Credit rating a utility scale solar project in India

Investors around the world use different investment routes, like foreign direct investment (FDI)[1], foreign institutional investment (FII)[2], foreign portfolio investment (FPI)[3], external commercial borrowing (ECB)[4] etc. to invest their capital. In India too, the infrastructure sector has seen capital flows through each of these investment routes. Solar assets are a recent addition to this long list of investor ready infrastructure investment opportunities available in India. Large solar assets are marked by - large initial capital investments, low operating costs, and a steady flow of underlying cash flows (up to 25 years) under long term electricity supply contracts. The return profile of these assets provides a perfect match for large institutional investors like insurance and sovereign funds. 

However, investments by these large foreign investors continue to be small. One of the constraining factors to investments by them, is the low credit rating of these projects. Thus, to shore up investments and to enable recycling of the capital in the sector an understanding of the drivers of the credit rating of these large solar assets is essential.

Credit rating drivers

The credit rating process to determine the debt repayment capacity of an entity/project is a mix of both science and art. This process uses both financial and technical ratios to analyse economic viability of a project based on its business plan, financial, and technical statements. These ratios are then subjected to a stress test under the lens of legal risk, technical risk, contractual risk, operational risks, underlying credit enhancement mechanism (if any), promoter profile and other risks. Further, credit profiles of the counter-party (usually distribution company, which serves as the sole source of cash inflows) are also considered in the rating exercise.

The principle determinants of the credit rating of large solar projects are:

1. Capital structure - which described in terms of leverage, cost of capital, debt-repayment structure and other parameters, is key to determining the project rating. Capital structure, along with the expected underlying cash inflows indicates a project’s ability to repay its debt obligation under both business as usual and stressful conditions. A conducive capital structure drives up the comfort of a rating agency, which usually materialises in form of a higher rating for the project vs a project with similar risk parameters and ratios but weak capital structure.
2. Revenue stream - of a large solar plant, is an another important variable in the rating assignment exercise. Revenue streams of large solar projects with long term power purchase agreement (PPA)[5] with distribution utilities (discoms) are usually fixed. This constant visibility of cash inflows adds to the strength of the rating assigned to project. However, the presence of a single or only a few counter-parties at the other end of a electricity supply contract, limits rating to a particular rating band.
3. Counter party profile- A project is dependent on the cash inflows (against the bill raised to the utility) to meet outstanding debt obligations. Thus the profile of the counter party can significantly impact the credit rating of projects. Utility’s repayment cycle and financial strength impacts both the risk and returns of the project. If the counter-party is weak and/or habitual of delays on payments, financial structuring of cash flows, gains importance. In such cases use of credit enhancement and buffers like debt service account (DSRA)[6] and letter of credit (LC)[7] or Bank Guarantees (BG)[8] helps drive up the rating assigned to a project.
4. Promoter profile – serves as an indicator of the promoter’s ability to run and support businesses successfully, and thus is an important rating driver. This profiling is usually based on promoter’s financial strength and prior track record of operations within similar or other businesses. A strong promoter/ investor group with an established track record usually commands a higher rating as compared to a similar project by a weak promoter group.
5. Operational performance – of a project is an important rating driver. Presence of a long term operations and maintenance (O&M) contract with a well-known player helps to reduce operational performance risk. Such contracts command higher credit ratings.
6. Other drivers – depending on the phase of project operations, various drivers and risk management methods are used to determine its credit rating. For example, for upcoming projects in addition to the above-mentioned drivers/risks, factors such as construction as per schedule, interconnection to the grid infrastructure, offtake clauses, technology used, warranties, location of the project, and nature of contract gain importance and help determine rating exercise outputs.

Improved investor confidence but interventions required

An analysis of rating assignments over the last few years presents a comforting fact – that both the investors and rating agencies display growing confidence for large solar projects. This is reflected in a general improvement of rating of these projects within a few years of operation. This improved outlook of the sector is verified by ongoing M&A activities leading to consolidation in large solar asset space.

The above trends point to the fact that promoters and investors are understanding project risks better and are taking more informed decisions to mitigate them. However, the sector requires some financial interventions to further drive up credit ratings of upcoming and operational projects for these projects to achieve the minimum credit rating threshold, required for large foreign investors. Financial intervention like a well-designed and cost effective payment security insurance against utility payment delays can help mitigate a few payments related risks and allow for an improvement. This can help to shore up investments by large pension and sovereign funds in the sector.