Global Infrastructure & Project Finance

India OutlookReport

Indian Infrastructure Outlook 2011

RatingOutlook
Stable Outlook: Fitch Ratings has a stable outlook for Indian infrastructure debt ratings in 2011. This expectation covers the spectrum of rated projects across the energy (thermal and biomass), transportation (roads, rail and airport) and urban infrastructure (solid waste management, desalination) sectors. The generally low ratings profile incorporates numerous and varied risks especially for the majority of projects which remain under construction but also accounts for the stable ratings outlook. The countrys positive economic performance and latent demand for key infrastructure assets are significant contributors to this outlook. Key Project Risks to Watch in 2011: with respect to infrastructure debt ratings, these are execution capacity, the propensity for construction risk, overdependence on project sponsors for risk mitigation and financing constraints. These risks have implications for the development of infrastructure finance in India beyond 2011. Toll Road Problems: Many of Indias toll road projects are still under construction and face lingering rightofway problems. In some cases, Fitch expects sponsors to continue extending support through adhoc equity injections, in order to maintain credit quality. Other toll roads which are in the early stages of traffic and revenue rampup could face financial stress, given the broad industry trend of underperformance visvis original traffic projections. The debt for some fully operational toll road projects could be upgraded, although such action will be limited by aggressive loan amortisation profiles and interest reset provisions. Construction Progress: Power projects which have the necessary physical and financial requirements in place should be able to register construction progress and retain stable credit profiles, especially where their sponsors have broad experience within the sector; a few may see upward rating migration as they become operational. Nevertheless, the unprecedented pace of new thermal power plant construction in India is placing stress on construction schedules and also on the value chain for skilled manpower, equipment and fuel supplies. Increase in Passenger Numbers: Airports have benefited from a continued uptick in passenger numbers throughout 2010, coupled with the slightly improved financial health of many airlines. Both trends are likely to continue in 2011. Residual construction risk for expansion and modernisation projects, and dependence on as yet unrealised real estate revenues, continue to constrain ratings.

RatingOutlook

S T A B L E E
Analysts
S. Nandakumar +91 44 4340 1710 s.nandakumar@fitchratings.com William Streeter +65 6796 7224 william.streeter@fitchratings.com R. Venkataraman +91 44 4340 1702 venkat.rajaraman@fitchratings.com

RelatedResearch
Applicable Criteria Rating Criteria for Infrastructure and Project Finance (August 2010) Other Outlooks Energy Infrastructure Outlook 2011 (December 2010) Indian Infrastructure Outlook 2010 The Accommodation of Project Risk (March 2010) 2011 Outlook: Global Transportation Infrastructure (January 2011) www.fitchratings.com/outlooks

WhatCouldChangetheOutlook
Individual project debt Outlooks could change. For projects under construction, unexpected delays in completion or positive surprises in terms of achieving early completion could trigger a change in Outlook or a rating action. In respect of operating projects, marked deviation in actual revenue performance (in comparison with initial forecasts) may result in an Outlook change. Continued hardening of interest rates, leading to pressure on coverage matrices, delayed loan disbursements or difficulties in raising residual sponsor equity commitments, could contribute negatively to a project debt Outlook.

www.fitchratings.com

24 January 2011

Global Infrastructure & Project Finance

2010inReview
Fitchs infrastructure ratings Outlooks were generally Stable to Positive during 2010, with 39% of ratings affirmed (see Chart 1) and 44% upgraded. The upgrades for the debt of these standalone specialpurpose vehicles (SPVs) were entirely due to betterthanexpected operating performance and significant reductions in construction and completion risk (often for very large projects). Downgrades in 2010 (16% of total rating actions) occurred in the transportation and municipal solid waste space, primarily due to a broad range of projectspecific factors, including construction delays, revenue underperformance and counterparty payment delays.
Chart1: Rating Actions 2010
(%) 50 38.89% 40 30 20 10 0 Affirm Source: Fitch Upgrade Downgrade 16.67% 44.44%

Chart 2: Current Outlooks

(%) 90 80 70 60 50 40 30 20 10 0 83.33%

6.67%

6.67%

3.33% RWN

Stable Source: Fitch

Positive

Negative

KeyIssuesfor2011
The majority of current rating Outlooks are Stable. Some transactions remain on Outlook Negative or even Rating Watch Negative (RWN) as a result of project specific factors, but in general, these characteristics are not typical of the body of debt ratings. The key interrelated credit concerns to watch in 2011, with respect to infrastructure debt ratings, are execution capacity, construction risk, sponsor dependence and financing constraints.

Execution Capacity
The agencys belief that this dearth of execution capacity represents a key credit risk has been influenced by three factors in particular: the growth in new project construction activity, particularly in the last four to five years; the increasing scale and complexity of projects (the road sector will soon have its own mega projects just like the power sector); and the small base of qualified developers available to accomplish these tasks.

Greenfield projects particularly those implemented by sponsors with no previous experience in the sector (a growing issue for power projects) tend to underestimate the shortage of skilled manpower and the pressure placed on equipment vendors capacity. Consequently, such projects will remain vulnerable to disruption in terms of schedules and costs, leading to pressure on credit quality. India is now one of the largest and most dynamic infrastructure and project finance markets in the world (the total number of projectbased SPVs is around 800). According to Indias Ministry of Finance publicprivate partnership (PPP) database (pppinindia.com), this includes roughly 500 concessionbased project SPVs (mostly in the transportation sectors); besides, there are several privately owned and financed independent power projects. Indias vast project pipeline (see Table 1, which excludes privately owned and financed independent power projects) includes projects in various stages of expression of interest (EoI), bidding, construction and operation (although projects under construction form the largest grouping); it spans

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almost all sectors, including energy, ports, roads, rail, airports, education and hospitals. While Indias achievements in this area are impressive, capacity constraints are now becoming a serious issue.

Table 1: PPP Project Pipeline India (Number of Projects)

Sector Transport Airports Ports Railways Roads Energy Education Hospitals Other Totals Expression of interest 0 1 0 5 1 0 0 6 13 Under bidding 0 9 0 78 1 0 0 26 114 Under construction 2 15 1 152 22 1 2 45 240 Operational 3 16 3 76 0 0 0 29 127

Source: Indias Ministry of Finance PPP database

Construction Risk
Chart 3 shows actual data for cost overruns (as a percent of original construction budget) and time overruns (in months) collected for projects rated by Fitch, which were under construction at the time of the initial rating (typically rated in the BBB(ind) category). Many of these projects are now operational. This data is mostly for toll road projects, although not exclusively so. Nevertheless, the data justifies initial concerns about the high construction risk profile of these projects and validates the findings of a previous government study about project construction risks (see Indian Infrastructure Outlook 2010: the Accommodation of Project Risk, published March 2010).
Chart 3: Cost and Time Overrun
(Time overrun in months) 25 20 15 10 5 0 0% Source: Fitch 5% 10% 15% (Cost overrun %) 20% 25% 30%

Fitchs views on these construction risks and their low levels of mitigation has evolved as the pool of project debt has increased. In its 2008 and 2009 India Infrastructure Outlook reports, Fitch stated that it expected a fair amount of loan restructuring to take place over the next few years. In addition, the agency stated that the relatively low project debt ratings reflected both the propensity for multiple project risks to occur, as well as the economic capacity (within the project cash flows) for project debt restructuring. Finally, in its 2010 India Infrastructure Outlook report, Fitch formally recognised jugaad the Hindi word for a process of accommodation between parties, in this case between project counterparties as an important rating factor. In the absence of rigorous adherence to contractual provisions, project companies and sponsors have been forced to take on additional costs, either through the drawdown of available cash, the raising of equity, or the issuance of debt. Governmental concessiongranting authorities have also appeared willing to extend the schedule

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for project delivery. Chart 4 documents this process for rated projects (again, most of the data relates to toll roads), demonstrating commercial operating date (COD) extensions of six months or more and additional sponsor equity injections of between 5% and 15% of total project costs (more in extreme cases). Recognising these systemic constraints and responding to the requests of project companies and concessiongranting authorities, banks have occasionally been willing to reschedule project loans, chiefly by postponing the commencement of principal amortisation. Some project bank loan agreements allow for principal amortisation to commence within six months of COD.
Chart 4: Extension of COD/Additional Equity
(A dditio nalequity%o fto talpro ject co statfinancialclo se) 60 50 40 30 20 1 0 0 0 So urce:Fitch 5 10 1 5 20 25 (Extensio no fCOD(mo nths))

However, the process of jugaad within the power sector could produce an outcome that is somewhat different; this is because offtake agreements create even more counterparties to negotiate with (eg, multiple state utility boards, power traders) and coal rights are intertwined with delicate considerations for the environment, wildlife and tribal rights. For these reasons, coupled with the expected scaling up of sponsor and commercial bank commitments for new projects over the next few years, Fitch recognises that the capacity for jugaad is limited, at least until the portfolios of operating and profitable projects increase, or until new capital market tools develop to offset some of these risks.

Sponsor Dependence
Construction risk mitigants including contingency budgets and funded reserves for capitalised interest and debt service are almost always inadequate. This leads to situations where a portion of the credit quality is determined by an evaluation of the sponsors willingness and ability to lend additional debt and equity support to their project SPVs. Fitchs project debt ratings take contractual provisions for credit enhancement into account by notching up from the underlying project credit profile, as long as the sponsors credit profile exceeds that of the project. Where support meets the required tests of credit substitution (an unconditional and irrevocable sponsor guarantee of project debt), Fitch rates the project debt equal to the rating of its corporate sponsor. Fitch also notches up project debt in the following instances (among others): the sponsor company has a strong presence and experience within the infrastructure sector; the project is integrally tied to the core business interests of its sponsor; and there are no contractual provisions for project support other than the initial injections of project equity.

Financing Constraints
Except for a brief period at the height of the financial crisis in 2008, infrastructure projects have been able to secure funding at costs that are reasonable, relative to the equity and commercial bank financing available in India. The commercial banking system has shown sufficient depth to accommodate the debt needs of most projects. Buoyant equity markets and foreign interest in the India growth story has meant that sponsors have been able to adequately manage equity commitments.

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However, this scenario could change. While significant levels of infrastructure project financing are likely to continue, the hoped for scaling up of financing activity called for in government plans and anticipated by project developers may not be so dramatic. Funding requirements are increasing, along with the size and number of projects which require financing. Volatility of capital flows and subdued equity markets could limit future equityraising exercises. With lending levels approaching the maximum permissible levels stipulated by regulatory exposure guidelines, commercial banks may find their ability to expand credit stressed. Tight liquidity conditions could further choke debt availability. Rising interest rates as monetary authorities try to quell persistent inflationary pressures could begin to impinge on project economics, although current rating levels anticipate higher borrowing costs. While the biggest effect of this could be to slow the time required for new projects to achieve financial closure, the credit quality of debt for existing projects could also be affected by delays in the drawdown of loan proceeds, or by contractual interest reset provisions. So far, the latter has not resulted in any ratings downgrades, but projects with marginal debt service coverage or weak revenue rampup are vulnerable to such interest reset clauses.

ThermalPowerProjects
2011 Outlook: Stable
Fitch expects the dynamics of the Indian power sector to remain largely stable in 2011.

Completion Risk
Most of the rated bank debt relates to projects still under construction and completion risk is often a constraint to the ratings of these projects. At an aggregate level, Fitch does not expect marked deviations from construction schedules to impact credit profiles, particularly since the ratings are at low levels and already factor in delay risk. However, individual projects could see some downward pressure, due to slippages arising from bottlenecks in completing residual land acquisitions, delays in receiving equipment, or difficulties in securing coal supplies. On the other hand, a few projects are close to announcing commercial operations, thereby triggering an upward rating movement (thanks to the elimination of construction risk). The surge of new thermal capacity creation places stress on the supply chain, in terms of finding and retaining skilled technical manpower to build plants and the threat of delays from Bharat Heavy Electricals Limiteds (AAA(ind)/Stable) overflowing order book for boilerturbinegenerator (BTG) units.

OffTake Arrangements
Moving Away from LongTerm Power Purchase Agreements (PPAs): the market is witnessing a shift in the offtake model away from generous longterm PPAs. Fitchs rated power project portfolio is almost evenly split between projects with power purchase or power tolling agreements and projects with merchant power risk (although in the latter category, Fitch notes that some projects have entered into power trading contracts). While longterm PPAs tend to be a positive rating consideration, many of the agreements for the ultra mega power projects allow for only a marginal level of debt service coverage. By way of contrast, many of the merchant power projects, which are inherently riskier, have somewhat favourable cost structures relative to the weighted average price of electricity traded by licensees and power exchanges over the last three years. Plant Margins Normalising: although merchant power prices are still at high levels, given Indias chronic power deficit, it is important to note that the price of traded

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power has steadily fallen over the last three years. Fitch expects that, in the medium term, this trend of price reduction will continue, due to the gradual reduction in the power supply deficit and the weakening ability of the state utilities to pay high prices. Prices should still offer reasonable margins to competitive producers; however, the ability to earn supernormal profits may no longer be possible. The base case tariff assumption of around INR3.5/kWh in the financial forecast models of many Fitchrated projects should still be sustainable.

Fuel Supply
Use of Natural Gas is Increasing: the use of natural gas which presently accounts for a mere 11% of the total generation capacity is likely to increase significantly, buoyed by recent domestic gas discoveries and proposed liquefied natural gas (LNG) imports. Even if projects secure the supply of natural gas under the Government of Indias administered price mechanism, they are unlikely to be immune from volatility in prices, which will likely retain some linkage to global trends. Coal Supply and Logistics are Key Risks: Fitch expects coal to remain the dominant source of power generation in India in the medium term (it currently accounts for 53%). Projects that have secured coal supply assurances from the stateowned Coal India Ltd. should benefit from relative insulation from price volatility (domestic coal prices have risen on average by only approximately 5% per year over the last decade, through four price increases). For projects located away from coal mines, the price advantage is slightly offset by the cost of transportation, as well as capacity constraints in the rail network. Difficulties in obtaining land for the creation of railway siding facilities tend to weigh negatively on the cost structure, while also leading to completion delays. Despite abundant reserves, it is becoming clear that domestic coal is grossly inadequate to fuel all of the new capacity creation (due to, amongst other reasons, environmental concerns). As such, companies are looking to tap overseas sources to secure supplies. Except where mines are actually acquired, projects that depend on international coal are susceptible to both availability and price volatility. Further, the need to establish port handling facilities, firm up shipping arrangements and the associated costs all increase the risk profile of such projects. Projects that have managed to secure captive coal blocks domestically are viewed as being the least vulnerable to fuel shocks and also, by virtue of their cost competitiveness, more resilient to drops in merchant power prices. However, Fitch notes that the ability to acquire the requisite land and also conclude contracts with specialist operators to exploit the mines remains a challenge, particularly for those sponsors with no track record in the industry. Furthermore, socioeconomic sensitivities include encroachment of adjacent tribal communities, rehabilitation of displaced persons and livelihoods and protection of endangered animal species.

Reliability of Equipment and Delivery Schedules

Given the aggressive implementation schedules, Fitch expects significant time overruns on account of delayed equipment deliveries. Recently, the agency has observed delays in achieving COD ranging from three to six months, though the projects emerged unscathed due to deferred term loan drawdowns and a hitherto favourable interest rate regime. For plants that rely on BTG units from China, there are concerns surrounding the performance of Chinese boilers in Indian operating conditions, as well as
Indian Infrastructure Outlook 2011 January 2011

Chart 5: India Installed Capacity (GW)

Renewable energy 10% Gas 11% Nuclear 3% Diesel 1%

Coal 53%

Hydro (renewable) 22% Source: Central Generating Authority

Global Infrastructure & Project Finance

the possibility of bilateral issues between India and China relating to visas for Chinese workers. By the end of 2010, major Chinese equipment makers were estimated to have commissioned power plants of an aggregate capacity of over 4,000MW, constituting nearly 25% of the total capacity added in the first three years of the ongoing 11th FiveYear Plan (the Plan). The government estimates that Chinese equipment will form around 39% of total new capacity by the end of the Plan period.
What to Watch Construction schedule delays Fuel supply and price stability Trends in merchant power prices Credit quality of state utility boards that purchase power

RenewableEnergyProjects
2011 Outlook: Stable
The federal governments Ministry of New and Renewable Energy has set an ambitious target of achieving 15% of total electricity generation from renewable sources by 2020. In Fitchs view, the key drivers of new investment in this space will be a function of financial and fiscal incentives. The weak financial health of state utilities acts as a constraint to the large scale and rapid development of renewable energy projects. For Fitchrated biomass project debt, while the fixed power tariff incorporated in the PPAs offers solid margins, the key to rating movements will be the behaviour of fuel prices (mainly agricultural waste), which have experienced sharp volatility, as well as the operational performance of the plants.
What to Watch Fuel supply and prices for biomass projects Continued ability and willingness of governments to incentivise this industry

TollRoadProjects
2011 Outlook: Stable
A preponderance of toll road construction projects are now at a stage where lingering rightofway problems may result in extensions of COD. This is likely to be followed by the need for additional project equity in some cases, as well as a potential rescheduling of the loan's first principal payment date (with a higher rate of interest likely). As a number of road projects complete construction and move into the critical rampup phase, Fitch, going by the evidence of 2010, expects to see varying degrees of traffic underperformance visvis original forecasts (which have turned out to be overly optimistic). Notwithstanding Indias buoyant economic growth providing an excellent prop for toll road revenues, individual projects could suffer from markedly reduced cash flows caused by faulty projections. However, some projects seem advantageously positioned to register betterthanexpected vehicular flows, leading to higher toll revenues, imparting a Positive Outlook to their ratings. A small portion of Fitchrated operating toll road and rail project debt was upgraded last year (often in cases where usage and revenue growth were significantly higher than the original base case financial forecast, or where the effects of the economic downturn were temporary and were later offset by robust growth). As more projects become operational, this scenario may repeat itself (Indias economic prospects certainly seem supportive). However, much of the
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boost in usage and revenues may be offset by higher interest costs, given the frequent interest reset provisions that are such a staple feature of Indias project finance loans. This, plus the financial implications of construction phase risks and the aggressiveness of project loan amortisation schedules, restricts the potential for future rating upgrades.
What to Watch Ability of projects to successfully complete construction and achieve COD, especially with the sectors propensity for delays in land acquisition Traffic and revenue rampup of toll road projects, given the aggressiveness of initial sponsor financial forecasts and varying performance within different economic regions of the country

Airports
2011 Outlook: Stable
The stable outlook emanates from the aeronautical revenues provided by the sustained recovery in passenger numbers witnessed through 2010 and expected to continue in 2011. The growing trend in passenger traffic, which began in 2009 after the global economic crisis, gained further momentum in 2010, as can be seen from Chart 6; although there was some degree of volatility, particularly in the domestic segment which was the primary driver of growth. Collection of airport development fees (ADF) to partfund modernisation capex was buoyant, mirroring the uptrend in passenger traffic. ADFs are authorised through 2012 and, to the extent to which they significantly mitigate debt issuance, could in some cases provide a boost to credit quality. Airlines are slowly moving towards profitable operations, raising equity and restructuring debt. Along with higher load factors, financial profiles are expected to improve, reducing counterparty risk for airport operators. In coming months, Fitch expects the newly constituted and independent regulator, the Aviation Economic Regulatory Authority (AERA), to finalise a statutory framework for determining aeronautical revenues, thus mitigating this potential uncertainty. Nevertheless, the overwhelming dependence on nonaeronautical revenue streams (particularly from real estate development) to meet capex and debt service needs in sponsor base case financial forecasts, is a continuing credit quality constraint. While lenders benefit from uninterrupted operations at major airports that are under expansion and improvement, and while construction progress has thus far been satisfactory, challenges to the successful completion of major modernisation/expansion projects remain. This risk is reflected in the current ratings.
What to Watch Ability to successfully complete massive capex plans within time and cost budgets Monetisation of real estate revenue streams Shocks in the global economic environment which may pose a setback to the rejuvenation of air travel demand

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Chart 6: Air Passenger Numbers
Sep 2007 to Oct 2010
(Passengers per month, m) 10 8 6 4 2 0 Sep 07 Feb 08 Jul 08 Jan 09 Jun 09 Dec 09 May 10 Oct 10 International Domestic

Source: Aiports Authority of India

Conclusion
Most projects should be able to contain and manage risks within the stress or tolerance levels assumed by their current ratings. Contributing to this stable ratings outlook for the debt of Indias infrastructure projects are: the latent demand for good quality infrastructure; the evolution of a working model (particularly over the last six years, and with all its limitations and imperfections) for private sector participation in the design, financing, construction and operation of infrastructure assets; the flexibility of the present banking system; and a supportive economy. The key interrelated concerns highlighted in this Outlook report for 2011 are execution capacity, construction risk, sponsor dependence and financing constraints. These broad themes will be monitored, since they are likely to shape the future development of infrastructure finance in India in the following ways. 1. Bank financing, characterised by mediumterm tenors and fluctuating interest rates, could be a limiting factor for new asset creation, given encroaching sector exposure guidelines. The problem may be aggravated if tight liquidity conditions in the banking system persist for a considerable period of time. 2. This trend is exacerbated by the current reluctance of project debt, particularly in the case of operating projects, to migrate from commercial banks to the fixed income market. 3. The limited number of large developers with the knowledge to execute large projects will find their financial resources and managerial/technical capacity stretched. Some level of consolidation within that industry is possible. 4. Systemic constraints such as sociopolitical and environmental issues that are involved in land acquisition and the exploitation of resources as well as an established but somewhat inconsistent and inefficient legal and regulatory regime, could dampen new investment, as India seeks to address its latent demand for quality infrastructure.

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