By widening the range of players who can invest in the sector, the bespoke ratings scale will ensure greater flow of long-term funds and aid the implementation of NIP
By Vinayak Chatterjee and Shubham Jain
Infrastructure financing and associated risks have always been viewed differently from conventional manufacturing and service industry risks. The reasons are clear: infra projects are characterised by high execution risks, long tenure concessions (often up to 60 years), regulated operations, and vulnerability to changes in public policy.
But the ratings approach over the years has tended to mimic conventional rating methods – whereas the risks associated with infra projects follow a different trajectory, viz., Development Risk, Construction Risk and Operating Risk. So, infra experts have for long argued for a specially tailored Rating Scale for infra vis-à-vis conventional sectors.
The conventional rating scale followed by all domestic Credit Rating Agencies (CRAs) is based on the “probability of default” (PD) approach, which implies assessing the likelihood of a default on the agreed repayment obligations. Thus, even a ‘single day, single rupee’ delay in the case of bank facilities or borrowing programmes with pre-defined repayment schedules is treated as a default, being totally independent of the prospects of subsequent recovery of lenders’ dues.
For infrastructure entities, the credit ratings anyway tend to be more conservative on account of the following: (i) high exposure to execution risks (during implementation phase); (ii) operational and maintenance risks; (iii) concentration on single asset cash flows; (iv) unpredictable ramp-up periods; (v) risks pertaining to counterparties and (vi) regulatory risks. Due to these multiple risks getting factored in together, infrastructure projects willy-nilly get projected as having vulnerable and volatile cashflows. This results in lower credit ratings on the conventional PD rating scale.
On the other hand, infrastructure projects tend to have some positive features which are ignored. Post-completion and stabilisation, they tend to generate a steady stream of long-term cash flows. They often have a nearly monopolistic market position, steady demand growth, stable pricing formats and low technological obsolescence risk. Further, Public Private Partnership (PPP) infrastructure projects have additional features like availability of termination payments, contractual protection through some form of non-compete clause, sovereign counterparty, etc. Structural features such as ring-fencing of cash flows, well-defined payments waterfall mechanism, low incremental capex risk also act as risk mitigation tools. These strengths are well corroborated by the high number of successful resolution plans (under the RBI’s restructuring scheme) implemented for operational infrastructure projects, where many had shown up as “defaulters” at some early stage due to some short-term blips or inappropriate loan structuring.
However, given the focus on timely servicing of financial obligations (single rupee, single day!!), the conventional PD rating scale has its limitations in taking cognisance of the positive characteristics, thereby resulting in undeserved lower ratings for infra projects. Such lower ratings, consequently, constrain participation from a wide range of long-term investors who are mandated to invest in or lend to only higher-rated projects. Indian insurance companies fall into this category.
To overcome these limitations and provide a broader perspective to prospective investors, a bespoke credit rating system for infrastructure projects has been a long-standing demand of infra players. The first formal announcement on the same was made in the Budget speech in February 2016, post which the Department of Economic Affairs (DEA, Ministry of Finance) worked with the domestic CRAs and other relevant stakeholders to look towards formulating an appropriate new scale. The CRAs responded with the Expected Loss (EL) framework around January 2017.
The EL approach brings in “Recovery, post default.” The EL structure thus retains the traditional aspect of the PD approach and integrates the same with Recovery Prospects (RP). The inclusion of RP allows a clear distinction to be made between entities with favourable fundamentals and recovery prospects and those without. Thus, EL is a combination of PD and RP. These EL ratings are assigned on a seven-point scale from EL1 to EL7.
Though this EL scale for infrastructure sector ratings was launched more than four years ago by all the major CRAs, very few infrastructure projects have got rated on this scale so far. The key reason for this tepid response is linkage of capital adequacy requirements with PD ratings, which tilts lenders’ preference in favour of the conventional scale.
The recent circular from the Insurance Regulatory and Development Authority of India (IRDAI) is a welcome step, as it allows insurance companies to invest in debt issued by infrastructure companies, rated not less than ‘A’ (on the conventional scale) along with an Expected Loss Rating of ‘EL1’ (highest rating on EL scale). This may help a significant number of operational and stable infrastructure projects to become eligible to access cheaper long-term capital from insurance companies. This additional information can also strongly support foreign investors being able to take a broader view of prospects.
In July 2021, SEBI also standardised the scale (EL1 to EL7) for these ratings across CRAs. Similar support from other regulators, especially the RBI, in recognising this scale and allowing lenders to provide capital on the basis of Expected Loss will enable wider acceptance of this scale, thus broadening the funding channels for infrastructure assets and aiding the implementation of the ambitious National Infrastructure Pipeline (NIP).
It is time to holistically adopt the new system.
Vinayak Chatterjee is Co-founder of Feedback Infra and its Non-Executive Chairman. Shubham Jain is Group Head and Senior Vice President – Corporate Ratings at ICRA