From the perspective of the capital markets, project risk takes on different characteristics during three main phases of activity: 1) project development and pre-construction; 2) construction; and 3) operation. These activity phases are briefly described below, and then information required to analyze credit risk is presented.
Inherent in the development and pre-construction period is a varied group of risks with probabilities that are quite difficult to estimate. These risks can significantly alter the timeline for a project. Typical pre-construction risks include acquiring the right-of-way or obtaining access to public property; securing state, local, and federal permits (environmental and construction); achieving requisite institutional coordination, and obtaining significant support from the various stakeholder groups or communities affected by the project. If stakeholder support is not forthcoming, then the project is unlikely to proceed, and costs invested up to that point are usually not recoverable.
For highway, transit, and high-speed rail projects, perhaps the biggest unknowns during development are environmental approvals (including legal and regulatory changes) and right-of-way acquisition. These two factors can delay the scheduled start and completion of the project and have the potential to cause significant cost overruns and impede the project's ability to procure financing. For other projects, such as ITS, institutional barriers are usually more problematic than technical barriers.
The construction period brings different risks, including the question of whether the project will be completed on schedule and at the indicated cost. The risk of completion delays and other cost overruns influences the financial structure of the project because financing is much more accessible after completion of construction. The construction team's experience on similar projects and ability to meet financial obligations is critical to executing the contract and delivering a project as guaranteed.
The contract format is an important factor in dealing with and assigning risk, particularly since the projects tend to use a turnkey development approach, such as design-build or build-operate-transfer. If franchise or license agreements are involved, the degree of market exclusivity is important. When construction risk is shouldered by the contractor through a design-build or design-build-operate contract structure, risks borne by the debtor are minimized and thus support a better credit rating.
Various contractual arrangements among the parties involved have been developed to deal with the substantial risks posed by the construction phase. One usual way to mitigate construction risk is through a fixed-price fixed-completion date construction contract, including carefully drawn provisions related to change orders and completion delays. In addition, even with a fixed-price or not-to-exceed contract, the availability of contingency funds to cover cost overruns, project delays, or other risks, adds protection for the lenders and benefits the overall credit rating of the project. For toll roads, a general rule of thumb is that contingency funds should equal five to ten percent of the construction contract. Contingencies for the San Joaquin and the Foothill/ Eastern TCAs were sized to cover two years of capitalized interest.
The ability of a project to service its debt depends on the uninterrupted, cost-effective operation of the facility or mechanism for delivering the product or service, and, therefore, the revenue stream. The operational phase includes risks related to traffic forecasts, revenue projections, and operating costs. Provisions for routine maintenance and major maintenance or overhaul of the facilities are an important part of the operational phase. Credit analysts examine who is responsible for operations, terms of operation and maintenance contracts, and the experience of the operator with similar facilities.
Operations and maintenance of facilities involving advanced technologies is a particular concern. Historically, state and local agencies have had difficulty maintaining many traffic control systems because of a lack of adequately trained staff or lack of resources. Lenders and rating agencies need assurance that new systems will be properly maintained and operated whether by the public sector, private sector, or both.
Recent toll road projects that have been debt-financed have all gone through a ramp-up phase in the early years of operation. For some projects, traffic volumes and the resulting toll revenues have been 30 percent below projected levels during this period. The market responds to this risk profile by using a break-even analysis coupled with a review of the underlying assumptions that form the basis for the estimated cash flows. The break-even scenario (typically run assuming adverse economic conditions), in conjunction with an evaluation of the revenue forecast, will provide investors with the information needed to make a reasoned determination of the likelihood of meeting scheduled debt service.
Table C.1 summarizes the relevant risks of each project phase.
| Phase of Project Life Cycle | |||
|---|---|---|---|
| Risk Category | Development | Construction | Operation |
| Economic Feasibility | X | X | |
| Political | X | X | X |
| Construction | X | ||
| Traffic and Revenue | X | ||
| Management | X | ||
Bond rating agencies become involved during a project's development phase or once the project is fully developed and ready to go to market. By getting involved early on, rating agencies can better evaluate the project's supporting data and agreements as they evolve. This involvement provides an opportunity to review the project's credit strengths and weaknesses and to inform project sponsors about what steps or changes would be beneficial to improve the credit quality of the project before formally soliciting the rating on the debt issue. With a preliminary review, rating agencies may be asked to provide a preliminary opinion on the rating that the project might receive either as currently structured or assuming the project incorporates the rating agency's advice on how to strengthen the credit.
A federal credit program would rely on existing marketplace assessment mechanisms to gauge the investment quality of debt-financed projects. Nationally recognized rating agencies typically require extensive information for their assessment of the credit quality of a project. This information falls into four categories:
Contractual documents for the construction and operation of the project (including all environmental and construction permits needed);
Financing documents (e.g., trust indenture, bond insurance, or letters of credit);
Regional and local economic trends and data pertinent to the project, such as employment levels, economic diversity, income levels, and assessment of the public support (general and local/state levels); and
Independent reports and analyses that support the project economics such as traffic and revenue forecasts and an independent engineer's feasibility report.
The availability of all the information required enables the analysts to conduct a thorough review and assign an appropriate credit rating. To the extent that key information is not available, analysts may not be able to assign a rating or may assign a conditional rating subject to the project meeting certain thresholds. It is not unusual for the rating agencies to undertake an initial review of a project and assign a preliminary rating opinion letter at the request of the project sponsors. The preliminary rating is often requested to assist a project sponsor in identifying what further steps must be taken or what revisions in the various contractual elements are required to secure an investment-grade rating (i.e., BBB or higher). As envisioned, the federal credit program would use the preliminary opinion to assess project applications.
The rating analysts evaluate all the available information to determine: 1) the reasonableness of assumptions made in the forecasts of traffic and revenue; 2) the external political and economic factors that could affect the outcome of the project; 3) existing or planned competition for the roadway, product or service and its interrelationship with regional economic conditions; 4) how the bondholder's interests are protected under the covenants in the financing documents; 5) the downside risks; and 6) the project's break-even point for servicing debt.
The contractual documents outline the scope of the project and the terms of the agreement between the project sponsor and contractor (for construction and/or operations). The contracts outline all the legal obligations of the contractor for the technical work; terms of any franchise involved; performance guarantees and warranties; schedules, workmanship, and financial commitments; default and performance bond provisions, including any cure periods; remedies and liquidated damage payments; insurance coverage; and bonding capabilities and requirements. Included in this category are all the necessary permits to construct the project (government approvals, environmental permits, and construction and operating permits) or an anticipated schedule for obtaining them. Financial statements showing the ability of the contractor to meet its own financial commitments should be included. Supporting information is required to show the experience and ability of the contractor to build and operate the project as guaranteed.
Information outlining who will control the facility and who is responsible for operations and maintenance is also needed to ensure that revenues generated by the facility products or services will be dedicated to support the required debt service payments and will not be diverted to support other transportation initiatives.
The financing documents include all the documents drafted by bond counsel governing the issuance of revenue bonds (tax exempt or taxable) to finance the project, including the trust indenture, letters of credit (if applicable), bond insurance, and resolutions of issuing authority. Depending on the financing structure, evidence of any third-party capital investments (such as equity) or contractor deferred-payment agreements would also be reviewed.
Understanding the regional and local economy is a key component underlying customer acceptance and demand for the proposed facility, product, or service. Population and housing trends, employment levels, economic diversity, and income levels of the local population are all indicators of the willingness and ability of users to pay. If, for example, the need for a project is based on future growth assumptions (that is, if traffic and revenue projections assume significant growth in local population, commercial activity, or other demand factors), then the revenue base is not considered as secure as would be the case for a facility providing relief to a highly congested corridor.
Equally important to the project is government (federal, state, and local) and public support for the project. Any available documentation that demonstrates strong support for the project, or at least indicates that there is no significant opposition, strengthens the market's perception of the project's success. Many projects do not succeed (or are not as successful as projected) because of opposition from various public groups or local governments.
Generally, an independent engineer is retained by the project sponsor or on behalf of the financing institutions to review the feasibility of the proposed project from both technical and financial perspectives. The independent engineer will review all the preliminary design and construction documents, permits, project capital costs, traffic and revenue forecasts, and projected cash flows and assumptions. In addition, the engineer will assess the technical and financial ability of the contractor and the entire project team to undertake the project to ensure completion.
All revenue-bond-financed projects require a traffic and revenue forecast to support their cash flow projections. The traffic and revenue forecast must be prepared by a reputable, experienced firm to be considered valid. The traffic and revenue projections are critical to the ability of the project to meet its debt service obligations. Significant deviations from the projected demand levels or revenues will directly affect the long-term viability of the project.
In structuring a federal credit program to assist large-scale infrastructure investments, it would be desirable to direct the majority of assistance to projects receiving at least a minimum investment-grade rating (Baa/BBB). The investment-grade rating demonstrates market acceptance, which is an important step in protecting the government's interest. To obtain a credit assessment from a bond rating agency, project sponsors would already have been required to submit extensive information. Project sponsors would submit similar information to DOT, to be followed by the rating agency's preliminary credit assessment, to be considered for federal credit assistance. The remainder of this section lists the information requirements for projects seeking federal credit assistance.
