be interesting to watch the eventual<br />
execution and the price at which that occurs, given the changing climate of the credit markets.<br />
Government support is and will remain a key credit factor, particularly for the rail industry. Yet,<br />
government budgetary constraints caused by weak economic conditions are putting increasing pressure<br />
on state support for some rail entities. State support is likely to remain integral to the operation of rail<br />
infrastructure and services in Europe, although more privatizations in the long term cannot be ruled out<br />
as countries look to alternative ownership and funding structures.<br />
During 2007, Standard & Poor’s assigned its first ratings in the transportation sector in the Middle<br />
East to Dubai-based port operator DP World Ltd. As part of the company’s financing activity a rating<br />
was also assigned to an Islamic finance sukuk instrument. The importance of the relationship with the<br />
government is fundamental to ratings within these jurisdictions, given the ownership structure and the<br />
significant social policy role that such companies often take.<br />
<strong>In</strong> general, most rated companies in the sector continue to perform well on the back of economic<br />
growth and positive industry developments such as the ongoing growth of low-cost airlines in the<br />
case of airports. The sustainability of these positive market features in the long term may become a<br />
challenge to transportation infrastructure credits, although companies with prudent management<br />
strategies, solid operations, and manageable financial risk are likely to continue to meet the challenges<br />
that the future brings.<br />
Jonathan MManley<br />
Senior Director and Co-Team Leader<br />
Project <strong>Finance</strong> and Transportation <strong><strong>In</strong>frastructure</strong><br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
Lidia PPolakovic<br />
Senior Director and Co-Team Leader<br />
Project <strong>Finance</strong> and Transportation <strong><strong>In</strong>frastructure</strong><br />
NOVEMBER 2007 ■ 51
Publication Date:
<strong>In</strong> addition, on March 22, 2007, the EU<br />
approved an aviation deal with the U.S. that will<br />
increase deregulation of the transatlantic airline<br />
market by opening up restricted routes. As a<br />
result, we expect air traffic between Europe and<br />
the U.S. to continue to increase over the next five<br />
years, starting in 2008. For instance, the lifting of<br />
previous U.K./U.S. bilateral constraints on air<br />
service provision between Heathrow and the U.S.<br />
is to be implemented at Heathrow in time for<br />
summer 2008. The impact is currently being<br />
assessed by BAA Ltd. (BBB+/Watch Neg/--) using<br />
latest airline thinking, but previous assessments<br />
suggested small net gains to London system<br />
airports (2.3 million passengers in total over the<br />
course of the next five-year regulatory periods Q5<br />
and Q6). The impact may be higher for hub<br />
airports with more slot capacity.<br />
Finally, 2007 traffic growth should be in line or<br />
slightly better than semi-annual growth for some<br />
airports. Traffic was very high this summer, which<br />
will benefit annual traffic levels: The 2006<br />
summer season was slightly affected by a<br />
temporary and limited passenger shortfall<br />
following the 2006 terrorist alerts in London and<br />
subsequent reinforcement of security measures<br />
across the EU.<br />
First-half 2007 annual traffic growth was<br />
healthy, but slowed down for one-half of the<br />
airports compared with the same period of 2006.<br />
Given increasing capacity constraints in most<br />
<strong>European</strong> airports, more limited but steady<br />
growth could prove easier to manage from a<br />
capital planning point of view.<br />
<strong>European</strong> Airports Traffic Growth<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
A detailed analysis suggests the following main<br />
traffic drivers:<br />
• <strong>In</strong>ternational traffic continues to grow more<br />
rapidly than domestic traffic, which is likely<br />
to remain the case.<br />
• Among international traffic, non-<strong>European</strong><br />
(transfer) traffic has proved particularly<br />
dynamic.<br />
•Low-cost carriers continue to grow more<br />
rapidly than others and represent a<br />
constantly climbing percentage of passengers<br />
at some airports; the airports’ traffic<br />
growth is, therefore, increasingly reliant on<br />
the success of these carriers.<br />
Successful airport operators are those that are<br />
not yet constrained by capacity and can<br />
accommodate growing passenger volumes, while<br />
some hubs (Heathrow and Frankfurt, for<br />
example) are increasingly constrained. As a result<br />
of its spare capacity, Aeroports de Paris (ADP;<br />
AA-/Stable/--) recorded the highest traffic growth<br />
rates among major <strong>European</strong> airports in first-half<br />
2007, as in the three previous years, and is likely<br />
to benefit again from strong traffic growth in<br />
2007; ADP has raised its full-year 2007 passenger<br />
growth guidance to between 4% and 4.4%,<br />
versus 3.7%-4.2% previously. Traffic was actually<br />
up 5.2% in the first nine months of 2007.<br />
Continental regional and O&D airports<br />
continued to post the strongest growth and to<br />
outperform hubs, mainly as a result of expansion<br />
in the low-cost segment. Only U.K.-based airport<br />
operator Birmingham Airport Holdings Ltd.<br />
Growth Growth Passengers Growth Growth Growth Growth<br />
2007f January 2007- 2006 January 2006- January 2006- January 2005- January 2004-<br />
June 2007 December 2006 June 2006 December 2005 December 2004<br />
(%) (%) (mil.) (%) (%) (%) (%)<br />
Aeroporti di Roma SpA 6.0-7.0 8.4 35.1 6.7 6.6 7.3 9.2<br />
Aeroports de Paris 4.0-4.4 4.4 82.5 4.8 5.0 4.4 6.5<br />
BAA Ltd. 1.5-2.0 0.5 147.6 2.3 3.1 3.0 6.9<br />
Birmingham Airport Holdings Ltd. N.A. (0.5) 9.3 (2.5) 0.4 5.8 (2.3)<br />
Brussels Airport Co. (The) 4.0-5.0 3.5 16.7 3.3 4.4 3.5 2.9<br />
Copenhagen Airports A/S 4.0-6.0 2.3 20.9 4.5 6.3 5.0 7.5<br />
Dublin Airport Authority PLC 7.5-8.0 8.4 27.8 15.0 16.2 12.4 6.6<br />
FML Ltd. (East Line Group) 19.0 19.0 15.4 10.1 12.5 15.6 29.0<br />
Manchester Airport Group PLC (The) 5.0 2.1 28.8 3.0 3.3 3.0 5.5<br />
N.V. Luchthaven Schiphol 4.0 3.9 46.1 4.3 4.0 3.8 6.5<br />
Unique (Flughafen Zurich AG)<br />
f--Forecast. N.A.--Not available.<br />
7.0 8.1 19.2 7.6 6.0 3.7 1.3<br />
NOVEMBER 2007 ■ 53
TRANSPORTATION INFRASTRUCTURE<br />
54 ■ NOVEMBER 2007<br />
(BIA; A-/Stable/A-2) showed negative 0.5%<br />
growth in the first half of 2007: the semi-annual<br />
figure suggests traffic is however decreasing less<br />
rapidly than in full-year 2006 (2.5%). Second-half<br />
2007 and 2008 will be crucial to confirm whether<br />
this decline suggests a departure from BIA’s longterm<br />
growth trend.<br />
Improved profitability and cash flow generation<br />
overall but pressures mounting for some airports<br />
We expect most rated <strong>European</strong> airports’ EBITDA<br />
to improve in 2007, on the basis of more traffic,<br />
increases in airport charges, higher nonaeronautical<br />
revenues, and the implementation of<br />
cost-cutting measures. Reported interim accounts<br />
at June 30, 2007 by ADP, Brussels, Copenhagen<br />
or Schiphol airports support that view; only<br />
Aeroporti di Roma SpA (AdR; BBB/Watch Neg/<br />
A-2) is showing a negative evolution. The disposal<br />
of ADR Handling and Italy’s 2007 budget law<br />
impacted AdR’s reported EBITDA, which was<br />
down 2.9% against the first semester of 2006.<br />
Without this, EBITDA would have grown by<br />
3.4%.<br />
<strong>In</strong>creased security and utilities costs could<br />
hamper EBITDA growth, however, particularly if<br />
rising costs are not offset by sufficient traffic and<br />
revenue growth or cost control. Brussels Airport<br />
reported a strong 14% EBITDA growth in its<br />
2007 interim accounts, illustrating management’s<br />
ability to cut operating costs; not all airports have<br />
such a track record and pressures could rise in the<br />
short to medium term for some of them.<br />
<strong>In</strong> some <strong>European</strong> regional airports (notably in<br />
the U.K.) aeronautical revenue is set to grow<br />
more slowly than passenger volume in the future,<br />
reflecting price incentives offered to grow traffic<br />
levels and the increasing proportion of low-cost<br />
traffic. This is due to smaller airports increasingly<br />
competing with more established regional hubs,<br />
as well as a continuing shift in market segments<br />
resulting in a growing reliance on low-cost traffic.<br />
Aeronautical yields per passenger have actually<br />
started to decline at Manchester Airport Group<br />
PLC (MAG; A/Stable/--) and the same could<br />
happen at BIA due to the company’s growing<br />
exposure to low-cost traffic and aggressive pricing<br />
competition. So far, decline in aeronautical<br />
income has been offset by the resilience of<br />
nonaeronautical income. That might not always<br />
be the case, though, and ultimately steady cash<br />
flow generation could be at risk.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Most airports have benefited from increasing<br />
revenues and profits from their real estate-related<br />
businesses in the past years. Future contributions<br />
from that segment could shrink or prove less<br />
buoyant than in the past if the business and<br />
commercial real estate markets stabilize or decline<br />
after several years of sustained growth. We will<br />
continue monitoring airports’ strategies in real<br />
estate, its stability as a revenue source, and if any<br />
property development risks are being taken that<br />
we would consider as weakening the airport’s<br />
business risk profile.<br />
Governance and financial aspects paramount for<br />
future ratings stability<br />
The rating implications of overall higher<br />
profitability and stronger internal cash flow<br />
generation will depend on the use shareholders<br />
make of additional cash flow: The funding of<br />
capital spending or capital structure improvement<br />
will be neutral to positive from a credit<br />
perspective. Conversely, increasing distribution<br />
payout or M&A activity could put some pressure<br />
on the ratings.<br />
A clear example of that is Brussels Airport.<br />
Profitability and cash flow generation have been<br />
on the rise following the 2005 privatization, but<br />
we lowered the rating to ‘BBB’ from ‘BBB+’ in<br />
June 2007, following a significant special<br />
distribution of €310 million to shareholders<br />
(subject to meeting certain performance hurdles).<br />
As the company was operating under a financing<br />
structure limiting extraordinary dividends,<br />
the shareholders had to make a recapitalization to<br />
repay existing debt in order to make<br />
their distribution.<br />
Looking ahead, it is crucial that airports<br />
maintain good credit quality and access to<br />
external funding for their capital expenditures<br />
and refinancing needs. <strong>In</strong> this respect, not only do<br />
operational and financial performance matter<br />
but ownership and governance are also key<br />
credit factors.<br />
<strong>In</strong>creasingly complex structures are being put in<br />
place in order to extract money from the airport<br />
operating companies for distribution and/or<br />
refinancing of acquisition debt, due to a spike in<br />
investor interest in acquiring airports. Standard &<br />
Poor’s rigorously examines ownership<br />
arrangements and changes so as to measure the<br />
debt obligations that are, directly or indirectly,<br />
supported by an airport’s operations. <strong>In</strong> June
2007, the ‘BBB/A-2’ ratings on AdR were placed<br />
on CreditWatch with negative implications. The<br />
placement reflected the growing short-term risk to<br />
AdR’s credit quality posed by the--ultimately<br />
successful--proposal by Gemina SpA (not rated)<br />
to buy out Macquarie Airports’ (Map)<br />
(BBB/Stable/--) 45% stake in AdR. Now that<br />
Gemina indirectly owns a 96% stake we will<br />
review the new ownership structure, focusing<br />
particularly on the now single, dominating<br />
shareholder. We will also evaluate any revisions to<br />
AdR’s business and financial strategies.<br />
Governance and financial policies are<br />
increasingly important considering the<br />
releveraging that has taken place in the airport<br />
industry over the past few years; in most airports<br />
financial flexibility is weak. <strong>In</strong> addition, some<br />
airports need to strengthen their financial<br />
profiles or complete a refinancing to maintain<br />
current ratings.<br />
Regulation will remain a long-term rating driver<br />
One key factor to stable credit quality is to<br />
recoup short-term operating and long-term capital<br />
costs, which speaks to regulation. 2007 has<br />
already brought some regulatory changes and<br />
more are on the agenda with several regulatory<br />
reviews of airport charges in progress. <strong>In</strong> any<br />
event, the way in which the regulators allow<br />
airports to fund construction and remunerate<br />
their investments will remain an important<br />
rating factor.<br />
The Competition Commission’s report to the<br />
U.K. Civilian Aviation Authority (CAA),<br />
published Oct. 3, 2007, proposes price controls at<br />
BAA’s primary airport facilities at Heathrow and<br />
Gatwick that are not materially different from the<br />
CAA’s December 2006 initial proposal. The report<br />
itself does not compromise BAA’s ability to<br />
execute a proposed corporate securitization<br />
refinancing, including the refinancing of BAA’s<br />
existing bonds into an investment-grade ringfenced<br />
entity. However, the proposed price<br />
controls are likely to affect the timetable for<br />
doing this, and, if the initial proposals remain<br />
unchanged, the overall amount of debt eventually<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
placed into the ring-fence structure. Firm<br />
proposals for the new price controls will not be<br />
revealed for the five-year period from April 2008-<br />
2013 until November 2007.<br />
On July 30, 2007, the Irish Commission for<br />
Aviation Regulation published its final decision on<br />
the maximum level of airport charges that may be<br />
set at Dublin Airport for 2006-2010. The<br />
commission decided not to increase the cap on<br />
airport charges at Dublin until 2010. The<br />
regulator made it clear that the financial<br />
sustainability of the airport (one of the regulator’s<br />
three main duties) can be achieved with an IG<br />
rating (high ‘BBB’ category), and, therefore,<br />
maintaining the current ‘A’ rating is not part of its<br />
statutory duty. However, airport passenger<br />
charges are likely to rise 22% between 2010 and<br />
2014. The price rise is aimed at helping DAA to<br />
pay for Terminal 2 and related projects. As the<br />
cost can only be recovered when the terminal is<br />
operational, DAA will have to borrow a<br />
significant amount to pay for the investment<br />
program. Standard & Poor’s will be reviewing<br />
DAA’s business plan in the next few weeks to<br />
assess the impact of the new debt on the rating.<br />
The ratings and outlook on ADP remained<br />
unchanged in July 2007 following the decision by<br />
the Conseil d’Etat (France’s highest administrative<br />
court) to cancel the 2006 tariff increase charged<br />
to carriers last year, on the grounds that the<br />
company did not supply adequate financial<br />
information to the consultative committee. The<br />
decision did not call into question the level of<br />
tariffs itself or imply repayment by ADP of the<br />
corresponding amounts. ADP will have to apply<br />
again to the consultative committee to validate<br />
last year’s tariff increase, as well as tariffs decided<br />
for 2007. Importantly, on April 25, 2007, the<br />
court had confirmed the validity of the five-year<br />
regulatory contract between ADP and the state,<br />
paving the way to implement annual tariff<br />
increases of up to 3.25% plus inflation until<br />
2010. On that basis, we expect ministerial<br />
confirmation of previously accepted 2006 and<br />
2007 tariff increases in the course of 2007. ■<br />
NOVEMBER 2007 ■ 55
TRANSPORTATION INFRASTRUCTURE<br />
Publication Date:<br />
Aug. 21, 2007<br />
Issuer Credit Rating:<br />
BBB+/WatchNeg/NR<br />
Primary Credit Analyst:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
Secondary Credit Analyst:<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
56 ■ NOVEMBER 2007<br />
BAA LTD.<br />
Major Rating Factors<br />
Strengths:<br />
■ Excellent competitive position as the<br />
dominant U.K. airport operator and the<br />
key hub in Europe<br />
■ Strong cash-generative business<br />
■ Diversification through ownership of a<br />
portfolio of airports assets<br />
■ Expected continued supportive regulatory<br />
environment and government policies<br />
Rationale<br />
The ratings on U.K.-based airports operator BAA<br />
Ltd. are supported by the company’s excellent<br />
business risk profile. BAA benefits from its<br />
ownership and operation of a portfolio of key<br />
U.K. airports catering for a diverse mix of<br />
passengers, and from supportive regulation and<br />
government policies. <strong>In</strong> addition, the key strategic<br />
position of its main asset, London Heathrow<br />
Airport, as a hub airport supports the company’s<br />
competitive position, while its capacity constraints<br />
are expected to ease gradually with the opening of<br />
Terminal 5 (T5) at Heathrow and the ongoing<br />
capital program. The ratings are constrained by<br />
BAA’s weakened financial profile, which reflects<br />
the company’s debt-funded capital program and<br />
limited financial flexibility.<br />
BAA was delisted following its effective<br />
acquisition by Airport Development and<br />
<strong>In</strong>vestment Ltd. (ADIL) (a consortium led by<br />
Grupo Ferrovial S.A.) on Aug. 15, 2006. The<br />
company was renamed BAA Ltd. in November<br />
2006. Work is underway for the ultimate<br />
financing structure, which is expected to conclude<br />
toward the end of 2007. The ring-fencing<br />
structure to be implemented under the financing<br />
will be key, as--given existing debt and acquisition<br />
debt at ADIL--the ratings on a consolidated basis<br />
would be in the ‘BB’ category.<br />
<strong>In</strong> the first six months of fiscal 2007, BAA’s<br />
passenger growth slowed to 0.5%, reflecting the<br />
impact of the tightening of security measures and<br />
uncertainty over further terrorist attacks.<br />
Higher pension and security costs as well as a<br />
lower retail income per U.K. passenger limited<br />
profitability and cash flow growth to lower-thanexpected<br />
levels in the 12 months to December<br />
2006, with the adjusted EBITDA margin--at<br />
41.6%--lower than in previous fiscal years (about<br />
45%). Adjusted funds from operations (FFO) to<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Weaknesses:<br />
■ Currently highly leveraged finance structure<br />
■ Major capital expenditure program resulting<br />
in steady negative free cash flow<br />
■ Forecast gradual increase in leverage, which<br />
will reduce financial flexibility<br />
debt and FFO interest coverage over the same<br />
period, at 10.6% and 2.7x, respectively, were,<br />
however, similar to those at fiscal year-end March<br />
2006 (10.8% and 2.8x, respectively).<br />
The ongoing CreditWatch status reflects<br />
uncertainties about the ultimate financing<br />
structure, which is expected to allow existing<br />
bonds to achieve a rating that is the same or<br />
higher than the corporate credit rating. Although<br />
the transaction is taking more time than originally<br />
anticipated in 2006, it has been progressing<br />
satisfactorily so far. Standard & Poor’s Ratings<br />
Services expects to resolve the CreditWatch<br />
placement by the end of 2007. If, as currently<br />
expected, all rated debt migrates to a new,<br />
investment-grade structure, the corporate credit<br />
rating would be withdrawn. <strong>In</strong> the event that the<br />
long-term financing strategy that ADIL is<br />
contemplating is not implemented, the ratings on<br />
BAA could fall to the ‘BB’ category, based on<br />
consolidated debt (including ADIL’s debt).<br />
Liquidity<br />
BAA’s liquidity is good, reflecting strong cash<br />
flow generation. At Dec. 31, 2006, available bank<br />
lines and cash in hand combined was £2.135<br />
billion (£1.764 billion at the end of June 2007).<br />
BAA is a joint obligor with its 100% parent ADIL<br />
on a £2.25 billion facility maturing in April 2011.<br />
At Dec. 31, 2006, £200 million had been drawn<br />
on the facility. <strong>In</strong> addition, overdraft facilities of<br />
£25 million were available. These facilities<br />
comfortably cover BAA’s negative free operating<br />
cash flow for 2007 (mainly due to capital<br />
expenditure investments) and forthcoming debt<br />
maturities. At June 30, 2007, BAA’s short-term<br />
debt maturities were modest, with only one bond<br />
maturing in the next 12 months--the convertible<br />
£424 million notes due in April 2008, which are<br />
100% owned by ADIL.
Business Description<br />
BAA’s core business is the ownership and<br />
operation of seven U.K. airports, including its<br />
three designated airports: Heathrow (including<br />
the Heathrow Express rail link), Gatwick, and<br />
Stansted, which serve London and southeast<br />
England, and together generate about 90% of<br />
group revenues. The company’s other airports are<br />
Southampton in southern England, and Aberdeen,<br />
Glasgow, and Edinburgh in Scotland.<br />
BAA also operates and owns a majority stake in<br />
Naples airport in Italy, has ownership and<br />
operational interests in six Australian airports,<br />
and runs retail or management contracts at three<br />
airports in the U.S. <strong>In</strong> addition, the company<br />
owns and operates World Duty Free and property<br />
management business BAA Lynton, although this<br />
operation is up for sale. Airport-related businesses<br />
(excluding duty free) account for more than 70%<br />
of total revenues.<br />
The ultimate parent company of ADIL in the<br />
U.K. is FGP Topco Ltd., a company owned by<br />
Ferrovial <strong>In</strong>fraestructuras S.A. (62%), Caisse de<br />
dépôt et placement du Québec (28%), and Baker<br />
Street <strong>In</strong>vestment Pte Ltd. (10%), an investment<br />
vehicle controlled by GIC Special <strong>In</strong>vestments.<br />
Rating Approach<br />
Since the June 2006 downgrade when ADIL’s<br />
offer for shares and convertible bonds became<br />
unconditional, we’ve adopted a forward-looking<br />
approach to the ratings. The ratings will remain<br />
on CreditWatch pending final execution of ADIL’s<br />
proposed permanent financing strategy following<br />
the acquisition. The ‘BBB+’ ratings reflects our<br />
expectation that existing bondholders will be<br />
migrated to a special-purpose vehicle, allowing<br />
BAA’s existing debt to be rated at least at the<br />
current rating level.<br />
The ring-fencing structure should also isolate<br />
the future credit quality of the regulated airport<br />
companies backing the new financing from ADIL<br />
and its ultimate parents.<br />
Business Risk Profile: Very Strong<br />
Competitive Position, Solid Operations,<br />
Supportive Regulation, High Profitability<br />
Excluding industry event risk, we expect BAA’s<br />
business risk profile to remain stable<br />
and supportive.<br />
BAA’s excellent business profile reflects its<br />
strong competitive position owing to: its location;<br />
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TRANSPORTATION INFRASTRUCTURE<br />
ownership of Europe’s main hub airport; diversity<br />
of airlines, destinations, and passengers; sound<br />
traffic growth prospects in the U.K.; and a<br />
supportive regulatory environment. The business<br />
profile is also supported by the diversification<br />
benefits of the company’s ownership of seven<br />
U.K. airports, each with different traffic<br />
characteristics. These strengths are only partly<br />
tempered by current capacity constraints at<br />
Heathrow and Gatwick and operational<br />
challenges pending the completion of the capital<br />
expenditure program.<br />
Competitive position<br />
BAA is the largest airport operator in Europe,<br />
handling about 148.0 million passengers (on a<br />
rolling basis) at its U.K. airports in the 12 months<br />
to June 2007. The company’s strong passenger<br />
potential derives from its large and wealthy<br />
catchment area and London’s position as Europe’s<br />
major financial center and a leading tourist<br />
destination. A further competitive strength is that<br />
all three London airports are linked to the center<br />
of London via high-speed rail links. BAA’s main<br />
hub, Heathrow, is Europe’s largest airport, with<br />
67.0 million passengers in the 12 months to June<br />
2007. Gatwick is also an important <strong>European</strong> hub<br />
airport, handling 34.5 million passengers in the<br />
same period.<br />
BAA’s Heathrow and Gatwick airports compete<br />
with Europe’s other major international hub<br />
airports for connecting passengers only, most<br />
notably Frankfurt, Amsterdam Airport Schiphol,<br />
and Paris Charles de Gaulle (CDG). Capacity<br />
constraints at Heathrow and Gatwick have<br />
somewhat affected their competitive positions. <strong>In</strong><br />
addition, the number of destinations served by<br />
Heathrow and Gatwick lags behind that of CDG,<br />
Frankfurt, and Schiphol. BAA, however, has<br />
higher frequency service to major destinations,<br />
which is an important factor for both travelers<br />
and airlines because it gives a choice of<br />
connections. <strong>In</strong> addition, Heathrow and Gatwick<br />
are less exposed than their peers to competition<br />
for transfer passengers or to any one particular<br />
airline, as both constitute a smaller proportion<br />
of traffic.<br />
Despite the additional capacity to be provided<br />
by T5 from 2008, Heathrow’s traffic is expected<br />
to grow more slowly than the expected long-term<br />
growth average in the U.K. and for other<br />
<strong>European</strong> hubs. This is due to runway capacity<br />
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constraints. Although the U.K. Aviation White<br />
Paper “The Future of Air Transport” (the White<br />
Paper), published in December 2003, proposes the<br />
construction of a third runway at Heathrow and<br />
additional terminal capacity, this is only expected<br />
by 2015-2020 if environmental conditions are<br />
met and the planning process runs smoothly.<br />
Aeronautical activity<br />
BAA is forecasting average passenger traffic<br />
growth for its three designated airports of 2.8%<br />
per year over the 2007-2018 period. This is below<br />
the expected natural growth rate in England of<br />
4.5% to 5.0%, reflecting capacity constraints at<br />
the London airports. <strong>In</strong>dustry events, erosion of<br />
passenger confidence, and a weak economic<br />
climate, could result in lower-than-expected<br />
passenger growth. Our long-term scenario is<br />
annual passenger growth of about 2%.<br />
Historical trends have demonstrated the<br />
stability of aeronautical activity at BAA’s airports<br />
and the increasing resilience of passenger demand<br />
behavior to external shocks. This supports BAA’s<br />
business profile. BAA has a record of more than<br />
40 years of almost continual traffic growth.<br />
During this period, only the years following the<br />
first oil crisis in 1974, the 1991 Gulf War, and the<br />
events of Sept. 11, 2001 showed traffic decreases.<br />
Nevertheless, with the exception of 1991, when<br />
traffic decreased by 7%, the rate of passenger<br />
volume decline was in the low single digits and<br />
was short lived.<br />
Since the beginning of the 2003-2008<br />
regulatory period, traffic performance at the<br />
designated airports has been mixed. BAA’s<br />
designated airports underperformed the<br />
regulatory assumptions in the fiscal years ended<br />
March 31, 2006, and Dec. 31, 2006 (the<br />
company’s fiscal year-end was changed during<br />
2006; see “Accounting” section), and<br />
outperformed the U.K. Civil Aviation Authority’s<br />
(CAA) assumptions in 2005. Based on first-half<br />
traffic figures, 2007 is likely to be below the<br />
CAA’s assumptions.<br />
<strong>In</strong> the first six months of fiscal 2007, traffic at<br />
BAA’s regulated airports was stable compared<br />
with the same period of the previous year, after a<br />
decline of 0.6% in June 2006. Performance at<br />
group level was stronger, with passenger growth<br />
at 0.5% (below the 1.1% increase in the 12<br />
month rolling period to June 2007), thanks to the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
performance of Southampton and the Scottish<br />
airports, which saw growth of 3.2% and 3.5%,<br />
respectively, over the period. The recent attempted<br />
terrorist attack at Glasgow airport contributed to<br />
a fall of 2.4% in June 2007, as more than 60% of<br />
flights were cancelled or diverted when the airport<br />
was temporarily closed in the immediate<br />
aftermath of the incident. Less than 24 hours<br />
after the incident the airport was reopened and<br />
operating a full flight schedule.<br />
A diversified airline, destination, and passenger<br />
mix supports traffic stability at BAA’s airports.<br />
Customer concentration and dependence on the<br />
lower rated airline sector are perceived as<br />
weaknesses for airports in general, when<br />
compared with gas and water utilities.<br />
Nevertheless, airports with strong competitive<br />
positions are partially insulated from this risk, as<br />
the strength of routes is key for traffic stability. If<br />
there is sufficient demand for a particular<br />
destination, it is expected that a failing airline<br />
serving that route would be substituted. Although<br />
BAA’s four largest customers contribute about<br />
one-half of its designated airports’ passenger<br />
traffic (the revenue contribution is lower),<br />
customer concentration is not perceived as a<br />
credit risk, particularly at Heathrow, where<br />
demand for slots exceeds supply. Of the hub<br />
airport operators rated by Standard & Poor’s,<br />
BAA has the lowest exposure to its flag carrier.<br />
For the nine months ended December 2006, 27%<br />
of total passenger traffic came from British<br />
Airways PLC (BBB-/Stable/--) (Heathrow 41%,<br />
Gatwick 21%). <strong>In</strong> comparison, Air France-KLM<br />
represented more than 50% of passengers at<br />
Aeroports de Paris (AA-/Stable/--) and more than<br />
60% at Schiphol (N.V. Luchthaven Schiphol and<br />
Schiphol Nederland B.V.; AA-/Negative/--).<br />
Each of BAA’s larger airports caters for different<br />
segments of the aviation market. This<br />
diversification is supportive of BAA’s business<br />
profile because the negative effects of a downturn<br />
in one segment can be offset by strong<br />
performance in others. Heathrow is the largest<br />
hub in Europe, and almost all carriers are<br />
scheduled rather than charter, while Gatwick is<br />
the main U.K. charter airport, with a growing<br />
low-cost carrier presence. Stansted is an origin<br />
and destination airport and the U.K. center for<br />
the low-cost airline business. Stansted’s rapid<br />
growth rates over the past 10 years result from
the rapid expansion of low-cost carriers Ryanair<br />
and easyJet. The Scottish and Southampton<br />
airports have a mixture of carrier types.<br />
BAA’s traffic base is relatively diversified across<br />
different markets. At the three London airports,<br />
the major destinations are Europe and North<br />
America, which accounted for 70% and 13% of<br />
total traffic in 2006, respectively. A balanced<br />
breakdown of business and leisure travel between<br />
U.K. and overseas residents supports<br />
diversification of the passenger mix.<br />
Revenue diversity and stability<br />
BAA’s revenue stability is directly linked to the<br />
stability of traffic and a tested tariff-setting regime<br />
(see “Regulation and government policy”). A high<br />
proportion of revenues also comes from retail<br />
activities. The company conducts a large<br />
percentage of its commercial activity directly.<br />
About 45% of retail revenues come from the<br />
World Duty Free franchise, which is directly<br />
managed by BAA. This direct involvement is not a<br />
negative factor because airport retail activities,<br />
particularly airside, are more stable than highstreet<br />
retail.<br />
BAA recognizes revenues and costs associated<br />
with the World Duty Free operations, and so<br />
retail revenues represent about 35% of total<br />
revenues. This contrasts with other <strong>European</strong><br />
airports, where commercial revenues, excluding<br />
properties, represent 20%-30% of the rated hubs’<br />
revenue structure.<br />
Regulation and government policy:<br />
London airports<br />
<strong>In</strong> 2007, BAA will be reviewed by the U.K.<br />
Competition Commission (CC) in two parallel<br />
reviews.<br />
The regulatory review for the period from<br />
2008-2009 to 2012-2013 (Q5, or the fifth<br />
quinquennium) will consider BAA’s past and<br />
forecast future performance, assess its costs of<br />
capital, make recommendations on the price-cap,<br />
and determine whether the company, in its<br />
management of the three London airports, has<br />
acted against the public interest.<br />
<strong>In</strong> a separate process, a review by the Office of<br />
Fair Trading (OFT) will investigate the structure<br />
of the U.K. airport market.<br />
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General principles.<br />
The framework for airport regulation in the U.K.<br />
is set by the Airports Act 1986, with aviation<br />
policy determined by the Department for<br />
Transport (DfT).<br />
Although the CAA is the primary economic<br />
regulator of U.K. airports, the CC has a<br />
mandatory role as an adviser to the CAA. The<br />
regulatory responsibilities of the CAA and the CC<br />
include a duty to encourage investment in new<br />
facilities at airports in time to satisfy anticipated<br />
passenger demand. Unlike other regulators, such<br />
as those in the water industry, the regulator has<br />
no wider responsibility to ensure that BAA attains<br />
a specified credit rating level. It must, however,<br />
ensure that the company is able to finance its<br />
activities. The CAA does not have the power to<br />
dedesignate an airport; this is held by the DfT.<br />
BAA benefits from strong government support<br />
for its business as it provides key infrastructure<br />
for economic growth in the U.K. Although there<br />
is no expectation that the government will provide<br />
funds to finance airport infrastructure, Standard<br />
& Poor’s expects that it and the economic<br />
regulator will continue to create conditions for<br />
longer term investment in the expansion of<br />
aviation capacity in southeast England.<br />
The White Paper clarified the government’s<br />
policies regarding airport expansion for the U.K.<br />
It emphasized the need for airport operators to<br />
invest in delivering new capacity.<br />
Price-cap mechanisms.<br />
Since 1986, the CAA has been required to set a<br />
five-year period price control formula fixing the<br />
maximum airport charges that may be levied at<br />
Heathrow, Gatwick, and Stansted on a standalone<br />
regulation basis (that is, by reference to<br />
each airport’s own air traffic, costs, and assets).<br />
The charges within the price-cap include runway<br />
landing, aircraft parking, and the departing<br />
passenger charge.<br />
The price-cap is set with reference to forecasts<br />
for traffic volumes, capital investment, operating<br />
costs, and operating revenues, as well as allowing<br />
BAA a reasonable rate of return on its<br />
investments. The formula follows a “single-till”<br />
approach, where retail and property activities<br />
subsidize aeronautical activities. To determine the<br />
price-cap, required revenues are calculated based<br />
on the sum of net expenditures, regulatory<br />
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60 ■ NOVEMBER 2007<br />
depreciation of remunerated assets, and<br />
required returns on the average value of<br />
remunerated assets.<br />
Although the CAA has demonstrated flexibility<br />
by allowing BAA to offset revenue losses caused<br />
by external events, such as the loss of duty free<br />
revenues in 1999, BAA does not benefit from<br />
regulatory protection in a situation of financial<br />
distress caused by financing decisions.<br />
Price control review: initial proposals.<br />
The formal process for setting the charges for Q5<br />
began in December 2005 when the CAA<br />
published its policy issues paper for consultation.<br />
BAA then rejected the CAA’s December 2006<br />
initial regulatory proposals as failing to<br />
incentivize the company to invest at its airports.<br />
The next stage in the process sees a review by the<br />
CC before the CAA sets prices in early 2008.<br />
The CAA has proposed that the allowed<br />
weighted average cost of capital (WACC) should<br />
be cut to 5.90%-6.20% for Heathrow and<br />
6.30%-6.70% for Gatwick, which would be a<br />
marked reduction from the 7.75% allowed in<br />
2003. This change could arguably prompt ADIL<br />
to lower its intended capital program. Such large<br />
movements between quinquennia may well result<br />
in rating volatility for BAA in the future.<br />
Significantly, the CAA has stated that it will not<br />
reconsider the level of WACC in view of the tax<br />
shield provided by the higher leverage ADIL<br />
intends to implement, or adopt a higher<br />
proportion of debt in the WACC calculation. This<br />
is a credit positive for BAA.<br />
The CAA has put forward indicative ranges for<br />
caps on airport charges at Heathrow of the retail<br />
price index (RPI) plus 4.0%-8.0%, compared<br />
with the current rate of growth in price-caps of<br />
RPI plus 6.5%. For Gatwick airport, the CAA has<br />
proposed a price-cap ranging from RPI minus 2%<br />
to RPI plus 2%, compared with the current rate<br />
of growth of RPI plus 0%. Standard & Poor’s<br />
does not consider that these changes will affect its<br />
analysis. Importantly, Heathrow will be<br />
authorized to continue implementing high fee<br />
increases. This is a credit strength, given that<br />
Heathrow remains the largest airport in the U.K.<br />
in terms of passengers, and given the significant<br />
capital expenditure plan underway.<br />
The price control proposals suggested by the<br />
CAA are now with the CC. Given the CC’s track<br />
record, we expect it to continue the supportive<br />
regulatory regime for investment that it delivered<br />
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in the fourth quinquennium.<br />
Finally, the CAA has recommended that the<br />
government should consider removing the<br />
requirement for the CAA to set price controls at<br />
Stansted, and instead dedesignate the airport. <strong>In</strong><br />
theory, BAA could therefore implement higher<br />
charges, but this may prove difficult considering<br />
the airport’s focus on low-cost carriers. This<br />
decision reflects the CAA’s acknowledgement that<br />
BAA currently charges below the regulator’s pricecap,<br />
and the view that Stansted does not have<br />
significant market power. The dedesignation is<br />
viewed as mildly positive overall, depending on<br />
the future competitive position of Stansted and<br />
how “stranded asset risk” is mitigated. We<br />
understand that ADIL continues to see Stansted<br />
airport as a core asset.<br />
The potential removal of Stansted from the<br />
regulated asset base (RAB) is unlikely to affect the<br />
proposed securitization of BAA, given that the<br />
airport only accounts for about 9% of the<br />
combined RAB of £11.3 billion (at March 2007).<br />
About £10.3 billion of regulated assets will<br />
remain to back the securitization financing, which<br />
should ensure that the transaction goes forward.<br />
Standard & Poor’s recognizes the importance of<br />
the method by which Stansted’s potential<br />
dedesignation will be accounted for within the<br />
ring-fence structure.<br />
Office of Fair Trading and Competition<br />
Commission investigation.<br />
The OFT launched an investigation into the U.K.<br />
airports sector in 2006. <strong>In</strong> December 2006, it<br />
reported its preliminary findings that BAA’s<br />
ownership of its airports, the system of economic<br />
regulation of airports in the U.K., and capacity<br />
constraints combine to prevent, restrict, or distort<br />
competition and referred the supply of airport<br />
services by BAA within the U.K. to the CC. This<br />
review is expected to take up to two years to<br />
complete. On Aug. 9, 2007, the CC released a<br />
statement of issues it would look at following the<br />
reference made to it by the OFT in March 2007.<br />
The CC declared it would now determine whether<br />
there are any features of the market that prevent,<br />
restrict, or distort competition, and, if so, what<br />
remedial action might be taken. The CC expects<br />
to publish for consultation in the early part of<br />
2008 a document setting its “emerging thinking”<br />
on all the key issues. It currently aims to publish<br />
its provisional findings around this time<br />
next year.
BAA has already been subject to a number of<br />
government sponsored studies of airports, which<br />
concluded previously that it would not be<br />
desirable to break up the airports in the southeast<br />
of England. The OFT referral includes the<br />
designated airports that are subject to an RABbased<br />
regulation with price-caps designed to<br />
offset their monopoly characteristics. We believe<br />
that a breakup would be negative from a rating<br />
perspective, as it would reduce the supportive<br />
portfolio diversification stemming from operating<br />
several airports with different airlines, traffic<br />
types, and capital cycles. We would expect ADIL’s<br />
proposed permanent financing to factor<br />
in any breakup of the designated airports.<br />
The potential rating impact would depend in<br />
part on the allocation of BAA’s existing debt<br />
postbreakup.<br />
Nondesignated airport regulation<br />
BAA’s nondesignated airports are subject either to<br />
much lighter economic regulation or no economic<br />
regulation and are therefore free to set<br />
airline charges directly with the customers (the<br />
airline users).<br />
Operations<br />
The company has strong aviation and retail<br />
operations, as reflected in its strong operating<br />
margin compared with some of its peers. External<br />
consultants used by the CAA for the ongoing<br />
regulatory review have not raised any severe<br />
issues in terms of operating or capital spending.<br />
They have, however, suggested ways to further<br />
improve operations.<br />
BAA has a good track record for capital<br />
projects. Phase 1 of T5, which incorporates the<br />
main terminal building and Satellite 1, was<br />
approximately 90% complete at Dec. 31, 2006.<br />
The project continues to make good progress and<br />
the development remains on budget and on<br />
schedule to open in March 2008. To incentivize<br />
further investment at Heathrow and Gatwick<br />
airports, the CAA is proposing that all of the £6<br />
billion capital expenditures incurred over the<br />
2003-2008 period be factored into the RAB<br />
and remunerated.<br />
Congestion and queuing times at BAA’s airports<br />
have been the subject of severe public discontent<br />
in recent months. To alleviate this, BAA is in the<br />
process of recruiting 1,400 extra security guards<br />
and opening 22 new security lanes across its seven<br />
U.K. airports. The company is committed to<br />
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reducing queues to five minutes or less for 95%<br />
of the time.<br />
Capacity shortage, which is a negative rating<br />
factor, is being addressed. Existing planning<br />
approvals provide for approximate passenger<br />
traffic growth at Heathrow (including T5) to 90<br />
million (55 million capacity at the moment),<br />
Gatwick to about 40 million, and Stansted to<br />
about 25 million.<br />
BAA’s additional projects are to knock down<br />
Terminal 2 and replace it with a new terminal,<br />
Heathrow East. The terminal would not increase<br />
the capacity of the airport but would replace<br />
outdated buildings. Stansted Generation 2<br />
includes the provision of a second runway and<br />
terminal, with initial capacity for about 10<br />
million passengers per year.<br />
The current estimate of the net cost of the<br />
blight and compensation schemes for those people<br />
most affected by the Stansted development is up<br />
to £100 million. The White Paper also commits<br />
BAA to offering noise mitigation measures.<br />
Payments under the noise schemes are estimated<br />
at £7 million per year for the next four years and<br />
up to £350 million over the next 29 years for<br />
blight schemes.<br />
BAA has interests in various airports outside<br />
the U.K. The company also owns 50% of Airport<br />
Property Partnership, a property joint venture<br />
with Morley Fund Management that is in the<br />
process of being disposed as it is considered<br />
noncore activity. Budapest Airport was sold to a<br />
consortium led by Hochtief in June 2007.<br />
Profitability<br />
Airports tend to have high operating margins<br />
owing to growing revenues, a high proportion of<br />
fixed costs, and relatively low staff levels. BAA<br />
has demonstrated stability of earnings and cash<br />
flow despite adverse events. Passenger numbers,<br />
tariff changes, and retail activities are the main<br />
drivers of revenue growth. Although the<br />
company’s operating margins will be subject to<br />
pressure in the years immediately following the<br />
opening of its new terminal at Heathrow, BAA’s<br />
new owners expect profitability to eventually<br />
benefit from the additional capacity provided<br />
by T5.<br />
As a mechanism to encourage BAA to carry out<br />
its proposed investments, the CAA is considering<br />
maintaining the price profiling (or revenue<br />
advancement), which was incorporated in the<br />
Heathrow price review for 2003-2008. This<br />
NOVEMBER 2007 ■ 61
TRANSPORTATION INFRASTRUCTURE<br />
BAA Ltd. amounts<br />
62 ■ NOVEMBER 2007<br />
allows a proportion of the costs associated with a<br />
future investment (depreciation) to be recovered<br />
before that new investment comes into operation.<br />
<strong>In</strong> addition, assets are remunerated during the<br />
course of construction at the regulatory cost of<br />
capital. This mechanism has significantly reduced<br />
risk in the T5 investment. Although the recovery<br />
of 75% of incremental security costs incurred in<br />
the event of additional security requirements<br />
(subject to minimal costs) being introduced by the<br />
government is viewed favorably, this is lower than<br />
in previous regulatory reviews.<br />
Although historically BAA has achieved or<br />
beaten operating cost forecasts assumed in the<br />
regulatory review, the group has underperformed<br />
in the current regulatory period due to new legal<br />
security requirements, market-driven costs such as<br />
utilities and business rates, and White Paper<br />
obligations on noise and blight. <strong>In</strong> the 12 months<br />
--12 months to Dec. 31, 2006--<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
to December 2006, the adjusted operating margin<br />
before depreciation was 42.1%. <strong>In</strong> previous years,<br />
margins have ranged close to or above 45%.<br />
Operating income in 2006 was affected by<br />
reorganization costs, bid advisory costs, staffrelated<br />
costs due to the change in ownership, and<br />
costs incurred to ensure that T5 becomes<br />
operational in March 2008. An increase in<br />
pension contributions put further pressure on<br />
operating costs.<br />
Financial Risk Profile: High Leverage<br />
Reflects Capital Returns, Expected<br />
Releveraging After Takeover, And Weak<br />
Credit Metrics<br />
BAA’s weakened financial profile reflects the<br />
company’s debt-funded capital program and<br />
limited financial flexibility.<br />
Table 1 - Reconciliation Of BAA Ltd. Estimated Amounts With Standard & Poor's Adjusted Amounts (Mil. £)*<br />
Operating Operating Operating Cash flow Cash flow<br />
Shareholders' income income income <strong>In</strong>terest from from Capital<br />
Debt equity (before D&A) (before D&A) (after D&A) expense operations operations expenditure<br />
Reported 6,392.0 6,339.0 972.0 972.0 702.0 159.0 558.0 558.0 1,106.0<br />
Standard & Poor's adjustments<br />
Operating leases<br />
Postretirement<br />
895.9 -- 72.0 53.8 53.8 53.8 18.2 18.2 16.9<br />
benefit obligations<br />
Additional items<br />
162.0 -- 4.0 4.0 4.0 -- (4.9) (4.9) --<br />
included in debt 192.0 -- -- -- -- -- -- -- --<br />
Capitalized interest<br />
Share-based<br />
-- -- -- -- -- 137.0 -- -- --<br />
compensation expense<br />
Reclassification of<br />
nonoperating income<br />
-- -- -- 5.0 -- -- -- -- --<br />
(expenses)<br />
Reclassification of<br />
working-capital<br />
-- -- -- -- 29.0 -- -- -- --<br />
cash flow changes -- -- -- -- -- -- -- 48.0 --<br />
Minority interest -- 10.0 -- -- -- -- -- -- --<br />
Other -- -- 31.0 31.0 (40.0) 50.0 192.0 191.0 399.0<br />
Total adjustments 1,249.9 10.0 107.0 93.8 46.8 240.8 205.3 252.3 415.9<br />
Standard & Poor's adjusted amounts<br />
Operating<br />
Cash<br />
flow Funds<br />
income <strong>In</strong>terest from from Capital<br />
Debt Equity (before D&A) EBITDA EBIT expense operations operations expenditures<br />
Adjusted 7,641.9 6,349.0 1,079.0 1,065.8 748.8 399.8 763.3 810.3 1,521.9<br />
*Please note that two reported amounts (operating income before D&A and cash flow from operations) are used to derive more than one Standard & Poor's-adjusted amount (operating income before<br />
D&A and EBITDA, and cash flow from operations and funds from operations, respectively). Consequently, the first section in some tables may feature duplicate descriptions and amounts.
Accounting<br />
BAA changed its reporting date to Dec. 31<br />
(previously March 31) to align with Grupo<br />
Ferrovial S.A., its ultimate majority shareholder.<br />
Auditors issued an unqualified audit report for<br />
the last fiscal period.<br />
The consolidated financial statements for BAA<br />
Ltd. (formerly BAA PLC) are prepared in<br />
accordance with IFRS and under the historical<br />
cost convention, with the exception of investment<br />
properties, available-for-sale assets, derivative<br />
financial instruments, and financial liabilities that<br />
qualify as hedged items under a fair value hedge<br />
accounting system.<br />
During the course of 2006, BAA changed its<br />
accounting treatment for joint venture entities to<br />
proportionately consolidate the financial<br />
performance for the reporting period and the<br />
financial position at Dec. 31, 2006 (previously<br />
joint venture entities were equity accounted).<br />
This change in policy has no impact on net profit<br />
or reserves.<br />
The financial information presented in this<br />
report is based on the segregation of the fourth<br />
quarter of the fiscal year ended March 2006 from<br />
the financial report for the nine months to<br />
December 2006, and reflects the balance sheet at<br />
December 2006. Comparability with the fiscal<br />
year ended March 2006 must be considered in<br />
view of the three-month crossover.<br />
The main adjustments to the company’s<br />
reported debt figures concern leases,<br />
postretirement obligations (£192 million), and<br />
contingent liabilities.<br />
BAA has changed the disclosure of its lease<br />
obligations under IFRS. Comparing the previous<br />
2004/2005 accounts with the 2005/2006<br />
accounts, the amounts payable in 2005/2006 did<br />
not correlate to the previous disclosure or the<br />
actual charge in the accounts. The accounts for<br />
the year to December 2006 (with restated figures<br />
at March 2006) show a large lease liability. For<br />
comparison purposes, the adjustment of future<br />
lease obligations for the net present value at 6%<br />
has also been made for the years ended March<br />
2005 and March 2006.<br />
Our adjustments to operating income (before<br />
D&A) and EBITDA (see table 1 on previous<br />
page) reflect three key components: the operating<br />
income contribution for three months (£216<br />
million) less the gain on investments (£206<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
million) plus the derivatives losses (£21 million)<br />
recognized in operating income. The adjustments<br />
to EBIT reflect the same items along with three<br />
months of depreciation (£81 million) and interest<br />
income (£10 million). The adjustments to interest<br />
expense, cash flow from operations, funds from<br />
operations, and capital expenditure relate entirely<br />
to the three-month pro forma adjustment.<br />
Corporate governance/Risk tolerance/<br />
Financial policies<br />
ADIL’s strategy and intention is to migrate<br />
existing bondholders into an investment-grade<br />
ring-fenced entity backed by BAA’s three<br />
designated airports. BAA’s other airports in the<br />
U.K. (Southampton, Aberdeen, Glasgow, and<br />
Edinburgh) will remain outside of the ringfence<br />
and are expected to be financed on a standalone<br />
basis.<br />
We expect the future ring-fenced structure<br />
financing to be supported by:<br />
• A strong overall covenant package;<br />
•Limitations on additional debt and business<br />
activities, such as a rating confirmation<br />
requirement for acquisitions above certain<br />
thresholds (the latter creating certainty that<br />
the revenue profile will not change);<br />
• Restrictions on upstream distributions<br />
outside the ring-fence;<br />
•Likely achievable fixed and floating charges<br />
on the assets of the three designated<br />
airports; and<br />
•The stability provided by BAA’s designated<br />
airports business.<br />
BAA’s main financial policy objectives are:<br />
• To maintain a minimum of 70% of existing<br />
debt on fixed rates.<br />
• To use foreign currency forward contracts to<br />
hedge capital expenditure in foreign<br />
currency once a project is certain to go<br />
ahead. At December 2006, there were no<br />
significant unmatched exposures.<br />
• To ensure that the company is not exposed<br />
to excessive refinancing risk in any one year.<br />
<strong>In</strong> addition:<br />
•Covenants are standardized wherever<br />
possible and are monitored on an ongoing<br />
basis. BAA continues to comply with all<br />
borrowing obligations and financial<br />
covenants.<br />
NOVEMBER 2007 ■ 63
TRANSPORTATION INFRASTRUCTURE<br />
64 ■ NOVEMBER 2007<br />
The treasury function is not permitted to<br />
speculate in financial instruments. An interim<br />
dividend of £165 million was proposed for the<br />
year ended March 31, 2006, and was paid during<br />
the nine-month period to Dec. 31, 2006. Further,<br />
an interim dividend of £78 million was paid to<br />
ADIL out of postacquisition profits on Nov. 11,<br />
2006. Also, BAA made a £114 million loan to<br />
ADIL in 2006.<br />
Cash flow adequacy<br />
The high operating margins and the relatively<br />
stable and predictable cash flows produced by<br />
BAA’s diversified airports are a significant<br />
credit strength.<br />
The £9 billion-plus 2007-2018 investment<br />
program for the three southeast England airports<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
will continue to drive BAA’s financial risk profile<br />
for the next 10 years. Standard & Poor’s expects<br />
free cash flow generation to be negative during<br />
this period. From a credit perspective, the ability<br />
to recover the cost of investment in the course of<br />
construction is positive as it allows BAA to collect<br />
revenues associated with long-term projects before<br />
completion, boosting operating cash flow and,<br />
therefore, reducing the impact of the long-term<br />
investment plan on the company’s financial<br />
profile. BAA has publicly stated that investments<br />
contemplated in the White Paper will only be<br />
made if future regulatory determinations are<br />
supportive, and if there are appropriate levels of<br />
demand to support the investment without<br />
putting the group’s financial robustness at risk.<br />
Adjusted FFO coverage of interest and debt in<br />
--12 months to Dec. 31, 2006-- --Fiscal year ended Dec. 31, 2006--<br />
BAA Ltd.¶ N.V. Luchthaven Schiphol Aeroports de Paris<br />
Rating as of Aug. 13, 2007 BBB+/Watch Neg/NR AA-/Negative/-- AA-/Stable/--<br />
(Mil. mixed currency) GBP EUR EUR<br />
Revenues 2,564.0 1,036.7 2,076.8<br />
EBITDA 1,065.8 440.4 665.1<br />
Net income from continuing operations 463.0 526.9 152.1<br />
Funds from operations (FFO) 810.3 348.6 537.7<br />
Cash flow from operations 763.3 359.3 464.0<br />
Capital expenditures 1,521.9 241.4 712.5<br />
Free operating cash flow (758.6) 117.9 (248.5)<br />
Discretionary cash flow (1,001.6) 62.5 (311.7)<br />
Cash and investments 93.0 257.1 509.2<br />
Debt 7,641.9 1,075.0 2,682.1<br />
Common equity 6,339.0 2,702.8 2,794.6<br />
Adjusted ratios<br />
EBITDA/sales (%) 41.6 42.5 32.0<br />
Operating income/sales (%) 42.1 42.8 32.0<br />
EBIT interest coverage (x) 1.9 5.1 3.7<br />
EBITDA interest coverage (x) 2.7 7.3 5.6<br />
Return on capital (%) 5.0 8.5 8.2<br />
FFO/debt (%) 10.6 32.4 20.0<br />
Cash flow from operations/debt (%) 10.0 33.4 17.3<br />
Free operating cash flow/debt (%) (9.9) 11.0 (9.3)<br />
Debt/EBITDA (x) 7.2 2.4 4.0<br />
Debt/total capital (%) 54.6 28.3 49.0<br />
Ratios before adjustments for postretirement obligations<br />
Table 2 - BAA Ltd. Peer Comparison*<br />
Operating income/sales (before D&A) (%) 41.9 42.9 30.8<br />
EBIT interest coverage (x) 1.9 5.3 4.0<br />
FFO/debt (%) 10.9 33.8 22.3<br />
Debt/EBITDA (x) 7.0 2.3 3.8<br />
Debt/total capital (%) 54.1 27.6 46.5<br />
*Fully adjusted (including postretirement obligations). ¶Excess cash and investments netted against debt.
the 12 months to December 2006 at 10.6% and<br />
2.7x were quite similar to those at fiscal year-end<br />
March 2006 (10.8% and 2.8x, respectively).<br />
The debt-financed acquisition of BAA by ADIL<br />
and expected refinancing will have a significant<br />
impact on cash flow adequacy measures.<br />
Although financial ratios are likely to be weak,<br />
they should be interpreted in light of BAA’s<br />
relatively low business risk and the transaction’s<br />
structural features. We would expect BAA to fund<br />
its future capital investment program in respect of<br />
the designated airports through further debt<br />
issuance from the ring-fenced designated airports,<br />
limiting the future cost of debt.<br />
Capital structure/Asset protection<br />
Leverage is forecast to increase as ongoing capital<br />
expenditure will be debt-financed. Future ratings<br />
will be constrained by an anticipated aggressive<br />
capital structure, moderate debt protection<br />
measures, and the ongoing need to raise debt to<br />
finance capital expenditures.<br />
At Dec. 31, 2006, gross unadjusted debt was<br />
£6.4 billion, as at March 31, 2006. Adjusted debt<br />
to capitalization in the 12 months to December<br />
2006 increased to 54.6%, from 53.3% at<br />
March 2006.<br />
Table 3 - BAA Ltd. Financial Summary<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
BAA’s debt structure was adequate at Dec. 31,<br />
2006, with 80% of debt maturing in more than<br />
five years. Of the debt portfolio, 86% was at<br />
fixed interest rates.<br />
During the nine months to Dec. 31, 2006,<br />
ADIL acquired BAA’s outstanding convertible<br />
bonds (£424 million 2.94% and £425 million<br />
2.625%). Unless previously redeemed or<br />
converted, BAA will redeem the bonds at par on<br />
April 4, 2008, and Aug. 19, 2009, respectively.<br />
At year-end 2006, secured debt was marginal at<br />
£234 million, out of gross unadjusted debt of<br />
£6.4 billion. Structural subordination for<br />
unsecured lenders is therefore minimal.<br />
BAA’s long-term bonds benefit from upstream<br />
guarantees from Heathrow, Gatwick, and<br />
Stansted. Those due in 2016, 2021, 2028, and<br />
2031 also carry interest coverage and gearing<br />
covenants, but do not contain negative pledge<br />
clauses. Under the terms of the ADIL senior and<br />
junior finance documents, BAA Ltd., as an<br />
obligor, jointly and severally guarantees the<br />
ADIL senior and subordinated facilities. The<br />
maximum value of this guarantee is limited by the<br />
threshold at which the financial and other<br />
covenants contained in the existing bonds would<br />
be breached.<br />
--12 months to Dec. 31-- --Fiscal year ended March 31--<br />
(Mil. £) 2006 2006 2005 2004 2003<br />
Rating history A/Watch Neg/A-1 A/Watch Neg/A-1 A+/Stable/A-1+ A+/Stable/A-1+ AA-/Negative/A-1+<br />
Revenues 2,564.0 2,313.0 2,115.0 1,970.0 1,909.0<br />
Net income from continuing operations 463.0 531.0 672.0 377.0 374.0<br />
Funds from operations (FFO) 810.3 738.3 732.4 680.0 636.5<br />
Capital expenditures 1,521.9 1,502.2 2,288.9 1,314.6 719.6<br />
Free operating cash flow (758.6) (805.9) (1,597.5) (680.5) (96.1)<br />
Discretionary cash flow (1,001.6) (1,036.9) (1,811.5) (886.5) (294.1)<br />
Cash and investments 93.0 83.5 83.5 890.0 1,156.0<br />
Debt 7,641.9 6,842.7 4,381.7 3,983.9 3,506.1<br />
Common equity 6,339.0 5,982.0 5,623.0 5,018.0 4,575.0<br />
Total capital 13,990.9 12,834.7 10,013.7 9,009.9 8,089.1<br />
EBIT interest coverage (x) 1.9 2.3 3.7 3.2 3.2<br />
EBITDA interest coverage (x) 2.7 3.0 4.7 4.1 4.0<br />
FFO interest coverage (x) 2.7 2.8 3.3 3.9 3.9<br />
FFO/debt (%) 10.6 10.8 16.7 17.1 18.2<br />
Discretionary cash flow/debt (%) (13.1) (15.2) (41.3) (22.3) (8.4)<br />
Net cash flow/capital expenditure (%) 37.3 33.8 22.6 36.1 60.9<br />
Debt/total capital (%) 54.6 53.3 43.8 44.2 43.3<br />
Return on common equity (%) 7.5 9.2 12.6 7.9 8.0<br />
Common dividend payout ratio (unadjusted) (%) 16.8 45.8 33.8 56.2 54.0<br />
NOVEMBER 2007 ■ 65
TRANSPORTATION INFRASTRUCTURE<br />
66 ■ NOVEMBER 2007<br />
The 2012, 2013, 2014, 2018, and 2023, and<br />
convertible bonds contain a negative pledge<br />
clause, meaning that, as long as these bonds<br />
remain outstanding, the issuer will not permit its<br />
assets to be pledged in favor of any new bonds<br />
with a tenor of less than 20 years, unless the<br />
bonds are secured equally. Limited protection is<br />
also derived from a put option, under which bond<br />
investors can sell the bonds back to BAA if<br />
airport operations cease to be the company’s<br />
major business and if this results in the long-term<br />
corporate credit rating falling below ‘BBB-’.<br />
The £1 billion revolving credit facility was<br />
cancelled on Aug. 21, 2006. BAA is a joint<br />
obligor with its 100% parent ADIL on a £2.25<br />
billion facility maturing in April 2011. At Dec.<br />
31, 2006, £200 million had been drawn on<br />
the facility. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
Sept. 19, 2007<br />
Primary Credit Analysts:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
Michela Bariletti,<br />
London,<br />
(44) 20-7176-3804<br />
Secondary Credit Analyst:<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
CHANNEL LINK ENTERPRISES FINANCE PLC<br />
Transaction Summary<br />
Standard & Poor’s Ratings Services assigned<br />
credit ratings to the secured index-linked, secured<br />
floating-rate and secured fixed-rate notes issued<br />
by Channel Link Enterprises <strong>Finance</strong> PLC, a<br />
public limited liability company incorporated in<br />
England and Wales.<br />
At closing, the original lenders transferred the<br />
original loan and the rights attached to it to<br />
Channel Link Enterprises <strong>Finance</strong> PLC.<br />
The ‘AAA’ ratings on the class G notes reflect<br />
the unconditional guarantee provided by AMBAC<br />
Assurance U.K. Ltd. (AMBAC) for the class G1<br />
and G4 notes, FGIC UK Ltd. (FGIC) for the class<br />
G2 and G5 notes, and Financial Security<br />
Assurance (U.K.) Ltd. (FSA) for the class G3 and<br />
G6 notes. The underlying rating assigned to the<br />
class G1, G2, G3, and G4 notes is ‘BBB’. <strong>In</strong><br />
addition, the rating assigned to the class A notes<br />
is ‘BBB’.<br />
The ‘BBB’ ratings reflect, among other things:<br />
• For the first time, the senior-loan leverage<br />
resulting in sustainable debt levels for the<br />
company under steady operations;<br />
• Forecasted cash flow generation, which<br />
should provide some cushion for slowdowns<br />
limited in magnitude and in time;<br />
• The concession to operate the tunnel, which<br />
runs for another 80 years until 2086;<br />
• Strong operating margins: the EBITDA<br />
margin for Eurotunnel has consistently been<br />
over 50% since 1999; and<br />
• Limited capital expenditure requirements<br />
resulting in positive free cash flow.<br />
On the issue date, the issuer also issued<br />
floating-rate liquidity notes to fund the liquidity<br />
Transaction Key Features<br />
Transaction Summary<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
reserve accounts. The payment to the liquidity<br />
reserve accounts in case of funds withdrawn, and<br />
the interest and principal on the liquidity notes,<br />
rank senior to the class G and class A notes. The<br />
rating assigned to the sterling and euro liquidity<br />
notes is ‘A-’. The higher ratings assigned to the<br />
liquidity notes reflect, among other things, their<br />
seniority in the waterfall and their better<br />
recovery potential.<br />
Notable Features<br />
To rate the notes, Standard & Poor’s applied a<br />
mixed approach combining corporate/concession<br />
financing to reflect the borrower’s characteristics<br />
(Eurotunnel Group, an infrastructure provider<br />
operating under a concession) and structured<br />
analysis (reflecting the repackaging of the<br />
borrower’s loan).<br />
The analysis does not rely on looking through a<br />
post-insolvency scenario, as the underlying ‘BBB’<br />
rating on the notes is below Standard & Poor’s<br />
estimate of the borrower’s business risk, the latter<br />
classified as satisfactory to strong (BBB+/A-). As<br />
such, this is not a standard corporate<br />
securitization cash flow transaction. <strong>In</strong> standard<br />
cash flow corporate securitizations, where the<br />
rating on the notes is typically above the business<br />
risk of the underlying entity, noteholders normally<br />
rely on enforcement of security (such as step-in<br />
rights and the appointment of a receiver) to take<br />
control over the company in the event of<br />
insolvency, and repay the rated debt.<br />
For Channel Link Enterprises <strong>Finance</strong> PLC,<br />
Standard & Poor’s analysis does not rely on the<br />
post-insolvency enforcement of the security.<br />
There is no right to appoint a receiver in France<br />
as there is in the U.K. As regards step-in rights,<br />
Closing date Aug. 20, 2007<br />
Collateral A permanent facility to the Channel Tunnel Group Ltd. (sterling tranches) and France<br />
Manche S.A. (euro tranches). The U.K. security includes first-fixed and first-floating<br />
charges over freehold and leasehold properties, charges and assignment over the principal<br />
project agreement and insurances, charges over bank accounts and intellectual properties,<br />
and a first-floating charge over all present and future assets. <strong>In</strong> France, security includes<br />
security over debt, pledges over bank accounts, trademarks, other intellectual property,<br />
and over shares in the Eurotunnel group members in France.<br />
Countries of origination U.K. and France<br />
Sterling floating-rate liquidity notes<br />
(Mil. £) 175<br />
Euro floating-rate liquidity notes<br />
(Mil. € ) 160<br />
NOVEMBER 2007 ■ 67
TRANSPORTATION INFRASTRUCTURE<br />
68 ■ NOVEMBER 2007<br />
Class Rating* Amount <strong>In</strong>terest** Legal final<br />
(mil.) maturity<br />
G1¶ AAA§, (SPUR BBB) £300 Formula that accounts for relevant<br />
index-linked UKTi and interest rate<br />
of 3.487%<br />
June 30, 2042<br />
G2¶ AAA§, (SPUR BBB) £150 Formula that accounts for relevant<br />
index-linked UKTi and 3.487%<br />
June 30, 2042<br />
G3¶ AAA§, (SPUR BBB) £300 Formula that accounts for relevant<br />
index-linked UKTi and 3.487%<br />
June 30, 2042<br />
G4 AAA§, (SPUR BBB) € 73 Formula that accounts for relevant<br />
index-linked OATi and 3.377%<br />
June 30, 2041<br />
G5 AAA§, (SPUR BBB) € 147 Formula that accounts for relevant<br />
index-linked OATi and 3.377%<br />
June 30, 2041<br />
G6 AAA§, (SPUR BBB) € 147 Formula that accounts for relevant<br />
index-linked OATi and 3.377%<br />
June 30, 2041<br />
A1 BBB £400 6.341% June 30, 2046<br />
A2 BBB € 645 5.892% June 30, 204<br />
A3 BBB £350 Six-month LIBOR plus 1.25% June 30, 2050<br />
A4 BBB € 953 Six-month EURIBOR plus 1.25% June 30, 2050<br />
Sterling liquidity notes A- £175 Six-month LIBOR plus 0.60% Dec. 30, 2050<br />
Euro liquidity notes A- € 160 Six-month EURIBOR plus 0.60% Dec. 30, 2050<br />
R NR<br />
*Standard & Poor’s ratings address timely interest and ultimate principal on the notes.<br />
¶The margin is 3.47% until June 30, 2009 and 2.887% thereafter.<br />
§The ‘AAA’ ratings are supported by the unconditional guarantee provided by AMBAC Assurance U.K. Ltd. for the class G1 and G4 notes, FGIC UK Ltd. for the<br />
class G2 and G5 notes, and Financial Security Assurance (U.K.) Ltd. for the class G3 and G6 notes.<br />
**Subject to a step-up fee from July 30, 2012 for the class A3 and A4 notes. As part of Standard & Poor’s analysis, the step-up fee was modeled as being<br />
fully subordinated to the payments on all the classes of notes and not rated.<br />
NR--Not rated.<br />
Standard & Poor’s notes that, although there are<br />
arguments to sustain the view that the lenders’<br />
right of substitution under the concession should<br />
remain enforceable in the insolvency of the<br />
borrower, this has never been tested and therefore<br />
is not a determinant of the rating. Hence, the<br />
rating approach is closer to a concession or<br />
corporate financing than a traditional<br />
securitization.<br />
The rating approach is also reflected in the<br />
transaction’s leverage. Compared with traditional<br />
corporate securitization transactions, the leverage<br />
is high given Eurotunnel’s business risk, and the<br />
legal and structure features. Conversely, other<br />
infrastructure operators can bear similar<br />
leverages; for instance, Autoroutes Paris-Rhin-<br />
Rhone’s (APRR) facility is rated ‘BBB-’ with a<br />
maximum consolidated leverage of about 11.2x<br />
(in 2006) and minimum DSCR of 1.31x (in<br />
2012). APRR is the third-largest toll road<br />
operator in Europe, with a network of 2,205<br />
kilometers in service, and is under concession<br />
until 2032.<br />
Ratings Detail<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
<strong>In</strong> the project finance market, transactions with<br />
higher leverages have reached investment grade.<br />
For instance, 407 <strong>In</strong>ternational <strong>In</strong>c. (a toll road in<br />
Canada) had total debt/EBITDA of about 12.7x<br />
at the end of 2006, including subordinated debt.<br />
The senior rating is ‘A’, while the rating is ‘BBB’<br />
for subordinated debt. The subordinated debt was<br />
stripped of most of its covenants (no pledge of<br />
shares) and the rating resides mostly on strong<br />
coverage, and solid performance and demand<br />
characteristics. Total DSCR (including notional<br />
amortization of principal) is estimated to be 1.4x<br />
in 2009 and 2010. Debt amortizes in 2039 for a<br />
99-year concession.<br />
Supporting Ratings<br />
<strong>In</strong>stitution/role Ratings<br />
Deutsche Bank AG as issuer bank account<br />
provider and hedging provider<br />
AA/Stable/A-1+<br />
Goldman Sachs Group <strong>In</strong>c. as hedging provider AA-/Stable/A-1+<br />
AMBAC Assurance U.K. Ltd. AAA/Stable/--<br />
FGIC UK Ltd. AAA/Stable/--<br />
Financial Security Assurance (U.K.) Ltd. AAA/Stable/--
Strengths, Concerns, And Mitigating Factors<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
Strengths:<br />
■ The business risk profile is considered “Satisfactory To Strong” (equating to a high ‘BBB’ to low<br />
‘A’ category) based on long concession, high profitability, and strong free cash flow generation.<br />
■ The management has a proven track record, with the successful implementation of significant<br />
cost reductions and revenue-enhancing strategy based on market segmentation.<br />
■ Eurotunnel has the exclusive concession to operate the only fixed transportation link between<br />
the U.K. and France, which runs for another 80 years until 2086.<br />
■ Strong operating margins: EBITDA margin for Eurotunnel has consistently been over 50%<br />
since 1999.<br />
■ There are limited capital expenditure requirements resulting in positive free cash flow.<br />
Concerns:<br />
■ The transaction is highly leveraged. The £2.9 billion of novated debt represents about 10.5x<br />
2007 forecast EBITDA, increasing to £3.0 billion or 11x forecast EBITDA in 2013 due to<br />
debt accretion.<br />
■ The amortization holiday may enable distribution to shareholders in the initial years, subject<br />
to a dividend lock-up trigger.<br />
■ The transaction has a back-ended amortization profile with final maturity in 2050.<br />
■ There is uncertainty regarding future competitive position over the medium to long term, due<br />
to unpredictable behavior of competing transport modes between the U.K. and France.<br />
■ There is exposure to demand risk from core shuttle services and, to some extent, railway<br />
services, although the latter benefit from some government backing through guaranteed access<br />
charges.<br />
■ As there is no currency hedge, there might be a mismatch between funds available in<br />
euro/sterling and the amount paid in the respective currency.<br />
■ The ratings do not rely on enforcement of security, as the survivability of the issuer’s right of<br />
substitution post-insolvency, and the practical implementation of this right, have never<br />
been tested.<br />
Mitigating factors:<br />
■ The transaction’s high leverage is sustainable and should be considered in view of Eurotunnel’s<br />
long concession and strong business position, and of a mortgage-style amortization profile to<br />
alleviate refinance risk.<br />
■ The total senior debt will fully amortize by 2050, two years ahead of the RUC term.<br />
■ A payment test based on the synthetic debt-service coverage restricts distributions.<br />
■ The substitution right, coupled with the security package (which includes the right for the<br />
security trustee to appoint an administrative receiver in England), and provisions ensuring that<br />
the issuer retains a blocking stake in creditors’ committees, should put the issuer in a favorable<br />
position in restructuring negotiations.<br />
■ The debt breakdown between British pound sterling- and euro-denominated loans aims to<br />
replicate the revenue breakdown from the U.K. (in British pounds sterling) and from the<br />
continent (in euros).<br />
NOVEMBER 2007 ■ 69
TRANSPORTATION INFRASTRUCTURE<br />
70 ■ NOVEMBER 2007<br />
Transaction Background<br />
<strong>In</strong> November 2006, Eurotunnel’s junior- and<br />
senior-secured bank debt holders and trade<br />
creditors approved a restructuring proposal to<br />
reduce the company’s debt from £6.20 billion to<br />
£2.84 billion. The plan was put forward under<br />
the French “procédure de sauvegarde” granted on<br />
Aug. 2, 2006, by the Paris commercial court, to<br />
Eurotunnel and 17 related entities. This was<br />
followed by the approval of bondholders on Dec.<br />
14, 2006, the approval of the Paris commercial<br />
court in January 2007, and a successful share<br />
exchange in May 2007.<br />
Standard & Poor’s considers the proposed new<br />
financial structure as offering a credible base for<br />
future operations and a sustainable leverage.<br />
The Concession Agreement<br />
The Concession Agreement (CA) was signed on<br />
March 14, 1986 by the states and the<br />
concessionaires, under the Treaty of Canterbury.<br />
The CA expires in 2086. <strong>In</strong>itially entered into for<br />
a period of 55 years, the CA was extended by 10<br />
years and then 34 years in 1994 and 1999.<br />
Under the terms of the CA, the concessionaires<br />
have the right and the obligation, jointly and<br />
severally, to design, finance, construct, and<br />
operate Eurotunnel (the “Fixed Link”), and to do<br />
so at their own risk, without any government<br />
funds or state guarantees.<br />
Transaction Participants<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Tariffs and commercial policy<br />
The concessionaires are free to set their tariffs.<br />
However, they must not discriminate between<br />
users, notably with regard to their nationality or<br />
direction of travel.<br />
Penalties<br />
Any failure by the concessionaires to perform<br />
their obligations under the CA entitles the states<br />
to impose penalties after a grace period.<br />
Early termination of the CA and compensation<br />
Each of the states may terminate the CA in the<br />
event of a fault committed by the concessionaires<br />
if, within six months, the concessionaires have<br />
not remedied the relevant breach, and subject to<br />
giving prior notice to the lenders of their right of<br />
substitution. The CA defines a fault as a breach<br />
of a particularly serious nature of the<br />
concessionaires’ obligations under the CA, or<br />
ceasing to operate the Fixed Link.<br />
Each of the states may terminate the concession<br />
for reasons of national defense. <strong>In</strong> this case, the<br />
concessionaires may claim a compensation<br />
governed by the law of the relevant state. Each<br />
party to the CA may request the arbitration<br />
tribunal, established under the Treaty of<br />
Canterbury, to declare the termination of the CA<br />
in exceptional circumstances, such as war,<br />
invasion, nuclear explosion, or natural disaster. <strong>In</strong><br />
Transaction Participants<br />
Borrowers The Channel Tunnel Group Ltd. (sterling tranches) and France Manche S.A.<br />
(euro tranches)<br />
Original lenders Deutsche Bank AG and Goldman Sachs <strong>In</strong>ternational Bank<br />
Lead managers Deutsche Bank AG and Goldman Sachs <strong>In</strong>ternational<br />
Substituted entities Sub CLEF Ltd. (the English substituted entity) and Sub CLEF S.A.S.<br />
(the French substituted entity)<br />
Issuer cash manager and issuer account provider The London branch of Deutsche Bank AG<br />
Security agent, note trustee, and issuer security trustee Deutsche Trustee Co. Ltd.<br />
Facility agent The London branch of Deutsche Bank AG<br />
Security trustee Deutsche Trustee Co. Ltd.<br />
Principal paying agent and agent bank The London branch of Deutsche Bank AG<br />
Borrowers’ hedge counterparties The London branch of Deutsche Bank AG and Goldman Sachs <strong>In</strong>ternational<br />
Total return swap counterparties Deutsche Bank AG, London Branch and Goldman Sachs <strong>In</strong>ternational<br />
Total return swap custodian Deutsche Bank Aktiengesellschaft<br />
Issuer corporate services provider Wilmington Trust SP Services (London) Ltd.<br />
Monoline providers AMBAC Assurance U.K. Ltd., FGIC UK Ltd. and Financial Security<br />
Assurance (U.K.) Ltd.
such cases, in principle, no compensation is owed<br />
to the concessionaires. However, the states may<br />
pay the concessionaires an amount representing<br />
the financial benefits, if any, that they may derive<br />
from the termination.<br />
Any termination of the CA by the states, other<br />
than in a situation described above, gives the<br />
concessionaires the right to payment of<br />
compensation. This compensation is for the entire<br />
direct and certain loss actually suffered by the<br />
concessionaires and attributable to the states,<br />
within reasonably estimated limits at the date of<br />
the termination, including damage suffered and<br />
operating losses.<br />
Substitution<br />
Article 32 of the CA provides the lenders with<br />
step-in or substitution rights to allow the transfer<br />
of the concession and the assets required to<br />
operate the concession to two entities owned by<br />
the issuer. Step-in rights are triggered by certain<br />
predefined events including a payment default<br />
under the loan, an insolvency-related event<br />
regarding the concessionaires, or if it appears<br />
from an objective test that the estimated final<br />
maturity date for repayment of lenders will be<br />
materially extended.<br />
The U.K. and French governments, through a<br />
series of government letters, have confirmed that<br />
the issuer is a “lender” for the purpose of<br />
substitution, and that the rights to operate the<br />
fixed link will be transferred to one French and<br />
one English substitution entity.<br />
This right of substitution would in any case be<br />
subject to French and U.K. government<br />
confirmation that the substituted entities have<br />
the technical and financial capabilities to<br />
undertake substitution--a process that can take up<br />
to two months.<br />
<strong>In</strong> addition, under the provisions of intercreditor<br />
arrangements, the issuer (and hence the<br />
noteholders) always maintains at least 51% of the<br />
vote in any creditors’ committee, allowing the<br />
creditors to retain control of any future<br />
insolvency/restructuring process. This ensures the<br />
ability to effect its step-in rights.<br />
Transaction Characteristics<br />
The debt restructuring details<br />
The proposed Eurotunnel refinancing plan is<br />
structured around the existing concessionaires<br />
entering into a new long-term senior loan of<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
£2.84 billion, and the incorporation and<br />
formation of a new French holding company<br />
which, through an exchange tender offer, holds at<br />
least 93% of the current Eurotunnel group. The<br />
proceeds from the debt restructuring, as approved<br />
by the safeguard procedure, were used to repay<br />
Eurotunnel’s senior debt, Tier 1A, Tier 1, and Tier<br />
2 in cash at 100% of par including accrued<br />
interests (£892 million); to finance a cash<br />
payment to the holders of Tier 3 junior debt<br />
facilities; and to pay certain fees, costs and<br />
expenses related to the debt restructuring,<br />
including any interest accrued on existing<br />
Eurotunnel facilities.<br />
A subsidiary of Groupe Eurotunnel S.A. issued<br />
£1,275 million of notes redeemable in Groupe<br />
Eurotunnel S.A.’s shares (NRS) that were offered<br />
to the Tier 3 debt holders in exchange for their<br />
existing £1.78 billion of lendings, and to the<br />
bondholders in exchange for their part of the<br />
debt. NRS were issued in addition to a cash<br />
element paid to both parties. NRS convert into up<br />
to 87% of the common equity over three years;<br />
they are structurally and contractually<br />
subordinated to the senior debt. The dilution may<br />
be lessened, however, by the exercise of warrants<br />
issued to existing shareholders and bondholders,<br />
and the company’s ability, depending on its future<br />
operating performance, to repurchase the hybrid<br />
notes at a premium through proceeds from rights<br />
issues, or through the issuance of an additional<br />
Chart 1<br />
Channel Link Enterprises <strong>Finance</strong> PLC<br />
Debt Restructure Summary<br />
NOVEMBER 2007 ■ 71
Termination events under the swap agreements<br />
are limited to failure to pay, an event of default<br />
and acceleration of the notes, insolvency, illegality,<br />
and tax events.<br />
There is no foreign-currency hedge, as the debt<br />
breakdown between British pound sterling- and<br />
euro-denominated loans aims to replicate the<br />
revenue breakdown from the U.K. (in British<br />
pounds sterling) and from the continent (in<br />
euros). This creates foreign-currency risk if the<br />
revenue breakdown diverges from the loans’<br />
currency split.<br />
Borrower call option agreement<br />
The issuer entered into a borrower call option<br />
agreement with the borrower hedge<br />
counterparties. Under this agreement, the issuer<br />
has an option to purchase a defaulting receivable<br />
for sums due but unpaid by the borrowers under<br />
their hedge agreements. The purpose is to allow<br />
the issuer to keep the borrower hedges current<br />
and therefore to avoid a termination of the<br />
borrowers’ swaps.<br />
The working capital facility<br />
There is a provision for a € 75 million working<br />
capital facility. The working capital facility ranks<br />
pari passu to the securitized loan.<br />
Additional debt<br />
Obligors under the permanent facility, including<br />
the borrowers and Eurotunnel Group, can incur<br />
additional secured indebtedness from a third<br />
party in connection with certain defined<br />
circumstances, including: (a) any refinancing of all<br />
or part of the existing facility; (b) a working<br />
capital facility up to € 75 million; and (c) any tap<br />
issues or new issues, subject to compliance with<br />
rating and financial tests. The obligors can also<br />
incur unsecured financial indebtedness subject to<br />
certain caps, rating, and/or financial testing.<br />
The intercreditor agreement limits the obligors’<br />
ability to incur new secured or unsecured<br />
indebtedness. If the principal amount outstanding<br />
under the permanent facility is lower than 51% of<br />
the aggregate principal amount of all financial<br />
indebtedness of the group, no member of the<br />
group can incur any additional debt unless the<br />
facility agent, on behalf of the lenders under the<br />
term loan agreement, is granted rights to control<br />
51% of the vote.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
Tranche Amount Legal maturity<br />
<strong>In</strong>flation-linked loans<br />
A1 £750.0 2042<br />
A2 € 367.0 2041<br />
Fixed-rate loans<br />
Table 1 - Description Of The Structure<br />
Of The Facility<br />
B1 £400.0 2046<br />
B2 € 367.0 2041<br />
Floating-rate loans<br />
C1 £350.0 2050<br />
C2 € 953.0 2050<br />
Loan Characteristics<br />
Table 1 summarizes the structure of the facility<br />
and details the different tranches. The tranches<br />
are all pari passu obligations of the borrowers.<br />
<strong>In</strong>terest on the loan<br />
The rate of interest on the loan is the aggregate of<br />
the following rate:<br />
• From the issue date of the notes, a cash<br />
margin of 1.39%;<br />
• A rate equal to 2.097% for tranche A1;<br />
• A rate equal to 2.587% for tranche A2;<br />
• A rate equal to 5.241% for tranche B1;<br />
• A rate equal to 4.792% for tranche B2;<br />
• A rate equal to six-month LIBOR plus 2%<br />
from June 20, 2012 for tranche C1;<br />
• A rate equal to six-month EURIBOR plus<br />
2% from June 20, 2012 for tranche C2; and<br />
• Mandatory cost.<br />
Redemption profile<br />
The loans are payable according to a schedule,<br />
and payments start as follows:<br />
• Tranches A1 and A2 are paid in installments<br />
starting on June 20, 2018, and ending on<br />
June 20, 2042 and June 20, 2041<br />
respectively;<br />
• Tranches B1 and B2 are paid in installments<br />
starting on June 20, 2013, and ending on<br />
June 20, 2046 and June 20, 2041<br />
respectively; and<br />
• Tranches C1 and C2 are paid in installments<br />
starting on June 20, 2046 and June 20, 2041<br />
respectively, and ending on June 20, 2050.<br />
NOVEMBER 2007 ■ 73
ack rolling last-twelve-month basis is at<br />
least 1.25x; and<br />
• Certain prepayments, capitalization, or<br />
waiver do not give rise to a tax liability.<br />
Synthetic DSCR is defined as the ratio of net<br />
cash flow (NCF) to the higher of debt service and<br />
synthetic debt service. NCF is defined as EBITDA,<br />
minus capital expenditures and working capital<br />
change, plus any interest revenue received.<br />
Synthetic debt service is defined as net finance<br />
charges other than the step-up amount, the<br />
synthetic amortization schedule of the loan, and<br />
any actual amortization profile of any debt<br />
obligation other than the loan. Synthetic<br />
amortization profile is modeled as if the loan was<br />
paid down as an annuity.<br />
Business Profile<br />
Business description<br />
Eurotunnel operates the Channel Tunnel between<br />
the U.K. (Folkestone) and France (Calais; see the<br />
system map in chart 5) under a concession<br />
granted by the U.K. and French governments until<br />
2086. The Dover-Calais/Dunkerque corridor (the<br />
“short straits”) is the shortest and most widely<br />
used of all cross-channel routes.<br />
Eurotunnel offers a service that it operates itself<br />
between Calais and Folkestone, and which<br />
Chart 5<br />
The Eurotunnel System<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
competes directly with ferry operators in the<br />
transport of passengers, cars, coaches, and trucks<br />
in specially designed railway carriages<br />
(Eurotunnel’s own shuttle services generated 56%<br />
of € 830 million turnover in 2006).<br />
It also offers an infrastructure facilitating a<br />
direct rail link for the Eurostar trains and freight<br />
trains; 50% of tunnel capacity is made available<br />
to the British Railways Board (BRB; a U.K.<br />
government agency) and Société Nationale des<br />
Chemins de Fer Français (SNCF; the French stateowned<br />
railway operator). Railway revenues<br />
represented 42% of turnover in 2006.<br />
The tunnel is directly linked to the British and<br />
French motorway and railway networks. All rail<br />
traffic in the tunnel is controlled from railway<br />
control centers on the French and British<br />
terminals.<br />
The system comprises three tunnels. Two of the<br />
tunnels are single-track rail tunnels, which in<br />
normal service are used by trains traveling in one<br />
direction only. The third tunnel provides a safe<br />
means of emergency evacuation and access for<br />
maintenance of the tunnel. There are also four<br />
crossing points between the rail tunnels, so that<br />
when maintenance work is being done on a<br />
section of one tunnel, trains can switch to<br />
the other.<br />
NOVEMBER 2007 ■ 75
TRANSPORTATION INFRASTRUCTURE<br />
76 ■ NOVEMBER 2007<br />
Profitability: large portion of operating costs<br />
fixed in nature<br />
Standard & Poor’s forecasts the EBITDA margin<br />
to remain high and above 50% in the coming<br />
years. The yield management strategy, through<br />
higher load factors and efficient pricing policy, is<br />
expected to keep the operating margin high, with<br />
more revenue and yield stability than in the past.<br />
<strong>In</strong> addition, the DARE plan has resulted in a<br />
lower break-even level, meaning the company is<br />
in a better position to withstand any future<br />
economic downturn or increased competition.<br />
As summarized in table 2, the combined effects of<br />
higher revenues (up 4.7%) and well-controlled<br />
operating expenses (up 3.8%) led to an 11.9%<br />
increase in EBITDA, to €490 million in 2006. The<br />
EBITDA margin reached a record 59% of<br />
revenues in 2006, up from 55% in 2005 and 53%<br />
in 2004.<br />
On the operating expenses side, the main<br />
increases in energy costs (up 25%), maintenance<br />
costs (up 6%), and local taxes (up 7%), were<br />
partially offset by reductions in the cost of<br />
consumables (down 11%), in consultants’ fees<br />
(down 10%), and in employee benefit expenses<br />
(down 15%).<br />
Total revenues for Eurotunnel during the first<br />
half of 2007 reached £252 million, 8% down<br />
from the previous comparable period. Excluding<br />
the effect of the loss of the MUC, revenues have<br />
Table 2 - Eurotunnel Financial Summary<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
increased by 7% on trucks, Eurostar and car<br />
traffic growth; operating costs have decreased 2%<br />
and EBITDA at 56% of revenues rose 15%. If<br />
this trend is maintained for the year, 2007<br />
revenues will exceed forecasts, resulting in higherthan-expected<br />
DSCR. The second half of the year<br />
will however include a proportion of the £88<br />
million restructuring costs.<br />
Outlook by revenue segment<br />
Truck shuttles.<br />
The growth rates in Eurotunnel volume until<br />
2009 are expected to be in line with GDP,<br />
reflecting the company’s yield focus. <strong>In</strong> the longer<br />
term (post-2009), Standard & Poor’s estimates<br />
that Eurotunnel’s market share will stabilize,<br />
growing by an average rate of approximately 1%<br />
to 2% per year.<br />
The company’s truck shuttle strategy is to give<br />
priority and cheaper prices to regular customers,<br />
who in return agree to forecast daily volumes.<br />
This policy, together with the regained control of<br />
distribution channels, has enabled Eurotunnel to<br />
match capacity with demand. As a result, load<br />
factors on the truck shuttle services have<br />
increased to 71% in 2006 from 59% in 2004;<br />
and revenue increased by 7% in 2006 over 2005,<br />
due to the increase in average prices. The first half<br />
of 2007 maintains strong momentum, with<br />
volumes up 9%, and overall shuttle revenues up<br />
(Mil. € ) 2006/2005 2005/2004<br />
<strong>In</strong>come statement (Mil. € ) Dec. 31, Dec. 31 Dec. 31, Change Change<br />
2006 2005 2004<br />
Exchange rate (€ /£) 1.462 1.465 1.466<br />
Revenue 830 793 789 37 4<br />
Operating expenses 219 211 213 7 (2)<br />
Employee benefit expenses 122 143 154 (22) (11)<br />
Operating income 490 438 421 51 17<br />
Depreciation 164 208 228 (45) (19)<br />
Current operating income 326 230 193 96 37<br />
Impairment of property, plant and equipment 2,490 475 (2,490) 2,016<br />
Other operating income (expenses) 7 (41) (68) 48 28<br />
Operating profit (loss) 333 (2,301) (350) 2,634 (1,951)<br />
<strong>In</strong>come from cash and cash equivalents 5 8 8 (2) 0<br />
Cost of servicing debt (gross) 492 497 501 (5) (3)<br />
Net cost of financing and debt service (487) (490) (493) 3 3<br />
Other financial income (charges) (50) (18) 6 (32) (24)<br />
<strong>In</strong>come tax expense 0 0 0 0 0<br />
Profit (loss) for the year (204) (2,808) (836) 2,604 (1,972)
8%, on the previous comparable period.<br />
Further downside risk cannot be excluded,<br />
however, and overall yields may come under<br />
significant pressure as ferry companies<br />
aggressively and increasingly compete for<br />
market share.<br />
The new approach has also yielded better<br />
visibility in terms of traffic forecasting, as some<br />
major customers have entered into multi-year<br />
contracts with Eurotunnel. These contracts enable<br />
customers to lock in their requirements in terms<br />
of number of crossings, and enable Eurotunnel to<br />
fine-tune its capacity planning. Further<br />
refinements of this approach are planned<br />
for 2007.<br />
Car shuttles.<br />
Standard & Poor’s considers that this segment<br />
will be relatively stable in the future.<br />
Eurotunnel’s share of the passenger car market<br />
on the short straits link has reduced to 43.5% in<br />
2006 from 45.5% in 2004. This was largely due<br />
to SpeedFerries’ entry into the market in May<br />
2005, to the gradual increase in Norfolkline’s<br />
passenger capacity in 2005 and 2006, and to the<br />
impact of Eurotunnel’s new commercial strategy.<br />
The new Eurotunnel strategy implemented<br />
during 2005 has focused on improving yields<br />
through dynamic ticket pricing after taking into<br />
account the load factor and time of arrival,<br />
changing the customer mix in favor of the nondaytrip<br />
passengers versus the daytrip passengers,<br />
and implementing a 34% reduction in capacity,<br />
with less availability for daytrip passengers.<br />
With this strategy, Eurotunnel has been able to<br />
increase the load factor on its passenger shuttles<br />
to 62.5% in 2006 from 45.1% in 2004, and car<br />
revenues by 10% (due to the 11% increase in the<br />
average yield). The first half of 2007 maintains<br />
strong momentum, with volumes up 8% on the<br />
previous comparable period.<br />
Coach shuttles.<br />
The coach market, which has declined by around<br />
4% per year between 1998 and 2006, is expected<br />
to remain a marginal contributor to revenues. The<br />
continuing decline is due to factors such as the<br />
loss of duty-free, and increased competition from<br />
airlines for leisure and price-sensitive non-leisure<br />
trips. Further decline cannot be excluded in this<br />
price-sensitive market.<br />
Eurotunnel’s share of the passenger coach<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
market on the short straits link has risen to<br />
38.9% in 2006 from 33.5% in 2004.<br />
Coach revenues were down 11%, mainly due to<br />
lower volumes, which decreased by 13% in 2006<br />
and returned to a level comparable to that of<br />
2004. Average yields increased by a modest 2%.<br />
Volumes decreased by another 2% in the first half<br />
of 2007 on the previous comparable period.<br />
Railways.<br />
Railway revenues (including MUC payments)<br />
increased by 2% to €350 million in 2006.<br />
Excluding the MUC, the underlying increase in<br />
railway revenues was 7% in 2006, due in part to<br />
the 5% increase in Eurostar passenger traffic<br />
traveling through the tunnel.<br />
<strong>In</strong> 2007, railway revenues are not protected by<br />
the MUC, and are forecasted to fall by<br />
approximately 25% (the actual figure was 27% in<br />
the first half of 2007).<br />
Passenger rail (Eurostar).<br />
Standard & Poor’s expects Eurostar’s long-term<br />
growth to be in line with GDP, with a market<br />
share stabilized a couple of years after CTRL2<br />
(Channel Tunnel Rail Link-2).<br />
Eurostar has shown impressive passenger<br />
growth since 1997 except between 2000 and<br />
2003, primarily due to low-cost airlines drawing<br />
passengers to other destinations. The company<br />
has however fallen short of expected volumes,<br />
which were overly optimistic. Further material<br />
growth is not expected before November 2007,<br />
when Eurostar’s competitive position should<br />
benefit from the second phase of the U.K. highspeed<br />
link CTRL2 (reducing inter-capital journey<br />
time by an additional 20 minutes, and the<br />
opening of two additional stations, increasing the<br />
catchment area). Thereafter, extension of<br />
Eurostar’s rail links to Amsterdam could<br />
potentially add some volume.<br />
Growth in Eurostar traffic, which had been<br />
restrained by the July 2005 terrorist attacks in<br />
London, resumed in 2006. Paris to London<br />
passenger numbers were up by 4.2% in 2006, at<br />
5.66 million (and by 4.8% over the first six<br />
months of 2007, at 3.90 million). <strong>In</strong> 2006,<br />
Eurostar had 70.2% of the Paris to London<br />
passenger market. On the Brussels to London<br />
passenger market, the 2006 figures were 2.2<br />
million (up 8.5%) and 71.7% respectively.<br />
Eurostar, whose first-half sales were up 13.6% on<br />
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TRANSPORTATION INFRASTRUCTURE<br />
78 ■ NOVEMBER 2007<br />
the previous year, announced that it will increase<br />
the number of weekday trains it runs between<br />
Paris and London in February 2008, to 17 from<br />
15. This is positive for Eurotunnel.<br />
Rail freight.<br />
Stability of freight revenues in the short-tomedium<br />
term is a best-case scenario, while a<br />
further reduction is a more likely outcome.<br />
Future revenues are uncertain after the end of<br />
the subsidy to EWS in 2006, while the service has<br />
relied on state subsidy since services commenced<br />
in 1996. Also, the impact of the purchase of EWS<br />
by Deutsche Bahn AG (AA/Negative/A-1+) from<br />
BRB remains to be seen.<br />
Eurotunnel considers a possible upside,<br />
however. Eurotunnel intends to revive use of the<br />
tunnel by revising the fee structure for rail freight,<br />
making it cheaper for freight trains to run at<br />
night, while charging more at the busiest periods<br />
such as Friday evenings and Monday mornings.<br />
The move could be related to Eurotunnel’s<br />
intention to directly operate some cross-channel<br />
rail freight services (it has an operating license<br />
with its Europorte2 subsidiary). The group has<br />
purchased locomotives in the first half of 2007<br />
and has also ordered some additional locomotives<br />
to Bombardier to be used in the development of<br />
its rail freight activity.<br />
Rail freight services have tended to fare less<br />
well than other Eurotunnel markets. Perhaps the<br />
most important episode was the severe disruption<br />
associated with asylum seekers using trains to<br />
attempt to travel to the U.K. in 2001. This has led<br />
to freight users pulling out in favor of other<br />
transport alternatives, and the market has never<br />
really recovered.<br />
The volume of goods transported by freight<br />
trains declined by 1% compared with 2005, to<br />
1.57 million tons, after a 16% decline in 2005. <strong>In</strong><br />
1998, 3 million tons of freight moved through the<br />
tunnel, which is designed to carry a maximum of<br />
10 million tons. <strong>In</strong> the first half of 2007, traffic<br />
volumes were 14% down on the previous<br />
comparable period.<br />
Competition<br />
Eurotunnel is the operator of an essential<br />
infrastructure, but its revenue streams are not as<br />
predictable as for toll road network, airport, or<br />
port operators, which benefit from the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
monopolistic nature of their industries.<br />
The future strategy of competitors (such as<br />
ferry companies and airlines) remains difficult to<br />
predict, meaning GDP or market growth does not<br />
always materialize in volume or revenue growth.<br />
Since 1996 (1997 for Eurostar services), truck and<br />
rail passenger volumes have increased, whereas<br />
car, coach, and rail freight volumes have tended<br />
to fall.<br />
The primary competition risks in the passenger<br />
market are low-cost and flag airlines and, to a<br />
lesser extent, ferry operators. The shuttle service<br />
enjoys a competitive advantage in terms of speed,<br />
frequency of departures, and reliability, which is<br />
reflected in its premium pricing. A significant<br />
competition risk stems from the ferry operators<br />
P&O, SeaFrance, Norfolkline, and SpeedFerries.<br />
Standard & Poor’s considers the impact on<br />
Eurotunnel’s truck shuttle revenues to be limited<br />
as a result of the successful segmentation strategy;<br />
the expected impact on car and coach shuttle<br />
revenues could be higher, and was factored in the<br />
base case. Eurotunnel estimates that its share of<br />
the accompanied truck market on the short straits<br />
corridor decreased to 36.2% in 2006 from 39.5%<br />
in 2005, reflecting its new strategy.<br />
Finally, freight trains compete directly with<br />
road transport and maritime transport on<br />
container ships. <strong>In</strong>tense competition in the crosschannel<br />
freight market between road haulage<br />
companies has recently put downward pressure<br />
on freight rates, making it more difficult for the<br />
railways to compete. The goods transported by<br />
freight trains are mainly heavy, lower-yielding<br />
items for which speed of delivery is not generally<br />
a primary consideration.<br />
Capital expenditure and maintenance<br />
Scheduled weekly maintenance of the tunnel is<br />
organized and structured to minimize disruption<br />
to commercial operations and optimize capacity<br />
during peak periods.<br />
The second cycle of rail replacement began in<br />
2005, and will continue until 2008 without<br />
disrupting commercial services. Under current<br />
rolling stock maintenance programs, essential<br />
maintenance and safety inspections are carried<br />
out on average every 21 days for the locomotives,<br />
freight shuttles, and passenger shuttles. The largescale<br />
maintenance program that began in 2003 is<br />
accelerating considerably in 2007, to restore and
enhance the reliability of equipment that is now<br />
approaching one-third or one-half of its overall<br />
useful service life.<br />
At present, the tunnel’s capacity does not<br />
constrain the development of the different types<br />
of traffic. <strong>In</strong> the medium or long term, capacity<br />
could be improved by restricting access to slow<br />
freight trains at peak times, and by scheduling<br />
trains so that they run in batteries.<br />
Medium-term capital expenditures are expected<br />
to remain at about £30 million to £40 million per<br />
year, and are related to maintenance and upgrade<br />
programs. An increase in the existing shuttle fleet<br />
does not form part of Eurotunnel’s current<br />
strategy. Eurotunnel aims to take electric power<br />
for the entire tunnel from the French national<br />
grid, which distributes lower-priced energy than<br />
the British grid; this requires limited investment to<br />
help better control unhedged electricity costs.<br />
At the end of July 2006, Eurotunnel and the<br />
railways entered into an agreement, bringing an<br />
end to a dispute that began in 2001 over the<br />
calculation of the railways’ contribution to the<br />
tunnel’s operating costs. This confirmed the<br />
decisions made for the financial years before<br />
2004, set out the agreement for 2005, and set the<br />
contributions on a fixed-payment basis for the<br />
Table 3 - <strong>In</strong>terest By Class Of Notes<br />
Notes <strong>In</strong>terest<br />
Class G1* Formula that accounts for relevant<br />
index-linked UKTi and interest rate<br />
of 3.487%<br />
Class G2* Formula that accounts for relevant<br />
index-linked UKTi and interest rate<br />
of 3.487%<br />
Class G3* Formula that accounts for relevant<br />
index-linked UKTi and interest rate<br />
of 3.487%<br />
Class G4 Formula that accounts for relevant<br />
index-linked OATi and interest rate<br />
of 3.377%<br />
Class G5 Formula that accounts for relevant<br />
index-linked OATi and interest rate<br />
of 3.377%<br />
Class G6 Formula that accounts for relevant<br />
index-linked OATi and interest rate<br />
of 3.377%<br />
Class A1 6.341%<br />
Class A2 6.341%<br />
Class A3 Six-month LIBOR plus 1.25%<br />
Class A4 Six-month EURIBOR plus 1.25%<br />
*The margin is 3.470% until June 30, 2009 and 2.887% thereafter.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
financial years 2006 to 2014 inclusive. A<br />
consultation process was also established to<br />
determine the railway operators’ contributions to<br />
the renewal, and the related replacement costs.<br />
<strong>In</strong>surance coverage<br />
Eurotunnel’s insurance program primarily<br />
comprises policies covering material<br />
damage/business interruption (including terrorism<br />
risk) and third-party liability. The material<br />
damage/business interruption policy covers for an<br />
amount corresponding to the “maximum possible<br />
loss”. The indemnification period for business<br />
interruption is 24 months from the start of<br />
the interruption.<br />
The most notable incident was a major fire in<br />
1996, which interrupted the business for several<br />
months, but was covered by the insurance.<br />
The Railways Usage Contract (RUC)<br />
The railways’ use of the tunnel is governed by the<br />
RUC, which runs until 2052. Under this<br />
agreement, the railways must pay Eurotunnel a<br />
fixed annual charge, and variable charges<br />
determined by reference to the number of<br />
passengers traveling on Eurostar and the freight<br />
tonnage passing through the tunnel. The variable<br />
charges are determined according to a toll<br />
formula that takes into account inflation to a<br />
certain extent and makes adjustments when<br />
specified volume thresholds are exceeded. Any<br />
change to the RUC requires the lenders’ approval.<br />
Until the end of November 2006, the railways<br />
had to make additional monthly payments to<br />
bring Eurotunnel’s annual revenue up to the<br />
guaranteed minimum usage charge (MUC).<br />
<strong>In</strong> 2006, Eurotunnel received a total of<br />
€350 million in payments: €255 million in<br />
variable charges, fixed annual charges, and<br />
contributions to operating costs, and €95 million<br />
relating to the MUC.<br />
Note Terms And Conditions<br />
<strong>In</strong>terest<br />
<strong>In</strong>terest is paid semiannually on payment dates<br />
falling on June 28 and Dec. 28 of each year.<br />
However, the note interest accrual dates are the<br />
relevant loan interest payment dates, being June<br />
20 and Dec. 20 of each year. The eight-day<br />
difference between the payment dates under the<br />
loans and the payment dates under the notes was<br />
NOVEMBER 2007 ■ 79
TRANSPORTATION INFRASTRUCTURE<br />
80 ■ NOVEMBER 2007<br />
included to allow the issuer to make a drawdown<br />
under the liquidity notes in the event of a<br />
shortfall, and to enable the trustee to serve a<br />
notice of demand under the financial guarantees<br />
in the event of a payment default under the loans.<br />
The interest paid by each class of notes is<br />
summarized in table 3 on the previous page.<br />
Redemption Profile<br />
If the issuer receives any unscheduled prepayment<br />
amount from the borrowers, it prepays the debt<br />
outstanding on a pari passu basis with the<br />
following priority:<br />
• Any amounts due and payable on the X<br />
certificates;<br />
• Any principal redemption amounts on the<br />
prepayment due on the corresponding<br />
tranches of the notes; and<br />
• Any make-whole prepayment to the<br />
corresponding tranche of notes.<br />
On a mandatory prepayment, the issuer prepays<br />
the notes pro rata, except where the prepayment<br />
relates to refinancing of all or any tranche of the<br />
permanent facility, in which case the proceeds are<br />
applied by the issuer to redeem the corresponding<br />
tranches of notes pro rata.<br />
Each class of notes can be paid in whole or in<br />
part, subject to certain prepayment penalties, and<br />
in a minimum amount of £5.0 million or<br />
€ 7.5 million.<br />
On a substitution event of the existing<br />
concessionaires and the acceleration of the<br />
permanent facility, the issuer sweeps cash received<br />
to redeem the notes, unless it can invest in<br />
eligible investments that replicate the payment on<br />
the notes.<br />
Early redemption and the authorized investment<br />
(AI) Option<br />
Under condition 10(h), the monolines hold an<br />
option that can be exercised upon a full or partial<br />
prepayment of the tranche A loan (that<br />
corresponds to class G notes at the issuer level) in<br />
case the proceeds from prepayment of the loan<br />
are not sufficient to pay the relevant note<br />
redemption amount plus the net present value of<br />
the financial guarantee fee, provided no loan<br />
event of default has occurred. This option allows<br />
the monoline to invest the amount prepaid (which<br />
normally would have been applied in redemption<br />
of the tranche G notes) in a defeasance account to<br />
be invested in authorized investments. Such<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
investments need to produce amounts at least<br />
equal to amounts payable in respect of the notes<br />
(including the guarantee fee) on each scheduled<br />
payment date in respect of this principal amount<br />
and in respect of the relevant proportion of the<br />
tranche A loan prepaid.<br />
Practically, if the monolines exercise this option,<br />
they have to make sure that a defeasance account<br />
is opened with the issuer bank account provider<br />
in the name of the issuer--one for each class of G<br />
notes that would have been prepaid if the option<br />
were not exercised. <strong>In</strong> addition, a custodian is<br />
appointed with regard to defeasance accounts to<br />
hold the monoline authorized investments on the<br />
issuer’s behalf.<br />
The cash standing on these accounts together<br />
with the proceeds generated by the monoline<br />
authorized investments is taken into account in<br />
the waterfall for the payment of interest and<br />
principal of the relevant class G notes. This is<br />
because the loan has been prepaid and therefore<br />
no further interest or principal is paid by the<br />
borrower on that portion of the loan.<br />
If the tranche A1 or A2 loan has been prepaid<br />
in full and the authorized investment (AI) option<br />
has been exercised by the monolines, the trustee<br />
notifies the tranche G noteholders. Once the<br />
noteholders have been notified, within 30 days,<br />
they can ask to redeem the tranche G notes<br />
that they hold to the extent that the notes<br />
would have been redeemed had the prepayment<br />
not been the subject of the AI option. The amount<br />
received by the relevant tranche G noteholder<br />
follows the payment of amounts due to the<br />
relevant monoline.<br />
Issuers’ pre-enforcement priority of payments<br />
Before enforcement, the issuer applies the<br />
available funds plus any liquidity drawings, save<br />
that (i) if the monoline has exercised the AI<br />
option, any AI receipts generated from a certain<br />
defeasance account are used only to pay the<br />
relevant monoline or the relevant class G<br />
noteholder for which that account has been<br />
opened, and (ii) if the noteholders have<br />
exercised their AI option, the amounts received in<br />
the relevant defeasance account are used only to<br />
repay the relevant monoline, in the<br />
following order:<br />
• Senior expenses related to the transaction,<br />
including trustee fees, rating services fees,<br />
and corporate servicer fees, total return
swap custodian, plus any moneys to be paid<br />
into the issuer’s expenses reserve accounts<br />
and any amounts to be credited to the<br />
liquidity accounts up to the required<br />
liquidity amount;<br />
• Any interests due on the liquidity notes;<br />
• Any principal due on the liquidity notes;<br />
• Any amount due to the TRS counterparties;<br />
• Any amount due to the borrower hedge<br />
counterparties;<br />
• Pro rata and pari passu, according to the<br />
respective amounts;<br />
• Any interest due or accrued, any principal,<br />
any amount in excess of the par amount<br />
(always excluding step-up fees) on the<br />
tranche A notes, and any counterparty fixedrate<br />
note payment under the margin basis<br />
swap. All such amounts are applied pro rata<br />
and pari passu to all tranche A notes, but<br />
within each tranche applied according to the<br />
following order:<br />
♦ <strong>In</strong>terest due and accrued;<br />
♦ Principal due; and<br />
♦ The amount in excess of the par amount<br />
upon early redemption and any<br />
counterparty fixed-rate note payment<br />
under the margin basis swap.<br />
• For each class G note depending on the<br />
monoline, the aggregate of: (i) guarantee fees<br />
and other amounts then due to the relevant<br />
monoline, taking into account any AI receipt<br />
for that amount; (ii) all amounts of interest<br />
due or taking into account any AI receipt for<br />
that amount; (iii) any principal taking into<br />
account any AI receipt for that amount; and<br />
(iv) any amounts in excess of the indexed<br />
par amount payable on early redemption<br />
due and payable on the relevant tranche G<br />
notes, taking into account any AI receipt for<br />
that amount. This amount is applied<br />
pro rata and pari passu for the relevant<br />
tranche G notes, but in the following order<br />
of priority:<br />
♦ Guarantee fees and other amounts due to<br />
the relevant monoline;<br />
♦ <strong>In</strong>terest due and accrued on the relevant<br />
tranche G note;<br />
♦ Any amounts to be reimbursed to the<br />
relevant monoline with regard to any<br />
interest paid under the guarantee;<br />
♦ Scheduled principal due on the relevant<br />
tranche G note;<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
♦ Any amounts to be reimbursed to the<br />
relevant monoline with regard to any<br />
scheduled principal paid under the<br />
guarantee;<br />
♦ Any amounts to be reimbursed to the<br />
relevant monoline with regard to any<br />
unscheduled principal paid under the<br />
guarantee;<br />
♦ Any amount of unscheduled principal<br />
due to the relevant tranche G notes; and<br />
♦ Any amount in excess of the par amount<br />
upon early redemption on the relevant<br />
tranche G note.<br />
• Step-up amounts on the class A3 and class<br />
A4 notes;<br />
• Additional amounts including withholding<br />
tax gross-up;<br />
• Any subordinated amounts to the hedge<br />
counterparties; and<br />
• The amount in the issuer’s transaction<br />
account to the holder of the class R<br />
certificates, once all the amounts on the<br />
notes listed above have been paid in full.<br />
The issuer’s post-enforcement waterfall is the<br />
same as the issuer’s pre-enforcement priority of<br />
payments, except for additional payments to the<br />
trustee on enforcement.<br />
Notes’ events of default<br />
The issuer’s events of default are limited to:<br />
• Nonpayment under the notes;<br />
• Failure to comply with the transaction<br />
documents;<br />
• Misrepresentation; and<br />
• <strong>In</strong>solvency.<br />
Controlling creditors<br />
The controlling creditors are the monolines for as<br />
long as the wrapped tranches G1, G2, G3, and<br />
G4 are outstanding, or any payment due to the<br />
monolines is still outstanding. Once the tranche G<br />
notes have been redeemed in full and no further<br />
payments are due to the monolines, the tranche<br />
A1 and A2 notes become the controlling creditors.<br />
When the tranche A1 and A2 notes have been<br />
fully redeemed, the control passes to the tranche<br />
A3 and A4 noteholders. Once all the tranche G<br />
and A notes are redeemed, the trustee acts on<br />
behalf of the liquidity noteholders.<br />
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TRANSPORTATION INFRASTRUCTURE<br />
82 ■ NOVEMBER 2007<br />
Credit And Cash Flow Evaluation<br />
Standard & Poor’s analysis focused on a stressed<br />
business plan and EBITDA levels from the<br />
management’s base case. The company’s case that<br />
was used for the debt restructuring was<br />
elaborated in 2005 on reasonable assumptions.<br />
Standard & Poor’s implemented a 20% haircut<br />
to the net present value (NPV) of the company’s<br />
net cash flow (NCF) (equivalent to 23% of the<br />
sum of revenues) on the life of the transaction. <strong>In</strong><br />
this case, the business grows on average by a<br />
nominal 2.2% per year. Bearing in mind that<br />
Eurotunnel’s management case is already<br />
operating at a fairly low level, Standard & Poor’s<br />
estimates that the level of stress implemented is<br />
commensurate with a ‘BBB’ rating.<br />
Eurotunnel’s significant tax loss carry-forward<br />
allows all the pre-tax cash flow to be used for<br />
NCF DSCR (scheduled)<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
debt service in the first 10 years or so.<br />
NCF is used for the DSCR calculation. At the<br />
borrower level, under the management base case,<br />
the minimal scheduled NCF DSCR is at 1.48x<br />
(first year); it then improves, reflecting the<br />
expected volumes and cash flow growth. Under<br />
Standard & Poor’s stressed case, the ratio reaches<br />
a minimum of 1.36x in year six when principal<br />
amortization kicks off. This is a low but<br />
acceptable ratio for a concession with<br />
volume risk. That is above the 1.1x event of<br />
default covenant.<br />
The results from the cash flow analysis are<br />
shown in table 4.<br />
As a result of Standard & Poor’s cash flow<br />
analysis, £2.9 million (or 10.5x forecast EBITDA)<br />
is considered commensurate with a ‘BBB’ rating.<br />
Given the hybrid nature of the business, the<br />
Table 4 - Cash Flow Analysis Compared Outcomes Under Management And Standard & Poor’s Cases<br />
June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30, June 30,<br />
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br />
Management<br />
case (x)<br />
Standard & Poor’s<br />
1.48 1.54 1.62 1.67 1.75 1.59 1.63 1.73 1.90 2.05<br />
case (x) 1.47 1.44 1.46 1.49 1.53 1.36 1.40 1.44 1.48 1.53<br />
Debt/(EBITDA-essential capex)<br />
Management<br />
case (x)<br />
Standard & Poor’s<br />
12.53 12.11 11.54 11.18 10.72 10.28 10.01 9.41 8.52 7.89<br />
case (x) 12.64 12.90 12.81 12.53 12.27 11.95 11.58 11.22 10.87 10.52<br />
Synthetic DSCR (NCF/(Higher of actual and synthetic DS))<br />
Management<br />
case (x)<br />
Standard & Poor’s<br />
1.33 1.37 1.45 1.50 1.56 1.59 1.63 1.73 1.90 2.05<br />
case (x)<br />
NCF ICR<br />
Management<br />
1.31 1.29 1.30 1.33 1.36 1.36 1.40 1.44 1.48 1.53<br />
case (x)<br />
Standard & Poor’s<br />
1.48 1.54 1.62 1.67 1.75 1.82 1.88 2.01 2.23 2.42<br />
case (x)<br />
(FFO + interest)/interest<br />
Management<br />
1.47 1.44 1.46 1.49 1.53 1.56 1.62 1.68 1.74 1.80<br />
case (x)<br />
Standard & Poor’s<br />
1.75 1.80 1.92 1.99 2.00 2.07 2.17 2.28 2.42 2.58<br />
case (x)<br />
FFO/Net debt<br />
Management<br />
1.72 1.70 1.68 1.70 1.72 1.76 1.82 1.88 1.95 2.02<br />
case (%)<br />
Standard & Poor’s<br />
9.2 9.4 10.0 10.4 10.4 10.8 11.3 11.9 12.5 13.3<br />
case (%) 9.1 8.9 8.8 8.9 9.0 9.2 9.5 9.8 10.1 10.4
length of the concession, and its bi-national<br />
economics, it is impossible to find a suitable peer<br />
to Eurotunnel.<br />
Accounting Issues<br />
Since December 2005, Eurotunnel Group’s<br />
financial statements have been prepared in<br />
accordance with IFRS.<br />
Going concern<br />
The auditors and Commissaires aux Comptes<br />
have reported on the 2006 accounts. Their report<br />
contained matters of emphasis relating to going<br />
concern, the valuation of property, plant, and<br />
equipment, the consequences of the<br />
implementation of the safeguard plan on<br />
the accounts, and the nonapproval of the<br />
2005 accounts.<br />
Treatment of the accounts on a going concern<br />
basis depends on the full implementation of the<br />
safeguard plan, which seems increasingly likely<br />
now that the exchange tender offer has been<br />
successful, with 93% of the share capital finally<br />
tendered. Going concern involved, notably, the<br />
drawing of the term loan (this has now been<br />
successfully implemented), and the failure of any<br />
legal action aimed at blocking the safeguard plan<br />
(all recourses seem to have been rejected). If all of<br />
the elements of the safeguard plan are not put into<br />
place, Eurotunnel’s ability to trade as a going<br />
concern would not be assured. The accounts<br />
would be subject to certain adjustments, whose<br />
amounts cannot be measured at present. The<br />
adjustments would relate to the impairment of<br />
assets to their net realizable value, the recognition<br />
of liabilities, and the classification of noncurrent<br />
assets and liabilities as current assets and<br />
liabilities. The asset value on liquidation has been<br />
estimated at £890 million by the valuer/auctioneer<br />
appointed by the safeguard procedure.<br />
Impairment of property, plant, and equipment<br />
Since 2003, the group has applied IAS 36<br />
methodology, which requires the net book value<br />
of assets to be compared with discounted future<br />
operating cash flows. The application of this<br />
standard at Dec. 31, 2005 gave rise to a value in<br />
use £1.75 billion lower than the net book value of<br />
the assets, and led to an impairment charge for<br />
this amount in the 2005 accounts. Impairment<br />
charges for £1.3 billion and £395.0 million were<br />
already made in the 2003 and 2004 accounts.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
The recognition of impairment charges at Dec<br />
31, 2005 caused Eurotunnel’s main companies to<br />
have negative total equity. Under the safeguard<br />
plan, these companies’ equity was reconstituted<br />
through debt capitalization after the tender offer.<br />
<strong>In</strong> 2006, Eurotunnel did not make any<br />
impairment charge. The depreciation charge<br />
decreased by 21% in 2006 following the<br />
impairment charge in 2005.<br />
Recovery Rating Analysis<br />
Standard & Poor’s assigned a recovery rating of<br />
‘2’ to the €2.84 billion senior secured loans. This<br />
indicates Standard & Poor’s expectation of<br />
substantial (70% to 90%) recovery of principal in<br />
the event of a payment default.<br />
Approach<br />
For the loan recovery estimate, Standard & Poor’s<br />
combined an NPV approach (akin to project<br />
finance transactions) with a debt multiple<br />
approach (as for corporates), reflecting the hybrid<br />
nature of Eurotunnel.<br />
Standard & Poor’s used an enterprise valuation<br />
based on going concern because it considers that<br />
greater value will remain in the business if it is<br />
reorganized rather than liquidated.<br />
Based on the live example of Eurotunnel’s debt<br />
negotiations and financial restructuring between<br />
2005 and 2007, Standard & Poor’s assumes that<br />
an event of default at the borrower level would be<br />
followed by a successful negotiation with the<br />
creditors, leading to a consensual debt<br />
restructuring instead of a substitution. The new<br />
debt structure is becoming much simpler, favoring<br />
a consensual restructuring.<br />
Payment default scenario<br />
Standard & Poor’s simulated payment default<br />
assumes a severe traffic shock in 2013, leading to<br />
a borrower’s default at the time of the first<br />
principal payment that year.<br />
<strong>In</strong> 2013, the borrower’s total debt service will<br />
be about £182 million; NCF needs to fall to £200<br />
million for an event of default on the term loan.<br />
Assuming £15 million of saving could be made on<br />
capital and operating expenditures, the event of<br />
default requires EBITDA to fall to approximately<br />
£225 million (a 20% fall under Standard & Poor’s<br />
scenario, which is already stressing the<br />
management’s case).<br />
Following the event of default at the borrower’s<br />
NOVEMBER 2007 ■ 83
TRANSPORTATION INFRASTRUCTURE<br />
84 ■ NOVEMBER 2007<br />
level, Standard & Poor’s assumes the issuer would<br />
have to draw entirely on its debt-service reserve<br />
facility to meet its obligations on the notes.<br />
Estimated recovery<br />
Under the NPV approach, Standard & Poor’s<br />
assumes EBITDA to remain constant at £230<br />
million per year in real terms (assuming an annual<br />
2% inflation) from 2015 until 2050 (with capex<br />
and WC assumptions unchanged). The LLCR<br />
(loan life cover ratio) at year 2015 is at about<br />
0.9x, calculated with a discount rate of 8%.<br />
Standard & Poor’s focused more on LLCR than<br />
on CLCR (concession life cover ratio); although<br />
the concession matures in 2086 and there will be<br />
cash flows beyond 2050, the visibility of cash<br />
flows more than 40 years from now is limited<br />
(especially as the RUC ends in 2052). <strong>In</strong> addition,<br />
with regard to the period between 2052 and<br />
2086, the concessionaires will be obliged to pay<br />
to the states a total annual sum, including all<br />
corporate taxes of any kind, equal to 59% of all<br />
pre-tax profits.<br />
Under the debt multiple approach, Standard &<br />
Poor’s has estimated the recovery prospects<br />
based on:<br />
• A similar distressed EBITDA base of about<br />
£230 million; and<br />
• Average valuation multiples of 8x to 10x,<br />
representing a haircut with the current<br />
restructuring (10.5x to 11x), and more in<br />
line with some other infrastructure deals.<br />
This would result in a recovery ranging from<br />
about 60% to 74%. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
July 23, 2007<br />
Issuer Credit Rating:<br />
BBB+/Stable/--<br />
Primary Credit Analyst:<br />
Maria Lemos, CFA,<br />
London,<br />
(44) 20-7176-3749<br />
Secondary Credit Analyst:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
COPENHAGEN AIRPORTS A/S<br />
Rationale<br />
The rating on Copenhagen Airports A/S (CPH) is<br />
supported by the airport’s strong competitive<br />
position as a natural hub for Scandinavian<br />
countries. The rating also reflects CPH’s efficient<br />
aviation and strong commercial operations, the<br />
adequate regulatory environment, strong cash<br />
flow generation, and sound financial flexibility.<br />
Offsetting these strengths are CPH’s relatively<br />
large proportion of transfer traffic and high<br />
customer concentration. The rating is also<br />
constrained by the company’s weakened financial<br />
profile following Macquarie Airports (MAp)’s<br />
(BBB/Stable/--) acquisition of a controlling stake in<br />
CPH in December 2005 through financing vehicle<br />
Macquarie Airports Copenhagen Holdings ApS<br />
(MACH; BBB+/Stable/--). As a result of this<br />
partial acquisition we consolidate MACH’s debt<br />
with CPH’s own Danish krone (DKK) 2.0 billion<br />
debt (about €269 million), given the level of<br />
MACH’s control and ownership. The acquisition<br />
debt is nonrecourse to CPH, however, leaving<br />
CPH’s pre-existing debt structure unaffected.<br />
Copenhagen Airport handled 20.9 million<br />
passengers in 2006. <strong>In</strong> the first half of 2007,<br />
traffic increased by 2.3% year on year on the back<br />
of increased flight frequencies and new routes.<br />
CPH enjoys a strong competitive position,<br />
supported by its main carrier Scandinavian<br />
Airlines (SAS), which uses the airport as its<br />
regional hub. Nevertheless, CPH’s proportion of<br />
transfer traffic has been declining since 2003,<br />
albeit remaining high at about 30%, which<br />
Standard & Poor’s Ratings Services considers a<br />
weakness. Moreover, the company derives about<br />
half of its passenger volume from SAS and runs<br />
the risk of losing part of its transfer traffic if SAS<br />
ceases to operate.<br />
CPH achieved an EBITDA margin of 54.1% in<br />
2006--which is high compared with peers--owing<br />
to its efficient operations, strong cost manage-<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
ment, and successful commercial operations,<br />
which rank among the best in Europe.<br />
At June 30 2007, gross debt at MACH and<br />
CPH combined declined to DKK7.1 billion, from<br />
DKK8.9 billion at Dec. 31, 2006, as proceeds<br />
from a special dividend distribution from CPH’s<br />
associated company Newcastle <strong>In</strong>ternational<br />
Airport Ltd. and from the sale of CPH’s Chinese<br />
and part of its Mexican operations were used for<br />
debt repayment. At end-December 2006, funds<br />
from operations (FFO) to average total debt and<br />
FFO interest coverage were 12.6% and 3.2x,<br />
respectively, and free cash flow generation was<br />
DKK494.7 million, according to Standard &<br />
Poor’s calculations.<br />
Liquidity<br />
CPH has strong liquidity. At June 30, 2007, the<br />
company had about DKK1.0 billion in unused<br />
committed bank lines and DKK225.4 million in<br />
cash. Debt maturing within the next five years is<br />
not a concern, because maturities are manageable<br />
and we expect CPH to remain cash flow positive<br />
after dividend distributions. Liquidity is further<br />
supported by a modest and flexible capital<br />
expenditure program.<br />
Outlook<br />
The stable outlook reflects our expectation that<br />
CPH will maintain its strong competitive position<br />
and focus on growth of internal cash flow<br />
generation. Free cash flow generation is expected<br />
to continue, but is unlikely to result in significant<br />
early debt repayments given our expectation that<br />
the company will use the cash for dividend<br />
payments and capital spending. Any capital return<br />
to shareholders will limit rating upside.<br />
Major industry events causing a consistent<br />
passenger volume decline or a significant<br />
deterioration in SAS’ operations could pressure the<br />
rating, as could a further increase in leverage. ■<br />
NOVEMBER 2007 ■ 85
TRANSPORTATION INFRASTRUCTURE<br />
Publication Date:<br />
Sept. 19, 2007<br />
Issuer Credit Rating:<br />
AA/Negative/A-1+<br />
Primary Credit Analyst:<br />
Ralf Etzelmueller,<br />
Frankfurt,<br />
(49) 69-33-999-123<br />
Secondary Credit Analysts:<br />
Eve Greb,<br />
Frankfurt,<br />
(49) 69-33-999-124<br />
Amrit Gescher,<br />
London,<br />
(44) 20-7176-3733<br />
86 ■ NOVEMBER 2007<br />
DEUTSCHE BAHN AG<br />
Rationale<br />
The ratings on Germany-based integrated railway<br />
and logistics company Deutsche Bahn AG (DB<br />
AG) reflect the company’s strong business risk<br />
profile derived from its dominant position and<br />
strategic importance in the German transport<br />
sector, as well as the close relationship with, and<br />
support from, its current 100% owner, the<br />
Federal Republic of Germany (AAA/Stable/A-1+).<br />
DB AG’s strengths are offset by an intermediate<br />
financial risk profile and uncertainties related to<br />
the expected privatization of up to 49% of the<br />
company’s capital.<br />
Standard & Poor’s Ratings Services applies a<br />
top-down rating approach for governmentsupported<br />
companies, which notches down from<br />
the sovereign rating, as the credit standing is<br />
linked to that of the government. The ratings on<br />
DB AG, which are two notches lower than those<br />
on Germany, reflect the absence of direct state<br />
guarantees for outstanding debt and that<br />
timeliness of financial support for the company is<br />
not explicitly guaranteed. Nevertheless, the state<br />
has demonstrated its support for DB AG through<br />
the full backing of its acquisitions and<br />
investments in recent years, significant direct<br />
grants for network investments, and indirect<br />
payments through the regional states for services<br />
provided by DB AG and its subsidiaries. Ministry<br />
officials have also repeatedly given clear<br />
statements to Standard & Poor’s that the state<br />
will continue to support DB AG in its current<br />
form and ensure that it maintains a sustainable<br />
credit profile.<br />
DB AG continues to provide essential railway<br />
services within Germany, but its acquisitions,<br />
mainly in the logistics sector, have transformed<br />
the company into a worldwide integrated mobility<br />
and logistics firm that in 2006 derived about 50%<br />
of its revenues from non-railway services. State<br />
support is therefore a key consideration for the<br />
‘AA’ rating, as Standard & Poor’s assesses the<br />
business risk profile of the logistics industry as<br />
weaker than that of the railway business, and DB<br />
AG’s current stand-alone financial risk profile is<br />
not in line with an ‘AA’ rating.<br />
DB AG’s first-half 2007 results were in line<br />
with Standard & Poor’s expectations and boosted<br />
by a strong performance across all business areas.<br />
DB AG’s financial debt decreased by about<br />
€600 million to €18.9 billion compared with the<br />
end of December 2006 and its EBIT improved by<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
about €400 million to €1.35 billion. Standard &<br />
Poor’s expects that DB AG’s key debt and interest<br />
coverage ratios will improve further in 2007.<br />
Moreover, we expect that the company will<br />
continue to reduce leverage and improve its<br />
financial risk profile over the medium term.<br />
Short-term credit factors<br />
DB AG’s liquidity remains strong, owing mainly<br />
to its easy access to capital markets and a<br />
comfortable cash position of €992 million at the<br />
end of June 2007. <strong>In</strong> our view, DB AG should be<br />
able to refinance upcoming maturities owing to its<br />
very good access to the capital markets. <strong>In</strong><br />
addition, the company has sound liquidity<br />
through committed bank facilities.<br />
Outlook<br />
The negative outlook reflects our concerns and<br />
questions related to the expected partial<br />
privatization that was approved by the German<br />
government on July 24, 2007. Areas of<br />
uncertainty are DB AG’s ability to continue<br />
reducing leverage under a partial privatization,<br />
whether it could come under pressure to make<br />
dividend payments that are currently not part<br />
of its financial forecasts, and whether it<br />
would potentially adopt a more aggressive<br />
acquisition strategy.<br />
We will need to assess whether similar<br />
government support will and can be provided for<br />
the privatized entity. The service and financing<br />
agreement currently being negotiated would<br />
suggest consistent levels of financial commitment<br />
for extended time periods. We would also need to<br />
assess the company structure post privatization.<br />
An important factor will also be how much of the<br />
privatization proceeds will be used to improve the<br />
company’s balance sheet.<br />
After a minority privatization, we expect to<br />
switch to a bottom-up rating approach, most<br />
likely still factoring in state support, but reflecting<br />
reduced government ownership in the business.<br />
We would also adopt this approach if DB AG<br />
made additional large acquisitions in the<br />
meantime, similar to those of logistics companies<br />
BAX Global and Stinnes AG, which would<br />
further expose DB AG to logistics activities. The<br />
latter could have negative rating implications, as<br />
the business risk would increase because strategic<br />
rail and infrastructure services would become<br />
less relevant. ■
Publication Date:<br />
June 13, 2007<br />
Issuer Credit Rating:<br />
A+/Stable/A-1<br />
Primary Credit Analyst:<br />
Jonathan Manley,<br />
London,<br />
(44) 20-7176-3952<br />
Secondary Credit Analysts:<br />
Florian De Chaisemartin,<br />
London,<br />
(44) 20-7176-3760<br />
DP WORLD LTD.<br />
Rationale<br />
The ratings on Dubai-based port operator DP<br />
World Ltd. principally reflect Standard & Poor’s<br />
Ratings Services’ expectation of sovereign support<br />
based on the company’s indirect ownership by the<br />
government of Dubai and its pivotal role in<br />
diversifying the emirate’s revenues away from oil<br />
and fostering international expansion. DP World<br />
is a major international port operator and<br />
its key activities in Dubai benefit from a strong<br />
hub position. DP World also has geographic<br />
diversification after recent large international<br />
acquisitions.<br />
Like other port operators, DP World is exposed<br />
to the global economy and developing<br />
international trade streams, particularly to and<br />
from China and <strong>In</strong>dia. The company is also likely<br />
to face heightened port competition for<br />
transshipment along with increasing consolidation<br />
in the shipping industry.<br />
Given DP World’s national importance,<br />
Standard & Poor’s has factored implicit sovereign<br />
support into the rating; there are, however, no<br />
formal guarantees. State support for DP World is<br />
demonstrated by: the emirate’s 100% ownership<br />
through its Dubai World holding company; the<br />
emirate’s direct influence over the company<br />
through Dubai World’s representation on DP<br />
World’s board, including the position of<br />
chairman; the company’s strategic importance as a<br />
conduit for diversifying the economy of the<br />
emirate away from oil; and the previous tangible<br />
financial, operational, and extraordinary support<br />
for the company’s activities. The company’s standalone<br />
rating is solid investment grade within the<br />
‘BBB’ rating category.<br />
DP World benefits from a strong position in the<br />
global ports sector, where barriers to entry are<br />
high. The company has a highly diversified<br />
revenue base in terms of location and cargo,<br />
significant sector experience, and a good<br />
operating track record. DP World is not an<br />
integrated business, however, in that it is not, at<br />
present, a landlord. Within this context the<br />
emirate has demonstrated its support of DP<br />
World by awarding the company a 99-year lease<br />
for the Jebel Ali port facility located in Dubai-against<br />
an industry norm of 20-50 years--while<br />
making significant infrastructure investments in<br />
the hinterland surrounding the port. Reflecting<br />
the importance of the company to the emirate,<br />
Standard & Poor’s expects a significant<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
proportion of the company’s EBITDA to continue<br />
to be generated at the Jebel Ali and Port Rashid<br />
facilities in the medium term.<br />
Port activity is either as a transshipment hub or<br />
for the import and export of goods for a region<br />
or hinterland. The more a port relies on<br />
transshipment, the more it is exposed to world<br />
trade development. The port sector, like shipping,<br />
is experiencing very brisk business due to the<br />
current positive economic climate and, especially,<br />
China’s and <strong>In</strong>dia’s growth. Clearly, DP World’s<br />
ports--like other ports--would be negatively<br />
affected in the event of a global economic<br />
downturn or changes in trade patterns and/or<br />
volumes. A potential industry downturn could be<br />
exacerbated by increasing bargaining power, due<br />
to size, mounting concentration of container<br />
shipping companies, and intensifying competition<br />
between ports for transshipment cargo.<br />
Furthermore, the company faces the potential<br />
geopolitical risk of the location of its main port<br />
asset--Jebel Ali--in the Gulf region.<br />
DP World’s recent, sizable acquisitions include<br />
Peninsular & Oriental Steam Navigation Co.<br />
(P&O) and CSX World Terminals. The company<br />
has consequently faced the challenge of<br />
integrating these assets while maintaining existing<br />
performance and deriving expected returns from<br />
the new acquisitions. Furthermore, although the<br />
company may have some degree of flexibility over<br />
its future capital expenditure program, it needs to<br />
maintain its competitive position against other<br />
operators by investing in new technology and<br />
undertaking new projects, such as the recently<br />
announced £1.5 billion investment in the complex<br />
London Gateway Port facility.<br />
The company has a relatively aggressive<br />
financial profile. Debt leverage is likely to<br />
increase, primarily as a result of the debt<br />
financing of capital expenditures. At the same<br />
time, cash flow cover ratios are relatively low,<br />
leaving limited room for underperformance in<br />
executing future capital investment. There may be<br />
flexibility to postpone or cancel planned capital<br />
expenditures, however, should the need arise.<br />
Liquidity<br />
At Dec. 31, 2006, DP World benefited from more<br />
than $2.2 billion in back-up liquidity, primarily<br />
through free cash of $1.7 billion. The company’s<br />
future primary liquidity will, however, be<br />
provided via credit facilities of $0.5 billion. <strong>In</strong><br />
NOVEMBER 2007 ■ 87
TRANSPORTATION INFRASTRUCTURE<br />
88 ■ NOVEMBER 2007<br />
addition, DP World will likely be able to call on<br />
Dubai World to provide liquidity, as has occurred<br />
previously to fund acquisitions.<br />
Outlook<br />
The stable outlook assumes that DP World will<br />
continue to benefit from its close strategic<br />
relationship with, and ownership by, the<br />
government of Dubai. Any indication that the<br />
government’s support for the company has<br />
weakened would result in a change in the rating<br />
although, of itself, the sale of a minority stake<br />
in the company would be unlikely to affect<br />
the ratings.<br />
The outlook also assumes that the company<br />
will successfully execute its business plan and<br />
fulfill its financial forecasts, in<br />
the light of any global economic downturn,<br />
increased competition, and successful execution of<br />
the capital expenditure program, including<br />
acquisitions. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
June 7, 2007<br />
Issuer Credit Rating:<br />
A/Negative/A-1<br />
Primary Credit Analyst:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
Secondary Credit Analyst:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
SANEF<br />
Rationale<br />
The ratings on Sanef are equalized with those on<br />
Abertis <strong>In</strong>fraestructuras S.A. (A/Negative/--).<br />
Following its privatization, Sanef is controlled by<br />
Abertis through 52.6%-owned Holding<br />
d’<strong><strong>In</strong>frastructure</strong>s de Transport S.A.S. (HIT;<br />
A/Negative/--), the intermediary vehicle that<br />
acquired Sanef.<br />
The rating on Abertis reflects the company’s<br />
excellent business profile, with strong and stable<br />
cash flow generation derived largely from its tollroad<br />
concession business, a supportive regulatory<br />
framework both in Spain and France, and fairly<br />
manageable future capital-expenditure needs.<br />
These strengths are offset by Abertis’ weakened<br />
financial profile and lack of dividend flexibility, as<br />
well as its appetite for additional acquisitions,<br />
which could further impair its business and<br />
financial profile. It is important to note that<br />
without this support, HIT and Sanef’s underlying<br />
credit quality would be significantly weaker. On a<br />
combined, stand-alone basis, HIT and Sanef<br />
would have very low investment-grade ratings. If<br />
Abertis’ continued acquisitive strategy<br />
significantly reduces Sanef’s contribution to<br />
Abertis’ consolidated financial profile, HIT and<br />
Sanef could be rated one notch below Abertis.<br />
The ratings on Sanef reflect its strong market<br />
position as the third-largest interconnected tollroad<br />
network across key economic and tourist<br />
corridors in France, supportive concession<br />
agreements, high profitability, and increasing<br />
positive free cash flow generation. These strengths<br />
are offset by Sanef’s exposure to traffic risk, a<br />
weakened financial profile following its<br />
acquisition by HIT--particularly when HIT’s debt<br />
is factored in--and aggressive dividend payout to<br />
HIT limiting debt burden curtailment and<br />
exposing lenders to substantial refinancing risk.<br />
<strong>In</strong> the financial year ended Dec. 31, 2006,<br />
Sanef’s consolidated EBITDA amounted to €809<br />
million, up 8.6% on 2005. EBITDA essentially<br />
derived from toll revenues, which grew 6% in<br />
2006, and should continue to represent 90% or<br />
more of revenues over the medium term. The<br />
unadjusted EBITDA margin increased to 66%.<br />
Consolidated HIT and Sanef net debt peaked at<br />
about €6.8 billion (excluding Sanef’s debt<br />
revaluation following acquisition), in line with<br />
expectations, at year-end 2006. With a<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
consolidated net-debt-to-EBITDA ratio of 8.7x,<br />
the companies were still comfortably complying<br />
with the consolidated covenants at HIT’s level<br />
(maximum ratio of 10.5x) at year-end 2006.<br />
Based on the consolidated covenants at the HIT<br />
level, leverage is expected to decrease to 6.5x at<br />
year-end 2012. Sanef’s group net debt at 5.2x<br />
EBITDA at year-end 2006 is still well below the<br />
threshold of 7.0x set by Caisse Nationale des<br />
Autoroutes (AAA/Stable/--).<br />
Liquidity<br />
Sanef’s liquidity is satisfactory, owing to steady<br />
cash flow generation stemming from the tollroad<br />
business.<br />
Financing needs for 2007 include some €469<br />
million of debt maturing until Dec. 31, 2007, and<br />
a forecast €176 million dividend payment to HIT<br />
based on 100% payout of 2006 net income.<br />
These were partially covered by available cash<br />
and marketable securities of €223 million at yearend<br />
2006 and expected positive free operating<br />
cash flow (defined as funds from operations<br />
{FFO} plus working capital change, minus capital<br />
expenditures) of about €280 million in 2007,<br />
making debt refinancing necessary.<br />
Outlook<br />
The negative outlook mirrors that on Abertis and<br />
reflects mainly our concern that Abertis is now<br />
pursuing a more aggressive acquisition strategy<br />
following the purchase of a 32% stake in Eutelsat<br />
Communication S.A. (BB+/Stable/B), the holding<br />
company of Eutelsat S.A.<br />
We expect Abertis to be able to meet the target<br />
ratios we indicated on June 1, 2006: FFO to gross<br />
debt of about 13%-15% and FFO interest<br />
coverage of about 3.5x-4x. We expect Abertis to<br />
approach the lower end of these ranges over the<br />
next two years, and to make continued<br />
improvements toward the higher end of the<br />
ranges thereafter.<br />
Abertis does not have headroom for further<br />
debt-financed acquisitions at the current rating<br />
level. A stronger-than-originally-expected financial<br />
performance could lead to a revision of the<br />
outlook to stable on Abertis, and therefore on<br />
Sanef and HIT. ■<br />
NOVEMBER 2007 ■ 89
TRANSPORTATION INFRASTRUCTURE<br />
Publication Date:<br />
June 11, 2007<br />
Issuer Credit Rating:<br />
BBB+/Negative/A-2<br />
Primary Credit Analyst:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
Secondary Credit Analyst:<br />
Hugues De La Presle,<br />
Paris,<br />
(33) 1-4420-6666<br />
90 ■ NOVEMBER 2007<br />
VINCI S.A.<br />
Rationale<br />
The ratings on VINCI S.A. reflect its strong<br />
market positions in a wide variety of concession<br />
and construction activities, and the considerable<br />
contribution from its stable and profitable<br />
concession businesses--59% of pro forma<br />
operating profit from ordinary activities in 2006.<br />
These strengths are mitigated by the capitalintensive<br />
nature of the concessions business, high<br />
leverage, the cyclical and relatively lower margin<br />
nature of construction activities, and VINCI’s<br />
acquisitive strategy.<br />
At the beginning of 2007, VINCI increased its<br />
stake in Cofiroute, and is to do so in Soletanche<br />
(subject to approval by antitrust authorities). It<br />
acquired Nukem Ltd. and recently announced<br />
that it had agreed the acquisition of 41% of<br />
Entrepose Contracting and will file a takeover bid<br />
covering the remaining Entrepose Contracting<br />
shares within the next few days. Standard &<br />
Poor’s Ratings Services will monitor the impact of<br />
VINCI’s flow of acquisitions on the group’s<br />
business and financial risk profiles. The current<br />
ratings do not provide flexibility for any new<br />
large debt-financed acquisitions.<br />
Overall, we view the recent acquisitions as<br />
positive for VINCI’s business, even though they<br />
have increased leverage and pay-off for the<br />
Cofiroute stake will only come when Cofiroute<br />
completes its large construction program in 2008.<br />
Given that VINCI had ownership in or<br />
commercial involvement with these entities prior<br />
to the transactions, acquisition risk is limited.<br />
Nukem Ltd. and Entrepose Contracting will<br />
complement VINCI’s presence in value-added and<br />
specialty businesses, while broadening geographic<br />
coverage in rapidly growing markets.<br />
The share buyback of 12 million of VINCI<br />
shares announced in September 2006 (to the tune<br />
of more than €1 billion) has been factored into<br />
the ratings. However, our concerns on how<br />
VINCI intends to finance further buybacks and<br />
over its appetite for further external growth<br />
contribute to the negative outlook on the group.<br />
VINCI has, however, announced to investors that<br />
it will be less active on the share buyback front if<br />
interesting external growth opportunities arise.<br />
Acquisitions have delayed the improvement of<br />
the group’s financial profile and VINCI’s credit<br />
ratios will weaken slightly in 2007 versus 2006,<br />
despite an expected strong operating performance.<br />
However, we still expect the company to achieve<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
a financial profile commensurate with the ‘BBB+’<br />
rating, strengthening funds from operations (FFO)<br />
to net debt and FFO to net interest to about 20%<br />
and 5.0x by 2010, respectively, from 15% and<br />
about 4.5x in 2007. At year-end 2006 and on a<br />
pro forma basis, adjusted FFO to net debt was<br />
about 16%, and adjusted FFO to net interest<br />
close to 5.0x.<br />
Short-term credit factors<br />
The ‘A-2’ short-term rating reflects VINCI’s good<br />
liquidity, which stems from the group’s cashgenerative<br />
toll road and construction businesses.<br />
Liquidity was supported by about € 5.5 billion of<br />
cash and marketable securities at March 31 2007.<br />
VINCI also had € 5.7 billion fully available under<br />
five- to seven-year revolving credit facilities (out<br />
of which € 3.9 billion is not subject to financial<br />
covenants) maturing between 2011 and 2013.<br />
This figure includes ASF’s and Cofiroute’s<br />
facilities. <strong>In</strong> addition, VINCI’s liquidity benefits<br />
from a CP program--of which about € 1 billion<br />
was used at March 31, 2007--and positive free<br />
cash flow generation.<br />
A downgrade or negative CreditWatch<br />
placement of the ratings on VINCI following a<br />
winding up or dissolution of the company would<br />
allow bondholders to demand early redemption of<br />
the € 1 billion bonds maturing 2009, and in<br />
this case refinancing would be required. A normal<br />
acquisition would not trigger early redemption,<br />
however.<br />
Early redemption of the € 1 billion bonds could<br />
also be required if VINCI is placed on<br />
CreditWatch negative following the transfer of a<br />
principal subsidiary’s undertakings and assets.<br />
Principal subsidiary refers to a 51%-owned (85%<br />
for Cofiroute) subsidiary accounting for more<br />
than 1% of total sales, where the group has a<br />
board majority. We do not, however, expect any<br />
transfer of assets that would lead to early<br />
redemption of the bonds.<br />
VINCI’s € 500 million hybrid issued in<br />
February 2006 does not include a change of<br />
control clause.<br />
Outlook<br />
The negative outlook reflects our concerns that<br />
debt-financed acquisitions and share buybacks<br />
further to those we have already factored into the<br />
ratings could weaken VINCI’s financial profile<br />
and delay the achievement of target ratios.
To sustain a ‘BBB+’ rating, VINCI’s strong<br />
business risk profile requires continuing support<br />
from its solid and mature concessions businesses,<br />
which provide about two-thirds of EBITDA.<br />
The ratings will be lowered if the financial<br />
profile deteriorates or the target ratios are not<br />
met by 2010. Beyond what we have already<br />
factored into the rating in terms of acquisitions,<br />
share buybacks, public private partnership (PPP)<br />
investments, and dividends, there is very little<br />
headroom for a weakening in the financial profile.<br />
We have not assumed a further increase in<br />
VINCI’s ownership of Cofiroute.<br />
The outlook could revert to stable if it becomes<br />
clear that the company will achieve its target<br />
ratios by 2010, meeting our strategy expectations.<br />
The improvement of VINCI’s credit metrics is<br />
predicated on improved cash flow generation,<br />
rather than debt reduction. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
TRANSPORTATION INFRASTRUCTURE<br />
NOVEMBER 2007 ■ 91
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92 ■ NOVEMBER 2007<br />
PROJECT FINANCE AND PUBLIC-PRIVATE PARTNERSHIPS<br />
Our project finance ratings, including those for public-private partnerships (PPPs), remain<br />
relatively stable. Notwithstanding this, 2007 has continued to present credit challenges to the<br />
sector.<br />
The £1.6 billion debt-financed Metronet London Underground PPP projects, for example, entered PPP<br />
administration as the capital cost and progress of undertaking the upgrade works outstripped<br />
expectations. While the resolution of this situation is yet to unravel, the £2.8 billion launch of the<br />
Channel Link Enterprises transaction marked the rebirth of the Eurotunnel project--albeit following a<br />
significant reduction in debt.<br />
Our coverage of projects and PPPs continues to grow, particularly in the U.K. PPP sector for schools<br />
and hospitals, in road projects throughout Europe, and natural resource projects in the Middle East.<br />
Furthermore, increased activity has been noted in the project finance CLO market--where banks seek to<br />
transfer credit risk on existing project finance loans--as effective ways of recycling capital are sought.<br />
Although only one such transaction launched in 2007 (Smart PFI 2007), many wait in the wings until<br />
stability returns to the credit markets.<br />
During 2007, Standard & Poor’s updated its criteria for analyzing project finance transactions. While<br />
the overall framework for evaluation remains the same, our criteria has evolved to reflect the pace of<br />
change presented by the project finance market. Globally Standard & Poor’s has identified increasing<br />
risks and complexity in project structures, including accreting swaps, the introduction of facilities<br />
instead of reserves to support liquidity, and the removal of “debt-free” tails. All of these areas, and<br />
others, have been considered by the global analytical teams in the past year and, no doubt, 2008 and<br />
beyond will continue to present new challenges.<br />
As the infrastructure market has, at least until recent months, remained very much the focus of<br />
attention, so has the application of project finance techniques to corporate acquisition structures. The<br />
sponsors’ aim has been to isolate the acquired structure from their ownership. This has often proven to<br />
be a challenge and, in effect, a hybrid market has evolved that reflects the characteristics of corporate<br />
finance but with some of the structural protection of project finance. Although there are benefits from<br />
certain protections, it has proven elusive for many airport and port assets, for example, to fully mitigate<br />
the highly aggressive financial risk.<br />
We expect ratings to remain stable overall, as projects and PPPs are likely to continue to be structured<br />
to ensure relative operating stability. Nevertheless, counterparty risk such as the insolvency of<br />
contractors, inadequate estimates of future costs, and increasing construction costs in the Middle East<br />
present challenging credit factors that we will continue to monitor.<br />
Jonathan MManley<br />
Senior Director and Co-Team Leader<br />
Project <strong>Finance</strong> and Transportation <strong><strong>In</strong>frastructure</strong><br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Lidia PPolakovic<br />
Senior Director and Co-Team Leader<br />
Project <strong>Finance</strong> and Transportation <strong><strong>In</strong>frastructure</strong>
Publication Date:<br />
Sept. 18, 2007<br />
Primary Credit Analysts:<br />
Terry A Pratt,<br />
New York,<br />
(1) 212-438-2080<br />
Ian Greer,<br />
Melbourne,<br />
(61) 3-9631-2032<br />
Arthur F Simonson,<br />
New York,<br />
(1) 212-438-2094<br />
Secondary Credit Analyst:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
UPDATED PROJECT FINANCE SUMMARY DEBT<br />
RATING CRITERIA<br />
The world of project finance has continued<br />
to grow since Standard & Poor’s published<br />
its last comprehensive rating criteria.<br />
Project financing has become increasingly<br />
sophisticated and often riskier, with a wider<br />
investor base attracting new finance structures<br />
and investors across the globe. We have closely<br />
followed these developments over the years,<br />
extending and revising our criteria from time to<br />
time to enable appropriate assessment of projectfinance<br />
risk originating from new markets, new<br />
structures, and new avenues of ownership.<br />
Factoring different market circumstances into our<br />
analysis remains challenging, but global<br />
consistency of our criteria and approach has been<br />
our prime objective in responding to these new<br />
market developments. The combined magnitude<br />
of these criteria additions and changes is not<br />
great; it is, rather, more of a rearrangement that<br />
better reflects current practice and changes to<br />
associated criteria, such as recovery aspects.<br />
Additionally, we want to note that we have<br />
revised certain aspects of our internal analytical<br />
framework for rating projects, and stress that<br />
although we have adopted one significant change<br />
--eliminating our scoring approach--no ratings<br />
will be affected. We introduced scoring six years<br />
ago to facilitate the compare-and-contrast of key<br />
project risks across the spectrum of rated projects.<br />
The scores, and the criteria on which they were<br />
based, represented only guidelines. Scores were<br />
never meant to be additive, but nevertheless,<br />
many readers understood them as such. Because<br />
the scoring caused confusion among some users of<br />
our criteria, we decided to remove those suggested<br />
scores and focus more on other analytical tools to<br />
compare risk across projects. <strong>In</strong> response to the<br />
changing world of project finance and the<br />
blurring of boundaries from pure project-finance<br />
transactions to hybrid structures, our analysis has<br />
been expanded and now incorporates some<br />
corporate analytical practice, to look at a<br />
combination of cash-flow measures, capital<br />
structure, and liquidity management.<br />
We also have reincorporated our assessment of<br />
force majeure risk into our analysis of a project’s<br />
contractual foundation and technical risk, rather<br />
than addressing these as a separate risk category.<br />
The overall criteria framework has not been<br />
changed, however, and still provides a very<br />
effective framework for analyzing and<br />
understanding the risk dynamics of a<br />
project transaction.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Recent Trends<br />
As project finance continues to adjust to the<br />
increasingly diverse needs of project sponsors,<br />
their lenders, and investors, in many cases the<br />
analysis of risk continues to grow in complexity.<br />
Despite this growing variety of project-finance<br />
application and location, the continuing market<br />
desire for nonrecourse funding solutions suggests<br />
that project finance will remain a robust means of<br />
raising infrastructure capital. More aggressive<br />
financial structures sometimes blur the boundaries<br />
of nonrecourse finance both in reality and<br />
perception. Also, the greater exposure to market<br />
risk has forced many sponsors to seek greater<br />
flexibility in project structures to manage cash,<br />
take on additional debt, and enter new businesses<br />
with few restrictions--which makes some projects<br />
look more like corporates.<br />
Projects continue to evolve from their<br />
traditional basis of long-term contracted revenue,<br />
and now involve a greater exposure to a number<br />
of risks. <strong>In</strong>itial project finance primarily was<br />
focused on power markets that had strong<br />
contractual bases; but these days, more projects<br />
are exposed to the risks of volatile commodity<br />
markets or traffic volume exposure, among other<br />
types. Strong global demand for construction and<br />
commodities has increased construction risk, even<br />
for simple projects.<br />
Fewer projects have been able to secure the<br />
more creditor-friendly fixed-price, turnkey, datecertain<br />
construction contracts that better protect<br />
lenders from construction and completion risk.<br />
Term B loan structures--“mini-perms”, with<br />
minimal amortizations and risky bullet maturities<br />
--have established themselves firmly in the project<br />
world, but these capital plans have now been<br />
joined by more complex first- and second-lien<br />
structures, and more debt within holdingcompany<br />
structures, particularly for payment-inkind<br />
instruments that we view essentially as debt.<br />
Many long-term concession projects are<br />
maximizing leverage by employing accreting debt<br />
structures that enable sponsors to recoup quick<br />
equity returns--sometimes before any debt has<br />
been repaid--but that can greatly increase lenders’<br />
exposure to default risk in the later years (see<br />
“Credit FAQ: Accreting Debt Obligations And<br />
The Road To <strong>In</strong>vestment Grade For <strong><strong>In</strong>frastructure</strong><br />
Concessions” on page 105). Private equity has<br />
made strong inroads to project lending and<br />
ownership--either directly or through managed<br />
infrastructure funds. The trend away from<br />
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94 ■ NOVEMBER 2007<br />
ownership by experienced sponsors raises new<br />
concerns about ownership and long-term<br />
operational performance. Positively, the usage of<br />
project finance is growing in part thanks to these<br />
new structures. <strong>In</strong> particular, financing of publicprivate<br />
partnerships (PPPs) has grown<br />
significantly over the years, with PPPs often<br />
considered to be a lower-risk investment due to<br />
the involvement of a public authority or<br />
government entity.<br />
Another observation is the increase of insured<br />
project finance transactions. Monoline insurance<br />
companies providing guarantees for timely-andfull<br />
debt servicing in cases of projects being<br />
unable to do so has opened different investment<br />
opportunities for the financial markets.<br />
However, we closely monitor and analyze the<br />
underlying risk of these projects to determine the<br />
underlying credit quality, as a part of the insured<br />
rating exercise.<br />
Finally, the emergence of the Middle East<br />
markets as one of the largest global markets of<br />
project finance has challenges of its own. Driven<br />
by low default track records and strong<br />
government support or sponsorship, these projects<br />
have created a class of their own in terms of<br />
investors’ perception of risk allocation. Middle<br />
East project finance is an area that remains under<br />
criteria development while we aim to adequately<br />
weigh up the hard facts, such as risk structure and<br />
allocation, terms and conditions of project<br />
financings in the region, and stated support<br />
from governments.<br />
General Approach<br />
For lenders and other investors, systematic<br />
identification, comparison, and contrasting of<br />
project risk can be a daunting task, particularly<br />
because of the new complexity presented to<br />
investors. To assess project-finance risk, Standard<br />
& Poor’s continues to use a framework based on<br />
the traditional approach that grew out of rating<br />
U.S. independent power projects but which has<br />
been adapted to cover a growing range of other<br />
projects globally, such as more complex<br />
transportation schemes, stadiums and arenas,<br />
hotels and hospitals, and renewable energies.<br />
Our approach begins with the view that a<br />
project is a collection of contracts and agreements<br />
among various parties, including lenders, which<br />
collectively serves two primary functions. The<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
first is to create an entity that will act on behalf<br />
of its sponsors to bring together several unique<br />
factors of production or activity to generate cash<br />
flow from the sale/provision of a product or<br />
service. The second is to provide lenders with the<br />
security of payment of interest and principal from<br />
the operating entity. Standard & Poor’s analytic<br />
framework focuses on the risks of construction<br />
and operation of the project, the project’s longterm<br />
competitive position, its legal<br />
characterization, and its financial performance--in<br />
short, all the factors that can affect the project’s<br />
ability to earn cash and repay lenders.<br />
“Project <strong>Finance</strong>“ Defined<br />
A project-finance transaction is a cross between a<br />
structured, asset-backed financing and a corporate<br />
financing. A project-finance transaction typically<br />
is characterized as nonrecourse financing of a<br />
single asset or portfolio of assets where the<br />
lenders can look only to those specific assets to<br />
generate the cash flow needed to service its fixed<br />
obligations, chief of which are interest payments<br />
and repayment of principal. Lenders’ security and<br />
collateral is usually solely the project’s contracts<br />
and physical assets. Lenders typically do not have<br />
recourse to the project’s owner, and often,<br />
through the project’s legal structure, project<br />
lenders are shielded from a project owner’s<br />
financial troubles.<br />
Project-finance transactions typically are<br />
comprised of a group of agreements and contracts<br />
between lenders, project sponsors, and other<br />
interested parties who combine to create a form<br />
of business organization that will issue a finite<br />
amount of debt on inception, and will operate in<br />
a focused line of business over a finite period.<br />
There are many risks that need to be analyzed<br />
when rating a project-finance transaction;<br />
however the chief focus within Standard & Poor’s<br />
rating process is the determination of the project’s<br />
stability of projected cash flow in relation to the<br />
projected cash needs of the project. This criteria<br />
article addresses the areas on which we focus<br />
when conducting analysis, and how this translates<br />
into a rating on a project-finance transaction as a<br />
whole. For each focus area, we gauge the relative<br />
importance for the project being rated and the<br />
impact that focus area could have on the project’s<br />
overall cash-flow volatility. The process is very<br />
systematic, but is tailored to each project rating.
The rating<br />
Standard & Poor’s project debt ratings address<br />
default probability--or, put differently, the level of<br />
certainty with which lenders can expect to receive<br />
timely and full payment of principal and interest<br />
according to the terms of the financing<br />
documents. Unlike corporate debt, project-finance<br />
debt is usually the only debt in the capital<br />
structure, and typically amortizes to a schedule<br />
based on the project’s useful life. Importantly, also<br />
unlike our corporate ratings, which reflect risk<br />
over three-to-five years, our project debt ratings<br />
are assigned to reflect the risk through the debt‘s<br />
tenor. If refinancing risk is present, we<br />
incorporate into the rating the ability of the<br />
project to repay the debt at maturity solely from<br />
the project sources. Our project ratings often<br />
factor in construction risk, which in many cases<br />
can be higher than the risk presented by expected<br />
operations once the project is completed. <strong>In</strong> some<br />
cases, the construction risk is mitigated by other<br />
features, which enables the debt rating to reflect<br />
our expectations of long-term post-construction<br />
performance. Otherwise, we will rate to the<br />
construction risk, but note the potential for<br />
ratings to rise once construction is complete.<br />
Another important addition to our projectdebt<br />
ratings is the recovery rating concept that<br />
Standard & Poor’s began to assign to secured<br />
debt in late 2003. The recovery rating estimates<br />
the range of principal that lenders can expect to<br />
receive following a default of the project. Our<br />
recovery scale is defined in table 1. We define the<br />
likely default scenario, and then assess recovery<br />
using various techniques, such as discounted cashflow<br />
analysis or EBITDA multiples. Or, we will<br />
examine the terms and conditions of project<br />
assets, such as contracts and concession<br />
Table 1 - Standard & Poor’s Recovery Scale<br />
Recovery Recovery Recovery<br />
rating description expectations*<br />
1+ Highest expectation,<br />
full recovery<br />
100%¶<br />
1 Very high recovery 90%-100%<br />
2 Substantial recovery 70%-90%<br />
3 Meaningful recovery 50%-70%<br />
4 Average recovery 30%-50%<br />
5 Modest recovery 10%-30%<br />
6 Negligible recovery 0%-10%<br />
*Recovery of principal plus accrued but unpaid interest at the time of<br />
default. ¶Very high confidence of full recovery resulting from significant<br />
overcollateralization or strong structural features.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
agreements, for example, to estimate the expected<br />
recovery. The added importance of the recovery<br />
rating is that recovery can affect the ratings on<br />
certain classes of project debt when more than<br />
one class of debt is present.<br />
Framework for Project <strong>Finance</strong> Criteria<br />
Thorough assessment of project cash flows<br />
requires systematic analysis of five principle<br />
factors:<br />
• Project-level risk<br />
• Transactional structure<br />
• Sovereign risk<br />
• Business and legal institutional<br />
development risk<br />
• Credit enhancements<br />
Project-Level Risks<br />
Project-level risk, or the risks inherent to a<br />
project’s business and within its operating<br />
industry, will determine how well a project can<br />
sustain ongoing commercial operations<br />
throughout the term of the rated debt and, as a<br />
consequence, how well the project will be able to<br />
service its obligations (financial and operational)<br />
on time and in full.<br />
Specifically, we look at a project’s:<br />
• Contractual foundation. Operational and<br />
financing contracts--such as offtake<br />
agreements, concessions, construction<br />
arrangements, hedge agreements, loan<br />
contracts, guarantees--that, along with the<br />
physical plant, serve as the basis of the<br />
enterprise.<br />
• Technology, construction, and operations.<br />
Does it have a competitive, proven<br />
technology, can construction be performed<br />
on time and on budget, and can it operate in<br />
a manner defined under the base case?<br />
• Resource availability. Capacity to<br />
incorporate “input” resources, such as wind<br />
or natural gas.<br />
• Competitive-market exposure. Competitive<br />
position against the market in which it<br />
will operate.<br />
• Counterparty risk. Risk from relying on<br />
suppliers, construction companies,<br />
concession grantors, and customers.<br />
• Financial performance. Risks that may affect<br />
forecast results, and cash-flow variability<br />
under likely stress scenarios.<br />
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96 ■ NOVEMBER 2007<br />
Contractual foundation<br />
We analyze a project’s contractual composition to<br />
see how well the project is protected from market<br />
and operating conditions, how well the various<br />
contracted obligations address the project’s<br />
operating-risk characteristics, and how the<br />
contractual nexus measures up against other<br />
project contracts.<br />
The structure of the project should protect<br />
stakeholders’ interests through contracts that<br />
encourage the parties to complete projectconstruction<br />
satisfactorily and to operate the<br />
project competently in line with the requirements<br />
of the various contracts. The project’s structure<br />
also should give stakeholders a right to a portion<br />
of the project’s cash flow so that they can service<br />
debt, and should provide for the releasing of cash<br />
in the form of equity distributions (dividends or<br />
other forms of shareholder payments) in<br />
appropriate circumstances. Moreover, higher-rated<br />
projects generally give lenders the assurance that<br />
project management will align their interests with<br />
lenders’ interests; project management should<br />
have limited discretion in changing the project’s<br />
business or financing activities. Finally, higherrated<br />
projects usually distinguish themselves from<br />
lower-rated projects by agreeing to give lenders a<br />
first-perfected security interest (or fixed charge,<br />
depending on the legal jurisdiction) in all of the<br />
project’s assets, contracts, permits, licenses,<br />
accounts, and other collateral; in this way the<br />
project can either be disposed of in its entirety<br />
should the need arise, or the lenders can step in to<br />
effectively replace the project’s management and<br />
operation so as to generate cash for debt<br />
servicing.<br />
As infrastructure assets have become<br />
increasingly popular for concessions, not only is<br />
the analysis of the strengths and weaknesses of<br />
the concession critical but, also the rationale for<br />
the concession becomes an essential element of<br />
our analysis. Contract analysis focuses on the<br />
terms and conditions of each agreement. The<br />
analysis also considers the adequacy and strength<br />
of each contract in the context of a project’s<br />
technology, counterparty credit risk, and the<br />
market, among other project characteristics.<br />
Commercial versus collateral agreements.<br />
Project-contract analysis falls into two broad<br />
categories: commercial agreements and collateral<br />
arrangements.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Commercial project contracts analysis is<br />
conducted on contracts governing revenue and<br />
expenses, such as:<br />
• Power purchase agreements;<br />
• Gas and coal supply contracts;<br />
• Steam sales agreements;<br />
• Liquefied natural gas sales agreements;<br />
• Concession agreements;<br />
• Airport landing-fee agreements;<br />
• Founding business agreement; and<br />
• Any other agreements necessary for the<br />
operations of the project.<br />
Collateral agreements typically require analysis<br />
of a project’s ownership along with financial and<br />
legal structures, such as:<br />
• Credit facilities or loan agreement;<br />
• <strong>In</strong>denture;<br />
• Equity-contribution agreement;<br />
• Mortgage, deed of trust, or similar<br />
instrument that grants lenders a firstmortgage<br />
lien on real estate and plant;<br />
• Security agreement or a similar instrument<br />
that grants lenders a first-mortgage lien on<br />
various types of personal property;<br />
• Assignments to lenders of project assets,<br />
accounts, and contracts;<br />
• Project-completion guarantees;<br />
• Depositary agreements, which define how<br />
the project cash is handled;<br />
• Shareholder agreements;<br />
• Collateral and inter-creditor agreements; and<br />
• Liquidity-support agreements, such as letters<br />
of credit (LOCs), surety bonds, and targeted<br />
insurance policies.<br />
An important objective of our contractual<br />
assessment is the understanding of a project’s full<br />
risk exposure to potential force majeure risks, and<br />
how the project has mitigated such risk. Project<br />
financings rely on asset and counterparty<br />
performance, but force majeure events can excuse<br />
performance by parties when they are confronted<br />
with unanticipated events outside their control.<br />
A careful analysis of force majeure events is<br />
critical in a project financing because such events,<br />
if not properly recompensed, can severely disrupt<br />
the careful allocation of risk on which the<br />
financing depends. Floods and earthquakes, civil<br />
disturbances, strikes, or changes of law can<br />
disrupt a project’s operations and devastate its<br />
cash flow. <strong>In</strong> addition, catastrophic mechanical
failure due to human error or material failure can<br />
be a form of force majeure that may excuse a<br />
project from its contractual obligations. Despite<br />
excusing a project from its supply obligations, the<br />
force majeure event may still lead to a default<br />
depending on the severity of the mishap.<br />
Technology, construction, and operations<br />
<strong>In</strong> part, a project’s rating rests on the<br />
dependability of a project’s design, construction,<br />
and operation; if a project fails to achieve<br />
completion or to perform as designed, many<br />
contractual and other legal remedies may fail to<br />
keep lenders economically whole.<br />
The technical risk assessment falls into two<br />
categories: construction and operations.<br />
Construction risk relates to:<br />
■Engineering and design<br />
■Site plans and permits<br />
■Construction<br />
■Testing and commissioning<br />
Operations risk relates to:<br />
■Operations and maintenance (O&M)<br />
strategy and capability<br />
■Expansion if any contemplated<br />
■Historical operating record, if any<br />
Project lenders frequently may not adequately<br />
evaluate a project’s technical risk when making an<br />
investment decision but instead may rely on the<br />
reputation of the construction contractor or the<br />
project sponsor as a proxy for technical risk,<br />
particularly when lending to unrated transactions.<br />
The record suggests that such confidence may be<br />
misplaced. Standard & Poor’s experience with<br />
technology, construction, and operations risk on<br />
more than 300 project-finance ratings indicates<br />
that technical risk is pervasive during the pre- and<br />
post-construction phases, while the possibility of<br />
sponsors coming to the aid of a troubled project<br />
is uncertain. Thus, we place considerable<br />
importance on a project’s technical evaluation.<br />
We rely on several assessments to complete our<br />
technical analysis. One key element is a reputable<br />
independent expert’s (IE) project evaluation. We<br />
examine the IE’s report to see if it has the proper<br />
scope to reach fundamental conclusions about the<br />
project’s technology, construction plan, and<br />
expected operating results, and then we determine<br />
whether these conclusions support the sponsor’s<br />
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and EPC contractor’s technical expectations. We<br />
supplement our review of the IE’s report with<br />
meetings with the IE and visits to the site to<br />
inspect the project and hold discussions with the<br />
project’s management and construction contractor<br />
or manager. Without an IE review, Standard &<br />
Poor’s will most likely assign a speculative-grade<br />
debt rating to the project, regardless of whether<br />
the project is in the pre- or post-construction<br />
phase. Finally, we will assess the project’s<br />
technical risk using the experience gained from<br />
examining similar projects.<br />
Another key assessment relates to the potential<br />
credit effect of a major equipment failure that<br />
could materially reduce cash flow. This analysis<br />
goes hand-in-hand with the contractual<br />
implications of force majeure events, described<br />
above, and counterparty risk, described below. If<br />
the potential credit risk from such an event is not<br />
mitigated, then a project’s rating would be<br />
negatively affected. Mitigation could be in the<br />
form of business-interruption insurance, cash<br />
reserves, and property casualty insurance. The<br />
level of mitigation largely depends on the project<br />
type--some types of projects, such as pipelines and<br />
toll roads--are exposed to low outage risks and<br />
thus could achieve favorable ratings with only<br />
modest risk mitigation. <strong>In</strong> contrast, a<br />
mechanically complex, site-concentrated project-such<br />
as a refinery or bio-mass plant--can be<br />
highly exposed to major-equipment-failure risk,<br />
and could require robust features to deal<br />
with potential outages that could take months<br />
to repair.<br />
Resource availability<br />
All projects require feedstock to produce output,<br />
and we undertake a detailed assessment of a<br />
project’s ability to obtain sufficient levels. For<br />
many projects, the input-supply risk largely hinges<br />
on the creditworthiness of the counterparty that is<br />
obligated to provide the feedstock, which is<br />
discussed below under Counterparty Exposure.<br />
Other types of projects, however, such as wind<br />
and geothermal power, rely on the type of natural<br />
resources of which few third parties are willing to<br />
guarantee production. <strong>In</strong> these cases, we require<br />
an understanding of the availability of the natural<br />
resource throughout the debt tenor. We use<br />
various tools to reach our conclusions, but most<br />
important will be the analysis and conclusions of<br />
a reputable IE or market consultant on the<br />
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resource sufficiency throughout the debt tenor. <strong>In</strong><br />
many cases, such as wind, where the assessment<br />
can be highly complex, we may require two<br />
surveys to get sufficient comfort. Just as with IE<br />
technical reports, a project striving for<br />
investment-grade and high speculative-grade<br />
ratings will require a strong resource-assessment<br />
report. However, given the potential for<br />
uncertainty in many resource assessments,<br />
stronger ratings are likely to require either more<br />
than one IE resource assessment, geographic<br />
diversity, or robust liquidity features to meet debtrepayment<br />
obligations if the resource does not<br />
perform as expected.<br />
Competitive market exposure<br />
A project’s competitive position within its peer<br />
group is a principal credit determinant, even if the<br />
project has contractually-based cash flow.<br />
Analysis of the competitive market position<br />
focuses on the following factors:<br />
• <strong>In</strong>dustry fundamentals<br />
• Commodity price risk<br />
• Supply and cost risk<br />
• Regulatory risk<br />
• Outlook for demand<br />
• Foreign exchange exposure<br />
• The project‘s source of competitive<br />
advantage<br />
• Potential for new entrants or disruptive<br />
technologies<br />
Given that many projects produce a commodity<br />
such as electricity, ore, oil or gas, or some form of<br />
transport, low-cost production relative to the<br />
market characterizes many investment-grade<br />
ratings. High costs relative to an average market<br />
price in the absence of mitigating circumstances<br />
will almost always place lenders at risk; but<br />
competitive position is only one element of<br />
market risk. The demand for a project’s output<br />
can change over time (seasonality or commodity<br />
cycles), and sometimes dramatically, resulting in<br />
low clearing prices. The reasons for demand<br />
change are many, and usually hard to predict.<br />
Any of the following can make a project more or<br />
less competitive:<br />
• New products<br />
• Changing customer priorities<br />
• Cheaper substitutes<br />
• Technological change<br />
• Global economic and trade developments<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Experience has shown, however, that offtake<br />
contracts providing stable revenues or that limit<br />
costs, or both, may not be enough to mitigate<br />
adverse market situations. As an example,<br />
independent power producers in California had to<br />
restructure parts of fixed-price offtake agreements<br />
when the utilities there came under severe<br />
financial pressure in 2000 and 2001. Hence,<br />
market risk can potentially take on greater<br />
importance than the legal profile of, and security<br />
underlying, a project. Conversely, if a project<br />
provides a strategic input that has few, if any,<br />
substitutes, there will be stronger economic<br />
incentives for the purchaser to maintain a viable<br />
relationship with the project.<br />
Counterparty exposure<br />
The strength of a project financing rests on the<br />
project’s ability to generate stable cash flow as<br />
well as on its general contractual framework, but<br />
much of a project’s strength comes from<br />
contractual participation of outside parties in the<br />
establishment and operation of the project<br />
structure. This participation raises questions<br />
about the strength and reliability of such<br />
participants. The traditional counterparties to<br />
projects have included raw-material suppliers,<br />
principal offtake purchasers, and EPC<br />
contractors. Even a sponsor becomes a source of<br />
counterparty risk if it provides the equity during<br />
construction or after the project has exhausted its<br />
debt funding.<br />
Other important counterparties to a project can<br />
include:<br />
• Providers of LOCs and surety bonds;<br />
• Parties to interest rate and currency swaps;<br />
• Buyers and sellers of hedging agreements<br />
and other derivative products;<br />
• Marketing agents;<br />
• Political risk guarantors; and<br />
• Government entities.<br />
Because projects have taken on increasingly<br />
complex structures, a counterparty’s failure can<br />
put a project’s viability at risk.<br />
Standard & Poor’s generally will not rate a<br />
project higher than the lowest rated entity (e.g.,<br />
the offtaker) that is crucial to project<br />
performance, unless that entity may be easily<br />
replaced, notwithstanding its insolvency or failure<br />
to perform. Moreover, the transaction rating may
also be constrained by a project sponsor’s rating if<br />
the project is in a jurisdiction in which the<br />
sponsor’s insolvency may lead to the insolvency of<br />
the project, particularly if the sponsor is the sole<br />
owner of the project.<br />
During construction, often the project debt<br />
rating could be higher than the credit quality of<br />
the builder by credit enhancement and where<br />
there is an alternate builder available (see “Credit<br />
Enhancements (Liquidity Support) <strong>In</strong> Project<br />
<strong>Finance</strong> And PPP Transactions Reviewed,”<br />
published on RatingsDirect on March 30, 2007).<br />
Financial performance<br />
Standard & Poor’s analysis of a project’s financial<br />
strength focuses on three main attributes:<br />
• The ability of the project to generate<br />
sufficient cash on a consistent basis to pay<br />
its debt service obligations in full and on<br />
time;<br />
• The capital structure and in particular debt<br />
paydown structure; and<br />
• Liquidity.<br />
Projects must withstand numerous financial<br />
threats to their ability to generate revenues<br />
sufficient to cover operating and maintenance<br />
expenses, maintenance expenditures, taxes,<br />
insurance, and annual fixed charges of principal<br />
and interest, among other expenses. <strong>In</strong> addition,<br />
nonrecurring items must be planned for.<br />
Furthermore, some projects may also have to deal<br />
with external risk, such as interest rate and<br />
foreign currency volatility, inflation risk, liquidity<br />
risk, and funding risk. We factor into our credit<br />
evaluation the project’s plan to mitigate the<br />
potential effects on cash flow that could be<br />
caused by these external risks should they arise.<br />
Standard & Poor’s relies on debt-service<br />
coverage ratios (DSCRs) as the primary<br />
quantitative measure of a project’s financial credit<br />
strength. The DSCR is the cash-basis ratio of cash<br />
flow available for debt service (CFADS) to interest<br />
and mandatory principal obligations. CFADS is<br />
calculated strictly by taking cash revenues from<br />
operations only and subtracting cash operating<br />
expenses, cash taxes needed to maintain ongoing<br />
operations, and cash major maintenance costs,<br />
but not interest. As an operating cash-flow<br />
number, CFADS excludes any cash balances that a<br />
project could draw on to service debt, such as the<br />
debt-service reserve fund or maintenance reserve<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
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fund. To the extent that a project has tax<br />
obligations, such as host-country income tax,<br />
withholding taxes on dividends, and interest paid<br />
overseas, etc., Standard & Poor’s treats these<br />
taxes as ongoing expenses needed to keep a<br />
project operating (see “Tax Effects on Debt<br />
Service Coverage Ratios,” published on<br />
RatingsDirect on July 27, 2000).<br />
<strong>In</strong> our analysis, we examine the financial<br />
performance of the project under base-case and<br />
numerous stress scenarios. We select our stress<br />
scenarios on a project-by-project basis, given that<br />
each project faces different risks. We avoid<br />
establishing minimum DSCRs for different rating<br />
levels because once again, every project has<br />
different economic and structural features.<br />
However, we do require that investment-grade<br />
projects have strong DSCRs--well above 1.0x-under<br />
typical market conditions that we think are<br />
probable, to reflect the single-asset nature of the<br />
business. Strong projects must show very stable<br />
financial performance under a wide range of<br />
stress scenarios. We also note that DSCRs for<br />
project with amortizing debt may not be<br />
directly comparable to DSCRs for a project using<br />
capital structures that involve a small annual<br />
mandatory principal repayment--usually around<br />
1%--coupled with a cash-flow sweep to further<br />
reduce principal balances.<br />
Capital structure.<br />
Standard & Poor’s considers a project’s capital<br />
structure as part of any rating analysis. A project<br />
usually combines high leverage with a limited<br />
asset life, so the project’s ability to repay large<br />
amounts of debt within the asset lifetime is a key<br />
analytical consideration and one of the primary<br />
differences between rating a project and a typical<br />
corporate entity. The same holds true for projects<br />
that derive their value from a concession, such as<br />
a toll road, without which the ‘project’ has no<br />
value; these concession-derived project financings<br />
likely have very long asset lives that extend well<br />
beyond the concession term, but nevertheless<br />
the project needs to repay debt before the<br />
concession expiration. Projects that rely on cash<br />
balances to fund final payments demonstrate<br />
weaker creditworthiness.<br />
Refinancing risk associated with bullet<br />
maturities typical of corporate or public<br />
financings are becoming more common in projectfinance<br />
transactions. Examples include Term Loan<br />
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B structures, in which debt is repaid through<br />
minimal mandatory amortizations--usually 1%<br />
per year--coupled with a debt repayment from a<br />
portion of distributable cash flow. While these<br />
structures certainly reduce default risk due to<br />
lower mandatory principal repayments, they<br />
almost always involve a planned refinancing at<br />
around seven-to-eight years. <strong>In</strong> these types of<br />
arrangements, our credit analysis determines if the<br />
project can refinance debt outstanding at maturity<br />
such that it fully amortizes within the remaining<br />
asset life on reasonable terms.<br />
The finite useful life of projects also introduces<br />
credit risk from an operational standpoint. Given<br />
its depreciating characteristics, an aging project<br />
may find it more difficult to meet a fixed<br />
obligation near the end of its useful life. Thus, for<br />
projects in which the useful life is difficult to<br />
determine, those structured with a declining debt<br />
burden over time are more likely to achieve<br />
higher credit ratings than projects those that<br />
do not.<br />
Many projects with high leverage seek capital<br />
structures that involve second-lien debt,<br />
subordinated debt, and payment-in-kind<br />
obligations. These structures and instruments are<br />
used to tap different investor markets and buffer<br />
the senior-most debt from default risk. These<br />
other classes of debt are issued either at the<br />
operating project or at the holding company that<br />
wholly owns the project. Although such structures<br />
can be helpful for senior debt, it obviously is to<br />
the detriment of the credit quality of the<br />
subordinated debt because in most cases this debt<br />
class is inferior to senior lenders’ rights to cash<br />
flow until senior debt is fully repaid, or to<br />
collateral in the event of a bankruptcy.<br />
When looking at the creditworthiness of<br />
subordinate debt, the DSCR calculation is not<br />
CFADS to subordinate debt interest and principal,<br />
but is, rather, total cash available within the entire<br />
project--after payments of all expenses and<br />
reserve filling--divided by both senior and<br />
subordinate debt service. Such a formula more<br />
accurately measures the subordinated payment<br />
risk. This differs from the notching applied in<br />
corporate ratings, and the actual rating might be<br />
lower than the coverage ratio implies, depending<br />
on the level of structural lock-up and separation<br />
of senior debt.<br />
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Another analytical approach for multiple-debttype<br />
structures is to examine the performance of<br />
the project with all of the debt on a consolidated<br />
basis, and then determine the risk exposure for<br />
the different classes of debt based on structural<br />
features of the deal and provisions within<br />
the financing documents. To the extent that senior<br />
debt is advantaged, lesser obligations<br />
are penalized.<br />
Liquidity.<br />
Liquidity is a key part of any analysis, because<br />
lenders rely on a single asset for debt repayment,<br />
and all assets types have unexpected problems<br />
with unforeseen consequences that must be dealt<br />
with from time to time.<br />
Liquidity that projects typically have included:<br />
• A debt-service reserve account, to help meet<br />
debt obligations if the project cannot<br />
generate cash flow due to an unexpected<br />
and temporary event. This reserve is<br />
typically sized at six months of annual debt<br />
service, although amounts can be higher as a<br />
result of specific project attributes (e.g.,<br />
strong seasonality to cash flow, annual debt<br />
payments, etc.) The reserve should be cash<br />
or an on-demand cash instrument. However,<br />
if the reserve is funded with an LOC, we<br />
will factor in the potential for the additional<br />
debt burden that would occur if the reserve<br />
is tapped to help meet debt obligations. A<br />
maintenance reserve account is expected for<br />
projects in which capital expenditures are<br />
expected to be lumpy or where there is some<br />
concern about the technology being<br />
employed. Almost all investment-grade<br />
projects have such a reserve. We do not<br />
establish minimum funding level for these<br />
reserves, but gauge the need based on the<br />
findings of the IE’s technical evaluation and<br />
our experience.<br />
• Look-forward-and-back distribution and<br />
lock-up tests to preserve surplus but lower<br />
than expected cash flows. For investmentgrade<br />
consideration, a project structure will<br />
typically have a minimum of 12 months<br />
look forward and look back. The DSCR<br />
hurdle that should allow distribution is<br />
project dependent. The test ensures cash is<br />
retained to meet the projects liquidity needs<br />
in times of stress.
Transactional Structure<br />
Standard & Poor’s performs detailed assessment<br />
of the project’s structural features to determine<br />
how they support the project’s ability to perform<br />
and pay obligations as expected. Key items<br />
include assessing if the project is structured to be<br />
a single-purpose entity (SPE), how cash flow is<br />
managed, and how the insolvency of entities<br />
connected to the project (sponsors, affiliates<br />
thereof, suppliers, etc.), who are unrated or are<br />
rated lowly, could affect project cash flow.<br />
Special-purpose entities (SPEs)<br />
Projects generally repay debt with a specific<br />
revenue stream from a single asset, and since for<br />
projects we rate to debt maturity, we need to have<br />
confidence that the project will not take on other<br />
activities or obligations that are not defined when<br />
the rating is assigned. When projects are duly<br />
structured as and remain SPEs, we can have more<br />
confidence in project performance throughout the<br />
debt tenor. If such limitations are absent, we<br />
would tend to rate a project more like a<br />
corporation, which would typically assume higher<br />
credit risk. Standard & Poor’s defines a projectfinance<br />
SPE as a limited-purpose operating entity<br />
whose business purposes are confined to:<br />
• Owning the project assets;<br />
• Entering into the project documents (e.g.,<br />
construction, operating, supply, input and<br />
output contracts, etc.);<br />
• Entering into the financing documents (e.g.,<br />
the bonds; indenture; deeds of mortgage;<br />
and security, guarantee, intercreditor,<br />
common terms, depositary, and collateral<br />
agreements, etc.); and<br />
• Operating the defined project business.<br />
The thrust of this single-purpose restriction is<br />
that the rating on the debt obligations represents,<br />
in part, an assessment of the creditworthiness of<br />
specific business activities and reduces potential<br />
external influences on the project.<br />
One requirement of a project-finance SPE is<br />
that it is restricted from issuing any subsequent<br />
debt that is rated lower than its existing debt. The<br />
exceptions are where the potential new debt was<br />
factored into the initial rating, debt is<br />
subordinated in payment, and security to the<br />
existing debt does not constitute a claim on the<br />
project. A second requirement is that the project<br />
should not be permitted to merge or consolidate<br />
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with any entity rated lower than the rating on the<br />
project debt. A third requirement is that the<br />
project (as well as the issuer, if different)<br />
continues in existence for as long as the rated<br />
debt remains outstanding. The final requirement<br />
is that the SPE have an anti-filing mechanism in<br />
place to hinder an insolvent parent from bringing<br />
the project into bankruptcy. <strong>In</strong> the U.S., this can<br />
be achieved by the independent-director<br />
mechanism, whereby the SPE provides in its<br />
charter documents a specification that a voluntary<br />
bankruptcy filing by the SPE requires the<br />
consenting vote of the designated independent<br />
member of the board of directors (the board<br />
generally owing its fiduciary duty to the equity<br />
shareholder[s]). The independent director’s<br />
fiduciary duty, which is also to the lenders, would<br />
be to vote against the filing. <strong>In</strong> other jurisdictions,<br />
the same result is achieved by the “golden share”<br />
structure, in which the project issues a special<br />
class of shares to some independent entity (such<br />
as the bond trustee), whose vote is required for a<br />
voluntary filing.<br />
The anti-filing mechanism is not designed to<br />
allow an insolvent project to continue operating<br />
when it should otherwise be seeking bankruptcy<br />
protection. <strong>In</strong> certain jurisdictions, anti-filing<br />
covenants have been enforceable, in which case<br />
such a covenant (and an enforceability opinion<br />
with no bankruptcy qualification) would suffice.<br />
<strong>In</strong> the U.K. and Australia, where a first “fixed<br />
and floating” charge may be granted to the<br />
collateral trustee as security for the bonds, the<br />
collateral trustee can appoint a receiver to<br />
foreclose on and liquidate the collateral without a<br />
stay or moratorium, notwithstanding the<br />
insolvency of the project debt issuer. <strong>In</strong> such<br />
circumstances, the requirement for an<br />
independent director may be waived.<br />
The SPE criteria will apply to the project (and<br />
to the issuer if a bifurcated structure is<br />
considered), and is designed to ensure that the<br />
project remains nonrecourse in both directions: by<br />
accepting the project’s debt obligations, investors<br />
agree that they will not look to the credit of the<br />
sponsors, but only to project revenues and<br />
collateral for reimbursement; investors, on the<br />
other hand, should not be concerned about the<br />
credit quality of other entities (whose risk profile<br />
was not factored into the rating) affecting project<br />
cash flows.<br />
Where the project acts as operator, the analysis<br />
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will look to the ability of the project to undertake<br />
the activities on a stand-alone basis, and any links<br />
to external parties.<br />
Cash management<br />
Nearly all project structures employ an<br />
independent trustee to control all cash flow the<br />
project generates, based on detailed project<br />
documents that define precisely how cash is to be<br />
managed. This arrangement helps prevent cash<br />
from leaking out of the project prior to the<br />
payment of operating expenses, major<br />
maintenance, taxes, and debt obligations. <strong>In</strong> those<br />
cases where there is no trustee, the<br />
creditworthiness of the project will be linked<br />
directly to the cash manager, which is usually the<br />
sponsor. Projects seeking investment-grade ratings<br />
will have cash-management structures that<br />
prevent any distributions to sponsors--including<br />
tax payments--unless all expenses are fully paid,<br />
reserves are full, and debt-service coverage rations<br />
looking back and forward for a sufficient period<br />
are adequate.<br />
Sovereign Risk<br />
A sovereign government can pose a number of<br />
risks to a project. For example, it could restrict<br />
the project’s ability to meet its debt obligations by<br />
way of currency restrictions; it could interfere<br />
with project operations; and, in extreme cases,<br />
even nationalize the project. As a general rule, the<br />
rating on a project issue will be no higher than<br />
the local-currency rating of the project in its host<br />
country. For cross-border or foreign currencydenominated<br />
debt, the foreign currency rating of<br />
the country in which the project is located is the<br />
key determinant, although in some instances debt<br />
may be rated up to transfer and convertibility<br />
(T&C) assessments of the country Standard &<br />
Poor’s has established. A T&C assessment is the<br />
rating associated with the probability of the<br />
sovereign restricting access to foreign exchange<br />
needed for servicing debt obligations. For most<br />
countries, Standard & Poor’s analysis concludes<br />
that this risk is less than the risk of sovereign<br />
default on foreign currency obligations; thus,<br />
most T&C assessments exceed the sovereign<br />
foreign currency rating. A non-sovereign project<br />
can be rated as high as the T&C assessment if its<br />
stress-tested operating and financial<br />
characteristics support the higher rating.<br />
A sovereign rating indicates a sovereign<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
government’s willingness and ability to service its<br />
own obligations on time and in full. The<br />
sovereign foreign currency rating acts as a<br />
constraint because the project’s ability to acquire<br />
the hard currency needed to service its foreign<br />
currency debt may be affected by acts or policies<br />
of the government. For example, in times of<br />
economic or political stress, or both, the<br />
government may intervene in the settlement<br />
process by impeding commercial conversion or<br />
transfer mechanisms, or by implementing<br />
exchange controls. <strong>In</strong> some rare instances, a<br />
project rating may exceed the sovereign foreign<br />
currency rating if: the project has foreign<br />
ownership that is key to its operations; the project<br />
can earn hard currency by exporting a commodity<br />
with minimal domestic demand, or other riskmitigating<br />
structures exist.<br />
For cross-border deals, however, other forms of<br />
government risk could result in project ratings<br />
below the T&C rating. A government could<br />
interfere with a project by restricting access to<br />
production inputs, revising royalty and tax<br />
regimes, limiting access to export facilities, and<br />
other means (see “Ratings Above The Sovereign:<br />
Foreign Currency Rating Criteria Update,”<br />
published on RatingsDirect on Nov. 3, 2005).<br />
Business and Legal <strong>In</strong>stitutional<br />
Development Risk<br />
Even though a project’s sponsors and its legal and<br />
financial advisors may have structured a project<br />
to protect against readily-foreseeable<br />
contingencies, risks from certain country-specific<br />
factors may unavoidably place lenders at<br />
concomitant risk. Specifically, risk related to the<br />
business and legal institutions needed to enable<br />
the project to operate as intended is an important<br />
factor. Experience suggests that in some emerging<br />
markets, vital business and legal institutions may<br />
not exist or may exist only in nascent form.<br />
Standard & Poor’s sovereign foreign currency<br />
ratings do not necessarily measure this<br />
institutional risk or country risk, and so equating<br />
country risk with a sovereign’s credit rating may<br />
understate the actual risk the project may face<br />
(see “<strong>In</strong>vestigating Country Risk And Its<br />
Relationship To Sovereign Ratings <strong>In</strong> Latin<br />
America,” published on April 4, 2007).<br />
<strong>In</strong> some cases, institutional risk may prevent a<br />
project’s rating from reaching the host country’s<br />
foreign currency rating, despite the project’s other
strengths. That many infrastructure projects do<br />
not directly generate foreign currency earnings<br />
and may not be individually important for the<br />
host’s economy may further underscore the risk.<br />
<strong>In</strong> certain emerging markets, the concepts of<br />
property rights and commercial law may be at<br />
odds with investors’ experience. <strong>In</strong> particular, the<br />
notion of contract-supported debt is often a novel<br />
one. There may, for example, be little or no legal<br />
basis for the effective assignment of powerpurchase<br />
agreements to lenders as collateral, let<br />
alone the pledge of a physical plant. Even if<br />
lenders can obtain a pledge, it could be difficult<br />
for them to exercise their collateral rights in any<br />
event. Overall, it is not unusual for legal systems<br />
in developing countries to fail to provide the<br />
rights and remedies that a project or its creditors<br />
typically require for the enforcement of<br />
their interests.<br />
Credit Enhancement<br />
Some third parties offer various creditenhancement<br />
products designed to mitigate<br />
project-level, sovereign, and currency risks,<br />
among other types. Multilateral agencies, such as<br />
the Multilateral <strong>In</strong>vestment Guarantee Agency, the<br />
<strong>In</strong>ternational <strong>Finance</strong> Corporation, and the<br />
Overseas Private <strong>In</strong>vestment Corp. to name a few,<br />
offer various insurance programs to cover both<br />
political and commercial risks. Project sponsors<br />
can themselves provide some type of support in<br />
mitigation of some risks--a commitment that<br />
tends to convert a nonrecourse financing into a<br />
limited-recourse financing.<br />
Unlike financial guarantees provided by<br />
monoline insurers, enhancement packages<br />
provided by multilateral agencies and others are<br />
generally targeted guarantees and not<br />
comprehensive for reasons of cost or because such<br />
providers are not chartered to provide<br />
comprehensive coverage. These enhancement<br />
packages cover only specified risks and may not<br />
pay a claim until after the project sustains a loss.<br />
Since they are not guarantees of full and timely<br />
payment on the bonds or notes, S&P needs to<br />
evaluate these packages to see if they may<br />
enhance ultimate post-default recovery but not<br />
prevent a default. Once a project defaults, delays<br />
and litigation intrinsic in the claims process may<br />
result in lenders waiting years before receiving<br />
a payment.<br />
Therefore, our estimation of the timeliness<br />
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associated with the credit-enhancement<br />
mechanism is critical in the rating evaluation. For<br />
Standard & Poor’s to give credit value to insurers,<br />
the insurer must have a demonstrated history of<br />
paying claims on a timely basis. Standard &<br />
Poor’s financial enhancement rating (FER)<br />
for insurers addresses this issue in the case of<br />
private insurers.<br />
Outlook For Project <strong>Finance</strong><br />
Project finance remains a robust vehicle for<br />
funding all types of infrastructure across the<br />
globe, and its creative financing structures<br />
continue to attract different classes of both issuers<br />
and investors. Project finance continues to be a<br />
chosen financing technique due to a strong global<br />
push to add all types of energy and transportation<br />
infrastructure, and to build new or more publicoriented<br />
assets, such as stadiums, arenas,<br />
hospitals, and schools, just to name a few.<br />
<strong>In</strong> the Middle East, the continuing development<br />
of mega-sized, government-driven energy and<br />
real-estate projects is likely to continue for years<br />
to come. Related investment in shipping to deliver<br />
energy projects from the region is also enormous.<br />
<strong>In</strong> the U.S., project-finance transactions in the<br />
power sector, both for acquisitions but also for<br />
new gas- and coal-fired plants and a host of<br />
renewable energies, remain very robust.<br />
Additionally, development activity of new nuclear<br />
power plants, some of which are likely to be<br />
undertaken on a project-finance basis, is being<br />
studied. The U.S. market is also noteworthy for<br />
large investments in natural-gas prepay deals.<br />
<strong>In</strong> Europe, project investment in rail and air<br />
transportation remains sound, and private-finance<br />
initiative investment in the U.K. continues to be<br />
robust. Its cousin, public-private partnerships<br />
lending for transportation and social<br />
infrastructure investments in Australia and<br />
Canada, has also strengthened.<br />
These favorable trends offset less-favorable<br />
developments in other parts of the world, such as<br />
in Latin America, where policies in some<br />
countries (Venezuela, for example), have led to<br />
nationalization of some project assets and an<br />
unfavorable market for further project funding.<br />
<strong>In</strong>vestor attention to project risk is important,<br />
especially in light of the relatively easy lending<br />
covenants and asset valuations seen in a number<br />
of project transactions in recent years.<br />
Standard & Poor’s expects that project sponsors<br />
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104 ■ NOVEMBER 2007<br />
and their advisors will continue to develop new<br />
project structures and techniques to mitigate the<br />
growing list of risks and financing challenges. As<br />
investors and sponsors return to emerging<br />
markets, particularly as infrastructure investment<br />
needs increase, project debt will remain a key<br />
source of long-term financings. Moreover, as the<br />
march toward privatization and deregulation<br />
continues in markets, nonrecourse debt will likely<br />
continue to help fund these changes. Standard &<br />
Poor’s framework of project risk analysis<br />
anticipates the problems of analyzing these new<br />
opportunities, in both capital-debt and bank-loan<br />
markets. The framework draws on Standard &<br />
Poor’s experience in developed and emerging<br />
markets and in many sectors of the economy.<br />
Hence, the framework is broad enough to address<br />
the risks in most sectors that expect to use<br />
project-finance debt, and to provide investors<br />
with a basis with which to compare and contrast<br />
project risk. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
Sept. 5, 2007<br />
Primary Credit Analyst:<br />
Paul B Calder, CFA,<br />
Toronto,<br />
(1) 416-507-2523<br />
Secondary Credit Analysts:<br />
Kurt Forsgren,<br />
Boston,<br />
(1) 617-530-8308<br />
Ian Greer,<br />
Melbourne,<br />
(61) 3-9631-2032<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Additional Contact:<br />
Santiago Carniado,<br />
Mexico City,<br />
(52) 55-5081-4413<br />
Overview<br />
Since the groundbreaking Chicago Skyway<br />
transaction in late 2004 (Skyway Concession<br />
Company LLC), Standard & Poor’s Ratings<br />
Services has observed rapid growth globally in<br />
accreting debt and swap structures applied to<br />
project finance infrastructure transactions.<br />
<strong><strong>In</strong>frastructure</strong> is one of the hottest asset classes,<br />
with private and public pension fund equity and<br />
various long-term debt providers significantly<br />
funding long-term concessions or infrastructureasset<br />
purchases.<br />
<strong>In</strong> some transactions we have observed,<br />
accreting debt and swap structures have facilitated<br />
significant acquisition premiums (or refinancing<br />
gains). This is because accreting debt allows the<br />
partial deferral of interest payments to reduce<br />
debt service early in the concession or provides an<br />
additional non-operating source of funds to the<br />
project in the form of payments from an accreting<br />
swap early in a concession. The cash flow effects<br />
of a deferral of interest payments or the addition<br />
of swap inflows to operating revenue results in<br />
overstated debt service coverage ratios (DSCRs)<br />
that, in turn, allow for the tailoring of debt<br />
service to meet a project’s early-year cash flow<br />
deficiency and, in many instances, early outflows<br />
in the form of equity distributions. Without these<br />
structural features, a highly leveraged project’s net<br />
cash flows available to service debt early in the<br />
concession would not meet debt service<br />
obligations under a traditional amortizing or<br />
even interest-only debt service profile.<br />
Simple economics of numerous global capital<br />
pools pursuing a limited number of concessions or<br />
acquisition targets results in predictably high<br />
valuation multiples, boosted by financial<br />
structures that front-load dividends and returns to<br />
equity while risk for debt holders lies toward the<br />
end of a concession. As a result, metrics such as<br />
enterprise value-to-EBITDA and debt-to-EBITDA,<br />
on a current and pro forma basis, have become<br />
increasingly aggressive in a relatively short period<br />
while investors still assume these to be investment<br />
grade structures. Given that business risk has not<br />
shifted, this could be a challenging assumption.<br />
Moreover, the acquisition multiples are<br />
considerably higher for many infrastructure<br />
financings than investment-grade M&A<br />
transactions in other sectors. <strong>In</strong> the near term, the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
CREDIT FAQ: ACCRETING DEBT OBLIGATIONS AND<br />
THE ROAD TO INVESTMENT GRADE FOR<br />
INFRASTRUCTURE CONCESSIONS<br />
recent shift to conservatism in credit sentiment by<br />
lenders (as demonstrated by stricter covenant<br />
requirements, tighter loan underwriting standards,<br />
less aggressive structures etc.), together with a rise<br />
in nominal interest rates, could curb the fairly<br />
aggressive debt financing structures observed in<br />
many recent long-term infrastructure concessions<br />
and acquisitions. <strong>In</strong> the long term, we expect<br />
infrastructure assets to maintain their appeal<br />
given generally solid business positions and ability<br />
to leverage relatively stable cash flows through<br />
long-dated concessions--permitting long-term<br />
debt maturities.<br />
This report follows “Credit FAQ: Assessing The<br />
Credit Quality Of Highly Leveraged Deep-Future<br />
Toll-Road Concessions” and “Global<br />
<strong><strong>In</strong>frastructure</strong> Assets And Highly Leveraged<br />
Concessions Raise New Rating Considerations.”<br />
This article expands upon topics addressed in the<br />
previous reports and provides analytical insight to<br />
our approach in evaluating accreting debt within<br />
project finance transactions.<br />
Overall, Standard & Poor’s believes that<br />
infrastructure financings for long-term<br />
concessions capitalized with accreting debt can<br />
achieve investment-grade ratings; however, there<br />
are several key factors that will differentiate--in<br />
combination with the assets under consideration-investment-grade<br />
structures from those exhibiting<br />
speculative-grade characteristics. <strong>In</strong> particular, at<br />
the investment-grade level, we place greater<br />
emphasis on distribution test multiples, potential<br />
cash lock-ups and sweeps, examining the<br />
percentage of accretion relative to total debt at<br />
transaction inception--with little-to-none for<br />
short-term concessions (for example, 20-35<br />
years), limits to additional indebtedness, and<br />
emphasize the risk/reward allocation between<br />
sponsors and lenders.<br />
Question 1: Does accreting debt increase<br />
the probability of default for an infrastructure<br />
project?<br />
Yes and no. <strong>In</strong> the early years of an accreting debt<br />
structure, the probability of default is lower<br />
compared with that of a traditional amortizing<br />
structure, as the debt service is artificially low.<br />
However, towards the middle and end of the<br />
concession, when higher accreted debt balances<br />
amortize or when bullet payments are due as the<br />
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risk of refinancing is introduced while<br />
performance risk can have increased at an even<br />
higher debt burden. At this point, default risk<br />
increases significantly.<br />
Compared to an amortizing profile--all else<br />
being equal, including the proportion of equity<br />
contribution to a project--an accreting debt<br />
structure will have weaker credit quality.<br />
Accreting debt establishes a more aggressive<br />
financial risk profile and defers repayment of<br />
debt, often well into the future. The longer the<br />
debt repayment profile, the greater the cash flow<br />
uncertainty could lead to deterioration in a<br />
project’s financial risk profile, thereby raising<br />
default risk. Moreover, accreting debt and swap<br />
structures allow significant early period dividends<br />
paid to equity sponsors (before debt repayment)<br />
as a result of the excess cash flow produced by<br />
the accretion or “deferral” component of the debt<br />
structure. This practice and its effect on credit<br />
quality are discussed in Question 6.<br />
Even for infrastructure assets with strong<br />
business risk profiles, the presence of accreting<br />
debt in the capital structure would temper credit<br />
quality. Standard & Poor’s believes that the more<br />
aggressive the financial structure, the less robust<br />
the business risk profile; the weaker the legal<br />
provisions and the greater the contractual risk<br />
allocation to the concessionaire, the weaker the<br />
rating on a long-term concession or infrastructure<br />
asset will be. <strong>In</strong> addition to accreting debt’s<br />
influence on default probability, characteristics of<br />
transactions that, in the absence of offsetting<br />
credit strengths, are likely to experience weaker<br />
debt ratings, include the following:<br />
• A weaker business risk profile. The<br />
importance of the project rationale and<br />
business profile to credit quality cannot be<br />
understated and is discussed more fully in<br />
Question 4;<br />
• A shorter concession term and shorter<br />
equity tail;<br />
• Notable construction risk without<br />
commensurate offsetting third-party credit<br />
supports or cost and schedule risk mitigation<br />
strategies;<br />
• Annual increases in debt service payments<br />
that significantly exceed those in total<br />
project revenues;<br />
• Refinancing risk;<br />
• Unhedged currency risk;<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
• High country risk, including political<br />
stability, currency transferability and<br />
exchange matters; and,<br />
• Weak swap or transaction counterparties.<br />
Question 2: Why is early return to equity<br />
(through cash distributions) a concern?<br />
Project ratings address not only the ability but<br />
also the willingness to pay obligations in full and<br />
on time. An equity party that had already<br />
received a full return on an investment early in<br />
the concession would have reduced incentive in<br />
resolving issues in times of distress, as preserving<br />
the equity return might no longer be a<br />
consideration. As such, where an equity party<br />
reaped a full return in the early stages of the<br />
concession, Standard & Poor’s would want to be<br />
confident that the sponsors had sufficiently strong<br />
incentives to ensure the project would operate<br />
successfully throughout the debt’s life. <strong>In</strong> general,<br />
we consider that a more closely aligned interest of<br />
debt and equity is a project strength.<br />
<strong>In</strong> addition, the equity participants, through<br />
their agents--management--can also make<br />
decisions about timing of capital expenditure and<br />
other revenue or profit enhancing measures- such<br />
as toll increases, which could bring forward<br />
returns at the expense of the project’s viability.<br />
Question 3: <strong>In</strong> what asset classes have you<br />
observed accreting debt structures?<br />
Accreting debt structures arise in volume-driven<br />
transactions. The assumption in these transactions<br />
is that an increasing debt level can be absorbed as<br />
usage (traffic, tonnage, and containers, for<br />
example) and increases in revenue (tariff/toll<br />
increases) generate higher net cash flows. Assets<br />
that lack this characteristic will unlikely see<br />
accreting debt as a long-term funding source.<br />
The breadth of potential infrastructure<br />
acquisition and concession interests by private<br />
equity and public pension fund sponsors has<br />
increased with project finance structures<br />
becoming more aggressive and complex. Standard<br />
& Poor’s has observed a growing universe of<br />
potential asset classes to which long-term<br />
concessions might apply. Some of those sectors<br />
include airports, port and port terminal operators,<br />
parking facilities, toll roads and bridges, water<br />
and waste water facilities, lotteries and mass<br />
transit projects. Accreting structures are not only
found in project and concession financing but in<br />
corporate securitizations of the aforementioned<br />
sectors as well.<br />
Question 4: Why is the business risk profile so<br />
important to the credit quality of infrastructure<br />
transactions that use accreting debt?<br />
A project rating is a composite of many factors.<br />
To narrow the analysis to two factors--business<br />
and financial risks--some straightforward<br />
observations can be made. The stronger the<br />
business risk profile, the weaker the financial risk<br />
profile (including accreting debt and swaps) can<br />
be to achieve a certain rating, and vice versa. To<br />
gauge the appropriate financial risk at investmentgrade,<br />
the prime focus should be on the<br />
underlying business risk. Accordingly, to assess<br />
whether at investment-grade an accreting debt<br />
structure is commensurate, it is important to<br />
understand the business risk first, hence the<br />
importance of the business risk to the rating.<br />
As we view accreting debt structures to be more<br />
aggressive, for a similar rating an accreting<br />
transaction would need to have other strengths to<br />
compensate for this credit weakness.<br />
The strong business risk profiles and generally<br />
robust cash flow streams of infrastructure assets,<br />
together with strong covenant packages,<br />
compliance with SPE bankruptcy remoteness<br />
criteria, and supportive structural features allow<br />
infrastructure projects to be more highly<br />
leveraged and use accreting debt compared with a<br />
corporate entity at the same rating level.<br />
A strong business risk profile for long-term<br />
concessions and infrastructure providers would<br />
include a combination of the following<br />
characteristics (the listing below does not imply<br />
any ranking of relative importance):<br />
• An essential or high-demand service;<br />
• Where user fees are involved, a high degree<br />
of demand inelasticity with respect to rate<br />
increases;<br />
• Monopoly or near-monopoly characteristics,<br />
or, alternatively, few providers in the<br />
industry with substantial barriers to entry<br />
and limited incentives for competition<br />
among these service providers;<br />
• A limited reliance on increases in volume<br />
growth rates (for example, market exposure<br />
to traffic, parking activity, tonnage, or<br />
maritime containers), and aggressive<br />
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assumptions of price inelasticity to rate or<br />
tariff increases to meet base case revenue<br />
projections;<br />
• A favorable legal environment and<br />
regulatory regime;<br />
• Limited government interference probability,<br />
either through public policy changes and/or<br />
change-in-law risk;<br />
• A favorable rate-setting regime, although we<br />
recognize that it is rarely unfettered and,<br />
even then, can face challenges or political<br />
contention;<br />
• Strong bargaining power in relation to<br />
suppliers and customers;<br />
• Low, contained, or manageable ongoing<br />
capital expenditure requirements;<br />
• Strong counterparty arrangements with, for<br />
example, contractual offtaker agreements or<br />
remittance of payments from a highly rated<br />
public sector entity;<br />
• Strong historic track record of the asset. To<br />
this end, a project that is exposed to<br />
greenfield or start-up operations with no<br />
usage history (for example, a complete<br />
reliance on independent consultant<br />
projections) would be considered to have a<br />
weaker business risk profile; and<br />
• Proven technology for construction and<br />
major maintenance activities, as applicable.<br />
Question 5: Do you differentiate between<br />
the forms of debt increase in an infrastructure<br />
transaction?<br />
<strong>In</strong> our credit evaluation of long-term concessions,<br />
we attempt to understand the economic substance<br />
and evolving profile of the debt structure: its rise<br />
and repayments over time relative to the business<br />
risk profile of the project and the term of the<br />
concession. The project debt balance could<br />
increase based on a contractually agreed to<br />
schedule. Alternatively, the debt balance could<br />
vary based on required cash flows procured from<br />
an alternate financing source to meet debt service<br />
requirements and equity distribution targets.<br />
Finally, the project debt could rise due to a direct<br />
contractual link to an inflation index that<br />
increases during the term of the debt.<br />
Standard & Poor’s has observed several forms<br />
of debt instruments that can cause a project’s debt<br />
to increase early in a concession and result in<br />
overstated traditional DSCRs. For comparative<br />
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purposes, Standard & Poor’s will also calculate an<br />
adjusted DSCR assuming the accretion is a debt<br />
service cash flow item (see Question 10). Types of<br />
instruments in which debt could rise include:<br />
• Capital Appreciation <strong>Bonds</strong> (CABs)--These<br />
are debt instruments where a portion of the<br />
interest due and payable to the creditor is<br />
deferred and added (capitalized) to the<br />
principal balance according to an agreed<br />
debt service schedule between the borrower<br />
and lender.<br />
• Accreting swaps--These can be used<br />
alongside a conventional debt instrument to<br />
create the same economic effect as CABs. As<br />
the accreting swap counterparty is a debt<br />
provider, we expect that the accreting swap<br />
will be considered pari passu with senior<br />
debt obligations under the project financing<br />
documents. Although there could be<br />
variations on accreting swap use, one form<br />
uses a floating-rate (e.g. LIBOR-based) loan.<br />
<strong>In</strong> this case, the project enters into an<br />
interest rate swap to convert the floating<br />
rate exposure to a fixed basis. Part of the<br />
interest obligation on the project’s fixed-rate<br />
payment to the swap counterparty is<br />
deferred and capitalized with the swap<br />
principal balance to create the accreting<br />
structure. The floating-rate payments from<br />
the swap counterparty meet the project’s<br />
floating (LIBOR) based obligations<br />
originally incurred. This synthetically<br />
creates the CAB structure described in the<br />
first bullet.<br />
• Accreting swap with embedded loan--<strong>In</strong> this<br />
instance, the swap payment from the<br />
counterparty is a cash inflow for the project<br />
rather than an interest payment deferral and<br />
floating rate pass-through as noted in the<br />
second bullet.<br />
• Credit facilities--Ostensibly the same as the<br />
third bullet, a credit facility can be used to<br />
create the same economic effect as the<br />
accreting swap (an embedded loan). The<br />
credit facility can provide cash flow to a<br />
project in the early years of a concession,<br />
bridging debt service obligations that may be<br />
higher than cash flow available. The draws<br />
can also provide cash flow funding for<br />
equity distributions early in the concession.<br />
Similar to an embedded loan, this form of<br />
financing would likely also rank pari passu<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
with project senior debt.<br />
• <strong>In</strong>flation-indexed securities--Treasury<br />
inflation protected securities (TIPS) in the<br />
U.S.; capital indexing bonds in Australia;<br />
indexed linked notes in the U.K.; inflation<br />
units in Mexico; and real return bonds in<br />
Canada are examples of securities that see<br />
the principal payment or principal balance<br />
(if it is a bullet maturity instrument) and<br />
coupon payment adjusted upward based on<br />
changes in an inflation index (such as the<br />
consumer price index). Projects with revenue<br />
streams or rate increase mechanisms<br />
strongly linked to inflation benchmarks<br />
typically issue these securities. The weaker<br />
the revenue link to inflation, the greater the<br />
potential deterioration in DSCRs due to a<br />
mismatch over time between cash flow<br />
available to service debt and the project’s<br />
debt service obligations.<br />
Whether the accreting swap payment is<br />
included as income (or a credit facility is provided<br />
to the project as an inflow) or a project<br />
company’s debt and swap repayment schedule<br />
allows the partial deferral of interest payments<br />
(understating debt service), the economic effect is<br />
the same. DSCRs are overstated and less<br />
comparable with DSCRs in more traditional<br />
amortizing debt structures.<br />
While the form of the project debt increase and<br />
its subsequent repayment profile is important, so<br />
too is the absolute size of the debt increase<br />
relative to the original debt issuance at<br />
transaction inception. This is discussed in<br />
Question 7.<br />
Question 6: What are the observable effects of<br />
accreting debt on a transaction and its potential<br />
credit quality?<br />
The primary effects relate to imposing aggressive<br />
financial structures on the asset dependent on<br />
long-term revenue growth. <strong>In</strong> particular, we note<br />
the following compared with traditional<br />
amortizing or many bullet structures associated<br />
with infrastructure financings:<br />
• Growing debt levels. Unlike a conventional<br />
debt refinancing for a volume risk asset<br />
(which typically occurs when construction<br />
has been completed and/or a usage history is<br />
known), accreting debt or an accreting swap<br />
crystallizes the future debt burden before the
project economics and expected revenue<br />
growth are known. Unless revenue and<br />
EBITDA growth is at least equal to the<br />
proportion of debt accretion, DSCRs will<br />
narrow and the enterprise value of the<br />
project will decline.<br />
• Greater reliance on growth. Accreting debt<br />
structures cause an overstatement of DSCRs<br />
in the early years of a concession (by the<br />
amount of the interest accrual or swap<br />
inflow to the project). This allows early-year<br />
cash flow deficiency to be managed (relative<br />
to expected net revenue) while maintaining<br />
dividend payments. Moreover, to the extent<br />
the revenue, EBITDA, operating, and capital<br />
cost and refinancing assumptions are<br />
aggressive, as the accreting debt balance<br />
amortizes in the medium-to-long term, longterm<br />
DSCRs are at risk of not meeting base<br />
case projections.<br />
• <strong>In</strong>creased flexibility. Deferred-pay<br />
mechanisms and non-amortizing structures<br />
can inject flexibility into an infrastructure<br />
financing structure, especially under more<br />
aggressive revenue growth assumptions or<br />
during the project’s start-up phase.<br />
However, these deferability features<br />
introduce additional credit risks for senior<br />
lenders as debt increases.<br />
• Allocation of risk/reward altered. Significant<br />
dividend distributions remitted as a result of<br />
the accreting structure’s deferral of senior<br />
debt payments effectively puts equity ahead<br />
of debt in the payment structure. This is a<br />
reversal of the traditional role of capital<br />
structure priority and funds flow<br />
subordination, whereby equity acts as<br />
patient capital and a buffer for senior debt<br />
during periods of revenue ramp-up or<br />
project cash flow weakness and is not seen<br />
as earning a notable proportion of its<br />
projected return ahead of senior debt.<br />
Sponsors have advocated accreting debt<br />
structures by highlighting lengthy concession<br />
terms of many infrastructure transactions that<br />
provide ample time in later years to repay higher<br />
debt, although that same opportunity to earn cash<br />
flow returns later in the concession also applies to<br />
equity distributions. Nonetheless, combined with<br />
solid business positions and inflation-linked<br />
revenues streams, sponsors view the risk profile of<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
these assets as low.<br />
<strong>In</strong> many respects, long-term concessions can be<br />
viewed as corporate transactions (perpetual<br />
economic ownership of an asset). Generally,<br />
corporate entities debt-finance and refinance on<br />
an ongoing basis. For projects, we assume that<br />
finite debt is issued and repaid along the<br />
depreciating asset life. Also, the benefit of<br />
covenants in rating corporate type structures is<br />
less so than for projects. While the sponsor<br />
argument of more corporate style financing of<br />
very long-term concessions is reasonable, the<br />
rating challenge is that transaction participants<br />
cannot have both the benefit of undertaking a<br />
corporate-style financing but calling it a project<br />
financing by adding structural features that have<br />
less value in a corporate finance rating approach.<br />
To the extent that a good portion of equity<br />
returns in the early years of a concession is<br />
derived from excess cash flow that accreting debt<br />
or swap structures produce, rather than<br />
outperformance by the project, there are clear<br />
benefits and incentives for sponsors to promote<br />
financing structures that use accreting debt.<br />
Standard & Poor’s has observed financial models<br />
for infrastructure transactions in which aggressive<br />
growth assumptions for revenue, together with<br />
the cash flow benefits of using accreting debt (or<br />
accreting swaps), results in the original paid-in<br />
equity capital being returned to sponsors before<br />
any debt repayment occurs. This has appeal to<br />
project sponsors but a fundamental credit issue is<br />
how the shift in risk to long-term lenders and<br />
the enhanced returns to equity sponsors affect<br />
credit quality.<br />
Equity risk premiums (the difference between a<br />
project’s cost of debt and its expected equity<br />
return) can provide a quantitative proxy for the<br />
relative risk of an entity. The equity risk<br />
premiums observed for accreting debt structures<br />
in infrastructure financings have been as high as<br />
8%-12% (800-1,200 basis points). This reflects<br />
only pretax cash equity yields and excludes<br />
additional equity return benefit that might be<br />
earned by sponsors through tax deductibility of<br />
interest expense and amortization items (capital<br />
cost allowance deductions or amortization of<br />
goodwill) should economic ownership and tax<br />
benefits be conferred to the concessionaire due to<br />
the concession’s lengthy term. <strong>In</strong> contrast,<br />
regulated utilities, which we rate slightly higher<br />
than low investment-grade infrastructure projects<br />
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110 ■ NOVEMBER 2007<br />
with accreting debt, see equity risk premiums<br />
above their cost of debt of 300-400 basis points.<br />
A traditional risk-reward relationship between<br />
equity and debt capital providers includes equity<br />
capital taking more of a project’s cash flow risks<br />
(such as later-period uncertainty) than senior<br />
creditors given the significant risk premium that<br />
the project sponsors can earn. The expectation of<br />
higher equity returns than fixed-rate debt should<br />
incorporate the achievement of base case financial<br />
projections and reflect higher risk incurrence by<br />
sponsors, thus providing incentive for equity to<br />
take a longer view and keep “skin-in-the-game.”<br />
As noted earlier, to the extent a large proportion<br />
of the value is derived in the early years of the<br />
concession through accreting instruments, such<br />
incentives might be reduced and the interests<br />
of equity or sponsors and lenders are not as<br />
closely aligned.<br />
Question 7: How do we analyze peak debt<br />
accretion and subsequent amortization guidelines<br />
for long-term concessions?<br />
<strong>In</strong> analyzing transaction structures for mature<br />
assets that have used accreting debt or swaps,<br />
Standard & Poor’s has set out broad principles as<br />
to how far into the concession debt can rise; when<br />
we would expect a certain proportion of the<br />
maximum accreted debt balance to paid down;<br />
and when we would expect final maturity (100%<br />
paydown of the maximum accreted debt balance).<br />
This amortization principle has varied depending<br />
upon the concession’s length, the asset’s business<br />
risk profile, and offsetting structural features<br />
that might provide support to the credit risks of<br />
debt accretion.<br />
We are likely to view shorter term concessions<br />
(e.g. 20-35 year terms) with short-to-no tail or<br />
concessions with significant construction risk, for<br />
example, as more speculative unless their debt<br />
burden and accretion proportion is considerably<br />
lower than an asset with a longer concession<br />
term, all else being equal. <strong>In</strong> many cases, a shortterm<br />
concession is not likely to exhibit the<br />
characteristics that allow for accreting debt and<br />
still achieve investment grade.<br />
We have not previously commented on the<br />
magnitude of maximum debt accretion relative to<br />
the original debt at transaction inception. This<br />
will be a function of different asset classes,<br />
business profiles, structural protections, and<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
desired rating levels. Our credit analysis also<br />
focuses on the physical and economically useful<br />
life of an infrastructure asset to which to link<br />
amortization and the final maturity of debt<br />
(particularly if the asset risks physical or<br />
economic obsolescence, substitution, or increasing<br />
competition). For this reason, there are no fixed<br />
standards for acceptable investment-grade<br />
leverage levels, credit ratios, or debt accretion and<br />
subsequent amortization guidelines. We assess<br />
each credit independently on all these factors,<br />
although broad business risk profile distinctions<br />
reflect the strength of certain asset classes and the<br />
ability to support relative accreting debt burdens.<br />
For example, a long-term airport concession, all<br />
else being equal, would likely be considered to<br />
have a stronger business position than a parking<br />
facility concession, which is likely to have greater<br />
competition and substitution risks.<br />
(x)<br />
2.5<br />
2.0<br />
1.5<br />
1.0<br />
0.5<br />
0<br />
2005<br />
2010<br />
2015<br />
© Standard & Poor’s 2007.<br />
2020<br />
Debt Structure And<br />
Deferred Pay<br />
25-year amortizing debt Moderate accreting debt Significantly accreting debt<br />
2025<br />
2030<br />
2035<br />
Principal Outstanding<br />
The chart above illustrates project debt accretion<br />
proportion and subsequent principal amortization<br />
under three different payment profiles. The lines<br />
in the graph do not represent any specific project<br />
that Standard & Poor’s rates, but illustrates the<br />
potentially different risk profile of varying<br />
debt and maturity structures, as well as the<br />
impact the concession term length might have<br />
on credit quality.<br />
• The curve at the bottom of the table<br />
represents a traditional 25-year amortizing<br />
debt instrument common in the U.S. public<br />
2040<br />
2045<br />
2050<br />
2055<br />
2060<br />
2065<br />
2070
finance market that has a predominately<br />
interest-only payment profile in the first few<br />
years of the concession with full<br />
amortization occurring thereafter. This<br />
amortization schedule may be used to<br />
produce level annual debt service costs or, in<br />
concert with a capitalized interest period, to<br />
manage construction of an asset--for which<br />
there could be no revenue receipt until<br />
completion. Such a structure might have a<br />
modest (to no) equity tail based on a shorter<br />
concession.<br />
• The middle curve represents a long-term<br />
concession (a term of at least 50 years if<br />
there is no equity tail but up to 75 years if<br />
there is a 25-year tail). <strong>In</strong> this senior debt<br />
repayment profile, debt accretes to about<br />
25% higher than the original par issuance at<br />
or about year 20 and amortizes to zero in<br />
the next 30 years.<br />
• The top curve represents a concession that is<br />
likely at least 75 years in term, as the senior<br />
debt accretes to more than 2x (100%)<br />
relative to original par issuance in the first<br />
40 years of the concession and then<br />
amortizes rapidly in the next 15-20 years.<br />
Assuming the same asset and business risk<br />
profiles and debt-to-capital ratio at transaction<br />
inception, with the notable potential differences<br />
being variations in concession term, covenants,<br />
legal provisions, and debt and maturity structure,<br />
Standard & Poor’s would likely view the first<br />
curve (colored light green) as the most<br />
conservative financial risk profile and the third<br />
(red) as the most aggressive. This is the case given<br />
the absence of accretion and the proportion of<br />
debt repayment early in the concession for the<br />
first scenario and the very high proportion of<br />
accretion and the back-ended nature of the<br />
repayment profile for the third scenario, which<br />
would also likely imply high dividends payable to<br />
sponsors during the period of considerable<br />
accretion. Standard & Poor’s would not view the<br />
third scenario as investment-grade regardless of<br />
how strong the business risk profile or underlying<br />
asset quality. The second curve (dark green) could<br />
be investment grade if it had a solid business risk<br />
profile, supportive covenants and legal provisions,<br />
and a lengthier equity tail--although how close<br />
this scenario could get to the credit quality of the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
first one would be determined by the relative<br />
differences of these factors.<br />
<strong>In</strong> summary, our ratings will incorporate the<br />
maximum accretion relative to original par debt<br />
issuance, the proportion of back-ended principal<br />
repayments and the share of paid-in equity capital<br />
returned in the form of dividends referenced in<br />
Questions 5 and 6 into our analysis with less<br />
aggressive structures generally associated with<br />
higher rated concessions.<br />
Question 8: How would Standard & Poor’s<br />
analyze the accretion characteristics and<br />
subsequent amortization guidelines for public<br />
infrastructure owners and debt issuers?<br />
These transactions will be evaluated on a case-bycase<br />
basis. <strong>In</strong> the U.S. public finance market,<br />
capital appreciation bonds have been employed<br />
for many years, often in the start-up toll road<br />
sector. Although these structures provide cushion<br />
and flexibility during the initial years of toll<br />
projects when revenues are still growing, they in<br />
fact result in a higher debt burden in later years.<br />
This can be problematic for a start-up facility,<br />
especially during a restructuring, if net toll<br />
revenues fall short of projections and debt service<br />
requirements. All things being equal, the ability of<br />
a public sector entity to assume accreting debt<br />
structures is comparatively better than for<br />
projects for several reasons including the ability to<br />
pledge revenues from a variety of assets (not just<br />
a single project), the lack of a concession term, its<br />
long-term interests as the permanent asset owner<br />
and the lack of dividend payouts which<br />
presumably allows for better liquidity and capital<br />
expenditures that improve asset quality and<br />
enhance revenues. As such, adherence to our<br />
amortization guidelines is not necessary for<br />
consideration of investment grade structures.<br />
However, on a relative basis, the financial risk<br />
profile of a public sector debt issuer would be<br />
viewed as more aggressive and highly leveraged<br />
and a weaker credit compared to traditional<br />
amortizing debt structures. Additionally, the same<br />
fundamental credit concerns regarding shifting<br />
long-term risks to lenders exist, although they can<br />
be mitigated through the mechanisms discussed in<br />
this FAQ including cash sweeps and debt<br />
reduction under scenarios when revenue<br />
projections fall short of forecasts.<br />
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Question 9: Do you review ratios and financing<br />
assumptions differently when reviewing accreting<br />
debt structures?<br />
No. <strong>In</strong> addition to ratios and cash flows we<br />
examine the capital structure and liquidity as part<br />
of the financial analysis. Our approach to the<br />
analysis of ratios and financing assumptions<br />
places emphasis on:<br />
• The magnitude of the accretion in the<br />
concession’s early years along with the<br />
schedule and pace of debt repayment;<br />
• Distribution policy based on the accreting<br />
debt or swap structure;<br />
• Capital (debt-to-total capital) and<br />
debt structure;<br />
• Financing rates, including estimated credit<br />
spreads on risk-free reference rates and<br />
swap rates;<br />
• Refinancing risk, including market risk for<br />
refinanced debt and any exposure to<br />
changing interest rates and credit spreads at<br />
refunding dates;<br />
• <strong>In</strong>flation expectations and linkage to<br />
revenue setting ability;<br />
• Volume growth estimates for the assets;<br />
• Revenue projections and assumed growth<br />
rates--in particular, for proposed toll- or<br />
user-rate increases and the modeled demand<br />
elasticity associated with such increases;<br />
• Capital expenditure obligations;<br />
• The relationship between the growth in<br />
annual debt service costs for the project and<br />
the projected growth in revenue; and<br />
• Operating cost assumptions and forecast<br />
synergies or savings through a long-term<br />
concession respecting a formerly publicly<br />
managed asset.<br />
We believe that the private management of a<br />
formerly publicly managed infrastructure asset<br />
could present revenue optimization and costsaving<br />
opportunities that might not have<br />
historically been a priority for a public sector<br />
body that managed operations with rate<br />
affordability and a break-even financial position<br />
as strategic goals. Public infrastructure owners are<br />
currently reevaluating this approach to rate<br />
setting in the face of growing capital and<br />
maintenance needs, in addition to other fiscal<br />
pressures. Nevertheless, despite the financial<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
incentives inherent in an entity with equity<br />
sponsors, we consider the reasonableness of<br />
the financing and operating assumptions in<br />
our analysis.<br />
Tightly defined and higher permitted<br />
distribution tests (DSCR based equity lock-ups)<br />
provide some measure of protection for dividend<br />
distributions to equity ahead of debt. As part of<br />
future accreting debt transactions, Standard &<br />
Poor’s expects more aggressive structures will<br />
likely necessitate some form of debt repayment<br />
through a partial cash sweep mechanism funded<br />
from locked up equity proceeds. This provision<br />
would be linked to a period of time in which the<br />
permitted distribution test has been invoked and<br />
locked-up cash proceeds can be redirected for<br />
debt repayment. This provides additional<br />
incentive to sponsors to avoid equity lock-up all<br />
altogether, but particularly for a prolonged<br />
period, as it might significantly reduce their equity<br />
return by the amount of trapped cash that might<br />
be permanently redirected to debt reduction<br />
through mandatory prepayments.<br />
For investment-grade ratings, Standard &<br />
Poor’s also expects to see an alignment between<br />
cash flows allocated to a project’s equity sponsors<br />
and its long-term lenders. Among the ratios that<br />
we will analyze to guide our approach to better<br />
balancing cash flow returns between debt and<br />
equity is a dividends payable to EBITDA measure<br />
that more closely follows the metrics observed by<br />
regulated utilities or other infrastructure<br />
companies. Regulated utilities have dividends<br />
payable to EBITDA ratios of 15%-25%, whereas<br />
a credit such as 407 <strong>In</strong>ternational <strong>In</strong>c. (a 99-year<br />
Canadian toll road concession company) has<br />
posted dividend-to-EBITDA ratios in the mid-tohigh<br />
20% range. For many of the accreting debt<br />
concession transactions that we observe, this ratio<br />
is considerably higher because of debt accretion<br />
and swaps.<br />
Standard & Poor’s is reviewing using debt stock<br />
ratios (such as debt to EBITDA) and cash<br />
distribution measures (such as annual dividend<br />
distributions relative to annual project EBITDA)<br />
to complement DSCRs, traditional credit metrics,<br />
and stress testing scenarios. These ratios will play<br />
an increasing role in investment-grade credit<br />
metrics for infrastructure concession projects that<br />
use accreting debt structures.
Question 10: If traditional DSCRs are less<br />
meaningful, how do other measures such as Loan<br />
Life Coverage Ratios (LLCR) or Project Life<br />
Coverage Ratios (PLCR) factor into the analysis?<br />
Traditional DSCRs are of limited analytical value<br />
when a financial risk profile has significant<br />
accreting debt or accreting swaps because the cash<br />
flow effects (deferral of interest or nonoperational<br />
inflows) to the project early in the<br />
concession term overstates this ratio. To this end,<br />
we estimate the project’s cash flow based DSCR<br />
(including the effects of accreting debt or<br />
accreting swaps) but also calculate a DSCR<br />
profile that would adjust for the effects of<br />
accretion and debt capitalization. This is of<br />
particular value in the review of the early years of<br />
a concession, when accretion features tailor debt<br />
repayment to revenue growth assumptions.<br />
<strong>In</strong> calculating an alternative DSCR, we include<br />
in the denominator the project’s actual cash-based<br />
payment of debt and swap obligations, as well as<br />
the capitalized amount that is deferred and added<br />
to the project’s debt balance. For certain kinds of<br />
accreting swap structures, the adjustment removes<br />
from the numerator swap inflows payable to the<br />
project that achieve the same effect as the interest<br />
payment deferral. This adjusted DSCR calculation<br />
complements the review of the percent rise in debt<br />
(due to accretion) that occurs from the original<br />
issuance to the project’s maximum peak debt<br />
balance (including accrued swap amounts owing).<br />
<strong>In</strong> calculating the base case DSCRs for accreting<br />
debt projects, we include in the numerator<br />
operating revenue (excluding interest income,<br />
earnings from asset sales, debt or equity proceeds,<br />
and insurance proceeds) minus operating and<br />
maintenance expenses (including mandatory<br />
major maintenance reserve account deposits). The<br />
DSCR numerator can also exclude swap<br />
payments to the project from the swap<br />
counterparty if these payments are viewed as a<br />
pass-through to meet the project company’s<br />
obligation to a debt provider. Drawdowns on an<br />
LOC or accreting swap proceeds that achieve the<br />
same effect as an interest payment deferral can be<br />
an adjustment to the DSCR numerator given their<br />
primary cash flow structuring role. <strong>In</strong> addition to<br />
traditional cash interest obligations, which<br />
deferral features will understate, the DSCR<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
denominator includes any monoline bond<br />
insurance costs and swap costs associated with<br />
synthetic debt products.<br />
LLCRs and PLCRs are less relevant to debt<br />
ratings, which assess an issuer or debt issue’s<br />
probability of default; however, these ratios<br />
provide important analytical value to our<br />
recovery rating process, in which we assess the<br />
recovery of accrued interest and principal<br />
outstanding following an unremedied payment<br />
default. <strong>In</strong> addition to being based on projected<br />
revenues, LLCRs and PLCRs are generally higher<br />
than DSCRs, which typically reflects the equity<br />
tail at the end of the concession (when the project<br />
debt has been retired.)<br />
During cash flow weakness, LLCRs and PLCRs<br />
can remain well above 1.0x, whereas periodic<br />
DSCRs during the same time frame could fall<br />
below 1.0x, requiring draws on liquidity to avoid<br />
default. A project could default on its debt<br />
obligations, while depending on assumptions of<br />
capital structure, discount rate, and revenue<br />
growth following the default for the remainder of<br />
the concession, the LLCRs and PLCRs (a proxy<br />
for recovery) could be greater than 1.0x (or<br />
greater than 100% recovery). For projects with<br />
manageable peak accretion and a considerable<br />
equity tail, such a solid recovery scenario is<br />
quite possible.<br />
Question 11: Can security features and structure<br />
and protective covenants offset the relative higher<br />
risks of an accreting debt structure?<br />
Protective covenants can strengthen a<br />
transaction’s credit profile by limiting the ability<br />
of the project to incur more debt, acquire dilutive<br />
businesses or distribute cash when it performs<br />
below base case expectations. No amount of<br />
structuring or covenant protection, however, can<br />
completely compensate for a weak business risk<br />
profile or overly aggressive financial structure.<br />
Standard & Poor’s expects the standard<br />
structural features or covenants to be considered<br />
for a project rating, particularly one that<br />
incorporates accreting debt and has a more<br />
aggressive financial profile. Where covenants<br />
require quantitative limits (such as DSCR based<br />
tests), there is no fixed rule of thumb that can be<br />
applied to achieve an investment grade rating.<br />
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Question 12: Is the documentary and legal<br />
review for an accreting debt or swap structure<br />
different from other project finance or<br />
PPP ratings?<br />
No. The legal review across project structures is<br />
comparable, and Standard & Poor’s expects that<br />
transactions using accreting debt will have a<br />
robust legal structure. Our documentation and<br />
legal review includes a detailed examination of<br />
the concession agreement terms, and its<br />
supporting schedules and appendices, which<br />
govern the long-term relationship and risk<br />
allocation between the concessionaire and<br />
the concession grantor. Standard & Poor’s<br />
legal review will also examine any proposed<br />
intercreditor agreement and the<br />
covenant package.<br />
Certain jurisdictions benefit from more creditorfriendly<br />
legal regimes that can contribute to<br />
infrastructure project rating differences.<br />
<strong><strong>In</strong>frastructure</strong> project financings are generally<br />
more susceptible to local law exposure than other<br />
types of structured financing because of the<br />
physical location of the assets and the often<br />
essential and politically sensitive nature of the<br />
assets. For more information, see “Jurisdiction<br />
Matters For Secured Creditors <strong>In</strong> <strong>In</strong>solvency” and<br />
“Emerging Market <strong><strong>In</strong>frastructure</strong>: How Shifting<br />
Rules Can Stymie Private Equity.”<br />
Question 13: Beyond the already stated effects of<br />
accretion, how does Standard & Poor’s evaluate<br />
swap transactions as part of its credit analysis?<br />
Many project sponsors employ interest rate or<br />
currency swap strategies to achieve cost-effective<br />
debt financing. These swaps are generally<br />
integrated into an overall swap that includes<br />
accretion features.<br />
A capital structure that includes both debt and<br />
accreting swaps will require a review of the<br />
relevant swap documentation and inter-creditor<br />
agreement. As an accreting swap counterparty is<br />
allowing a portion of the project company’s<br />
interest payable under its swap arrangement to<br />
accrue, it is acting as debt provider, and these<br />
swap obligations will likely be considered pari<br />
passu with other debt obligations. It is important<br />
to determine if there are cross default provisions<br />
on events, such as early swap termination, which<br />
could lead to acceleration of the debt obligations.<br />
One potential credit issue is whether or not the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
transaction is swap-independent. For example, if<br />
the swap were to terminate, the issuer would pay<br />
or receive a payment to or from the swap<br />
counterparty. If the issuer did not receive a<br />
payment due to a counterparty default, it might<br />
not be able to replace its swap position at similar<br />
rates or terms, so might not be able to<br />
perform at previously expected (rated) coverage<br />
levels without rate increases or possible<br />
rating implications.<br />
For transactions originating in the U.S. with<br />
U.S. swap counterparties, Standard & Poor’s<br />
might undertake a debt derivative profile (DDP)<br />
exercise. Although we consider many factors, the<br />
DDP scores principally indicate an issuer’s<br />
potential financial loss from over-the-counter debt<br />
derivatives (swaps, caps, and collars) due to<br />
collateralization of a transaction or, worse, early<br />
termination resulting from credit or economic<br />
reasons. We integrate DDPs into rating analyses<br />
for swap-independent issuers, and they are one of<br />
many financial rating factors.<br />
These credit issues are central to our rating<br />
analysis as monoline bond insurance policies<br />
might guarantee swap payments due from (but<br />
not due to) the issuer. As a highly rated financial<br />
guaranty policy should maintain payments to the<br />
swap counterparty (should a wrapped project not<br />
be able to meet its swap and debt obligations due<br />
to poor performance), the project company<br />
should not be in default on its side of the swap.<br />
Swap renewal, if applicable, and swap<br />
counterparty credit quality remain analytical<br />
issues, even for monoline wrapped transactions.<br />
As a result, Standard & Poor’s will examine<br />
within a swap transaction the level and minimum<br />
credit quality of collateral posting, and<br />
replacement requirements should minimum credit<br />
rating levels be violated by swap counterparties.<br />
Question 14: Given the commitments of<br />
monoline bond insurers, how is refinancing risk<br />
factored into the credit rating for an accreting<br />
debt structure?<br />
A monoline insurer that provides a guarantee<br />
policy for refinancings reduces the market access<br />
risk and the spread risk at refinance. Even ‘AAA’<br />
interest rates and credit spreads vary and in the<br />
absence of a hedging strategy, the uncertain future<br />
cost of debt refunding could narrow coverage<br />
ratios in a stress case. We evaluate the underlying
credit quality of a transaction before overlaying<br />
and assessing the incremental contribution of<br />
credit substitutions such as monoline wraps.<br />
Moreover, our view of refinancing risk depends in<br />
large part on the expected cash flows of the<br />
project at the time of refinancing.<br />
Our starting point is to assume that refinancing<br />
risk within an accreting debt structure is<br />
manageable in long-dated concessions with a<br />
sufficient tail (about 10-30 years). We will<br />
examine financial models to understand the<br />
assumptions being made about refinancing (such<br />
as the interest rate employed) and stress tests will<br />
be used to evaluate the sensitivity of transactions<br />
to less-favorable interest rate assumptions at<br />
refinancing points. The history, record and<br />
expectation of local debt markets will have a<br />
different weight on emerging markets.<br />
<strong>In</strong>vestment-grade structures will typically have<br />
secured appropriate hedging arrangements in this<br />
regard. A monoline insurer’s commitment simply<br />
gives additional comfort to any refinancing<br />
risk analysis. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
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Publication Date:<br />
Sept. 19, 2007<br />
Primary Credit Analyst:<br />
Andrew Palmer,<br />
Melbourne,<br />
(61) 3-9631-2052<br />
Kurt Forsgren,<br />
Boston,<br />
(1) 617-530-8308<br />
Terry A Pratt,<br />
New York,<br />
(1) 212-438-2080<br />
Secondary Credit Analysts:<br />
Paul B Calder, CFA,<br />
Toronto,<br />
(1) 416-507-2523<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Santiago Carniado,<br />
Mexico City,<br />
(52) 55-5081-4413<br />
116 ■ NOVEMBER 2007<br />
CREDIT FAQ: THE EVOLVING LANDSCAPE FOR<br />
SUBORDINATED DEBT IN PROJECT FINANCE<br />
Emboldened by active competition and<br />
continued demand for project and<br />
infrastructure assets, the landscape for<br />
subordinated debt structures in project finance<br />
transactions continues to evolve. <strong>In</strong>deed, some<br />
debt arrangers are pushing new boundaries to<br />
structure and fund ambitious greenfield and<br />
brownfield asset developments or leveraged<br />
acquisitions (see “The Changing Face Of<br />
<strong><strong>In</strong>frastructure</strong> <strong>Finance</strong>: Beware The Acquisition<br />
Hybrid” on page 8). Notwithstanding the recent<br />
upheaval in credit markets, the driving force<br />
behind debt structuring is usually simple: lower<br />
the after-tax weighted-average cost of capital<br />
while providing flexibility to project sponsors and<br />
investors and enhancing cash returns on equity.<br />
The result is most often higher leverage and<br />
added complexity through a mix of senior and<br />
subordinated debt--more eloquently referred to as<br />
“structural optimization” by debt arrangers.<br />
As employed in project finance for many years,<br />
market participants are “tranching” a project’s<br />
liability structure into senior debt, subordinated<br />
debt, and in more recent years--depending on the<br />
window of opportunity--“payment in kind” (PIK)<br />
notes (see “LBO Equity Hybrids: Too Good To Be<br />
True” published on RatingsDirect on Aug. 10,<br />
2007). Importantly from a credit perspective,<br />
regardless of the underlying project, the common<br />
theme is increased gearing and more complex<br />
funding and documentation structures--both<br />
which have varying effects on a project’s debt<br />
ratings and recovery prospects in terms of the<br />
potential level of default and loss given default.<br />
This FAQ will highlight the criteria issues<br />
related to analyzing senior and subordinated<br />
structures in the context of issue ratings and<br />
recovery analysis.<br />
Frequently Asked Questions<br />
What is project subordinated debt?<br />
<strong>In</strong> its purist and simplest form, a project’s<br />
subordinated debt typically ranks behind a<br />
project’s senior debt in terms of priority over predefault<br />
cash flows and security over collateral,<br />
and in the event of insolvency behind any<br />
enforcement proceeds, assuming there is anything<br />
left. <strong>In</strong> this context, project subordinated debt is<br />
used in structures as a form of credit<br />
enhancement for senior debt that establishes the<br />
distribution of a project’s default and recovery<br />
over the life of the financing structure.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Typically, the rights for project subordinated<br />
debt are defined under a project’s structural,<br />
contractual, and legal framework. This structural<br />
framework for projects should incorporate a<br />
“ring-fenced” entity, a pre-default cash-flow<br />
waterfall, cash lock-up and sweep triggers, a debtservice<br />
reserve account, and post-default<br />
liquidation processes. Consequently, given the<br />
varying characteristics of subordinated debt the<br />
default and loss given default of any tranches of<br />
project subordinated debt may occur at different<br />
time intervals over the term of a transaction’s<br />
life cycle.<br />
Why is subordinated debt used in<br />
project transactions?<br />
Subordination gives project finance transactions<br />
the ability to create one or more classes of debt,<br />
which can allow access to more debt or alternate<br />
investor classes. One of the main objectives of<br />
using subordinated debt is to improve a project’s<br />
after-tax weighted-average cost of capital through<br />
improving the rating on senior debt while<br />
segregating credit risk and enhancing the return<br />
on equity. At the same time, sponsors of a project<br />
often use subordinated debt for tax and<br />
accounting reasons, particularly where there may<br />
be restrictions in distributing cash from a specialpurpose-vehicle<br />
structure due to retained<br />
accounting losses. Subordinated debt may also be<br />
an option explored by debt arrangers if seniorsecured<br />
financing options have be exhausted or<br />
capped out.<br />
Can subordinated debt be treated as equity for<br />
analytical purposes?<br />
Often project sponsors use subordinated debt as a<br />
substitute for equity. Depending on the underlying<br />
project ring-fence structure, security, contractual,<br />
and legal framework in each jurisdiction,<br />
Standard & Poor’s may consider treating<br />
subordinated debt as equity for analytical<br />
purposes on a case-by-case analysis. Such an<br />
analytical scenario may occur if a project’s debt: is<br />
deeply subordinated within a strongly ring-fenced<br />
vehicle with a structural waterfall and distribution<br />
triggers; has no rights to call default or accelerate<br />
payment; ranks after senior debt under predefault<br />
and post-default cash-flow waterfalls; and<br />
matures after senior debt. Like most financing<br />
structures, however, the answer will reside in the<br />
detail of a particular transaction in its relevant<br />
jurisdiction.
What are some of the key types of project<br />
subordinated debt?<br />
While there are project-specific nuances, in most<br />
instances the type and level of subordinated debt<br />
has been tailored to the cash-flow characteristics<br />
of each project. Standard & Poor’s has identified<br />
a variety of structural, contractual, and legal<br />
forms of subordinated debt in project finance<br />
transactions:<br />
Deeply subordinated (pre- and post-default) debt.<br />
A form of deeply subordinated debt is shareholder<br />
loans, which display many of the characteristics<br />
of equity, and have no rights to call default or<br />
rights on enforcement, or calls on the post-default<br />
recovery proceeds. This form of subordinated<br />
debt is often used in the public-privatepartnership<br />
(PPP) space as tax-efficient equity<br />
for sponsors.<br />
Residual value subordinated debt.<br />
This debt is structurally reliant on residual or<br />
dividend cash flow from another project-financed<br />
vehicle with senior-ranking debt and possibly even<br />
subordinated debt obligations. These residual cash<br />
flows or dividends are usually only available<br />
subject to certain debt lock-up tests being<br />
achieved at the underlying project funding vehicle.<br />
Dividends or residual flows may also be<br />
dependent on the ability of a project company to<br />
distribute cash flows due to retained<br />
accounting losses.<br />
PIK notes.<br />
Typically, PIK notes are structurally subordinated<br />
to senior debt or second-ranking lien debt in a<br />
project’s pre-default and post-default cash-flow<br />
waterfall, with coupon payments at the discretion<br />
of the issuer. If coupon payments under the PIK<br />
notes are not made in the form of cash<br />
distributions, the coupon is usually made whole<br />
by the issuance of PIK notes of equivalent value.<br />
Unlike true equity, PIK notes usually have a<br />
maturity date and at least some rights against the<br />
issuer to help ensure repayment. Standard &<br />
Poor’s will treat PIK notes as debt in calculating<br />
credit metrics.<br />
While it may be possible to carve-up a project’s<br />
cash flows to create a subordinated instrument in<br />
a number of forms, there is no “free lunch”, and<br />
at some point the key consideration is how a<br />
subordinated debt instrument will or will not<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
affect default or recovery of senior-ranking debt<br />
from a credit and legal perspective.<br />
What are the key structural elements considered<br />
by Standard & Poor’s?<br />
<strong>In</strong> examining a project’s liability and capital<br />
structure, we are often asked what the main<br />
structural and documentation considerations it<br />
undertakes to assess how a project’s debt is<br />
structurally, contractually, or legally subordinated.<br />
The objective is relatively simple: if subordinated<br />
debt obligations are to provide credit support and<br />
collateral to senior rated debt, then subordinated<br />
debt must have no rights that could accelerate or<br />
cause default or increase the level of loss given<br />
default of any senior-ranking debt. Nevertheless,<br />
Standard & Poor’s will typically review several<br />
aspects in any assessment:<br />
The rights of subordinated debt to call a default<br />
or cross default to senior classes of debt.<br />
It is not appropriate that a payment default on a<br />
tranche of subordinated debt could cause a<br />
default under the senior debt provisions.<br />
The rights of subordinated debt to accelerate<br />
payment while senior debt is outstanding.<br />
Subordinated debt should not have any right to<br />
accelerate while senior debt is outstanding.<br />
Senior debt rights to lock-up or sweep cash flow.<br />
Following any breach of a senior debt cash-flow<br />
lock-up trigger or cash-flow sweep trigger,<br />
subordinated debt should not be entitled to any<br />
cash flow, other than what might be available<br />
from reserves that are specifically dedicated to the<br />
subordinated debt obligations. Similar to the<br />
point above, this should also not give<br />
subordinated debt any rights to call or trigger<br />
default or acceleration as a result of a senior lockup<br />
or sweep trigger being breached.<br />
The pre-default and post-default cash-flow<br />
waterfall and transaction documentation.<br />
This is necessary to understand how subordinated<br />
debt is structurally and legally subordinated. This<br />
would include an understanding of how cash<br />
flows are distributed and shared in a transaction’s<br />
cash-flow waterfall. Typically, subordinated debt<br />
should be serviced after payments to operations,<br />
senior debt interest and principal, any net hedging<br />
settlements, and any senior debt-service reserves<br />
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118 ■ NOVEMBER 2007<br />
and maintenance accounts, which are there to<br />
support the senior debt rating. Likewise, collateral<br />
security interests or claims upon liquidation<br />
granted to subordinate lenders should rank after<br />
senior debt.<br />
The maturity profile of subordinated debt<br />
should be longer dated than senior debt,<br />
otherwise it is not truly subordinated.<br />
The voting rights of debt participants.<br />
These rights should be limited solely to senior<br />
debt participants; subordinated debt should have<br />
no rights while senior debt is outstanding.<br />
Nonpetition language.<br />
This needs to be considered to ensure that no<br />
winding-up provisions are allowed while senior<br />
debt is outstanding either permanently or for a<br />
specified period. Typically, the objective is to<br />
ensure that subordinated debt has no right to<br />
challenge any enforcement rights or validity in the<br />
priority of payments of senior debt holders.<br />
The events of default and termination events<br />
of any interest-rate swaps used to hedge<br />
subordinated debt.<br />
These need to be closely examined. Although the<br />
majority of subordinated debt is fixed-rate debt, if<br />
variable subordinated debt is used and overlaid<br />
and mitigated with a interest-rate hedge, the<br />
events of default and termination events of the<br />
swap would need to be limited so as not to<br />
accelerate or cross-default senior debt.<br />
Subordinated debt rights or remedies in a<br />
restructuring, insolvency, or<br />
bankruptcy proceeding.<br />
Deeply subordinated debt should not have any<br />
such rights or remedies. For beneficial equity<br />
treatment, project subordinated debt should only<br />
be able to enforce its security and creditor rights<br />
unless, and until, senior debt has done so.<br />
What is the analytical framework for project<br />
subordinated debt?<br />
Some market participants think of the analytical<br />
assessment behind rating subordinated debt as<br />
one of simply solving a target debt-service cover<br />
ratio (DSCR) or simply notching off the senior<br />
debt issue rating. But our approach is more<br />
sophisticated. No two projects are the same from<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
a business, industry, market, operational,<br />
structural, or legal perspective. Certainly, it is fair<br />
to say that a senior debt issue rating provides<br />
some starting point for the subordinated debt<br />
rating. However, in order to make a proper<br />
assessment, we assess a project’s cash flows to<br />
understand where the credit stress points may be<br />
relative to the payment structure under the<br />
subordinated debt instrument and its exposure<br />
horizon. <strong>In</strong> assessing the ability and willingness of<br />
a project’s subordinated debt to pay its<br />
obligations in full and on time, our analytical<br />
framework reviews and measures a number of<br />
elements that influence the level of potential<br />
default and rating of a subordinated debt tranche:<br />
The underlying business and industry risk of<br />
a project.<br />
This examines the key business and industry<br />
economic fundamentals that influence the<br />
underlying volatility of a project’s operating cash<br />
flow.<br />
A project’s financial ratios (for example, DSCR<br />
on a total debt basis {senior and subordinated<br />
debt} and segregated subordinated debt basis after<br />
{senior debt}). It is important to note that the<br />
DSCR should not be viewed in isolation. This is<br />
particularly true when a project includes accreting<br />
debt structures that can overstate a transaction’s<br />
DSCR, while also deferring senior debt<br />
amortization. (see “Accreting Debt Obligations<br />
And The Road To <strong>In</strong>vestment Grade For<br />
<strong><strong>In</strong>frastructure</strong> Concessions” on page 105). As a<br />
result, we closely examine all financial ratios,<br />
particularly revenue growth assumptions and the<br />
components of the coverage ratios that are can be<br />
overstated by such financing instruments.<br />
Senior debt cash lock-up triggers, sweep triggers,<br />
and reserve limits (for example, senior debtservice<br />
reserve and maintenance reserves).<br />
Understanding these triggers and reserves is a<br />
critical part of the analytical framework for<br />
subordinated debt, as such lock-up triggers and<br />
reserves are for the protection of senior lenders<br />
only, and may result in subordinated debt being<br />
more susceptible to default, particularly if<br />
subordinated debt does not have its own<br />
dedicated debt-service or liquidity reserve.
Sensitivity and break-even analysis on each<br />
project is undertaken.<br />
This takes into account the specific cash-flow<br />
waterfall structure and repayment terms and<br />
conditions of senior and subordinated debt.<br />
Sensitivity analysis helps demonstrate and<br />
highlight potential downside thresholds under<br />
which subordinated debt may miss a payment of<br />
interest or principal. Stress tests, which are<br />
usually in the form of break-even analysis, assist<br />
in understanding whether a missed payment is<br />
due to any lock-up triggers or other distribution<br />
stoppers being breached and stopping cash<br />
flowing through to subordinated debt (and any<br />
dedicated debt-service reserve running out), or<br />
just the fact that there is not enough cash after<br />
the senior debt has been serviced irrespective of<br />
any distribution trap or stopper. Stress sensitivities<br />
are run on revenues, availability, prices, operating<br />
costs, capital expenditure, inflation, and<br />
refinancing spreads. Typically, the level of stress<br />
placed on subordinated debt is reconciled with the<br />
overall risk of the project and likelihood of a<br />
stress scenario occurring.<br />
Assessing the level and type of credit<br />
enhancement supporting subordinated debt.<br />
Such credit enhancement can take the form of<br />
equity, and project cash flows available after<br />
senior debt-service and liquidity reserves, usually<br />
in the form of dedicated debt-service reserves for<br />
the benefit of subordinated debt. If a<br />
subordinated debt instrument does not have its<br />
own debt-service reserve, it is likely to be more<br />
susceptible to default under stressed scenarios.<br />
Ability for senior debt to raise additional debt or<br />
offer security ahead of subordinated debt.<br />
Most projects allow limited other financial<br />
indebtedness to be raised and security granted to<br />
enhance the rating of senior debt. However, if this<br />
right is too broad, it may affect the level of<br />
subordination, which may change over time.<br />
What will influence the probability of default on<br />
subordinated debt?<br />
Apart from a project’s underlying operating and<br />
business fundamentals, which will be the major<br />
influence on the performance of a project, the<br />
probability of default of a project’s subordinated<br />
debt will be influenced typically by:<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
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• The contractual and legal structure of a<br />
project, which usually incorporates a predefault<br />
cash-flow waterfall, cash lock-up<br />
and sweep triggers, a timeframe before cash<br />
is released from lock-up, and debt-service<br />
reserve accounts for senior debt; and<br />
• The terms and conditions of the underlying<br />
subordinated debt and any dedicated<br />
liquidity or debt-service reserve allocated for<br />
subordinated debt.<br />
Accordingly, key subordinated debt rating<br />
considerations include: how likely a project will<br />
go into distribution or equity lock-up; how long it<br />
will remain there; what happens to the trapped<br />
cash once in lock-up; and what type of credit or<br />
liquidity support (such as reserves) exist to lower<br />
default probability. If a distribution-trap<br />
mechanism does not last for an indefinite period,<br />
it could be argued that the resumption of debtservice<br />
payments on subordinated debt-depending<br />
on the project, scenario, and<br />
subordinated liquidity reserves--is likely to be<br />
certain. The analytical challenge is determining<br />
the duration of any under performance. We<br />
typically run stress scenarios for each project to<br />
analyze how long it would take for a rated<br />
tranche of subordinated debt to default under<br />
varying scenarios. Nonetheless, any significant<br />
deterioration in the performance of a project is<br />
likely to magnify the level of potential default on<br />
any subordinated debt.<br />
What will affect the recovery of<br />
subordinated debt?<br />
If a project suffers from poor performance and<br />
there is a missed payment of interest or principal<br />
on a project’s subordinated debt, a major<br />
determinant on the recovery prospects of<br />
subordinated debt is whether senior debt has also<br />
defaulted. If senior debt has not defaulted, it<br />
would prevent any recovery action of<br />
subordinated debt until senior debt is repaid or<br />
defaults. If this was to occur, there may be limited<br />
or zero recovery for subordinated debt.<br />
Should senior debt default or be repaid, factors<br />
that would influence the recovery prospects of<br />
subordinated debt include:<br />
• The nature of the default;<br />
• The type of security, collateral, and any<br />
first-loss protection;<br />
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• The type of security enforcement scenario<br />
(liquidation versus selling the project as a<br />
going concern);<br />
• Senior debt’s ability to influence the<br />
recovery for its benefit;<br />
• Macroeconomic conditions and its impact<br />
on the value of any collateral;<br />
• The level of any break costs under a hedging<br />
or derivative instrument;<br />
• The insolvency or bankruptcy regime in a<br />
jurisdiction or country;<br />
• Third-party costs, such as legal and<br />
insolvency-related costs;<br />
• The time it takes to emerge from default;<br />
• The length and value of a project’s cashflow<br />
tail after the repayment of senior debt;<br />
• Any other equal-ranking obligations.<br />
As each of these factors can vary considerably<br />
from market to market across the globe, so too<br />
will the level of recovery for each project’s<br />
subordinated debt. Consequently, each project<br />
needs to be examined on a case-by-case basis.<br />
Why can subordinated debt issues be rated one<br />
or more notches below the senior debt rating?<br />
As each project’s business profile is unique, so too<br />
is its financial, contractual, and legal structures.<br />
Depending on the unique features of each project,<br />
our ratings on project subordinated debt issues<br />
have on average ranged up to three notches below<br />
the senior debt rating. However, there have been<br />
exceptions in both directions, depending on the<br />
project and specific structural elements,<br />
covenants, and security features. Some credit<br />
features that have led to subordinated debt being<br />
rated more than one notch below senior debt (and<br />
hence more equity-like treatment) have included:<br />
• Severe cash-flow encumbrances on<br />
subordinated debt servicing due to senior<br />
debt distribution lock-ups, the timeframe<br />
before cash is released from lock-up, and<br />
debt-service reserve maintenance;<br />
• No rights or remedies in the event of a<br />
default affecting senior debt;<br />
• No cross-acceleration or cross-default<br />
mechanisms; and<br />
• Low debt-service coverage ratios and<br />
stress buffers.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Conversely, some credit features that have led<br />
to subordinated debt being rated closer to the<br />
senior debt rating have included:<br />
• Contingent support from sponsors to<br />
mitigate cash-flow encumbrances on<br />
subordinated debt servicing;<br />
• Lower probability of reaching equity lockup,<br />
which could occur in a project due to<br />
simple services to be delivered, a benign<br />
payment mechanism, strong and/or highly<br />
rated service providers to whom cost and<br />
revenue deduction risk is passed, and<br />
considerable third-party support;<br />
• Subordinated debt liquidity support in the<br />
form of a dedicated debt-service reserve (up<br />
to six months), the ability to capitalize or<br />
defer interest, PIK notes, and contingent<br />
third-party support;<br />
• Sharing of collateral security enforcement<br />
rights with senior lenders; and<br />
• Strong debt-service cover ratios and<br />
stress buffers.<br />
There are also examples of subordinate debt<br />
being rated on par with senior lien obligations.<br />
These have occurred in situations where the<br />
senior lien debt amounts are very small in relation<br />
to the subordinate lien, when a senior lien may be<br />
closed, or when the project operates with<br />
significant financial margins. (For examples of<br />
our ratings and related research on project<br />
subordinated debt issues, see the following issuers<br />
on RatingsDirect: 407 <strong>In</strong>ternational <strong>In</strong>c., Express<br />
Pipeline L.P., Reliance Rail <strong>Finance</strong> Pty Ltd., San<br />
Joaquin Hills Transportation Corridor Agency,<br />
and Alameda Corridor Transportation Authority.)<br />
Where to from here for subordinated<br />
debt structures?<br />
As active competition for project and<br />
infrastructure asset continues to move prices<br />
higher, market participants will continue to<br />
explore subordinated debt funding options and<br />
product structures to increase leverage to meet<br />
this strong demand. So long as the economic cycle<br />
continues, market participants will continue to<br />
push boundaries in debt structuring; however,<br />
market participants should remember that debt<br />
structuring is not a way to obtain funds at no risk
and that project fundamentals rather than<br />
financial engineering are the key to investmentgrade<br />
structures.<br />
So where to from here? Given the long-term<br />
nature of project and infrastructure assets, and<br />
the competitive nature of debt arrangers and the<br />
risk appetite of investors for long-term assets, the<br />
landscape for project subordinated debt will<br />
continue to evolve. Standard & Poor’s expects to<br />
see variations in subordinated debt products for<br />
project and infrastructure transactions.<br />
While cash flows from projects will continue to<br />
be carved up to create subordinated debt<br />
instruments, at the end of the day there is no<br />
“free lunch”, and the key credit consideration will<br />
remain--what will cause a rated tranche of<br />
subordinated debt to default and how will a<br />
particular subordinated debt instrument affect the<br />
default or recovery of any senior-ranking debt? ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
NOVEMBER 2007 ■ 121
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
April 13, 2007<br />
Primary Credit Analysts:<br />
Karim Nassif,<br />
London,<br />
(44) 20-7176-3677<br />
Terry A Pratt,<br />
New York,<br />
(1) 212-438-2080<br />
Secondary Credit Analyst:<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
122 ■ NOVEMBER 2007<br />
CREDIT FAQ: RECENTLY UPGRADED NAKILAT<br />
PROVIDES CASE STUDY FOR CREDIT ANALYSIS OF<br />
LNG SHIPPING PROJECTS<br />
Our first-ever public rating on a liquefied<br />
natural gas (LNG) shipping entity was<br />
recently raised when Qatar-based Nakilat<br />
<strong>In</strong>c. was upgraded to ‘A+’ with a stable outlook.<br />
The rating on Nakilat, a wholly owned subsidiary<br />
of Qatar Gas Transport Co. Ltd. (QGTC), was<br />
raised following the upgrade of the State of Qatar<br />
(AA-/Stable/A-1+). This reflected our continued<br />
expectation of strong potential extraordinary<br />
sovereign support for Nakilat in an event of<br />
stress. Since then, Standard & Poor’s Ratings<br />
Services has received several questions concerning<br />
our rating analysis of LNG shipping financings.<br />
Currently Nakilat is the only publicly rated LNG<br />
shipping entity and so, understandably, it<br />
represents the best case study of our rating<br />
approach. This article attempts to answer the<br />
most frequently asked questions we have been<br />
receiving concerning Nakilat and our general<br />
credit analysis of LNG shipping financings.<br />
Further information can also be read in the article<br />
titled “Global LNG Shipping Projects May Be On<br />
Course For <strong>In</strong>vestment Grade,” published on<br />
March 6, 2006, on RatingsDirect.<br />
Frequently Asked Questions<br />
What are the major factors that underpin<br />
Standard & Poor’s approach to rating LNG<br />
ship financings?<br />
Generally our approach is to consider LNG<br />
shipping as an integral part of the complete LNG<br />
supply chain, which starts from natural gas<br />
development and production from the gas field,<br />
moves through liquefaction of the natural gas,<br />
and ends with regasification at the import<br />
terminals and then sale to the end markets. The<br />
two key elements that underpin our approach are<br />
counterparty risk and the legal structure<br />
(including construction and charter agreements).<br />
Counterparty risk.<br />
One of the key elements determining the rating<br />
for LNG ships is related to counterparty risk,<br />
specifically to the upstream project producing the<br />
LNG. <strong>In</strong> most, if not all, cases the project is the<br />
source of payments to the shipper. If the project<br />
fails, the alternative use for the LNG ships is still<br />
limited given the absence of a large LNG spot<br />
market. As a result, the credit quality of the<br />
underlying LNG project usually provides one of<br />
the key constraints for the rating of the LNG ship<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
financing. The upstream project is often also the<br />
charterer under the charter agreement. If there is<br />
an alternative charterer other than the project<br />
company the credit quality of the alternative<br />
charterer would also be important, because it<br />
provides a measure of the certainty and reliability<br />
with which cash flows will be earned by the vessel<br />
owners under the charter agreement for the<br />
purposes of repaying debt.<br />
There is also a counterparty risk inherent in the<br />
construction of ships. The credit quality,<br />
experience, transaction support through thirdparty<br />
liquidity, and reputation of the shipbuilder<br />
are also essential elements, therefore, in the<br />
overall analysis of an LNG shipping project.<br />
Legal structure (including construction and<br />
charter agreements).<br />
The second key element in our analysis is the risk<br />
to lenders that arises based on the charterparty<br />
contract and construction contracts. For an<br />
investment-grade rating we would expect the<br />
charterparty contract to last through the debt<br />
tenor and guarantee availability-based fixed<br />
payments with inbuilt escalation clauses to cover<br />
growing operating and material costs. For<br />
construction contracts we would expect fixedprice,<br />
date-certain arrangements with established<br />
shipbuilders coupled with shipbuilder-completion<br />
guarantees.<br />
Most LNG ship financings we have reviewed<br />
have been structured as projects and have used<br />
special purpose entities (SPEs). There are specific<br />
contracts and documentation for single ships,<br />
although often several ships are operated as a<br />
group. <strong>In</strong> effect, the financings have involved a<br />
portfolio of ships with the contractual nature<br />
being determined on a ship-by-ship basis. For the<br />
single ships we look to our project finance criteria<br />
in analyzing underlying risks given the single-asset<br />
nature of the SPEs and the contractual structure.<br />
<strong>In</strong> many cases, however, there is a holding<br />
company sitting on top of the SPE that ultimately<br />
owns multiple ships, albeit through an SPE<br />
structure. The review of the holding company as<br />
part of a portfolio review might, therefore,<br />
require more of a corporate analysis. Ultimately, a<br />
portfolio of LNG ships is often presented as a<br />
hybrid structure featuring both project and<br />
corporate features. Our rating analysis, therefore,<br />
has to take into account these unique features.
What approach did you take when<br />
analyzing Nakilat?<br />
We regard Nakilat as more of a corporate entity<br />
than a typical project financing, due to the strong<br />
corporate features inherent in the transaction.<br />
Ultimately our ratings on Nakilat reflect the<br />
mainly corporate nature of the entity. Although<br />
some features of its lending package are<br />
structured like a corporate, however, its cash flow<br />
arises from asset-specific features. We, therefore,<br />
also analyzed some aspects of the transaction as if<br />
it were a project.<br />
We also consider Nakilat to be a governmentrelated<br />
entity. Our conclusion of this government<br />
link is supported by the importance of Nakilat’s<br />
LNG ships to Qatar’s economy and the state’s<br />
strategic plans to maintain its leading position as<br />
the world’s No. 1 LNG exporter. The overall<br />
capital investment by the Qatari state and its<br />
partners in the LNG sector (upstream, midstream,<br />
and downstream) is expected to total just over<br />
$65 billion by 2010.<br />
Qatar and QGCT plan to use the Nakilat LNG<br />
ships on some of the major LNG projects in<br />
Qatar. These include Ras Laffan Liquefied<br />
Natural Gas Co. Ltd. (3) (senior secured debt<br />
A/Stable), Qatar Liquefied Gas Co. Ltd.<br />
(QatarGas) 2, QatarGas 3, and QatarGas 4. The<br />
government is involved directly through its<br />
ownership of Qatar Petroleum (AA-/Stable/--),<br />
which is a majority owner of the LNG projects.<br />
Therefore, the ratings on Nakilat are linked to the<br />
credit quality of the Qatari state (currently rated<br />
AA-/Stable/A-1+).<br />
Nakilat’s financial profile is weak for the<br />
ratings but its business profile and strategy are<br />
very strong. Given the company’s important role<br />
in the Qatari LNG sector, which is a strategic<br />
sector for the nation’s GDP growth, we expect<br />
that as long as the government stands behind its<br />
LNG and gas monetization strategy, it will<br />
support Nakilat.<br />
The one-notch differential between the<br />
corporate credit rating on Nakilat and the<br />
sovereign rating on Qatar reflects the absence of<br />
explicit financial state support in the form of a<br />
guarantee or equivalent, despite implicit state<br />
support for the entity.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
What impact did the Qatari sovereign upgrade<br />
have on the Nakilat ratings?<br />
Following the upgrade of Qatar we raised our<br />
corporate credit rating on Nakilat to ‘A+’ with a<br />
stable outlook. The subordinated debt was also<br />
raised, to ‘A’. The senior secured debt rating was<br />
affirmed at ‘A+’.<br />
The one-notch increase in the corporate credit<br />
rating reflected the one-notch increase in the<br />
rating on Qatar and our top down approach for<br />
Nakilat as a government-related entity. The<br />
corporate credit rating continues to reflect our<br />
unchanged expectation of potential strong<br />
extraordinary sovereign support for Nakilat in an<br />
event of stress. The senior secured debt rating<br />
(previously one notch above the corporate credit<br />
rating) remained unchanged because, although the<br />
available security package and debt structures<br />
have not changed, the higher corporate rating on<br />
Nakilat now means that the added value of the<br />
security package relative to the rating is reduced.<br />
Similar sovereign support for the subordinated<br />
debt is expected as for the senior debt, and for<br />
that reason a one-notch differential between<br />
the corporate and subordinated debt ratings<br />
was maintained.<br />
How does the sovereign rating influence the<br />
ratings on LNG ship projects?<br />
<strong>In</strong> the case of Nakilat, the importance of LNG for<br />
Qatar and the implicit support provided by the<br />
state through the involvement of Qatar Petroleum<br />
along the supply chain supports our conclusion<br />
that Nakilat is a government-related entity. <strong>In</strong> a<br />
sense Nakilat is a unique entity given the state of<br />
Qatar’s LNG strategy. <strong>In</strong> other instances where<br />
state support is not deemed as significant, a<br />
project might not receive the same benefits of<br />
state support as Nakilat and the focus will<br />
therefore be more on that project’s own strengths<br />
and weaknesses. As noted above, the<br />
creditworthiness of the LNG shipping deal would<br />
be affected by the credit profile of the underlying<br />
LNG supply project. For a project to obtain<br />
rating uplift toward a sovereign rating, the<br />
strategic rationale for the country’s LNG sector<br />
must be very strong--that is, material to that<br />
country’s government. <strong>In</strong> other words, the<br />
NOVEMBER 2007 ■ 123
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
124 ■ NOVEMBER 2007<br />
government’s financial position would be<br />
materially harmed if the shipping entity were to<br />
default. Government ownership of a shipping<br />
company and direct financial support mechanisms<br />
are also ways to link the rating on a shipping<br />
project more closely to that of the sovereign.<br />
As with project finance analysis, sovereign and<br />
institutional risks are assessed as well as<br />
credit enhancements.<br />
Could LNG ships have a rating above the<br />
underlying project rating?<br />
Typically the creditworthiness of the underlying<br />
LNG supply project will constrain the rating of<br />
the shipping deal. The two are inextricably linked<br />
in the value chain because the ships rely on the<br />
project to produce the LNG and the project is<br />
paying the charter fees. It might be possible,<br />
however, for the LNG shipping project to achieve<br />
a rating above that on the supply project if some<br />
delinkage is achieved from the underlying supply<br />
project. <strong>In</strong> this situation, we require comfort that<br />
the ships could earn sufficiently robust cash flow<br />
without the supply project, through either<br />
redeployment by obtaining long-term contracts or<br />
through the spot market. <strong>In</strong> this case, our charterhire<br />
price assumptions would be very conservative<br />
given the likely long-term nature of the debt. This<br />
situation might be more realistic in the long term<br />
than in the short-to-medium term, assuming that<br />
in the long term a deeper spot market develops.<br />
The current high amount of ships contracted for<br />
LNG projects, the lack of a deep LNG spot<br />
market, and the expectation that older-generation<br />
LNG ships might also be available for the spot<br />
market once their charter agreements end, all<br />
render unlikely the potential redeployment of the<br />
vessels at rates commensurate with servicing of<br />
debt under severely stressed scenarios.<br />
What recovery potential would you ascribe to<br />
LNG ships?<br />
Although we have not issued any public recovery<br />
ratings on LNG ship projects and continue to<br />
refine appropriate recovery scenarios, our analysis<br />
of recovery potential for LNG ship financings is<br />
likely to include an assessment of the<br />
redeployment of LNG vessels after a project<br />
default in a similar way to the process described<br />
above under a delinking approach. Given the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
absence of any material sale and purchase market<br />
for LNG vessels, we would not typically ascribe<br />
much value to an enterprise value approach (such<br />
as using EBITDA multiples or net present values)<br />
when calculating our recovery ratings. Rather, we<br />
would likely focus our recovery analysis on the<br />
ability of the vessels to continue to service debt<br />
under low charter-hire rate assumptions, which<br />
could reflect historical lows witnessed in the spot<br />
market or long-term charter market or future<br />
lows anticipated in either market as appropriate.<br />
Do you view LNG ship projects with more than<br />
one vessel as less risky than single-ship deals?<br />
All else being constant, the greater the number of<br />
ships involved for a given financial profile, the<br />
greater the potential for higher ratings. Adding<br />
diversity can reduce operational risk as well as<br />
exposure to force majeure risk by having a safety<br />
cushion consisting of a residual operating fleet in<br />
the event that specific problems occur with some<br />
of the vessels. Although the LNG shipping<br />
industry has a very favorable performance record,<br />
the risk remains that some vessels might have<br />
their payment streams affected due to technical<br />
problems, political risk, or environmental<br />
conditions. The technical risk issue is present<br />
because LNG ships are becoming much larger to<br />
improve economies of scale and are employing<br />
reconfigured drive systems.<br />
If we were to hypothetically compare a<br />
standard single-ship project serving the same<br />
underlying LNG project (with all other risks<br />
remaining constant) with a multiple-ship project<br />
serving the same underlying LNG project, the<br />
chances are that rating would not be necessarily<br />
enhanced by having more ships. There would<br />
likely be more financial cushion at the same<br />
rating category for the LNG ship project with a<br />
higher number of vessels. The reason is that under<br />
the two different scenarios the credit quality of<br />
the same underlying LNG project continues to<br />
provide a constraint on the rating on the LNG<br />
shipping projects. Nevertheless, there could be<br />
examples where a ship project, because of its<br />
particular risk features, benefits by virtue of being<br />
structured with a large number of vessels, and<br />
therefore manages to achieve a rating above that<br />
of the underlying LNG project rating.
What leverage levels and debt service coverage<br />
ratios are required to ensure an investment-grade<br />
rating for LNG shipping projects?<br />
There are simply no magic numbers for debt<br />
service coverage ratios or leverage levels that<br />
would guarantee an investment-grade rating.<br />
Ultimately the financial risk that a project or<br />
entity can absorb is derived from the underlying<br />
project risks, structure of financing, liquidity, and<br />
other factors. As a starting point, the financial<br />
ratios are a result of the underlying risk analysis.<br />
One typical element of LNG ship financing is a<br />
refinance risk that is often incurred, despite<br />
contracts backing the transaction far beyond the<br />
anticipated refinancing or initial maturity date.<br />
Although we consider this a weakness, it can,<br />
nevertheless, be somewhat mitigated through a<br />
refinancing strategy as well as incentives to start<br />
looking early at refinancing (such as margin or<br />
coupon step-ups and cash sweeps). The most<br />
important mitigating factor is, however, the sale<br />
and purchase agreements that will support the<br />
transaction far beyond the refinancing date and<br />
provide comfort to the financial markets that the<br />
entity will generate sufficient cash to repay the<br />
new debt. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
NOVEMBER 2007 ■ 125
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
Sept. 12, 2007<br />
Primary Credit Analyst:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Parvathy Iyer,<br />
Melbourne,<br />
(61) 3-9631-2034<br />
Secondary Credit Analysts:<br />
Arthur F Simonson,<br />
New York,<br />
(1) 212-438-2094<br />
Dick P Smith,<br />
New York,<br />
(1) 212-438-2095<br />
David Veno,<br />
New York,<br />
(1) 212-438-2108<br />
126 ■ NOVEMBER 2007<br />
STANDARD & POOR’S METHODOLOGY FOR SETTING THE<br />
CAPITAL CHARGE ON PROJECT FINANCE TRANSACTIONS<br />
<strong>In</strong> recent years, project debt issuers worldwide<br />
have increasingly been using financial<br />
guarantee insurance provided by monoline<br />
insurers, also referred to as monoline wraps. A<br />
key element in the process of the monoline wrap<br />
is the capital charge Standard & Poor’s assigns.<br />
This capital charge is important for determining<br />
the capital adequacy of, and ultimately the rating<br />
on, the monoline insurers. This article aims to<br />
make transparent the way Standard & Poor’s<br />
determines each project’s capital charge and<br />
supersedes the capital charges listed in our Global<br />
Bond <strong>In</strong>surance criteria book, which are no longer<br />
valid for project finance transactions.<br />
A monoline wrap provides an “unconditional<br />
and irrevocable” financial guarantee from the<br />
insurer to pay all or a certain portion of a<br />
project’s scheduled principal and interest on time<br />
and in full to debt providers if the project is<br />
unable to do so. The project debt guaranteed by<br />
the monoline is assigned a higher rating than the<br />
project’s underlying rating. This higher rating is<br />
equalized with the financial strength rating on the<br />
monoline. The underlying project debt rating,<br />
which Standard & Poor’s assigns to each wrapped<br />
project, is generally lower, reflecting the project’s<br />
real underlying business and financial risks. As a<br />
result of providing the guarantee, monolines are<br />
exposed to the underlying risk of the project.<br />
This determines their portfolio risk and the charge<br />
to capital.<br />
Each project finance transaction is unique, both<br />
in terms of risks and structural features, and so is<br />
the capital charge. Consequently, Standard &<br />
Poor’s uses the same methodology for every<br />
monoline insured project to calculate the<br />
applicable capital charge.<br />
Capital charges have been assigned by Standard<br />
& Poor’s since the mid 1980s but have been<br />
adjusted over time to reflect credit conditions and<br />
market trends.<br />
Defining The Capital Charge<br />
Capital charge is the theoretical loss based on a<br />
worst-case economic environment, i.e. an<br />
economic depression case. The capital charge is<br />
expressed as a product of:<br />
• Likelihood of default by the issuer (i.e.<br />
default risk or frequency); and<br />
• Severity of default measured in terms of loss<br />
in asset value recovery.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
The default risk is equivalent to Standard &<br />
Poor’s default probability at a given rating. It does<br />
not vary between different projects that have been<br />
assigned the same rating. The severity factor is<br />
transaction specific, however, because each project<br />
has a unique combination of asset-related risks<br />
and contractual, financing, and legal issues.<br />
Consequently, the capital charge varies across<br />
asset classes and primarily reflects differences in<br />
the recovery potential.<br />
Once the two factors have been determined,<br />
the capital charge for issues is a percentage of<br />
par value.<br />
Standard & Poor’s applies the same capital<br />
charge across an entire rating category. Issues<br />
rated ‘A’, ‘A+’, and ‘A-’, for example, have the<br />
same capital charge. Once a capital charge has<br />
been assigned, Standard & Poor’s reviews it<br />
regularly as part of its surveillance.<br />
Furthermore, the same capital charge is used for<br />
all the insurers involved in that project,<br />
irrespective of which insurer provides the wrap.<br />
This is because the transaction default frequency<br />
and severity measure reflect the project risks and<br />
are independent of the insurance company that<br />
insures the project debt.<br />
The process of estimating capital charges can be<br />
complex and involve reasoning and modeling.<br />
Empirical data on new asset classes or new<br />
financing types, for example, is not always<br />
available or useful. Estimating loss-given default<br />
can also be complex in countries where the<br />
creditor regime has not been tested or the<br />
enforcement of security is complex and lengthy.<br />
The fundamental approach to calculating the<br />
capital charge for project debt is generally the<br />
same as that adopted for corporates.<br />
Nevertheless, the financing and structural aspects<br />
of a project can demand subjective judgment of<br />
recovery potential, and therefore the capital<br />
charge. Even so, similar transactions under a<br />
similar creditor regime are often likely to provide<br />
a good benchmark for a new transaction.<br />
Prerequisites<br />
Assigning an underlying rating to the project is a<br />
required step toward enabling the calculation of<br />
the capital charge. The underlying rating is<br />
determined in the same way as an unwrapped<br />
project debt rating and is based on the same<br />
criteria. The underlying rating is determined
irrespective of whether the monoline guarantee<br />
applies to all the project debt or only a portion<br />
of it.<br />
Standard & Poor’s relies only on in-house<br />
determinations of default frequency and recovery<br />
estimates. Ratings and recovery values estimated<br />
by other rating agencies or professional bodies are<br />
not used as reference points for assigning the<br />
capital charge. The in-house data enable<br />
Standard & Poor’s to maintain consistency<br />
across various jurisdictions, transactions, and<br />
operating environments.<br />
Calculating The Capital Charge<br />
Default frequency<br />
The default frequency for a given rating is<br />
determined using Standard & Poor’s corporate<br />
default study. The default study identifies the<br />
highest historical default rates across various<br />
sectors by rating category over a period of years.<br />
The leading global economies, the U.S. and<br />
Europe, have not, over the past 15 years,<br />
represented a worst-case depression-like scenario,<br />
and so the default rates are grossed up to what<br />
Standard & Poor’s believes to be worst-case<br />
levels. Through simulations of such scenarios<br />
across various sectors, Standard & Poor’s<br />
calculates worst-case default frequency for longterm<br />
risks across the rating categories (see table).<br />
Worst-Case Default Frequency<br />
Rating category Worst-case default frequency (%)<br />
AA 5.9<br />
A 7.1<br />
BBB 14.8<br />
BB 55.4<br />
Loss-given default<br />
Loss-given default is unique for each project, for<br />
the reasons given in “Defining The Capital<br />
Charge”. It can differ between two assets in the<br />
same sector and jurisdiction. There can also be<br />
different degrees of confidence regarding recovery.<br />
Subjective judgments are critical for deciding how<br />
to stress collateral values in hypothetical postdefault<br />
scenarios, but market trends can<br />
supplement theoretical estimates. For the purposes<br />
of assigning a capital charge, Standard & Poor’s<br />
currently assumes a maximum recovery of 90%.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Example.<br />
This example gives an illustration of how the<br />
capital charge on a project rated ‘A’ is determined.<br />
The steps are: to determine the ‘A’ underlying<br />
rating on the project; read the default frequency<br />
from the table above; estimate the loss-given<br />
default; and finally determine the<br />
capital charge.<br />
• The project’s underlying rating is ‘A’.<br />
• The default frequency for the ‘A’ rating<br />
category is 7.1%.<br />
• The estimated asset recovery value is 60%.<br />
• The loss-given default is 40% (100%<br />
minus 60%).<br />
• The capital charge is 7.1% multiplied by<br />
40%: 2.84% of par value.<br />
Cross-border issuance<br />
Projects located in one country often raise debt in<br />
another market. Such situations give rise to<br />
sovereign-related risks that could affect the ability<br />
and willingness of the entity to service its foreign<br />
currency debt. <strong>In</strong> the past, we adjusted capital<br />
charges to reflect these risks. Effective this year,<br />
however, our methodology for calculating capital<br />
charges for project cross-border issuance has<br />
been revised.<br />
Based on evidence that sovereigns under<br />
political and economic stress are less often<br />
restricting nonsovereign entities’ access to the<br />
foreign exchange needed for debt service, crossborder<br />
transactions (even without structural<br />
sovereign risk mitigation features) can be rated<br />
above the sovereign foreign currency rating, up to<br />
the “Transfer and Convertibility Risk<br />
Assessment” for the relevant sovereign<br />
jurisdiction. Project ratings incorporate all<br />
transfer and convertibility risk and other relevant<br />
country risks. Furthermore, many cross-border<br />
project finance transactions contain significant<br />
additional structural mitigants for direct sovereign<br />
interference risk, which make an additional<br />
“sovereign risk” adjustment to the capital<br />
charge unnecessary.<br />
Our new methodology for setting the capital<br />
charge for cross-border project finance<br />
transactions is therefore based on the default rate<br />
associated with the transaction’s foreign currency<br />
rating and severity of loss-given default. The latter<br />
will continue to be an analytical assessment based<br />
on the unique characteristics of each individual<br />
transaction analyzed by Standard & Poor’s.<br />
NOVEMBER 2007 ■ 127
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
128 ■ NOVEMBER 2007<br />
Surveillance Of The Capital Charge<br />
The capital charge is dynamic and all projects<br />
that have a monoline wrap have been surveilled<br />
since 2005. This surveillance enables an<br />
adjustment to the capital charge if the underlying<br />
project’s default risk or recovery prospects<br />
improve or worsen.<br />
The Capital Charge And New Ratings<br />
Project debt issuers and monoline insurers are<br />
encouraged to begin dialogue with Standard &<br />
Poor’s at an early stage in the project-financing<br />
process to help avoid any surprises later on. Early<br />
dialogue is particularly important because most<br />
projects are rated at the lower end of the rating<br />
scale, where the capital charge is substantially<br />
higher and can affect the premium payable to the<br />
monoline. Borderline differences in rating<br />
outcome can have a substantial impact on the<br />
applicable capital charge.<br />
Standard & Poor’s is often asked by monoline<br />
insurers to give indicative capital charges,<br />
sometimes even before the rating process is<br />
initiated. We provide this indication based on<br />
estimated default risk and recovery levels. Only<br />
once the rating (default risk) has been assigned to<br />
a project and the recovery rate determined is the<br />
final capital charge calculated. The final capital<br />
charge can therefore differ from the indicative<br />
one, as the latter is based on estimates and on<br />
very limited information. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Publication Date:<br />
Nov. 2, 2007<br />
Primary Credit Analyst:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Secondary Credit Analysts:<br />
Karin Erlander,<br />
London,<br />
(44) 20-7176-3584<br />
Michael Wilkins,<br />
London,<br />
(44) 20-7176-3528<br />
SWEDEN MOVES CLOSER TO PPP MODEL AS ALTERNATIVE<br />
FINANCING FOR INFRASTRUCTURE ASSETS<br />
Sweden is making significant steps in<br />
developing a model for public-private<br />
partnerships (PPPs) to provide an alternative<br />
means of financing public infrastructure. On June<br />
18, 2007, a joint working group commissioned by<br />
the Swedish government--made up of the public<br />
rail authority (Banverket), the public road<br />
authority (Vägverket), and the Swedish National<br />
Road and Transport Research <strong>In</strong>stitute (VTI)-published<br />
a proposal for a Swedish PPP model<br />
and identified a number of potential future<br />
PPP projects.<br />
Recently, the country’s public road and railway<br />
authorities announced the deferral of a substantial<br />
number of state-funded investments. A solution<br />
involving PPP financing could minimize future<br />
delays in necessary infrastructure developments.<br />
For private investors, the existence of a project<br />
pipeline detailing projects in terms of both<br />
number and size is important, given the relatively<br />
high costs associated with PPP bidding. It is also<br />
important for the public sector, to keep<br />
transaction costs low.<br />
For now, however, it is not clear if the PPP<br />
model will be selected and used on a larger scale,<br />
and, if so, how long implementation will take.<br />
Large <strong>In</strong>vestment Needed, But Grants Might<br />
Not Suffice<br />
Currently, transportation infrastructure<br />
investments are funded mainly through the state<br />
budget on a year-by-year basis. State budget<br />
grants for road investments for the 2006-2009<br />
period total about Swedish krona (SEK) 70 billion<br />
(SEK17 billion-SEK18 billion per year), while<br />
earmarked spending on rail for the period comes<br />
to about SEK52 billion (SEK11 billion-SEK14<br />
billion per year) (see table 1).<br />
While the need for investment in infrastructure,<br />
Table 1 - Major Rail Projects <strong>In</strong> State Budget<br />
Project <strong>In</strong>vestment (bil. SEK) Details<br />
Malmö city tunnel 9.5 (4.6 used) <strong>Finance</strong>d by the government, the municipality of<br />
Malmö, the county council of Skåne, and EU<br />
contributions<br />
Hallandsåsen railroad tunnel 7.5 N.A.<br />
Citybanan line in Stockholm 13.7 (1.0 used) SEK4 billion to be financed by Stockholm<br />
municipality and Stockholm county council<br />
Botniabanan railroad in northern Sweden<br />
SEK--Swedish krona. N.A.--Not available.<br />
13.2 (9.5 used) N.A.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
mainly roads and rail, is evident in certain regions<br />
to develop economic growth, in other areas<br />
investment is needed to alleviate congestion. <strong>In</strong><br />
these cases, the approval of projects via the<br />
budget on a year-by-year basis could prove too<br />
slow to meet increasing demand. <strong>In</strong> addition,<br />
budgeted state contributions for the infrastructure<br />
sector have remained largely unchanged, failing to<br />
reflect cost increases. Recently, both the<br />
Vägverket and the Banverket announced<br />
significant investment reductions due to<br />
insufficient funding. As an example, total<br />
Vägverket investment grants for 2007 amount to<br />
SEK42.5 billion, unchanged from 2004, while<br />
construction costs have increased by 16% since<br />
2004. Consequently, the Vägverket has had to cut<br />
spending on projects by a similar amount.<br />
Although investments can be delayed on a shortterm<br />
basis, the Vägverket is concerned about the<br />
long-term effects on road quality and safety if this<br />
situation continues. The rail sector faces a similar<br />
situation, with capacity shortages in major cities<br />
and traffic disruptions. If investment spending<br />
remains unchanged, investments in infrastructure<br />
are likely to slow further.<br />
The current system, in certain cases, allows<br />
public authorities with access to budget funds to<br />
finance major projects by taking loans from the<br />
national debt office. Total debt issued by the<br />
national debt office to the Vägverket and the<br />
Banverket stood at SEK32.4 billion at year-end<br />
2006. <strong>In</strong> some cases the government (Kingdom of<br />
Sweden; AAA/Stable/A-1+) has guaranteed private<br />
debt, as in the case of the Öresund bridge<br />
between Sweden and Denmark. <strong>In</strong> rare cases,<br />
infrastructure investments are financed by charges<br />
paid by the user (for example the train link<br />
between Stockholm and Arlanda airport and the<br />
Svinesund bridge between Sweden and Norway).<br />
NOVEMBER 2007 ■ 129
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
130 ■ NOVEMBER 2007<br />
Public And Private Support For Change<br />
The active search by the Swedish government<br />
together with public entities and private parties<br />
for a new model to finance public infrastructure<br />
marks a change from the past. <strong><strong>In</strong>frastructure</strong><br />
Minister Åsa Torstensson has said that the<br />
government is looking at alternative financing for<br />
infrastructure investments, with the intention of<br />
finding ways to achieve PPP solutions.<br />
The minister considers that there is a direct<br />
connection between new jobs, welfare, and<br />
efficient infrastructure.<br />
If the government and parliament approve a<br />
broad domestic PPP initiative, a concessional<br />
framework will have to be developed. A<br />
standardized PPP regime with similarities to<br />
existing regimes in Europe and elsewhere could<br />
attract more potential bidders. Concessions must<br />
be designed to provide optimum value, not only<br />
financially but also in terms of other targets.<br />
Environmental issues have recently become<br />
increasingly important in Sweden, as in many<br />
other countries. Setting the right goals and<br />
requirements from the start is key due to the longterm<br />
commitments involved.<br />
These considerations have been addressed<br />
by the findings of the joint working group,<br />
which propose a Swedish PPP model and<br />
potential projects.<br />
Working Group Scrutinizes PPP Alternative<br />
The findings center on the profitability of projects<br />
both from a social and economic perspective,<br />
transparency of state funding, procurement<br />
competition to ensure efficiency and lower costs,<br />
and a system that allows for program evaluation.<br />
<strong>In</strong>novation to introduce more efficient solutions,<br />
flexibility, and the potential to start projects at<br />
short notice were also identified as key features of<br />
a future PPP program.<br />
The key findings are:<br />
• Quality, safety, and environment. The<br />
investment should be of good quality, open<br />
to traffic, fulfill safety requirements, and<br />
ensure that environmental regulation is met.<br />
• Effective risk allocation. The project<br />
company should carry construction,<br />
operational, and lifecycle risks. The state<br />
should be left with risks associated with the<br />
use of the asset (for example traffic volume<br />
risk) as well as those risks that could be<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
better managed by the state (such as<br />
acquisition of land, permit processes,<br />
pollution, and archeological finds). <strong>In</strong> the<br />
longer term, the working group believes<br />
more appropriate risk allocation measures<br />
should be developed.<br />
• Financing. This should be a combination of<br />
a project’s own capital and borrowing to<br />
ensure that the sponsors’ incentives are in<br />
line with the aim of the project and that<br />
they remain committed.<br />
• Public financing as a last resort. If the<br />
agreements between companies and<br />
local/regional authorities fall short, the<br />
project should ultimately be financed by<br />
the state.<br />
• A long-term pipeline. PPP projects should be<br />
selected in line with long-term plans in order<br />
to control the expansion of infrastructure.<br />
Importantly, the working group believes it<br />
would be reasonable for the Swedish<br />
parliament and government to ultimately<br />
decide on the projects to be tendered, as<br />
long as taxes continue to finance the asset.<br />
• Comparison with public finance. The<br />
working group believes that a rule should be<br />
established to enable the government to<br />
directly compare the cost of a project, to<br />
ascertain whether it should be financed via a<br />
PPP contract or purely via public funds.<br />
• Drilling down. The PPP model should be<br />
applicable to smaller projects in the future,<br />
once the fixed costs of the bidding process<br />
are decreased.<br />
Essential Criteria Identified To Facilitate<br />
Project Selection<br />
<strong>In</strong> the same report, the working group identified<br />
projects it believed suitable for PPP financing. It<br />
achieved this by first establishing the criteria a<br />
project must fulfill:<br />
• <strong>In</strong>vestment volume: The amount invested<br />
should be between SEK1 billion and SEK3<br />
billion.<br />
• Planning stage: The design plans should be<br />
final and must be legally approved.<br />
• Profitability: The project’s profitability<br />
should measure “nettonuvärdeskvot” (NNK;<br />
a ratio that calculates society’s benefit from<br />
a project) of at least 0.5x.<br />
• Competition: The project should attract
oth national and international interest.<br />
• Holistic approach: The project must take<br />
due regard of lifecycle costs.<br />
• Duration of the contract: Approximately 25<br />
years should be permitted, with no<br />
reconstruction in the near future.<br />
• Final financing: This should be through<br />
cofinancing. Alternatively, user fees could<br />
finance all or part of the investment.<br />
Pipeline Of Potential PPP Projects<br />
The working group identified four projects it<br />
believed to fulfill all key criteria (see table 2).<br />
The working group subsequently identified<br />
projects that could be suitable for PPP, but that<br />
do not currently fulfill all essential criteria<br />
(see table 3).<br />
Similarly, the working group identified railroad<br />
projects that should be continually evaluated as to<br />
their suitability for PPP financing. These are:<br />
Railroad East (Ostlänken); Railroad Norrbotten<br />
(Norrbotniabanan); a railroad between Mölnlycke<br />
and Rävlanda/Bollebygd; a railroad between<br />
Malmö, Staffanstorp, and Dalby<br />
(Simrishamnsbanan); and combination terminals<br />
and connections to harbors. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Table 2 - Prospective Projects That Meet All Criteria For PPP Financing<br />
Length (kilometers) <strong>In</strong>vestment (mil. SEK) NNK* (x)<br />
Riksväg 50 road between Mjölby and Motala 28 1,330 1.4<br />
E22 motorway between Hurva and Kristianstad 41 (57) 1,100 (1,360) 0.7<br />
E4 Sundsvall South motorway 22 2,500 0.9<br />
Länsväg 259 Södertörn road 9 1,300 0.7<br />
*NNK (nettonuvärdeskvot) measures profitability and needs to be at least 0.5x. SEK--Swedish krona.<br />
Table 3 - Prospective Projects That Meet Some Criteria For PPP Financing<br />
Length (kilometers) <strong>In</strong>vestment (mil. SEK) NNK* (x)<br />
E22 motorway between Kristianstad and Karlshamn 53 1,430 0.5<br />
E22 motorway between Karlshamn and Jämjö 69 (74) 1,840 0.0<br />
E22 Söderköping motorway 17 700 0.7-1.9<br />
E6/45 new connection to river 1.5 2,500 2.2<br />
E20 motorway between Alingsås and Vårgårda 25 1,550 0.5<br />
E4 motorway between Hjulsta and Häggvik 7 4,500 0.2<br />
E4 motorway between Södertälje and Hallunda 15 3,300 N.A.<br />
E12 Umeå motorway (Umepaketet) 28 1,100 0.0-2.1<br />
*NNK (nettonuvärdeskvot) measures profitability and needs to be at least 0.5x. SEK--Swedish krona. N.A.--Not available.<br />
NOVEMBER 2007 ■ 131
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
Sept. 28, 2007<br />
Issuer Credit Rating:<br />
AA-/Stable/A-1+<br />
Primary Credit Analyst:<br />
Jonathan Manley,<br />
London,<br />
(44) 20-7176-3952<br />
Secondary Credit Analysts:<br />
Karim Nassif,<br />
London,<br />
(44) 20-7176-3677<br />
Luc Marchand,<br />
London,<br />
(44) 20-7176-7111<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
132 ■ NOVEMBER 2007<br />
ABU DHABI NATIONAL ENERGY COMPANY PJSC<br />
Rationale<br />
On Sept. 28, 2007, Standard & Poor’s Ratings<br />
Services affirmed its ‘AA-‘ long-term and ‘A-1+’<br />
short-term corporate credit ratings on Abu Dhabi<br />
National Energy Company PJSC (TAQA)<br />
following TAQA’s announcement of its intention,<br />
subject to various regulatory and administrative<br />
approvals, to acquire Canada-based PrimeWest<br />
Energy Trust for approximately C$5 billion,<br />
funded primarily by debt.<br />
The affirmation reflects our expectation of<br />
ongoing implicit sovereign support for TAQA<br />
given the company’s importance to the Emirate of<br />
Abu Dhabi (AA/Stable/A-1+) and its status as a<br />
government-related entity (GRE). The ratings<br />
continue to be based on a “top-down” rating<br />
approach, which takes the sovereign rating as the<br />
starting point of the analysis, reflecting the<br />
company’s position as a key entity in Abu Dhabi’s<br />
economy and its importance as a national vehicle<br />
for global investment and public policy.<br />
Following the PrimeWest acquisition, up to onehalf<br />
of the company’s forecast EBITDA will likely<br />
be generated outside of the United Arab Emirates<br />
(UAE). This is consistent with the company’s<br />
originally stated investment policy to undertake<br />
international infrastructure investments. Our<br />
opinion remains that, in a financial stress<br />
scenario, unlike the company’s UAE-based assets<br />
that are, for example, critical to the provision of<br />
water and power to the Emirate, non-UAE<br />
activities may not receive the same level and<br />
timeliness of sovereign financial support.<br />
<strong>In</strong> respect of this specific acquisition, however,<br />
Standard & Poor’s has analyzed the extent and<br />
timing of support that could be forthcoming in<br />
the event of a stress scenario. <strong>In</strong> this case, we<br />
understand that it is the Emirate’s intention to<br />
treat these non-UAE assets in the same manner as<br />
those in the UAE. <strong>In</strong> addition, the Emirate’s<br />
review of all acquisitions (including that proposed<br />
for PrimeWest) and the proposed corporate<br />
structure of the acquisition within the overall<br />
TAQA group of companies further substantiate<br />
the sovereign’s likely support for these assets. No<br />
explicit guarantee has been provided, however.<br />
<strong>In</strong>cluding the PrimeWest acquisition, TAQA has<br />
committed nearly $10 billion in the acquisition of<br />
various energy-related assets outside the UAE in<br />
the past 12 months. The acquisitions have been<br />
broadly consistent with the investment framework<br />
originally set out by management, although both<br />
the pace of the acquisitions and the level of<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
investment in Canadian assets have been greater<br />
than originally planned. We estimate that the<br />
investments acquired to date are likely to be of<br />
low investment-grade/high speculative-grade<br />
credit quality on a stand-alone basis. A key<br />
challenge for TAQA remains the successful<br />
integration and realization of anticipated returns<br />
from these various acquisitions. As a result of this<br />
debt-financed investment activity, TAQA’s<br />
financial profile is very aggressive, characterized<br />
by high leverage and relatively low interest<br />
coverage levels. Standard & Poor’s will<br />
increasingly focus on the credit quality of the<br />
underlying investment portfolio and the strength<br />
of the relationship with the sovereign as critical<br />
elements driving the ratings. <strong>In</strong>vestment in weaker<br />
credit quality assets, for example, increases the<br />
likelihood that sovereign financial support will be<br />
called on. Standard & Poor’s will meet with<br />
management and Emirate representatives in the<br />
next month to discuss the future investment<br />
strategy and the potential parameters and method<br />
by which sovereign support can be given to<br />
the company.<br />
Liquidity<br />
TAQA’s liquidity derives from its above-average<br />
UAE dirham 6.239 billion ($1.7 billion; as at June<br />
30, 2007, prior to the execution of recent<br />
acquisitions) cash balance invested in various<br />
short-term deposits. The company also has an<br />
established $1 billion revolving credit facility<br />
from a domestic bank.<br />
Outlook<br />
The stable outlook reflects Standard & Poor’s<br />
expectation that there will be no major changes in<br />
the implicit government support to the company<br />
as a GRE. This implies that the state will support<br />
TAQA in the event of financial distress should<br />
existing or future investments not perform in line<br />
with expectations. The outlook also assumes that<br />
the company will execute its business plan<br />
successfully and meet its financial forecasts.<br />
The rating would be raised, or the outlook<br />
revised to positive, if there is a similar change in<br />
the rating or outlook on the sovereign, or in the<br />
case of enhanced sovereign support. The rating<br />
would be lowered, or the outlook revised to<br />
negative, if there is any weakening of sovereign<br />
support for the company or if the underlying<br />
consolidated credit quality of the investment<br />
portfolio reduces. ■
Publication Date:<br />
June 13, 2007<br />
Issue Credit Rating:<br />
Senior secured debt<br />
BBB-; BBB-/Stable<br />
Primary Credit Analyst:<br />
Karim Nassif,<br />
London,<br />
(44) 20-7176-3677<br />
Secondary Credit Analyst:<br />
Alexandre de Lestrange,<br />
Paris,<br />
(33) 1-4420-7316<br />
AUTOROUTES PARIS-RHIN-RHONE<br />
Rationale<br />
The senior unsecured debt rating on the French<br />
toll road operator Autoroutes Paris-Rhin-Rhone’s<br />
(APRR) seven-year, €1.8 billion, revolving credit<br />
facility maturing in 2013 is ‘BBB-’. The outlook is<br />
stable. As of May 25, 2007, the facility had a<br />
utilization of €0.8 billion. At the same date, total<br />
debt was €6.4 billion.<br />
Since its privatization in 2006, APRR is<br />
81.48% owned by Eiffarie (not rated), a<br />
consortium controlled by Eiffage and Macquarie<br />
Autoroutes de France (MAF). The remaining<br />
shares are publicly held. Total debt at Eiffarie as<br />
at May 25, 2007, is €3.9 billion. The APRR<br />
group includes both APRR and Eiffarie, which,<br />
because Eiffarie is an 81.48% shareholder, leads<br />
us to consolidate the debt of Eiffarie into APRR.<br />
We have fully consolidated Eiffarie’s debt and<br />
related interest expenses with those of APRR<br />
because we treat the two entities as one group for<br />
default analysis purposes. Eiffarie’s debt is<br />
nonrecourse to APRR.<br />
APRR is the third-largest toll-road operator in<br />
Europe, with a network of 2,215 kilometers (km;<br />
1,370 miles) in service and 2,279 km under<br />
concession until 2032. APRR group’s highway<br />
concession network is well located across central<br />
and eastern France, representing the major axes<br />
between the two wealthiest French regions, Ile-de-<br />
France (AAA/Stable/A-1+) and Rhône-Alpes, and<br />
the two largest French cities of Paris<br />
(AAA/Stable/--) and Lyon, as well as links to<br />
Benelux and Germany. APRR’s subsidiary AREA<br />
has the major road network connection to the<br />
Alps, related ski resorts, and Geneva, Switzerland.<br />
The network therefore comprises key economic<br />
and tourist corridors to southern France. No<br />
major new competing roads or transport links<br />
are expected.<br />
The revolving credit facility is sized to support<br />
about two years of capital expenditures, debt<br />
repayments to Caisse Nationale des Autoroutes<br />
(CNA; AAA/Stable/--), and working capital at<br />
APRR following its acquisition by Eiffarie.<br />
The ‘BBB-’ rating reflects the following risks:<br />
• APRR has an aggressive financial structure,<br />
with low debt service coverage levels and<br />
high consolidated leverage, taking into<br />
account total debt at APRR and Eiffarie.<br />
Standard & Poor’s Ratings Services’ base<br />
case assumes traffic growth of 1.75% over<br />
the life of the concession, with consolidated<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
minimum debt service coverage at 1.31x.<br />
This minimum occurs in 2012, based on an<br />
assumed refinancing of the Eiffarie debt in<br />
2011, and an assumed amortization profile<br />
post refinancing. Prior to the forecast<br />
refinancing, the minimum coverage ratio is<br />
1.42x. Although this is low compared with<br />
other rated highways projects with traffic<br />
risk, the maturity and large scale of APRR’s<br />
road network mitigate this.<br />
• The structure contains considerable<br />
refinancing risk, as significant debt amounts<br />
are due from CNA by 2018. We understand<br />
that APRR is currently looking at ways to<br />
refinance CNA obligations due in late 2007<br />
and beyond. APRR also has large capital<br />
expenditure requirements, and the Eiffarie<br />
acquisition facility has little amortization<br />
until it needs to be refinanced. Although the<br />
revolving credit facility, the strong cash flow<br />
generating ability over the life of the<br />
concession, and an increasing cash sweep in<br />
the acquisition facility mitigate refinancing<br />
risk, it remains higher than that of<br />
comparable investment-grade transactions.<br />
• Although Standard & Poor’s takes a<br />
concession financing approach to APRR, we<br />
regard the overall structural package, with<br />
regard to shareholder lock-in periods, as<br />
weaker than those of comparable<br />
investment-grade concessions. The<br />
privatization process resulted in lock-in<br />
requirements for Macquarie and Eiffage of<br />
two and 10 years, respectively. Given the<br />
importance of retaining two balanced<br />
shareholders in the structure, the absence of<br />
further structural mitigants to prevent the<br />
emergence of a dominant shareholder<br />
remains a key structural weakness.<br />
• Traffic growth was weak in 2006, but has<br />
shown recovery in the first quarter of 2007.<br />
Traffic growth reported for 2006 at 1.3%<br />
was below what we considered to be a<br />
conservative assumption of 1.75% traffic<br />
growth under our base case. Nevertheless,<br />
although traffic growth has been low and is<br />
not expected to improve substantially over<br />
the short term, revenues have met budgeted<br />
targets and are expected to continue to do<br />
so going forward.<br />
• Although about 95% of all debt at Eiffarie<br />
and APRR is hedged, the structure remains<br />
NOVEMBER 2007 ■ 133
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
134 ■ NOVEMBER 2007<br />
sensitive to interest rate increases. This is a<br />
key consideration, given the existing<br />
refinancing risk.<br />
The following strengths offset these risks at the<br />
‘BBB-’ level:<br />
• APRR benefits from strong and recurring<br />
cash flow generation, stemming largely from<br />
a mature and very large toll road network.<br />
APRR’s concessions are regulated by<br />
supportive agreements, including<br />
management contracts that guarantee a<br />
minimum, inflation-linked toll rate increase<br />
for each five-year period.<br />
• APRR benefits from the combined<br />
experience of Macquarie Bank Ltd.<br />
(A/Stable/A-1) and Eiffage in the financing,<br />
construction, and operation of toll roads<br />
worldwide, although this is Macquarie’s first<br />
major investment in French toll roads.<br />
• APRR has a strong track record in toll road<br />
operation. The project is resilient to a<br />
number of downside scenarios, at the same<br />
time as being able to service debt at both<br />
APRR and Eiffarie. A zero traffic growth<br />
scenario results in a minimum debt service<br />
coverage ratio of 1.06x.<br />
• APRR is the third-largest toll-road operator<br />
in Europe, with a network of 2,215 km in<br />
service out of 2,279 km under concession<br />
until 2032, after Italy-based Atlantia SpA<br />
(A/Negative/A-1) and French peer<br />
Autoroutes du Sud de la France S.A. (ASF;<br />
BBB+/Negative/A-2). APRR’s 2006 turnover<br />
and EBITDA were €1.67 billion and €1.07<br />
billion, respectively, up 6.3% and 9.7% on<br />
2005 and in line with expectations.<br />
As at Dec. 31, 2006, APRR complied with<br />
the financial covenants set by the state as part of<br />
the privatization.<br />
The APRR network has shown moderate, but<br />
below budget, traffic growth of 1.3% overall for<br />
the 12 months to end-December 2006 compared<br />
with the same period of the previous year. This<br />
remains weaker relative to APRR’s peers ASF and<br />
Cofiroute (BBB+/Negative/A-2), but similar to<br />
traffic growth reported by French toll road<br />
operator Sanef (A/Negative/A-1) for the period.<br />
Poor weather conditions in the first quarter of the<br />
year and a heat wave in July that affected light<br />
vehicle traffic were responsible for lower-than-<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
expected traffic growth, somewhat offset by an<br />
upturn in the French economy and completion of<br />
repair work at the Epine and Fréjus tunnels.<br />
Overall revenues grew by 6.3% in 2006 year on<br />
year, exceeding budgeted targets by about €24<br />
million. Improvement in total revenues reflected<br />
the contractual increase of rates in October 2005<br />
and 2006, as well as a rebound in heavy traffic<br />
volumes and reduced discount rates for heavy<br />
vehicle subscribers. EBITDA margins improved by<br />
2% in 2006 compared with the previous year. We<br />
expect EBITDA margins to continue improving by<br />
1% per year over the short term based on similar<br />
traffic growth and continued implementation of<br />
cost controls and operational efficiency.<br />
Traffic growth for the first quarter of 2007 was<br />
3.5% above that of the same period the previous<br />
year due to better weather and macroeconomic<br />
conditions.<br />
Outlook<br />
The stable outlook reflects our expectation of<br />
continued stable, recurring cash flows from the<br />
road network under the concession agreements.<br />
The ratings could be lowered if one of the key<br />
sponsors gains a dominant position in the<br />
structure (in which case the ring-fencing would no<br />
longer hold), traffic falls consistently below our<br />
base case assumptions, or if the refinancing does<br />
not proceed as assumed in the base case. Upgrade<br />
potential is limited. Eiffage is subject to a takeover<br />
bid by its major shareholder Sacyr, a Spanish<br />
construction company, but we do not expect any<br />
change of ownership to affect the structure and<br />
working of the APRR group.<br />
Concession Financing Factors<br />
The structure implemented following privatization<br />
led us to adopt a concession financing approach<br />
to APRR, rather than the previous corporate<br />
approach.<br />
This was due to:<br />
• Compliance with Standard & Poor’s criteria<br />
for special-purpose entities at the level of the<br />
Eiffage and Macquarie consortium, which<br />
owns the majority of APRR after<br />
privatization;<br />
• Restrictions on individual sponsor control in<br />
APRR, owing to Eiffage and Macquarie’s<br />
roughly equal shareholder ownership;<br />
• Commitment of the two shareholders to<br />
maintaining their equity interests in the
consortium for at least two years (Eiffage<br />
has committed for 10 years); and<br />
• The sponsors’ commitment to ensuring the<br />
single business focus of APRR.<br />
The key supporting factor for our concession<br />
financing approach is that the sponsors’ respective<br />
control of Eiffarie and APRR is roughly balanced.<br />
If this were to change--for example through one<br />
sponsor selling its equity interest to the other,<br />
leading to majority ownership by a single<br />
sponsor--we would likely review our rating<br />
approach to the structure. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
NOVEMBER 2007 ■ 135
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
Sept. 10, 2007<br />
Issue Credit Rating:<br />
Senior secured bank loan<br />
BB+/Watch Neg;<br />
senior secured debt AAA,<br />
BB+(SPUR)/Watch Neg<br />
Primary Credit Analyst:<br />
Jonathan Manley,<br />
London,<br />
(44) 20-7176-3952<br />
Secondary Credit Analysts:<br />
Beata Sperling-Tyler,<br />
London,<br />
(44) 20-7176-3687<br />
Liesl Saldanha,<br />
London,<br />
(44) 20-7176-3571<br />
136 ■ NOVEMBER 2007<br />
METRONET RAIL BCV FINANCE PLC/<br />
METRONET RAIL SSL FINANCE PLC<br />
Rationale<br />
On Sept. 10, 2007, Standard & Poor’s Ratings<br />
Services kept its ‘BB+’ long-term and underlying<br />
debt ratings on the £1.620 billion combined<br />
senior secured bank loans and debt issued by<br />
U.K.-based underground rail infrastructure<br />
financing companies Metronet Rail BCV <strong>Finance</strong><br />
PLC and Metronet Rail SSL <strong>Finance</strong> PLC<br />
(Metronet BCV and Metronet SSL; the Metronet<br />
companies) on CreditWatch with negative<br />
implications, where they were placed on May 22,<br />
2007. This follows the agreement of bilateral<br />
standstill arrangements between Transport for<br />
London (TfL; AA/Stable/--) and the funders to the<br />
Metronet companies. A public-private partnership<br />
(PPP) administration order was granted over<br />
Metronet Rail BCV Ltd. and Metronet Rail SSL<br />
Ltd. (the <strong>In</strong>fracos) on July 18, 2007.<br />
At the same time, Standard & Poor’s affirmed<br />
its ‘AAA’ insured rating on the £165 million<br />
index-linked bonds and £350 million fixed-rate<br />
bonds outstanding at Metronet BCV, reflecting<br />
the unconditional and irrevocable guarantee of<br />
payment of interest and principal by Financial<br />
Security Assurance (U.K.) Ltd. (FSA; AAA/<br />
Stable/--) and Ambac Assurance U.K. Ltd.<br />
(Ambac; AAA/Stable/--), respectively. <strong>In</strong> addition,<br />
Standard & Poor’s affirmed its ‘AAA’ insured<br />
rating on the £165 million index-linked bonds<br />
and £350 million fixed-rate bonds outstanding at<br />
Metronet SSL, reflecting the unconditional and<br />
irrevocable guarantee of payment of interest and<br />
principal by Ambac and FSA, respectively.<br />
As at Sept. 10, 2007, Metronet BCV had £515<br />
million bonds and a combined £433 million bank<br />
debt outstanding. At the same date, Metronet SSL<br />
had £515 million bonds and £194 million bank<br />
debt outstanding.<br />
The CreditWatch status continues to reflect the<br />
risks and uncertainties regarding both the PPP<br />
administration process and the ultimate<br />
restructuring of the <strong>In</strong>fracos to deliver their<br />
responsibilities under their respective service<br />
contracts. The PPP administration process is<br />
untested and the outcome is therefore uncertain.<br />
On Sept. 4, 2007 a standstill agreement was<br />
entered into between TfL and the funders to the<br />
Metronet companies (representing both the bond<br />
and bank debtholders) that will run until January<br />
2008. Under the terms of this agreement, TfL will<br />
provide funding to the Metronet companies to<br />
enable them to fund the combined £46.4 million<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
debt service payment due on Sept. 15, 2007, and<br />
associated financing costs including swap<br />
payments. <strong>In</strong> return, the funders will not take any<br />
enforcement action to seek, for example,<br />
accelerated payment of the debt outstanding.<br />
Standard & Poor’s expects that there will be<br />
ongoing negotiations between TfL, London<br />
Underground Ltd. (LUL), the PPP administrators,<br />
and the senior lenders in relation to the future of<br />
the PPP service contracts. On Aug. 24, 2007, TfL<br />
lodged an expression of interest to the PPP<br />
administrators to take over the PPP contracts and<br />
assets of the Metronet companies. We believe that<br />
the most likely long-term outcome is that a<br />
restructuring of the contracts will occur that gives<br />
a new <strong>In</strong>fraco revised PPP service contract<br />
responsibilities. The restructured contract will be<br />
based on a new prioritization of service<br />
requirements, reflecting the revised level of<br />
ongoing infrastructure service charge (ISC) to be<br />
paid to the <strong>In</strong>fracos. The support and role of the<br />
various parties to the PPP service contract,<br />
including the Statutory Arbiter, TfL, LUL, and the<br />
U.K. Department of Transport (DoT) will remain<br />
critical to the analysis.<br />
Standard & Poor’s will resolve the CreditWatch<br />
as the PPP administration process and the<br />
contract restructuring proposal develops and the<br />
likely outcome becomes clear. The long-term and<br />
underlying debt ratings would be lowered if there<br />
was a significant downturn in the <strong>In</strong>fracos’<br />
operating performance or it became clear that<br />
existing senior debtholders would not be kept<br />
whole in any new <strong>In</strong>fraco structure. <strong>In</strong> particular,<br />
we will focus on the ongoing performance of the<br />
<strong>In</strong>fracos during the PPP administration as<br />
significant performance-related deductions from<br />
the ISC may result in a deterioration in credit<br />
quality. <strong>In</strong> addition, we will monitor the ongoing<br />
process of negotiations between the relevant<br />
parties including TfL and DoT to understand the<br />
potential ownership and capital structure of any<br />
new <strong>In</strong>fraco that will assume the PPP service<br />
contract responsibilities.<br />
Standard & Poor’s will also review the likely<br />
treatment of senior debtholders within any new<br />
capital structure to ensure that they receive full<br />
and timely payment of debt service obligations<br />
and that any restructuring proposal does not<br />
result in a loss of value to the debtholders. Should<br />
a proposal be brought forward that would result<br />
in a loss of value, the long-term and underlying
debt ratings would likely be lowered. If the<br />
proposal was subsequently implemented, the longterm<br />
and underlying debt ratings would likely be<br />
lowered to ‘D’.<br />
Although the <strong>In</strong>fracos are in administration, we<br />
have maintained the ‘BB+’ ratings on debt issued<br />
by the Metronet companies, reflecting the<br />
structural protections within the PPP service<br />
contract that are likely to benefit debtholders. For<br />
example, as an insolvency event has occurred for<br />
the <strong>In</strong>fracos, the funders ultimately have the<br />
ability to exercise a put option, requiring TfL to<br />
pay a put option price--that is, at least 95% of<br />
the outstanding debt at each company. It is<br />
therefore unlikely that the funders will accept any<br />
proposed restructuring that would result in them<br />
receiving less than the amount they would receive<br />
through the exercise of the put option. There is<br />
no track record of implementing any of these<br />
arrangements, however, including determining the<br />
value of the put option, or enforcing these<br />
obligations. Although they provide significant<br />
comfort at the rating level, the protections may be<br />
subject to challenge and delay.<br />
If, as part of the PPP service contract<br />
restructuring process, the various debt obligations<br />
of the Metronet companies are assumed by TfL-prior<br />
to a final restructuring solution being<br />
implemented--the long-term and underlying debt<br />
ratings could be raised. ■<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
NOVEMBER 2007 ■ 137
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
June 20, 2007<br />
Issue Credit Rating:<br />
AAA (insured);<br />
BBB-(SPUR)/Stable<br />
(preliminary)<br />
Primary Credit Analyst:<br />
James Hoskins,<br />
London,<br />
(44) 20-7176-3393<br />
Secondary Credit Analysts:<br />
Lidia Polakovic,<br />
London,<br />
(44) 20-7176-3985<br />
Hugo Foxwood,<br />
London,<br />
(44) 20-7176-3781<br />
138 ■ NOVEMBER 2007<br />
PETERBOROUGH (PROGRESS HEALTH) PLC<br />
Rationale<br />
On June 20, 2007, Standard & Poor’s Ratings<br />
Services assigned its preliminary ‘AAA’ long-term<br />
insured debt rating to the proposed £442.8<br />
million (including £50.0 million variation bonds)<br />
fixed rate guaranteed bonds due October 2042, to<br />
be issued by U.K.-based health funding special<br />
purpose vehicle Peterborough (Progress Health)<br />
PLC (ProjectCo). The preliminary rating<br />
reflects the unconditional and irrevocable<br />
payment guarantee of scheduled interest and<br />
principal provided by FGIC UK Ltd. (FGIC;<br />
AAA/Stable/--).<br />
At the same time, Standard & Poor’s assigned<br />
its preliminary ‘AAA’ long-term insured debt<br />
rating on the liquidity facility, change-in-law<br />
facility (CiLF), and swap facility provided by<br />
ABN AMRO Bank N.V. (AA-/Watch Pos/A-1+).<br />
The preliminary rating reflects the unconditional<br />
and irrevocable payment guarantee of scheduled<br />
interest and principal provided by FGIC.<br />
The preliminary underlying long-term ratings<br />
on the proposed debt are all ‘BBB-’ with a stable<br />
outlook. The debt and all the facilities have also<br />
been assigned preliminary recovery ratings of ‘2’,<br />
reflecting expectations of substantial (70%-90%)<br />
recovery of principal in the event of a default.<br />
Final ratings will depend on receipt and<br />
satisfactory review of all final transaction<br />
documentation, including legal opinions.<br />
Accordingly, the preliminary ratings should not be<br />
construed as evidence of final ratings. If Standard<br />
& Poor’s does not receive final documentation<br />
within a reasonable timeframe, or if final<br />
documentation departs from materials reviewed,<br />
Standard & Poor’s reserves the right to withdraw<br />
or revise its ratings.<br />
The proposed debt will finance the design,<br />
construction, and operation of three new<br />
buildings on two sites for three separate National<br />
Health Service (NHS) Trusts as part of the<br />
Greater Peterborough Health <strong>In</strong>vestment Plan:<br />
• A new mental health unit will be built on<br />
the existing Edith Cavell Hospital site for<br />
Cambridge and Peterborough Mental Health<br />
Partnership NHS Trust (the MHU Trust).<br />
• A new acute hospital will be built on the<br />
existing Edith Cavell Hospital site for the<br />
Peterborough and Stamford Hospitals NHS<br />
Foundation Trust (the Acute Trust).<br />
• A new integrated care center will be built on<br />
the existing Peterborough District Hospital<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
site for the Greater Peterborough Primary<br />
Care Partnership Trust, which is acting<br />
through the Peterborough Primary Care<br />
Trust (the ICC Trust).<br />
All three Trusts are acting jointly, but not<br />
severally, via a project agreement (PA) with a term<br />
of 35 years and four months under a U.K.<br />
government private finance initiative (PFI)<br />
program. The Acute Trust has full termination<br />
rights over the project, as it will provide about<br />
86% of the unitary payments, while the two<br />
smaller Trusts only have termination rights over<br />
the part they are responsible for.<br />
The preliminary ‘BBB-’ underlying senior debt<br />
and facilities ratings take into account the<br />
following project risks:<br />
• The project is exposed to the counterparty<br />
risk of unrated Australia-based construction<br />
group Multiplex Ltd. and a number of its<br />
U.K.-based subsidiaries--also unrated--as<br />
shareholder, design, and construction<br />
contractor, and hard facilities management<br />
(FM) services providers. Although this<br />
integrated approach to project delivery<br />
might have advantages such as enhanced<br />
coordination, there is no diversification of<br />
counterparty risk.<br />
• This is the first health construction project<br />
undertaken by Multiplex Ltd. in the U.K.<br />
Although the company has experience in<br />
complex construction projects worldwide, its<br />
experience in health construction is limited<br />
to a small number of relatively low-value<br />
projects in Australia. <strong>In</strong> line with standard<br />
industry practice, the works will be fully<br />
subcontracted in packages. Multiplex may,<br />
however, be subject to fallout from the<br />
difficulties it encountered during the<br />
construction of Wembley Stadium in terms<br />
of availability and pricing of suitable<br />
subcontractors. All fixed price appointments<br />
required before financial close have now<br />
been made, however, and the technical<br />
adviser, Faithful & Gould, considers them<br />
satisfactory. The size of the largest phase of<br />
construction (£280 million) may limit the<br />
number of contractors able to take over<br />
should Multiplex Construction (UK) Ltd.<br />
be replaced.<br />
• This is also the first hard FM contract<br />
Multiplex Facilities Management UK Ltd.
(Multiplex FM) has signed in the U.K.<br />
Multiplex FM has some health experience<br />
but on a smaller scale and with shorter<br />
contracts. It provides FM services to several<br />
hospitals in Australia totaling 2,100 beds-this<br />
PFI project alone provides 780 beds.<br />
The Australian contracts have an average<br />
duration of 10 years, significantly lower<br />
than for this project. The technical adviser<br />
has reviewed Multiplex FM’s processes and<br />
procedures and considers them satisfactory.<br />
• Unlike most rated PFI projects to date, the<br />
project makes use of a liquidity facility and<br />
CiLF instead of cash reserve accounts. The<br />
facilities have minimal drawstops and<br />
should provide relatively timely liquidity to<br />
the project if required.<br />
• The project is highly leveraged (94%) and<br />
the structure is quite aggressive with no tail.<br />
<strong>In</strong> lieu of a tail, a cash reserve is built up by<br />
the start of the last year of the concession,<br />
assuming sufficient cash is available.<br />
• ProjectCo is exposed to increased labor costs<br />
beyond those budgeted for, and for which it<br />
cannot claim relief from the Trusts through<br />
the market testing process.<br />
• The project is exposed to the uncertainty of<br />
more than 35 years of capital-replacement<br />
costs.<br />
• The contractor is dependent on key<br />
personnel. Given its lack of experience in the<br />
U.K., Multiplex Construction (UK) has had<br />
to recruit a new construction team<br />
specifically for this project. As this<br />
experience is vested within individuals,<br />
rather than the organization, Multiplex<br />
could be exposed if it failed to retain the<br />
services of these personnel, as it would need<br />
to recruit externally, and therefore may not<br />
be able to rapidly transfer staff internally if<br />
necessary.<br />
The following strengths mitigate these risks at<br />
the preliminary ‘BBB-’ rating level:<br />
• Construction risk is partially mitigated by an<br />
18% (£60 million) LOC provided by ABN<br />
AMRO, which would be sufficient to fund<br />
construction delays of 12 months and<br />
replacement cost premiums of about<br />
15% or more through the whole<br />
construction period.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
• An LOC equivalent to about 20% of the<br />
annual hard FM fee and a cash reserve<br />
equivalent to about 20% of the annual hard<br />
FM fee (replaceable by an additional LOC<br />
for the same amount) by the planned<br />
commencement of full services provides<br />
third-party liquidity support for the hard<br />
FM services. This liquidity can only be<br />
removed once Multiplex FM has met<br />
specific performance and financial targets<br />
consistently over a three-year period.<br />
• There are alternative hard FM providers<br />
capable of undertaking the services if<br />
Multiplex FM is replaced.<br />
• A 24-month longstop date is included for<br />
the acute facility. This is significantly longer<br />
than for similar hospital projects (usually<br />
12-18 months). The building contract<br />
longstop is 12 months, which gives<br />
ProjectCo a minimum 12 months to appoint<br />
a replacement contractor if necessary.<br />
• The Trusts have invested significant<br />
resources in assessing the design and<br />
working with Multiplex to develop and<br />
verify the details. <strong>In</strong> particular, all 1:50 scale<br />
drawings have been signed off by clinical<br />
user groups before financial close.<br />
• The construction works, although large, are<br />
relatively simple, with limited decanting and<br />
phasing requirements. A large part of the<br />
Acute and MHU hospital works are on a<br />
greenfield site next to the existing hospital.<br />
• Capital-replacement risk is partially<br />
mitigated by a three-year, forward-looking<br />
lifecycle reserve, and a 12-year guarantee<br />
from the construction contractor for latent<br />
defects. Sensitivity testing also indicates that<br />
ProjectCo could withstand significant<br />
increases in lifecycle costs before<br />
encountering financial distress.<br />
• Multiplex’s construction liability is limited<br />
only on termination to 55% of the<br />
construction contract sum. Termination<br />
liability steps down to 40% on completion<br />
of the Acute facility and to 20% six years<br />
after practical completion. <strong>In</strong> addition, the<br />
liquidated damages cap is sized to enable<br />
damages to be paid until the PA longstop<br />
date of 24 months from programmed<br />
completion. This is 60% of the expected<br />
construction period.<br />
NOVEMBER 2007 ■ 139
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
140 ■ NOVEMBER 2007<br />
The liquidity facility is revolving and pari passu<br />
with the senior debt in all respects. The facility is<br />
fully committed, and valid requests must be<br />
honored by the lender unless there is a liquidity<br />
facility event of default outstanding. The facility<br />
events of default are limited to the following:<br />
• Nonpayment of principal and interest on an<br />
outstanding liquidity loan.<br />
• Each liquidity loan has a term of six months<br />
only. If the loan is not repaid within the<br />
term, a new request for an additional<br />
liquidity loan may be made by ProjectCo.<br />
The lenders must make a new liquidity loan<br />
available to repay the previous loan and<br />
meet any additional liquidity shortfalls so<br />
long as the maximum commitment of the<br />
facility is not exceeded.<br />
• ProjectCo insolvency.<br />
• It becoming illegal for ProjectCo to make or<br />
receive payments under the liquidity facility.<br />
• If the bonds are accelerated or the bonds are<br />
made immediately due and payable under<br />
the terms of the collateral deed by the<br />
controlling creditor.<br />
The facility may be drawn to service senior<br />
liabilities, including liquidity facility payments.<br />
With written permission from the controlling<br />
creditor, however, it may also be used to fund<br />
specified operating costs as defined by the<br />
accounts agreement. This applies only to<br />
operational costs that are senior to senior debt<br />
liabilities in the operational cash waterfall. The<br />
liquidity facility may not be used to fund<br />
increases in capital costs. The distribution<br />
covenant will be triggered if any liquidity loans<br />
are outstanding.<br />
The facility is available from the start of the<br />
concession until replaced by the earlier of an<br />
equivalent cash debt service reserve account, or<br />
the end of the concession. Under the base case, a<br />
cash reserve is to be built up toward the end of<br />
the concession to replace the liquidity facility.<br />
During this period, a full six-month debt service<br />
reserve is available at all times, which will be<br />
based on a part cash/part liquidity facility reserve.<br />
Standard & Poor’s project finance ratings<br />
approach does not address the potential for<br />
changes in law within its ratings methodology.<br />
The U.K. PFI standard form contract specifically<br />
addresses the allocation of risk in relation to<br />
potential future changes in law. <strong>In</strong> this project, the<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
standard risk allocation for change in law<br />
is adopted.<br />
The Trusts will assume the risk of<br />
discriminatory and NHS-specific changes in law<br />
in terms of compensation and extensions to<br />
construction completion dates.<br />
ProjectCo has shared general change-in-law risk<br />
up to a maximum liability of 3.13% of the capital<br />
cost of the project during the operational period.<br />
During the construction period, general changein-law<br />
risk has been passed in full to the<br />
construction contractor. Change in law in relation<br />
to medical equipment services is treated separately<br />
from this regime and is fully borne by the relevant<br />
technology contractor.<br />
This project has a facility available to meet<br />
possible change-in-law requirements during the<br />
operational period of the concession. The changein-law<br />
facility is pari passu to the senior debt and<br />
the facility is available from the start of the<br />
concession until the time of the mandatory<br />
drawdown--scheduled to occur toward the end of<br />
the concession--of any undrawn proceeds, which<br />
are deposited in the change-in-law account. Any<br />
drawings used to fund valid changes in law before<br />
the mandatory drawdown are interest only until<br />
then and the facility is subsequently repaid under<br />
a predetermined schedule.<br />
With prior written permission from the<br />
controlling creditor, the facility may also be used<br />
to fund operational or finance costs. If it is used<br />
in this manner, any drawings must be repaid in<br />
full (principal and interest) under a cash sweep,<br />
and the distribution covenant will be triggered<br />
until full repayment of the facility has been made.<br />
The swap facility is provided under a standard<br />
form ISDA master agreement with a projectspecific<br />
schedule. Standard & Poor’s has reviewed<br />
the details of this agreement and confirmed that it<br />
complies with the criteria.<br />
Recovery analysis<br />
The senior secured debt and the facilities have<br />
each been assigned preliminary recovery ratings of<br />
‘2’, indicating Standard & Poor’s expectation of<br />
substantial recovery of principal (70%-90%) in<br />
the event of a payment default. To date, however,<br />
there has been limited experience regarding<br />
default or loss in this sector.<br />
The senior debt facilities benefit from a strong<br />
security package, covenants, and contractual<br />
features for compensation on termination that are
standard in U.K. PFI transactions. The creditorfriendly<br />
U.K. insolvency framework gives secured<br />
creditors of PFI transactions with step-in rights<br />
who have floating charges the ability to appoint<br />
an administrative receiver to enforce security and<br />
thereby control the insolvency process.<br />
Additional features supporting substantial<br />
recovery include the relative clarity of the<br />
termination regime (although this remains largely<br />
untested), the expectation of timely repayment by<br />
the Trusts according to defined procedures and<br />
dates, and the robust credit quality of the Trusts<br />
as payers of termination sums. Exposure to a<br />
Trust credit default following termination is,<br />
therefore, minimal.<br />
The PA stipulates the mechanism for<br />
determining how ProjectCo (and its lenders) will<br />
be compensated for various events leading to<br />
termination. <strong>In</strong> the event of a Trust default, force<br />
majeure, or a voluntary termination,<br />
compensation will fully cover senior debt service,<br />
i.e. 100% recovery will be possible. As the Trusts’<br />
responsibility is joint but not several, however, the<br />
PA only terminates for Trust default if the Acute<br />
Trust (representing 86% of the unitary payment)<br />
defaults. If one of the two smaller Trusts defaults,<br />
full compensation is payable to ProjectCo in<br />
standard terms but the PA does not terminate.<br />
The medical equipment services agreement does<br />
not have any partial termination provisions.<br />
A ProjectCo event of default arising from issues<br />
like insolvency, prohibited change of control,<br />
construction delay beyond the longstop date (24<br />
months after the scheduled completion of the<br />
Acute hospital), material breach of obligations, or<br />
accumulation of excessive penalty points,<br />
however, can trigger a termination where the<br />
repayment of debt is not guaranteed by the Trust.<br />
These scenarios have therefore been considered in<br />
order to arrive at potential recovery rates.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Senior lenders have step-in rights to resolve a<br />
ProjectCo event of default. If termination occurs,<br />
compensation is based on a market retendering<br />
process (if a liquid market exists) or a net-presentvalue<br />
calculation, less certain expenses.<br />
Recovery rates for the project should improve<br />
as time passes because debt will be paid down<br />
and reserves built up. The recovery analysis<br />
assumes a relatively unfavorable scenario where a<br />
severe delay occurs in the initial years of<br />
construction, with a substantial increase in costs<br />
following contractor replacement. Scenarios that<br />
reduce the unitary payment by various amounts<br />
have also been considered, reflecting ProjectCo’s<br />
inability to achieve its original operating<br />
performance. The liquidity available to the project<br />
through reserves (such as the guaranteed<br />
investment contract) and cash is factored into the<br />
analysis. The recovery scenarios also assume that<br />
both the liquidity facility and the CiLF are fully<br />
drawn at default.<br />
Outlook<br />
The stable outlook on the preliminary underlying<br />
ratings reflects Standard & Poor’s expectation<br />
that construction will proceed in line with the<br />
planned program and budget. This expectation is<br />
based on the contractor’s ability and the<br />
professional team it has assembled, the favorable<br />
opinion of the technical adviser on the proposals,<br />
and the significant third-party construction<br />
support provided. The rating could be lowered if<br />
there were substantial delays in construction-increasing<br />
concerns about the contractor’s ability<br />
to deliver and maintain the hospitals--and/or<br />
substantially higher-than-expected cost increases.<br />
An upgrade in the short to medium term<br />
is unlikely. ■<br />
NOVEMBER 2007 ■ 141
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Publication Date:<br />
Oct. 11, 2007<br />
Issue Credit Rating:<br />
Senior secured debt<br />
AAA, BBB-(SPUR)/Stable<br />
Primary Credit Analyst:<br />
James Hoskins,<br />
London,<br />
(44) 20-7176-3393<br />
Secondary Credit Analyst:<br />
Jose R Abos,<br />
Madrid,<br />
(34) 91-389-6951<br />
142 ■ NOVEMBER 2007<br />
TRANSFORM SCHOOLS (NORTH LANARKSHIRE)<br />
FUNDING PLC<br />
Rationale<br />
The £88.7 million index-linked senior secured<br />
bonds due 2036 and the £70 million <strong>European</strong><br />
<strong>In</strong>vestment Bank (EIB; AAA/Stable/A-1+) loans<br />
due 2034 issued by U.K.-based special purpose<br />
vehicle Transform Schools (North Lanarkshire)<br />
Funding PLC (Issuer) have a ‘AAA’ insured rating<br />
and a ‘BBB-’ Standard & Poor’s underlying rating<br />
(SPUR). The outlook on the SPUR is stable. <strong>In</strong><br />
addition, the underlying rating on the bonds has a<br />
recovery rating of ‘2’, indicating Standard &<br />
Poor’s expectation of substantial recovery of<br />
principal (70%–90%) in the absence of a<br />
guarantee in the event of a debt default.<br />
The insured rating reflects the unconditional<br />
and irrevocable payment guarantee of scheduled<br />
interest and principal provided by XL Capital<br />
Assurance (U.K.) Ltd. (AAA/Stable/--). The<br />
underlying ‘BBB-’ rating represents a composite of<br />
credit factors, outlined below.<br />
The funds have been onlent by the Issuer to<br />
Transform Schools (North Lanarkshire) Ltd.<br />
(ProjectCo), and are being used to finance the<br />
design and construction of 17 new facilities for 24<br />
schools for North Lanarkshire Council in<br />
Scotland. Following the completion of<br />
construction, ProjectCo, via its subcontractor<br />
Haden Building Management Ltd. (HBML), will<br />
provide hard and limited soft facilities<br />
maintenance services, including building<br />
maintenance, lifecycle, security, energy<br />
management, cleaning and janitorial services to<br />
the schools for the remainder of the 32-year<br />
project agreement, which expires in 2037.<br />
Construction commenced in October 2004<br />
under an advanced works agreement and<br />
continued under the private finance initiative<br />
(PFI) contract upon financial close in April 2005.<br />
Final completion is due to occur in October 2008<br />
and works are being undertaken by an<br />
unincorporated joint venture between Balfour<br />
Beatty Construction Ltd. and Balfour Kilpatrick<br />
Ltd. (construction joint venture; CJV), both of<br />
which are subsidiaries of Balfour Beatty PLC (not<br />
rated). Construction works are currently<br />
proceeding reasonably well, with 11 facilities<br />
successfully completed, two facilities due to be<br />
completed in October 2007, two in November<br />
2007, and the final two schools in October 2008.<br />
The ‘BBB-’ underlying rating reflects the<br />
following credit risks:<br />
• Although the completion of this multisite<br />
project should be within the capabilities of<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
the contractor Balfour Beatty PLC to deliver<br />
successfully, it is being run concurrently<br />
with a number of other Scottish education<br />
PFI portfolio projects. The ability to procure<br />
sub-contractors to carry out key<br />
construction activities in a reasonably<br />
constrained labor market will be crucial,<br />
therefore, in ensuring construction delivery<br />
in line with the contractually agreed<br />
timetable. Furthermore, Balfour Beatty itself<br />
is undertaking a number of significant PFI<br />
projects at this time so its ability to manage<br />
this project alongside others will be<br />
challenging, although achievable given<br />
the company’s significant experience in<br />
the sector.<br />
• One school facility, St. Ignatius and Wishaw<br />
Academy Primary, which was handed over<br />
in August 2007, was found to be about 136<br />
square meters smaller than required by the<br />
output specification immediately prior to<br />
handover. <strong>In</strong> addition, one school is<br />
currently in delay by around 12 weeks due<br />
to poor ground conditions. ProjectCo is<br />
being protected from the financial impact of<br />
these two issues by CJV. At Wishaw, CJV is<br />
currently implementing the additional works<br />
required to bring the floor area of the school<br />
up to standard at its own expense.<br />
• The project relies on about £23 million of<br />
revenue earned through phased construction<br />
to provide funding for further construction<br />
activities. Any delays to the attainment of<br />
these revenues could reduce the funding<br />
available for construction.<br />
• The third-party financial support and<br />
liquidity during the construction phase is<br />
relatively low, although adequate.<br />
Construction risk is partially financially<br />
mitigated through an adjudication bond<br />
from Banco Bilbao Vizcaya Argentaria S.A.<br />
(AA-/Positive/A-1+).<br />
• ProjectCo is exposed to the uncertainty, in<br />
terms of budgeting and timing, of more than<br />
32 years of capital-replacement risk. This<br />
risk is partially mitigated by: a three-year<br />
forward-looking reserve; a 12-year limit on<br />
the construction joint-venture liabilities for<br />
serious latent defects; and the relatively<br />
simple nature of schools projects.<br />
• The financial structure is aggressive, as is<br />
typical for the PFI sector. Senior debt to<br />
total funds is 90% (excluding construction
evenue), and base-case senior debt-service<br />
coverage levels are a minimum of 1.19x and<br />
average 1.21x, which is low but in line with<br />
most recently rated PFI projects in the U.K.<br />
<strong>In</strong> addition, forward and historical<br />
distribution lock-up levels are slightly lower<br />
than recent transactions at 1.125x.<br />
The financial model, however, performs<br />
satisfactorily under a range of<br />
stress scenarios.<br />
These risks are mitigated at this rating level by<br />
the following credit strengths:<br />
• The project receives an availability-based<br />
revenue stream, with no volume or market<br />
exposure, no reliance on third-party<br />
revenues, and a relatively benign payment<br />
mechanism.<br />
• The experience and capability of Balfour<br />
Beatty and its subsidiaries in their capacities<br />
as sponsor, constructor, and facilities<br />
maintenance (FM) provider.<br />
• All individual schools will be 100% newbuild,<br />
with construction on largely vacant<br />
sites within the existing school sites.<br />
Furthermore, the project is likely to benefit<br />
from the portfolio effect of construction on<br />
various sites.<br />
• The FM service requirements are relatively<br />
simple and, therefore, are likely to be within<br />
the capabilities of the FM provider. <strong>In</strong><br />
addition, benchmarking and market testing<br />
provides an adequate pass-through of<br />
operational risks from ProjectCo.<br />
• With the exception of the two schools<br />
mentioned above, progress on the<br />
construction is adequate to date, with a total<br />
of eight sites (accounting for 11 schools)<br />
completed so far, with works having<br />
commenced on all tranche-2 schools as<br />
anticipated. A number of minor grantorfunded<br />
variations have been executed and<br />
relations between parties continue to be<br />
positive. Construction remains on schedule<br />
for final completion and handover in<br />
October 2008.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
PROJECT FINANCE/PUBLIC-PRIVATE PARTNERSHIPS<br />
Recovery analysis<br />
The secured bonds and EIB loan have been<br />
assigned a recovery rating of ‘2’. This indicates<br />
Standard & Poor’s expectation of substantial<br />
recovery of principal (70%-90%) in the absence<br />
of a guarantee in the event of a debt default. To<br />
date, however, there has been limited experience<br />
regarding default or loss in this sector.<br />
This recovery rating reflects the strong security<br />
package, covenants, and contractual features for<br />
compensation on termination that are inherent in<br />
U.K. public-private partnership (PPP)<br />
transactions. A key feature supporting this<br />
assessment is the creditor-friendly U.K. insolvency<br />
framework. Secured creditors of PPP transactions<br />
with step-in rights that have floating charges have<br />
additional advantages, because they are one of the<br />
categories of creditors that can appoint an<br />
administrative receiver to enforce security and<br />
thereby control the insolvency process.<br />
Additional features supporting Standard &<br />
Poor’s expectation of substantial recovery include<br />
the relative clarity of the termination regime<br />
(although this is largely untested), the expectation<br />
of timely repayment according to defined<br />
procedures and dates by the procuring authority,<br />
and the robust credit quality of the procuring<br />
authority as payor of termination sums. Exposure<br />
to authority credit default following termination<br />
is, therefore, minimal.<br />
Outlook<br />
The stable outlook reflects our expectation that<br />
the necessary rectification works at St. Ignatius<br />
and Wishaw Academy Primary will be completed<br />
to the satisfaction of ProjectCo and in a timely<br />
manner. If further significant delays are<br />
encountered or the rectification works are not<br />
adequately completed the outlook may be revised<br />
to negative or the rating lowered. There is<br />
currently limited scope for an upgrade. ■<br />
NOVEMBER 2007 ■ 143
RATINGS LIST<br />
RATINGS LIST<br />
Utilities<br />
Standard & Poor's <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
Name Issuer credit rating* Country<br />
Acea SpA A/Stable/A-1 Italy<br />
Acquedotto Pugliese SpA BBB/Negative/A-3 Italy<br />
AEM SpA BBB/Watch Pos/A-2 Italy<br />
Anglian Water Services Financing PLC Guaranteed debt AAA; senior secured debt A-; subordinated debt BBB U.K.<br />
Artesian <strong>Finance</strong> PLC Senior secured debt AAA U.K.<br />
ASM Brescia SpA A+/Watch Neg/A-1 Italy<br />
Bord Gais Eireann A/Stable/A-1 Ireland<br />
BOT Elektrownia Turow S.A. B/Positive/-- Poland<br />
British Energy Group PLC BB+/Watch Neg/-- U.K.<br />
CE Electric U.K. Funding Co. BBB-/Positive/A-3 U.K.<br />
Centrica PLC A/Negative/A-1 U.K.<br />
CEZ a.s. A-/Stable/-- Czech Republic<br />
C.N. Transelectrica S.A. BB+/Positive/-- Romania<br />
Delta N.V. A-/Negative/-- The Netherlands<br />
DONG Energy A/S BBB+/Positive/A-2 Denmark<br />
Drax Power Ltd. BBB-/Stable/-- U.K.<br />
Dwr Cymru (Financing) Ltd. Secured bank loan A-; senior secured guaranteed AAA; senior secured A-;<br />
subordinated BBB<br />
U.K.<br />
E.ON AG A/Stable/A-1 Germany<br />
E.ON Sverige AB A/Stable/A-1 Sweden<br />
E.ON U.K. PLC A-/Stable/A-2 U.K.<br />
Edison SpA BBB+/Positive/A-2 Italy<br />
EDP - Energias de Portugal, S.A. A-/Negative/A-2 Portugal<br />
Eesti Energia AS A-/Negative/-- Estonia<br />
Electricite de France S.A. AA-/Stable/A-1+ France<br />
EDF Energy PLC A/Stable/A-1 U.K.<br />
RTE EDF Transport S.A. AA-/Stable/A-1+ France<br />
Elia System Operator S.A./N.V. A-/Stable/A-2 Belgium<br />
Enagas S.A. AA-/Stable/A-1+ Spain<br />
EnBW Energie Baden-Wuerttemberg AG A-/Stable/A-2 Germany<br />
Endesa S.A. A/Watch Neg/A-1 Spain<br />
ENECO Holding N.V. A/Negative/A-1 The Netherlands<br />
Enel SpA A/Watch Neg/A-1 Italy<br />
Enemalta Corp. BBB+/Stable/-- Malta<br />
Energie AG Oberoesterreich A+/Negative/-- Austria<br />
Energie Steiermark AG A/Positive/-- Austria<br />
Energinet.dk SOV AA+/Stable/A-1+ Denmark<br />
ESKOM Holdings Ltd. Foreign currency BBB+/Stable/-- South Africa<br />
Essent N.V. A+/Negative/A-1 The Netherlands<br />
EVN AG A/Stable/-- Austria<br />
EWE AG A/Negative/-- Germany<br />
Federal Grid Co. of the Unified Energy System BB+/Watch Pos/-- Russia<br />
Fingrid Oyj A+/Stable/A-1 Finland<br />
Fortum Oyj A-/Stable/A-2 Finland<br />
Gas Natural SDG, S.A. A+/Negative/A-1 Spain<br />
Gaz de France S.A. AA-/Watch Neg/A-1+ France<br />
Hera SpA A/Stable/A-1 Italy<br />
Hrvatska Elektroprivreda d.d. BBB/Stable/-- Croatia<br />
Iberdrola S.A. A/Watch Neg/A-1 Spain<br />
Irkutskenergo, AO EiE<br />
*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.<br />
B+/Positive/-- Russia<br />
144 ■ NOVEMBER 2007<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Utilities<br />
Standard & Poor's <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
Name Issuer credit rating* Country<br />
Israel Electric Corp. Ltd. BBB+/Negative/-- Israel<br />
Kazakhstan Electricity Grid Operating Co. (JSC) BB+/Stable/-- Kazakhstan<br />
KazTransGas BB/Stable/-- Kazakhstan<br />
KazTransOil BB+/Positive/-- Kazakhstan<br />
KELAG AG A+/Negative/-- Austria<br />
Kelda Group PLC A-/Stable/A-2 U.K.<br />
Landsvirkjun Foreign currency A+/Negative/A-1 Iceland<br />
Lietuvos Energija A-/Negative/A-2 Lithuania<br />
Lunds Energikoncernen AB (publ) BBB+/Stable/A-2 Sweden<br />
Mosenergo (AO) BB/Stable/-- Russia<br />
N.V. Nederlandse Gasunie AA+/Stable/A-1+ The Netherlands<br />
N.V. NUON A+/Negative/A-1 The Netherlands<br />
National Central Cooling Co. PJSC BBB-/Stable/-- United Arab Emirates<br />
National Grid PLC A-/Stable/A-2 U.K.<br />
Natsionalna Elektricheska Kompania EAD BB/Developing/-- Bulgaria<br />
Northern Gas Networks Holdings Ltd. BBB+/Stable/-- U.K.<br />
Northumbrian Water Ltd. BBB+/Stable/-- U.K.<br />
Polish Oil and Gas Co. BBB+/Stable/-- Poland<br />
Public Power Corp. S.A. BBB+/Stable/-- Greece<br />
Rand Water Foreign currency BBB+/Stable/-- South Africa<br />
RAO UES of Russia BB/Watch Pos/-- Russia<br />
Red Electrica de Espana S.A. AA-/Stable/A-1+ Spain<br />
RWE AG A+/Negative/A-1 Germany<br />
Saudi Electric Co. AA-/Stable/-- Saudi Arabia<br />
S.C. Hidroelectrica S.A. BB/Positive/-- Romania<br />
Scotland Gas Networks PLC BBB/Positive/-- U.K.<br />
Southern Gas Networks PLC BBB/Positive/-- U.K.<br />
Scottish and Southern Energy PLC A+/Stable/A-1 U.K.<br />
Scottish Power PLC A-/Watch Neg/A-2 U.K.<br />
Severn Trent PLC A/Stable/A-1 U.K.<br />
Sociedad General de Aguas de Barcelona S.A. A/Stable/A-1 Spain<br />
South East Water (<strong>Finance</strong>) Ltd. Senior secured guaranteed AAA; senior secured BBB U.K.<br />
South Staffordshire PLC A-/Watch Neg/A-2 U.K.<br />
Southern Water Services Ltd. Bank loan A- U.K.<br />
S.N.T.G.N. Transgaz S.A. Medias BB+/Positive/-- Romania<br />
Statkraft AS BBB+/Stable/A-2 Norway<br />
Statnett SF AA/Stable/A-1+ Norway<br />
Suez S.A. A-/Watch Pos/A-2 France<br />
Sutton and East Surrey Water PLC BBB+/Stable/-- U.K.<br />
Tekniska Verken i Linkoeping AB A-/Stable/A-2 Sweden<br />
Terna SpA AA-/Stable/A-1+ Italy<br />
Thames Water Utilities Ltd. BBB+/Watch Neg/-- U.K.<br />
Union Fenosa S.A. BBB+/Stable/A-2 Spain<br />
United Utilities PLC A/Watch Neg/A-1 U.K.<br />
Vattenfall AB A-/Stable/A-2 Sweden<br />
Veolia Environnement S.A. BBB+/Stable/A-2 France<br />
Vodokanal St. Petersburg BB+/Positive/B Russia<br />
Three Valleys Water PLC<br />
Verbundgesellschaft (Oesterreichische<br />
A-/Stable/-- U.K.<br />
Elektrizitaetswirtschafts Aktiengesellschaft) A/Stable/-- Austria<br />
Wasser und Gas Westfalen GmbH BBB+/Stable/-- Germany<br />
Wessex Water Services Ltd. BBB+/Stable/-- U.K.<br />
Western Power Distribution Holdings Ltd.<br />
*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.<br />
BBB-/Stable/A-3 U.K.<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
RATINGS LIST<br />
NOVEMBER 2007 ■ 145
RATINGS LIST<br />
Transportation <strong><strong>In</strong>frastructure</strong><br />
Name Issuer credit rating* Country<br />
Abertis <strong>In</strong>fraestructuras S.A. A/Negative/-- Spain<br />
Aeroporti di Roma SpA BBB/Watch Neg/A-2 Italy<br />
Aeroports de Paris AA-/Stable/-- France<br />
Angel Trains Ltd. A/Negative/A-2 U.K.<br />
Atlantia SpA A/Negative/A-1 Italy<br />
BAA Ltd. BBB+/Watch Neg/NR U.K.<br />
Birmingham Airport Holdings Ltd. A-/Stable/A-2 U.K.<br />
BRISA Auto-Estradas de Portugal S.A. A/Watch Neg/A-1 Portugal<br />
Brussels <strong>In</strong>ternational Airport Co. BBB/Stable/-- Belgium<br />
Caisse Nationale des Autoroutes AAA/Stable/-- France<br />
CFR Marfa S.A. B-/Watch Neg/-- Romania<br />
CFR S.A. BB/Negative/-- Romania<br />
Cofiroute BBB+/Negative/A-2 France<br />
Copenhagen Airports A/S BBB+/Stable/-- Denmark<br />
Deutsche Bahn AG AA/Negative/A-1+ Germany<br />
DFS Deutsche Flugsicherung GmbH AAA/Negative/A-1+ Germany<br />
DP World Ltd. A+/Stable/A-1 Dubai<br />
Dublin Airport Authority PLC A/Negative/A-1 Ireland<br />
Fjellinjen AS AA/Stable/-- Norway<br />
Hutchison Ports (U.K.) Ltd. A-/Stable/A-2 U.K.<br />
INFRABEL AA+/Stable/A-1+ Belgium<br />
Kazakhstan Temir Zholy BB+/Stable/-- Kazakhstan<br />
Macquarie Airports Copenhagen Holdings ApS BBB+/Stable/-- Denmark<br />
Macquarie Motorways Group Ltd. BBB/Stable/-- U.K.<br />
Manchester Airport Group PLC (The) A/Stable/-- U.K.<br />
N.V. Luchthaven Schiphol AA-/Negative/-- The Netherlands<br />
NATS (En-Route) PLC A/Stable/-- U.K.<br />
Network Rail <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> PLC Senior secured debt AAA U.K.<br />
Network Rail MTN <strong>Finance</strong> PLC Senior secured debt AAA U.K.<br />
Norges Statsbaner AS AA/Stable/A-1+ Norway<br />
NS Groep N.V. AA/Stable/-- The Netherlands<br />
Oresundsbro Konsortiet Senior unsecured debt AAA Denmark<br />
Rede Ferroviaria Nacional REFER, E.P. A/Stable/-- Portugal<br />
Reseau Ferre de France AAA/Stable/A-1+ France<br />
Russian Railways (JSC) BBB+/Stable/-- Russia<br />
Societe Nationale des Chemins de Fer Belges Holding AA+/Stable/A-1+ Belgium<br />
Societe Nationale des Chemins de Fer Francais AAA/Stable/A-1+ France<br />
Transnet Ltd. Foreign currency BBB+/Stable/-- South Africa<br />
Unique (Flughafen Zurich AG) BBB+/Stable/-- Switzerland<br />
VINCI S.A. BBB+/Negative/A-2 France<br />
West Coast Train <strong>Finance</strong> PLC Senior secured debt A/Stable U.K.<br />
*At Nov. 8, 2007. All ratings are issuer credit ratings unless otherwise stated.<br />
146 ■ NOVEMBER 2007<br />
Standard & Poor's <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
Project <strong>Finance</strong><br />
Standard & Poor's <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
Name Issue credit rating* Country<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
RATINGS LIST<br />
Abu Dhabi National Energy Company PJSC (TAQA) AA-/Stable/A-1+ (issuer credit rating) United Arab Emirates<br />
Ajman Sewerage (Private) Co. Ltd. AAA (insured); BBB (SPUR)/Stable United Arab Emirates<br />
Alpha Schools (Highland) Project PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Alte Liebe 1 Ltd. AAA (insured); BBB- (SPUR)/Stable Channel Islands<br />
Aspire Defence <strong>Finance</strong> PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Autolink Concessionaires (M6) PLC AAA (insured); BBB+ (SPUR)/Stable U.K.<br />
Autoroutes Paris-Rhin-Rhone Senior unsecured bank loan, term loan BBB-/Stable;<br />
senior unsecured MTN BBB<br />
France<br />
Autovia del Camino S.A. AAA (insured); BBB (SPUR)/Stable Spain<br />
Bina-Istra, d.d. Senior secured debt BBB-/Stable Croatia<br />
Breeze <strong>Finance</strong> S.A. Senior secured debt AAA (insured), BBB (SPUR)/Stable;<br />
subordinated debt BB-/Stable (preliminary)<br />
Luxembourg<br />
Capital Hospitals (Issuer) PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Catalyst Healthcare (Manchester) Financing PLC AAA (insured); BBB (SPUR)/Negative U.K.<br />
Catalyst Healthcare (Romford) Financing PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Central Nottinghamshire Hospitals PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Consort Healthcare (Birmingham) Funding PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Consort Healthcare (Mid Yorkshire) Funding PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.<br />
Consort Healthcare (Salford) PLC AAA (insured); BBB (SPUR)/Stable (preliminary) U.K.<br />
Consort Healthcare (Tameside) PLC AAA (insured); BBB (SPUR)/Stable (preliminary) U.K.<br />
CountyRoute (A130) PLC Senior secured debt BBB/Stable; subordinated debt BB/Stable U.K.<br />
Coventry & Rugby Hospital Co. PLC (The) AAA (insured); BBB (SPUR)/Stable U.K.<br />
CRC Breeze <strong>Finance</strong> S.A. Senior secured debt BBB/Stable; subordinated debt BB+/Stable Luxembourg<br />
CTRL Section 1 <strong>Finance</strong> Class A1 and A2 debt AAA U.K.<br />
Delek & Avner - Yam Tethys Ltd. Senior secured debt BBB-/Stable Israel<br />
DirectRoute (Limerick) <strong>Finance</strong> Ltd. AAA (insured); BBB- (SPUR)/Stable (preliminary) Ireland<br />
Discovery Education PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Education Support Enfield Ltd. Senior secured bank loan A/Stable U.K.<br />
Exchequer Partnership (no. 1) PLC Senior secured debt AAA (insured) U.K.<br />
Exchequer Partnership (no. 2) PLC AAA (insured); BBB+ (SPUR)/Stable U.K.<br />
Fixed-Link <strong>Finance</strong> B.V. G1 and G2 notes: AAA; junior subordinated class C notes:<br />
C/Negative; senior secured class A notes and subordinated<br />
class B notes: AAA/Stable<br />
The Netherlands<br />
Health Management (Carlisle) PLC Senior secured debt AAA (insured) U.K.<br />
Healthcare Support (Newcastle) <strong>Finance</strong> PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Healthcare Support (North Staffs) <strong>Finance</strong> PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.<br />
Highway Management (City) <strong>Finance</strong> PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Hospital Co. (Swindon & Marlborough) Ltd. (The) AAA (insured); BBB+ (SPUR)/Stable Channel Islands<br />
<strong>In</strong>spirED Education (South Lanarkshire) PLC AAA (insured); BBB- (SPUR)/Watch Neg U.K.<br />
<strong>In</strong>tegrated Accommodation Services PLC AAA (insured); A (SPUR)/Stable U.K.<br />
<strong>In</strong>ternational Power PLC BB-/Stable/-- (issuer credit rating) U.K.<br />
M6 Duna Autopalya Koncessios Zartkoruen Mukodo Eszvenytarsasag Senior secured bank loan and debt AAA Hungary<br />
Max Two Ltd. Senior secured debt BBB-/Negative Channel Islands<br />
Metronet Rail BCV <strong>Finance</strong> PLC and Metronet Rail SSL <strong>Finance</strong> PLC Senior secured bank loan BB+/Watch Neg; senior secured<br />
debt AAA, BB+(SPUR)/Watch Neg<br />
U.K.<br />
Nakilat <strong>In</strong>c. A+/Stable/-- (issuer credit rating) Marshall Islands<br />
NewHospitals (St. Helens and Knowsley) <strong>Finance</strong> PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Octagon Healthcare Funding PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Peterborough (Progress Health) PLC AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.<br />
Premier Transmission Financing PLC AAA (insured); A (SPUR)/Stable U.K.<br />
Ras Laffan Liquefied Natural Gas Co.<br />
*At Nov. 9, 2007. All ratings are issue ratings unless otherwise stated.<br />
AAA (insured); A/Stable Qatar<br />
NOVEMBER 2007 ■ 147
RATINGS LIST<br />
Project <strong>Finance</strong><br />
Name Issue credit rating* Country<br />
Ras Laffan Liquefied Natural Gas Co. Ltd. (II) and<br />
Ras Laffan Liquefied Natural Gas Co. Ltd. (3)<br />
Senior secured debt A/Stable Qatar<br />
RMPA Services PLC AAA (insured); BBB- (SPUR)/Positive U.K.<br />
Road Management Consolidated PLC AAA (insured); BBB (SPUR)/Stable U.K.<br />
Services Support (Manchester) Ltd. Senior secured bank loan BBB/Stable U.K.<br />
Société Marseillaise du Tunnel Prado-Carénage (SMTPC) Senior secured bank loan AAA (insured) France<br />
Sutton Bridge Financing Ltd. Senior secured debt BBB-/Stable U.K.<br />
TAQA North Ltd. Senior unsecured debt AA- United Arab Emirates<br />
THPA <strong>Finance</strong> Ltd. Class A2 debt A; class B debt BBB; class B debt BB U.K.<br />
Transform Schools (North Lanarkshire) Funding PLC AAA (insured); BBB- (SPUR)/Stable U.K.<br />
Tube Lines (<strong>Finance</strong>) PLC Senior secured bank loan AAA/Stable (insured); senior secured<br />
B notes BBB/Stable; senior secured A-1 notes AA/Stable;<br />
subordinated C notes BBB-/Stable; subordinated D notes BB/Stable<br />
U.K.<br />
Walsall Hospital Co. PLC (The)<br />
*At Nov. 9, 2007. All ratings are issue ratings unless otherwise stated.<br />
AAA (insured); BBB- (SPUR)/Stable (preliminary) U.K.<br />
148 ■ NOVEMBER 2007<br />
Standard & Poor's <strong><strong>In</strong>frastructure</strong> <strong>Finance</strong> Ratings<br />
STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK
KEY ANALYTICAL CONTACTS<br />
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STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
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NOVEMBER 2007 ■ 149
CONTACTS<br />
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150 ■ NOVEMBER 2007 STANDARD & POOR’S EUROPEAN INFRASTRUCTURE FINANCE YEARBOOK<br />
Milan<br />
Monica Mariani<br />
Director<br />
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monica_mariani@standardandpoors.com<br />
Moscow<br />
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Group E-mail Address<br />
<strong><strong>In</strong>frastructure</strong>Europe@standardandpoors.com
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